INVENTORIES
RAMOS
Nature of inventories
Inventories include:
 Assets held for sale in the ordinary course of business
(finished goods),
 Assets in the production process for sale in the ordinary
course of business (work in process), and
 Materials and supplies that are consumed in production (raw
materials).
Whose inventory is it?
Goods in transit
 Shipping terms determine when title to goods passes to the
purchaser.
a. FOB (free on board) shipping point—title passes to the
buyer with the loading of goods at the point of shipment.
b. FOB destination—legal title does not pass until the goods
are received by the buyer.
 Goods shipped FOB shipping point belong to the buyer while
they are in transit and should normally be included in the
buyer’s inventory while in transit.
 Goods shipped FOB destination belong to the seller while in
transit and are normally included in the seller’s inventory.
Goods on consignment
 Goods held by the dealer (consignee) for which title is held by
the shipper (consignor).
 Consigned goods are included in the inventory of the
consignor.
Conditional sales, installment sales, and repurchase agreements
 If title to the goods is retained by the seller, the seller may
report as an asset the cost of the goods less the purchaser’s
equity in the goods such as established by collections.
 Generally however, in the usual case where the possibilities of
default or return are low, the seller, in anticipation of contract
completion and ultimate passing of title, will recognize the
transaction as a regular sale and remove the goods from
reported inventory at the time of sale.
 Repurchase agreements result in no sale being recorded; the
inventory is thus not removed from the books, and instead the
“seller” records a liability for the proceeds of the “sale”, which
more accurately in substance is a short-term loan secured by
inventory as collateral.
Measurement of inventories (PAS 2)
Inventories are required to be stated at the lower of cost and net
realizable value (NRV).
Cost should include all
 costs of purchase (including taxes, transport, and handling)
net of trade discounts received
 costs of conversion (including fixed and variable
manufacturing overheads) and
 other costs incurred in bringing the inventories to their
present location and condition
Inventory cost should not include:
 abnormal waste
 storage costs
 administrative overheads unrelated to production
 selling costs
 foreign exchange differences arising directly on the recent
acquisition of inventories invoiced in a foreign currency
 interest cost when inventories are purchased with deferred
settlement terms.
Net realizable value is the estimated selling price in the ordinary
course of business less the estimated costs of completion and the
estimated costs necessary to make the sale.
Fair value is the amount for which an asset could be exchanged, or
a liability settled, between knowledgeable, willing parties in an
arm’s length transaction.
PROF.B.
Other measurement bases
Repossessed merchandise–fair value or best approximation of fair
value
Trade-in inventory–net realizable value minus normal profit margin
Commodities of brokers-traders–fair value less costs to sell.
Broker-traders are those who buy or sell commodities for others or
on their own account.
Agricultural, forest and mineral products–net realizable value
Agricultural produce at the point of harvest–fair value less point of
sale costs
Inventory cost formulas
The purpose of an inventory valuation method is to allocate the
total inventory cost of good available for sale during the period
between cost of goods sold and ending inventory.
Specific identification
 Required for inventories that are not ordinarily interchangeable
and goods or services produced and segregated for specific
projects.
 Using the specific identification method, the original cost of
each item is identified, resulting in actual costs being
accumulated for the specific items on hand and sold.
Average cost method
 This method assigns the same average cost to each unit.
 Based on the assumption that goods sold should be charged at
an average cost, with the average being weighted by the
number of units acquired at each price.
First- in, first-out method (FIFO)
 The first goods purchased are the first goods sold.
 Using the FIFO method, the accountant computes the cost of
goods sold and ending inventory as if the first items purchased
are the first to be sold, leaving the most recently purchased
items in inventory.
 This often matches the physical flow of goods.
 FIFO best approximates the current replacement value of ending
inventory.
Comparison of methods: cost of goods sold and ending inventory
The average cost method:
 Differs from the other methods in that no assumption is made
about the sale of specific units.
 Rather, all sales are assumed to be of the “average” unit at the
average cost per unit.
 The gross profit margin tends to follow a similar pattern to
FIFO in response to changing prices.
 Generally provides inventory values similar to FIFO values,
since average costs are heavily influenced by current costs.
FIFO:
 In a period of rising prices, matches oldest low-cost inventory
with rising sales prices, thus expanding the gross profit margin.
 In a period of declining prices, oldest high-cost inventory is
matched with declining sales prices, thus narrowing the gross
profit margin.
 Inventories are reported on the balance sheet at or near
current costs.
Specific identification:
 Can produce any variety of results depending on which
particular units are selected for shipment.
Accounting for inventory write down
The cost of inventories may not be recoverable if:
 those inventories are damaged
 they have become wholly or partially obsolete
 their selling prices have declined
 the estimated costs of completion or the estimated costs to be
incurred to make the sale have increased
The practice of writing inventories down below cost to net realizable
value is consistent with the view that assets should not be carried in
excess of amounts expected to be realized from their sale or use.
Inventories are usually written down to net realizable value item by
item.
Recognition as an Expense
When inventories are sold, the carrying amount of those inventories
shall be recognized as an expense in the period in which the
related revenue is recognized. The amount of any write-down of
inventories to net realizable value and all losses of inventories shall
be recognized as an expense in the period the write-down or loss
occurs. The amount of any reversal of any write-down of
inventories, arising from an increase in net realizable value, shall
be recognized as a reduction in the amount of inventories
recognized as an expense in the period in which the reversal
occurs.
Inventory systems
Periodic inventory system
 An inventory system in which only revenue is recorded each
time a sale occurs; the inventory balance is determined by a
periodic physical inventory.
 Using the periodic system, items must be physically counted to
determine quantities on hand.
 Quantities of items sold are determined indirectly by
subtracting the units on hand from the sum of the units in the
beginning inventory and units purchased during the year.
Perpetual inventory system
 An inventory system which provides a continuous summary of
goods on hand.
 Using the perpetual system, entries for revenue, cost of goods
sold, and the reduction of inventory are recorded for each
sales transaction.
 A continuous record of quantities in inventory and items sold is
maintained.
 Shrinkage is a term related to any observed differences,
attributable to a variety of possible factors, between the
inventory quantity at year-end as indicated by the perpetual
record and the actual quantity on hand as determined by a
physical inventory.
 Benefits of a perpetual system.
1. Provides a continuous check and control mechanism on
inventory.
2. Facilitates purchasing and production planning
3. Ensures adequate on-hand inventories
4. Helps identify and measure the magnitude of inventory
shrinkage.
5. Advances in, and cost reductions relating to, technology
have made perpetual systems much more feasible, and
it’s a good thing – today’s fast-paced, competitive
business environment magnifies the importance of a
perpetual system’s benefits.
Purchase commitments
 A lock on the inventory purchase price in advance. An
executory contract (an exchange of promises about future
actions).
 No journal entry is required to record an asset and liability at
the commitment date.
 However, when price declines take place subsequent to the
commitment and it is outstanding at the end of an accounting
period, the loss is recorded just as losses with goods on hand
are recognized (i.e., as with LCM, in the period in which the
inventory price decline took place).
 Acquisition of the goods in a subsequent period is also
recorded.
1. Purchases are recorded at current market value.
2. Difference between current market value of goods and
total amount owed per the purchase commitment is
reflected by the removal of the estimated loss on purchase
commitments account (a balance sheet account created
above).
 Current loss recognition is not appropriate when:
1. Commitments can be cancelled,
2. Commitments provide for price adjustment,
3. Hedging transactions prevent losses, or
4. Declines do not suggest reductions in sales prices.
 If, prior to delivery, the market price increases, the estimated
loss on purchase commitments account is reduced and a gain
is recorded, though such “recovery” can only be recognized to
the extent of the original loss recorded.
Estimating Inventories
Gross profit method
The gross profit method is an inventory estimation technique based
on a relationship between gross profit and sales that is assumed to
be fairly stable. Its use is not appropriate for financial reporting
purposes; however, it can serve a useful purpose when an
approximation of ending inventory is needed. Such approximations
are sometimes required by auditors or when inventory and
inventory records are destroyed by fire or some other catastrophe.
The gross profit method should never be used as a substitute for a
yearly physical inventory unless the inventory has been destroyed.
The gross profit method is based on the assumptions that (a) the
beginning inventory plus purchases equal total goods to be
accounted for; (b) goods not sold must be on hand; and (c) if sales,
reduced to cost, are deducted from the sum of the opening
inventory plus purchases, the result is the ending inventory.
In developing a reliable gross profit percentage, reference is made
to past years and adjustments are made for current circumstances.
Retail method
The retail inventory method is an inventory estimation technique
based upon an observable pattern between cost and sales price
that exists in most retail concerns. This method requires that a
record be kept of (a) the total cost and retail of goods purchased,
(b) the total cost and retail value of the goods available for sale,
and (c) the sales for the period.
Basically, the retail method requires the computation of the cost-to-
retail ratio of inventory available for sale. This ratio is computed by
dividing the cost of the goods available for sale by the retail value
(selling price) of goods available for sale. Once the ratio is
determined, total sales for the period are deducted from the retail
value of inventory available for sale. The resulting amount
represents ending inventory priced at retail. When this amount is
multiplied by the cost to retail ratio, an approximation of the cost of
ending inventory results. Use of this method eliminates the need
for a physical count of inventory each time an income statement is
prepared. However, physical counts are made at least yearly to
determine the accuracy of the records and to avoid overstatements
due to theft, loss, and breakage.
To obtain the appropriate inventory figures under the retail inventory
method, proper treatment must be given to markups, markup
cancellations, markdowns, and markdown cancellations.
When the cost to retail ratio is computed after net markups
(markups less markup cancellations) have been added, the retail
inventory method approximates lower of cost or market. This is
known as the conventional retail inventory method. If both net
markups and net markdowns are included before the cost to retail
ratio is computed, the retail inventory method approximates cost.
The retail inventory method becomes more complicated when such
items as freight-in, purchase returns and allowances, and purchase
discounts are involved. In essence, the treatment of the items
affecting the cost column of the retail inventory approach follows
the computation of cost of goods available for sale. Freight costs
are treated as a part of the purchase cost; purchase returns and
allowances are ordinarily considered both a reduction of the price at
both cost and retail; and purchase discounts usually are considered
as a reduction of the cost of purchases.
Other items that require careful consideration include transfers-in,
normal shortages, abnormal shortages, and employee discounts.
Transfers-in from another departments should be reported in the
same way as purchases from an outside enterprise. Normal
shortages should reduce the retail column because these goods
are no longer available for sale. Abnormal shortages should be
deducted from both the cost and retail columns and reported as a
special inventory amount or as a loss. Employee discounts should
be deducted from the retail column in the same way as sales.

The retail inventory method is widely used (a) to permit the

computation of net income without a physical count of inventory, (b)
as a control measure in determining inventory shortages, (c) in
regulating quantities of inventory on hand, and (d) for insurance
information.

The retail method is often used in the retail industry for measuring
inventories of large numbers of rapidly changing items with similar
margins for which it is impracticable to use other costing methods.
 The percentage used takes into consideration inventory that
has been marked down to below its original selling price.
 An average percentage for each retail department is often
used.