Inventories

Chapter 8

Maria Jessalen B. Azul

 What is ‘Inventories’?
Inventories - assets held for sale in the ordinary course of business, in the
process of production for such sale or in the form of materials or supplies to be
consumed in the production process or in the rendering of services.
Inventories encompass goods purchased and held for resale, for example:
a. Merchandise purchased by a retailer and held for resale
b. Land and other property held for resale by a subdivision entity and real
estate developer.
 Classes of inventories
1. Trading concern – one that buys and sells goods in the same form
purchased. The term merchandise inventory is generally applied to goods
held by a trading concern.

2. Manufacturing concern - one that buys goods which are altered or

converted into another form before they are made available for sale. The
inventories of a manufacturing concern are finished goods, goods in
process, raw materials and factory or manufacturing supplies.
 Statement Presentation
Inventories are generally classified as current assets.
The inventories shall be presented as one line item in the statement of financial
position, but the details of the inventories shall be disclosed in the notes to
financial statements.
For example, the note shall disclose the composition of the inventories of a
manufacturing concern as finished goods, goods in process, raw materials and
manufacturing supplies
 Definitions

1. Finished goods - completed products which are ready for sale. Finished goods
have been assigned their full share of manufacturing costs.
2. Goods in process or work in process - partially completed products which
require further process or work before they can be sold.
3. Raw materials - goods that are to be used in the production process. No work or
process has been done on them as yet by the entity inventorying them. Broadly,
raw materials cover all materials used in the manufacturing operations.
4. Factory or manufacturing supplies - similar to raw materials but their relationship
to the end product is indirect. It may be referred to as indirect materials.
Goods Includible In The Inventory
The general rule is that all goods to which the entity has title shall be included in
the inventory, regardless of location.
‘Passing the title’ – legal language which means the point of time at which
ownership changes.
Applying the legal test, goods owned and on hand, goods out on consignment to
consignee, goods in the hands of salesmen or agents and goods held by
customers on approval or trial are included in inventory.
 Consigned Goods
A consignment is a method of marketing goods in which the owner called the
consignor transfers physical possession of certain goods to an agent called the
consignee who sells them on the owner's behalf.
Consigned goods shall be included in the consignor's inventory and excluded
from the consignee's inventory.
Freight and other handling charges on goods out on consignment are part of the
cost of goods consigned.
 Exception to the Legal Test
Installment contracts may provide for retention of title by the seller until the selling
price is fully collected.
Following the legal test, the goods sold on installment basis are still the property of
the seller and therefore normally includible in his inventory.
However, in such a case, it is an accepted accounting procedure to record the
installment sale as a regular sale on the part of seller and as a regular purchase
on the part of the buyer.
Thus, the goods sold on installment are included in the inventory of the buyer and
excluded from that of the seller, the legal test to the contrary notwithstanding.
This is a clear example of economic substance prevailing over legal form.
Who Is The Owner Of Goods In Transit?

FOB Destination FOB Shipping Point

Title passes upon receipt of Title passes upon shipment of
goods goods

Property of Seller Property of Buyer

 Freight Terms

Freight Collect Freight Prepaid

Freight charge is to be paid Freight charge is already
by the buyer upon receipt of paid by the seller upon
goods shipment of goods
 Maritime shipping terms
FAS or Free Alongside Ship - A seller who ships FAS must bear all expenses and risk involved in delivering
the goods to the dock next to or alongside the vessel on which the goods are to be shipped.
The buyer bears the cost of loading and shipment and thus, title passes to the buyer when the carrier
takes possession of the goods.

CIF or Cost, Insurance and Freight - Under this shipping contract, the buyer agrees to pay in a lump sum
the cost of the goods, insurance cost and freight charge.
The shipping contract may be modified as CF which means that the buyer agrees to pay in a lump sum the
cost of the goods and freight charge only.
In either case, the seller must pay for the cost of loading. Thus, title and risk of loss shall pass to the buyer
upon delivery of the goods to the carrier.

Ex-ship - A seller who delivers the goods ex-ship bears all expenses and risk of loss until the goods are
unloaded at which time title and risk of loss shall pass to the buyer.
 Accounting for inventory
1. Periodic system - calls for the physical counting of goods on hand at the end of the
accounting period to determine quantities the quantities are then multiplied by the
corresponding unit costs to get the ending inventory value. This approach gives actual or
physical inventory under the periodic system, the cost of goods sold is computed only at the
end of the reporting period by deducting the physical inventory from the cost of goods
available for sale.
The periodic inventory procedure is generally used when the individual inventory items have
small peso investment such as groceries hardware and auto parts.

2. Perpetual system - requires the maintenance of records called stock cards that usually offer
a running summary of the inventory inflow and outflow.
Inventory increases and decreases are reflected in the stock cards and there is resulting balance
represents the inventory this approach gives book or perpetual inventory.
 Illustration - Periodic system

1.Purchase of merchandise on account, P300,000. 4. Sale of merchandise on account, P400,000, at 40% gross profit.
Purchases 300,000 Accounts receivable 400,000
Sales 400,000
Accounts payable 300,000
5. Return of merchandise sold from customer, P25,000.
2. Payment of freight on the purchase, P20,000. Sales return 25,000
Accounts receivable 25,000
Freight in 20,000
Cash 20,000 6. Adjustment of ending inventory, P65,000.
3. Return of merchandise purchased to supplier, P30,000. Merchandise inventory-end 65,000
Income summary 65,000
Accounts payable 30,000
Purchase return 30,000
 Illustration - Perpetual system
1. Purchase of merchandise on account, P300,000.
Merchandise inventory 300,000
Accounts payable 300,000

2. Payment of freight on the purchase, P20,000.

Merchandise inventory 20,000
Cash 20,000
3. Return of merchandise purchased to supplier, P30,000,
Accounts payable 30,000
Merchandise inventory 30,000
 Illustration - Perpetual system
4. Sale of merchandise on account, P400,000 at gross profit of 40%. The cost of merchandise sold is 60% or P240,000.
Accounts receivable 400,000
Sales 400,000
Cost of goods sold 240,000
Merchandise inventory 240,000
Under the perpetual system, the cost of merchandise sold is immediately recorded because this is clearly determinable
from the stock card.
5. Return of merchandise sold from customer, P25,000. The cost of the merchandise returned is 60% or P15,000.
Sales return 25,000
Accounts receivable 25,000
Merchandise inventory 15,000
Cost of goods sold 15,000
6. Adjustment of ending inventory.
The balance of the merchandise inventory account represents the ending inventory.
As a rule, the ending merchandise inventory is not adjusted unless there is an inventory shortage.
 Inventory Shortage or Overage
Illustration. The merchandise inventory account has debit balance of P65,000.
If at the end of the accounting period, a physical count indicates a different
amount, an adjustment is necessary to recognize inventory any shortage or
overage.
For example, if the physical count shows inventory on hand of P55,000, the
following adjustment is necessary:
Inventory shortage 10,000
Merchandise inventory (65,000 - 55,000) 10,000
 Trade Discounts And Cash Discounts
1. Trade Discounts - deductions from the list or catalog price in order to arrive at the
invoice price which is the amount actually charged to the buyer. Trade discounts are
not recorded.

2. Cash discounts - deductions from the invoice price when payment is made within
the discount period. The purpose of cash discounts is to encourage prompt payment.

Cash discounts are recorded as purchase discount by the buyer and sales discount
by the seller.
Purchase discount is deducted from purchases to arrive at net purchases and sales
discount is deducted from sales to arrive at net sales revenue.
 Illustration
The list price of a merchandise purchased is P500,000 less 20% and 10%, with
credit terms of 5/10, n/30.
This means that trade discounts are 20% and 10%, and the cash discount is 5%
if payment is made in 10 days.
The full amount of the invoice is paid if the payment is made after 10 days and
within the credit period of 30 days.
 List price 500,000
First trade discount (20% x 500,000) (100,000)
400,000
Second trade discount (10% x 400,000) (40,000)
Invoice price 360,000
Cash discount (5% x 360,000) (18,000)
Payment within the discount period 342,000

Another Approach
Invoice Price (500,000 x 90%) 360,000
Cash Discount (18,000)
Payment within the discount period 342,000
The Journal Entry to record the purchase is:
Purchase 360,000
Accounts Payable 360,000

Note that the trade discounts are not recorded. The journal entry to record the
payment of the invoice within the discount period is:
Accounts payable 360,000
Cash 342,000
Purchase discounts 18,000
The entry to record the payment beyond the discount period is:
Accounts payable 360,000
Cash 360,000
 Method of Recording Purchases
1. Gross method - purchases and accounts payable are recorded at gross amount of invoice.
Illustration:
1. Purchases on account, P200,000, 2/10, n/30.
Purchases 200,000
Accounts payable 200,000

2. Assume payment is made within the discount period.

Accounts payable 200,000
Cash 196,000
Purchase discount (2% x 200,000) 4,000

3. Assume payment is made beyond the discount period.

Accounts payable 200,000
Cash 200,000
 Method of Recording Purchases
2. Net method - Purchases and accounts payable are recorded at net amount of the invoice.
Illustration:
1. Purchases on account, P200,000, 2/10, n/30.
Purchases 196,000
Accounts payable 196,000

2. Assume payment is made within the discount period.

Accounts payable 196,000
Cash 196,000
3. Assume payment is made beyond the discount period.
Accounts payable 196,000
Purchase discount lost (other expense) 4,000
Cash 200,000
4. Assume it is the end of accounting period, no payment is made and the discount period has expired.
Purchase discount lost 4,000
Accounts payable 4,000
Cost of Inventory
The cost of inventory shall comprise cost of purchase, cost of conversion and
directly attributable cost incurred in bringing the inventory to the present location
and condition.

Cost of Purchase
The cost of purchase comprises the purchase price, import duty, irrecoverable
tax, freight, handling and other cost directly attributable to the acquisition.
Trade discounts, rebates and other similar items are deducted in determining
the cost of purchase.
The cost of purchase shall not include foreign exchange differences which arise
directly from the acquisition of inventory involving a foreign currency.
 Cost Of Conversion
Cost of conversion - includes cost directly related to the units of production
such as direct labor, a systematic allocation of fixed and variable production
overhead incurred in converting materials into finished goods.
Fixed production overhead - the indirect cost of production that remains
relatively constant regardless of the volume of production.
Examples are depreciation and maintenance of factory building and equipment
and the cost of factory management and administration.
Variable production overhead is the indirect cost of production that varies
directly with the volume of production.
Variable production overhead includes indirect labor and indirect materials.
 Directly Attributable Cost
Directly attributable cost is the cost incurred in bringing the inventory to the
present location and condition.
For example, it may be appropriate to include the cost of designing product for
specific customers in the cost of inventory. Abnormal amount of wasted material,
storage cost, administrative overhead and distribution or selling cost are
recognized as expense when incurred.
However, storage cost related to goods in process or part-finished goods should
be included in cost of inventory.
Cost Of Inventory Of A Service Provider

The cost of inventory of a service provider comprises primarily:

a. Labor and other cost of personnel directly engaged in providing the service,
including supervisory personnel
b. Directly attributable overhead
Labor and other cost relating to sales and general administrative personnel are
recognized as expenses when incurred.
Thank you!