unit 2 chapter 6: inventory costing unit 2 test (covering chapter 5 and 6) will occur on oct 24...

Unit 2 Chapter 6: INVENTORY COSTINGUnit 2 Chapter 6: INVENTORY COSTING•Unit 2 Test (covering chapter 5 and 6) will occur on Oct 24 (Friday)Unit 2 Test (covering chapter 5 and 6) will occur on Oct 24 (Friday)

•I will hand out the group quiz on Tuesday.

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 - INVENTORY ERRORS - INCOME STATEMENT EFFECTSINCOME 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 FORMULA FOR COST OF GOODS SOLDCOST OF GOODS SOLD

FORMULA FOR FORMULA FOR COST OF GOODS SOLDCOST OF GOODS SOLD

+ =BeginningInventory

Cost of Goods

Purchased

EndingInventory

Cost of GoodsSold

_

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.

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 EFFECTS OF INVENTORY ERRORS ON CURRENT YEAR’S ERRORS ON CURRENT YEAR’S

INCOME STATEMENT INCOME STATEMENT

EFFECTS OF INVENTORY EFFECTS OF INVENTORY ERRORS ON CURRENT YEAR’S ERRORS ON CURRENT YEAR’S

INCOME STATEMENT INCOME STATEMENT

An error in ending inventory of the current periodwill have a reverse effect on net income of the next

accounting period.

An error in ending inventory of the current periodwill have a reverse effect on net income of the next

accounting period.

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 calculation in current year Over the two years, total net income is correct because two errors offset each other.

ENDING INVENTORY ERROR – ENDING INVENTORY ERROR – BALANCE SHEET EFFECTSBALANCE SHEET EFFECTS


Overstated Overstated None Overstated Understated Understated None Understated

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

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.

VALUING INVENTORY AT THE VALUING INVENTORY AT THE LOWER OF COST AND MARKETLOWER OF COST AND MARKETVALUING INVENTORY AT THE VALUING INVENTORY AT THE

LOWER OF COST AND MARKETLOWER OF COST AND MARKET

LCM (Lower of Cost and Market)LCM (Lower of Cost and Market)LCM (Lower of Cost and Market)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?

LCMLCMLCMLCM

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 MarketLower of Cost and MarketLower of Cost and MarketLower 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”.


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


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)


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.


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 / HomeworkClasswork / HomeworkClasswork / HomeworkClasswork / 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.

unit 2 chapter 6: inventory costing unit 2 test (covering chapter 5 and 6) will occur on oct 24...

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