(c) 1997 prentice hall business publishing financial accounting, 3/e harrison and horngren 6 - 1...

(c) 1997 Prentice Hall Business Publishing Financial Accounting, 3/e Harrison and Horngren 6 - 1

CHAPTER 6

Accounting for Merchandising Inventory, Cost of Goods Sold, and

the Gross Margin


Opening Vignette - Huntington Galleries

Change in way Huntington accounts for inventory helped increase company’s net income

Significant because Huntington is a merchandising company Earns substantial portion of revenues

selling products to customers What is the relationship between inventory

accounting and financial statements?


Inventory accounting decisions have “trickle-down” effect

Income statement - Cost of goods sold

Balance sheet - Inventory (asset)

Statement of cash flows Cash flows from

operating activities

Opening Vignette - Huntington Galleries


Chapter Learning Objectives

1. Account for inventory by the perpetual and periodic systems

2. Apply the inventory costing methods: specific unit cost, weighted-average cost, FIFO, and LIFO

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

4. Apply the lower-of-cost-or-market rule to inventory


Chapter Learning Objectives

5. Compute the effects of inventory errors on cost of goods sold and net income

6. Estimate inventory by the gross margin method

7. Use the gross margin percentage and the inventory turnover ratio to evaluate a business


Chapter Objective 1

Account for inventory by the perpetual and periodic systems


The Basic Concept of Inventory Accounting

Record amount and quantity of inventory on hand at end of accounting period



Record amount and quantity of inventory on hand at end of accounting period

Recognize cost of sales

(an “expense”) to be matched against period sales revenues


Inventory is primary current asset for merchandising organization

Cost of goods sold (cost of sales) is organization’s primary expense

Refer to Lands’ End’s financial statements (textbook Chapter 1)



COST OF GOODS SOLD $588,017,000 57 cents of every sales

dollar earned goes to pay for cost of merchandise sold to customers by Lands’ End



COST OF GOODS SOLD $588,017,000 57 cents of every sales

dollar earned goes to pay for cost of merchandise sold to customers by Lands’ End

INVENTORY $164,816,000 Comprises 74.2% of

Lands’ End total current assets

Comprises nearly 51% of total company assets



Inventory Accounting - Perpetual System

Generally used for expensive merchandise items: trucks, jewelry, furniture

Point-of-sale technology eases implementation

Keeps perpetual (continuous) accounting records for every inventory item purchased and sold by company


Allows quick determination of cost of goods sold and merchandise inventory from ledger account balances

Facilitates inventory resource management activities Links to electronic document interchange (EDI)

systems decrease inventory ordering time Product managers perform multidimensional

analyses of inventory/sales data Managers make realtime changes to sales plans,

purchasing budgets, etc.

Perpetual System Advantages


Improves internal control over merchandise inventory

Physical counts should agree with amounts reported in records

Otherwise, adjust records for spoilage, theft, etc.



Improves internal control over merchandise inventory

Physical counts should agree with amounts reported in records

Otherwise, adjust records for spoilage, theft, etc.

Enhances customer service Report up-to-date information to

customers: quantity, expected delivery dates, etc.



Entries Under the Perpetual System

Goods purchased debited to Inventory (or Merchandise Inventory) ledger account

Cash or A/P credited

SITUATION:

On November 14, Asian Art, Inc. purchases $43,000 of sculptures and watercolors on account for resale to customers.


How would you record this transaction?

11/14/xx Inventory $43,000

A/P $43,000

To record inventory purchased on account





A/P $43,000


Inventory

11/14 $43,000





A/P $43,000


Inventory Accounts Payable

11/14 $43,000 $43,000 11/14




Sales to customers captured through two journal entries

(1) record sales revenue (2) reduce inventory and

increase cost of goods sold



Sales to customers captured through two journal entries

(1) record sales revenue (2) reduce inventory and

increase cost of goods sold How would Asian Art

journalize a $7,000 sale on account on Nov. 29, assuming cost of goods sold is $2,900?


11/29/xx A/R $7,000

Sales Revenue $7,000

To record sale on account



11/29/xx A/R $7,000



Accounts Receivable

11/29 $7,000



11/29/xx A/R $7,000



Accounts Receivable Sales Revenue

11/29 $7,000 $7,000 11/29



11/29/xx Cost of Goods Sold $2,900

Inventory $2,900

To record cost of sales




Inventory $2,900


Cost of Goods Sold

11/29 $2,900




Inventory $2,900


Cost of Goods Sold Inventory

11/29 $2,900 $2,900 11/29



Accounting records do not continuously track on-hand inventory

At period end, physical count performed to determine proper ending inventory account balance

Inventory and cost of goods sold account balances adjusted before preparing financials

Inventory Accounting - Periodic System

INVENTORY

COUNT

SCHEDULE:

March 31


Fewer journal entries required during accounting period

Easy to use for small companies with rather homogenous goods Although computerized

accounting and sales systems make perpetual system just as easy to work with

Periodic System Advantages


Entries Under the Periodic System

Goods purchased debited to Purchases ledger account

Cash or A/P credited

SITUATION:

On February 20, Ray’s Seafood Shack purchases $850 of shark, red snapper, and black grouper filets for the next week’s dinner specials.



2/20/xx Purchases $850

A/P $850






A/P $850


Purchases

2/20 $850





A/P $850


Purchases Accounts Payable

2/20 $850 $850 2/20




Only entry necessary to capture Seafood Shack’s sales to customers is one to record sales revenues earned

REMEMBER: inventory and cost of goods sold adjusted at month-end only



Textbook Exhibit 6-2 details adjusting entries used to update account balances




INVENTORY

Beginning

balance

COST OF GOODS SOLD




INVENTORY

Beginning

balance

COST OF GOODS SOLD

Beginning bal.




INVENTORY

Ending Beginning

balance balance

COST OF GOODS SOLD

Beginning bal.




INVENTORY

Ending Beginning

balance balance

COST OF GOODS SOLD

Beginning bal. Ending bal.




INVENTORY PURCHASES

Ending Beginning Net purchases

balance balance during period

COST OF GOODS SOLD

Beginning bal. Ending balance




INVENTORY PURCHASES



COST OF GOODS SOLD


Net purchases




INVENTORY PURCHASES



COST OF GOODS SOLD


Net purchases

Cost of goods sold


Cost of Goods Sold (Cost of Sales)

Represents net purchase costs of inventory sold to customers during accounting period

Cost of goods sold = beginning inventory

+ net purchases

- ending inventory

$0$100,000$200,000$300,000$400,000$500,000$600,000$700,000

Revenues Cost of Sales

Other Exp. Net Income


How do product managers and corporate buyers at Pier 1 Imports, Sears, or Williams-Sonoma decide how much inventory to buy for the upcoming year?

Want to have enough product on hand to meet customer demand

But not TOO much inventory - requiring company to discount sales prices to rid itself of excess merchandise!

Managers’ Use of theCost of Goods Sold Model


Rearranging model allows managers to determine appropriate amount of inventory purchases

Budgeted Cost of Goods Sold

- budgeted ending inventory

= cost of goods available for sale

- actual beginning inventory

= budgeted purchases

Managers’ Use of theCost of Goods Sold Model


Gross Margin (Gross Profit)

Difference between sales revenue and cost of sales




Revenues = $700,000

$0$100,000$200,000$300,000$400,000$500,000$600,000$700,000






Revenues = $700,000 Cost of sales = $450,000

$0$100,000$200,000$300,000$400,000$500,000$600,000$700,000






Revenues = $700,000 Cost of sales = $450,000 Gross margin = $250,000

$0$100,000$200,000$300,000$400,000$500,000$600,000$700,000






Revenues = $700,000 Cost of sales = 450,000 Gross margin = 250,000 What is the significance of

the gross margin?

$0$100,000$200,000$300,000$400,000$500,000$600,000$700,000




Low gross margin % indicates possible difficulties in covering all other company operating expenses And being able to earn a profit

ILLUSTRATION:

Huntington Galleries’ gross margin is $75,100,000 ($165,900,000 - 90,800,000). Can the company cover its operating costs and still earn profits acceptable to its shareholders?



Information taken from textbook Chapter 6 opening pages

Net sales $165,900,000

Cost of sales 90,800,000

Gross margin 75,100,000

All other expenses 40,000,000

Net income $35,100,000




Net sales $165,900,000




Net income $35,100,000 Huntington’s gross margin seems sufficient




Net sales $165,900,000




Net income 35,100,000 Huntington’s gross margin seems sufficient Company generated a 21% return on sales



Computing the Cost of Inventory

Inventory cost calculationInventory quantities in units

x

Unit cost


Determining Inventory Quantities

Physical count of merchandise owned taken on last day of fiscal year - regardless of method Sometimes taken monthly or quarterly for

interim financial reports Complicating factors

Who owns merchandise in transit between vendor and company?

Who owns goods on consignment?


Goods in Transit

Inventory has left supplier’s place of business

Topeka, Kansas


Goods in Transit

At accounting period end, goods still “in transit”

Haven’t yet reached their destination

Las Cruces, New Mexico


Goods in Transit





Goods in Transit

Who owns/records inventory at period end?

Supplier? Buyer?





Goods in Transit

Entity possessing legal title to inventory Generally based on shipping terms FOB shipping point

Title passes at seller’s place of business Cost/units reflected in buyer’s inventory

FOB destination Title passes at buyer’s business location Seller retains cost/units in its accounting

records


Consigned Goods

Inventory stored/sold on company premises but not owned by entity

Antiques store or used clothing store accepts inventory owned by others

Tries to sell it for owners

Earns commission on each piece of furniture or clothing sold


Consigned Goods

Consigned goods included in inventory of owner

Excluded from inventory of antiques store or used clothing store Not assets of the store


Unit Cost of Inventory

Amount paid to



Amount paid to

purchase



Amount paid to

purchase

transport



Amount paid to

purchase

transport

store



Amount paid to

purchase

transport

store

insure

inventory held for sale to customers



Amount paid to

purchase

transport

store

insure

inventory held for sale to customers Several cost methods exist ...


Chapter Objective 2

Apply the inventory costing methods: specific unit cost, weighted-average cost,

FIFO, and LIFO


Inventory Costing Methods

Specific Unit Cost



Specific Unit Cost

Weighted-Average Cost



Specific Unit Cost


First-In-First-Out (FIFO)



Specific Unit Cost



Last-In-First-Out (LIFO)



Business free to use any inventory method




Inventory cost flow doesn’t necessarily match PHYSICAL flow of goods




Inventory cost flow doesn’t necessarily match PHYSICAL flow of goods

Assigns value to Cost of goods sold Ending inventory


Assume following data for Asian Art, Inc. Purchases of silk and paper lanterns during 19x1

1/5/x1 20 units @ $20

5/19/x1 25 units @ $30

10/23/x1 40 units @ $31 Total purchases in units 85 Units sold during 19x1 70 Ending inventory in units 15



Inventory Costing Methods -Sales Information

Sales in units

1/8/x1 = 17

5/21/x1 = 18

10/28/x1 = 35 Total sales = 70

units


17 units @ $20

Specific Identification

COST OF GOODS SOLD

JAN 8 $340


17 units @ $20

3 units @ $20


COST OF GOODS SOLD

JAN 8 $340

ENDING INVENTORY

$60


18 units @ $30

17 units @ $20

3 units @ $20

COST OF GOODS SOLD

MAY 21 $540

JAN 8 $340

ENDING INVENTORY

$60



ENDING INVENTORY

$210

$60

18 units @ $30

7 units @ $30

17 units @ $20

3 units @ $20

COST OF GOODS SOLD

MAY 21 $540

JAN 8 $340



35 units @ $31

18 units @ $30

7 units @ $30

17 units @ $20

3 units @ $20

COST OF GOODS SOLD

OCT 28 $1085

MAY 21 $540

JAN 8 $340

$1965

ENDING INVENTORY

$210

$60



35 units @ $31

5 units @ $31

18 units @ $30

7 units @ $30

17 units @ $20

3 units @ $20

COST OF GOODS SOLD

OCT 28 $1085

MAY 21 $540

JAN 8 $340

$1965

ENDING INVENTORY

$155

$210

$60

$425




COST OF GOODS SOLD

$400

15 units @ $31

25 units @ $31

25 units @ $30

20 units @ $20


COST OF GOODS SOLD

$750

$400

15 units @ $31

25 units @ $31

25 units @ $30

20 units @ $20



COST OF GOODS SOLD

$775

$750

$400

$1925

15 units @ $31

25 units @ $31

25 units @ $30

20 units @ $20



COST OF GOODS SOLD

$775

$750

$400

$1925

ENDING INVENTORY

$465

15 units @ $31

25 units @ $31

25 units @ $30

20 units @ $20




COST OF GOODS SOLD

$ 1240

40 units @ $31

25 units @ $30

5 units @ $20

15 units @ $20



COST OF GOODS SOLD

$ 1240

$ 750

40 units @ $31

25 units @ $30

5 units @ $20

15 units @ $20



COST OF GOODS SOLD

$ 1240

$ 750

$ 100

$2090

40 units @ $31

25 units @ $30

5 units @ $20

15 units @ $20



COST OF GOODS SOLD

$ 1240

$ 750

$ 100

$2090

40 units @ $31

25 units @ $30

5 units @ $20

15 units @ $20

ENDING INVENTORY

$300



40 units @ $ 31

25 units @ $ 30

20 units @ $ 20

$2390 total cost goods available for sale



40 units @ $ 31

25 units @ $ 30

20 units @ $ 20


85 units available for sale



40 units @ $ 31

25 units @ $ 30

20 units @ $ 20



$28.12 cost per unit



40 units @ $ 31

25 units @ $ 30

20 units @ $ 20



$28.12 cost per unit $28.12 x 70 units sold in

19x1 = $1968 cost of goods sold



40 units @ $ 31

25 units @ $ 30

20 units @ $ 20



$28.12 cost per unit $28.12 x 70 units sold in

19x1 = $1968 cost of goods sold

$28.12 x 15 units on hand = $422 ending inventory


Chapter Objective 3

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


Income Effects of Each Method

SPECIF. WEIGHTED

IDENTIFIC. AVERAGE FIFO LIFO



SPECIF. WEIGHTED


SALES $3,000 $3,000 $3,000 $3,000



SPECIF. WEIGHTED


SALES $3,000 $3,000 $3,000 $3,000

COST OF GOODS SOLD

BEGINNING INVENTORY 0 0 0 0



SPECIF. WEIGHTED


SALES $3,000 $3,000 $3,000 $3,000

COST OF GOODS SOLD


PURCHASES 2,390 2,390 2,390 2,390



SPECIF. WEIGHTED


SALES $3,000 $3,000 $3,000 $3,000

COST OF GOODS SOLD


PURCHASES 2,390 2,390 2,390 2,390

COST OF GOODS AVAILABLE FOR SALE 2,390 2,390 2,390 2,390



SPECIF. WEIGHTED


SALES $3,000 $3,000 $3,000 $3,000

COST OF GOODS SOLD


PURCHASES 2,390 2,390 2,390 2,390


LESS ENDING INVENTORY 425 422 465 300



SPECIF. WEIGHTED


SALES $3,000 $3,000 $3,000 $3,000

COST OF GOODS SOLD


PURCHASES 2,390 2,390 2,390 2,390



COST OF GOODS SOLD 1,965 1,968 1,925 2,090


SPECIF. WEIGHTED


SALES $3,000 $3,000 $3,000 $3,000

COST OF GOODS SOLD


PURCHASES 2,390 2,390 2,390 2,390



COST OF GOODS SOLD 1,965 1,968 1,925 2,090

GROSS MARGIN $1,035 $1,032 $1,075 $910



SPECIF. WEIGHTED


GROSS MARGIN $1,035 $1,032 $1,075 $910

In times of rising prices, LIFO yields lowest gross margin (net income)



SPECIF. WEIGHTED


GROSS MARGIN $1,035 $1,032 $1,075 $910

FIFO yields highest gross margin



Income Tax Advantage of LIFO

When income is lower, taxes are lower

Most attractive aspect of LIFO

Recall the textbook opening vignette ... Huntington Galleries

saved nearly $1.3-million in taxes by using LIFO!

TAXES


Income Tax Advantages of LIFO

Why would a company use FIFO?


Incentives for Using FIFO

Higher net income results in larger bonuses

Industries experiencing falling costs end up with lower net income - still save on taxes

Higher net income looks better to creditors/investors


Accounting Principles and Their Relevance to Inventory

CONSISTENCY Entity employs same

methods of accounting from period to period

Enhances users’ ability to compare financial statements for company over time

Trend analysis Forecasts







FULL DISCLOSURE Entity reports sufficient

quantity and quality of information for users







FULL DISCLOSURE Entity reports sufficient

quantity and quality of information for users

Failure to disclose important data can result in financial reports which mislead readers

Impacts their decision-making activities


Consistency and Disclosure

Company can change inventory methods, but must disclose impact of change on net income

Financials should provide investors/creditors with adequate information on which to base their actions

Relevant Reliable Comparable



MATERIALITY Information is material if its omission from financial

statements would cause users to alter their decisions Measured in relation to other information provided on

financial statements

CONSERVATISM Statement preparers use accounting methods and

principles which Least overstate net assets Least overstate net income


Chapter Objective 4

Apply the lower-of-cost-or-market rule to inventory


Lower-of-Cost-or-Market Rule

Inventory reported on balance sheet at lower of original cost or current replacement (market) value

Communicates to statement users the decline in value of inventory


Suppose a retailer sells laptop computers ...

Laptop original cost/unit = $1,200 Laptop replacement cost/unit = $900 Retailer would reduce ending

inventory value by $300 per unit Rapid changes in technology quickly

diminishes utility of this inventory item



Doesn’t this violate historical cost principle?

Yes, but ... Other principles provide

more compelling reasons to depart from historical cost

Conservatism Full disclosure Materiality



Chapter Objective 5

Compute the effects of inventory errors on cost of goods sold and net income


Effects of Inventory Errors

Textbook Exhibits 6-9 and 6-10 demonstrate the carry-forward effects of errors related to ending inventory

How many periods’ financial statements will be affected by an error in ending inventory?




How many periods’ financial statements are affected by an error in ending inventory?

1? 1?





1? 1? 2?2?





1? 2?1? 2? More?More?


Ending inventory errors impact TWO periods’ financial statements




Current period Ending inventory


1998


1999



Next period Beginning

inventory


1998


1999



Next period Beginning

inventory Error counterbalanced

by end of second period


1998


How do errors in ending inventory impact ...

Cost of sales? Gross margin? Net income?

Effect of Inventory Errors on Cost of Sales and Net Income


UNDER OVER CORRECT STATED STATED

COST OF GOODS SOLD

BEGINNING INVENTORY 4 4 4




COST OF GOODS SOLD


NET PURCHASES 34 34 34




COST OF GOODS SOLD



GOODS AVAILABLE FOR SALE 38 38 38




COST OF GOODS SOLD




ENDING INVENTORY 5 1 9

Errors during physical count!




COST OF GOODS SOLD





COST OF GOODS SOLD 33 37 29


OVER-STATED

UNDER-STATED



COST OF GOODS SOLD






INCOME STATEMENT

NET SALES 60 60 60




COST OF GOODS SOLD






INCOME STATEMENT

NET SALES 60 60 60


GROSS MARGIN 27 23 31




COST OF GOODS SOLD






INCOME STATEMENT

NET SALES 60 60 60



OPERATING EXPENSES 22 22 22




COST OF GOODS SOLD






INCOME STATEMENT

NET SALES 60 60 60



OPERATING EXPENSES 22 22 22

NET INCOME 5 1 9


OVER-STATED

UNDER-STATED


Ethical Issues in Inventory Accounting

Pressure to report positive earnings picture

Bonuses linked to gross margin or net income

Stockholders’ expectations

Creditor or analyst forecasts


Chapter Objective 6Estimate inventory by the

gross margin method


Estimating Inventory

Sometimes necessary to estimate ending inventory

Why?




Why? Not practical to

perform physical count every month




Why? Not practical to

perform physical count every month

Losses related to fire, natural disaster, theft, or other causes


Gross Margin (Gross Profit) Method

Relying on income statement information, can use gross margin % to estimate cost of sales

Rearrange cost of goods sold model to solve for the unknown variable, ending inventory

Beginning inventory

+ net purchases

- cost of sales

= ending inventory


Ray’s Seafood Shack lost all of its inventory due to coastal flooding: What’s the amount of the loss to be filed with the insurance company?

Period net sales = $150,000 Gross margin = 31.5% Beginning inventory = $18,500 Period purchases = $110,500





Net sales x Gross margin %

$150,000 x .315

= $47,250 Gross margin





Net sales x Gross margin %

$150,000 x .315

= $47,250 Gross margin

Net sales - gross margin

$150,000 - $47,250

= $102,750 Cost of sales





Beg. inventory $ 18,500






Purchases 110,500






Purchases 110,500

Available for sale $ 129,000






Purchases 110,500


Cost of sales (102,750)






Purchases 110,500


Cost of sales (102,750)

Estimated

ending inventory

lost in flood $ 26,250



Chapter Objective 7

Use the gross margin percentage and the inventory turnover ratio to

evaluate a business


Analyzing Financial Statements

Two important ratios used to measure merchandiser’s success



Gross margin percentage11



Inventory turnover 22


Gross margin percentage measures average percentage of gross profit generated by one dollar of sales

Changes in gross margin alert users to possible shifts in profitability

Examine Lands’ End’s gross margin %







Gross Margin

Net Sales






Gross Margin

Net Sales

$443,531,000

$1,031,548,000






Gross Margin

Net Sales

$443,531,000

$1,031,548,000

= 43%

Every sales dollar generates 43 cents profit before all other

expenses


Inventory turnover indicates number of times per year, on average, inventory is sold

Quicker turnover generally indicates more profitable entity

Allows business to invest current assets in more productive resources




Cost of Goods Sold

Average Inventory






Cost of Goods Sold

Average Inventory

Lands’ End’s turnover ratio:

$588,017,000

$166,734,000









Cost of Goods Sold

Average Inventory

Lands’ End’s turnover ratio:

$588,017,000

$166,734,000

3.53 times


Periodic physical count Effective purchasing, receiving, and shipping procedures Limited/restricted access to inventory storage locations Computerization/perpetual recordkeeping for high cost

inventory Adequate stock of on-hand inventory to prevent

shortages/stockouts Automatic reorder points/EOQ models to minimize

investment

Internal Control Over Inventory


Reporting Inventory Transactions on the Statement of Cash Flows

Inventory purchases and sales of inventory to customers reflected in cash flows from operating activities section of statement

Refer to textbook Exhibit 6-15 to view the statement of cash flows for Huntington Galleries


World Wide Web Sites

Black and Decker http://www.blackanddecker.com/

Wendy’s

http://www.wendys.com/


THE

END

(c) 1997 prentice hall business publishing financial accounting, 3/e harrison and horngren 6 - 1...

Documents

inventory accounting

business slide

merchandising inventory

quantity of inventory

e harrison

estimate inventory

inventory item

end of accounting period