Final Topics in Chp. 6 BUA111: Weeks 14 and 15

Final 3 topics LOCM Rule (Lower-of Cost-or-Market) Inventory Control (2 cases presented) Inventory Errors 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

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?

Accounts and Explanation Date Accounts and Explanation Debit Credit May 31 Cost of Goods Sold 1,000 *   Merchandise Inventory To write merchandise inventory down to market value.

Topic: Inventory Control 2 Cases Presented with Solutions Dr. K. Moon

LO 1 Control of Inventory Two primary objectives of control over inventory are: Safeguarding the inventory from damage or theft. Reporting inventory in the financial statements. Dr. K. Moon

Safeguarding Inventory LO 1 Safeguarding Inventory Controls for safeguarding inventory should include security measures to prevent damage and customer or employee theft. Some examples of security measures include the following: Storing inventory in areas that are restricted to only authorized employees. Locking high-priced inventory in cabinets. Using two-way mirrors, cameras, security 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. 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 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? $1,300. What are the correct amounts for cost of goods sold and gross profit? Assume that the ending merchandise inventory was accidentally overstated by Requirements 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: 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 $ 29,400 Correct cost of goods sold If ending inventory is overstated by $1,300, then cost of goods sold is understated by $1,300.

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

Average merchandise inventory 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