Valuation and Reporting of Receivables and Inventory Chapter 6

Uncollectible Receivables The matching principle requires that the expense related to uncollectible receivables must be recorded in the same period as the related revenue  Often requires an estimate of uncollectible receivables Sale may be made in one period, but the uncollectible receivable is not identified until a later period

Uncollectible Receivables Balance sheet presentation requires reporting of the estimated value of the receivables that will be collected (net realizable value)  An allowance for doubtful accounts is used to estimate the amount of receivables that will not be collected Usually do not know which receivables will be uncollectible  The allowance is offset against the receivable account

Uncollectible Receivables Estimation methods  Percent of sales method Bad debt expense is calculated as a percent of credit sales made during the period The expense increases the allowance for doubtful accounts  Percent of receivables method The required allowance for doubtful accounts is calculated as the percent of receivables that are expected to be uncollectible (aging) Bad debt expense is the amount required to bring the allowance up to its required balance

Uncollectible Receivables Recording bad debt expense at year-end increases the allowance account and reduces retained earnings  It does not affect accounts receivable Writing off a customer’s account reduces accounts receivable and the allowance  It does not affect bad debt expense  Net realizable value of receivables is the same after the writeoff as it was before

Valuation of Inventory Inventory valuation relies on estimates since it is often impossible to determine exactly which goods have been sold and which remain in inventory Cost flow assumptions  Specific identification  Weighted average  First-in, first-out (FIFO)  Last-in, first-out (LIFO)

Valuation of Inventory Specific identification  Can specifically identify which goods remain, and match them to their cost No estimate is needed Weighted average cost  Determine the average cost of all goods available for sale Total cost / total units

Inventory Valuation First-in, first-out  Assumes oldest goods are sold first, newer ones remain in inventory  Assigns the oldest costs to the income statement May understate cost of merchandise sold  Assigns the newest costs to the balance sheet Provides good estimate of replacement cost of inventory

Inventory Valuation Last-in, first-out  Assumes newest goods are sold first, oldest ones remain in inventory  Assigns most recent costs to the income statement Good matching of cost to revenue, except when old units are sold  Assigns oldest costs to balance sheet May understate inventory value

Inventory Valuation Example

Inventory Valuation Weighted average cost  $2,608 / 400 units = $6.52 per unit  Ending inventory 110 $6.52 = $  Cost of merchandise sold 290 $6.52 = $1,890.80

Inventory Valuation First-in, first-out  Ending inventory  Cost of merchandise sold

Inventory Valuation Last-in, first-out  Ending inventory  Cost of merchandise sold

Inventory Valuation Lower of cost or market rule  Inventory is reported at cost unless The replacement cost is below the recorded cost, or The items cannot be sold at their normal selling price  Cost, as determined by one of the cost flow assumptions, is compared to the market value Whichever is lower is the amount reported on the financial statements Avoids overstating the value of inventory