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Monday, November 2, 2015

Accounting for Inventories: Fundamental Concepts and Principles

Adopted and Summarized from the Philippine Financial Reporting Standards (PFRS)

Nature of inventories 

Inventories include:
1. Assets held for sale in the ordinary course of business (finished goods),
2. Assets in the production process for sale in the
ordinary course of business (work in process), and
3. Materials and supplies that are consumed in production (raw materials).

Whose inventory is it? 

Goods in transit
1. Shipping terms determine when title to goods passes to the purchaser.
      a. FOB (free on board) shipping point - title passes to the buyer with the loading of goods at the point of shipment.
      b. FOB destination - legal title does not pass until the goods are received by the buyer.

2. Goods shipped FOB shipping point belong to the buyer while they are in transit and shOuld normally be included in the buyer's inventory while in transit.
3. Goods shipped FOB destination belong to the seller while in transit and are normally included in the seller's inventory.

Goods on consignment
1. Goods held by the dealer (consignee) for which title is held by the shipper (consignor).
2. Consigned goods are included in the inventory of the consignor.

Conditional sales, installment sales, and repurchase agreements
1. If title to the goods is retained by the seller, the seller may report as an asset the cost of the goods less the purchaser's equity in the goods such as established by collections.
2. Generally however, in the usual case where the possibilities of default or return are low, the seller, in anticipation of contract completion and ultimate passing of title, will recognize the transaction as a regular sale and remove the goods from reported inventory at the time of sale.
3. Repurchase agreements result in no sale being recorded; the inventory is thus not removed from the books, and instead the "seller" records a liability for the proceeds of the "sale", which more accurately in substance is a short-term loan secured by inventory as collateral.
Measurement of inventories (PAS 2) 

Inventories are required to be stated at the lower of cost and net realizable value (NRV).

Cost should include all
1. costs of purchase (including taxes, transport, and handling) net of trade discounts received
2. costs of conversion (including fixed and variable manufacturing overheads) and
3. other costs incurred in bringing the inventories to their present location and condition

Inventory cost should not include:
1. abnormal waste
2. storage costs
3. administrative overheads unrelated to production
4. selling costs
5. foreign exchange difference arising directly on the recent acquisition of inventories invoiced in a foreign currency
6. interest cost when inventories are purchased with deferred settlement terms.

Net realizable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated cost necessary to make the sale.

Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction.

Other measurement bases 

Repossessed merchandise - fair value or best approximation of fair value

Trade-in inventory - net realizable value minus normal profit margin

Commodities of brokers-traders - fair value value less costs to sell. Broker-traders are those who buy or sell commodities for others or on their own account.

Agricultural, forest and mineral products - net realizable value

Agricultural produce at the point a harvest - fair value less costs to sell

Inventory cost formulas

The purpose of an inventory valuation method is to allocate the total inventory cost of good available for sale during the period between cost of goods sold and ending inventory.

Specific identification
1. Required for inventories that are not ordinarily interchangeable and goods or services produced and segregated for specific projects.
2. Using the specific identification method, the original cost of each item is identified, resulting in actual costs being accumulated for the specific items on hand and sold.
3. This method is consistent with the physical flow of goods (though note, it is not required that one has to choose a cost-flow method which corresponds to the actual, underlying physical flow of goods).
4. Though theoretically attractive and useful when each inventory item is unique and has a high cost, it is frequently not economically feasible (even if taking into account advances in technology), particularly where inventory is composed of a great many items or identical items acquired at different times and at different prices.
5. It is subject to manipulation, as seller has the flexibility of selectively choosing specific items of higher/lower-costing inventory depending on particular income goals at the time of sale.
6. It is the least common method observed in practice.

Average cost method
1. This method assigns the same average cost to each unit.
2. Based on the assumption that goods sold should be charged at an average cost, with the average being weighted by the number of units acquired at each price.
3. The average cost method can be supported as realistic and as paralleling the physical flow of goods, particularly where there is an intermingling of identical inventory units.
4. It provides the same cost for similar items of equal utility.
5. It does not permit profit manipulation.
6. Its limitation is that inventory values may lag significantly behind current prices in periods of rapidly rising or failing prices.

First-in, first-out method (FIFO)
1. The first goods purchased are the first goods sold.
2. Using the FIFO method, the accountant computes the cost of goods sold and ending inventory as if the first items purchased are the first to be sold, leaving the most recently purchased items in inventory.
3. This often matches the physical flow of goods.
4. FIFO affords little opportunity fr profit manipulation.
5. FIFO best approximates the current replacement value of ending inventory.

Comparison of methods: cost of foods sold and ending inventory

The average cost method:
1. Differs from the other method in that no assumption is made about the sale of specific units.
2. Rather, all sales are assumed to be of the "average" unit at the average cost per unit.
3. The gross profit margin tends to follow a similar pattern to FIFO in response to changing prices.
4. Generally provides inventory values similar to FIFO values, since average costs are heavily influenced by current costs.

FIFO:
1.In a period of rising prices, matches oldest low-cost inventory with rising sales prices, thus expanding the gross profit margin.
2. In a period of declining prices, oldest high-cost inventory is matched with declining sales prices, thus narrowing the gross profit margin.
3. Inventories are reported on he balance sheet at or near current costs.

Specific identification:
1. Can produce any variety of results depending on which particular units are selected for shipment.

Copyright @PhilCPAReview

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