12.4 What happens when the value of inventory falls below its cost? Flashcards
What does a trading business do?
- Holds inventory for resale
2. Seeks to sell the inventory at a value higher than its cost
How is inventory recorded in the accounts?
At cost, i.e. based on what is incurred to own the inventory. Normally, the cost of the inventory recorded in the accounts should be lower than the potential selling price. However, there are situations when the cost is higher than the sales value.
What must the business do when the cost of the inventory is higher than the sales value?
or
What must the business do when the value of the inventory falls below its cost?
The business must follow the prudence concept to write down, i.e. reduce the cost of the inventory.
Explain the “Prudence Concept”.
The business must report and adjust for losses that are likely to incur, even though the losses may not be confirmed yet. However, the business does not record profits that are likely to occur. Profits are recorded when they are actually earned.
What is “Net Realisable Value (NRV)”?
The potential amount receivable, i.e. selling price less additional cost to make the sale, from selling the inventory.
What is the rule for the valuation of ending inventory?
At the lower of cost or net realisable value.
Inventory must be valued at cost or net realisable value, whichever is lower.
How is a decrease in inventory recorded?
As a credit entry in the inventory account. The loss in the value of an asset becomes an expense, and a reduction in value of an asset is called an impairment.
Define “impairment’.
A reduction in the value of an asset.
What is the journal entry to adjust inventory to net realisable value, i.e. to adjust for a decrease in inventory?
Dr Impairment loss on inventory (increase expense) Cr Inventory (decrease asset)
Several textbooks in a bookstore, which cost $500, were damaged due to a leaking roof. The textbooks can now be sold for only $350.
What should be done?
The cost of the textbooks is to be written down from $500 to $350. The potential loss of $150 is recorded even though the books have not been sold.
Antique furniture bought for resale cost $5000 at the time of purchase but is worth $15000 now.
What should be done?
The increase in value of $10000 (i.e. potential profit) is not recorded as the antique furniture has not been sold.
Due to great demand, the inventory of rice in a provision store can now be sold for $1300. Its cost price was $600.
What should be done?
The increase in the value of rice is not recorded as it has not been sold. The profit of $700 will be recorded when the rice is actually sold and the profit is earned.
When may inventory be lost?
When they are damaged by fire or floods, or when they are stolen.
What happens when there is a loss of inventory?
The recorded cost of the inventory will be higher than the net realisable value of the inventory. Again, in accordance with the prudence concept, the ending inventory must be written down to the net realisable value.
What is the journal entry for loss on inventory?
Dr Impairment loss on inventory (increase expense) Cr Inventory (decrease asset)
