ACCOUNTING ENGLISH II

By : 1. Isnani Puji Lestari 2. Rina Fitriana 3. Zuhdi Triyanto 2010-12-078 2010-12-080 2010-12-081

ECONOMIC FACULITY MURIA KUDUS UNIVERSITY 2011

7. VALUING INVENTORY AT THE LOWER OF COST OR MARKET (LCM) When the inventory is lower than it cost, the inventory is writtendown to its market value. This is accomplished by valuing the inventory at the lower of cost market (LCM) in the period in which the price decline occurs, LCM is an example of the accounting concept of conservatism. Conservatism means that when chooseing among accounting alternatives, the best choice is to select the method that is least likely to overstate and net income. Under the LCM basis, market is defined as current replacement cost, now selling price. For a merchandising company, market is the cost of purchasing the same goods at the present time from the usual suppliers in the usual quantities. Current replacement cost is used because a decline in the replacement cost of a item usually leads to a decline in the selling price of the item. The lower of cost or market basis may be applied to individual items a inventory, major categories of inventory, or total inventory. For example, assune that Lens TV has the following lines of merchandise with cost and market values as indicated. LCM produces the following three result : Lower of Cost or Market by : Individual Cost Television sets Console Portables Total Video equipment Recorders Movies Total Total inventory 48,000 15,000 63,000 45,000 14,000 59,000 $159,000 45,000 14,000 59,000 $164,000 $166,000 $ 60,000 45,000 105,000 $ 55,000 52,000 107,000 $ 55,0000 45,000 $ 105,000 Major Total Items Categories inventory Market

$168,000 $166,000

The amount entered in the individual items column in the lower of the cost of market amount for each item. For the major categories coloumn the amount is the lower of the total cost or total market for each category. Finally, the amount for the total inventory column is the lower of the cost or market for the entire inventory. The common practice is to use individual item in determining the LCM valuation. This approach give the most conservative valuation for balance sheet purposes and also the lowest net income. LCM should be applied consistently from period to period. LCM is applied to the item in inventory after one of the costing methoss (specific identification, FIFO, LIFO, or average cost) has been applied to determine cost. INVENTORY ERRORS Unfortunately, errors occasionally occur in taking or costing inventiory, in same cases, errors are caused by failure to count for price the inventory correctly. Is other cases, errors occur because proper recognitition is not given to the transfer of legal title to goods that are in transit. When errors occur, they affect both the income statement and the balance sheet. Income Statemen Effects Remember that both the beginning and ending inventories are used to determine cost of goods sold in a periodic system. 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. The effects on cost of goods sold can be determined by entering the incorerrect data in the following formula and then substituting the correct data. If beginning inventory is understated, cost of goods sold will be understated. One the under hand, and under statement of ending inventory will overstate cost of goods sold. The effects of inventory errors on the current years income statement are shown illustration below. Cost of Inventory errors Understate beginning inventory Overstated beginning inventory Understate ending inventory Overstated ending inventory Goods Sold Understated Overstated Overstated Understated Net Income Overstated Understated Understated Overstated

An error in ending inventory of current period will have a reverse effect on set income of the next accounting period. This is shown in illustration. Note that the understatement of ending inventory in 1999 results in an understatement of beginning inventory in 2000 and on overstatement of net income in 2000. Over the 2 years, total net income is correct because the errors offset one another. Notice that total income using incorrect data is $35,000 ($22,000 + $13,000), which is same as the total income of $35,000 ($25,000 + $10,000) using correct data. Also not in this example that an error in the beginning inventory does not result in a corresponding error in the ending inventory for that period. The corecness of the ending inventory depends entirely on the accuracy of taking and costing the the inventory at the balance sheet date. BALANCE SHEET EFFECTS THE effect of ending inventory errors on the balance sheet can be determiner by using the basic accounting aquation : assets equal liabilities plus owner's

Condensed Income Statement 1999 Incorrect Correct Sales $90,000 Beginning inventory Cost of goods purchased Cost of goods available for sale Ending inventory Cost of goods sold 60,000 Gross profit 30,000 Operating expenses 20,000 10,000 10,000 20,000 32,000 35,000 33,000 $20,000 40,000 60,000 12,000 48,000 $20,000 40,000 60,000 15,000 $12,00 68,000 80,000 23,000 45,000 57,000 $15,000 $80,000 $80,000 $90,000 Correct 2000 Incorrect

Net income $10,000

$22,000 ($3,000) Net Income Understated

$25,000 $13,000 ($3,000) Net Income Overstated

Total income for 2 year correct

Equity. Errors in the ending inventory have the following effect on these components Ending inventory Error Overstated Understated Understated Recall that if the error is not income fir the two periods would be correct. Thus,total owner's equity reported on the balance sheet at the end of 2000 will also be correct. STATEMENT PRESENTATION AND ANALYSIS A inventory is classified as a current asset after receivablein the balance sheet,and cost of goods sold is subtracted from sales in a multiple-step income statement. In adition, there should be disclosure of (1) the major inventory classifications,(2) the basis of a accounting (cost or lower of cost or market), and (3) the costing method (FIFO,LIFO, or Average). Kellogg Company,for example, in its December 31, 1997, balance sheet reported inventory of $434,300,000 under current assets. The accompanying notes to the financial statement, disclosed the following information : Assets Overstate Understated Liabilities None None Owners Equity Overstated

KELLOGG COMPANY Notes to the financial statements Notes 1 Accounting policies inventories inventories are valued at the lower of cost ( principally average ) or market. Company values its inventories at the lower of cost or market using the average cost method to apply costs to inventory and cost of goods sold. The amount of inventory carried by a company has significant economic consequences. And, inventory management is a double-edged sword that requires constant attention. On the one hand, management want to have a great variety and quantity on hand so customers have the greatest selection and inventory items are always in stock. But, such an inventory policy may excessive carrying costs (e.g., investment, storage, insurance, taxes, obsolescence, and damage). On the other hand, low inventory levels lead to stock outs, lost sales, and disgruntled customers. Common ration used in the management and evaluation of inventory levels are inventory turnover and a related measure, average days to sell the inventory. The inventory turnover ratio measures the number of times on average the inventory is sold during the periods. Its purpose is to measure the liquidity of the inventory. The inventory turnover is computed by dividing cost of goods sold by the average inventory during the period. Unless seasonal factors are significant, average inventory can be computed from the beginning and ending inventory balances. Companies that are able to keep their inventory ar lower levels and higher turnovers and still satisfy customer needs are the most successful. 8. GROSS PROFIT METHOD The gross profit estimates the cost of ending inventory by applying gross profit rate to net sales. It is used in preparing monthly financial under a periodic system when physical inventories are not taken. This method is a relatively simple but effective estimation technique. Accountants, auditor, and managers frequently use the gross profit method to test the reasonableness of the ending inventory amount. This method will detect large errors. To use this method, a company needs to know its net sales, cost of goods available for sale, and gross profit rate. The company

then uses the gross profit rate to estimate its gross profit rate to estimate its gross profit for the accounting period. The gross profit method is based on the assumption that the rate of gross profit will remain constant from one year to the next. It may not remain constant though, because of a change either in merchandising policies or in market conditions. In such cases, the rate of the prior period should be adjusted to reflect current operating conditions. In some cases, more accurate estimate may be obtained by applying this method on a department or product-line basis. The gross profit method should not be used in preparing a companys financial statement at the end of the year. These statements should be based on a physical inventory count. 9. RETAIL INVENTORY METHOD A retail store such as Kmart, Ace Hardware, or Wal-Mart has thousands of different types of merchandise at low unit cost. In such cases the application of unit cost to quantities is difficult and time-consuming. An alternative is to use the retail inventory method to estimate the cost of inventory. In most retail concerns, a relationship between cost and sales price can be established. Under the retail inventory method, the cost to retail percentage is then applied to the ending inventory at retail prices to determine inventory at cost. To use to retail method, a company must maintain record that show both the cost and retail value of the goods available for sale. The application of the retail method based in the accounting records and supplementary data for Lacy Co. is shows in illustration below. Not that it is not necessary to take a physical inventory to determine the estimated cost of goods on hand at any given time. At Cost Beginning inventory Goods purchased Goods available for sale Net sales (1) Ending inventory at retail (2) Cost to retail ratio = (3) Estimated cost of ending inventory = ($75,000 : $100,000) ($30,000 x 75%) $14,000 61,000 $75,000 At Retail $21,500 78,500 100,000 70,000 $30,000 75% $22,500

The retail inventory method also facilities taking a physical inventory at the end of year. With this method, the goods an hand can be valued et the prices marked on the goods actually on hand at retail to determine to ending inventory at cost. The major disadvantage of the retail method is that it is an averaging technique. It may produce a incorrect inventory valuation if the mix of the ending inventory is not representative of the mix in the goods available for sale. 10. INVENTORY COST FLOW METHODS IN PERPETUAL INVENTORY SYSTEM Each of the inventory cost flow methods described in the chapter for a period inventory system may be used in a perpetual inventory system. To illustrate the application of the three assumed cost flow methods (FIFO, LIFO, and average cost), we will use the data shown below and this chapter for Bow Valley Electronics' product Z202 Astro Condenser. BOW VALLEY ELECTRONIC Z202 Astro Condenser Unit Date Explanation 1/1 4/15 8/24 9/10 Beginning inventory Purchase Purchase Sales Units 100 200 300 550 400 13 5200 $12.000 FIRST-IN, FIRST-OUT (FIFO) Under FIFO, the cost of the earliest goods on hand prior to each sale is charged to cost of goods sold. Therefore, the cost of goods sold on September 10 consists of the units on hand January 1 and the units purchased April 15 and August 31. The inventory on a FIFO method perpetual system is show in illustration below. Cost $10 11 12 Total Cost $1.000 2.200 3.600 Balance In units 100 300 600 50 450

11/27 Purchase

Date 1/1 4/15 8/24

Purchases (200@$11) (300@$12) $2.200 $3.600

Sales

Balance (100@$10) (100@$10) (200@$11) (100@$10) (200@$11) (300@$12) $6.800 $1.000 $3.200

9/10

(100@$10) (200@$11) (300@$12) $6.200 (50@$12) (50@$12) (400@$13) $600 $5.800

11/27

(400@$13)

$5.200

The results under FIFO in a perpetual system are the same as in periodic system. Regardless of the system, the first cost in are the cost assigned to cost of goods sold. LAST-IN, FIRST-OUT (LIFO) Under the LIFO methods using a perpetual system, the cost of the most recent purchase prior to sale is allocated to the units sold. Therefore, the cost of the goods sold on September 10 consists of all the units from the August 24 and April 15 purchase and 50 of the units in beginning inventory. The ending inventory on a LIFO method is computed in illustration below. Date 1/1 4/15 8/24 (200@$11) (300@$12) $2.200 $3.600 Purchases Sales Balance (100@$10) (100@$10) (200@$11) (100@$10) (200@$11) (300@$12) 9/10 (300@$12) (200@$11) (50@$10) (50@$10) $500 $6.800 $1.000 $3.200

$6.300 11/27 (400@$13) $5.200 (50@$10) (400@$13) The use of LIFO in a perpetual system will usually produce cost allocations that differ from using LIFO in a periodic system. In a perpetual system, the latest units incurred prior to each sale are allocated to cost of goods sold. In contrast, in a periodic system, the latest unit incurred during a period are allocated to cost of goods sold. Thus, when a purchase is made after the last sale, the LIFO periodic system will apply this purchase to the previous sale. AVERAGE COST The average cost method in a perpetual system is called the moving average method. Under this method a new average is computed after each purchase. The average cost is computes by dividing the cost of goods available for sale by the units on hand. The average cost in the applied to : (1) the units sold, to determine the cost of goods sold, and (2) the remaining units on hand, to determine the ending inventory amount. $5.700

POWER POINT

A retail store such as Kmart, Ace Hardware, or WalMart has thousands of different types of merchandise at low unit cost. In such cases the application of unit cost to quantities is difficult and time-consuming. An alternative is to use the retail inventory method to estimate the cost of inventory. In most retail concerns, a relationship between cost and sales price can be established. Under the retail inventory method, the cost to retail percentage is then applied to the ending inventory at retail prices to determine inventory at cost. To use to retail method, a company must maintain record that show both the cost and retail valueof thegoods availablefor sale.

AtC os t AtR etail Beginninginventory Goodspurchased Goodsavailable for sale Net sales Endinginventoryat retail Cost to retail ratio =($75,000 : $100,000) =75% Estimatedcost of endinginventory=($30,000x75% ) $22,500 $14,000 61,000 $75,000 $21,500 78,500 100,000 70,000 $30,000

Theretail inventory method also facilities taking a physical inventory at the end of year. With this method, the goods an hand can be valued et the prices marked on the goods actually on hand at retail to determineto ending inventory at cost. The major disadvantage of the retail method is that it is an averaging technique. It may produce a incorrect inventory valuation if the mix of the ending inventory is not representative of the mix in the goods available for sale.

INVE NT OR YC OS TF L OWMETH ODS IN P ER P ETUALINVENT OR Y S Y S TEM

Each of the inventory cost flow methods described in the chapter for a period inventory system may be used in a perpetual inventory system. To illustrate the application of the three assumed cost flow methods (FIFO, LIFO, and averagecost).

INVENT OR YC OS TF L OWMETH OD S IN P ER P ETU ALINVENT OR Y S Y S TEM

Each of the inventory cost flow methods described in the chapter for a period inventory system may be used in a perpetual inventory system. To illustrate the application of the three assumed cost flow methods (FIFO, LIFO, and averagecost).

BOWV AL L E YE L E C TR ONIC Z 2 02As troC ondenser Unit Date E xplanation 1/1 Beginning inventory 4/15 Purchase 8/24 Purchase 9/10 Sales 11/27 Purchase Units C os t 100 200 300 550 400 13 $12.000 $10 11 12 T otal Balance C os t Inunits $1.000 100 2.200 300 3.600 600 50 5200 450

F IR S T-IN, F IR S T-OUT(F IF O)
Under FIFO, the cost of theearliest goods on hand prior to each sale is charged to cost of goods sold. Therefore, the cost of goods sold on September 1 0 consists of the units on hand January 1and the units purchased April 1 5 and August 31 . The inventory on a FIFO method perpetual system is show in illustration below. The results under FIFO in a perpetual system are the same as in periodic system. Regardless of the system, the first cost in are the cost assigned to cost of goodssold.

illustration D ate P urchas es 1/1 4/15 (200@$11) $2.200 8/24 (300@$12) $3.600 S a les B alance (100@$10) (100@$10) (200@$11) (100@$10) (200@$11) (300@$12) (100@$10) (200@$11) (300@$12) $6.200 $1.000 $3.200

$6.800

9/10

(50@$12) (50@$12) (400@$13)

$600 $5.800

11/27 (400@$13) $5.200

Illustration D ate P urchases 1/1 4/15 (200@$11) $2.200 8/24 (300@$12) $3.600 S ales Balance (100@$10) (100@$10) (200@$11) (100@$10) (200@$11) (300@$12) (300@$12) (200@$11) (50@$10) $6.300 $1.000 $3.200

A VER AGEC OS T
The average cost method in a perpetual system is called the moving averagemethod. Under this method a new average is computed after each purchase. The average cost is computes by dividing the cost of goods available for sale by the units on hand. The average cost in the applied to : (1 ) the units sold, to determine the cost of goods sold, and (2) the remaining units on hand, to determinetheending inventoryamount.

$6.800

9/10

(50@$10) (50@$10) (400@$13)

$500 $5.700

11/27 (400@$13) $5.200

VOCABULARY Available Cost Determine Difficult Disadvantage Earliest Establish Estimate Major Merchandise Percentage Ratio Relationship Retail Sale price : tersedia : harga : menentukan : sukar : merugikan : lebih dulu : dibuat : perkiraan/taksiran : utama : bsarang dagangan : persentasi : perbandingan : hubungan : penjualan : harga jual