CHAPTER 6

ACCOUNTING FOR MATERIALS

TOPIC OVERVIEW:
This chapter describes the detailed procedures and documents required to account for purchasing,
storing, and issuing materials. This also illustrates how to calculate the cost of materials issued,
how physical inventories of materials are taken and valued, and how inventory adjustments are
recorded. Accounting for production losses such as scrap, spoiled goods, and defective goods are
also covered in this chapter.

LEARNING OBJECTIVES:
After studying this chapter, the students should be able to:
1. Describe the necessary controls over raw materials.
2. Discuss the functions of each department in materials acquisition.
3. Explain the materials purchasing procedures.
4. Compute for the reorder point and economic order quantity.
5. Discuss the documents required to account for purchasing materials.
6. Discuss the necessary documents for the issuance of materials.
7. Calculate the cost of materials issued using different inventory costing methods.
8. Determine the difference between cost and net realizable value.
9. Discuss the application of the rule of cost or net realizable value whichever is lower.
10. Discuss the accounting procedures for production losses.
11. Journalize the transactions regarding production losses.

Materials Control
Certain requirements are essential to an effective internal control system for materials, as follows:
 Materials of the desired quality must be available when needed.
 Correct quantities and types of materials must be on hand at the right time for production
to proceed on schedule.
 Materials must be purchased at the most favorable prices.
 Materials must be protected from loss or theft.
 Risks of spoilage and obsolescence must be minimized.
 Cost of materials handling and storage must be kept to a minimum.

Specific procedures and methods for controlling materials vary from company to company. Size,
organization, and type of goods produced are some of the factors involved. Modern systems of
inventory control include the following features:
 Physical safeguards for receiving, storing, and issuing materials
 Formal procedures for ordering and paying for materials
 Perpetual inventory system to provide an ongoing record of the quantity and value of each
type of materials received and issued and the balance on hand

Organization for Control

Control is achieved in part through an organizational structure that allows specialization at the
same time that it defines authority, fixes responsibility, and provides a system of checks and
balances. To secure the advantages of specialization and know-how, the functions related to
materials acquisition and use are usually subdivided into the following departments:
1. Purchasing Department. This department is charged with the responsibility of placing
orders for materials with reliable suppliers, at the right time and at the right price.
 2. Receiving Department. This department is charged with the inspection of incoming
shipments and verification of the quantities received on order.
3. Storeroom (Stockroom). This department is responsible for protecting materials against
physical deterioration and ensuring that stocks are properly issued.
4. Accounting Department. This department records all transactions in the accounts after
documentary evidences have been supplied by other departments.
5. Cash Department. This department pays all invoices after approval by the accounting
department.
NOTE: Checks and balances (that is, effective internal control) are provided by making each
department independent from the others.

MATERIALS PURCHASING PROCEDURES

The responsibility for purchasing materials is given to the purchasing agent. This person must buy
materials in correct quantities, at the proper time, and at the lowest price. The purchasing agent's
staff is part of the procurement section of the purchasing department. The purchasing staff keeps
informed of various sources of supply, negotiates purchase contracts, prepares purchase orders,
and follows up deliveries. The routine work of the purchasing staff begins with the receipt of a
purchase requisition.

Re-order Point
To determine when an item has reached a level at which it should be reordered, the following
factors should be considered:
 The frequency at which the materials is used
 The length of time it takes for the material to be delivered from the supplier after an order
has been placed. This is known as the lead time.
 The minimum level of materials that should be maintained to ensure that the company does
not run out of materials. This is known as the safety stock.
For example, the reorder point is 200 cans of ink. Jenjen Printers wants to have at least 100 cans
on hand at all times. Since 20 cans are used in production each day and it takes five days to receive
an order, the reorder point is computed as follows:
20 cans (daily usage) × 5 days (lead time) 100
Add: Safety Stock 100
Reorder point 200

Economic Order Quantity (EOQ)

The standard quantity to be ordered varies from item to item. It should reflect the quantity
necessary to get the best price while keeping inventory at an appropriate level to ensure
uninterrupted production. To determine the most advantageous number of units to order, a formula
called the economic order quantity has been developed. It is computed as follows:
2 𝑥 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑚𝑒𝑛𝑡𝑠 𝑥 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑎𝑛 𝑜𝑟𝑑𝑒𝑟
𝐸𝑂𝑄 = √
𝐶𝑜𝑠𝑡 𝑡𝑜 𝑐𝑎𝑟𝑟𝑦 𝑎 𝑠𝑖𝑛𝑔𝑙𝑒 𝑖𝑡𝑒𝑚

If Jenjen printers' cost to order is ₱108, the cost to carry an item in inventory is ₱75; and if the
company requires 5,000 cans of ink during the year, the EOQ is computed as follows:
2 𝑥 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑚𝑒𝑛𝑡𝑠 𝑥 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑎𝑛 𝑜𝑟𝑑𝑒𝑟
𝐸𝑂𝑄 = √
𝐶𝑜𝑠𝑡 𝑡𝑜 𝑐𝑎𝑟𝑟𝑦 𝑎 𝑠𝑖𝑛𝑔𝑙𝑒 𝑖𝑡𝑒𝑚

2 𝑥 5,000 𝑥 108
𝐸𝑂𝑄 = √
75
𝐸𝑂𝑄 = √14,400
 𝐸𝑂𝑄 = 𝟏𝟐𝟎

The determination of the total cost to order and carry materials at various order sizes is shown
below:
Order Size Number of Total Cost to Average Total Cost to Total Cost to
Orders Order ( P108 Inventory ( Carry ( Order and
(5,000÷Order × No. Of Order Size ÷ Average Total Cost to
Size) Orders) 2) Inventory × Carry
P75)

80 63 6,804 40 3,000 9,804

100 50 5,400 50 3,750 9,150

120 42 4,536 60 4,500 9,036

140 36 3,888 70 5,250 9,138

160 32 3,456 80 6,000 9,456

An examination of the table shows that an order of 120 cans produces the lowest total cost. Order
sizes below 120 and above 120 produce higher total costs. This is because, as the order size
increases, the total cost to order decreases and the total cost to carry increases. When the order size
decreases, the opposite happens; the order size decreases and the cost to carry decreases. The EOQ
is the point at which the total of these two costs is at a minimum.

Illustration
 Assume that a company's production requires 400 kilos of materials each day, that it takes
four days to receive these materials from the supplier, and that the company want to have
400 kilos of materials on hand at all times. Compute the reorder point.
 Assume that a company uses 10,000 kilos of materials each year, that the cost to carry a
kilo of material in inventory is P30, and that the cost to place an order is P135. Calculate
the EOQ.
Answers:
400 kilos (daily usage) × 4 days (lead time) 1,600
Add: Safety Stock 400
Reorder point 2,000

2 𝑥 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑚𝑒𝑛𝑡𝑠 𝑥 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑎𝑛 𝑜𝑟𝑑𝑒𝑟

𝐸𝑂𝑄 = √
𝐶𝑜𝑠𝑡 𝑡𝑜 𝑐𝑎𝑟𝑟𝑦 𝑎 𝑠𝑖𝑛𝑔𝑙𝑒 𝑖𝑡𝑒𝑚

2 𝑥 10,000 𝑥 135
𝐸𝑂𝑄 = √
30
𝐸𝑂𝑄 = √90,000
𝐸𝑂𝑄 = 𝟑𝟎𝟎

Purchase Requisition
Once the materials reach the reorder point, the storeroom supervisor completes a purchase
requisition requesting that materials be ordered. A purchase requisition is a properly approved,
written request for materials and is prepared in duplicate. The original copy is sent to the
purchasing department as a request for the materials. The duplicate copy is retained in the
storeroom files. Purchase requisitions must be numbered for easy reference.

Purchase Order
When the purchasing department receives the purchase requisition, source of supply must be
selected. Several suppliers may be asked to quote prices or make bids. In choosing the supplier,
the purchasing agent considers factors such as dependability, quality of material, delivery date and
price.
After choosing the supplier, the purchasing agent prepares a purchase order. The purchase order
is a written authorization to the supplier to ship the specified material. The purchase order is
prepared in five copies to be distributed as follows:
 Suppliers - as an authority to deliver the materials
 Storeroom - as a notification that the materials requested are on order
 Receiving Department - as an authorization to accept an incoming shipment
 Purchasing Department (2 copies) - for file in unfilled order
NOTE: Effective internal control procedures require that all purchase orders be prenumbered. At
the end of each month, the cost accountant verifies that all numbered purchase orders either have
been sent to suppliers or are on hand. This ensures that purchase orders are used only for authorized
purposes.

Receiving Report
The materials are received by the receiving clerk from the supplier. The receiving clerk is
responsible for unpacking them, checking quantities, and transferring them to the storeroom. The
receiving clerk, upon receipt of the materials, takes out his copy of the purchase order and
compares its content with the shipment. After counting and inspecting the materials, the clerk
prepares a receiving report. The receiving report shows all details of the shipment including
comments on the condition of the materials received.

The receiving report is usually prepared in quadruplicate. The original and one copy are sent to
the purchasing department, where they are compared with the purchase order and the supplier's
invoice. One copy accompanies the materials to the storeroom for comparison with the purchase
order and entry in the storeroom records. The storeroom supervisor signs the final copy to confirm
that the materials have reached the storeroom. This copy is then kept in the receiving clerk's
permanent file.

The storeroom clerk records the receipt of materials in a subsidiary ledger, the materials ledger,
by making an entry on the appropriate materials ledger card. Materials are also called stores, hence,
the materials ledger is sometimes called stores ledger. A separate card is kept for each type of
material.

Comparing Documents
When the invoice is received from the supplier, it is sent to the purchasing department. Normally,
the invoice will arrive before the shipment to allow the verification of the purchase order before
the shipment is accepted. The purchasing department then compares the supplier's invoice
(purchase invoice) with the purchase order and the receiving report to make sure that:
 Materials ordered have been received in good condition and these are listed only in the
invoice.
 Terms, unit prices, shipping charges and other details are in accordance with order
specifications
 Computations are correct.
Recording the Voucher
When the voucher and supporting documents reach the accounting department, the voucher clerk
checks all the documents if they are properly approved and signed. This double-checking is another
part of an effective internal control system. In verifying the account distribution against the
purchase order, the voucher clerk enters the purchase in the voucher register. (Vouchers are
prenumbered for control purposes). The purchase of direct materials or indirect materials is entered
as a debit in the Raw Materials column and as a credit in the Vouchers Payable column. After the
entry is made in the voucher register, the voucher is sent to the cash department for filing in the
unpaid vouchers file.

Paying the Voucher

Before the due date, the voucher is removed from the unpaid vouchers file. A staff in the Cash
Department prepares a check for the amount in the voucher. The check is then recorded in the
check register. The voucher is marked "Paid" by using a rubber stamp and enters the check number
and date paid on the voucher. The check is sent to the supplier, and the voucher is returned to the
voucher clerk. The voucher clerk records the check number and date of payment in the voucher.
The voucher, with invoice and other supporting documents, is then filed in the paid vouchers file.

Bill of Materials
To avoid the problem of insufficiency of materials needed, the production manager may prepare a
bill of materials when a new sales order is received. The bill of materials lists all materials needed
on the job and the date they will be needed. This record enables the storeroom supervisor to check
the quantity of material on hand to ensure that sufficient material is available. To avoid costly
delays, the purchasing agent may be required to buy more materials in advance. The bill of
materials used by some companies usually contains columns for unit costs and total costs. Such a
bill may later be used as a materials requisition.

Debit and Credit Memorandums

Damaged or defective materials are immediately returned to the supplier. A note on the return, is
made on the receiving clerk's copy of the purchase order and on the receiving report. The
purchasing agent then prepares a debit memorandum. The debit memorandum is a notice to the
vendor of a deduction from the invoice for the cost of the returned materials.
If the supplier ships more materials than were ordered and the materials are not needed, the
purchasing agent normally authorizes their return. However, if they are retained for future use and
the materials have not been included in the supplier's invoice, the purchasing agent prepares a
credit memorandum for the additional cost. The purchase order may be amended to include the
extra materials shipped instead of issuing a credit memorandum.

CONTROL PROCEDURES
Because inventory represents a major investment to a firm, adequate control is necessary. The
level of raw materials inventory is based on scheduled production, which is in turn based on sales
forecasts. Five control procedures are commonly used as follows:
 Order Cycling. Materials are reviewed on a regular cycle, and orders are placed to maintain
a desired inventory level.
 Min-max method. Minimum and maximum inventory levels are determined. Reordering -
is done when the minimum level is reached.
 Two-bin method. This is used for inexpensive items. When the first bin is empty, an order
is placed. The second bin provides coverage until the order is received.
 ABC plan. This is used with a wide variety of items having different values. The more
expensive items receive more frequent review and closer monitoring.
A items — most expensive items, usually few on hand
B items — moderately priced items and moderate quantity on hand
 C items — inexpensive items, generally kept in large quantities.
 Automatic order system. An order is automatically placed when the inventory reaches a
predetermined level. This system works best when used with a computer.

STORING MATERIALS
Admission to the storeroom area is to be restricted to the employees under the immediate
supervision of the storeroom supervisor. The storeroom supervisor is responsible for the protection
of materials in the storeroom, and for identification of the materials. Each type of material is
assigned a number, indicating the type of materials and its location. Materials are stored in a
systematic manner in bins, on racks, or on shelves. Attached to each bin or rack is a bin tag. The
bin tag is an informal record showing the quantities of the materials received, issued, and on hand
at all times.

ISSUANCE OF MATERIALS
Materials Requisition
No materials are issued from the storeroom without a material requisition. The material requisition
is prepared in duplicate by the department head or job supervisor. The requisition indicates the
quality, material number description, and job number to which the materials are to be charged.
Upon receipt of the materials requisition, the storeroom supervisor issues the materials and makes
the necessary notations on the requisition. One copy is filed as a receipt, and the second copy is
given to the storeroom clerk.

Materials Ledger
The storeroom clerk computes and records the cost of the materials issued in the Issued section of
the materials ledger card, computes the new quantity on hand, and records it in the Balance section.
A material ledger card is kept for each type of material on hand. Each card serves as a perpetual
inventory record. The material ledger is a subsidiary ledger which is verified against the Materials
account in the general ledger. At the end of accounting period, the balance on the materials ledger
card should equal the balance of the Materials account.

Materials Requisition Journal

After recording the requisition in the related materials ledger card, the requisition is forwarded to
the cost clerk, who journalizes the transaction in a special journal, the materials requisition journal,
so that the effect of the issuance will be reflected in the general ledger cost accounts.
Job Cost Sheet
The cost clerk's next step is to post the information from the requisition to the Materials section of
the job cost sheet. Only direct materials are posted in Job Cost Sheet to charge a particular job.

Departmental Overhead Analysis Sheet

All indirect manufacturing expenses such as indirect materials are posted from a requisition for
such materials to the Indirect Materials section of the departmental overhead analysis sheet.

Materials Internal Control

The internal control procedures for storing and issuing materials should reflect the following
principles:
 Admittance to the storage area should be restricted.
 Materials ledger cards covering all receipts and issues should be maintained.
 Each type of material should be clearly identified, stored and carefully protected while in
storage.
 Materials should be issued only upon proper written authorization.
 The accounting system should permit a periodic check of the materials ledger against the
balance of the Materials account.
  Different persons should be involved in storage and issuance operations.

COSTING PROBLEM
To illustrate the problem of costing materials inventory, assume that the materials ledger card
shows unit prices of materials purchases ranged from ₱100 to ₱175. Assume further that 150 units
of materials are issued and 25 units are on hand at the end of the month.
The problems which have to be resolved are:
 What would be the value of the 150 units issued?
 What would be the value of the 25 units on hand?

It is important to determine the valuation of these units as this will have an effect on the company's
profit or loss for the accounting period. If other factors remain the same, the higher the ending
inventory valuation, the lower the cost of goods sold resulting in greater profits or smaller losses.
On the other hand, the lower the ending inventory valuation, the higher the cost of goods sold,
resulting in a smaller profit and greater losses.

INVENTORY COSTING METHODS

When the inventory items are few and are not ordinarily interchangeable, specification
identification technique may be used. Specific identification of cost means that specific costs are
attributed to identify items of inventory.

When there are large numbers of items of inventory that are usually interchangeable, perpetual
inventory system is usually used. Under the system, unit costs and total costs should be computed
each time materials are received or issued. The primary basis of inventory valuation is cost. Since
unit prices vary from one purchase to another, an assumption should be made about the flow of
costs. There are three methods to determine the cost of ending inventory to be reported. These
methods are as follows:
 First in, first out (FIFO) method. Under this method, the first materials purchased (the
oldest or earliest) are the first materials to be used. The materials on hand are therefore
assumed to be the last one purchased.
 Last in, first out (LIFO) method. Under this method, the last materials purchased (the most
recent) are the first materials to be used. Then the materials on hand are assumed to be the
first one purchased.
 The moving average method. In this method all the costs are commingled and an average
cost is computed with each new purchase and assigned to materials issued and on hand.

Illustration
To illustrate the application of these methods, assume the following transactions relating to
Material IJ-4, ink jet:
May 1: The beginning balance on hand is 150 units, costing P 150 each.
May 6: 150 units are purchased under Purchase Order 08 at P 155 each.
May 10: 180 units are issued for use per Requisition 10.
May 21: 150 units are purchased on Purchase Order 9 for P 156.
May 23: 160 units are issued for use on Requisition 16.
May 25: 10 units are returned to the storeroom as noted on Returned Materials Report 3. These
units had been issued on May 10 for use on Requisition 10.
First In, First Out Method

The following should be noted in the Materials Ledger Card above:

1. The price for each issue is individually computed.
2. The issue of 180 units on May 10 includes all the 150 units from the beginning inventory
(150 units at P 150 each) plus 30 of the units purchased on May 6 (30 units at P 155 each).
3. The issue of 160 units on May 23 includes the remaining 120 units from the May 6
purchases (120 units at P 155 each) plus 40 units purchased on May 21 (40 units at P 156
each).
4. The 10 excess units returned to the storeroom on May 25 are priced at P 155 because they
relate to the issue of May 10 and are assumed to be part of the group of 30 units. The job
finally will be charged only with the costs that would have been charged if the correct
quantity had been issued on May 10 (150 units at P 150 each + 20 units at P 155 each).
5. Of the 120 units on hand on May 15, all except 10 units returned are priced at the most
recent cost, P 156 per unit.

Arguments in favor of the first in, first out method are that it is easier and less costly to use because
FIFO requires less recordkeeping than the LIFO; that it reflects the actual physical flow of goods;
and that the inventory shown in the balance sheet is more relevant because it includes the most
recent costs and is- an estimation of replacement cost.

On the other hand, a strong argument against the first in, first out method is that it does not match
current costs against current sales revenue, because under this method, the ending inventory is
priced at the most recent costs, resulting the cost of goods sold to be priced at the oldest costs.
Therefore, when the net income is computed, the cost of goods sold that is deducted from sales
revenue does not include the most recent costs. This can lead to distortions of net income in period
of rising prices since the costs of goods sold is understated.
Moving Average Method

Neither the FIFO nor the LIFO method is entirely satisfactory in valuing inventories. Therefore,
the moving average method may be used as a compromise. Under this method, the units and cost
of each new purchase are added to the balances already on hand when the purchase is received,
and a new average cost per unit is computed. When materials are issued, they are charged out at
this average cost until another purchase is received or a return is recorded, when a new average
cost per unit is computed. Materials Ledger Card under the Moving Average Method showing
different values from FIFO and LIFO is shown below.

The following should be noted in the Materials Ledger Card above:

 The 180 units issued on May 10 are priced at P 152.50 per unit (the unit price appearing in
the Balance section on the line above).
 The 160 units issued on May 23 are priced at P 154.44 per units (P 16,988.40 divided by
270 units).
 The 10 excess units returned to the storeroom on May 25 are priced at P 152.50, the price
on May 10.
 The 120 units remaining in stock on May 25 valued at P 154.27, the current average price.

One advantage of the moving average method is that it is relatively simple to apply, especially
with computers. Moreover, the weighted average method produces inventory valuation that
approximates current value if there is a rapid turnover of inventory.
The argument against the weighted average method is that there may be a considerable lag between
the current cost and inventory valuation since the average unit cost involves early purchases.
Philippine Accounting Standard (PAS) No. 2 (Inventories) prescribes the use of the FIFO and the
Moving Average Methods to compute the cost of inventories. LIFO is no longer permitted under
PAS 2.

VALUATION AT COST OR NET REALIZABLE VALUE, WHICHEVER IS LOWER

PAS No. 2 provides that inventories shall be measured at the lower of cost and net realizable value.
Net realizable value (NRV) refers to the estimated selling price in the ordinary course of business
less the estimated cost of completion and the estimated cost necessary to make the sale. When the
net realizable value has declined below the original cost, inventory should be valued at net
realizable value instead of cost.
The rule of cost or net realizable value, whichever is lower may be applied as follows:
Lower of Cost or Net Realizable Value by Item
Under this plan, the cost and the net realizable value of each item in inventory are determined.
After which, the basis of valuation (the lower figure) is identified for each item and is multiplied
by the quantity on hand to obtain the value of the lower of cost or NRV. The lower valuation figure
for each item is used to compute the value of the inventory as a whole, as shown below:
Description Quantity Cost per NRV per Valuation Lower of
Unit Unit Basis Cost or NRV
Material X 100 P100 P110 Cost P10,000
Material Y 200 150 120 NRV 24,000
Inventory P34,000
Valuation

Lower of Total Cost or Total NRV

Another method of valuation is to calculate the total cost and the total NRV of the entire inventory.
The lower of this total is then used as inventory valuation as illustrated below:
Description Quantity Cost per NRV per Total Cost Total NRV
Unit Unit
Material X 100 P100 P110 P10,000 P11,000
Material Y 200 150 120 30,000 24,000
P40,000 P35,000
Inventory P35,000
Valuation

APPLICATION OF THE RULE OF COST OR NET REALIZABLE VALUE,

WHICHEVER IS LOWER
Materials held for use in the production of inventories is not written down below cost if the finished
products in which they will be incorporated are expected to be sold at or above cost. However,
when a decline in the price of materials indicates that the cost of the finished products exceeds net
realizable value, the materials are written down to net realizable value. In such circumstances, the
replacement cost (market price) of the materials may be the best available measure of their net
realizable value.
To adjust inventory to lower value, two approaches may be used when perpetual inventory records
are kept, as follows:
 Each materials ledger card is adjusted to show the new unit values.
 A valuation account is set up to reduce the total value of the inventory to net realizable
value. The individual materials ledger cards are not changed and continue to reflect cost.

Under the first approach, each materials ledger card is adjusted according to the lower of cost or
NRV. The cards are then totaled to determine the new valuation. The loss is recorded by a general
journal entry debiting an account called Loss on Inventory Write-down and crediting Materials.
After posting this entry in the general ledger, the total of the materials ledger cards will be equal
to the balance of the Materials account in the general ledger. This method results in an increase on
the cost of goods sold for the difference between the cost and the NRV and does not show the
inventory loss as a separate item on the' income statement.
Under the second approach, inventory is recorded at cost and any loss on inventory write-down is
accounted for separately by debiting a loss account, Loss on Inventory Write-down and crediting
a valuation account Allowance for Inventory Write-down.
In subsequent years, the allowance account is adjusted upward or downward depending on the
difference between the cost and net realizable value of the inventory at year-end.
Preferably, the second approach is used in order that the effects of write-down and reversal of
write-down can be clearly identified.
To illustrate how this valuation technique is applied, assume the following data for 2017, the first
year of operations and 2018:
December 31, 2017 December 31, 2018
Inventory at Cost, per Materials Ledger Card P360,000 P420,000
Inventory at Net Realizable Value 348,000 416,000

On December 31, 2017, an adjusting entry is made to set up the valuation account for P12,000, the
difference between the inventory cost and NRV as follows:
Loss on Inventory Write-down 12,000
Allowance for Inventory Write-down 12,000

NOTE: The Loss on Inventory Write-down is treated as an addition to Cost of Goods Sold in the
Income Statement while the Allowance for Inventory Write-down is a deduction from the
Inventory account in the Balance Sheet.
At the end of the later periods, the allowance account will again be adjusted to reflect the inventory
value at that time. Continuing our illustration, at the end of 2017, the allowance account of P
12,000 should be reduced to P4,000, which is the difference between the cost of P420,000 and the
NRV of P416,000. To reduce the balance of the allowance account from P 12,000 to P4,000, the
allowance account is debited by P8,000, the difference between these amounts. This adjustment is
recorded as follows:
Allowance for Inventory Write-down 8,000
Recovery from Inventory Write-down 8,000

NOTE: The Recovery from Inventory Write-down is a deduction from Cost of Goods Sold.
The allowance account balance of P4,000 at the end of 2018 will again be treated as a deduction
from the inventory at cost on the balance sheet.
If the net realizable value exceed the Cost of the inventory, the valuation account is no longer
necessary. An entry would be made to close the Allowance for Inventory Write-down by debiting
the account for its current balance and crediting Recovery from Inventory Write-down. The
inventory would be shown in the statement of financial position at cost.

CUTOFF DATE
To prepare reliable financial statements, accuracy in computing the costs of materials, work in
process, and finished goods inventories is important. For ending inventories to be valued as
accurately as possible, all costs related to the inventory should be determined and recorded. To
ensure that these costs are recorded, a cutoff date is established for including transactions in a
specified period. Usually the cutoff date is the last day of the company's fiscal year or the end of
an interim period such as a calendar quarter or month.

All transactions associated with items in the ending inventories are included in the current period.
Transactions affecting events after the cutoff date either are not included or are deferred.

If a company operates on the calendar-year basis, December 31 becomes the annual cutoff date for
those transactions that are to be included in the current year. For example, all invoices for materials
received on or before December 31 must be recorded in the materials ledger and posted to the
materials ledger cards. The same principle applies in accounting for labor and overhead
transactions.

ACCOUNTING FOR PRODUCTION LOSSES IN A JOB ORDER COSTING SYSTEM

In a job order costing system, production losses that happen in the manufacturing process include
cost of scrap materials, spoiled goods (spoilage) and reworking defective goods. In most cases,
these losses originated from lack of quality control and should be prevented if not eliminated at
all.
A system must be designed to record these losses, so that the unit cost figures will be as accurate
as possible. The accounting technique varies according to the type of loss involved.

ACCOUNTING FOR SCRAP

Scrap is the residue of manufacturing process. These are materials left over when making a
product.

The accounting procedures for scrap will depend on the following:

1. When should the value of scrap be recognized in the accounting records, at the time scrap is
produced or at the time scrap is sold?
2. How should revenues from scrap be accounted for?

Illustration:
Tan Lumber Company accumulates sawdust and that the scrap from a job has a net sales value of
₱2,000.

Recognizing Scrap at the Time of its Sale

If the value of scrap is low or immaterial, the entry would be:
Accounts Receivable (or Cash) 2,000
Scrap Revenues 2,000
To record sale of scrap

In case the value of scrap is material and it is sold quickly after it is produced, the accounting
depends on whether the scrap is attributable to a specific job or common to all jobs.
If the scrap is attributable to a specific job, the entry would be:
Accounts Receivable (or Cash) 2,000
Work in Process Inventory 2,000
To record sale of scrap

If the scrap cannot be identified with a specific job, the journal entry is as follows:
Accounts Receivable (or Cash) 2,000
Manufacturing Overhead Control 2,000
To record sale of scrap

Recognizing Scrap at the Time of its Production

The journal entries would be:
Scrap Inventory 2,000
Work in Process Inventory 2,000
To record scrap attributable to specific job returned to storeroom

Scrap Inventory 2,000

Manufacturing Overhead Control 2,000
To record scrap common to all jobs returned to storeroom

Accounts Receivable (or Cash) 2,000

Scrap Inventory 2,000
To record sale of scrap

NOTE: Sometimes scrap is sold for more or less than the value at which it is recorded. Any
difference between the sales price and the recorded value is treated as an adjustment to the account
that was originally credited (WIP or MOC). For example,
 Accounts Receivable (or Cash) 1,500
Work in Process Inventory 500
Scrap Inventory 2,000
To record sale of scrap at less than it’s recorded value

NOTE: Sometimes scrap is reused as direct material rather than sold as a scrap. In this case, the
entries would be
Materials 2,000
Manufacturing Overhead Control (if common to all jobs) 2,000
To record scrap returned to storeroom

Work in Process Inventory 2,000

Materials 2,000
To record reuse of scrap

Waste, as distinguished from scrap materials, refers to amount of raw materials left over from a
production process for which there is no further use.

ACCOUNTING FOR SPOILED GOODS

Goods that have been damaged through imperfect machining or processing is called spoiled goods.
Illustration
Assume that Job 888 calls for the production of 200 painted office tables. These tables were put
into production and costs accumulated to date are as follows:
Materials P 456,000
Direct Labor 240,000
Applied overhead (150% of DL cost) 360,000
Total costs charged to Job 888 P 1,056,000
Unit cost (P1,056,000 ÷ 200) P 5,280

Suppose that ten tables are spoiled because the lumber used was improperly cured. These spoiled
tables may be sold as seconds at its net disposal value of P3,000 each (a loss of P2,280 per table).
The journal entries under two assumptions are:

Spoilage Attributable to a Specific Job (Due to customer’s specifications)

1.
Spoiled Goods Inventory 30,000
Work in Process Inventory 30,000
To remove estimated disposal value of spoiled goods from WIP (10 × P3,000)
2.
Finished Goods Inventory 1,026,000
Work in Process Inventory 1,026,000
To record the cost of the 190 completed tables (P1,056,000 - P30,000)
If Job 888 is sold with a 30% mark up on cost. The entry would be:
3.
Accounts Receivable (or Cash) 1,333,800
Sales 1,333,800
To record sales (P1,026,000 × 130%)
4.
Cost of Goods Sold 1,026,000
Finished Goods Inventory 1,026,000
To record cost of goods sold
5.
Accounts Receivable (or Cash) 30,000
Spoiled Goods Inventory 30,000
To record sale of spoiled goods at net disposal value

Spoilage Common to All Jobs (Due to Internal Failure)

The following are the required journal entries:
1.
Spoiled Goods Inventory 30,000
Manufacturing Overhead Control 22,800
Work in Process Inventory 52,800
To record estimated sales value of spoiled goods and charged loss to Manufacturing Overhead
Control
2.
Finished Goods Inventory 1,003,200
Work in Process Inventory 1,003,200
To record the cost of the 190 completed tables (P1,056,000 - P52,800)
3.
Accounts Receivable (or Cash) 1,304,160
Sales 1,304,160
To record sales (P1,003,200 × 130%)
4.
Cost of Goods Sold 1,003,200
Finished Goods Inventory 1,003,200
To record cost of goods sold

NOTE: If the spoilage is due to internal failure or common to all jobs, unit cost remains the same
while if it is attributable to a specific job, unit cost changes.

ACCOUNTING FOR DEFECTIVE GOODS

Units of production that fail to meet production standards but can be brought up by adding more
materials, labor, and overhead are generally referred to as defective goods.
Rework costs are the additional costs required to bring defective goods up to standard.

Illustration
Consider the data from the previous illustration. Assume that the ten spoiled tables are reworked.
The journal entry to record the total costs of the spoiled goods before considering rework costs is:
Work in Process Inventory 52,800
Materials 22,800
Payroll 12,000
Applied Manufacturing Overhead 18,000
To record cost of 10 tables

Assume that the ten spoiled tables are reworked. The additional costs of reworking the tables equal
P9,500 (comprising P2,000 direct materials, P3,000 direct labor, and P4,500 manufacturing
overhead)

Rework Costs Charged to a Specific Job

Work in Process Inventory 9,500
Materials 2,000
Payroll 3,000
 Applied Manufacturing Overhead 4,500
To record rework costs of 10 tables
Finished Goods Inventory 62,300
Work in Process Inventory 62,300
To record costs of 10 tables transferred to finished goods (P52,800 + P9,500)

 If the tables are sold with a 30% mark up on cost. The entries would be:
Accounts Receivable (or Cash) 80,990
Sales 80,990
To record sales (P62,300 × 130%)

Cost of Goods Sold 62,300

Finished Goods Inventory 62,300
To record cost of goods sold

Rework Costs Charged to All Jobs

Manufacturing Overhead Control 9,500
Materials 2,000
Payroll 3,000
Applied Manufacturing Overhead 4,500
To transfer costs of reworked units to Manufacturing Overhead

 Since the rework costs were charged to Manufacturing Overhead Control, the total Work
in Process of Job 888 did not increase, hence, the cost remains at P1,056,000.
Finished Goods Inventory 1,056,000
Work in Process Inventory 1,056,000
To record total costs of Job 888

 If the 200 tables are sold after the reworking of the 10 tables at 130% of cost, the entry is:
Accounts Receivable (or Cash) 1,372,800
Sales 1,372,800
To record sales of 200 tables (P1,056,000 × 130%)

Cost of Goods Sold 1,056,000

Finished Goods Inventory 1,056,000
To record cost of goods sold

Reference:
Guerrero, P. (2018) Cost Accounting Principles and Procedural Application, Manila,
Philippines: GIC Enterprises and Co., Inc.