INVENTORIES

1. Definition of inventories -these are assets that are (1) Held for sale in the normal course of business, or
(2) In the process of production for such sale, or (3) In the form of materials or supplies to be
consumed in the production process or in the rendering of services

2. Classification of inventories:
a. Merchandising business
1. Merchandise inventory or Inventory – goods purchased by a trading company for resale in the
enterprise’s ordinary course of business
b. Manufacturing business:
1. Raw materials inventory- tangible goods purchased for direct use in the manufacture of goods for
sale
2. Work in process inventory – manufactured items requiring further processing
3. Finished goods inventory - manufactured goods completed and ready for sale
4. Manufacturing supplies inventory – items purchased for indirect use in the manufacture of goods for
resale
c. Service provider business
1. Work in process inventory – the cost of the service.

3. Measurement of inventories
A. Initial measurement – inventories are initially measured at historical cost. The cost of inventories
should include all costs of purchase, costs of conversion and other costs incurred in bringing the
inventories to their present location and condition.
1. Cost of purchase includes the purchase price plus all directly attributable costs of purchase such as
import duties and purchase taxes (other than those subsequently recoverable by the enterprise
from the taxing authorities), transport and handling costs and freight insurance minus trade
discounts (if any), rebates (if any) and other similar allowances and goods and service taxes paid.
The cost of inventory also includes the costs of unloading, unpacking and preparing the
merchandise inventory for sale or for raw materials for use.

Costs that relate generally to the purchase, such as salaries of purchasing officers in the
administrative department and all selling costs and administrative overheads of an entity shall not
be included.

2. For manufacturing companies – their finished goods shall include the conversion costs of labor and
production overheads. PAS 2 generally requires application of the full absorption costing principle
to inventories and this will invariably require a systematic allocation of variable and fixed production
overheads that are incurred in converting raw materials into finished product.
Some other costs which are non-production in nature shall also be included in the cost of
inventories if they are incurred in bringing the inventories to their present location and condition.
These costs may include costs of designing products for specific customers and borrowing costs
incurred to bring the inventories to their condition for sale (such as borrowing costs of development
projects of property developers).
3. Cost of agricultural produce harvested from biological assets (in accordance with IAS 41)- are
measured on initial recognition at their fair value less estimated point of sale costs at the point of
harvest.
4. Cost of inventories of a service provider- the labor and other costs of personnel directly engaged in
providing the service, including supervisory personnel and attributable overhead cost excluding any
profit margins or non-attributable overheads.

The following are excluded from the cost of inventories:

a. Abnormal amounts of wasted materials, labor, or other production costs
b. Storage costs, unless these costs are necessary in the production process prior to a further
production stage
c. Administrative overheads that do not contribute to bringing inventories to their present location and
condition, and
d. Selling costs

B. Balance sheet measurement- should be measured at the lower of cost or net realizable value. This
basis is basically an application of the prudence principle, which requires that inventories shall be
carried at cost generally, and if a loss on sale is foreseeable, it shall be written down to the net
realizable amount immediately.

The net realizable value is the net selling price in the course of the business less the estimated cost of
completion and the estimated costs necessary to make the sale. Inventories are usually written down
to net realizable value on an individual basis. However, in the circumstance where items of inventory
relate to the same product line, have similar purposes and uses, and are produced and marketed in the
same geographical area, the group of similar items basis may be more appropriate. Whichever basis is
used shall be consistently applied.
 Materials and other supplies held for use in the production of inventories are not written down below
cost if the finished products in which they will be incorporated are expected to be sold at cost 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 of the materials may be the best available measure of their net
realizable value. (PAS 2 par. 32)

When an item of inventory has been written-down to its net realizable value, and if in subsequent
balance sheet period the same item of inventory still on hand, a new assessment of net realizable value
should be made. If there is clear evidence of an increase in net realizable value because of change in
economic condition the amount of the write-down should be reversed. The amount of reversal should
not exceed the original amount of write-down that was recognized previously.

5. Establishment of the year-end inventory – the periodic system of recording inventories calls for the physical
counting of goods while the perpetual system provides a record of the cost and units remaining as of a
particular date, however, physical counting is necessary to determine the reasonableness of the records.

However, when physical count is not possible or practicable it would be necessary to estimate the value of
the inventory.

Include in the year-end inventory, all item of inventories owns and controlled by the enterprise that are in
good, usable and salable condition with in the enterprise’s premises and adjust the count by including those
items of inventories that are also own and controlled by the entity. Therefore, the following items of
inventories should be considered:
a. Merchandise in transit – if the term of shipment is shipping point, include as inventory of the buyer but
if the term is destination, include as inventory of the seller.
b. Goods on consignment – include as inventory of the consignor.

c. Sales on approval - goods sent on approval to a potential buyer should remain as inventory on the
seller until payment is received for items kept by the buyer
d. Special sales contract:
1. Product-financing (Sale with a buyback agreement) – also known as a park sale because the seller
parks (transfers) its inventory in the buyer’s premises thru sales contract that clearly specifies to
purchase back the same inventory over a specified period of time at a specified amount. Include as
inventory of the seller.

2. Sale but buyer given the right to return – the revenue from the sales transaction shall be
recognized at of sale only if all the following conditions are met: (a) the seller’s price to the buyer is
substantially fixed or determinable at the date of sale, (b) the buyer has paid the seller, or the
buyer is obligated to pay the seller and the obligation is not contingent on resale of the product, (c)
the buyer’s obligation to the seller would not be changed in the event of theft or physical
destruction or damage of the product, (d) the buyer acquiring the product for resale has economic
substance apart from that provided by the seller, (e) the seller does not have significant obligations
for future performance to directly about the resale of the product by the buyer, and (f) the amount
of future returns can be reasonably estimated.

If the above conditions are not met, the seller should continue to recognize the inventory.

3. Installment sales – goods should be considered sold or removed from inventory, even though legal
title has yet to pass to the buyer. Include as inventory of the buyer.
e. Segregated goods – mere segregation does not exclude such inventory, however, if the segregation is
due to sales contract such as special order, such inventory is excluded in the inventory of the seller.

6. Techniques for the measurement of Cost:

The retail method or standard cost method may be used for convenience if the results approximate cost.
Standard costs take into account normal levels of materials and supplies, labor efficiency and capacity
utilization, but a regular review is a requirement and if necessary, revised in the light of current conditions.

The retail method is often used in the retail industry for measuring inventories of large numbers of rapidly
changing items with similar margins for which it is impracticable to use other costing methods. The cost of
inventory is determined by reducing the sales value of the inventory by the appropriate percentage of gross
margin.

7. The cost formulas for inventory:

The cost of inventory that are not ordinarily interchangeable and goods or services produced and
segregated for specific projects shall be assigned using specific identification of their individual costs. The
cost of inventories that are ordinarily interchangeable shall be assigned by using the FIFO or weighted
average method. An entity shall use the same cost formula for all inventories having a similar nature and
use. For inventories with a different nature or use, different cost formulas maybe justified.
8. The financial statements shall disclose
a) the accounting policies adopted in measuring inventories, including the cost formula used
b) The total carrying amount of inventories and the carrying amount in classifications appropriate to the
entity
c) The carrying amount of inventories carried at fair value less cost to sell
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 int the period
f) The amount of any reversal of any write-down that is recognized as a reduction in the amount of
inventories recognized as expense in the period
g) The carrying amount of inventories pledged as security for liabilities