PAS 2 – Inventories

Objectives:
a. To prescribe the accounting treatment for inventories, primarily the
amount of cost to be recognized as and asset and carried forwards
until the related revenues are recognized;
b. To provide guidance on the determination of cost and its subsequent
recognition as an expense, including any write-down to net realizable
value; and
c. To provide guidance on the cost formulas that are used to assign costs
to inventories
Inventories not totally within PAS 2
a. Financial Instruments
b. Biological assets related to agricultural activity and agricultural
produce at the point of harvest
Inventories not within PAS 2 – Measurement
a. Inventories held by producers of agricultural and forest products,
agricultural produce after harvest, and minerals and mineral products.
b. Inventories held by commodity brokers who measure their inventories
at fair value less costs to sell
However, the requirement of PAS 2 with respect to recognition,
disclosure, and presentation continues to apply
Inventories are assets
a. Held for sale in the ordinary course of business (Finish Goods
Inventory)
b. In the process of production for such sale (Work in Process Inventory)
c. In the form of materials or supplies to be consumed in the production
process or in the rendering of services (Raw Materials Inventory)
Entities that consider accounting for inventories
a. Merchandising Entities – has a single inventory account usually
entitled merchandise inventory. These are goods on hand that are
purchased for resale
b. Manufacturing Entities - has three inventory accounts: Raw Materials
Inventory, Work in Process Inventory, and Finished Goods Inventory.

RECOGNITION of Inventories
Inventories are recognized as an ASSET when
- Owned by the entity regardless of location
- Determination of legal title or ownership of inventory will not matter
on day to day transactions but critical on cut-off date to properly
determine the inventory value.
Inventories are recognized as an EXPENSE when
- Inventories are sold
- When the inventories are written down to net realizable value and all
losses of inventories
- Inventories that are allocated to other asset accounts wherein the
expense are recognized during the useful life of the asset
Ownership
- For inventories on FOB (free on board) destination, ownership title will
transfer to the buyer upon receiving the item. Seller is responsible for
payment of the shipment
- For inventories on FOB shipping point, ownership title will transfer to
the buyer upon shipment or when in the possession of the carrier.
Buyer is responsible for the payment of the shipment
- For inventories shipped FAS (free alongside). The seller is responsible
for all expenses and risks in delivering the items alongside the vessel
while the buyer is only responsible for the costs only of loading and
shipment. Thus, title is only passed when the carrier is in possession of
the items.
- For inventories shipped CIF (cost, insurance, freight) the buyer agrees
to pay in lump sum the cost, insurance, and freight charges. Transfer of
title and risk of loss will be passed to the buyer upon the delivery of
the items to the carrier
- For inventories delivered ex-ship, transfer of title to the buyer happens
only after the goods are unloaded, before that seller bears all risks and
expenses.
- For inventories under consignment the ownership is given to the
consignor (owner of the goods) since all inventories are owned by
entities regardless of location
- In case of buyers given the exceptional right to return the merchandise
acquired, the seller must continue to include the items in its
measurement and valuation of inventory.
MEASUREMENT
Accounting Systems
 - Periodic Inventory System requires a physical count of goods. A cost
formula is used to quantify the cost of inventories. The cost of goods
sold is computed by adding beginning inventory an net purchases less
ending inventory
- Perpetual Inventory System requires the maintenance of record and
monitors the balance of inventory on hand by recording all sales and
purchases as they occur. Physical count is only needed to verify the
perpetual records and to satisfy regulations.
Inventories are generally measure at the lower of cost and net realizable
value and not to its fair value or current replacement cost like the PPE
because inventories are held only for a short time period.
Cost
Comprises of:
- Cost of purchase includes the purchase price, import duties and
irrecoverable taxes, handling and other costs directly attributable to
the acquisition of finished goods, materials and services. Trade
discount, rebates and other similar items are deducted in the costs of
purchase
- Cost of conversion are costs associated in converting the raw materials
into finished goods
 Fixed production overhead are indirect costs of production that
remain relatively constant regardless of the volume of
production.
 Variable production overhead are indirect costs of production
that vary directly or near directly, with the volume of production.
- Other costs incurred in bringing the inventories to their present
location and condition
Normal Capacity – is the capacity of production expected to achieve on
average over a number of periods or seasons under normal circumstances
Joint Process - is a type of production process that may result in more than
one product being produced simultaneously. The cost will be allocated on a
rational and consistent basis. The byproduct is measured at net realizable
value and the amount will be deducted to the join/main product.
Agricultural produce harvested from biological assets are measured
according to their fair value less the costs to sell at the point of harvest.
Costs Excluded from the costs of inventories and are an expense in the
period they are incurred:
 - Abnormal amounts of wasted materials, labor, or other production
costs
- Storage costs, unless the costs are necessary in the production process
before further production
- Administrative overheads that do not contribute to bringing inventories
to their present location and condition
- Selling costs
- Difference between the purchase price for normal credit terms and the
amount paid interest expense
- Foreign currency difference
Measurement Cost Techniques
- Standard Cost Method takes into account the normal levels of materials
and supplies, labor efficiency, and capacity utilization.
- Retail method is used in the retail industry for measuring inventories of
large numbers of rapidly changing items with similar margins when
using other costing methods are impractical
Formulas for Computation of Costs
- Specific Identification Method is used for costing of inventories that are
not ordinarily interchangeable and goods or services produced for
specific projects, whether bough or produced. This method should not
be used when there is a large number of ordinarily interchangeable
inventory items.
- First in – First out (FiFo) assumes that the inventory that were
purchased or produced first are sold first.
- Weighted Average in this method the cost of each item is determined
from the weighted average cost of similar items at the beginning and
during the period. Calculations can be on a period basis or as each
shipment is received.
Companies may use different cost formulas if the inventories are different
in nature or use. The difference in the geographical location of inventories
does not justify using different cost formulas.

Net Realizable Value vs. Fair value

 -

NET REALIZABLE VALUE -

Net realizable value is the
estimated selling price under
FAIR VALUE -
the ordinary course of the
While Fair Value is the price at
business less estimated costs
which an orderly transaction
of completion and estimated
to sell the same inventory in
costs necessary to make the
the principal market for the
sale.
inventory would take place
- Is an entity-specific Value
between market participants
- Based on the
at the measurement date
most reliable eviddence
- Is not an entity Specific
available at the time the
Value
estimations are made, of the
amount the inventories are
expected to realize

Considerations taken in estimating NRV

- The fluctuations of price or cost directly relating to events occurring
after the end of the periods to the extent that such events confirm
conditions existing at the end of the period
- The purpose for which the inventory is held

Inventory Writedown
- Inventories are measured at lower of cost and NRV. If cost is lower than
NRV, there will be no adjustment as the inventory amount is usually
recorded at cost already. Otherwise, it NRV is lower that the cost, an
adjustment must be made by reducing the cost to its NRV value as
assets should not be carried in excess of amounts expected to be
realized from their sale or use.
Instances when inventories are not recoverable and must be written down
from cost to NRV
- If inventories are damaged
- If inventories have become wholly or partially obsolete
- If the selling prices of inventories have declined
- If the estimated cost of completion or the estimated costs to be
incurred to make the sale have increased
 Inventories are written down item by item or in an individual basis
however in some circumstances it is appropriate to group similar or
related items before writing it down.
Methods of inventory writedown
- Direct method or Cost of Goods Sold method does not recognize the
loss on inventory writedown which is the difference between Cost and
NRV, thus the ending inventory will be automatically recorded at NRV
- Allowance Method or Loss method records the ending inventory first at
cost and the amount will be reduced by recognizing a Loss on
inventory writedown
Materials and other supplies held for use in production of inventories are
not written down below cost if the finished product in which they will be
incorporated are expected to be sold at or above cost
Inventories that are previously written down can be reversed if the
circumstance that caused the write down no longer exists or there is a
clear evidence that the NRV will increase. This reversal in only limited to
the amount of original write down
Inventories are generally classified as current assets and are presented a
online item in the statement of financial position. The details of the
inventories are shall be shown in the notes to financial statements
Necessary disclosures for inventories
- The accounting policies adopted in measuring inventories, including
the cost formula used
- The total carrying amount of inventories and the carrying amount in
classification appropriate to the entity
- The carrying amount of inventories carried at fair value less cost to sell
- The amount of inventories recognized as an expense during the period
- The amount of any write down of inventories recognized as an expense
in the period
- 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
- The circumstances or events that led to the reversal of a write down of
inventories
- The carrying amount of inventories pledged as security for liability