Learning Outcomes
- Create journal entries to adjust inventory to NRV
Let’s recap the effect of the different methods of applying COGS, gross profit, and ultimately, net income, assuming that total selling, general, and administrative expenses of Geyer Co. are $735,000.
Description | by total | by individual item | by class |
---|---|---|---|
Beginning Inventory | $ 0 | $ 0 | $ 0 |
Net purchases and freight in | 1,522,453 | 1,522,453 | 1,522,453 |
Ending Inventory, LCNRV | (238,687) | (186,872) | (227,952) |
Cost of good sold | Single Line$1,741,663Double Line | Single Line$1,793,478Double Line | Single Line$1,752,398Double Line |
Net sales | $2,548,959 | $2,548,959 | $2,548,959 |
Cost of goods sold | 1,741,663 | 1,793,478 | 1,752,398 |
Gross Profit | Single Line807,296 | Single Line755,481 | Single Line796,561 |
Operating Expenses | 735,000 | 735,000 | 735,000 |
Net income | Single Line$72,296Double Line | Single Line$20,481Double Line | Single Line$61,561Double Line |
Applying LCNRV to total inventory gave us a NRV of $274,610 (see Inventory List in prior reading) which was higher than total cost, so there would be no adjustment necessary. We just left each inventory item listed at cost, even though some of the items had an NRV less than cost (first column).
However, when we applied the LCNRV rule to each individual item, we found that we had to adjust some inventory downward, such as the Rel 5 HQ Speakers that are listed at FIFO at $110 each, but only have an NRV of $50 each. Overall, we calculated that the NRV of inventory assessing each item individually was only $186,872. Recognizing that loss in the year incurred (rather than waiting for them to sell, if ever) brought gross profit down from $807,296 to $755,481, and of course that reduced net income by the same amount (second column).
Assessing LCNRV by class also reduced ending inventory, which reduced gross profit and net income (third column).
If the amount of a write-down caused by the LCNRV analysis is minor, we could charge the expense to the COGS. If the loss is material, then we might want to track it in a separate account (especially if such losses are recurring), such as “Loss on LCNRV adjustment.”
In addition, instead of adjusting the merchandise inventory account, which would involve adjusting the cost of each individual item in the subsidiary ledger, you may want to post the adjustment to a contra-asset account called something like “Allowance to Reduce Inventory to NRV.”
So, we end up with four possible combinations (using the “by item” analysis):
- Post the adjustment to inventory and COGS.
- Post the adjustment to inventory and a loss account.
- Post the adjustment to a contra-asset account and COGS.
- Post the adjustment to a contra-asset account and a loss account.
Step 1
Post the adjustment to inventory and COGS.
Date | Description | Post. Ref. | Debit | Credit |
---|---|---|---|---|
20– | ||||
Dec 31 | COGS | 51,815.00 | ||
Dec 31 | Merchandise Inventory | 51,815.00 | ||
Dec 31 | To adjust year end inventory to net realizable value |
Which results in the following:
Step 2
Post the adjustment to inventory and a loss account.
Date | Description | Post. Ref. | Debit | Credit |
---|---|---|---|---|
20– | ||||
Dec 31 | Loss on LCNRV Adjustment | 51,815.00 | ||
Dec 31 | Merchandise Inventory | 51,815.00 | ||
Dec 31 | To adjust year end inventory to NRV |
Step 3
Post the adjustment to a contra-asset account and COGS.
Date | Description | Post. Ref. | Debit | Credit |
---|---|---|---|---|
20– | ||||
Dec 31 | COGS | 51,815.00 | ||
Dec 31 | Allowance to Reduce Inventory to NRV | 51,815.00 | ||
Dec 31 | To adjust year end inventory to NRV |
Step 4
Post the adjustment to a contra-asset account and a loss account.
Date | Description | Post. Ref. | Debit | Credit |
---|---|---|---|---|
20– | ||||
Dec 31 | Loss on LCNRV Adjustment | 51,815.00 | ||
Dec 31 | Allowance to Reduce Inventory to NRV | 51,815.00 | ||
Dec 31 | To adjust year end inventory to NRV |
All of these methods of recording the adjustment are acceptable. It just depends on how you want to capture the data for your own internal and external reporting purposes.
For instance, Dynatronics Corporation shows on the balance sheet a line item called, “Inventories, net” and provides details in a footnote:
Note 3. Inventories
Inventories consist of the following as of June 30:
Inventories, net 2019 2018 Raw materials $5,830,140 $6,216,150 Work in process 706,128 625,830 Finished goods 5,129,806 4,604,264 Inventory Reserve (138,553) (458,389) Single Line$11,527,521Double Line Single Line$10,987,855Double Line Included in cost of goods sold for the years ended June 30, 2019, and 2018, are inventory write-offs of $0 and $692,000, respectively. The write-offs reflect inventories related to discontinued product lines, excess repair parts, product rejected for quality standards, and other non-performing inventories.
The company reports COGS (cost of sales) as a single line item, but may be posting inventory write-downs to a separate expense line item in order to capture the data for the note, and also includes this statement in its Summary of Significant Accounting Principles:
Inventories
Finished goods inventories are stated at the lower of standard cost, which approximates actual cost using the first-in, first-out method, or net realizable value. Raw materials are stated at the lower of cost (first-in, first-out method) or net realizable value. The Company periodically reviews the value of items in inventory and records write-downs or write-offs based on its assessment of slow moving or obsolete inventory. The Company maintains a reserve for obsolete inventory and generally makes inventory value adjustments against the reserve.
Next, we’ll look at how inventory is presented on the financial statements, along with disclosures and an analysis of what happens when inventory is under or overstated.
Practice Question