Inventory Valuation and Receivables Accounting

Posted on Jan 2, 2026 in Accounting and Finance

Allowance Method for Uncollectible Accounts

We use the Allowance Method to record estimated uncollectible accounts, which is used to estimate and record expected bad debts. This method ensures that Accounts Receivable (A/R) is stated at Net Realizable Value (NRV) and matches bad debt expense with the related sales revenue.

• Adjusting Entry: Updates the allowance balance to the target ending balance (usually a percentage of A/R or based on an aging schedule).
• Write-Off: Removes a specific A/R from the books. This has no effect on total assets or net income, since the expense was already recorded earlier. It reduces both A/R and the Allowance for Doubtful Accounts by the same amount.
• Recovery: Recognizes estimated uncollectible accounts. This increases expense, reduces net income, and reduces the net value of A/R.

Gross and Net Methods for Sales Discounts

Gross Method

Record the sale at the full amount.

• Initial Sale: Dr. Accounts Receivable 2,000; Cr. Sales 2,000
• Paid within discount period: Dr. Cash 1,960; Dr. Sales Discount 40; Cr. Accounts Receivable 2,000
• Paid after discount period: Dr. Cash 2,000; Cr. Accounts Receivable 2,000

Net Method

Record the sale net of the discount.

• Initial Sale: Dr. Accounts Receivable 1,960; Cr. Sales 1,960
• If customer misses discount: Dr. Cash 2,000; Cr. Accounts Receivable 1,960; Cr. Interest Revenue 40

Inventory Costing: Inclusion and Exclusion

Include in Inventory:

• Purchase price of goods.
• Freight-in, import duties, and insurance during transit.
• Handling and storage costs before sale.
• Direct labor and overhead (for manufacturers).

Exclude from Inventory:

• Freight-out (delivery to customers).
• Advertising and marketing costs.
• Interest and administrative costs.
• Goods held on consignment (where you are the consignor).

FOB Shipping Point vs. FOB Destination

• FOB Shipping Point: The buyer owns the goods once shipped. The buyer pays freight, and goods are included in the buyer’s inventory during transit.
• FOB Destination: The seller owns the goods until received. The seller pays freight, and goods are included in the seller’s inventory until delivery.

FIFO, LIFO, and Average Cost Methods

• FIFO (First-In, First-Out): The first unit purchased is the first unit sold. The most recent costs appear on the balance sheet.
• LIFO (Last-In, First-Out): The last unit purchased is the first unit sold. The most recent costs appear on the income statement.
• Average Costs: The weighted-average unit cost applies to both units in ending inventory and units sold.

Weighted-Average Unit Cost = Cost of Goods Available for Sale / Units (quantity) available for sale.

LIFO Reserve Formulas:

• LIFO Reserve = FIFO Inventory – LIFO Inventory
• Δ LIFO Reserve = Change in income between methods
• Deferred Tax = Δ LIFO Reserve × Tax Rate

COGS Equation and Inventory Error Impacts

Equation: Cost of Goods Sold (COGS) = Beginning Inventory + Purchases – Ending Inventory

If Ending Inventory is Overstated:

• Year 1: COGS ↓ | Net Income ↑ | Retained Earnings ↑
• Year 2: COGS ↑ | Net Income ↓ | Retained Earnings corrected

If Ending Inventory is Understated:

The effects are the opposite of those listed above.

Lower of Cost or Net Realizable Value (LCNRV)

Inventories are reported at the lower of cost or NRV. This represents a departure from historical cost to recognize losses when value declines rather than when the inventory is sold. The basic rationale is accounting conservatism.

• NRV = Selling Price – Selling Costs
• If Cost < NRV: Do nothing.
• If Cost > NRV: Dr. Loss or COGS; Cr. Inventory

Gross Profit Method for Inventory Estimation

This is an approximation of inventory value and is not acceptable for annual financial reporting purposes. The primary advantage is that a physical count is not required.

• Estimated COGS = Net Sales × (1 – Gross Profit Percentage)
• Ending Inventory = Goods Available for Sale – COGS

Example:
Beginning Inventory = 128,000; Purchases = 420,000; Sales = 650,000; GP% = 30%
COGS = 650,000 × (1 – 0.3) = 455,000
Ending Inventory = (128,000 + 420,000) – 455,000 = 93,000

Retail Inventory Method and Cost-to-Retail

This method estimates ending inventory using the relationship between cost and retail price and is acceptable for financial reporting.

Steps:

1. Compute Cost-to-Retail % = Goods at Cost / Goods at Retail
2. Determine Ending Inventory @ Retail = Goods Available – Sales
3. Estimate Ending Inventory @ Cost = Ending Inventory @ Retail × Cost-to-Retail %
4. Compute COGS = Goods Available @ Cost – Ending Inventory @ Cost

Practical Applications and FRQ Practice

1) Accounts Receivable Calculations

Gross A/R = Receivables net of (c) + …
First: Compute ending gross A/R → Ending Gross A/R = Beginning Gross A/R + Credit Sales − Cash Collections − Write-offs.
(b) Target Allowance = % × Ending Gross A/R.

Journal Entries:

1. Dr. Accounts Receivable; Cr. Sales Revenue
2. Dr. Cash; Cr. Accounts Receivable
3. Dr. Allowance; Cr. Accounts Receivable
4. Dr. Accounts Receivable; Cr. Allowance / Dr. Cash; Cr. Accounts Receivable

Dr. Bad Debt Expense; Cr. Allowance. If the adjustment is negative: Dr. Allowance for Uncollectible A/R; Cr. Bad Debt Expense.

2) Retail Method Comparison Table

3) Dollar-Value LIFO

Formula: Ending Inventory at Year-End Prices / Current Price Index = Ending Inventory at Base Prices.
Split into layers × Proper Price Index = Ending Inventory at Dollar-Value LIFO.

4) LIFO Reserve Analysis