3.1 Inventories & Cost of Sales

Inventories & Cost of Sales (PAS 2)

In financial accounting under Philippine Financial Reporting Standards (PFRS), inventory accounting is governed primarily by PAS 2 (Inventories). Inventories frequently constitute one of the largest current assets on the statement of financial position for merchandising and manufacturing entities, directly dictating gross profit, net income, working capital metrics, and tax liabilities.

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1. Definition and Scope of PAS 2

Under PAS 2, paragraph 6, inventories are defined as assets:

1. Held for sale in the ordinary course of business (finished goods or merchandise inventory);
2. In the process of production for such sale (work in process);
3. In the form of materials or supplies to be consumed in the production process or in the rendering of services (raw materials and factory supplies).

Scope Inclusions and Exclusions

PAS 2 applies to all inventories, with specific exceptions categorized into complete exclusions and measurement-only exclusions:

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2. Inventoriable Costs vs. Period Costs

The cost of inventories comprises all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition.

A. Costs of Purchase

• Purchase price (net of trade discounts, rebates, and volume discounts);
• Import duties and other non-recoverable taxes levied by tax authorities;
• Transport, handling, freight-in, and transit insurance directly attributable to the acquisition.
• Cash Discounts (Settlement Discounts): Under PFRS, purchase discounts are deducted from the initial cost of purchase regardless of whether the net method or gross method of recording purchases is employed.

B. Costs of Conversion

Conversion costs apply to manufacturing entities and encompass direct labor, direct production expenses, and a systematic allocation of fixed and variable production overhead:

• Variable production overheads vary directly with the volume of production (e.g., indirect materials, indirect labor) and are allocated to each unit on the basis of actual facility usage.
• Fixed production overheads remain relatively constant regardless of production volume (e.g., depreciation of factory buildings, factory maintenance, plant management). They must be allocated based on the normal capacity of production facilities.

$\text{Allocated Fixed Overhead per Unit} = \frac{\text{Budgeted Fixed Overhead at Normal Capacity}}{\text{Normal Capacity Units}}$

Normal capacity is the production expected to be achieved on average over a number of periods or seasons under normal circumstances.

• In periods of abnormally low production or idle capacity, unallocated overhead is recognized immediately as an expense in profit or loss in the period incurred. Fixed overhead allocation per unit is never increased to absorb idle capacity.
• In periods of abnormally high production, the allocation rate per unit is decreased so inventories are not valued above actual cost.

C. Costs Strictly Excluded and Expensed as Period Costs

PAS 2 paragraph 16 explicitly prohibits capitalizing the following costs into inventory:

1. Abnormal amounts of wasted materials, labor, or other production costs (e.g., excessive scrap, machine breakdown waste);
2. Storage costs, unless those costs are necessary in the production process before a further production stage (e.g., storage during wine aging, cheese curing, or timber seasoning is inventoriable; storage of finished goods is expensed);
3. Administrative overheads that do not contribute to bringing inventories to their present location and condition;
4. Selling and distribution costs (e.g., advertising, freight-out, sales commissions);
5. Foreign exchange differences arising directly on the recent acquisition of inventories invoiced in a foreign currency;
6. Interest expense / borrowing costs under PAS 23, unless the inventory qualifies as a qualifying asset (an asset that necessarily takes a substantial period of time to get ready for its intended use or sale, such as maturing spirits or large real estate construction projects).

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3. Cost Formulas: FIFO vs. Weighted Average

For inventories that are ordinarily interchangeable, PAS 2 permits two primary cost formulas:

1. First-In, First-Out (FIFO): Assumes that items of inventory purchased or produced first are sold first, leaving items purchased or produced most recently in ending inventory. FIFO yields identical cost of goods sold and ending inventory figures under both the periodic system and the perpetual inventory system.
2. Weighted Average: Assumes that the cost of each item is determined from the weighted average of the cost of similar items at the beginning of a period and the cost of similar items purchased or produced during the period.
   • Periodic Weighted Average: Calculated once at the close of the accounting period across total goods available for sale: $\text{Weighted Average Unit Cost} = \frac{\text{Total Cost of Goods Available for Sale}}{\text{Total Units Available for Sale}}$
   • Perpetual Moving Average: Recomputed after every individual purchase receipt: $\text{Moving Average Unit Cost} = \frac{\text{Carrying Cost of Existing Balance} + \text{Cost of New Purchase}}{\text{Units in Existing Balance} + \text{Units Purchased}}$

Strict Prohibition of LIFO

Under PFRS (and Philippine CPALE standards), the Last-In, First-Out (LIFO) formula is strictly prohibited. The standard setters eliminated LIFO because it does not faithfully reflect actual inventory flows and understates inventory values on the statement of financial position during inflationary environments, creating artificial tax-deferral matching rather than objective economic reporting.

Consistency Rule

An entity must use the same cost formula for all inventories having a similar nature and use to the entity. A difference in geographical location of inventories alone is not sufficient to justify the use of different cost formulas.

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4. Measurement: Lower of Cost and Net Realizable Value (LCNRV)

Under PAS 2 paragraph 9, inventories must be measured at the lower of cost and net realizable value (NRV).

Net Realizable Value Formula

$\text{NRV} = \text{Estimated Selling Price in Ordinary Course} - \text{Estimated Costs of Completion} - \text{Estimated Costs to Make the Sale}$

NRV is an entity-specific value representing the net cash inflow expected from the realization of inventory. It differs from fair value under PFRS 13, which is an exit price determined by market participants in an orderly transaction.

Level of Assessment: Item-by-Item Principle

Inventories are evaluated for write-down on an item-by-item (individual) basis. Grouping is permitted only when items belong to the same product line, have similar purposes or end uses, are produced and marketed in the same geographical area, and cannot practicably be evaluated separately. Writing down entire inventory categories (e.g., all finished goods or an entire operating segment) en masse is prohibited.

Raw Materials Rule

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 or above cost.

However, when a decline in the price of materials indicates that the cost of the finished products will exceed their net realizable value, the materials are written down to net realizable value. In such circumstances, the replacement cost of the materials provides the best available measure of their net realizable value.

Accounting for Inventory Write-Downs and Reversals

When cost exceeds NRV, the difference is recognized as an expense in profit or loss:

Loss on Inventory Write-Down              XXX
    Allowance for Inventory Write-Down            XXX

(Alternatively, under the direct write-off method, Cost of Goods Sold is debited and Inventory is credited directly.)

If the conditions that caused the write-down cease to exist (e.g., market recovery, selling prices rebound), the write-down is reversed. The reversal is recognized in profit or loss as a reduction in the amount of inventories recognized as an expense (cost of sales) in the period the reversal occurs:

Allowance for Inventory Write-Down        XXX
    Gain on Reversal of Inventory Write-Down      XXX

Ceiling on Reversals: The reversal amount is strictly limited to the amount of the original write-down. The newly adjusted carrying amount can never exceed the original historical cost.

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5. Inventory Estimation Methods

When physical counts cannot be conducted (interim reporting, natural catastrophes, fire or flood damage claims), entities employ estimation methods.

A. Gross Profit Method

The gross profit method relies on the historical relationship between gross profit and sales. It is acceptable for interim reporting and insurance damage settlements, but not acceptable for annual financial statement year-end reporting under PFRS.

Gross Profit Rate Conversions

$\text{Gross Profit Rate on Sales} = \frac{\text{Gross Profit Rate on Cost}}{1 + \text{Gross Profit Rate on Cost}}$

$\text{Gross Profit Rate on Cost} = \frac{\text{Gross Profit Rate on Sales}}{1 - \text{Gross Profit Rate on Sales}}$

Computational Sequence

1. $\text{Cost of Goods Available for Sale (GAS)} = \text{Beginning Inventory} + \text{Net Purchases} + \text{Freight-In}$
2. $\text{Estimated Cost of Goods Sold} = \text{Net Sales} \times (1 - \text{Gross Profit Rate on Sales})$
3. $\text{Estimated Ending Inventory} = \text{GAS} - \text{Estimated Cost of Goods Sold}$

Sales Discounts and Allowances: Sales returns are deducted from gross sales to calculate net sales. Sales discounts and sales allowances represent financing or settlement adjustments and do not reduce the volume of physical goods sold; therefore, they are not deducted from sales when estimating cost of goods sold.

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B. Retail Inventory Method (RIM)

The Retail Inventory Method is widely utilized in high-volume retail businesses with rapid turnover and similar markups. It calculates a cost-to-retail percentage to convert retail ending inventory to estimated cost.

Method Variations

1. Conventional / Lower of Cost and Net Realizable Value Method (LCM): Net markups are included in the denominator of the cost-to-retail ratio, but net markdowns are excluded. By omitting markdowns, the denominator is larger, producing a lower cost ratio. When applied to ending retail inventory, this yields an ending inventory figure that approximates lower of average cost and NRV.
2. Average Cost Method: Both net markups and net markdowns are included in the denominator, computing a cost ratio reflective of historical average cost.
3. FIFO Retail Method: Excludes beginning inventory from the ratio calculation entirely, focusing strictly on current purchases, net markups, and net markdowns.

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6. Comprehensive Worked Example: Retail Inventory Method

Manila Retailers Inc. provides the following operating data for the year ended December 31, 2026:

• Beginning Inventory: Cost PHP 480,000; Retail PHP 800,000
• Purchases: Cost PHP 2,820,000; Retail PHP 4,200,000
• Freight-In: Cost PHP 100,000
• Purchase Returns: Cost PHP 60,000; Retail PHP 90,000
• Markups: Retail PHP 150,000; Markup cancellations: Retail PHP 30,000
• Markdowns: Retail PHP 120,000; Markdown cancellations: Retail PHP 20,000
• Abnormal Theft / Spoilage: Cost PHP 40,000; Retail PHP 60,000
• Gross Sales: Retail PHP 3,900,000
• Sales Returns: Retail PHP 100,000
• Employee Discounts granted: Retail PHP 50,000
• Normal Shrinkage / Breakage: Retail PHP 40,000

Step 1: Compute Goods Available for Sale at Cost and Retail

Cost Analysis:
Beginning Inventory:                      PHP   480,000
Net Purchases (PHP 2,820,000 - 60,000):   PHP 2,760,000
Freight-In:                               PHP   100,000
Less Abnormal Spoilage at Cost:          (PHP    40,000)
Total Cost of Goods Available:            PHP 3,300,000

Retail Analysis:
Beginning Inventory:                      PHP   800,000
Net Purchases (PHP 4,200,000 - 90,000):   PHP 4,110,000
Net Markups (PHP 150,000 - 30,000):       PHP   120,000
Subtotal (for Conventional Ratio):        PHP 5,030,000
Less Net Markdowns (PHP 120,000 - 20,000):(PHP   100,000)
Less Abnormal Spoilage at Retail:        (PHP    60,000)
Total Goods Available at Retail:          PHP 4,870,000

Step 2: Determine Ending Inventory at Retail

Total Goods Available at Retail:          PHP 4,870,000
Deduct Sales and Shrinkage:
  Net Sales (PHP 3,900,000 - 100,000):   (PHP 3,800,000)
  Normal Shrinkage:                      (PHP    40,000)
  Employee Discounts:                    (PHP    50,000)
Ending Inventory at Retail:               PHP   980,000

Step 3: Compute Ratios and Ending Inventory at Cost

1. Conventional (LCM) Method

$\text{Conventional Cost Ratio} = \frac{\text{Cost Available}}{\text{Retail Subtotal before Markdowns}} = \frac{\text{PHP }3{,}300{,}000}{\text{PHP }5{,}030{,}000 - \text{PHP }60{,}000} = \frac{\text{PHP }3{,}300{,}000}{\text{PHP }4{,}970{,}000} = 66.40\%$ $\text{Ending Inventory at Cost (Conventional)} = \text{PHP }980{,}000 \times 66.40\% = \text{PHP }650{,}720$

2. Average Cost Method

$\text{Average Cost Ratio} = \frac{\text{Cost Available}}{\text{Total Retail Goods Available}} = \frac{\text{PHP }3{,}300{,}000}{\text{PHP }4{,}870{,}000} = 67.76\%$ $\text{Ending Inventory at Cost (Average)} = \text{PHP }980{,}000 \times 67.76\% = \text{PHP }664{,}048$

Notice that the Conventional method produces a lower ending inventory valuation (PHP 650,720 vs. PHP 664,048), faithfully illustrating how excluding markdowns from the denominator establishes a conservative valuation that approximates LCNRV.