ABC Impairing Existing Inventory & Estimating Ending Inventory pt 2 - YouTube

Welcome back to intermediate Financial Accounting class. In our last segment, we walked through the lower cost of market logic, we talked about

estimating ending inventory, why that was important, and how we can use it, and just the importance of inventory. Again, in general, things

we've talked about in the past, or you should have learned about in the past,

but now it's time to refresh, and talk about them again.

We ended up our discussion talking about the steps to doing the lure of cost or market

calculation, and they looked like this.

Now that we've gone through these steps, it's time to actually use them. Journal entries, yes! I'm so excited.

So let's take a look at an example of this lower of cost or market

adjustment. Jones company is worried that some of their inventory is obsolete, so that takes care of step one.

We think that we've got some obsolete inventory.

Remember, that was that key step. If you don't believe that, then nothing else matters.

Using the chart below, and I'm gonna bring that up right now,

we want to make the necessary journal entry,

if any, for Jones to account for the drop in inventory value, under both the direct and the

allowance methods. Remember, this allowance method is what FASB prefers, but most companies

choose use this direct method.

So for the purposes of learning, we'll go ahead and make sure we've got them both,

but just be aware that chances are, what you'll see the most will be this direct method.

Here's our information,

I'll give you a second to find that in your PowerPoint file, or jot some of those numbers down, so you don't have to flip back

and forth, and then let's go ahead and start doing some

calculations.

Now I'm gonna start with a table, and

I'm gonna put the item over here,

and

then I'm gonna calculate the historical cost, or I guess I'm not really calculating it, I'll just jot it down.

We need the current sales price,

and then any we're gonna call them disposal costs.

And please note that these won't always been labeled as disposal costs,

but these are anything and everything we have to spend in order to actually make this sale.

So if there's been a fire, I think things have dropped because they were, you know, soaked with the water from the fire

department, or smoke damage, or whatever, my disposal costs may be cleaning things up. If

I just can't sell them at this store,

but maybe if I could get them downtown, I could sell them there, then the disposal cost would be the transfer.

Could be that I need to put a monogram on them for the people buying, or

Making the order. Fine, we'll put that in there. It's anything and everything we have to spend to get them ready to sell.

Once I've got my sales price and my disposal costs, then I can calculate my net realizable value, and

finally, I'll have a lower of cost or market

column as well.

So let's start with item A, and then we'll give you a few minutes and let you do the

calculations on your own, for the other three items.

So the historical cost that I have on our books right now for item A is a hundred and ten dollars.

My current sales price is a hundred and twenty five, and if I were to stop right there, I think I was fine.

I mean, I paid 110 for them, I can sell for 125. I can still make a profit here. I

shouldn't have a problem,

but if you look at the table, it'll cost me thirty bucks to get these ready to sell,

so if I take the 125, and subtract the $30, my net realizable value, or what

I think I can get from these items, is only ninety five dollars a piece. And if I compare that with the 110,

I need to do a write down. And my lower of cost or market,

I should label this better, my adjustment, or custom market adjustment, is going to be

$15. That's the 110,

minus the 95.

Now I'll put in the other items here: b, c, and d.

Before going on with the video, take a minute and do the rest of the calculations yourself.

Let's go ahead and pick back up with our discussion. Hopefully you came up with a table that looks something like this.

There's our historical cost, current sales price, disposal costs, and net realizable value

for each of our other three items. If we compare historical cost to net realizable value

for item B, I need another $10 adjustment, for item C I don't have to adjust it all, for item D

it looks like I need to write everything down by $5. Now that I know the adjustment amounts,

I can figure out the amount of my journal entry.

So let's do another little table, or if you've got space you can put it off to the side.

We'll put down the number of units, and then the lower of cost or market

adjustment, and you'll also see this called a wright down.

So let's see, our write down was 15 for item A,

$10,

nothing, and then $5. And our units were given to us,

a hundred units of A, we've got a hundred and fifty of B, I don't even care about C, we don't have any

adjustment that I need to make, and then 50 units of item D. And that allows me to get my total,

by just multiplying.

So 100 times 15, is a $1,500 adjustment,

another $1,500 adjustment,

no adjustment here, and down at the bottom a very small $250 adjustment. If I add all that up,

my total adjustment

will be 3,250. On to the best part of this, and that's the journal entry. And I'm gonna break this into two pieces,

let's do the direct method on the left, and we'll do the allowance method

over here on the right. Starting with the direct method,

I know the amount: it was 3250, under the direct method as an adjusting entry,

for year, well we'll just say year four, just so we've got a year here. Cost of goods sold

would get debited by the 3250, and

inventory would decrease

for the same amount, and of course, I always have a description, so this is an adjusting entry

for lower of cost or market

adjustment. And then I would put a reference

to wherever my calculations were, so that I know how I calculated that 3250. For the allowance method,

same exact number, the only difference, let's see, 12/31/

and again, we just randomly chose that year four, just so we'd have a number, this is a loss due

to market decline of

inventory (say that five times fast), 3,250. And I'll have an allowance

for market decline

inventory. And I'll squeeze that in here, hopefully making it look offset, phew, made it. Again, this is an adjusting entry

for a lower of cost or market

adjustment or write down. Now, hopefully that makes sense. I've got my journal entries, I've got the calculation,

I've dropped the value, the other piece we need to talk about though, is. Well, what happens next year?

Let's say somebody comes into our shop and buys just one item of B, after

we do this write down.

Well, what will our journal entries look like under the two methods if we have this person buy one of these

less valuable units that we've written down? So let's take a look at that.

I'm gonna split this off here,

this will be, oh, let's say it was February 23rd,

now, of year five. So it's the year after we've made the adjustment. Well if you remember, our

cashing amount, or our sales price

for this item was a hundred and sixty dollars. That was our best guess on what we thought we could sell it for.

So I'll record cash and sales revenue of

a hundred and sixty,

the next thing I would need to record would be cost of goods sold, and

then I need to get rid of my inventory. Now, we wrote this item down in

inventory to a hundred and forty dollars.

Right? That was what we dropped it to. In addition, now before we're done here, remember there's a disposal cost. It's gonna cost us

twenty dollars. This is, again, the cleanup costs, or to get it shipped to the right place, or whatever it is

we have to spend to get it ready to sell. And

notice

that these numbers match.

My sales revenue and my cost of goods sold match up. Now

that was the point of a lower of cost or market write down.

I wrote it down to its market value, the revenue and the cost are now the same.

That's the point. And I would make a note, this is to sell

one unit

of item

B. And if I wanted to, I could refer back to that adjusting entry last year under the allowance method.

Same basis up here,

my revenue and my cash stay the same.

What changes is this second entry.

Again, I've got cost of goods sold I'm going to record, I'm going to record my inventory,

but in this case, I didn't write the inventory down. I used an allowance account instead.

So my inventory is still at 150, and I have an allowance

for market

decline, I'm not going to put all the rest of that in there, but my allowance was $10

per unit... for B. It was 150, wrote it down to 140, and the net of these two, that gives me the hundred and

$40.

Again, I'm paying cash for those disposal costs, and

I end up with cost of goods sold to make this balance. Let's say, 150 plus 20, minus 10. There's that 160 again.

So you'll notice a couple of important things here. Whoops, before we do that, don't leave it naked Jason.

First, as we've already discussed,

there's no profit on these items, because I wrote them down to what I thought I was gonna get out of them,

and unless I can sell them for more than my guess,

then there's no profit anymore. I wrote them down just low enough that my profit and my cost would equal out.

That was the goal. I can still show an extra loss here, if the disposal cost go up,

It could show maybe a bit of a gain, or some profit. Wouldn't be a gain,

it would just be revenue above cost of goods sold. If that disposal cost is less, or if I can sell it for a little

more than I thought.

The other thing that's really important between the two methods, notice that the net revenue amount is the same, and

the cost of goods sold ends up exactly the same.

So the only thing you're really getting that is beneficial, and

FASB really likes this again, is we have that allowance on our books.

We show it as a loss originally,

so it's a little more informative to our investors, but the net effect is gonna come out to be exactly the same between the two.

Now just be aware: there are some problems with lower of cost or market. First off,

we recognize drops in value, but we don't recognize increases, so we're lopsided. Now accounting, for a long time, has been conservative.

That's how we identify as accountants,

we're gonna be conservative in what we do, but we're moving towards neutrality, and this is not neutral.

This is conservative still. We're writing down, but not back up. In addition, it leads to

inconsistent numbers between years. Last year, in year three, I recorded this as being worth 150 dollars. Now

I'm recording it as a hundred and forty, and moving forward, I may have to write it down again.

So my numbers aren't comparable anymore on my balance sheet, because I've written this down.

The third issue here, is the conservatism. Part of the conservatism is

that it's lopsided. We go down but not up, but the other part of conservatism is if I do a big write down, now

later on in the future I can show a large increase, because if I say, "oh, you know what?

I think those units are only worth a hundred dollars. I I'm having a bad year, anyway, I'll drop my my

inventory value all the way down from 150 for that item, down to a hundred,

that brings down my net income, everything looks horrible that year, but when I sell it, I can sell it for 160 bucks.

Even with that twin dollar disposal cost, I can show a

$40 profit, extra profit, on these items.

So this is one of the big issues with this lower of cost or market method, is that I can conceivably create

some earnings manipulations, or some

extra profit in the future, by playing around with the numbers. And and that's what that last point is about too, is i'm using estimates,

And as the manager I can play around with estimates.

This process used to be a lot longer. FASB just simplified it just a little while ago.

It was this three-step process that we're trying to use to keep people from manipulating numbers, and

FASB ultimately decided that the benefit wasn't big enough to offset the cost. So because of that, they've eliminated

these extra steps, and just brought it back to being this one simple calculation. And because of that, we're really very

consistent with IFRS now: so IFRS requires companies to assess inventory periodically,

we don't have to have a reason to believe it,

we're just supposed to check everyone's to make sure our inventory hasn't dropped in value. The other major change that remains between

IFRS and US GAAP, is the fact that we can write inventory back up under IFRS.

So if item B all of a sudden becomes hot again, people decide they want to collect records, and they need

stereos that allow them to play records,

all of my inventory jumps up in value. I can write it back up. I can go,

let's see, our item B was originally 150, I wrote it down to 140,

I can write it back up to 150. Can't go higher, but I can at least write it back up to that original historical cost.

Before we wrap this up, let's take a look at one last example.

This is an international company, Sanchez Co, they have a lower cost American issue that they think they need to deal with.

This time, I've given you the numbers a little bit differently. In the example

we just did, I gave you individual items, and then we multiplied by the number of units to get to a total at the end.

This time, I've given you totals, so that you can do it in

what is, for some companies, a more common way. And I've given you not just one set of numbers,

but two. Before you move on to the next segment, please take a few minutes, do these two

separate examples. The two A column, two B column, so you can see a couple of options, and how things change.

Do those calculations,

and we come back, we'll review them briefly, before we move on to our discussion of ending inventory.

I'll see you then. Thanks.