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Chapter 3.5® - Recording Inventory Valuation at Market instead of Cost - Direct & Indirect Methods assuming Periodic & Perpetual Inventory Systems

Two methods are used for recording inventory at market. One method is referred to as the direct method and involves simply recording the ending inventory at the market figure at year-end if lower than cost. Then, the market value number is substituted for cost when valuing the inventory. As a result of this, no loss is reported separately on the income statement because the loss is hidden in cost of goods sold (not the best accounting practice, although it is a legal method). The second method is referred to as indirect method (allowance method) and it does not change the cost amount, but establishes a separate contra asset account and a loss account to record the write-off.

Let’s consider an example to make these terminologies easier. Consider the following inventory data for Kali Denali Corp. for the year 2009. We will use the periodic inventory system for both direct & indirect methods, and compare this with the perpetual inventory system using still the direct & indirect methods.

 Inventory At Cost At Market Beginning of period \$85,000 \$85,000 End of period \$97,000 \$90,000

i) Direct Method assuming Periodic Inventory System - Ending Inventory Recorded at Market

 December 31st, 2009 Account Name Debit Credit Dr. Cost of Goods Sold \$85,000 Cr. Inventory \$85,000 December 31st, 2009 Dr. Inventory \$90,000 Cr. Cost of Goods Sold \$90,000 To record ending inventory at ‘market’

ii) Indirect Method assuming Periodic Inventory System - Ending Inventory Recorded at Cost and reduced to Market using an Allowance

 December 31st, 2009 Account Name Debit Credit Dr. Cost of Goods Sold \$85,000 Cr. Inventory \$85,000 To transfer out beginning inventory balance

 December 31st, 2009 Dr. Inventory \$97,000 Cr. Cost of Goods Sold \$97,000 To record ending inventory at ‘cost'

 December 31st, 2009 Dr. Loss Due to Market Decline of Inventory \$7,000 Cr. Allowance to reduce inventory to market \$7,000 Establish a separate contra asset account and write off the loss of inventory from cost to market.

iii) Direct Method assuming Perpetual Inventory System

Note: No inventory closing entries are necessary under the perpetual inventory system, thus only a reduction to market is recorded.

 December 31st, 2009 Account Name Debit Credit Dr. Cost of Goods Sold \$7,000 Cr. Inventory \$7,000 To reduce inventory from cost to market (Ending Inventory recorded at Market)

iv) Indirect Method assuming Perpetual Inventory System

 December 31st, 2009 Dr. Loss Due to Market Decline of Inventory \$7,000 Cr. Allowance to reduce inventory to market \$7,000 Entry to establish a separate contra asset account and write off the loss of inventory from cost to market.

The advantage of identifying the loss due to decline in market is that it is shown separately from cost of goods sold on the income statement, without distorting the cost of goods sold for the year. Below, we show the gross profit section of the income statement using the direct & indirect accounting methods.

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