Question

Inventory is a critical asset for retailers. Retail firms are at risk that their inventory will become obsolete. What can a firm do to minimize this risk? Describe how they should account for the loss from that obsolescence. Describe and compare the four methods of measuring the cost of goods sold under GAAP?

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Answer 1

Solution:

Inventories when held for longer period it becomes obsolete and cannot be processed for production. These types of inventories cannot be sold in the market because of being outdated and obsolete in nature. As they cannot be sold in the market the inventories fall in its value. The company has to write off obsolete inventory. An account called allowance for obsolete inventory is created to write off the obsolete inventory.

Minimizing the risk of obsolete inventory:

Accurate Forecast of Purchases: The company should forecast accurately so that there will not be an excess purchase of inventory. Avoid inventories being held for a long period (for more than 12 months). Check with the suppliers whether the excess inventories can be refunded.

Analysing Marketplace and shift in technology: As a company it is very important to foresee shift in technology to avoid overstock of inventory. It helps in accurate forecast of purchases and can avoid inventories getting obsolete.

Donation of Obsolete Inventories: Obsolete inventories can be used in donation. Donating excess inventory to not-for-profit organisation gives the company tax benefit.

Reprocess of Obsolete Inventories: Obsolete inventories can be scrapped and recycled. Municipalities has lot recycling programs. Recyclable inventories have value and can find purchaser for recyclable inventories.

Online Sale: With the advent of online sale, it has become easy for the company to find auction for obsolete inventories. This helps in avoiding write-off of obsolete inventory.

Inventory Management: It is very important to avoid long lead time. Inventory management should efficiently manage supply chain to avoid long lead time. The supply chain needs to be streamed line to avoid excess of stock in hand. Managing the Purchase Order that can accurately meet the customers demand.

Accounting for the loss due to obsolescence:

Obsolete inventory can be written down or written off in accordance to Generally Accepted Accounting Principles (GAAP). An obsolete inventory can be either written down or written off. The obsolete inventories are written down when it can be sold in the market but sale value of the inventory is fallen. The obsolete inventories are written off when it has no sale value in the market and the company is left with the only option to write off the inventories. GAAP requires to create an account called allowance for obsolete inventory to write down or write off the obsolete inventory. Allowance for obsolete inventory contra asset account.

Written down of inventory

For example, an inventory worth $ 10,000 is written down to $ 2,000, then Inventory obsolescence is debited by $ 8,000 and Allowance for Obsolete inventory will be credited by $ 8,000 to write down the inventory. Inventory obsolescence will appear in income statement and Allowance for obsolete appears as contra asset account in the balance sheet.

If the written down inventory is sold for $ 1,500, then cash is debited by $ 1,500, Allowance for obsolete inventory is debited by $ 8,000 and Cost of goods sold is debited by $ 500 and Inventory is credited by $ 10,000.

Write-off of inventory

For example, an inventory worth $ 10,000 is completely written off, then Inventory obsolescence is debited by $ 10,000 and Allowance for Obsolete inventory will be credited by $ 10,000 to write down the inventory. Inventory obsolescence will appear in income statement and Allowance for obsolete appears as contra asset account in the balance sheet.

Measuring Cost of Goods Sold under GAAP:

The four methods to measure the cost of goods sold are First In First Out (FIFO), Last In Last Out (LIFO), Weighted average method, and periodic method.

First In First Out: Under FIFO method the inventories that are purchased first will be accounted while calculating the cost of goods sold. It comes with an assumption that the goods purchase first will be sold first.

Last In Last Out: Under LIFO method the inventories that are purchased last will be accounted while calculating the cost of goods sold. It comes with and assumption that the goods that are purchase last will be sold first.

Weighted Average Method: This is one of the commonly used method by the company. Under this method the cost of goods sold are calculated using the weighted average method. Weight average cost is arrived by multiplying the cost per unit with the total units purchase at different cost and dividing it with total units purchased.

Period Cost: It is simple method which need to keep track of cost of each unit’s purchase. It considers the total cost incurred for purchase.

Beginning Inventory + Purchases = Available for sale

Available for Sale – Ending Inventory = Cost of Goods Sold