CHAPTER

BLUE NOTES
7 S
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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 Conversion
 Purchase price  Direct materials
 Import duties  Direct Labor
 Irrevocable Taxes  Fixed and variable production overhead
 Freight  Abnormal amounts of waste and spoilage
 Handling  Storage costs
 Other Cost Directly attributable to the  Administrative Overheads
purchase  Selling Costs
Deduct
- Trade Discounts
- Rebates
- Other Similar Items
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.

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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.

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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 Allowance Method
 Loss on inventory write-down is not  Loss on inventory write-down is accounted
accounted for separately but buried in the for separately and credited to “allowance
cost of goods sold. 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 Retail Inventory Method
This method is based on the assumption that the rate of This method is generally employed by department stores,
gross profit remains approximately the same from period 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 wide variety of goods because keeping track of unit cost
net sales is relatively constant from period to period. at all times is difficult.
1. Gross profit rate “based on sales” 1. Conservative Cost Approach (conventional or
2. Gross profit rate “based on cost” lower of average cost or market approach)
 Include mark-up, exclude mark-down
Note: Sales Allowances and Sales Discounts are ignored in 2. Average Cost Approach
computing the net sales for purposes of using gross profit  Mark-up and mark-down are included
rate method in computing COGS.
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.

 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.

 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.

 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.

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

 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 7, 600, 000

Goods out on consignment 1, 000, 000
Goods purchased, FOB shipping point 250, 000
Goods sold, FOB shipping point ( 850, 000)
Goods sold, FOB destination 260, 000
Goods sold, FOB destination 840, 000
Correct Inventory, 2013 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 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

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3. Assume the following data:

Units Unit Cost Total Cost
January 1 Beginning balance 5, 000 200 1, 000, 000
10 Purchase 5, 000 250 1, 250, 000
15 Sale (7, 000)
16 Sales return 1, 000
30 Purchase 16, 000 150 2, 400, 000
31 Purchase return (2, 000) 150 300, 000
Ending Balance 18, 000

Solutions:
FIFO (Periodic or Perpetual)
Units Unit Cost Total Cost
January 10 Purchase 4, 000 250 1, 000, 000
30 Purchase 14, 000 150 2, 100, 000
Inventory, End 18, 000 3, 100, 000

Weighted Average – Periodic

Units Unit Cost Total Cost
January 1 Beginning Balance 5, 000 200 1, 000, 000
10 Purchase 5, 000 250 1, 250, 000
30 Purchase 16, 000 150 2, 400, 000
31 Purchase return (2, 000) 150 (300, 000)
24, 000 4, 350, 000

Weighted average unit cost (4, 350, 000 / 24, 000 units) 181.25
Cost of ending inventory (18, 000 x 181.25) 3, 2262, 500
Moving Average
Units Unit Cost Total Cost
January 1 Beginning balance 5, 000 200 1, 000, 000
10 Purchase 5, 000 250 1,250, 000
Balance 10, 000 225 2, 250, 000
15 Sale (7, 000) 225 (1, 575, 000)
16 Sales Return 1, 000 225 225, 000
Balance 4, 000 225 900, 000
30 Purchase 16, 000 150 2, 400, 000
Balance 20, 000 165 3, 300, 000
31 Purchase return (2, 000) 150 (300, 000)
Balance 18, 000 167 3, 000, 000

4. Assume the following data for the current year:

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Inventory, January 1:
Cost 5, 000, 000
NRV 4, 500, 000
Net Purchases 20, 000, 000
Inventory, December 31:
Cost 6, 000, 000
NRV 5, 900, 000

Solutions:
Direct Method – cost of goods sold
Inventory, January 1 4, 500, 000
Net Purchases 20, 000, 000
Goods available for sale 24, 500, 000
Inventory, December 31 5, 900, 000
Cost of goods sold 18, 600, 000

Allowance Method – cost of goods sold

Inventory, January 1 at cost 5, 000, 000
Net Purchases 20, 000, 000
Goods Available for Sale 25, 000, 000
Inventory, December 31 at cost 6, 000, 000
COGS before reversal of writedown 19, 000, 000
*Gain on reversal of inventory writedown (400, 000)
COGS after reversal of writedown 18, 600, 000

*Required allowance – December 31 (6, 000, 000 – 5, 900, 000) 100, 000
Required allowance – January 1 (5, 000, 000 – 4, 500, 000) 500, 000
Reversal of inventory writedown – decrease in allowance (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 Number of lots Sale price per lot

A 100 240, 000
B 100 160, 000
C 200 100, 000

Using the relative sales price method, what amount of cost should be allocated to Class A lots?

Class Sales price Fraction Allocated Cost

A (100 x 240, 000) 24, 000, 000 24/60 6, 000, 000
B (100 x 160, 000) 16, 000, 000 16/60 4, 000, 000
C (200 x 100, 000) 20, 000, 000 20/60 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 420, 000

Loss on purchase commitment 30, 000
Estimated liability on purchase commitment 50, 000
Accounts payable 500, 000

Case 2. If the replacement cost of the purchase commitment is 600, 000 when the actual purchase is made.

Purchases 500, 000

Estimated liability on purchase commitment 50, 000
Accounts payable 500, 000
Gain on purchase commitment 50, 000

Case 3. If the replacement cost of the purchase commitment is 480, 000 when the actual purchase is made.

Purchases 480, 000

Estimated liability on purchase commitment 50, 000
Accounts payable 500, 000
Gain on purchase commitment 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

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Sales allowance 50, 000

Sales discount 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 600, 000
Purchases 2, 530, 000
Freight in 50, 000
Total 2, 580, 000
Less: Purchase return 15, 000
Purchase allowance 5, 000
Purchase Discount 10, 000 30, 000 2, 500, 000
Goods available for sale 3, 150, 000
Less: Cost of sales:
Sales 3, 100, 000
Less: Sales return 100, 000
Net Sales 3, 000, 000
Multiply by cost ratio 75% 2, 250, 000
Ending inventory 900, 000

Gross profit rate “based on cost”

Goods available for sale 3, 150, 000
Less: Cost of sales:
Sales 3, 100, 000
Less: Sales return 100, 000
Net Sales 3, 000, 000
Divided by sales ratio 125% 2, 250, 000
Ending inventory 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 180, 000 250, 000
Net purchases 1, 020, 000 1, 575, 000
Additional mark up 200, 000
Mark up cancelation 25, 000
Markdown 140, 000
Markdown cancelation 15, 000
Sales 1, 450, 000

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Sales return 50, 000

Sales allowance 10, 000
Sales discount 20, 000
Employee discount 40, 000
Spoilage and breakage 35, 000

Retail method – Conservative and Average Cost Approach

Cost Retail
Beginning inventory 180, 000 250, 000
Net Purchases 1, 202, 000 1, 575, 000
Additional Mark-up 200, 000
Mark-up cancelation (25, 000)
GAS – Conservative 1, 200, 000 2, 000, 000
Cost ratio (1, 200, 000 / 2, 000, 000) 60%
Markdown (140, 000)
Markdown cancelation 15, 000
GAS – Average 1, 200, 000 1, 875, 000
Cost ratio (1, 200, 000 / 1, 875, 000) 64%
Less: Sales 1, 450, 000
Sales return (50, 000)
Employee discount 40, 000
Spoilage and breakage 35, 000 1, 475, 000
Ending Inventory at retail 400, 000

Conservative cost (400, 000 x 60%) 240, 000

Average Cost (400, 000 x 64%) 256, 000

9. Cost Retail
Beginning inventory 495, 000 900, 000
Purchases 1, 800, 000 3, 300, 000
Net mark-up 300, 000
Net markdown 600, 000
Sales 2, 700, 000

Solution:

Cost Retail
Beginning inventory 495, 000 900, 000
Purchases 1, 800, 000 3, 300, 000
Net mark-up 300, 000
Net markdown (600, 000)
Net Purchases 1, 800, 000 3, 000, 000
Current year ratio cost
(1, 800, 000 / 3, 000, 000) 60%
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Goods available for sale 2, 295, 000 3, 900, 000

Less: Sales 2, 700, 000
Ending inventory at retail 1, 200, 000
FIFO Cost (1, 200, 000 x 60%) 720, 000

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