Merchandise Inventory, Cost of Goods Sold, and Gross Profit Chapter 6

Merchandising Company General Motors Corporation Income Statements Service revenue $XXX Expenses Salary expense X Depreciation expense X Income tax expense X Net income $ X Service Company Century 21 Real Estate Income Statement Year Ended December 31, 20xx Sales revenue $185 Cost of goods sold 146 Gross profit 39 Operating expenses: Salary expense X Depreciation expense X Income tax expense $ X Net income $ 4 Merchandising Company General Motors Corporation Income Statement Year Ended December 31, 20xx

Merchandising Company General Motors Corporation Balance Sheets Current assets: Cash $X Short-term investments X Accounts receivable, net X Prepaid expenses X Service Company Century 21 Real Estate Balance Sheet Year Ended December 31, 20xx Current assets: Cash $ X Short-term investments X Accounts receivable, net X Inventory 11 Prepaid expenses X Merchandising Company General Motors Corporation Balance Sheet Year Ended December 31, 20xx

Accounting for Inventory Current assets: Cash $ XXX Short-term investments XXX Accounts receivable XXX Inventory (1 truck @$15,000) $15,000 Prepaid expenses XXX General Motors Corporation Balance Sheet (partial) Sales revenue (2 trucks @ $20,000) $40,000 Cost of goods sold (2 trucks @ $15,000) 30,000 Gross profit $10,000 General Motors Corporation Income Statement (partial)

Gross Profit (Gross Margin) Sales revenues – Cost of goods sold = Gross profit (before operating expenses) Gross profit – Operating expenses = Net income

Use the cost-of-goods- sold model.

Cost of Goods Sold Model Beginning inventory $20 Ending inventory $30 Cost of goods sold $90 Cost of goods available for sale $120 Purchases $100

How Much Inventory Should Be Purchased? Budgeted cost of goods sold $6,000 + Budgeted ending inventory 1,500 = Budgeted cost of goods available for sale $7,500 – Actual beginning inventory 1,200 = Budgeted purchases $6,300

How Much Inventory Should Be Purchased? EI 1500 -BI 1200 +COGS 6000 =P 6300

What is EI or what is COGS? BI +P -EI =COGS BI +P -COGS =EI OR…

Account for inventory transactions.

Inventory Accounting Systems Periodic systems do not keep a continuous record of inventory on hand. Perpetual systems maintain a running record to show the inventory on hand at all times.

Recording Transactions in the Perpetual System Debit Inventory Credit Cash or Accounts Payable Debit Cash or Accounts Receivable Credit Sales Revenue Debit Cost of Goods Sold Credit Inventory

Recording Transactions in the Perpetual System Purchase price of the inventory $600,000 + Freight-in 4,000 – Purchase returns – 25,000 – Purchase allowances – 5,000 – Purchase discounts – 14,000 = Net purchases of inventory $560,000

Recording Transactions and the T-Accounts Inventory 560,000 Accounts Payable 560,000 Purchased inventory on account Beg. 100,000 560,000 Inventory Accounts Payable 560,000

Recording Transactions and the T-Accounts Sale on account $900,000 (cost $540,000): Accounts Receivable 900,000 Sales Revenue 900,000 Cost of Goods Sold 540,000 Inventory 540,000

Recording Transactions and the T-Accounts Inventory Cost of Goods Sold 540,000 Beg. 100,000 560,000 120,000 540,000

Reporting in the Financial Statements Income Statement (partial) Sales revenue $900,000 Cost of goods sold 540,000 Gross profit $360,000 Ending Balance Sheet (partial) Current assets: Cash $ XXX Short-term investments XXX Accounts receivable, net XXX Inventory 120,000 Prepaid expenses XXX

Reporting in the Financial Statements Net purchases = Purchases + Freight-in – Purchase returns & allowances – Purchases discount Net sales = Sales revenue – Sales returns & allowances – Sales discounts

Analyze the various inventory methods.

What Goes Into Inventory Cost? The cost of any asset, such as inventory, is the sum of all the costs incurred to bring the asset to its intended use. Generally accepted inventory costing methods: Specific unit cost Weighted-average cost First-in, first-out (FIFO) Last-in, first-out (LIFO)

Illustrative Data Beginning inventory (10 units @ $10) $100 No. 1 (25 units @ $14 per unit) $350 No. 2 (25 units @ $18 per unit 450 Total purchases 800 Cost of goods available for sale $900 Ending inventory: 20 units Cost of goods sold: 40 units

Specific Unit Cost 5 Units @ $10 Cost of Goods Sold $ 50 350 180 $580 $ 50 350 180 $580 25 Units @ $14 10 Units @ $18

Weighted-Average $900 total cost ÷ 60 units = $15/unit Cost of goods sold = 40 × $15 = $600

First-In, First-Out 10 Units @ $10 Cost of Goods Sold $100 350 90 $540

Last-In, First-Out 25 Units @ $18 Cost of Goods Sold $450 210 $660

Income Effects of Inventory Methods Cost of Goods Sold Specific unit cost $580.00 Weighted-average $600.00 FIFO $540.00 LIFO $660.00

Income Effects of Inventory Methods Ending Inventory Specific unit cost $320.00 Weighted-average $300.00 FIFO $360.00 LIFO $240.00

Income Effects of Inventory Methods Assumed Sales Revenue Cost of Goods Sold Gross Profit Specific unit cost $1,000 – 580 = $420 Weighted-average $1,000 – 600 = $400 FIFO $1,000 – 540 = $460 LIFO $1,000 – 660 = $340

Income Effects – Inventory Costs Are Increasing Gross profit, and net income FIFO Weighted- average LIFO

Income Effects – Inventory Costs Are Decreasing Gross profit, and net income LIFO Weighted- average FIFO

Identify the income and the tax effects of the inventory methods.

The Tax Advantage of LIFO Gross profit $460 $340 Operating expenses 260 260 Income before taxes $200 $ 80 Income tax expense (40%) $ 80 $ 32 FIFO LIFO The most attractive feature of LIFO is low income tax payments.

Comparison of Inventory Methods FIFO produces inventory profits during periods of inflation. LIFO liquidation occurs when inventory quantities fall below the pervious level resulting in higher net income and increased taxes.

Accounting Principles and Inventories Consistency Principle Businesses should use the same accounting methods and procedures from one period to the next. A company may change inventory methods, but it must disclose the effects of the change on net income.

Accounting Principles and Inventories Disclosure Principle The financial statements should report enough information to enable an outsider to make knowledgeable decisions about the company.

Accounting Principles and Inventories Materiality Concept An item is material if it has the potential to alter a statement user’s decision to invest in the stock of the company. Materiality is different For different firms.

Accounting Principles and Inventories Conservatism Err on the side of caution when reporting any item in the financial statements.

Lower-of-Cost-or-Market Rule Inventory is reported at the lower of its historical cost or market (replacement) value. If the replacement cost falls below its historical cost, the business must write down the value of its inventory.

Show how inventory errors affect cost of goods sold and income.

Effects of Inventory Errors An error in the ending inventory creates errors for cost of goods sold and gross profit. The current year’s ending inventory is next year’s beginning inventory.

Effects of Inventory Errors Period 1 Ending Inventory Overstated by $5,000 Period 1 Beginning Inventory Overstated by $5,000 Period 1 Correct Sales revenue Cost of goods sold: Beg. inventory Purchases Cost of goods available for sale Ending inventory Cost of goods sold Gross profit $100,000 $10,000 50,000 $60,000 (15,000) 45,000 $ 55,000 $100,000 $15,000 50,000 $65,000 (10,000) 55,000 $ 45,000 $100,000 $10,000 50,000 $60,000 (10,000) $ 50,000

Ethical Considerations Managers of companies whose profits do not meet stockholder expectations are sometimes tempted to “cook the books” to increase reported income. What are some possibilities? 1. Overstating ending inventory 2. Creating fictitious sales revenue

percentage and inventory Use the gross profit percentage and inventory turnover to evaluate business.

Using the Financial Statements for Decision Making Gross profit percentage = Gross profit ÷ Net sales revenue Inventory turnover = Cost of goods sold ÷ Average inventory

Gross Profit on $1 of Sales for Two Merchandisers $1.00 — $0.75 — $0.50 — $0.25 — $0.00 Gross profit $0.21 Gross profit $0.61 Cost of goods sold $0.79 Cost of goods sold $0.39 General Motors Pepsi Co.

End of Chapter 6