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

2. 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
Gross profit
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

3. 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
Prepaid expenses X
©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

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

5. Learning Objective 1
Account for inventory transactions.

6. 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.

7. 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

8. 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

9. 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

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

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

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

13. Learning Objective 2
Analyze the various inventory costing methods.

14. 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)

15. Illustrative Data (Text Exhibit 6-6)
Beginning inventory (10 $10) $ 100
No. 1 (25 $14 per unit) $350
No. 2 (25 $18 per unit) 450
Total purchases
Cost of goods available for sale $ 900
Ending inventory: units
Cost of goods sold (60 avail left) units

16. 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

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

18. 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

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

20. 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

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

22. 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

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

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

25. Use of the Various Inventory Methods

26. 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

27. 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!

28. 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

29. 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

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

31. 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

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

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

34. 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

35. 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

36. 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

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

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

39. 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