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Ateneo de Zamboanga University

ACCOUNTANCY ACADEMIC ORGANIZATION


A School of Management and Accountancy Student Government

ACCOUNTING 230 TUTORIALS (2014)


Chapter 4: Inventory
As described in International Accounting Standards (IAS) 2, paragraph 6,
inventories are assets of an enterprise, which are
a. held for sale in the ordinary course of business;
b. in the process of production for such sales; or
c. in the form of materials or supplies to be consumed in the production process
or in the rendering of services.
Inventories encompass the following:
o Merchandise Inventory (goods purchased and held for resale)
o Finished Goods Inventory (finished goods produced)
o Work in Process Inventory (work in progress being produced by the
enterprise)
o Materials Inventory and Factory Supplies Inventory (materials and supplies
awaiting use in production process)
*In case of a service provider, inventories include the cost of the service for which
the enterprise has not yet recognized the related revenue.
Cost of Inventories
The cost of inventories should comprise all costs of purchase, costs of
conversion and other costs incurred in bringing the inventories to their present
location and condition.
Exclusions from Cost of Inventories
Abnormal amounts of wasted materials, labor, or other production costs
Storage costs, unless those costs are necessary in the production process
prior to a further production stage
Administrative overhead that do not contribute to bringing inventories to
their present location and condition
Selling costs
Labor and other costs relating to sales and general administrative personnel
Profit margins or non-attributable overheads that are often factored into
prices charged by service providers
Financial element involved in purchases under deferred payment
arrangement
In general, borrowing costs incurred in connection with inventory acquisition.
In limited circumstances, borrowing costs are included in the cost of
inventory, as identified in IAS 23, Borrowing Costs.
Trade and Cash Discounts
The purchase of goods is recorded net of trade discounts, while cash
discounts may be accounted for using either the gross price method, net price
method, or allowance method.
A. Gross Price Method The purchase is recorded at the gross amount and a
Purchase Discount is recognized if payment is made within the discount
period. Purchase Discount is generally reported as a deduction from gross
purchases to arrive at net purchases.
B. Net Price Method The purchase is recorded at the price of goods, net of
cash discounts. The discount is recorded only if it is not taken; that is, when
payment is made after the discount period. The discount not taken is
recorded in Purchase Discounts Lost or Interest Expense account, which is
reported on the Statement of Comprehensive Income as a finance cost.

C. Allowance Method Purchases are recorded at net prices and accounts


payable at gross prices, with the difference debited to an allowance account.
Items that may require special attention in determining the proper inventory items
at the end of the period:
1. Goods in Transit
Normally, some inventories are in transit to the company or its customers at
the reporting date. When goods are in transit at the end of the accounting
period, the terms of shipment determine whether the seller or the buyer includes
them in its inventory.
Ownership of goods still in transit may be summarized as follows:
Disposition by
Terms of Shipment
Seller
Buyer
FOB shipping point
Exclude
Include
FOB destination
Include
Exclude
2. Consigned Goods
Goods may be transferred from one party to another for purposes of sale
without the ownership and ultimate economic control changing hands. The company
delivering the goods, called consignor, retains ownership, while the company
receiving the goods, called consignee, attempts to sell them.
The consignor includes goods out on consignment in its inventory while the
consignee excludes goods held on consignment in its inventory.
3. Segregated Goods
These are special order goods manufactured according to customer
specifications. Even if they are still in the possession of the selling company, they
should be considered as sold when completed, and therefore excluded from the
selling companys inventory.
Rationale: The manufacturer undertakes and completes the processing of the goods
based on the order and specifications by the customers. Thus, at the point of
completion, revenue is considered to have been earned.
4. Conditional Sales and Installment Sales
Goods under installment contract are recorded as sold when delivered and,
therefore, excluded from the inventory of the seller.
Other merchandise owned by an enterprise but in the possession of others,
such as goods in the hands of salespersons and agents, goods held by customer on
approval and goods held by others for storage, processing or shipment, should also
be shown as part of the ending inventory of the enterprise that owns the goods.
5. Goods Sold in Buyback Agreement
6. Goods Sold with Refund Offers
Inventory Accounting Systems
Periodic Inventory System
This is a method of accounting for inventory in which cost of goods sold is
determined and inventory is adjusted to the proper balance at the end of the
reporting period. Purchases are recorded in the purchases account, and ending
inventory is determined by a physical count.
2

The following are the pro-forma entries to record transactions using the periodic
inventory system:
Transaction
a. Purchase of goods

Pro-forma entries
Purchases
xx
Accounts Payable/Cash
xx
Accounts Payable/Cash
xx
Purchase Returns
xx
Accounts Receivable/Cash
xx
Sales
xx
Sales Returns
xx
Accounts Receivable/Cash
xx
Merchandise Inventory, end
xx
Income Summary
xx
Income Summary
xx
Merchandise Inventory, beg.
xx

b. Purchase returns

c. Sale of goods

d. Sales returns

e. Year-end entry to set up ending


inventory

f. Year-end entry to close beginning


inventory

Perpetual Inventory System


This is a method of accounting for inventory in which detailed records of each
inventory purchase and sale are maintained. This system provides a current record
of inventory on hand and cost of goods sold to date.
The following are the pro-forma entries to record transactions using the perpetual
inventory system:
Transaction
a. Purchase of goods

Pro-forma entries
Merchandise Inventory
xx
Accounts Payable/Cash
xx
Accounts Payable/Cash
xx
Merchandise Inventory
xx
Accounts Receivable/Cash
xx
Sales
xx

b. Purchase returns

c. Sale of goods

Cost of Sales
xx
Merchandise Inventory
xx
Sales Returns
xx

d. Sales returns

Accounts Receivable/Cash
xx
Merchandise Inventory
xx
Cost of Sales
xx
At the end of the accounting period, because the inventory account is
updated, there is no need to take up adjusting entry to set up ending inventory.
Cost Formulas
When inventories are sold, the carrying amount of those inventories shall be
recognized as expense in the period in which the related revenue is recognized.
Accordingly, the objective in accounting for inventories is the proper determination
of cost and consequently, the cost of goods sold.
The cost of inventories shall be determined by using either:
1. First in, First out
2. Weighted average
The standard does not permit anymore the use of the last in, first out (LIFO) as an
alternative formula in measuring cost of inventories. However, LIFO is discussed for
theoretical or conceptual purposes.
First in, First out (FIFO)
The FIFO method assumes that the goods first purchased are first sold and
consequently the goods remaining in the inventory at the end of the period are
those most recently purchased or produced.
The FIFO periodic and the FIFO perpetual methods result in the same
inventory cost because the goods are assumed to be sold in the same sequence
that they were acquired. Compared with other costing formulas, in periods of rising
prices, FIFO reports the lowest cost of goods sold and the highest amount of ending
inventory and net income.
Weighted Average
This method considers goods to be undistinguishable and are, therefore,
valued at an average of the costs incurred.
Disclosure Requirements
The financial statements shall disclose:
the accounting policies adopted in measuring inventories, including the cost
formula used;
the total carrying amount of inventories and the carrying amount in
classifications appropriate to the entity;
the carrying amount of inventories carried at fair value less costs to sell;
the amount of inventories recognized as an expense during the period;
the amount of any write-down of inventories recognized as an expense in the
period;
the amount of any reversal of any write-down that is recognized as expense
in the period;
the circumstances or events that led to the reversal of a write-down of
inventories; and
the carrying amount of inventories pledged as security for liabilities.
References:
Robles & Empleo (2012). Intermediate Accounting Volume 1.
Valix, C., Peralta & Valix, C.A. (2012). Financial Accounting Volume One.