FINANCIAL ACCOUNTING & REPORTING 1

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Inventories

Module 018 Accounting for Inventories

In this topic for Inventories, you will learn about the following:
8.4 Inventory recording systems
✓ Periodic inventory system
✓ Perpetual inventory system
8.5 Inventory costing methods
✓ Items not ordinarily interchangeable
✓ Specific identification
✓ For items that are interchangeable
✓ First in, First out method
✓ Weighted average cost method

At the end of this module, you will be able to:

1. differentiate the perpetual inventory system from the periodic inventory
system
2. compute inventory values using the different inventory costing
procedures

8.4 Inventory recording systems

Inventory quantities and costs may be accounted for using either the periodic system or the
perpetual system.
Periodic inventory system
An entity using the periodic system also called a physical system, does not maintain a
continuous record of the physical quantities (or cost) of inventory on hand. Therefore, the
company will not be able to determine its inventory accurately until a physical inventory is
taken at the end of the period. This approach gives the actual or physical inventories.
The periodic inventory procedure is generally used when the individual inventory turnover
rapidly and has a small value such that it may prove impractical or inconvenient to record
inventory inflow or outflows, such as grocery store items, hardware, and auto parts.
Under the periodic system, all acquisitions of inventory are charged to a nominal account –
The purchases account. Separate accounts are usually maintained for purchases, returns
and allowances, purchases discounts, and freight. Net cost of purchases is the sum of
purchases and freight reduced by purchase discounts, returns, and allowances.

Course Module
At that time, the following computation is used to determine the cost of goods sold by a
merchandising concern:
Merchandise Inventory, beginning x
Add: Net cost of purchases x
Cost of Goods Available for Sale xx
Less: Merchandise Inventory, ending (x)
Cost of Goods Sold x
The following are the pro-forma entries to record transactions using a periodic inventory
system:
a. Purchase of goods Purchases
Accounts Payable / Cash

b. Purchase returns Accounts Payable / Cash

Purchase returns

c. Sale of Goods Accounts Receivable / Cash

Sales

d. Sales returns Sales Returns

Accounts Receivable / Cash

e. Yearend entry to set up inventory Merchandise Inventory, end

Income Summary

f. Yearend entry to close the Income Summary

beginning inventory Merchandise Inventory, beg

At that time, the following computation is used to determine the cost of goods sold by a
merchandising concern:
Merchandise Inventory, beginning xx
Add: Net cost of purchases xxx
Cost of Goods Available for Sale xxxxx
Less: Merchandise Inventory, ending xx
Cost of Goods Sold xxx
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Alternatively, the entry to set up ending inventory and to close beginning inventory may be
made simultaneously, setting up the cost of sales for the period.
The year-end entry is:
Merchandise inventory, end xx
Cost of Sales xx
Purchase Returns and Allowances xx
Purchase Discounts xx
Freight in (xx)
Merchandise Inventory, beginning (xx)
Purchases (xx)
The periodic inventory system is appropriate for relatively low-value but numerous
inventory items, particularly when the costs of a perpetual system are likely to outweigh its
benefits.
Enterprises are presenting expenses in the Statement of Comprehensive Income (SCOI),
according to their nature, neither computing nor setting up the cost of sales. Rather, the net
cost of purchases (adjusted for the change in inventories from the beginning to the end of
the period) is shown among other expenses classified according to their nature. Thus, no
cost of sales and gross profit are presented.
In such a case, the entry to set up the ending inventory as an asset is:
Merchandise inventory, end xx
Income Summary xx
In the profit or loss section of the SCOI showing the expenses according to nature, the
balance of the net purchases and the change in inventory will be shown as follows:
Revenue
Net Sales P xx
Miscellaneous Revenue xx
Total Revenue P xx
Expenses
Net purchases P xx
Increase (Decrease) in inventory (xx)
Salaries xx
Deprecation xx

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Perpetual inventory system
An entity using the perpetual system maintains a continuous record of the movement of
the items in its inventory. Such a system is essential when the management wants to
maintain effective planning and control over and avoid stockouts. Companies maintaining
inventory items in small quantities with high unit costs usually adopt this method. The
purchase, production, and use of each item of inventory are recorded in detailed subsidiary
records either in units only or both in costs and units.
An example of a perpetual inventory system is a modern shipping and receiving
department. Every box that is delivered is scanned into the accounting system and added to
the inventory balance automatically. Products that are being shipped out to customers are
marked with a bar code and scanned when they leave the shipping dock. This removes
them from the accounting system and decreases the inventory.
As you can see, this modern system updates itself in real-time. No transactions need to be
batch processed like in a periodic inventory system, and all of the reports are always
current.
A retail firm that uses a perpetual inventory system and records the costs of inventory
transactions would prepare the following journal entries:

a. Purchase of goods Merchandise Inventory

Accounts Payable / Cash

b. Purchase returns Accounts Payable / Cash

Merchandise Inventory

c. Sale of Goods Accounts Receivable / Cash

Sales

Cost of Sales

Accounts Receivable /
Cash

d. Sales returns Sales Returns

Accounts Receivable /
Cash

Merchandise Inventory

Cost of Sales

At the end of the accounting period, the inventory is updated, and there is no need to take
up adjusting entries to set up the ending inventory.
The system has the advantage of providing inventory information on a timely basis but
requires the maintenance of a full set of inventory records. For internal control purposes, a
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physical count is made at least once a year, but not necessarily at year-end, to confirm the
inventory balance per book.
Variation between the physical count and the ledger balance may result from errors in
recording, shrinkage, waste, breakage, theft, and other causes, and the cost of the difference
in the two quantities is entered into the accounts to bring the perpetual records into an
agreement with the physical count.
Any excess of the balance of the inventory control account over the physical count, if due to
normal causes, such as shrinkage and breakage, is debited to cost of sales (using the
function of expense method) or may be debited to Inventory Shortage (using either the
function or nature of expense method).
Any balance in the Inventory Shortage is presented as other operating expenses in the
Profit or Loss section of the SCOI. If the excess of the inventory control account over the
physical count is due to theft, a separate loss account is charged.

8.5 Inventory Costing Methods

Paragraph 23 emphasized that the cost of inventories of items that are not ordinarily
interchangeable and goods or services produced and segregated for specific projects shall
be assigned by using specific identification of their individual costs.
The cost of inventories, other than those dealt with in paragraph 23, shall be assigned by
using the first-in, first-out (FIFO) or weighted average cost formula. An entity shall use the
same cost formula for all inventories having a similar nature and use to the entity. For
inventories with a different nature or use, different cost formulas may be justified.
For example, inventories used in one operating segment may have a use to the entity
different from the same type of inventories used in another operating segment. However, a
difference in the geographical location of inventories (or in the respective tax rules), by
itself, is not sufficient to justify the use of different cost formulas.

Specific identification
Specific identification of cost means that specific costs are attributed to
identified items of inventory. This is the appropriate treatment for items that are
segregated for a specific project, regardless of whether they have been bought or
produced.
However, specific identification of costs is inappropriate when there are large
numbers of items of inventory that are ordinarily interchangeable. In such
circumstances, the method of selecting those items that remain in inventories could
be used to obtain predetermined effects on profit or loss.
This method requires a means of identifying the historical cost of each unit of
inventory up to the time of sale.
Within this method, the flow of recorded costs matches the physical flow of
goods, which assures the exact matching of costs and revenues.

Course Module
First In, First Out Method
The "first-in-first-out" or FIFO technique assumes that any item sold was the
oldest item purchased and still held and, therefore, that the items remaining
in inventory at the end of the period are those most recently purchased or
produced. The FIFO method is generally used since it is most likely to approximate
the physical flow of goods sold, resulting in the most accurate measurement of cost
flows. Meanwhile, it will be observed that there is no proper matching of cost
against revenue since the earliest cost is matched to current revenues.
The FIFO periodic and the FIFO perpetual methods result in the same inventory cost
because the goods are assumed to be in the same sequence they were acquired.
Compared with other costing formulas, in periods of rising prices, FIFO reports the
lowest cost of goods sold and the highest amount of ending inventory and net
income.

Weighted Average Cost Method

The weighted average cost method allows you to mingle the costs of similar
items purchased and use weighted averages to measure inventories held,
either on a periodic basis or as each shipment is received. The weighted
average cost method is used in packaged inventory systems that are computer
controlled, although its results are not very different from FIFO in times of relatively
low inflation or where inventory turnover is high. PAS 2 requires that no matter
which cost method is used, it must be applied consistently to all inventories of a
similar nature and use to the entity.
During the period of rising prices, the use of this method produces not such a high
cost of goods sold and not so low net income as the earlier lower costs tend to
stabilize the effect of increasing prices on both cost of goods sold and ending
inventory.
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Cost Formula Sample Problem

To review examples of the application of the cost formulas, refer to below:
The A Merchandising Co. inventory records show the following data:

Transactions Units Unit

Cost
1. Inventory 2,000 P50
2. Purchases 18,000 P52
3. Sales (P130 per unit) 7,000
4. Purchases 6,000 P55
5. Sales (P135 per unit) 16,000
6. Purchases 3,000 P60

Determine the cost of ending inventory and cost of goods sold under the three cost
formula.
Specific Identification Method:
1. Cost of ending inventory
From No.1 2, 000 x P50 P100, 000
From No.4 1,000 x P55 55, 000
From No. 6 3,000 x P60 180, 000
Total cost of ending inventory P335, 000

2. Cost of goods sold

From No.3 7,000 x P52 P364, 000
From No. 5 11,000 x P52 572, 000
5,000 x P55 275, 000
Total cost of goods sold P1, 211, 000

Course Module
FIFO Method:
1. Cost of ending inventory
Most recent costs 3, 000 x P60 P180, 000
Next most recent 3,000 x P55 165, 000
Total cost of ending inventory P345, 000
2. Cost of goods sold
Cost of goods available for sale:
2,000 x P50 P100, 000
18,000 x P52 936,000
6,000 x P55 330,000
3,000 x P60 180,000 1,546,000
Less: Cost of ending inventory 345,000
Total cost of goods sold P1, 869, 000
The FIFO formula assumes that the items of inventory that were purchased
first are sold first, and consequently, the items remaining in inventory at the
end of the period are those most recently purchased.

Weighted Average Method:

1. Cost of ending inventory
Cost of goods available for sale:
2,000 x P50 P100, 000
18,000 x P52 936,000
6,000 x P55 330,000
3,000 x P60 180,000 1,546,000
Divide by: Units available 29,000
Average cost per unit 53.31
Multiply by: Units on hand, end 6,000
Total cost of ending inventory P319, 860
2. Cost of goods sold
Cost of Goods available for sale P1, 546, 000
Less: Ending Inventory 319,860
Cost of goods sold P1, 226, 140
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Glossary
Periodic inventory system: a method of accounting for inventory in which the cost of
goods sold is determined, and inventory is adjusted to the proper balance at the end of the
accounting period. Purchases are recorded in the purchase account, and ending inventory
is determined by a physical count.
Perpetual inventory system: a method of accounting for inventory in which detailed
records of each inventory purchase and sale are maintained. This system provides a
current record of inventory on hand and the cost of goods sold to date.
FIFO: this method probably gives the closest approximation to actual cost flows since it is
assumed that when inventories are sold or used in a production process, the oldest are sold
or used first.
Specific identification: a method of allocating cost to inventory based on identifying and
aggregating all costs directly related to each individual inventory item.
Weighted average: this method, which like FIFO, is suitable where inventory units are
identical or nearly identical, involves the computation of an average unit cost by dividing
the total cost of units by the number of units

References and Supplementary Materials

Books and Journals
1. PAS 2, Inventories
2. Robles, N. S., & Empleo, P. M. (2014). Intermediate Accounting (2014 ed., Vol. 1). Manila,
Philippines.
3. Valix, C. T., Peralta, J. F., & Valix, C. M. (2017). Financial Accounting (2017 ed., Vol.
2).Manila, Philippines.

Online Supplementary Reading Materials

1. 8.2 Perpetual and Periodic Inventory Systems;
http://open.lib.umn.edu/financialaccounting/chapter/8-2-perpetual-and-periodic-
inventory-systems/; 21 October 2017
2. 8.3 The Calculation of Cost of Goods Sold;
http://open.lib.umn.edu/financialaccounting/chapter/8-3-the-calculation-of-cost-of-
goods-sold/; 21 October 2017
3. 8.5 Determining Inventory on Hand;
http://open.lib.umn.edu/financialaccounting/chapter/8-5-determining-inventory-
on-hand/; 21 October 2017
4. 9.1 The Necessity of Adopting a Cost Flow Assumption;
http://open.lib.umn.edu/financialaccounting/chapter/9-1-the-necessity-of-adopting-
a-cost-flow-assumption/; 21 October 2017

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5. 9.2 The Selection of a Cost Flow Assumption for Reporting Purposes;
http://open.lib.umn.edu/financialaccounting/chapter/9-2-the-selection-of-a-cost-
flow-assumption-for-reporting-purposes/; 21 October 2017
6. 9.4 Merging Periodic and Perpetual Inventory Systems with a Cost Flow Assumption;
http://open.lib.umn.edu/financialaccounting/chapter/9-4-merging-periodic-and-
perpetual-inventory-systems-with-a-cost-flow-assumption/; 21 October 2017
7. IAS 2 Inventories; http://www.ifrs.org/issued-standards/list-of-standards/ias-2-
inventories/; 21 October 2017
8. Perpetual inventory system; http://www.accountingformanagement.org/perpetual-
inventory-system/; 21 October 2017
9. Periodic inventory system; http://www.accountingformanagement.org/periodic-
inventory-system/; 21 October 2017
10. First-in, first-out (FIFO) method in perpetual inventory system;
http://www.accountingformanagement.org/first-in-first-out-method-fifo-method-
perpetual/; 21 October 2017
11. First-in, first-out (FIFO) method in periodic inventory system;
http://www.accountingformanagement.org/first-in-first-out-fifo-method-in-periodic-
inventory-system/; 21 October 2017
12. Average costing method; http://www.accountingformanagement.org/weighted-
average-costing-method-of-inventory-valuation/; 21 October 2017
13. Specific identification method; http://www.accountingformanagement.org/specific-
identification-method/;21 October 2017

Online Instructional Videos

1. Chapter 9: Why Does a Company Need a Cost Flow Assumption in Reporting
Inventory?; http://app.wistia.com/embed/medias/5e5e1b75e6;
2. Chapter 8: How Does a Company Gather Information about its inventory;
http://app.wistia.com/embed/medias/e2105b22a3; 21 October 2017
3. Accounting - Inventory, and Cost of Goods Sold;
https://www.youtube.com/watch/MeRusrAouA4 ; 21 October 2017
4. Perpetual Inventory Accounting Vs Periodic Inventory Accounting (Basic Differences);
https://www.youtube.com/watch/s9DQ7aAi-hs/perpetual-inventory-accounting-vs-
periodic-inventory-accounting-basic-differences.html; 21 October 2017
5. Perpetual vs Periodic Inventory System (Financial Accounting Tutorial #29);
https://www.youtube.com/watch/FcRT5-5tYh8/perpetual-vs-periodic-inventory-
system-financial-accounting-tutorial-29.html; 21 October 2017
6. Purchasing inventory: periodic and perpetual journal entries;
https://www.youtube.com/watch/cEXK9nUz5sM/purchasing-inventory-periodic-
and-perpetual-journal-entries.html; 21 October 2017