Unit 2 Chapter 6: INVENTORY COSTING Unit 2 Test (covering chapter 5 and 6) will occur on Oct 24 (Friday) I will hand out the group quiz on Tuesday.

INVENTORY ERRORS - INCOME STATEMENT EFFECTS Sometimes errors occur in taking or calculating inventory. Some errors are caused by mistakes in counting or pricing the inventory. Other errors can be caused by mistakes in recognizing the transfer of legal title for goods in transit. When errors happen, they affect both the income statement and the balance sheet.

INVENTORY ERRORS - INCOME STATEMENT EFFECTS Both beginning and ending inventories appear on the income statement. (under COGS section) The ending inventory of one period automatically becomes the beginning inventory of the next period. Inventory errors affect the determination of cost of goods sold and net income.

FORMULA FOR COST OF GOODS SOLD Beginning Inventory Cost of Goods Purchased Ending Sold _ + = The effects on cost of goods sold can be determined by entering the incorrect data in the above formula and then substituting the correct data.

EFFECTS OF INVENTORY ERRORS ON CURRENT YEAR’S INCOME STATEMENT Understate beginning inventory Understated Overstated Overstate beginning inventory Overstated Understated Understate ending inventory Overstated Understated Overstate ending inventory Understated Overstated An error in ending inventory of the current period will have a reverse effect on net income of the next accounting period.

ENDING INVENTORY ERROR – BALANCE SHEET EFFECTS An error in ending inventory calculation in current year  Over the two years, total net income is correct because two errors offset each other. Overstated Overstated None Overstated Understated Understated None Understated

ENDING INVENTORY ERROR – BALANCE SHEET EFFECTS The effect of ending inventory errors on the balance sheet can be determined by using the basic accounting equation: Assets = Liabilities + Owner’s Equity Overstated Overstated None Overstated Understated Understated None Understated

VALUING INVENTORY AT THE LOWER OF COST AND MARKET When the current market value of inventory is lower than the cost, the inventory is written down to its market value. This is known as the lower of cost and market (LCM) method. Market is defined as replacement cost or net realizable value.

LCM (Lower of Cost and Market) Before reporting inventory on the financial statements, we must first ensure that it is properly valued. The value of inventory items sometimes falls due to change in technology or trend. For example, Bestbuy realized on December 31 that many laptops’ value (inventory value) have decreased by 25%. Do you still have to honour Cost Principle?

LCM In this case, we can violate cost principle. When the current value of inventory is lower than its cost, the inventory is written down to market value. This is done by valuing the inventory at the lower of cost and market (LCM) in the same period in which the decline occurs.

Lower of Cost and Market LCM is an example of the conservatism. Conservatism : When choosing among alternatives, the best choice is the one that is least likely to overstate assets and net income. “Market” = Net Realizable Value or FMV or Replacement Cost Cost = any costs which is required to make the goods ready for sale. For example, if we had to package the inventory, then the packaging cost should be included in the “Cost”.

Lower of Cost and Market LCM is applied to the inventory after one of the cost flow assumptions has been applied to calculate the inventory cost. Items Cost Market LCM LCD 60000 55000 55000 Plasma 45000 52000 45000 Total 105000 107000 100000

Lower of Cost and Market Inventories are usually written down to net realizable value item by item, rather than in total. LCM should be applied consistently from period to period. In this example, Bestbuy’s ending inventory would be 100,000. (EI decreased by 5000) This means COGS in income statement would increase by 5000. (compared to the original ending inventory value of 105000)

Lower of Cost and Market If Bestbuy used perpetual system, then they would make the following adjusting entry: COGS 5000 Merchandise Inventory 5000 The result is the same in both perpetual and periodic inventory system. In both system, the ending inventory is reported on the balance sheet at 100,000, which is 5000 lower than original cost amount.

Lower of Cost and Market Historically companies were not allowed to reverse a write-down to market even if the market price increased in subsequent period.  very rare situation If there is clear evidence of an increase in its market value then the amount of the write-down can be reversed.

Classwork / Homework P321 E6.7 P326 P6.5 P322 E6.9 P325 P6.4 Which question should I take up after 15 minutes? Ahmed and Scot should see me now.