ACG 2021Financial Accounting

Merchandise Inventory and Cost of Goods Sold

Learning Objectives

Account for inventory transactionsAnalyze the various inventory methodsIdentify the income and the tax effects of the

inventory methodsUse the gross profit percentage and inventory

turnover to evaluate a businessEstimate inventory by the gross profit methodShow how inventory errors affect cost of goods

sold and income

Inventory and Cost of Goods Sold Inventory

Products purchased or manufactured for Sale to Customers

Beginning Inventory Quantities of Merchandise on hand

Purchases New Purchases or Manufactured products

Available for Sale = Beginning Inventory + Purchases Most that a company can sell during an accounting

periodEnding Inventory

Remaining Unsold MerchandiseCost of Goods Sold

Cost of Inventory Sold during accounting Period

Purchases consist of the following:

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

Calculation

Cost of Beginning Inventory

+Cost of Purchases___________________=Cost of Goods

Available for Sale- Cost of Ending

Inventory___________________=Cost of Goods Sold

Cost of Beginning Inventory

+Cost of Purchases___________________=Cost of Goods

Available for Sale- Cost of Goods Sold___________________=Cost of Ending

Inventory

Inventory vs Cost of Goods Sold

Inventory Cost of Goods Sold

Beginning

PurchasesInventory Sold

Ending

Inventory Sold

As Inventory is Sold we remove it’s cost from the Asset side of A=L+E andInsert it’s cost into an Expense on the Equity side of A = L + E

This property exists for all Assets: As they are used up or sold the costTransfers from the Balance Sheet as a Future Economic Resource (Asset)To the Income Statement as an Expense incurred to generate Revenue

Relationship between Balance Sheet and Income StatementIncome Statement Items:

Sales revenue is based on sale pricesale price of Inventory sold.

Cost of goods sold is based on costcost of Inventory sold.

Gross profit (gross margin) is sales revenue less cost of goods sold.

Balance Sheet Item:Inventory on the balance sheet is based on

costcost.

Income Statement – Service Company

Balance Sheet – Service Company

Income Statement – Retail Company

Best Buy

Balance Sheet – Retail CompanyBest Buy

Inventory Accounting Systems

Periodic systemDoes not keep a running record of all goods

bought and sold.Inventory counted at least once a yearUsed for inexpensive goods

Perpetual systemKeeps a running record of all goods bought and

sold.Inventory counted at least once a year.Used for all types of goods.

Accounting for Inventory

Inventory(balance sheet) = Number of units of

inventory on hand X Cost per unitof inventory

Cost of Goods Sold(income statement) = Number of units of

inventory sold X Cost per unitof inventory

General Journal

Date Accounts and Explanations PR Debit Credit

Recording Transactions and the T-Accounts

Accounts Payable560,000Beg. 100,000

560,000

Inventory

Inventory 560,000Accounts Payable 560,000

Purchased inventory on account

Recording Transactionsand the T-Accounts

Sale on account $900,000 of Inventory which cost $540,000:

General Journal

Date Accounts and Explanations PR Debit Credit Accounts Receivable 900,000

Sales Revenue 900,000Cost of Goods Sold 540,000

Inventory 540,000

Recording Transactionsand the T-Accounts

Cost of Goods Sold540,000

InventoryBeg. 100,000

560,000120,000

540,000

Reporting in theFinancial Statements

Income Statement (partial)Sales revenue $900,000Cost of goods sold 540,000Gross 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

ACG 2021Financial Accounting

Inventory Cost Methods

Inventory Costing

Sum of all costs incurred to bring asset to its intended use

Methods for determining per unit Inventory CostSpecific unit costAverage costFirst-in, first-out (FIFO) costLast-in, first-out (LIFO) cost

Which Method will a Company Use?

Decision is up to ManagementNOT based on Actual Inventory Movements

A tool for managing EarningsA tool for managing Taxes

Beginning inventory (10 units @ $10) $ 100No. 1 (25 units @ $14 per unit) $350No. 2 (25 units @ $18 per unit) 450Total purchases 800Cost of goods available for sale $ 900

Ending inventory: 20 unitsCost of goods sold: 40 units

Illustrative Data

Specific Unit Cost

Identify each inventory unit and determine the costOf the 20 Units left, how many came from the:Of the 40 Units sold, how many came from the:

$10, $14, or $18 purchaseMultiply each unit by that specific units cost

For example if we assume: Inventory: 10@10, 5@14 and 5@18

Inventory = $260Cost of Goods Sold: 20@14 and 20@18

CGS = $640

Average Costing

Average Costper unit =

Cost of Goods Available

Number of units available

Inventory (at average cost)

Beg Bal (10 units @ $10) 100

25 units @ $14 350Purchases:

25 units @ $18 450Cost of goods sold (40 units @ average cost of $15 per unit 600

Ending Bal (20 units @ average cost of $15 per unit 300

Weighted-Average

$900 total cost ÷ 60 units = $15/unit

Cost of goods sold = 40 × $15 = $600

Ending inventory = 20 × $15 = $300

FIFO

Inventory (at FIFO cost)

Beg Bal (10 units @ $10) 100

25 units @ $14 350Purchases:

25 units @ $18 450

Cost of goods sold (40 units):(10 units @ $10 = 100)(25 units @ $14 = 350)( 5 units @ $18 = 90) 540

Ending Bal (20 units @ $18) 360

First costs into inventory are first costs assigned to cost of goods sold.

LIFO

Inventory (at LIFO cost)

Beg Bal (10 units @ $10) 100

25 units @ $14 350Purchases:

25 units @ $18 450 Cost of goods sold (40 units): (25 units @ $18 = 450)(15 units @ $14 = 210) 660

Ending Bal (10 units @ $10 = 100)(10 units @ $14 = 140) 240

Last costs into inventory are first costs assigned to cost of goods sold.

Income Effects ofInventory Methods

Specific unit cost $1,000 – 640 = $360Weighted-average $1,000 – 600 = $400FIFO $1,000 – 540 = $460LIFO $1,000 – 660 = $340

AssumedSales

Revenue

Cost ofGoodsSold

GrossProfit

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

Income Effects

When inventory costs are increasingLIFO cost of goods sold is highest, gross profit

is lowest.FIFO cost of goods sold is lowest, gross profit

is highest.When inventory costs are decreasing

FIFO cost of goods sold is highest.LIFO cost of goods sold is lowest.

Other Issues

Tax advantages of LIFO in periods of rising pricesHigher Cost of Goods Sold = Lower Net Income

= Lower Income TaxesInventory Method & managing incomeInternational issue – LIFO not allowed in

some countries

Inventory Errors

Each inventory error affects:InventoryCost of goods soldGross profitNet income

Inventory Errors

Period 1 Period 2

Inventory Error Cost of

Goods Sold Gross Profit

and Net Income Cost of

Goods Sold Gross Profit

and Net Income Period 1 Ending inventory overstated Understated Overstated Overstated Understated Period 1 Ending inventory understated Overstated Understated Understated Overstated

ACG 2021Financial Accounting

More accounting Principles and Concepts

Accounting Principles

Consistency principle Same Accounting Methods from Period to Period Accounting Changes must be disclosed

Effect of accounting Change must be disclosedDisclosure principle

Enough information must be reported for stakeholders to make informedinformed decisionsRelevant, Reliable, and Comparable Information

Accounting conservatism Anticipate or disclose all likely losses, but gains are not reported

until they occur Assets are recorded as lowest reasonable amount Liabilities are recorded at highest reasonable amount:

Lower of Cost or Market Lower-of-Cost-or-Market rule (LCM)

Inventory is reported at the lowest valueHistorical CostOr Market (Replacement Cost)

Inventory is below costRecord an increase in Cost of Goods Sold (debit)Record the reduction in Inventory (credit)

To record a $1,000 decline in inventory value

Cost of Goods Sold 1,000Inventory 1,000

Wrote inventory down to market value

ACG 2021Financial Accounting

Inventory Ratios

Ratios

Gross ProfitPercentage =

Gross ProfitNet Sales Revenue

InventoryTurnover =

Cost of goods soldAverage Inventory

Ratios

Gross ProfitProfit indicator

Inventory Turnover – Liquidity ratioHow quickly is Inventory Sold?

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ACG 2021Financial Accounting

Estimating Inventory and/orCost of Goods Sold using

Gross Profit

Gross Profit Method

Gross profit method is a way to estimate inventory based on the cost of goods sold model.

Also called gross margin method.

Calculation Cost of Beginning

Inventory+Cost of Purchases___________________=Cost of Goods

Available for Sale- Cost of Ending

Inventory___________________=Cost of Goods Sold

Cost of Beginning Inventory

+Cost of Purchases___________________=Cost of Goods

Available for Sale- Cost of Goods Sold___________________=Cost of Ending

Inventory

Calculation Continued

Sales – Cost of Goods Sold = Gross ProfitGross Profit% = Gross Profit / SalesCost of Goods Sold = Sales x (1- Gross Profit%)

Estimate CGS using GP%

We know Beginning Inventory = 14,000We know Purchases = 66,000We know Sales = 100,000We know Gross Profit % = 43%

We Don’t know Cost of Goods SoldWe Don’t know Ending Inventory

Gross Profit Method

Beginning inventory $14,000Purchases 66,000Goods available 80,000Cost of goods sold:

Net sales revenue $100,000Less estimated gross profit 43% (43,000)Estimated cost of goods sold 57,000

Estimated cost of ending inventory $23,000

End of Chapter 6