Retail has always been an important industry for the Philippines economy. Retailing represents around 23% of the entire services industry in the country.
The emergence of online platforms, giving companies wider access to marketing and selling products, has also made a big impact.
The Philippine retail industry grew by 5.9% in 2018 and the outlook remains positive through 2019.
In our last article, we highlighted some key accounting concepts that owners and managers operating in any industry should know.
In this article, we focus specifically on the retail industry and explain the important connection between bookkeeping and inventories.
First things first – what is a retail business?
What is a Retail Business?
A “retail business” is usually accepted as meaning a business that buys finished products and then sells those products to end consumers. Retail sales can originate from a traditional bricks and mortar store or through the internet. See our recent article on operating e-commerce and online marketplace businesses in the Philippines.
In a strictly retail business, the company will not develop, produce or modify products before selling them. This is more relevant to a manufacturing business.
So what is it about the industry that requires tailored bookkeeping processes and bespoke financial protocols to achieve success? A key reason is that a retail business relies heavily on one really valuable asset – inventory.
Inventory costing methods
The inventories (stocks) of a retail business are one of the most (maybe even the most) important and valuable assets it owns.
The costing of inventories is an activity that retailers must understand to ensure they get as much value as possible out of their prized asset.
Retailers should, at a minimum, understand:
- the total cost to the business of the inventories they have sold;
- the total cost of the inventories that they continue to hold in stock; and
- how the cost of their inventories is being computed.
Why? It will enable accurate planning, better use of resources, generation of KPIs, understanding of profits and losses. It will also allow management to make more informed commercial decisions about their business.
Retail businesses have a number of inventory costing options to choose from, depending on the category of product and purchasing/selling practices:
First In, First Out Method (FIFO)
Under the FIFO method, the first items purchased by a business will be considered the first to be sold, regardless of the order in which the items are actually sold.
For example, say a business has 150 units of a product in its inventory. Fifty of those 150 units were bought earlier than the rest and cost P1 each. The remaining 100 units were purchased later by the business and cost P2 each. During a particular period, the business sold 100 units of the product. How much should you consider to be the cost of sale?
Under the FIFO method, the answer is P150, computed as 50 units x P1 (first purchase) and 50 units x P2 (second purchase). The cost of your remaining inventory is then P100 (50 units at P2 each).
Last In, First Out Method (LIFO)
This is the opposite of the above FIFO method. In the above case, the cost of the 100 units that were purchased later (i.e. for P2) would be used as the basis for computing the cost of the 100 units sold and the first purchase (50 units at P1) will be the basis for the cost of the remaining stock.
Weighted Average Method
This inventory valuation is used when a business has a lot of inventories that are similar to one another.
In our example above, let’s say that the products bought are similar to one another. Using the weighted average method, the average cost of each unit will be P1.67 (rounding up) – that is (50 units x P1) + (100 units x P2) = P250 divided by 150 units.
The cost of selling the first 100 units is therefore P167. This is computed by multiplying 100 units against the average cost per unit. The cost of the remaining inventory is therefore P83 (rounding down).
Specific Identification Method
This costing method is used when the inventories sold cannot be interchanged with one another or where the costs cannot be applied across a number of similar products. This method is normally used by businesses retailing high-value items such as jewelry or vehicles.
For example, suppose a jewelry shop has an inventory of 3 diamond rings. One of the rings costs P25,000, the second one costs P40,000 and the third costs P60,000.
If the first diamond ring was sold, its cost under the ‘specific identification’ method is P25,000. An average cost cannot be used because each ring is of significantly different value (and high-value) and cannot be interchanged with one another.
Retail businesses must deal with various accounting and compliance related documentation when purchasing products from suppliers and selling to consumers.
The paper trail can be quite extensive throughout the inventory journey.
In the Philippines, every transaction involving the purchase, sale, transfer, exchange or return of a product or stock should be recorded by a business. This is also very helpful for following a paper trail when attempting to balance your Books of Accounts or conduct a Bank Reconciliation process.
These are just some of the most important documents that retailers will deal with when purchasing and selling products:
Purchase Requisition – this is an internal company document used to request inventories from the company’s purchasing department. It doesn’t generally include a value because normally, the requester will not know the cost of the items requested.
Quotation – this document shows the price at which a supplier is willing to sell items to a purchaser. It will generally identify the number of items to be purchased, the cost of the items and sometimes any irregular terms and conditions relating to the product or purchase.
Purchase Order – Commonly referred to as a PO, this is the official document sent from the purchaser to the supplier which communicates the purchaser’s desire to buy from the supplier. Many businesses will put in place financial controls and processes that do not allow the purchase of goods without a pre-approved and signed PO.
Receiving Report – receiving reports are used to document items that are received by a business and to record any issues or discrepancies with the received goods. This document can act as confirmation of delivery and proof of payment. If any issues do arise with an order or receipt of goods, this should be reported to the supplier via this document.
Official Receipt – S.237 of the Tax Code of the Philippines requires any company that is subject to an internal revenue tax to issue registered receipts for sales. In the case of a retail business, therefore, consumers must be provided with an official receipt with their purchase. Receipts must be prepared in duplicate and show the date of the sale transaction, quantity, unit cost and description of the merchandise or nature of the service. A retail business will also require and should receive a sale or service receipt from their supplier or vendor for the purchase of goods or receipt of vendor services.
That’s a lot of documentation and steps required for every sale and purchase!
However, having a fully integrated inventory system can help automate the documentation process. Also, if the business is benefiting from the use of a cloud accounting system, the inventory and documentation process can be integrated within the cloud accounting platform.
This means that inventory-related documentation is automatically sent to a company’s accounting system and can be recorded in the Books of Accounts much more efficiently.
The result? A much more time and cost effective process with less risk of important documents getting lost or falling through the cracks.
Inventory shrinkage arises where a business has less stock than is actually recorded in its inventory list.
A constant pain for retail businesses is the loss of inventories through wastage or obsoleteness. It is generally a bigger issue for retailers selling perishable items such as food, dairy, fresh flowers, etc.
However, it still remains a consideration for sellers of non-perishable goods – clothes and accessories can go out of fashion; technology can be replaced by newer models.
As painful as it might be, obsolete inventories must be accounted for and recorded in a company’s books of accounts. In the Philippines, guidance on accounting for inventory shrinkage is given under International Accounting Standards (IAS) 2 Inventories.
Generally, shrinkage should form part of the Cost of Goods Sold. Examples of “normal shrinkage” are stocked inventories that have degraded or become obsolete due to normal wear and tear.
An example of “abnormal shrinkage” is when a warehouse holding inventories is destroyed by a flood or other type of natural disaster.
Abnormal shrinkages should form part of a company’s operating expenses. Why? Because adding unusual shrinkages to the Cost of Goods Sold will inaccurately compute the cost the business incurred in generating its sales for a particular period.
Obsolete inventories may be allowed as a deductible expense by the BIR provided there is proof of actual disposal or physical destruction. An example of “proof” would include a signed Declaration of Loss from the company.
If your business has in place a quality inventory management system which is fully optimized to align with your business model and internal processes, management can save a lot of time, cost and resources on inventory.
On the retail to customer side, an integrated Point of Sale system (POS) can really help a business manage its inventory levels, generate the necessary sales documentation and interface with the company’s accounting books. Best results are achieved here through the utilisation of cloud accounting and online accounting solutions such as Xero and Quickbooks online.
A POS system can also generate daily sales reports, help develop KPIs and provide data on employee sales/performance.
Importantly, an optimized POS system will indicate to a company when stocks are low and when more orders are needed.
Depending on how the POS system is set up, it may even be possible to generate automatic notifications to be sent to suppliers when inventory levels decrease to a certain point.
Inventory management is a key activity for any business – a POS system can be a really helpful way to achieve efficiency, quality and automation.
Requirement for inventory list at year-end
In the Philippines, retail businesses are required to record and submit an accurate list of the company’s year-end inventories.
What should the format be?
For retail businesses, Annex A of RMC 57-2015 is the required format for the inventory list. There are 11 columns that need to be completed including: product code, location, quantity and inventory valuation method. For Unit Price, it is the purchase price that must be indicated – not the selling price (see costing methods above).
A sworn declaration (Annex D) must also be prepared, signed and notarized.
The details that go into the inventory report should be reconciled with other tax forms that the company may submit during the taxable year (ex. 1702, VAT forms, SLSP).
Bookkeeping and accounting services for retail businesses in the Philippines
Do you own or manage a retail business in the Philippines? Are you looking to improve efficiencies across the organisation? Optimizing your internal processes for purchasing, recording and selling inventories is crucial for business growth – and we are happy to help.
At CloudCfo, we are intensely process driven and output focused. Through our extensive knowledge and experience, we understand the importance of ensuring that a retailer’s accounting and bookkeeping processes are properly aligned with their inventory systems.
We can help implement processes to ensure your inventory management systems enable scaling for your business.