 Hello, and welcome to the session. This is Professor Farhad. In this session, I would look at three topics, lower of cost or market, LCM, inventory errors, and inventory ratios. These topics are typically covered in financial accounting introductory course. They're also covered in intermediate accounting. So if you feel that this explanation is not sufficient enough for you if you're studying for your CPA exam, please visit my intermediate accounting course because I do visit those topics much, much more in details. As always, I would like to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1,600 plus accounting, auditing, finance, and tax lectures. This is a list of all the courses that I cover. If you like my lectures, please like them. Click on the like button. It doesn't cost you anything. Share them, especially these days with the coronavirus. They might help other people as well. So share the wealth and connect with me on instagram. On my website, you will find supplemental material. If you're studying for your CPA exam, I strongly suggest you check it out. So let's take a look at the first topic in today's session. Lower of cost or market. One more time, I'm gonna remind you that I do have this topic much, much more in detail covered in my intermediate accounting course. And the reason I say this because today I'm gonna be covering this topic very briefly. So if you want more in depth, go to my intermediate accounting. So what is this idea? Lower of cost or market? What's the idea behind it? Well, let's assume your company is selling calculators. And you purchased a calculator for $15. Now, three months later or a year later, you're counting your inventory and what you need to do, you need to take and you still have that calculator. For one thing, it's not good if you still have it a year later, but that's beside the point. Now what you have to do is you have to figure out what is the market. And we're not gonna call the technical word as market. Really what you're looking at is the replacement cost. You went back to that supplier or you went back to the catalog or you check out the company's website where you bought the calculator. And if you wanna buy the same calculator today, you only have to pay $11. Same calculator, you bought it for $15 a year ago today if you want to replace it, it's worth $11. What does that tell you? It tell you that your calculator lost some utility. Lost utility. How do I know it's lost utility? Well, it's cheaper. If I want to buy it, I can buy it at a lower price. Lost some utility. Why? Because it lost $4. It means it's not as good as it was a year ago. What does that mean for me? As far as I'm concerned as the company, I have to report the lower, I have to report the lower of one cost to market. So rather than reporting my calculator at 15, I have to report it at 11. What does that mean? It means I'm gonna take a loss of $4. That's based on conservatism. And accounting, if you buy something and it lost value, you have to report that loss although before you sell it. So that's the idea. So let's take a look at the terms. Inventory must be reported at market value when the market value is lower. So notice the market value of lower. If you went back to that supplier and told you now this calculator is selling at 18, guess what? You keep it at 15. That's good. You don't report it at 18. You reported at 15 because of conservatism, okay? So how do we define the word market when we say lower of cost or market? As I told you, it's the replacement cost. If you want to replace it, how much will you pay for it? Not the sales price. Again, as I said, this is consisting with the conservatism principle. Now LCM can be applied to each item individually. So you could look at each item in your inventory or you can look at the major categories. For example, you could look at each TV separately or you can combine all the similar TVs. Or you could take a look at your whole inventory. So there's three ways to apply LCM. You don't have to worry about it. The point is there are more than one way. And the most conservative way is to look at each item separately. If you look at each item separately and compare cost to market and write it down, you're gonna have the most losses. Or for example, you combine the TVs together, the computers together, and you do LCM or you look at your whole inventory. It doesn't matter for you. Just know the basic concept, okay? So let's take a look at an example to illustrate this concept. Let's assume a motorsport retailer has the following item in inventory. They have 20 units of Roadster and they have 10 units of Sprint. For the Roadster, they paid 8,500 per unit, which gave them a total cost of 170,000. Today, if they want to replace those Roadster, they could replace each unit for 7,000. What does that mean? The Roadster is not fashionable anymore because if you want to replace it, it went down in value. Therefore, the market price for all these units is 140. Now, what's gonna happen is this. This retailer, they would report the inventory at the lower of 140 or 170 or 140. Obviously, 140 is lower. Therefore, they would report the inventory at 140. For the Sprint, they have 10 units. They paid $5,000 per each unit. If they want to replace those units, they have to pay 6,000. Well, it seems the Sprint is in fashion. It didn't lose any value. So the total cost is 50. The replacement cost is 60, which the lower of these two, 50. Therefore, 50. Therefore, the inventory is 140 plus 50. The inventory we should be reported at 190. We paid for the inventory 220. Bad news. We have to book a loss and the loss is what we call is a write down. The loss is 30,000. We debit cost of goods sold and we credit merchandise inventory. So this is basically what you need to know about LCM as far as financial accounting. The next topic in this recording is the income statement effect of inventory errors. So when you make an error, what happened to the income statement? So we're gonna work a senior. You're to illustrate this concept. So the first senior you were gonna illustrate, we're gonna assume that the company understated inventory, okay? What does it mean understated inventory and specifically understated ending inventory? So they reported less inventory that they have. So let's take a look at some numbers to see what's the effect on the bottom line. Okay, so we have this company. Sales is 100,000. Their beginning inventory is correct 20,000. Their cost of goods purchase is correct 60,000. Goods available for sale is 20 plus 60. Now, the correct inventory should have been 20,000. So the correct inventory is 20,000. They underreported the inventory by 4,000. So they underreported their inventory. So let's see what's gonna happen. So beginning inventory plus purchases equal to 80,000 minus cost minus ending inventory gives us cost of goods available for sale of 64,000. So let's switch the number and let's assume, so notice cost of goods sold is 64. Let's see what happened if the inventory was correct at 20,000. If the inventory was correct, your cost of goods sold would have been 60,000. So notice, what do we need to know here? If ending inventory is underreported, cost of goods sold is overreported. Well, if cost of goods sold is overreported, your profit is lower because you have more cost. Okay, so the first thing is what? The first relationship that we learned, if your ending inventory is lower, your cost of goods sold is higher, which means your profit is lower. Okay, your profit is lower by 4,000. So let's take a look at this. So your cost of goods sold is higher, your net income is lower, your profit is lower. So let's take a look at year two. Here's what happened in year two. In year two, your ending inventory that's incorrect will become your beginning inventory which also incorrect, which also incorrect. Now, sales is correct, your beginning inventory is incorrect, which is, it's your ending inventory. This is correct, the 60,000 is correct, and now your ending inventory is correct. Now, what happened is this? Since, so be careful about the relationship now. Since your big, sorry. So notice, since your beginning inventory is understated, your beginning is understated. Why? Because it was underreported from the prior year. Cost of goods sold is also understated. It means your profit is higher. Your profit is higher. So simply put, the profit that you underreported last year, the following year in 2017, it balanced back. And now you have $4,000 more profit. Because if you reported 20,000 in year one, the proper amount, your profit should have been 30,000. And if, if you reported the proper amount, your profit also in year two should have been 30,000. Now, what happened is, in total you should have 60,000 of profit. In total, you have 60,000 of profit. 26 plus 34 is 60,000. The only thing that you did in year one in 2016, your profit was 4,000 below, because your ending inventory is correct. In 2017, your profit is 4,000 more because your beginning inventory is incorrect. So now in total, you are correct. So it's self-correcting, inventory self-correct. If it happens by mistake, it's self-correct. Now, so in year two, your cost of goods sold is lower and your profit is higher. So this is year two. Now, if we look at 2018, if no mistakes happen, now everything is back to normal, 20,000 in the beginning, 20,000 in the ending correct, and you have the correct net income. You have the correct net income. Now, let's assume your ending inventory was overstated. Let's assume that was overstated, work the other scenario. The opposite will be true. If your ending inventory was overstated in year one, your cost will be understated and your profit will be overstated in year one, then in year two, your cost will be overstated and your net income will be understated. It's exactly the opposite, exactly the opposite. What's the takeout from all of this? After I went all of this, here's what's the takeout? Or what's the, if I want to summarize this, ending inventory and cost of goods sold, they have a negative relationship. What's negative relationship? It means when one goes up, the other one goes down. Beginning inventory and cost of goods sold, they have a positive relationship. When beginning inventory goes up, cost of goods sold goes up as well. So that's the relationship between, I'm watching Polly in this name. Between beginning inventory and cost of goods sold. Now, what's the effect on the balance sheet? Basically, we already kind of know the effect on the balance sheet. When ending inventory is down, your assets are lower. If your assets are lower, your equity is lower. Because if your assets are lower, your cost is higher, your net income is lower, your equity is lower. If your ending inventory is higher, obviously your assets are higher and your equity is higher. So that's the relationship on the balance sheet, which I told you because the profit goes into equity. So if you have more profit, you have more equity. If you have less profit, you have less equity. Inventory turnover, this is the ratio. We're gonna look at two ratios about inventory. The first one is inventory turnover. What is inventory turnover? It shows you how many times, how many times a company turnover is inventory during a period. Simply put, you have inventory. How many times you empty your shelves, replace the shelves, empty the shelves, replace the shelves. And you want to do this as many times as possible if you are a business. As a business owner, you want to empty your shelves and replace them as many times as possible. And if that's the case, if that's fast, it's a good indicator how well you are managing your inventory. How do you compute this? Here's how you compute this. You will take cost of goods sold. So for example, I'm gonna assume cost of goods sold is 12,000 and you divide cost of goods sold by your average inventory. Why do you compute it by average? Because cost of goods sold is an income statement account. It goes for the whole year. Inventory is a balance sheet account. Therefore, what you need to do, you have to show the balance, the, I'm sorry, not the balance. You have to show the average. Otherwise, you are taken a period number, which is the cost of goods sold is a period, not a point in time because cost of goods sold is an income statement. It's a period. Sorry, my pen is acting up. Cost of goods sold is a period. Because remember, the income statement is a period account to a point in time, point inventory is on the balance sheet. It's one point in time. Therefore, you need to find the average. And how do you compute the average of inventory? It's the beginning of the year plus the end of the year or year one plus year two of inventory divided by two. And let's assume that's the answer is 1,000. Now the answer for average inventory is 1,000. The answer is 12. It means your inventory turnover is 12. What does it mean? It means you replaced your inventory 12 times during the year. You put everything on the shelves, sold everything, replenish your shelves again 12 times. Is this good? Is this bad? It all depends on the prior period. If you did it 13 times the prior year, that's not good. If the prior year you did it only four 10 times, that's good. Now this is inventory turnover. Another way to interpret inventory turnover is to compute something called day sales and inventory. How do you compute day sales and inventory? Well, there's two ways to do it. What I can do is I can take 365 days per year divided by 12 and it's approximately 30 days. It means I replace my inventory every 30 days or you can take ending inventory divided by cost of goods sold multiplied by 365. Basically it gives you the same answer day sales and inventory. So notice you take ending inventory divided by cost of goods sold multiplied by 365. I like to take 365 divided by inventory turnover ratio and it will give you how many days it took you to turn over your inventory. Now to put this in perspective, let's take a look at actual company numbers. For example, here we have Costco and Walmart which is kind of comparable. The inventory turnover for the current year at Costco is 11.9, a year ago was 11.5 and two years ago was 11.6. So Costco is doing better, year to year it's doing better. Day sales and inventory, day sales and inventory 32.1 days, 32.1 days for the current year, they're replacing their inventory every 32.1 days. Last year was 31.8 and the prior year 32.6. I'm not sure if there is an error here. I think there's an error on this, I'm not sure. Because if we take, let me just do this real quick. I think there is an error on this slide. Let me just, if I take 365 divided by 11.9, it's 30.6, that's what I thought. 30.6, depending how they're computing this, but you want, if your inventory turnover is better than the prior year, it should be 30.67 days, 30.67. So yes, this year should be shorter for the current year, for Costco should be shorter. That's why I don't like to use ending inventory because ending inventory by itself, it's not a good indication because it's a balance sheet account. Anyhow, for the McGraw-Hell, for your homework, follow the formula that gives you the answer. But this doesn't make, the answer doesn't make any sense here because they sales and inventory should be shorter for the current year. Now, if we look at Walmart, Walmart, their inventory turnover 8.3, 8.3, which is, Costco is better, Costco is better because 11.9, that you're turning your inventory more and it's taken Walmart on average 43.5 days. What does that mean? It means Costco is doing a better job. I'm questioning those numbers, but it doesn't, the questioning like, I think Walmart is faster in the real world, but I'm not sure we're gonna go with the numbers that we have here, but it could be. I just, I think Walmart will have a higher turnover, but I could be totally wrong. I'm not very familiar with Costco. It's taken the prior year 45 days was longer and 45.1 days. So around 45 days. So think of Walmart, you walk into Walmart, if you come back 45 days later, all the items that you saw that day are basically gone, are basically gone. So they got turned over, they replaced them. If you have any questions about this recording, by all means, let me know. Once again, if you're studying for your exam, for your CPA, if you are hunkered at home and due to the coronavirus, take advantage of this time, study. And don't forget to like my lectures, subscribe, and pay a visit to my website. Study hard, good luck.