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
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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
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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 _ Ending
Goods
Inventory
Purchased
=
Cost of
Goods
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
Inventory Error
Cost of
Goods Sold
Understate beginning inventory Understated
Overstate beginning inventory
Overstated
Understate ending inventory
Overstated
Overstate ending inventory
Understated
Net Income
Overstated
Understated
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.
Ending Inventory
Error
Overstated
Understated
Assets
Overstated
Understated
Liabilities
None
None
Owner’s Equity
Overstated
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
Ending Inventory
Error
Overstated
Understated
Assets
Overstated
Understated
Liabilities
None
None
Owner’s Equity
Overstated
Understated
VALUING INVENTORY AT THE
LOWER OF COST AND MARKET
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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)
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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
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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
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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
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Lower of Cost and Market
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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.
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Lower of Cost and Market
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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
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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.