In the past, average inventory was just average of beginning and ending inventory.Now, practice problem talks about using gross inventory instead of net inventory(taking into account the valuation allowance) to solve to for the average inventory. Some please explain.
Here’s my take…
When inventory is recorded at cost of acquisition on the balance sheet the inventory reserve (valuation allowance) is a negative contra account that is credited based on some estimate of the inventory that won’t be sold at cost. It results in an immediate expense, but allows for the inventory to be written down without impacting the income statement (since expense was taken @ t=0), just the balance sheet, when companies dip into the reserve.
It helps the inventory reflect economic reality since companies normally acquire inventory gradually anyway, not all at once. That way as they dribble credits into the reserve account the inventory is maintained with some smoothness rather than big chunky writedowns and writeoffs.
All companies have different criteria for building the reserve and could even manipulate it, so by adding it back you can level the playing field.