Final Topics in Chp. 6
BUA111: Weeks 14 and 15
Final 3 topics
1. LOCM Rule (Lower-of Cost-or-Market)
2. Inventory Control (2 cases presented)
3. Inventory Errors
4. Ratio Analysis
LOCM
In e-text, p.355: S6-8
S6-8
S6-8 Applying the lower-of-cost-or-market rule
Assume that a Mega Burger restaurant has the following
perpetual inventory record for hamburger patties:
At July 31, the accountant for the restaurant determines that
the current replacement cost of the ending merchandise
inventory is $431. It was recorded at a cost of $380. Make any
adjusting entry needed to apply the lower-of-cost-or-market
rule. Merchandise inventory would be reported on the
balance sheet at what value on July 31?
S6-8: LOCM
(Good for Q#5 on EXAM #3)
S6-8
No adjusting entry is needed because the
current replacement cost (market value) is
higher than the recorded cost of ending
merchandise inventory. Thus, merchandise
inventory should be reported on the balance
sheet at its recorded cost of $380.
Dr. keith D. Moon
5
In text: S6-21
This example illustrates an adjusting entry for
LOCM Rule.
S6-21
E6-21 Applying the lower-of-cost-or-market rule to merchandise inventories
Rapid Resources, which uses the FIFO inventory costing method, has the
following account balances at May 31, 2017, prior to releasing the financial
statements for the year:
Rapid has determined that the current replacement cost (current market
value) of the May 31, 2017, ending merchandise inventory is $13,500. The
inventory had been recorded at $14,500.
Requirements
Prepare any adjusting journal entry required from the information given.
What value would Rapid report on the balance sheet at May 31, 2017, for
merchandise inventory?
E6-21
Date
May 31
Accounts and Explanation
Cost of Goods Sold
Merchandise Inventory
To write merchandise inventory down
to market value.
Debit
Credit
1,000 *
1,000 *
Topic: Inventory Control
2 Cases Presented with Solutions
Dr. K. Moon
LO 1
Control of Inventory
• Two primary objectives of control over
inventory are:
1. Safeguarding the inventory from damage or
theft.
2. Reporting inventory in the financial
statements.
Dr. K. Moon
LO 1
Safeguarding Inventory
• Storing
inventory in areas
that are
restricted
Controls
for safeguarding
inventory
should
to only
authorized
employees.
include
security
measures
to prevent damage
and• customer
or employee
theft. Some
Locking high-priced
inventory
in cabinets.
examples of security measures include the
• Using two-way mirrors, cameras, security
following:
tags, and guards.
• Think of cost of safeguarding inventory.
• What other major cost(s) when inventory is
held?
Dr. K. Moon
LO 1
Reporting Inventory
• A physical inventory or count of inventory
should be taken near year-end to make sure
that the quantity of inventory reported in the
financial statements is accurate.
• Why count?
Dr. K. Moon
Inventory Control: Case 1
A4A Hardware Store currently uses a periodic inventory system. Ray Ballard, the owner,
is considering the purchase of a computer system that would make it feasible to switch
to a perpetual inventory system.
Ray is unhappy with the periodic inventory system because it does not provide timely
information on inventory levels. Ray has noticed on several occasions that the store runs
out of good-selling items, while too many poor-selling items are on hand.
Ray is also concerned about lost sales while a physical inventory is being taken. A4A
Hardware currently takes a physical inventory twice a year. To minimize distractions, the
store is closed on the day inventory is taken. Ray believes that closing the store is the
only way to get an accurate inventory count.
Dr. K. Moon
Inventory Control: Case 1 (con’t.)
QUESTIONS:
Will switching to a perpetual inventory system
strengthen A4A Hardware’s control over
inventory items? Why?/Why not?
Will switching to a perpetual inventory system
eliminate the need for a physical inventory
count? Explain.
Dr. K. Moon
Solution: Inventory Control: Case 1
Switching to a perpetual inventory system will strengthen A4A
Hardware’s internal controls over inventory, since the store managers
will be able to keep track of how much of each item is on hand. This
should minimize shortages of good-selling items and excess
inventories of poor-selling items.
On the other hand, switching to a perpetual inventory system will
not eliminate the need to take a physical inventory count. A physical
inventory must be taken to verify the accuracy of the inventory
records in a perpetual inventory system. In addition, a physical
inventory count is needed to detect shortages of inventory due to
damage or theft.
Dr. K. Moon
Inventory Control: Case 2: Part a
Lincoln Luggage Shop is a small retail establishment located in a large
shopping mall.
This shop has implemented the following procedures regarding inventory
items. State whether each of these procedures is appropriate or
inappropriate. If it is inappropriate, state why.
a.
Since the shop carries mostly high-quality, designer luggage, all inventory
items are tagged with a control device that activates an alarm if a tagged
item is removed from the store.
Dr. K. Moon
Solution: Inventory Control: Case 2:
Part a
a. Appropriate. The inventory tags will
protect the inventory from customer theft.
Dr. K. Moon
Inventory Control Case 2: Part b
b. Since the display area of the store is limited,
only a sample of each piece of luggage is kept on
the selling floor. Whenever a customer selects a
piece of luggage, the salesclerk gets the
appropriate piece from the store’s stockroom.
Since all salesclerks need access to the
stockroom, it is not locked. The stockroom is
adjacent to the break room used by all mall
employees.
Dr. K. Moon
Solution: Inventory Control Case 2:
Part b
b. Inappropriate. The control of using
security measures to protect the inventory is
violated if the stockroom is not locked.
Dr. K. Moon
Inventory Control Case 2: Part c
c. Whenever Lincoln receives a shipment of new
inventory, the items are taken directly to the
stockroom. Lincoln’s accountant uses the
vendor’s invoice to record the amount of
inventory received.
Dr. K. Moon
Solution: Inventory Control Case 2:
Part c
c.
Inappropriate. Good controls include a
receiving report, prepared after all inventory
items received have been counted and
inspected. Inventory purchased should only be
recorded and paid for after reconciling the
receiving report, the initial purchase order, and
the vendor’s invoice.
Dr. K. Moon
Topic: Inventory Errors
Note that inventory errors will effect BOTH the
Balance Sheet (Current Asset: Merchandise
Inventory) AND the Income Statement (COGS).
In addition, there might be an effect on more
than just the current year.
S6-9
S6-9 Determining the effect of an inventory error
Learning Objective 5
Mountain Pool Supplies’s merchandise inventory data for the year ended
December 31, 2017, follow:
Requirements
Assume that the ending merchandise inventory was accidentally overstated
by
$1,300. What are the correct amounts for cost of goods sold and gross profit?
How would the inventory error affect Mountain Pool Supplies’s cost of goods
sold and gross profit for the year ended December 31, 2018, if the error is not
corrected in 2017?
S6-9 solution
Requirement 1
For the year ended December 31, 2017, the
correct amounts for cost of goods sold and gross
profit are $29,400 and $16,600, respectively.
S6-9 solution (Con’t.)
$ 28,100 Incorrect cost of goods sold
1,300 Understatement
If ending inventory is overstated by $1,300,
then cost of goods sold is understated by $1,300.
$ 29,400 Correct cost of goods sold
S6-9solution (con’t.)
If cost of goods sold is understated by $1,300,
then gross profit is overstated by $1,300.
S6-9solution (con’t.)
$ 17,900 Incorrect gross profit
(1,300)
Overstatement
$ 16,600 Correct gross profit
S-9 solution (completed)
Requirement 2
Ending merchandise inventory on December 31, 2017 is the same as
beginning merchandise inventory on January 1, 2018. Thus, if ending
merchandise inventory on December 31, 2017 is overstated by $1,300,
beginning merchandise inventory on January 1, 2018 is also overstated
by $1,300.
Effects for the year ended December 31, 2018: If beginning inventory
is overstated by $1,300, then cost of goods sold is overstated by
$1,300 and gross profit is understated by $1,300.
Topic: Ratio Analysis
See S6-10 in text
S6-10
S6-10 Computing the rate of inventory turnover and
days’ sales in inventory
Clear Communications reported the following figures in
its annual financial statements (see next slide)
Compute the rate of inventory turnover and days’ sales in
inventory for Clear Communications. (Round to two
decimal places.)
S6-10
S6-10 Solution
Inventory turnover is 35.85 times and days’ sales
in inventory is 10.18 days.
Average merchandise inventory
=
=
=
(Beginning merchandise inventory
+ Ending merchandise inventory) / 2
($600 + $460) / 2
$530
S6-10 Solution (con’t.)
Inventory turnover
=
Cost of goods sold
/ Average merchandise inventory
$19,000 / $530
=
35.85 times per year
=
S6-10 Solution (completed)
Days’ sales in inventory
= 365 days / Inventory turnover
365 days / 35.85 times
=
10.18 days
=