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

Income Statements
Service Company Century 21 Real Estate Income Statement Year Ended December 31, 20xx Service revenue $XXX Expenses Salary expense X Depreciation expense X Income tax expense X Net income $ X Merchandising Company General Motors Corporation 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

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

Accounting for Inventory

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

Gross Profit (Gross Margin)

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

Use the cost-of-goodssold model.

Cost of Goods Sold Model

Beginning inventory $20 Ending inventory $30 Cost of goods sold $90

Purchases $100

Cost of goods available for sale $120

How Much Inventory Should Be Purchased?

Budgeted cost of goods sold + Budgeted ending inventory = Budgeted cost of goods available for sale Actual beginning inventory = Budgeted purchases $6,000 1,500 $7,500 1,200 $6,300

How Much Inventory Should Be Purchased?

EI -BI +COGS =P 1500 1200 6000 6300

What is EI or what is COGS?

BI +P -COGS =EI OR BI +P -EI =COGS

Account for inventory transactions.

Inventory Accounting Systems

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

Recording Transactions in the Perpetual System

Debit Debit Inventory Inventory Credit Credit Cash Cash or or Accounts Accounts Payable Payable Debit Debit Cash Cash or or Accounts Accounts Receivable Receivable Credit Credit Sales Sales Revenue Revenue Debit Debit Cost Cost of of Goods Goods Sold Sold Credit Credit Inventory Inventory

Recording Transactions in the Perpetual System

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

Recording Transactions and the T-Accounts

Inventory 560,000 Inventory 560,000 Accounts Accounts Payable Payable Purchased Purchased inventory inventory on on account account Inventory Beg. 100,000 560,000 560,000 560,000

Accounts Payable 560,000

Recording Transactions and the T-Accounts

Sale Sale on on account account $900,000 $900,000 (cost (cost $540,000): $540,000): Accounts Accounts Receivable Receivable Sales Sales Revenue Revenue Cost Cost of of Goods Goods Sold Sold Inventory Inventory 900,000 900,000 540,000 540,000

900,000 900,000 540,000 540,000

Recording Transactions and the T-Accounts

Inventory Beg. 100,000 540,000 560,000 120,000 Cost of Goods Sold 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 Net purchases purchases = = Purchases Purchases + + Freight-in Freight-in Purchase Purchase returns returns & & allowances allowances Purchases Purchases discount discount Net Net sales sales = = Sales Sales revenue revenue Sales Sales returns returns & & allowances allowances Sales Sales discounts 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) No. 1 (25 units @ $14 per unit) $350 No. 2 (25 units @ $18 per unit 450 Total purchases Cost of goods available for sale Ending inventory: 20 units Cost of goods sold: 40 units $100 800 $900

Specific Unit Cost

5 Units @ $10 Cost of Goods Sold $ 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 25 Units @ $14 5 Units @ $18

Last-In, First-Out

Cost of Goods Sold $450 210 $660

25 Units @ $18

15 Units @ $14

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 Weighted-average FIFO LIFO

$1,000 $1,000 $1,000 $1,000

580 600 540 660

= = = =

$420 $400 $460 $340

Income Effects Inventory Costs Are Increasing

Gross profit, and net income

LIFO

Weightedaverage

FIFO

Income Effects Inventory Costs Are Decreasing

Gross profit, and net income

LIFO

Weightedaverage

FIFO

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

The Tax Advantage of LIFO

Gross profit Operating expenses Income before taxes Income tax expense (40%) FIFO $460 260 $200 $ 80 LIFO $340 260 $ 80 $ 32

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

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

Accounting Principles and Inventories

The The financial financial statements statements should should report report enough enough information information to to enable enable an an outsider outsider to to make make knowledgeable knowledgeable decisions decisions about about the the company. company.

Accounting Principles and Inventories

An An item item is is material material if if it it has has the the potential potential to to alter alter a a statement statement users users decision decision to to invest invest in in the the stock stock of of the the company. company. Materiality Materiality is is different different For For different different firms. firms.

Accounting Principles and Inventories

Err Err on on the the side side of of caution caution when when reporting reporting any any item item in in the the financial financial statements. 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 years ending inventory is next years 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 $100,000 $100,000 $100,000 Cost of goods sold: Beg. inventory $10,000 $15,000 $10,000 Purchases 50,000 50,000 50,000 Cost of goods available for sale $60,000 $65,000 $60,000 Ending inventory (15,000) (10,000) (10,000) Cost of goods sold 45,000 55,000 50,000 Gross profit $ 55,000 $ 45,000 $ 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.

1. Overstating ending inventory 2. Creating fictitious sales revenue

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

Using the Financial Statements for Decision Making

Gross Gross profit profit percentage percentage = = Gross Gross profit profit Net Net sales sales revenue revenue Inventory Inventory turnover turnover = = Cost Cost of of goods goods sold sold Average Average inventory inventory

Gross Profit on $1 of Sales for Two Merchandisers

$1.00 $0.75 $0.50 $0.25 $0.00 Cost of goods sold $0.79 Gross profit $0.21 Gross profit $0.61

Cost of goods sold $0.39 Pepsi Co.

General Motors

End of Chapter 6