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