Merchandise Inventory, Cost of Goods Sold, and Gross Profit Pr. Zoubida SAMLAL 1

Accounting for Inventory Inventory (balance sheet) = Number of units of inventory on hand X Cost per unit of inventory Cost of Goods Sold (income statement) = Number of units of inventory sold X Cost per unit of inventory

Recording Transactions and the T-Accounts Accounts Payable 560,000Beg.100, ,000 Inventory Inventory560,000 Accounts Payable560,000 Purchased inventory on account

Recording Transactions and the T-Accounts Sale on account $900,000 of Inventory which cost $540,000: Accounts Receivable900,000 Sales Revenue900,000 Cost of Goods Sold540,000 Inventory540,000

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

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

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, netX Inventory 11 Prepaid expensesX Merchandising Company General Motors Corporation Balance Sheet Year Ended December 31, 20xx ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Gross Profit (Gross Margin) Sales Revenue - Gross Profit - Operating Expenses Net Income 9

Learning Objective 1 Account for inventory transactions. 10

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. 11

Recording Transactions in the Perpetual System 12 Purchase price of the inventory$600,000 + Freight-in4,000 – Purchase returns– 25,000 – Purchase allowances– 5,000 – Purchase discounts – 14,000 = Net purchases of inventory$560,000

Recording Transactions and the T-Accounts Accounts Payable 560,000Beg.100, ,000 Inventory Inventory560,000 Accounts Payable560,000 Purchased inventory on account

Recording Transactions and the T-Accounts Sale on account $900,000 (cost $540,000): Accounts Receivable900,000 Sales Revenue900,000 Cost of Goods Sold540,000 Inventory540,000

Recording Transactions and the T-Accounts 15 Cost of Goods Sold 540,000 Inventory Beg.100, , , ,000

Reporting in the Financial Statements 16 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 17 Net sales Sales revenue – Sales returns & allowances – Sales discounts Net purchases Purchases + Freight-in – Purchase returns & allowances – Purchases discount

Learning Objective 2 Analyze the various inventory methods. 18

What Goes Into Inventory Cost? Sum of all costs incurred to bring asset to its intended use Inventory costing methods: – Specific unit cost – Weighted-average cost – First-in, first-out (FIFO) – Last-in, first-out (LIFO) 19

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

Specific Unit Cost 21 Cost of Goods Sold $ $580 $900 – $580 = $ $14 10 $18 5 $10

Weighted-Average 22 $900 total cost ÷ 60 units = $15/unit Cost of goods sold = 40 × $15 = $600 Ending inventory = 20 × $15 = $300

First-In, First-Out Ending Inventory Cost: units Less units sold40 Ending inventory20 units 20 units × $18 per unit = $360

First-In, First-Out 24 Cost of Goods Sold $ $ $10 25 $14 5 $18

Last-In, First-Out Ending Inventory Cost: units Less units sold40 Ending inventory20 units 10 units × 10 =$ units × 14 = 140 Total$240

Last-In, First-Out 26 Cost of Goods Sold $ $ $18 15 $14

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

Learning Objective 3 Identify the income and the tax effects of the inventory methods. 28

The Tax Advantage of LIFO 29 Gross profit$460$340 Operating expenses Income before taxes$200$ 80 Income tax expense (40%)$ 80$ 32 FIFOLIFO The most attractive feature of LIFO is low income tax payments when prices are increasing.

Use of the Various Inventory Methods 30

Comparison of Inventory Methods FIFO produces inventory profits during periods of inflation LIFO allows managers to manipulate net income LIFO liquidation 31

Consistency Principle Use the same accounting methods and procedures from one period to the next May change inventory methods, but must disclose the effects of the change on net income 32

Disclosure Principle Financial statements should report enough information to enable an outsider to make knowledgeable decisions about the company. 33

Conservatism The least favorable figures are presented in the financial statements. 34

Lower-of-Cost-or-Market Rule Report inventory at the lower of its historical cost or market (replacement) value If the replacement cost falls below its historical cost, write down the value of the inventory 35

Learning Objective 4 Use the gross profit percentage and inventory turnover to evaluate business. 36

Using the Financial Statements for Decision Making 37 Inventory turnover = Cost of goods sold ÷ Average inventory Gross profit percentage = Gross profit ÷ Net sales revenue

Learning Objective 5 Estimate inventory by the gross profit method. 38

Estimating Inventory Gross profit method - based on computation of cost-of-goods-sold 39 Beginning inventory +Purchases =Cost of goods available for sale –Ending inventory =Cost of goods sold -Cost of goods sold = Ending inventory

Objective 6 Show how inventory errors affect cost of goods sold and income. 40

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. 41

Reporting Inventory Transactions on the Statement of Cash Flows Inventory transactions are operating activities The purchase of inventory requires a cash payment, and the sale a cash receipt 42