Unit 2 Chapter 6: INVENTORY COSTING Unit 2 Chapter 6: INVENTORY COSTING • Unit 2 Test (covering chapter 5 and 6) will occur Unit 2 Test (covering chapter 5 and 6) will occur on Oct 24 (Friday) on Oct 24 (Friday) •I will hand out the group quiz on Tuesday.
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. - PowerPoint PPT Presentation
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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.
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”.
Lower of Cost and MarketLower of Cost and MarketLower of Cost and MarketLower 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 MarketLower of Cost and MarketLower of Cost and MarketLower 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 MarketLower of Cost and MarketLower of Cost and MarketLower 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 MarketLower of Cost and MarketLower of Cost and MarketLower 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.