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

Merchandising Company General Motors Corporation Income Statements Service Company Century 21 Real Estate Income Statement Year Ended December 31, 20xx Merchandising Company General Motors Corporation Income Statement Year Ended December 31, 20xx Service revenue $XXX Expenses Salary expense X Depreciation expense X Income tax expense X Net income $ X 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 ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Merchandising Company General Motors Corporation Balance Sheets Service Company Century 21 Real Estate Balance Sheet Year Ended December 31, 20xx Merchandising Company General Motors Corporation Balance Sheet Year Ended December 31, 20xx Current assets: Cash $X Short-term investments X Accounts receivable, net X Prepaid expenses X Current assets: Cash $ X Short-term investments X Accounts receivable, net X Inventory 11 Prepaid expenses X ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Gross Profit (Gross Margin) Sales Revenue -Cost of Goods Sold =Gross Profit - Operating Expenses Net Income

Learning Objective 1 Account for inventory transactions.

Inventory Accounting Systems Periodic (a.k.a. physical inventory) systems do not keep a continuous record of inventory on hand: Inventory quantities can only be determined based upon a 100% physical count, usually annually Quantities x relevant prices = inventory valuation Perpetual systems maintain a running record to show the inventory on hand at all times.

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 ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

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 ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

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

Learning Objective 2 Analyze the various inventory costing methods.

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

Illustrative Data (Text Exhibit 6-6) 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 (60 avail. - 20 left) 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 $900 – $580 = $320

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

First-In, First-Out Ending Inventory Cost: Available units 60 units Less units sold 40 Ending inventory 20 units 20 units × $18 per unit = $360

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

Last-In, First-Out Ending Inventory Cost: Available units 60 units Less units sold 40 Ending inventory 20 units 10 units × 10 = $100 10 units × 14 = 140 Total $240

Last-In, First-Out 25 Units @ $18 Cost of Goods Sold $450 210 $660 25 Units @ $18 (All of Last batch) 15 Units @ $14

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 ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

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

The Tax Advantages 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 when prices are increasing.

Use of the Various Inventory Methods

Comparison of Inventory Methods FIFO produces “inventory profits” during periods of inflation, but you are eating your seed corn LIFO can allow managers to manipulate net income by purchasing more costly inventories, which will be associated with revenue LIFO liquidation: when old LIFO balance sheet layers are associated with current revenues If the liquidated layers are 10 or 20 years old, those old inventory costs might be a fiction compared to current costs, artificially inflating profits

Why do 50% More Public Companies Use FIFO vs. LIFO? [Re: Slide no. 25] FIFO is easier to account for, and a more natural cost flow assumption Public companies will pay the price of higher taxes to report better earnings than LIFO would, in a period of rising prices That’s all we’ve had since the 1930’s!

Consistency Principle Use the same accounting methods and principles from one period to the next Cannot change accounting principles whimsically May change inventory methods, but must: be able to demonstrate that the new inventory costing method is preferable to the old method disclose the effects of the change on net income in the financial statement footnotes

Disclosure Principle Financial statements should report enough information to enable an outsider to make knowledgeable decisions about the company All material facts must be fully and fairly disclosed

Conservatism The least favorable figures are presented in the financial statements

Lower-of-Cost-or-Market Rule is an Example of Conservatism 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 However, never write up inventories to market if it higher than cost

Learning Objective 4 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

Learning Objective 5 Estimate inventory by the gross profit method Gross profit method can be used: To estimate inventories for quarterly balance sheets so physical count not needed, or To estimate value of inventories lost in a fire or other catastrophe for insurance indemnification, or To test reasonableness of a physical count of inventories

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

An Example Using Gross Profit Method to Estimate Inventories Mav Co. has a fire, losing all inventories Assume usual gross profit is 25% [$.25 of every sales dollar is gross profit] Therefore, usual CGS percent would be 75% [$.75 of every sales dollar is inventory cost] Assume Beg inventory = $10,000 Purchases to date of fire = $60,000 Therefore goods available = $70,000 Sales to date of fire = $55,000

An Example Using Gross Profit Method (con.) Goods available (last slide) $70,000 Est’d CGS ($55,000 x 75%) 41,250 Est’d inventory lost to fire 28,750

Objective 6 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: Income will be overstated by exact amount of an inventory overstatement, because CGS will be understated by exact amount of the inventory overstatement (CGS=Beg+Purchs-Ending) The current year’s ending inventory becomes next year’s beginning inventory: Income will be understated by that same amount CGS will be overstated by that same amount That is, the error washes out over two periods