Question

L Co. has not been very profitable for the past three years. Additionally, a recently-ousted manager purchased a substantial quantity of inventory earlier this year…inventory whose customer desirability has waned to some extent. As such, the inventory value has declined below its cost and two methods of handling the write-down are being discussed: showing the amount of the write-down ($3,000,000) as a line item loss on the income statement and showing the loss as part of cost of goods sold. Both methods are GAAP.

a. What is the ethical accounting issue in this situation? (1 pt.)

b. Considering the qualitative characteristics of accounting as well as basic accounting concepts, discuss pros and cons of using (1) the loss method and (2) the CGS method. (3 pts.)

c. What other information might be useful in making the decision as to how the loss will be recognized on the income statement? (2 pts.)

d. What method would you choose and why? (1 pt.)

Answer 1

The write down of inventory involves charging a certain amount of the inventory asset to expense in the current period. Inventory is written down when goods are lost or stolen, or their value has declined. This should be done at once, so that the financial statements immediately reflect the reduced value of the inventory. Otherwise, the inventory asset will be too high, and so is misleading to the readers of a company's financial statements.

There are two ways to write down inventory. First, if inventory write-downs are not significant, debit the general cost of goods sold account and credit inventory.

Alternatively, if inventory write-downs are significant in size, record the expense in a separate account, so you can track their aggregate size.

If inventory has been tagged for disposition but not yet disposed of, the accounting staff should immediately create a reserve (contra account) for the total amount that is expected to be lost from the disposition of all the identified items. This would be a debit to the cost of goods sold expense and a credit to the reserve for obsolete inventory account. The reserve would appear on the balance sheet as an offset to the inventory line item. Then, as items are actually disposed of, the reserve would be debited and the inventory account credited. This approach immediately recognizes the full amount of the loss, even if the related inventory has not yet been disposed of.

If you are aware of an inventory issue that requires a write-down, charge the entire amount to expense at once. Do not spread the write-down over future periods, because that would imply that some benefit is accruing to the business over the write-down period, which is not the case.

Recording loss directly in inventory account

If entity choose to record written-down loss directly in inventory account then it has to be credited. However, which account is to be debited depends on the presentation of expenses in income statement and entity’s policy to record such losses. Entity may choose either of the following options:

1. Report the loss as cost of sales/cost of goods sold
2. Report the loss separately

Recording LCNRV loss as cost of goods sold and directly in inventory

Under this method once the loss is determined, cost of goods sold account is debited and inventory account is credited to record the write-down loss on inventory.

Recording LCNRV loss as separate account and directly in inventory

Under this method instead of debiting the loss to cost of goods sold, a separate account with appropriate name is debited and then closed in profit and loss. Credit aspect is however, recorded in same inventory account.

The debit in the entry to write down inventory is reported in an account such as Loss on Write-Down of Inventory, an income statement account. If the amount of the Loss on Write-Down of Inventory is relatively small, it can be reported as part of the cost of goods sold.

As the amount is considerably big ,it should be reported in income statement and not be a part of cost of goods sold.