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Intermediate Accounting 1
PAS 2 paragraph 23 provides that this method is appropriate for inventories that
are segregated for a specific project and inventories that are not ordinarily
interchangeable.
Under this formula, cost of sales represents costs from earlier purchase while the
cost of ending inventory represents costs from the most recent purchase.
Accordingly, in a period of inflation or rising prices, the FIFO method would result
to the highest net income. However, in a period of deflation or declining prices,
the FIFO method would result to the lowest net income.
3. Weighted Average – Under this formula, cost of sales and ending inventory are
determined based on the weighted average cost of beginning inventory and all
inventories purchased or produced during the period. It is computed by dividing
the total cost of goods available for sale by the total number of units available for
sale.
This method is relatively easy to apply and approximates current value if there is
a rapid turnover of inventory.
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4. Last-in, First-Out (LIFO) – The standard does not permit the use of LIFO as a formula in
measuring the cost of inventories. This method assumes that the goods last
purchased are first sold and consequently, the goods remaining in the ending
inventory are those first purchased or produced.
Under this formula, cost of sales represents costs from recent purchase while the
cost of ending inventory represents earlier or old prices.
Accordingly, in a period of inflation or rising prices, the LIFO method would result
to the lowest net income. However, in a period of deflation or declining prices,
the LIFO method would result to the highest net income.
ILLUSTRATION
ABC Corp. is a wholesaler; the activity for product “A” during August is show below:
Requirements: Compute for (a) ending inventory and (b) cost of goods sold under the following
cost formulas:
1. FIFO – A. periodic
B. perpetual
2. Weighted average – A. periodic
B. perpetual
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Using the concept of FIFO, the cost of ending inventory will be based from the most recent
purchases. The ending inventory in units is allocated as follows:
Total cost
Beginning inventory P 72,000
Add: Net purchases
(111,600 + 182,400 + 73,340 - 11,580) 355,760
Less: Ending inventory at cost (152,960)
Cost of goods sold P 274,800
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It is important to note that ending inventory and cost of goods sold under the FIFO method are the
same both the periodic and perpetual inventory system. Only the recording and record keeping differs
between the two systems when using this method of costing.
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The average cost per unit is then used to compute for the ending inventory and cost of goods sold.
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Notes:
A new average unit cost is computed by dividing total goods available for sale in pesos by
the total goods available for sale in units after every purchase. The computed moving
average unit costs are used in computing for costs of goods sold in subsequent sales.
Sales returns are reverted back to inventory at the average unit cost used to record the
related sale.
Purchase returns are deducted from total goods available for sale at the unit cost of the
related purchase, in this case, the unit cost of the August 29 purchase (i.e., P 38.60).
Since each movement in inventory is recorded in one account, the Company’s records
would show ending inventory amounting to P 152,270. Beginning inventory plus all
purchases (net of purchase returns), less all sales (net of sales returns) in pesos to get the
ending inventory in pesos.
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Cost of goods sold for the period is derived by adding up the cost for each sales
transaction (net of sales returns). In this example:
Total goods available for sale (already given in the problem) P 427,760
Less: Ending inventory (152,270)
Total cost of goods sold P 275,490
LIFO - PAS 2 prohibits the use of LIFO, below illustration shows how LIFO is applied to differentiate
from the other methods. LIFO is the exact opposite of FIFO. Under LIFO, items of inventory that
were purchased or produced first are sold last. Consequently, the cost of ending inventory is
based on the cost of the beginning inventory and earliest purchases.
Total goods available for sale (already given in the problem) P 427,760
Less: Ending inventory (146,400)
Total cost of goods sold P 281,360
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Net realizable value (NRV) is the “estimated selling price in the ordinary course of business less
the estimated cost of completion and the estimated costs necessary to make the sale.” (PAS 2.6)
Selling price xx
Less: Estimated cost to complete (xx)
Less: Estimated cost to sell (xx)
Net realizable value xx
Measuring inventories at the lower of cost and NRV is in line with the basic accounting concept
that an asset shall not be carried at an amount that exceeds its recoverable amount.
The cost of an inventory may exceed its recoverable amount if:
a. the inventory is damaged
b. becomes obsolete
c. prices have declined, or
d. the estimated costs to complete or to sell the inventory have increased.
In these circumstances, the cost of the inventory is written-down to NRV. The amount of write-
down is recognized as an expense.
Write-down of inventory
If the cost of an inventory exceeds its NRV, the inventory is written down to NRV, the lower
amount. The excess of cost over NRV represents the amount of write-down. If the cost of an
inventory is lower than its NRV, no write-down is necessary.
Write-downs of inventories are usually carried out on an item by item basis, although in some
circumstances, it may be appropriate to group similar items. It is not appropriate to write down
inventories on the basis of their classification (e.g., finished goods or all inventories of an
operating segment).
Write-downs of inventories are normally charged to cost of goods sold. However, material write-
downs and those arise from abnormal losses, such as theft, obsolescence, and casualties are
charged to loss.
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Illustration:
ABC Co. buys and sells products A & B. The following unit costs are available for the inventory as
of December 31, 2019.
Product A Product B
Number of units 2,000 3,000
Purhcase cost per unit P 100 P 200
Delivery cost from supplier 20 30
Estimated selling price 150 250
Selling costs 22 40
General and administrative 15 18
Requirements:
a. Compute for the valuation of the inventories in ABC’s December 31, 2019 statement of
financial position.
b. Determine the amount of write-down.
Solution:
a. Valuation of inventories in ABC’s December 31, 2019 statement of financial position
Product A Product B
Cost:
Purchase cost per unit P 100 P 200
Delivery cost from supplier (freight-in) 20 30
Cost per unit P 120 P 230
Multiply by: Number of units 2,000 3,000
Total cost P 240,000 P 690,000
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Product A Product B
Total cost (recorded per books) P 240,000 P 690,000
Should be balance of Inventory (LCNRV) P 240,000 P 630,000
Notes:
First solve for the cost of the inventories, this will represent the amount recorded in the
books. Then, solve for the net realizable value (NRV).
Compare both amounts on a per item basis.
a. For product A, the cost of P 240,000 is lower than the NRV so we will use the cost as
the value of the inventory. Therefore, no write-down is necessary for product A.
b. However, for product B, the NRV of P 630,000 is lower than the recorded cost of
P 690,000, thus the inventory will be written down to equal the NRV. Amount of write-
down will be the difference between the recorded cost and the NRV. This write-down
is the deduction from recorded cost to equal the NRV.
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Decrease in allowance:
Dr. Allowance for inventory write-down xx
Cr. Gain on reversal of inventory write-down xx
However, the gain is only limited to the balance of the allowance account. The gain
on reversal of inventory write-down is presented as a deduction from cost of goods
sold.
2. Direct method or cost of goods sold method – any loss on inventory write-down is not
accounted or recorded separately. The lower of cost or net realizable value is
recorded directly and in effect, any loss on inventory write-down or gain on the
reversal of inventory write-down is already included in the cost of goods sold.
The allowance method is preferred over the direct method since the movement in the allowance
account shows the loss on inventory write-down and any gain on reversal. This complies with the
requirement of PAS 2, paragraph 36, which states that the amount of any inventory write-down
and any reversal of inventory write-down should be disclosed.
Illustration:
Using the information in the previous illustration, the entries to recognize the inventory write-
down under the two methods are shown below:
1. Allowance method
Dr. Inventories (at cost) P 930,000
Cr. Income Summary P 930,000
The allowance account will be deducted from the inventory account to present the net value of
inventory at LCNRV.
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2. Direct method
Dr. Inventories (at LCNRV) P 870,000
Cr. Income Summary P 870,000
The amount of LCNRV is directly recorded as the amount of inventory.
Continuing Illustration:
On December 31, 2020, the total cost of inventory is P 1,500,000 and the net realizable value is
P 1,480,000.
1. Allowance method
2. Direct method
Dr. Inventories (at LCNRV) P 1,480,000
Cr. Income Summary P 1,480,000
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Additional Illustration:
Inventory - January 1
Cost P 5,000,000
Net Realizable Value 4,500,000
Net Purchases 20,000,000
Inventory - December 31
Cost 6,000,000
Net Realizable Value 5,300,000
1. Allowance method
Using the allowance method, beginning and ending inventories are reported at cost to
get the cost of goods sold before write-down, then any loss on allowance is added or gain
on reversal is deducted to reflect the total cost of goods sold.
2. Direct method
Under the direct method, both beginning and ending inventory are reported at lower of
cost or net realizable value. (LCNRV).
Note that the amount for cost of goods sold should be the same under both methods.
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Purchase Commitments
Purchase commitments are obligations of the entity to acquire certain goods sometime in the
future at a fixed price and fixed quantity.
A contracting party under a noncancelable purchase commitment cannot cancel the contract
without incurring penalty. Thus, the buyer has to accept future delivery even if the goods
promised to be purchased decline in value. In such case, the buyer recognized a loss on purchase
commitment. When the prices subsequently increase, the buyer recognizes gain on purchase
commitment. However, the gain should not exceed the loss on purchase commitment previously
recognized.
The recognition of a loss in purchase commitment is an adaptation of the measurement at the
lower of cost or net realizable value.
Illustration:
The contract purchase price is P 500,000 and the replacement cost at year-end is P 450,000. The
market decline of P 50,000 is recorded as follows:
Dr. Loss on purchase commitment P 50,000
Cr. Estimated liability for purchase commitment P 50,000
The loss on purchase commitment is classified as other expense and the estimated liability for
purchase commitment is classified as current liability.
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Scenario 2: Increase in price but still lower than the contracted/agreed purchase price
If the replacement cost of the purchase commitment is P 480,000 when the actual purchase is
made, the journal entry to record the purchase is:
c. The carrying amount of inventories carried at fair value less cost of disposal.
d. The amount of inventories recognized as an expense during the period.
e. The amount of any write-down of inventories recognized as an expense during the period
f. The amount of reversal of write-down that is recognized as income
g. The circumstances or events that led to reversal of a write-down of inventories.
h. The carrying amount of inventories pledged as security for liabilities.
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