1. Merchandise Inventory,
Cost of Goods Sold, and
Gross Margin
Chapter 6

2. Income Statements Revenue $758 Service revenue $XXX
Expenses
Operating and
administrative expense X
Amortization expense X
Income tax expense X
Net income $ X
Service Company
Century 21 Real Estate
Income Statement
For the Year Ended December 31, 2002
Revenue $758
Cost of goods sold
Gross margin
Operating expenses:
Operating and
administrative expense X
Amortization expense X
Income tax expense $ X
Net income $ 4
Merchandising Company
The Foranzi Group Ltd.
Income Statement
For the Year Ended January 27, 2002

3. Merchandising Company
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
December 31, 2002
Current assets:
Cash $ X
Short-term investments X
Accounts receivable, net X
Inventory
Prepaid expenses X
Merchandising Company
The Foranzi Group Ltd.
Balance Sheet
January 27, 2002

4. Accounting for Inventory
Current assets:
Cash $ XXX
Short-term
investments XXX
Accounts receivable XXX
Inventory (1 Impala
@$22,000) $22,000
Prepaid expenses XXX
General Motors of Canada
Balance Sheet (partial)
Sales revenue
(2 $27,000) $54,000
Cost of goods sold
(2 $22,000) 44,000
Gross margin $10,000
General Motors of Canada
Income Statement (partial)

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

6. Computing Cost Balance Sheet Cost of inventory on hand
= Number of units on hand × unit cost
Balance Sheet
Cost of goods sold
= Number of units sold × unit cost
Income Statement

7. Use the cost-of-goods-
Learning Objective 1
Use the cost-of-goods-
sold model.

8. 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

9. 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

10. Learning Objective 2
Account for inventory
transactions.

11. 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.

12. 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

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

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

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

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

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

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

19. Learning Objective 3
Analyze the various
inventory methods.

20. 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)

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

22. Specific Unit Cost 5 Units @ $10 Cost of Goods Sold $ 50 350 180 $580
$ 50
350
180
$580
25 $14
10 $18
$900 – $580 = $320

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

24. First-In, First-Out Ending inventory cost 60 units Less units sold 40
Ending inventory 20 units
20 units × $18 per unit = $360

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

26. Last-In, First-Out Ending inventory cost 60 units Less units sold 40
Ending inventory 20 units
10 units × 10 = $100
10 units × 14 = 140
Total $240

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

28. Income Effects of Inventory Methods
Ending Inventory
Specific unit cost $320
Weighted-average $300
FIFO $360
LIFO $240

29. Income Effects of Inventory Methods
Cost of Goods Sold
Specific unit cost $580
Weighted-average $600
FIFO $540
LIFO $660

30. Income Effects of Inventory Methods
Assumed
Sales
Revenue
Cost of
Goods
Sold
Gross
Margin
Specific unit cost $1,000 – = $420
Weighted-average $1,000 – = $400
FIFO $1,000 – = $460
LIFO $1,000 – = $340

31. Income Effects – Inventory Costs Are Increasing
Ending inventory, gross margin, and net income
FIFO
Weighted-
average
LIFO

32. Income Effects – Inventory Costs Are Decreasing
Ending inventory, gross margin, and net income
LIFO
Weighted-
average
FIFO

33. Learning Objective 4
Identify the income
effects of the
inventory methods.

34. Use of the Various Inventory Methods

35. Comparison of Inventory Methods
FIFO produces inventory profits
during periods of inflation.
LIFO allows managers to
manipulate net income.
LIFO liquidation occurs when
inventory quantities fall below the
level of the previous period resulting
in higher net income.

36. International Perspective
LIFO is not allowed for tax
purposes in Canada.
Almost no Canadian companies
use LIFO.

37. 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 apply the
new method retroactively, per GAAP.

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

39. Accounting Principles and Inventories
Materiality Concept
An item is material if it has the potential
to alter a statement user’s decision.
Materiality is specific to
the entity being evaluated.

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

41. 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.

42. Show how inventory errors affect cost of goods sold
Objective 5
Show how inventory errors
affect cost of goods sold
and income.

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

44. 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 margin
$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

45. percentage and inventory
Learning Objective 6
Use the gross margin
percentage and inventory
turnover to evaluate
business.

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

47. Gross Margin on $1 of Sales for Two Merchandisers
$1.00 —
$0.75 —
$0.50 —
$0.25 —
$0.00
Gross
margin $0.17
Gross
margin
$0.61
Cost of
goods sold
$0.83
Cost of
goods sold
$0.39
Magna
Int’l Inc.
Pepsi Co.

48. Reporting Inventory Transactions on the Cash Flow Statement
Inventory transactions are operating activities
because the purchase and sale of merchandise
drives a company’s operations.
The purchase of inventory requires a cash
payment, and the sale a cash receipt.

49. Estimate inventory by the gross margin method and the retail method.
Learning Objective 7
Estimate inventory by the gross margin method and the retail method.

50. Estimating Inventory The gross margin method of estimating
ending inventory is based on the
cost-of-goods-sold model.
Beginning inventory
+ Purchases
= Cost of goods available for sale
– Ending inventory
= Cost of goods sold

51. Estimating Inventory Rearranging ending inventory and
cost of goods sold makes the model
useful for estimating ending inventory.
Beginning inventory
+ Purchases
= Cost of goods available for sale
– Cost of goods sold
= Ending inventory

52. Estimating Inventory Step 1 Step 2 + = – = Beginning inventory Net
purchases +
Goods
available
for sale =
Cost of
goods
sold –
Ending
inventory =
Step 2
Goods
available
for sale

53. Estimating Inventory Beginning inventory $14,000 Purchases 66,000
Cost of goods available for sale ,000
Cost of goods sold:
Net sales revenue $100,000
Less estimated gross margin of 42% – 42,000
Estimated cost of goods sold ,000
Estimated cost of ending inventory $22,000

54. Ethical Considerations
Managers of companies whose profits
do not meet shareholder 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

55. Appendix: Periodic System
All purchases are recorded with a debit
to Purchases, an expense account.
A physical count of inventory at the end of the
accounting period will be needed to update
the accounting records.

56. End of Chapter 6