CHAPTER 5

INVENTORIES AND
RELATED EXPENSES

Reporter: Angelica Castillo & Victoria Manaday

Chapter 5 – Inventories and Related Expenses

Learning Objectives:
1. Describe inventories of manufacturing companies and servicing companies.
2. Describe the initial recognition, initial measurement, subsequent measurement,
derecognition and financial statement presentation of inventories.
3. Describe the sequence of activities in the conversion cycle and warehousing cycle
4. Cite the general internal control procedures in the conversion and warehousing cycle.
5. Identify the situations in which periodic or perpetual system is appropriate and
compare and contrast perpetual and periodic inventory system.
6. Calculate the cost of inventory using inventory estimation
7. Describe the difference between full PFRS and PFRS for SMEs
8. Calculate the correct balance of inventory and related accounts.
Chapter 5 – Inventories and Related Expenses

Inventories
As defined in PAS 2 paragraph 6, inventories are assets 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
the rendering of service. Therefore, inventories include the following:
a) Assets held for sale in the ordinary course of business (finished goods)
b) Assets in the production process for sale in the ordinary course of business
(work in process)
c) Materials and supplies that are consumed in production (raw materials)
d) Purchase subcomponents
e) Goods held by a trader for resale
Chapter 5 – Inventories and Related Expenses

Initial Recognition
An entity should recognize an inventory only when
A) the entity controls the asset as a result of past events and
B) it is probable that future economic benefits will flow to the entity.

Initial Measurement: Cost of Inventories

The cost of inventories shall comprise all costs of purchase, cost of conversion and other cost
incurred in bringing the inventories to their present location and condition.
Chapter 5 – Inventories and Related Expenses

Cost of Purchase
The cost of purchase of inventories comprise the
1) Purchase price
2) Import duties and other taxes (other than subsequently recoverable by the entity from the
taxing authorities)
3) Transport, handling and other cost directly attributable to the acquisition of finished goods,
materials and services.

◦ Any trade discounts, rebates and other similar items are deducted in determining the cost of purchase.
Chapter 5 – Inventories and Related Expenses

Cost of Conversion
Cost of conversion includes the following:
a) Variable production overheads. These are defined as those indirect cost of production that
vary directly, or nearly directly, with the volume of production, such as indirect materials and
indirect labor. Variable production overheads are allocated to each unit of production based
on the actual use of the production facilities.
b) Fixed production overheads. Fixed production overheads are those indirect costs of
production that remain relatively constant regardless of the volume of production, such as
depreciation and maintenance of factory and buildings and equipment, and the cost of
factory management and administration. Fixed production overheads are allocated to each
unit of production based on the normal capacity of the production facilities
c) Joint products. Where joint products are produced and their costs of conversion are not
separately identifiable, COC are allocated between them on rational and consistent basis.
Chapter 5 – Inventories and Related Expenses

Other Costs
Other costs are included in the cost of inventories only to the extent that are incurred in bringing
the inventories to their present location and condition. Examples of other costs are as follows:
a) Borrowing cost – PAS 23 requires capitalizing interest on inventories which take a substantial
amount of time to create. However, an entity should not capitalize borrowing costs for
inventories that are manufactured in large quantities on a repetitive basis.
b) Storage cost - this can be included for products that require a maturation process or
substantial amount of time to create.
c) Non-production overheads or costs of designing products for specific customer- this can be
included in cost if they contribute in bringing the inventories to their present condition and
location.
Chapter 5 – Inventories and Related Expenses

Excluded From Cost of Inventories

◦ Abnormal amounts of wasted materials, labor, or other production costs
◦ Storage costs (unless essential to the production process)
◦ Administrative overheads unrelated to production
◦ Selling cost
◦ 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.
Chapter 5 – Inventories and Related Expenses

Illustration 1: Cost of Inventories

ITEMS
1 Supplier’s gross price for raw materials, P150,000
2 Material purchased from another supplier on extended credit amounting to P570,000. The price to be paid under normal credit
term is P550,000
3 Invoice price of raw materials purchased amounting to P180,000 Quantity discounts of 10,5 are allowed by supplier.
4 Materials purchased from a supplier amounting to P616,000, inclusive of 12% VAT. The company is VAT registered and can claim
this as an input VAT.
5 Materials purchased from a supplier amounting to P515,000 is inclusive of non recoverable purchase tax of P15,000

6 Cost of transporting raw materials to the business premises, P5,000

7 Import duties paid to authorities on import of raw materials to be used during the manufacturing process, P25,000

8 Labor cost directly incurred in the processing of raw materials, P420,000

9 Normal amount of wasted labor, P57,000
10 Abnormal amounts of wasted labor P69,000

11 Variable costs (electricity) incurred in the processing of raw materials, P10,000

Chapter 5 – Inventories and Related Expenses

The Warehousing Cycle and Conversion Cycle

The acquisition of goods or services and issuance of inventories is the inventory and
warehousing cycle. This group of activities includes the following sequential steps:
a) An employee or a department recognizes a need for the purchase of goods, prepares a
requisition form and sends it to the purchasing department;
b) The purchasing department locates an appropriate supplier, after considering quality and
price, and prepares and issues a purchase order to supplier;
c) The receiving department receives and inspects the goods, verifying quality and quantity,
and prepares receiving report.
d) The receiving department transfers the goods to the warehouse.
e) The goods are transferred from the warehouse to the production department, upon
requisition latter.
Chapter 5 – Inventories and Related Expenses

Internal Control over Inventories

Internal control procedures on inventories focus on the following:
a) Physical inspection and counting of all items of inventories received by the company from suppliers to
immediately remedy any discrepancy between delivery and purchase order.
b) Keeping inventories in a warehouse that restricts access to unauthorized persons;
c) Monitoring movements of inventories, from receiving department, to stockroom, to the production
department, to finished goods warehouse, to shipping department, etc.;
d) Appropriate storage of inventories by classification, using inventory tags, so that inventory
requirements are served without undue delay
e) Monitoring inventory quantities to minimize losses due to stock outs and losses from obsolescence;
f) Conducting a periodic obsolete inventory review;
g) Periodic reconciliation of stock cards inventory and physical inventory
h) Auditing of bill of materials, which is a record of parts used to construct a product; and
i) Creating a procedure to track scrap transactions
Chapter 5 – Inventories and Related Expenses

Audit Procedures
•To establish existence of inventories and to satisfy themselves about the condition of inventories
at the reporting date, the auditors observe physical count of inventories, conducted by the
client’s personnel. It is not the auditor’s function to take inventory; the auditors merely observe
the taking of the inventory.
•If the client has a physical inventory system, the physical inventory count determines the
balance in inventory account at yearend; as such, the count is conducted at the reporting date.
•If the client has a perpetual inventory system, the physical inventory count may be conducted at
any convenient time during the reporting period.
•The auditors normally participate in the client’s advanced planning of the physical inventory and
review the written instructions prepared by management for the employees who will make the
counts.
Chapter 5 – Inventories and Related Expenses

Audit Procedures
•If the auditors do not observe the taking of the inventory because it is impossible to do so, some
audit procedures must be undertaken to validate the existence of the amount reported as
inventory.
•The auditors should take exceptions for indications of goods that are damaged or otherwise
obsolete or non-salable.
•Goods stored in public warehouse and goods held by consignee should be confirmed by direct
communication with the custodian of the warehouse or the consignee.
•The auditors’ tests of the cost accounting system are designed to determine that appropriate
costs have been assigned to work-in process, finished goods, and cost of good sold.
•To establish completeness and correctness of inventory balances, the auditor conducts a
purchase cut-off test by reviewing purchase invoice and receiving report several days before and
several days after the end of the reporting period, noting the date that the enterprise obtains
economic control and the date the transaction was recorded.
Chapter 5 – Inventories and Related Expenses

Audit Procedures
•For audits of a manufacturing entity, the auditor has to review the bill of materials for a sample
of finished goods to test whether the cost of materials has been properly included in the cost of
work in process or finished goods inventories.
•Analytical review procedures may be conducted to disclose the presence of obsolete inventory
items, material errors in counting and pricing.
•In the audit of a new client, the auditors must obtain evidence that the client’s beginning
inventories are fairly stated, as errors in beginning inventory balances will misstate current year
profit.
•The auditor determines whether inventories are properly presented and measures in the
financial statements. The financial statement should disclose the inventory costing formula in
use, any amount of inventories pledged for liabilities, and significant sales or purcahase
commitments.
Chapter 5 – Inventories and Related Expenses

Repurchase Agreements
A repurchase agreement is a contract in which an entity sells an asset and also promises or has
the option (either in the same contract or in another contract) to repurchase asset may be the
asset originally sold to the customer, an asset that is substantially the same asset, or another
asset of which the asset that was originally sold is component. [PFRS 15 B.64]
Repurchase agreements generally come in three forms:
a) An entity’s obligation to repurchase the asset (a forward contract)
b) An entity’s right to repurchase the asset (a call option)
c) An entity’s obligation to repurchase the asset at the customers request (a put option)

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(ASUNCION D.J)
Chapter 5 – Inventories and Related Expenses

Consignment Arrangements
A product that has been delivered to another party (e.g., consignee) may be held in a
consignment arrangement if that other party has not obtained control of the product.
Indicators than an arrangement is a consignment arrangement include, but are not limited to, the
following:
a) The product is controlled by the entity until a specified event occurs, such as sale of the product
to a customer of the dealer or until a specified period expires;
b) The entity is able to require the return of the product or transfer the product to a third party
(such as another dealer);and
c) The dealer does not have an unconditional obligation to pay for the product (although it might
be required to pay a deposit)
The consignor recognize revenue when:
a) The consignee sold the product to the customer; or
b) After an expiration of a specified period
Chapter 5 – Inventories and Related Expenses
Accounting for Consignment of Inventories
Transactions CONSIGNOR CONSIGNEE
1. Shipment of goods on Inventory on Consignment xx No entry
consignment Finished goods xx
2. Payment of expenses by Inventory on Consignment xx No entry
consignor (e.g.Freight) Cash xx

3. Payment of expenses by Inventory on Consignment xx Consignor receivable xx

consignee (e.g.Freight) Consignee Payable xx Cash xx

4. Sale of Merchandise No entry Cash xx

Consignor payable xx
5. Notification of sale to Commission exp. xx Consignor payable xx
consignor and payment of cash Cash xx Cash xx
due Consignee payable xx Commission revenue xx
Consignment sale revenue xx Consignor Receivable xx

Cost of good sold xx

Inventory on consignment xx Go to page 367
(ASUNCION D.J)
Chapter 5 – Inventories and Related Expenses

Two systems of Accounting for Inventories

Perpetual Inventory System
Used for low-volume, high cost items, such as
automobiles and jewelry. Because of technology,
perpetual inventory system may be used also for low
value inventory with the aid of point-of-sale (POS)
devices connected with the company’s inventory
system.
The inventory account is updated for each purchase,
sale and return (i.e., sales return and purchase
return) of inventory.
Physical count is performed to determine the
accuracy of the balance per records.
Periodic Inventory System
Use for relatively low value inventory items such as
inventory of grocery stores.
The inventory account is updated only when
financial statements are prepared.
Physical count is performed to determine the ending
balance of inventory and to compute for the cost of
goods sold. Unlike in perpetual inventory system,
cost of goods sod is a residual amount.
Chapter 5 – Inventories and Related Expenses
Two systems of Accounting for Inventories
Perpetual Inventory System
Purchase returns, discounts and allowances are
recorded by crediting the inventory account.
Freight in is debited directly to inventory account.
Account used: Inventory
Periodic Inventory System
Purchases returns, discounts and allowances are
recorded by crediting the appropriate purchase
account.
Freight incurred when the inventory was purchased
is debited to “Freight-in” account
Accounts used: Inventory beginning, inventory
ending purchases, freight in, purchase allowance
and purchase discount
Chapter 5 – Inventories and Related Expenses

Transaction Perpetual Inventory System Periodic Inventory System

1. To record purchase and freight in Inventory xx Purchases xx
Accounts Payable/ Cash xx Freight-in xx
Accounts Payable/ Cash xx

2. To record purchase returns, Accounts Payable xx Accounts Payable xx

discounts and/ or allowances Inventory xx Purchases ret./allow./disc. xx
3. To record sales and cost of Cash/Account Receivable xx Cash/Account Receivable xx
inventory sold Sales xx Sales xx
Cost of good sold xx No journal entry yet
Inventory xx
4. To record sales return Sales return xx Sales return xx
Account Receivable xx Account Receivable xx
Inventory xx No journal entry yet
Cost of good sold xx
5. To record sales allowance or Sales allowance/discount xx Sales allowance/discount xx
sales discount Account Receivable xx Account Receivable xx
Chapter 5 – Inventories and Related Expenses

Transaction Perpetual Inventory System Periodic Inventory System

6. Closing Entries No closing inventories Inventory-end xx
Cost of good sold xx
Cost of good sold xx
Purchase ret. And allow. xx
Purchases xx
Freight-in xx
Inventory-beg xx
7. To record shortage or shrinkage Loss on inventory xx No journal Entry
Inventory xx

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(ASUNCION D.J)
Chapter 5 – Inventories and Related Expenses

Subsequent Measurement of Inventories

Inventories are required to be stated at the lower of cost and net realizable value
(NRV). Inventories are usually written down to net realizable value item by item. In
some circumstances, however, it may be appropriate to group similar or related items.

Net Realizable Value

The following are the net realizable values of the different types of inventories:
1) Raw Materials and Factory supplies
2) Work in process partially completed goods
3) Finished Goods