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Accounting principles determine rules which have to be followed in order to account for business transactions properly and to provide fair and reliable information on the business activities to the users of the financial statements. Inventory accounting is a major part of the accounting theory and practice, therefore it is essential to understand the main accounting principles to be applied to inventory accounting. One of them is an application of the net realizable value concept.
Usually inventory is acquired or produced with the purpose to be sold to earn profit. So most of inventory will be sold at a price higher than acquisition or manufacturing cost. However it might happen that part of inventory will be sold at a price lower than acquisition or manufacturing cost of inventory. Reasons for that are the following:
Accounting principles require that in case sales price of inventory business has on hand is lower than its acquisition or manufacturing price, such inventory must be valued at net realizable value. Net realizable value is an estimated proceeds from the sale of inventory reduced by costs to be incurred to prepare inventory for sale and marketing, selling and distribution expenses directly related to the inventory. So in case inventory is valued at the acquisition or manufacturing cost and sales price is lower than this cost, value of inventory must be reduced.
Business might have different types of inventory, i.e. raw materials, goods purchased for resale, manufactured goods for resale, work in progress. Net realizable value estimation and inventory value reduction rule is applied to all types of inventory. This is essential to reflect fair value of all inventory types in the financial statements of an entity.
In case value of inventory must be reduced, the reduction impact is accounted for as expenses and the following accounting entry is made:
D Expenses $1000
C Inventory $1000
This is done at the end of each accounting period.
Assume that in May, 2010 a company has acquired 100 inventory items for resale. Acquisition price was $5 per item. The company intended to sell inventory at a price of $15 per item.
The following entry was made in the accounting books:
D Inventory $500
C Cash $500
At the end of April due to changes in the market sales price of one item fell to $3. At the end of April value of inventory has to be reduced to $3, i.e. to $300. The following entry will have to be made:
D Expenses $200
C Inventory $200
After this is done the value of inventory of the company will be equal to $300.