ACC214A

Intermediate Accounting 1

INVENTORY COST FORMULAS, LCNRV AND FS DISCLOSURES

INVENTORY COST FORMULAS
One of the major objectives of inventory accounting is the determination of costs of inventories
recognized as expense when the related revenues are recognized. This is important for the
proper determination of periodic income. Proper determination of such costs may be obtained
by selecting an appropriate cost formula from the following:

1. Specific Identification – Specific costs are attributed to identified items of inventory.

Accordingly, cost of sales represents the actual costs of the specific items sold
while ending inventory represents the actual costs of the specific items on hand.
Records should be maintained hat enables the entity to identify the cost and the
movement of each specific inventory.

PAS 2 paragraph 23 provides that this method is appropriate for inventories that
are segregated for a specific project and inventories that are not ordinarily
interchangeable.

2. First-In, First-Out (FIFO) – It is assumed that inventories that were purchased or

produced first are sold first, and therefore unsold inventories at the end of the
period are the most recently purchased or produced.

Under this formula, cost of sales represents costs from earlier purchase while the
cost of ending inventory represents costs from the most recent purchase.

Accordingly, in a period of inflation or rising prices, the FIFO method would result
to the highest net income. However, in a period of deflation or declining prices,
the FIFO method would result to the lowest net income.

3. Weighted Average – Under this formula, cost of sales and ending inventory are
determined based on the weighted average cost of beginning inventory and all
inventories purchased or produced during the period. It is computed by dividing
the total cost of goods available for sale by the total number of units available for
sale.

This method is relatively easy to apply and approximates current value if there is
a rapid turnover of inventory.

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4. Last-in, First-Out (LIFO) – The standard does not permit the use of LIFO as a formula in
measuring the cost of inventories. This method assumes that the goods last
purchased are first sold and consequently, the goods remaining in the ending
inventory are those first purchased or produced.

Under this formula, cost of sales represents costs from recent purchase while the
cost of ending inventory represents earlier or old prices.

Accordingly, in a period of inflation or rising prices, the LIFO method would result
to the lowest net income. However, in a period of deflation or declining prices,
the LIFO method would result to the highest net income.

ILLUSTRATION
ABC Corp. is a wholesaler; the activity for product “A” during August is show below:

Date Transaction Units Unit cost Total cost

1-Aug Inventory 2,000 P 36.00 P 72,000
7 Purchase 3,000 37.20 111,600
12 Sales 4,200
13 Sales return 600
21 Purchase 4,800 38.00 182,400
22 Sales 3,800
29 Purchase 1,900 38.60 73,340
30 Purchase return 300 38.60 (11,580)
Total Goods available for sale P 427,760

Requirements: Compute for (a) ending inventory and (b) cost of goods sold under the following
cost formulas:
1. FIFO – A. periodic
B. perpetual
2. Weighted average – A. periodic
B. perpetual

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1.A FIFO – periodic

Under the periodic inventory system, there is no record for each movement in inventory.
Thus, the formula below will be used.
In Units
Beginning inventory 2,000
Net purchases
(3,000 + 4,800 + 1,900 - 300) 9,400
Total goods available for sale 11,400 units
Goods sold (7,400)
Ending inventory 4,000 units

Using the concept of FIFO, the cost of ending inventory will be based from the most recent
purchases. The ending inventory in units is allocated as follows:

Units Unit cost Total cost

Ending inventory allocated as follows:
From Aug 29 net purchases
(1,900 - 300) 1,600 P 38.60 P 61,760
From Aug 21 purchase
(4,000 - 1600) 2,400 38.00 91,200
Ending inventory 4,000 units P 152,960

Cost of goods sold is then computed as follows:

Total cost
Beginning inventory P 72,000
Add: Net purchases
(111,600 + 182,400 + 73,340 - 11,580) 355,760
Less: Ending inventory at cost (152,960)
Cost of goods sold P 274,800

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1.B FIFO – perpetual

Date Transaction Units Unit cost Total cost

1-Aug Beginning Inventory 2,000 P 36.00 P 72,000
7 Purchase 3,000 37.20 111,600
7 Inventory Balance 5,000 P 183,600
12 Net sales (4,200 -600)
Allocation:
fom beg. Inventory (2,000) 36.00 (72,000)
from Aug 7 purchase (1,600) 37.20 (59,520)
12 Inventory Balance 1,400 P 52,080
21 Purchase 4,800 38.00 182,400
21 Inventory Balance 6,200 P 234,480
22 Sales (3,800)
Allocation:
from Aug 7 purchase (1,400) 37.20 (52,080)
from Aug 21 purchase (2,400) 38.00 (91,200)
22 Inventory Balance 2,400 P 91,200
29 Purchase (1,900 - 300) 1,600 38.60 61,760
Ending Inventory 4,000 P 152,960

It is important to note that ending inventory and cost of goods sold under the FIFO method are the
same both the periodic and perpetual inventory system. Only the recording and record keeping differs
between the two systems when using this method of costing.

2. A Weighted Average – Periodic

Under the periodic inventory system, the average cost is computed at the end of the period
accounting for all purchases and purchase returns. The weighted average unit cost is computed
as follows:
Total goods available for sale in pesos
Weighted average cost =
Total goods available for sale in units

To illustrate using the given details:

In Units In Pesos
Beginning inventory 2,000 P 72,000
Purchases 7-Aug 3,000 111,600
21-Aug 4,800 182,400
29-Aug 1,900 73,340
30-Aug (300) (11,580)
Total goods available for sale 11,400 427,760

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Total goods available for sale in pesos

Weighted average cost =
Total goods available for sale in units
427,760
Weighted average cost =
11,400 units

Weighted average cost = 37.52 / unit

The average cost per unit is then used to compute for the ending inventory and cost of goods sold.

Total goods available for sale in units 11,400

Less: Sold units net of returns
(4,200 - 600 + 3,800) (7,400)
Ending inventory in units 4,000
Multiplied by average unit cost P 37.52
Ending inventory in pesos P 150,080

Total goods availabe for sale in pesos P 427,760

Less: Ending inventory (150,080)
Cost of goods sold P 277,680

2. A Weighted Average – Perpetual (Moving Average)

Since the perpetual method keeps continuous records and accounts for cost of goods sold for
each sale, a new average unit cost is computed after every purchase, thus it is called moving
average. To differentiate, the periodic method has one average unit cost for one product during
the period while under the perpetual method, the average unit cost changes after each purchase.

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Date Transaction Units Unit cost Total cost

1-Aug Beginning Inventory 2,000 P 36.00 P 72,000
7 Purchase 3,000 37.20 111,600
7 Inventory Balance 5,000 P 183,600
Moving average unit cost = Total cost / Total units
Moving average unit cost = P 183,600 / 5,000 units
Moving average unit cost = P 36.72
12 Sales (4,200) 36.72 (154,224) Cost of goods sold for each sale is
recorded using the computed average
Sales returns 600 36.72 22,032 unit cost
12 Inventory Balance 1,400 P 51,408
21 Purchase 4,800 38.00 182,400
21 Inventory Balance 6,200 P 233,808
Moving average unit cost = P 233,808 / 6,200 units A new average unit cost is computed
after every purchase, thus it is called
Moving average unit cost = P 37.71
moving average

Cost of goods sold will now be computed

22
Sales (3,800) 37.71 (143,298) using the new average cost per unit
22
Inventory Balance 2,400 P 90,510
29
Purchase 1,900 38.60 73,340
30
Purchase returns (300) 38.60 (11,580)
30
Inventory Balance 4,000 P 152,270
Ending Inventory 4,000 P 152,270
Moving average unit cost = P 152,270 / 4,000 units
Moving average unit cost = P 38.07

Notes:

 A new average unit cost is computed by dividing total goods available for sale in pesos by
the total goods available for sale in units after every purchase. The computed moving
average unit costs are used in computing for costs of goods sold in subsequent sales.
 Sales returns are reverted back to inventory at the average unit cost used to record the
related sale.
 Purchase returns are deducted from total goods available for sale at the unit cost of the
related purchase, in this case, the unit cost of the August 29 purchase (i.e., P 38.60).
 Since each movement in inventory is recorded in one account, the Company’s records
would show ending inventory amounting to P 152,270. Beginning inventory plus all
purchases (net of purchase returns), less all sales (net of sales returns) in pesos to get the
ending inventory in pesos.

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 Cost of goods sold for the period is derived by adding up the cost for each sales
transaction (net of sales returns). In this example:

Aug 12 sales P 154,224

Aug 12 sales returns (22,032)
Aug 22 sales 143,298
Total cost of goods sold P 275,490

 Alternatively, cost of goods sold may also be computed this way:

Total goods available for sale (already given in the problem) P 427,760
Less: Ending inventory (152,270)
Total cost of goods sold P 275,490

LIFO - PAS 2 prohibits the use of LIFO, below illustration shows how LIFO is applied to differentiate
from the other methods. LIFO is the exact opposite of FIFO. Under LIFO, items of inventory that
were purchased or produced first are sold last. Consequently, the cost of ending inventory is
based on the cost of the beginning inventory and earliest purchases.

Units Unit cost Total cost

Ending inventory allocated as follows:
From Beginning inventory 2,000 P 36.00 72,000
From Aug 7 purchase
(4,000 - 2,000) 2,000 37.20 74,400
Ending inventory 4,000 units P 146,400

Total goods available for sale (already given in the problem) P 427,760
Less: Ending inventory (146,400)
Total cost of goods sold P 281,360

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Intermediate Accounting 1

MEASUREMENT OF INVENTORIES (LOWER OF COST AND NET REALIZABLE VALUE)

PAS 2, paragraph 9, provides that inventories shall be measured at the lower of cost and net
realizable value, also known as LCNRV.

Net realizable value (NRV) is the “estimated selling price in the ordinary course of business less
the estimated cost of completion and the estimated costs necessary to make the sale.” (PAS 2.6)

Selling price xx
Less: Estimated cost to complete (xx)
Less: Estimated cost to sell (xx)
Net realizable value xx

Measuring inventories at the lower of cost and NRV is in line with the basic accounting concept
that an asset shall not be carried at an amount that exceeds its recoverable amount.
The cost of an inventory may exceed its recoverable amount if:
a. the inventory is damaged
b. becomes obsolete
c. prices have declined, or
d. the estimated costs to complete or to sell the inventory have increased.
In these circumstances, the cost of the inventory is written-down to NRV. The amount of write-
down is recognized as an expense.

Write-down of inventory
If the cost of an inventory exceeds its NRV, the inventory is written down to NRV, the lower
amount. The excess of cost over NRV represents the amount of write-down. If the cost of an
inventory is lower than its NRV, no write-down is necessary.
Write-downs of inventories are usually carried out on an item by item basis, although in some
circumstances, it may be appropriate to group similar items. It is not appropriate to write down
inventories on the basis of their classification (e.g., finished goods or all inventories of an
operating segment).
Write-downs of inventories are normally charged to cost of goods sold. However, material write-
downs and those arise from abnormal losses, such as theft, obsolescence, and casualties are
charged to loss.

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Illustration:
ABC Co. buys and sells products A & B. The following unit costs are available for the inventory as
of December 31, 2019.

Product A Product B
Number of units 2,000 3,000
Purhcase cost per unit P 100 P 200
Delivery cost from supplier 20 30
Estimated selling price 150 250
Selling costs 22 40
General and administrative 15 18

Requirements:
a. Compute for the valuation of the inventories in ABC’s December 31, 2019 statement of
financial position.
b. Determine the amount of write-down.

Solution:
a. Valuation of inventories in ABC’s December 31, 2019 statement of financial position

Product A Product B
Cost:
Purchase cost per unit P 100 P 200
Delivery cost from supplier (freight-in) 20 30
Cost per unit P 120 P 230
Multiply by: Number of units 2,000 3,000
Total cost P 240,000 P 690,000

Net realizable value:

Estimated selling price 150 250
Selling costs (22) (40)
NRV per unit P 128 P 210
Multiply by: Number of units 2,000 3,000
Total NRV P 256,000 P 630,000

Lower of cost or NRV P 240,000 P 630,000

Inventory December 31, 2019 P 240,000 P 630,000

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b. The amount of write-down is computed as follows:

Product A Product B
Total cost (recorded per books) P 240,000 P 690,000
Should be balance of Inventory (LCNRV) P 240,000 P 630,000

Write-down (Cost less LCNRV) P - P 60,000

Notes:

 First solve for the cost of the inventories, this will represent the amount recorded in the
books. Then, solve for the net realizable value (NRV).
 Compare both amounts on a per item basis.
a. For product A, the cost of P 240,000 is lower than the NRV so we will use the cost as
the value of the inventory. Therefore, no write-down is necessary for product A.
b. However, for product B, the NRV of P 630,000 is lower than the recorded cost of
P 690,000, thus the inventory will be written down to equal the NRV. Amount of write-
down will be the difference between the recorded cost and the NRV. This write-down
is the deduction from recorded cost to equal the NRV.

Accounting for Inventory Write-down

1. Allowance / loss method – any loss on inventory write-down is accounted for separately
by using a valuation account called “allowance for inventory write-down”. This is
also called the loss method since a loss account is debited, journal entry will be:

Dr. Loss on inventory write-down xx

Cr. Allowance for inventory write-down xx
The loss on inventory write-down is included in the computation for cost of goods
sold. In this method, inventory is recorded at cost and the allowance account will be
deducted from the inventory account (contra-asset account) to present the net value
of inventory at LCNRV. This allowance account is adjusted during year-end to reflect
the LCNRV.
Increase in allowance:
Dr. Loss on inventory write-down xx
Cr. Allowance for inventory write-down xx

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Decrease in allowance:
Dr. Allowance for inventory write-down xx
Cr. Gain on reversal of inventory write-down xx
However, the gain is only limited to the balance of the allowance account. The gain
on reversal of inventory write-down is presented as a deduction from cost of goods
sold.

2. Direct method or cost of goods sold method – any loss on inventory write-down is not
accounted or recorded separately. The lower of cost or net realizable value is
recorded directly and in effect, any loss on inventory write-down or gain on the
reversal of inventory write-down is already included in the cost of goods sold.
The allowance method is preferred over the direct method since the movement in the allowance
account shows the loss on inventory write-down and any gain on reversal. This complies with the
requirement of PAS 2, paragraph 36, which states that the amount of any inventory write-down
and any reversal of inventory write-down should be disclosed.
Illustration:
Using the information in the previous illustration, the entries to recognize the inventory write-
down under the two methods are shown below:

1. Allowance method
Dr. Inventories (at cost) P 930,000
Cr. Income Summary P 930,000

Dr. Loss on inventory write-down P 60,000

Cr. Allowance for inventory write-down P 60,000

The allowance account will be deducted from the inventory account to present the net value of
inventory at LCNRV.

Inventories (at cost) P 930,000

Allowance for inventory write-down ( 60,000)
Inventories (LCNRV) P 870,000

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2. Direct method
Dr. Inventories (at LCNRV) P 870,000
Cr. Income Summary P 870,000
The amount of LCNRV is directly recorded as the amount of inventory.

Continuing Illustration:
On December 31, 2020, the total cost of inventory is P 1,500,000 and the net realizable value is
P 1,480,000.
1. Allowance method

Cost- Dec 31, 2020 P 1,500,000

NRV - Dec 31, 2020 1,480,000
Required allowance - Dec 31, 2020 20,000
Less: allowance balance-Dec 31, 2019 60,000
Decrease in allowance P (40,000)

Dr. Allowance for inventory write-down P 40,000

Cr. Gain on reversal of inventory write-down P 40,000

2. Direct method
Dr. Inventories (at LCNRV) P 1,480,000
Cr. Income Summary P 1,480,000

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Additional Illustration:

Inventory - January 1
Cost P 5,000,000
Net Realizable Value 4,500,000
Net Purchases 20,000,000
Inventory - December 31
Cost 6,000,000
Net Realizable Value 5,300,000

1. Allowance method
Using the allowance method, beginning and ending inventories are reported at cost to
get the cost of goods sold before write-down, then any loss on allowance is added or gain
on reversal is deducted to reflect the total cost of goods sold.

Inventory - Jan 1 at cost P 5,000,000

Add: Net Purchases 20,000,000
Goods available for sale 25,000,000
Inventory - Dec 31 at cost (6,000,000)
Cost of goods sold before inventory writedown P 19,000,000
Loss on invetory write-down - current year 200,000
Cost of goods sold after inventory writedown P 19,200,000

Required allowance - Ending (Dec 31)

(6,000,000 - 5,300,000) P 700,000
Required allowance - Beginning (Jan 1)
(5,000,000 - 4,500,000) 500,000
Increase in allowance - loss on write-down P 200,000

2. Direct method

Under the direct method, both beginning and ending inventory are reported at lower of
cost or net realizable value. (LCNRV).

Inventory - Jan 1 at LCNRV P 4,500,000

Add: Net Purchases 20,000,000
Goods available for sale 24,500,000
Inventory - Dec 31 at LCNRV (5,300,000)
Cost of goods sold after inventory writedown P 19,200,000

Note that the amount for cost of goods sold should be the same under both methods.

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Purchase Commitments
Purchase commitments are obligations of the entity to acquire certain goods sometime in the
future at a fixed price and fixed quantity.
A contracting party under a noncancelable purchase commitment cannot cancel the contract
without incurring penalty. Thus, the buyer has to accept future delivery even if the goods
promised to be purchased decline in value. In such case, the buyer recognized a loss on purchase
commitment. When the prices subsequently increase, the buyer recognizes gain on purchase
commitment. However, the gain should not exceed the loss on purchase commitment previously
recognized.
The recognition of a loss in purchase commitment is an adaptation of the measurement at the
lower of cost or net realizable value.

Illustration:
The contract purchase price is P 500,000 and the replacement cost at year-end is P 450,000. The
market decline of P 50,000 is recorded as follows:
Dr. Loss on purchase commitment P 50,000
Cr. Estimated liability for purchase commitment P 50,000
The loss on purchase commitment is classified as other expense and the estimated liability for
purchase commitment is classified as current liability.

Scenario 1: Further decrease/decline in price

When the actual purchase is made in the subsequent period and the current replacement cost
drops further to P 420,000, the journal entry to record the purchase and payable is:

Dr. Purchases P 420,000

Loss on purchase commitment 30,000
Estimated liability for purchase commitment 50,000
Cr. Accounts payable P 500,000
An additional loss of P 30,000 is recorded to reflect the decline in value from P 450,000 to
P 420,000.

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Scenario 2: Increase in price but still lower than the contracted/agreed purchase price
If the replacement cost of the purchase commitment is P 480,000 when the actual purchase is
made, the journal entry to record the purchase is:

Dr. Purchases P 480,000

Estimated liability for purchase commitment 50,000
Cr. Accounts payable P 500,000
Gain on purchase commitment 30,000
A gain of P 30,000 is recorded to reflect the increase in value from P 450,000 to P 480,000.
The gain on purchase commitment is classified as other income.

Scenario 3: Increase in price to more than the contracted/agreed purchase price

If the price increased to P 600,000 when the actual purchase was made, the journal entry to
record the actual purchase is:

Dr. Purchases P 500,000

Estimated liability for purchase commitment 50,000
Cr. Accounts payable P 500,000
Gain on purchase commitment 50,000
The purchase is still recorded at P 500,000 because the cost is lower than the net realizable value
of P 600,000. The gain recorded should only be limited to the balance of loss on purchase
commitment previously recorded.

FINANCIAL STATEMENT DISCLOSURES

The financial statements shall disclose the following information for inventories:
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.
Common classifications of inventories are merchandise, production supplies, goods in
process and finished goods.

c. The carrying amount of inventories carried at fair value less cost of disposal.
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 during the period
f. The amount of reversal of write-down that is recognized as income
g. The circumstances or events that led to reversal of a write-down of inventories.
h. The carrying amount of inventories pledged as security for liabilities.

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