of Financial 1

PAS 2 Inventories

Learning Objectives
I. Define inventories.
2. Measure inventories and apply the cost formulas.
3. State the accounting for inventory write-down and the reversal thereof.

Introduction
PAS 2 prescribes the accounting treatment for inventories. PAS 2 recognizes that a primary issue in the accounting for
inventories is the determination of cost to be recognized as asset and carried forward until it is expensed. Accordingly, PAS 2
provides guidance in the determination of cost of inventories, including the use of cost formulas, and their subsequent
measurement and recognition as expense.

PAS 2 applies to all inventories except for the following: Assets accounted for under other standards

a. Financial instruments (PAS 32 and PFRS 9); and

b. Biological assets and agricultural produce at the point of harvest (PAS 41).

Assets not measured under them lower of cost or net realizable value (NRV) under PAS 2

a. Inventories of producers of agricultural, forest, and mineral products measured at net realizable value in
accordance with well-established practices in those industries.

b. Inventories of commodity broker-traders measured at fair value less costs to sell.

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Inventories
Inventories are as assets:

a. Held for sale in the ordinary course of business (finished good5.

b. In the process of production for such sale (work in process); or

c. In the form of materials or supplies to be consumed in thf production process or in the rendering of services (rm materials
and manufacturing supplies).
(PAS 2.6)

Examples of inventories:
a. Merchandise purchased by a trading entity and held for resale.
b. Land and other property held for sale in the ordinary course of business.

c. Finished goods, goods undergoing production, and raw materials and supplies awaiting use in the production process by a
manufacturing entity.

Ordinary course of business refers to the necessary, normal or usual business activities of an entity.

Measurement
Inventories are measured at the lower of cost and net realizable value•

Cost
The cost of inventories comprises the following:
a. Purchase cost — this includes the purchase price (net of trad e discounts and other rebates), import duties, non-refundable or
non-recoverable purchase taxes, and transport, handling and other costs directly attributable to the acquisition of th e
inventory.
b. Conversion costs — these refer to the costs necessary in converting raw materials into finished goods. Conversion costs
include the costs of direct labor and producti011 overhead.
c. Other costs necessary in bringing the inventories 'to their present location and condition,
The following are excluded from the cost of inventories and are expensed in the period in
which they are incurred:
a. Abnormal amounts of • wasted materials, labor or other production costs;
b. Storage costs, unless those costs are necessary in the production process before a further production
stage (e.g., the storage costs of partly finished goods may be capitalized as cost of inventory, but the
storage costs of completed goods are expensed);
c. Administrative overheads that do not contribute to bringing inventories to their present location and
condition; and
d. Selling costs. (PAS 2.16)

When a purchase transaction effectively contains a financing element, such as when payment of the purchase
price is deferred, the difference between the purchase price for normal credit terms and the amount paid is recognized as
interest expense over the period of the financing.

Illustration:
Entity A acquires inventories and incurs the following costs:
Purchase price, gross of trade discount 100,000
Trade discount 20,000
Non-refundable purchase tax, not included in the purchase price above 5,000
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Freight-in (Transportation costs) 15,000

Commission to broker 2,000
Advertisement costs 10,000

Requirement: How much is the cost of the inventories purchased?

Solution:
Purchase price, gross of trade discount 100,000

Trade discount (20,000)

Non-refundable purchase tax 5,000

Freight-in (Transportation costs) 15,000

Commission to broker 2,000

Total cost of inventories 102,000

The advertisement costs are selling costs. These are expensed in the period in which they are incurred.

Cost Formulas
The cost formulas deal with the computation of cost of inventories that are charged as expense when the related revenue is
recognized (i.e., 'cost of sales' or 'cost of goods sold') as well as the cost of unsold inventories at the end of the period that are
recognized as asset (i.e., 'ending inventory'). PAS 2 provides the following cost formulas:

1. Specific identification — this shall be used for inventories that are not ordinarily interchangeable (i.e., those that are
individually unique) and those that are segregated for specific projects.
Under this formula, 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.
For example, if an inventory with a serial number of "ABC-123" costing PIO,948.67 is sold, the amount
charged to cost ofsales is also PIO,948.67. If that inventory remains unsold, the amount included in ending inventory is
also PIO,948.67.
In this regard, records should be maintained that enables the entity to identify the cost and movement of each
specific inventory.

Specific identification, however, is not appropriate when inventories consist of large number of items that are
ordinarily interchangeable. In such cases, the entity shall choose between formulas 2 and 3 below.

2. First-in, First-Out (FIFO) — Under this formula, 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 those most recently purchased or produced.
Accordingly, cost of sales represents costs from earlier purchases while the cost of ending inventory
represents costs from the most recent purchases.
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3. Weighted Average — Under this formula, cost ofsales and ending inventory are determined based on the weighted
average cost of beginning inventory and all inventories purchased or produced during the period. The average may be
calculated on a periodic basis, or as each additional purchase is made, depending upon the circumstances of the entity.

The cost formulas refer to "cost flow assumptions," meaning they pertain to the flow of costs (i.e., from inventory
to cost of sales) and not necessarily to the actual physical flow of inventories. Thus, the FIFO or Weighted Average can be used
regardless of which item of inventory is physically sold first.
Same cost formula shall be used for ail inventories with similar nature and use. Different cost formulas may be
used for inventories with different nature or use. However, a difference in geographical location of inventories, by itself, is
not sufficient to justify the use of different cost formulas. (PAS 2.26)
PAS 2 does not permit the use Of a last-in, first out (LIFO) cost formula.

Illustration:
Entity A, a trading entity, buys and sells Product A. Movements in the invento of Product A durin the eriod are as follows:
Date Transaction units unit cost Total cost

Jan. 1 Beginning inventory 100

7 Purchase 300 12 3,600
12 Sale 320
21 Purchase 200 14 2,800

Case 1: FIFO Compute for the ending inventoty and cost of sales using the FIFO cost formula.

Step 1: Compute for ending inventory in units.

Step 2: Compute for ending inventory at cost.

Step 3: Compute for cost of sales.

Date Transaction Units Total cost

unit cost
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Jan. 1. Beginning inventory 100 p 10

7 Purchase 300 12
21 Purchase 200 14
Total goods availablefor sale 600 3,600
Less: Ending inventory (280) 2,800
Cost o sales 320 7,400
(3,760)

P3,640

Case 2.1: Weighted Average

Compute for the ending inventory and cost of sales using the Weighted Average cost formula. The average is calculated on a
periodic basis.
Inventories

Step 1: Compute for the total goods available for sale in units and at cost.
Transaction units unit cost Total cost
Date
Jan. 1 Beginning inventory 100 91,000
7 Purchase 300 12 3,600
21 Purchase 200 2,800
Total oods available or sale 600

p7,400

Step 2: Compute for the weighted average unit cost.

Formula:
Weighted ave. cost Total goods available for sale (TGAS) in pesos
Total oods available for sale (TGAS) in units

Weighted average unit cost = P7,400 + 600 = P12,33

Step 3: Compute for ending inventory at cost.

Ending inventory (at cost) 93,452.40

Ending
Step inventory
4: Compute (incost
for units)
of -sales.
see computation in Case 1
280
Weighted average unit cost
912.33
Total goods available for sale (at cost)

Less: Ending inventory (at cost) (3,452.40)

Cost of sales
P3,947.60
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Case 2.2: Weighted Average

Compute for the ending inventory and cost of sales using the Weighted Average cost formula. The average is calculated as
each additional purchase is made (also called 'moving average').
cost

600.00
4,600.00

2,800.00

Moving ave. cost = TGAS at cost + TGAS in units

= (P4,600 * 400) = PI 1.50

Cost ofsales = 320 units sold x PI 1.50 moving ave. cost = P3,680

Net realizable value (NRV)

Net realizable value is "the estimated selling price in the ordinary course of business less the estimated costs of
completion and the estimated costs necessary to make the sale." (PAS 2.6)
NRV is different from fair value. "Net realizable value refers to the net amount that an entity expects to
realize from the sale of inventory in the ordinary course of business. Fair value reflects the price at which an orderly
transaction to sell the same inventory in the principal (or most advantageous) market for that inventory would take
place between market participants at the measurement date. The former is an entity-specific value; the latter is not. Net
realizable value for inventories may not equal fair value less costs to sell." (PAS 2.7)
Measuring inventories at the lower ofcost 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, for example, the inventory is damaged,
becomes obsolete, prices have declined, or 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 expense.
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If the NRV subsequently increases, the previous writedown is reversed. However, the amount of reversal shall
not exceed the original write-down. This is so that so that the new carrying amount is the lower of the cost and the revised
NRV.
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).
Raw materials inventory is not written down below cost if the finished goods in which they will be incorporated
are expected to be sold at or above cost. If, however, this is not the case, the raw materials are written down to their NRV. The
best evidence of

NRV for raw materials is replacement cost.

Illustration 1:
Information on Entity A's inventories is as follows:
Product A Product B

100,000 200,000
Cost
Estimated selling price 140,000 220,000

Estimated costs to sell 20,000 30,000

Requirement:

Compute for the valuation of Products A and B in statement of financial position.

Lower 100,000 190,000

Amount of write-down 10,000
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Analysis:
Product A need not be written-down because its cost is lower than its NRV.

Product B shall be written-down by because its cost exceeds its NRV (200,000 cost less 190,000 NRV).

The total inventory to be shown in the statement of financial position is P290,000 (100,000 for Product A + 190,000 for

Product B). The PIO,OOO write-down is recognized as expense in profit or loss.

Continuation:
Assume that in a subsequent period, the NRV of Product B increases as follows:
Product B
Cost 80,000
Net realizable value 100,000
Analysis:
The increase is P20,OOO (100,000 — 80,000). However, the amount of reversal that Entity A can recognize is limited to

i.e., the amount of the original write-down.

The amount of inventory to be shown in the statement of financial position is P90,000 (80,000 cost + 10,000 reversal).

Illustration 2:
Information on Entity A's inventories is as follows:
Raw materials Finished goods
Cost 60,000 100,000
Replacement cost/NRV 50,000 120,000

Requirement: Compute for the valuation of the inventories in Entity A's statement of financial position.

Answer:
2160,000 total cost (60,000 + 100,000). The raw materials need not be written-down to replacement cost because the NRV of
the finished goods exceeds the cost.
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Recognition as an expense
The carrying amount of an inventory that is sold is charged as expense (i.e., cost of sales) in the period in which the related
revenue is recognized. Likewise, the write-down of inventories to NRV and all losses of inventories are recognized as
expense in the period the write-down or loss occurs.
"The amount of any reversal of any write-down of inventories, arising from an increase in net realizable value,
shall be recognized as a reduction in the amount of inventories recognized as an expense in the period in which the reversal
occurs." (PAS 2.34)
Inventories that are used in the construction of another asset is not expensed but rather capitalized as cost of
the constructed asset. For example, some inventories may be used in constructing a building. The cost of those inventories is
capitalized as cost of the building and will be included in the depreciation of that building.

Disclosures
a. Accounting policies adopted in measuring inventories, including the cost formula used;
b. Total carrying amount of inventories and the carrying amount in classifications appropriate to
the entity;
c. Carrying amount of inventories carried at fair value less costs to sell;

d. Amount of inventories recognized as an expense during the period;

e. Amount of any write-down of inventories recognized as an expense in the period;
f. Amount of any reversal of write-down that is recognized as a reduction in the amount of inventories recognized as
expense in the period;
g. Circumstances or events that led to the reversal of a writedown of inventories; and
h. Carrying amount of inventories pledged as security for liabilities. (PAS 236)
Summa
PROBLEMS
PROBLEM 1: TRUE OR FALSE
1. According to PAS 2, inventories are measured at net realizable value.

2. According to PAS 2, net realizable value and fair value less costs to sell are the same.

3. Storage costs of part-finished goods may be included in the cost of inventory, but not storage costs of finished goods.

4. Trade discounts are added to the cost of inventories.

5. Import duties, freight-in and non-refundable purchase taxes form part of the cost of inventories.

6. Raw materials inventory is not written down below cost if the finished goods to which they will be incorporated are
expected to be sold at or above cost.
7. Reversals of inventory write-downs may exceed the amount of the original write-down previously recognized.

8. The cost of factory management is included in the cost of inventory.

9. The maintenance costs of a machine used in the manufacturing process are not included in the cost of inventories.

10. If the cost of an inventory is P8 while its net realizable value is P6, the amount of write-down is P2.

PROBLEM 2: MULTIPLE CHOICE

I. Which of the following is not included as part of the cost of an inventory?

a. Purchase cost, net of trade discount

b. Direct labor cost

c. Freight in
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d. Selling cost

2. Conversion costs do not include which of the following costs? a. Direct materials
c. Production
b. Direct labor d. All of these are included

3. These deal with the computation of cost' of sales and cost of ending inventory.

a. net realizable value c. cost formulas

b. perpetual inventory system d. costing

4. Entity A's inventories consist of items that are ordinarily interchangeable. According to PAS 2, which of the
following cost formulas shall Entity A use?

a. Specific identification c. Weighted Average

b. FIFO d. b orc

5. Which of the following statements is incorrect regarding the use of cost formulas?

a. PAS 2 requires the use of specific identification of costs for inventories that are not
ordinarily interchangeable.
b. Entities may choose between the FIFO and the Weighted Average cost formulas for inventories that are
ordinarily interchangeable.

c. Different cost formulas may be used for each class of inventory with dissimilar nature and use.

d. Only one formula shall be used for all inventories regardless of differences in their nature and use.

6. Entity A's buys and sells two types of products — Product A and Product B. Items of Product A are not ordinarily
interchangeable while items of Product B are ordinarily interchangeable. According to PAS 2, what cost formula
shall Entity A use? (specific identification 'SI', first-in, first out 'FIFO', weighted
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average 'WA')
Product A Product B
FIFO or WA

b. Sl,FIFOorWA Sl, FIFO or WA

c. FIFO

7. Entity A is a distributor of Oil. Entity A's inventories are ordinarily interchangeable. Entity A maintains a specific level
of inventory such that the latest purchases are the ones dispatched first to the sales outlets. Consequently, the latest
purchases are sold first. Which of the following cost formulas shall be used by Entity A?

a. Last-in, First-out (LIFO) c. Weighted Average

b. FIFO

8. In which of the following instances is a write-down of inventories to net realizable value may not be required?

a. the inventories are damaged

b. the inventories have become wholly or partially obsolete

c. the estimated costs to complete or costs to sell have increased

d. selling prices are rising because demand has increased

9. Write-downs of inventories to their net realizable value are recognized

a. in profit or loss c. directly in equity

b. in other comprehensive income d. any of these

10. Inventories are uSuaIIy written-down to net realizable value

a. on an item by item basis.

b. on the basis of their classification, for example, as all finished goods, all work in process and all raw materials
and supplies.

c. every year.

d. on the basis of their relative stand-alone selling prices.

PROBLEM 3: FOR CLASSROOM DISCUSSION
Cost of inventories
1. Which of the following is incorrect regarding the determination of the cost of an inventory?

a. Import duties and non-refundable taxes are included.

b. Insurance costs while the inventory is in transit are included.

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c. Purchase price, gross of trade discounts, is included.

d. Purchase price, net of trade discounts, is included.

Cost formula
Information on Entity A's inventory of Product A is as follows:
a. 116,495 324,300

b. 118,685 205,615

c. 116,495 207,805
units unit Cost Total Cost
Balance at Jan. I Purchases: 3,000 P19.55 P 58,650

Jan. 6 10,200 21.50 219,300

Jan. 26 Sales: 2,250 20.60 46,350

Jan. 7 2,700

Jan. 31 7,200

2. How much are the ending inventory and cost of sales under the FIFO cost formula?
Ending inventory Cost ofsales
a. 117,300
207,000
b. 120,300 204,000

c. 121,300 203,000

d. 124,300 200,000

3. How much are the ending inventory and cost of sales under the Weighted Average cost formula? (The average is
calculated on a periodic basis.)
Ending inventory Cost ofsales
d. 118,685 324,300

4. How much are the ending inventory and cost of sales under the Weighted Average cost formula? (The average is
calculated as each additional purchase is made, i.e., 'moving average'. )
Ending inventory Cost of sales

a. 116,832 207,918

116,382 207,918
b.
118,685 205,615
c.
116,495 207,805
d.
Lower of Cost and NRV

5. Information on ABC Co.'s December 31, 20x1 inventory is shown below:

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100,000 250,000
Product C
Purchase price 300,000
Freight-in 12,000 30,000 36,000

Selling price 210,000 300,000 570,000

Freight-out 10,500 75,000 11,400

General overhead costs 6,300 9,000

17,100
How much is the valuation of ABC's total inventory on December 31, 20x1?

a. 983,100

b. 938,100

c. 763,000

d. 673,000