University of Southern Philippines Foundation
College of Accountancy
Financial Accounting and Reporting – Problems Review
Module.02_Estimating Inventory
Introduction
There may be instances where the value of inventories must be estimated, such as when it is not possible to
take a physical count of inventory. For example, in the interest of timeliness and cost consideration, an entity
may elect to rely on estimates of inventory at interim dates. Another instance is when records of inventories are
incomplete and inventories must be approximated. The use of estimates is permitted under PAS 2 only when
they reasonably approximate cost. Generally, inventory estimation is made only for interim reporting. For
annual reporting, physical count of inventories on hand is more appropriate. This module focuses on estimating
inventory in accordance with PAS 2. This module introduces the learner to the proper accounting treatment of
inventory estimation through the online lecture, develops l0the learner’s understanding of the requirements
through the use of examples and indicates significant judgements that are required in accounting for inventory
estimation. Furthermore, the module includes questions designed to test the learner’s knowledge of the
requirements and to develop the learner’s ability to account for inventory estimation in accordance with
applicable standards.
Learning Outcomes
At the end of this module you MUST be able to:
1. Apply the different methods of estimating inventory.
Learning Activities:
1. Submission of assignment through Canvas.
2. Read lecture notes.
3. Answer pre-assessment activities through Canvas.
4. Download the pre-recorded lecture.
Lecture Notes
Gross profit method
The gross profit method is an inventory estimation technique based on a relationship between gross profit and
sales that is assumed to be fairly stable. Its use is not appropriate for financial reporting purposes; however, it
can serve a useful purpose when an approximation of ending inventory is needed. Such approximations are
sometimes required by auditors or when inventory and inventory records are destroyed by fire or some other
catastrophe. The gross profit method should never be used as a substitute for a yearly physical inventory unless
the inventory has been destroyed.
The gross profit method is based on the assumptions that
a. the beginning inventory plus purchases equal total goods to be accounted for;
b. goods not sold must be on hand; and
c. if sales, reduced to cost, are deducted from the sum of the opening inventory plus purchases, the
result is the ending inventory.
The estimated ending inventory of a trading company is computed as follows:
Inventory, beginning P xx
Purchases, net xx
GAS xx
Cost of goods sold (xx)
Inventory, ending P xx
The cost of goods sold is computed as follows:
If GPR is based on sales:
Net sales x Cost ratio (1-GPR)
If GPR IS based on cost:
Net sales / (1+GPR)
In developing a reliable gross profit percentage, reference is made to past years and adjustments are made
for current circumstances.
Techniques for the Measurement of Cost under PAS 2
Techniques for the measurement of the cost of inventories, such as the standard cost method or the retail
method, may be used for convenience if the results approximate cost.
Retail method
The retail inventory method is an inventory estimation technique based upon an observable pattern between
cost and sales price that exists in most retail concerns. This method requires that a record be kept of
a. the total cost and retail of goods purchased,
b. the total cost and retail value of the goods available for sale, and
c. the sales for the period.
Basically, the retail method requires the computation of the cost-to-retail ratio of inventory available for sale.
This ratio is computed as follows:
Cost Ratio = GAS at cost/ GAS at retail
The estimated ending inventory is computed as follows:
Inventory, beginning at retail P xx
Purchases, net – at retail xx
TGAS at retail xx
Sales (+/- sales adjustments) (xx)
Inventory, ending at retail xx
X cost ratio %
Inventory, ending at cost P xx
Use of this method eliminates the need for a physical count of inventory each time an income statement is
prepared. However, physical counts are made at least yearly to determine the accuracy of the records and to
avoid overstatements due to theft, loss, and breakage.
To obtain the appropriate inventory figures under the retail inventory method, proper treatment must be given
to markups, markup cancellations, markdowns, and markdown cancellations.
Conventional Average FIFO
Net Markdown Exclude Include (Deduct) Include (Deduct)
Inventory, beginning Include Include Exclude
Conventional Retail Inventory Method
When the cost to retail ratio is computed after net markups (markups less markup cancellations) have been
added, the retail inventory method approximates lower of cost or market. This is known as the conventional
retail inventory method. If both net markups and net markdowns are included before the cost to retail ratio is
computed, the retail inventory method approximates cost.
The retail inventory method becomes more complicated when such items as freight-in, purchase returns and
allowances, and purchase discounts are involved. In essence, the treatment of the items affecting the cost
column of the retail inventory approach follows the computation of cost of goods available for sale. Freight
costs are treated as a part of the purchase cost; purchase returns and allowances are ordinarily considered
both a reduction of the price at both cost and retail; and purchase discounts usually are considered as a
reduction of the cost of purchases.
Other items that require careful consideration
i. Transfers-in from another departments should be reported in the same way as purchases from an
outside enterprise.
ii. Normal shortages should reduce the retail column because these goods are no longer available for
sale.
iii. Abnormal shortages should be deducted from both the cost and retail columns and reported as a
special inventory amount or as a loss.
iv. Employee discounts should be deducted from the retail column in the same way as sales.
The retail inventory method is widely used (a) to permit the computation of net income without a physical
count of inventory, (b) as a control measure in determining inventory shortages, (c) in regulating quantities of
inventory on hand, and (d) for insurance information.
The retail method is often used in the retail industry for measuring inventories of large numbers of rapidly
changing items with similar margins for which it is impracticable to use other costing methods.
• The percentage used takes into consideration inventory that has been marked down to below its
original selling price.
• An average percentage for each retail department is often used.
Average Cost Approach
Under the average approach, it includes both net markup and the net markdown in the computation of cost
ratio. It rationalizes that the inventory should approximate or equal to historical cost.
FIFO Approach
The FIFO approach is similar to the average cost approach that it considers both the net markup and net
markdown but it excludes the beginning inventory in the computation of cost ratio. It rationalizes that the
markup and markdown will apply to the goods purchased during the year but not the beginning inventory.
Standard cost method
Standard costs take into account normal levels of materials and supplies, labor, efficiency and capacity
utilization. They are regularly reviewed and, if necessary, revised in the light of current conditions.
-- end of lecture notes --
Pre-Assessment Activity on Inventory Estimation
1. On May 6, 2019 a flash flood caused damage to the merchandise stored in the warehouse of Vergie Co.
You were asked to submit an estimate of the merchandise destroyed in the warehouse. The following data
were established:
a. Net sales for 2018 were P800,000, matched against cost of P560,000.
b. Merchandise inventory, Jan. 1, 2019 was P200,000, 90% of which was in the warehouse and 10% in
downtown showrooms.
c. For Jan. 1, 2019 to date of flood, you ascertained invoice value of purchases (all stored in the
warehouse), P100,000; freight inward, P4,000; purchases returned, P6,000.
d. Cost of merchandise transferred from the warehouse to show-rooms was P8,000, and net sales from
January 1 to May 6, 2019(all warehouse stock) were P320,000.
Assuming gross profit rate in 2019 to be the same as in the previous year, the estimated merchandise
destroyed by the flood was
2. The Tiktok Corporation was organized on January 1, 2018. On December 31, 2019, the corporation lost most
of its inventory in a warehouse fire just before the year-end count of inventory was to take place. Data
from the records disclosed the following:
2018 2019
Beginning inventory,
January 1 P 0 P1,020,000
Purchases 4,300,000 3,460,000
Purchases returns and
allowances 230,600 323,000
Sales 3,940,000 4,180,000
Sales returns and
allowances 80,000 100,000
On January 1, 2019, the Corporation’s pricing policy was changed so that the gross profit rate would be
three percentage points higher than the one earned in 2018. Salvaged undamaged merchandise was
marked to sell at P120,000 while damaged merchandise was marked to sell at P80,000 had an estimated
realizable value of P18,000. How much is the inventory loss due to fire?
3. Sky Manufacturing began operations 5 years ago. On August 13, 2019, a fire broke out in the warehouse
destroying all inventory and many accounting records relating to the inventory. The information available is
presented below. All sales and purchases are on account.
January 1, 2019 August 13, 2019
Inventory P143,850
Accounts Receivable 130,590 P128,890
Accounts Payable 88,140 122,850
Collections on accounts rec., Jan. 1- Aug. 13 753,800
Payments to suppliers, Jan. 1- Aug. 13 487,500
Goods out on consignment at Aug. 13, at cost 52,900
Summary on previous years’ sales:
2016 2017 2018
Sales P626,000 P705,000 P680,000
Gross Profit 187,800 183,300 231,200
GPR 30% 26% 34%
Determine the inventory loss suffered as a result of the fire.
4. The work-in-process inventory of Luna Company were completely destroyed by fire on June 1, 2019. You
were able to establish physical inventory figures as follows:
January 1, 2019 June 1, 2019
Raw materials P 60,000 P120,000
Work-in-process 200,000 -
Finished goods 280,000 240,000
Sales from January 1 to May 31, were P546,750. Purchases of raw materials were P200,000 and freight on
purchases, P30,000. Direct labor during the period was P160,000. It was agreed with insurance adjusters
that an average gross profit rate of 35% based on cost be used and that direct labor cost was 160% of
factory overhead.
The work in process inventory destroyed by fire is
Use the following information for the next two questions.
Kyrz uses the retail inventory method. The following information is available for the current year:
Cost Retail
Beginning inventory P 1,300,000 P 2,600,000
Purchases 18,000,000 29,200,000
Freight in 400,000
Purchase returns 600,000 1,000,000
Purchase allowances 300,000
Departmental transfer in 400,000 600,000
Net markups 600,000
Net markdowns 2,000,000
Sales 24,700,000
Sales returns 350,000
Sales discounts 200,000
Employee discounts 600,000
Loss from breakage 50,000
5. The estimated cost of inventory at the end of the current year using the conventional (lower of cost or
market) retail inventory method is
6. The estimated cost of inventory at the end of the current year using the average retail inventory method is
7. The estimated cost of inventory at the end of the current year using the FIFO retail inventory method is
8. The records of SM’s Department Store report the following data for the month of January:
Beginning inventory at cost 440,000
Beginning inventory at sales 800,000
price
Purchases at cost 4,500,000
Initial markup on purchases 2,900,000
Purchase returns at cost 240,000
Purchase returns at sales price 350,000
Freight on purchases 100,000
Additional mark up 250,000
Mark up cancellations 100,000
Mark down 600,000
Mark down cancellations 100,000
Net sales P6,500,000
Sales allowance 100,000
Sales returns 500,000
Employee discounts 200,000
Theft and other losses 100,000
Using the average retail inventory method, Binmaley’s ending inventory is
9. Ave Company provided the following data:
Cost Retail
Beginning inventory P 160,000 P 400,000
Purchases 2,800,000 3,200,000
Freight in 40,000
Markups 300,000
Markups cancellation 30,000
Markdowns 160,000
Markdowns cancellation 40,000
Sales 3,000,000
Physical inventory at year end 500,000
Estimated normal shrinkage is 4% of sales
Assuming the company uses the average retail inventory method, the estimated inventory shortage is
-- end of Pre-Assessment Activity --
Assessment
1. Online assessment through Canvas.
Optional Activities/Resources
1. Intermediate Accounting 1B 2019 Edition by Zeus Vernon B. Millan
2. https://www.iasplus.com/en/standards/ias/ias2
SMC
