7. Inventories7. Inventories7. Inventories7. Inventories7. Inventories PDF

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Theory of Accounts Practical Accounting 17 BLUE NOTESUSLCHAPTERInventories are assets which are 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 rendering of services.Me...

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Inventories are assets which are 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 rendering of services.

Measurement of Inventory Initial Measurement = Cost* Subsequent Measurement = Lower of Cost or Net Realizable Value** Note: **Net Realizable Value (NRV) is the estimated selling price in the ordinary course of business less estimated cost of completion and the estimated cost necessary to make the sale.

Measurement of Cost* Purchase  Purchase price  Import duties  Irrevocable Taxes  Freight  Handling  Other Cost Directly attributable to the purchase Deduct - Trade Discounts - Rebates - Other Similar Items

Conversion  Direct materials  Direct Labor  Fixed and variable production overhead  Abnormal amounts of waste and spoilage  Storage costs  Administrative Overheads  Selling Costs

Note: When purchased with deferred settlement terms, the difference between the purchase price for normal credit terms and the amount paid is recognized as interest expense over the period of financing.

Freight on Board (Fob) Terms a. FOB destination – ownership of goods purchased is transferred only upon the receipt of goods by the buyer at the point of destination. The seller shall be responsible for the freight charges and other charges up to the point of destination. b. FOB shipping point – ownership is transferred upon shipment of the goods. The buyer shall be responsible for the freight charges and other charges up to the point of destination. c. Freight collect – freight charge is paid by the buyer. d. Freight prepaid – freight charge is paid by the seller.

Maritime Shipping Terms a. Free alongside (FAS) – seller must bear the 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. Theory of Accounts Practical Accounting 1

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b. Cost, insurance and freight (CIS) – buyer agrees to pay in a lump sum the cost of the goods, insurance cost and freight charges. 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. c. Ex-ship (super FOB destination) - seller bears all expenses and risk of loss until the goods are unloaded at which time and risk of loss shall pass to the buyer.

Consigned Goods Consignment –method of marketing of 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. Rule: Consigned goods shall be included in the consignor’s inventory and excluded from the consignee’s inventory. Freight and other charges on goods out on consignment are part of the cost of goods consigned.

Periodic System and Perpetual System Periodic System – calls for the physical counting of goods on hand at the end of the accounting period to determine quantities. This procedure is generally used when the individual inventory items turn over rapidly and have small peso investment such that it may prove impractical or inconvenient to record inventory inflow and outflow, such as groceries, hardware and auto parts. Perpetual System – requires the maintenance of records called stock cards that usually offer a running summary of the inventory inflow and outflow. This procedure is commonly used where the inventory items treated individually represent a relatively large peso investment. This is designed for control purposes.

Trade Discounts and Cash Discounts Trade discounts  deductions from the list catalog price in order to arrive at the invoice price which is the amount actually charged to the buyer  to encourage trading or increase sale. Cash discounts  deductions from the invoice price when payment is made within the discount period  to encourage prompt payment.

Inventory Costing Methods First in, First out (FIFO) Method  Goods first purchased are first sold  Inventory is stated at current replacement cost.  In the period of inflation, FIFO method would result to the highest net income. I  In a period of deflation or declining prices, FIFO method would result to the lowest net income. Note: Under FIFO-periodic and FIFO-perpetual, the inventory costs are the same.

Weighted Average – Periodic  The cost of beginning inventory plus the total costs of purchases during the period is divided by the total number of units purchased plus those in the beginning inventory to get the weighted average unit cost. Such weighted average unit cost is then multiplied by the units on hand to derive the inventory value. Weighted Average – Perpetual (moving average method)  A new weighted average unit cost must be computed every after purchase. Such weighted average unit cost is then multiplied by the units on hand to get the inventory cost. Practical Accounting 1 Theory of Accounts

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Specific Identification  The cost of inventory is determined by simply multiplying the units on hand by their actual unit cost.  Appropriate for inventories that are segregated for a specific project and inventories that are not ordinarily interchangeable.

Accounting for Inventory Write-down Direct Method  Loss on inventory write-down is not accounted for separately but buried in the cost of goods sold.

Allowance Method  Loss on inventory write-down is accounted for separately and credited to “allowance for inventory write-down  The loss on inventory write down and gain on reversal is included in the computation of COGS Note: Gain on reversal of inventory write-down is limited only to the extent of the allowance balance.

Relative Sale Price Method When different commodities are purchased at a lump sum, the single cost is apportioned among the commodities based on their respective sale price.

Purchase Commitments Purchase commitments are obligations of the entity to acquire certain goods sometime in the future at a fixed price and fixed quantity.  market price = gain on purchase commitment market price = loss on purchase commitment

Agricultural, Forest and Mineral Products  measured at net realizable value at certain stages of production(PAS 2, par 4)  This occurs when agricultural crops have been harvested or mineral products have been harvested and a sale is assured under a forward contract or a government guarantee, or when a homogenous market exists and there is a negligible risk of failure to sell.

Commodities of Broker-Traders  measured at fair value less cost to sell. Note: Broker-traders are those who buy and sell commodities for others or on their own account for the purpose of selling them in the near future and generating a profit from fluctuations in price or broker-traders’ margin.

Inventory Estimation Reasons:  inventory is destroyed by fire and other catastrophe, or theft  to prove the correctness or reasonableness of physical count  for interim financial statements Gross Profit Method This method is based on the assumption that the rate of gross profit remains approximately the same from period

Retail Inventory Method This method is generally employed by department stores, supermarkets and other retail concerns where there is a

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to period and therefore the ratio of cost of goods sold to net sales is relatively constant from period to period. 1. Gross profit rate “based on sales” 2. Gross profit rate “based on cost”

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wide variety of goods because keeping track of unit cost at all times is difficult. 1. Conservative Cost Approach (conventional or lower of average cost or market approach)

 Include mark-up, exclude mark-down Note: Sales Allowances and Sales Discounts are ignored in computing the net sales for purposes of using gross profit rate method in computing COGS.

2. Average Cost Approach  Mark-up and mark-down are included 3. FIFO Approach 4. LIFO Approach Note: PAS 2 requires either the FIFO or Average Cost Approach

Cost ratio = Goods available for sale at cost Goods available for sale at selling price

Terminologies: Initial Mark-up - Original mark-up on the cost of goods Original Retail - Sales price at which the goods are first offered for sale Additional mark-up - Increase in sales price above the original sales price Mark-up Cancelation - Decrease in sales price that does not decrease the sales price below the original sales price Net additional mark-up or net mark-up - Mark-up minus mark-up cancelation Markdown - Decrease in sales price below the original sales price Markdown Cancelation - Increase in sales price that does not increase the sales price above the original sales price Net Markdown - Markdown minus markdown cancelation Maintained Mark-up or mark-on - Difference between cost and sales price after adjustment for all the above items

Treatment of other items: Purchase Discount – deducted from purchases at cost only Purchase Return – deducted from purchases at cost and at retail Purchase Allowance – deducted from purchases at cost only Freight in – addition to purchases at cost only Departmental transfer in or debit – addition to purchases at cost and at retail Departmental transfer out or credit – deduction from purchases at cost and at retail Sales discount and sale allowance – disregarded, meaning, not deducted from sales Sales return – deducted from sales. If the account is “sales return and allowances”, the same should be deducted from sales. Employee discounts – added to sales. Normal shortage, shrinkage, spoilage and breakage – this are deducted from goods available for sale at retail. Abnormal shortage, shrinkage, spoilage and breakage – this are deducted from goods available for sale both at cost and at retail so as not to distort the cost ratio. Any abnormal amount is recorded separately as loss. Illustrative Problems 1. Sterling Company is preparing its 2013 year-end financial statements. Prior to any adjustments, inventory is valued at P7, 600,000. The following information has been found relating to certain inventory transactions: 

Goods valued at P1, 000,000 are on consignment with a customer. These goods are not included in the

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year-end inventory. Goods costing P250, 000 were received from a vendor on January 5, 2014. The related invoice was received and recorded on January 12, 2014. The goods were shipped on December 31, 2013, terms FOB shipping point.

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Goods costing P850, 000 were shipped on December 31, 2013, and were delivered to the customer on January 2, 2014. The terms of the invoice was FOB shipping point. The goods were included in ending inventory for 2013 even though the sale was recorded 2013.

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A P350, 000 shipment of goods to a customer on December 31, 2013, terms FOB destination, was not included in the year-end inventory. The goods cost P260, 000 and were delivered to the customer on January 8, 2014. The sale was properly recorded in 2014.

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An invoice for goods costing P350, 000 was received and recorded as a purchase on December 31, 2013. The related goods, shipped FOB destination, were received on January 2, 2014, and thus were not included in the physical inventory.

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Goods valued at P650, 000 are on consignment from a vendor. The goods are not included in the year-end inventory.

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A P1, 050, 000 shipment of goods to a customer on December 30, 2013, terms FOB destination, was recorded as a sale in 2013, the goods, costing P840, 000 and delivered to the customer on January 6, 2014, were not included in 2013 ending inventory. What is the correct inventory in 2013? Inventory before adjustment Goods out on consignment Goods purchased, FOB shipping point Goods sold, FOB shipping point Goods sold, FOB destination Goods sold, FOB destination Correct Inventory, 2013

7, 600, 000 1, 000, 000 250, 000 ( 850, 000) 260, 000 840, 000 9, 100, 000

2. The list price of merchandise purchased is P500, 000 less 20% and 10%, with credit terms of 5/10, n/30. Compute for the payment within the discount period. List price First trade discount (20% x 500, 000)

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 Theory of Accounts Practical Accounting 1

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3. Assume the following data: January 1 10 15 16 30 31

Beginning balance Purchase Sale Sales return Purchase Purchase return Ending Balance

Units 5, 000 5, 000 (7, 000) 1, 000 16, 000 (2, 000) 18, 000

Unit Cost 200 250

Total Cost 1, 000, 000 1, 250, 000

150 150

2, 400, 000 300, 000

Unit Cost 250 150

Total Cost 1, 000, 000 2, 100, 000 3, 100, 000

Solutions: FIFO (Periodic or Perpetual) January 10 30

Purchase Purchase Inventory, End

Units 4, 000 14, 000 18, 000

Weighted Average – Periodic January 1 10 30 31

Beginning Balance Purchase Purchase Purchase return

Units 5, 000 5, 000 16, 000 (2, 000) 24, 000

Weighted average unit cost (4, 350, 000 / 24, 000 units) Cost of ending inventory (18, 000 x 181.25) Moving Average Units January 1 Beginning balance 5, 000 10 Purchase 5, 000 Balance 10, 000 15 Sale (7, 000) 16 Sales Return 1, 000 Balance 4, 000 30 Purchase 16, 000 Balance 20, 000 31 Purchase return (2, 000) Balance 18, 000

4. Assume the following data for the current year: Practical Accounting 1 Theory of Accounts

Unit Cost 200 250 150 150

Total Cost 1, 000, 000 1, 250, 000 2, 400, 000 (300, 000) 4, 350, 000

181.25 3, 2262, 500 Unit Cost 200 250 225 225 225 225 150 165 150 167

Total Cost 1, 000, 000 1,250, 000 2, 250, 000 (1, 575, 000) 225, 000 900, 000 2, 400, 000 3, 300, 000 (300, 000) 3, 000, 000

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Inventory, January 1: Cost NRV Net Purchases Inventory, December 31: Cost NRV

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5, 000, 000 4, 500, 000 20, 000, 000 6, 000, 000 5, 900, 000

Solutions: Direct Method – cost of goods sold Inventory, January 1 Net Purchases Goods available for sale Inventory, December 31 Cost of goods sold

4, 500, 000 20, 000, 000 24, 500, 000 5, 900, 000 18, 600, 000

Allowance Method – cost of goods sold Inventory, January 1 at cost Net Purchases Goods Available for Sale Inventory, December 31 at cost COGS before reversal of writedown *Gain on reversal of inventory writedown COGS after reversal of writedown

5, 000, 000 20, 000, 000 25, 000, 000 6, 000, 000 19, 000, 000 (400, 000) 18, 600, 000

*Required allowance – December 31 (6, 000, 000 – 5, 900, 000) Required allowance – January 1 (5, 000, 000 – 4, 500, 000) Reversal of inventory writedown – decrease in allowance

100, 000 500, 000 (400, 000)

5. On July 1, Dash Company purchased a tract of land for P12, 000, 000. Dash incurred additional cost of P3, 000, 000 during the remainder of the year in preparing the land for sale. The tract was subdivided into residential lots as follows: Lot class A B C

Number of lots 100 100 200

Sale price per lot 240, 000 160, 000 100, 000

Using the relative sales price method, what amount of cost should be allocated to Class A lots? Class A (100 x 240, 000) B (100 x 160, 000) C (200 x 100, 000)

Sales price 24, 000, 000 16, 000, 000 20, 000, 000

Fraction 24/60 16/60 20/60

Allocated Cost 6, 000, 000 4, 000, 000 5, 000, 000

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60, 000, 000

15, 000, 000

Cost each class A lot is 6, 000, 000 divided by 100 lots or 60, 000.

6. Assume contract price of 500, 000 and replacement cost at year-end, 450, 000. Entry is as follows: Loss on purchase commitment 50, 000 Estimated liability for purchase commitment 50, 000 Case 1.When the actual purchase commitment is made in the subsequent period and the current replacement cost drops further to 420, 000. Purchases Loss on purchase commitment Estimated liability on purchase commitment Accounts payable

420, 000 30, 000 50, 000 500, 000

Case 2. If the replacement cost of the purchase commitment is 600, 000 when the actual purchase is made. Purchases Estimated liability on purchase commitment Accounts payable Gain on purchase commitment

500, 000 50, 000 500, 000 50, 000

Case 3. If the replacement cost of the purchase commitment is 480, 000 when the actual purchase is made. Purchases Estimated liability on purchase commitment Accounts payable Gain on purchase commitment

480, 000 50, 000 500, 000 30, 000

The loss on purchase commitment is classified as other expense and the estimated liability on purchase commitment is classified as current liability. The gain on purchase commitment is classified as other income.

7. The following data are gathered for the current year: Inventory beginning 600, 000 Purchases 2, 530, 000 Purchase return 15, 000 Purchase allowance 5, 000 Purchase discount 10, 000 Freight in 50, 000 Sales 3, 100, 000 Sales return 100, 000 Practical Accounting 1 Theory of Accounts

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Sales allowance Sales discount

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50, 000 150, 000

Gross profit is computed under each of the following assumptions: a. Gross profit rate is 25% based on sales b. Gross profit rate is 25% based on cost Gross profit rate “based on sales” Inventory beginning Purchases Freight in Total Less: Purchase return Purchase allowance Purchase Discount Goods available for sale Less: Cost of sales: Sales Less: Sales return Net Sales Multiply by cost ratio Ending inventory

600, 000 2, 530, 000 50, 000 2, 580, 000 15, 000 5, 000 10, 000

Gross profit rate “based on cost” Goods available for sale Less: Cost of sales: Sales Less: Sales return Net Sales Divided by sales ratio Ending inventory

30, 000

3, 100, 000 100, 000 3, 000, 000 75%

2, 500, 000 3, 150, 000

2, 250, 000 900, 000

3, 150, 000 3, 100, 000 100, 000 3, 000, 000 125%

2, 250, 000 750, 000

Note: Sales allowance and sales discount are ignored, that is, not deducted from sales. While these items decrease the amount of sales, they do not affect the physical volume of goods sold. They do not increase the physical inventory of goods, unlike sales return where there is an actual addition to goods on hand.

8. Cost Retail Beginning Inventory Net purchases Additional mark up Mark up cancelation Markdown Markdown cancelation Sales

180, 000 1, 020, 000

250, 000 1, 575, 000 200, 000 25, 000 140, 000 15, 000 1, 450, 000 Theory of Accounts Practical Accounting 1

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Sales return Sal...