Merchandise Inventory, Cost ofGoods Sold, and Gross Profit
Pr. Zoubida SAMLAL
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Accounting for Inventory
Inventory(balance sheet)
=Number of units ofinventory on hand
XCost per unitof inventory
Cost of Goods Sold(income statement)
=Number of units of
inventory soldX
Cost per unitof inventory
General JournalDate Accounts and Explanations PR Debit Credit
Recording Transactions and theT-Accounts
Inventory 560,000
Accounts Payable 560,000
Purchased inventory on account
General JournalDate Accounts and Explanations PR Debit Credit
Accounts Payable560,000Beg. 100,000
560,000
Inventory
Inventory 560,000
Accounts Payable 560,000
Purchased inventory on account
Recording Transactionsand the T-Accounts
Sale on account $900,000 of Inventory whichcost $540,000:
General JournalDate Accounts and Explanations PR Debit Credit
General JournalDate Accounts and Explanations PR Debit Credit
Accounts Receivable 900,000
Sales Revenue 900,000
Cost of Goods Sold 540,000Inventory 540,000
Recording Transactionsand the T-Accounts
Cost of Goods Sold540,000
InventoryBeg. 100,000
560,000120,000
540,000 540,000Beg. 100,000560,000120,000
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 $ XXXShort-term investments XXXAccounts receivable, net XXXInventory 120,000Prepaid expenses XXX
Ending Balance Sheet (partial)Current assets:
Cash $ XXXShort-term investments XXXAccounts receivable, net XXXInventory 120,000Prepaid expenses XXX
Income Statements
Service revenue $XXXExpenses
Salary expense XDepreciation expense XIncome tax expense X
Net income $ X
Service CompanyCentury 21 Real Estate
Income StatementYear Ended December 31, 20xx
Sales revenue $185Cost of goods sold 146Gross profit 39Operating expenses:
Salary expense XDepreciation expense XIncome tax expense $ X
Net income $ 4
Merchandising CompanyGeneral Motors Corporation
Income StatementYear Ended December 31, 20xx
Service revenue $XXXExpenses
Salary expense XDepreciation expense XIncome tax expense X
Net income $ X
Sales revenue $185Cost of goods sold 146Gross profit 39Operating expenses:
Salary expense XDepreciation expense XIncome tax expense $ X
Net income $ 4
Balance Sheets
Current assets:Cash $XShort-term investments XAccounts receivable, net XPrepaid expenses X
Service CompanyCentury 21 Real Estate
Balance SheetYear Ended December 31, 20xx
Current assets:Cash $ XShort-term investments XAccounts receivable, net XInventory 11Prepaid expenses X
Merchandising CompanyGeneral Motors Corporation
Balance SheetYear Ended December 31, 20xx
Current assets:Cash $XShort-term investments XAccounts receivable, net XPrepaid expenses X
Current assets:Cash $ XShort-term investments XAccounts receivable, net XInventory 11Prepaid expenses X
©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
Gross Profit (Gross Margin)
Sales Revenue
- Gross Profit
- Operating Expenses
Net Income
Sales Revenue
- Gross Profit
- Operating Expenses
Net Income
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Learning Objective 1
Account for inventory transactions.
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Inventory Accounting Systems
• Periodic systems do not keep a continuousrecord of inventory on hand.
• Perpetual systems maintain a running recordto show the inventory on hand at all times.
• Periodic systems do not keep a continuousrecord of inventory on hand.
• Perpetual systems maintain a running recordto show the inventory on hand at all times.
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Recording Transactionsin 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
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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
Recording Transactionsand the T-Accounts
General JournalDate Accounts and Explanations PR Debit Credit
Inventory 560,000
Accounts Payable 560,000
Purchased inventory on account
General JournalDate Accounts and Explanations PR Debit Credit
Accounts Payable560,000Beg. 100,000
560,000
Inventory
Inventory 560,000
Accounts Payable 560,000
Purchased inventory on account
Recording Transactionsand the T-Accounts
Sale on account $900,000 (cost $540,000):
General JournalDate Accounts and Explanations PR Debit Credit
General JournalDate Accounts and Explanations PR Debit Credit
Accounts Receivable 900,000
Sales Revenue 900,000
Cost of Goods Sold 540,000Inventory 540,000
Recording Transactionsand the T-Accounts
Cost of Goods Sold540,000
InventoryBeg. 100,000
560,000120,000
540,000
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540,000Beg. 100,000560,000120,000
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 $ XXXShort-term investments XXXAccounts receivable, net XXXInventory 120,000Prepaid expenses XXX
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Ending Balance Sheet (partial)Current assets:
Cash $ XXXShort-term investments XXXAccounts receivable, net XXXInventory 120,000Prepaid expenses XXX
Reporting in theFinancial Statements
Net purchasesPurchases+ Freight-in– Purchase returns & allowances– Purchases discount
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Net salesSales revenue– Sales returns & allowances– Sales discounts
Net purchasesPurchases+ Freight-in– Purchase returns & allowances– Purchases discount
Learning Objective 2
Analyze the various inventory methods.
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What Goes Into Inventory Cost?
• Sum of all costs incurred to bring asset to itsintended use
• Inventory costing methods:– Specific unit cost– Weighted-average cost– First-in, first-out (FIFO)– Last-in, first-out (LIFO)
• Sum of all costs incurred to bring asset to itsintended use
• Inventory costing methods:– Specific unit cost– Weighted-average cost– First-in, first-out (FIFO)– Last-in, first-out (LIFO)
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Illustrative Data
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
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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
Specific Unit Cost
Cost of Goods Sold$ 50350180
$580
25 Units @ $14
5 Units @ $10
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Cost of Goods Sold$ 50350180
$580
$900 – $580 = $320
25 Units @ $14
10 Units @ $18
Weighted-Average
$900 total cost ÷ 60 units = $15/unit
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Cost of goods sold = 40 × $15 = $600
Ending inventory = 20 × $15 = $300
First-In, First-Out
Ending Inventory Cost:
60 unitsLess units sold 40Ending inventory 20 units
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60 unitsLess units sold 40Ending inventory 20 units
20 units × $18 per unit = $360
First-In, First-Out
Cost of Goods Sold$100
35090
$540
10 Units @ $10
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Cost of Goods Sold$100
35090
$540
25 Units @ $14
5 Units @ $18
Last-In, First-Out
Ending Inventory Cost:
60 unitsLess units sold 40Ending inventory 20 units
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60 unitsLess units sold 40Ending inventory 20 units
10 units × 10 = $10010 units × 14 = 140Total $240
Last-In, First-Out
Cost of Goods Sold$450
210$660
25 Units @ $18
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Cost of Goods Sold$450
210$660
25 Units @ $18
15 Units @ $14
Income Effects ofInventory Methods
Specific unit cost $1,000 – 580 = $420Weighted-average $1,000 – 600 = $400FIFO $1,000 – 540 = $460LIFO $1,000 – 660 = $340
AssumedSales
Revenue
Cost ofGoodsSold
GrossProfit
Specific unit cost $1,000 – 580 = $420Weighted-average $1,000 – 600 = $400FIFO $1,000 – 540 = $460LIFO $1,000 – 660 = $340
Learning Objective 3
Identify the income and the tax effects of theinventory methods.
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The Tax Advantage of LIFO
Gross profit $460 $340Operating expenses 260 260Income before taxes $200 $ 80Income tax expense (40%) $ 80 $ 32
FIFO LIFO
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Gross profit $460 $340Operating expenses 260 260Income before taxes $200 $ 80Income tax expense (40%) $ 80 $ 32
The most attractive feature of LIFO is lowincome tax payments when prices are
increasing.
Use of the VariousInventory Methods
Other3%
Average20%
LIFO31% FIFO
46%
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Other3%
Average20%
LIFO31% FIFO
46%
Comparison of InventoryMethods
• FIFO produces inventory profits during periodsof inflation
• LIFO allows managers to manipulate netincome
• LIFO liquidation
• FIFO produces inventory profits during periodsof inflation
• LIFO allows managers to manipulate netincome
• LIFO liquidation
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Consistency Principle
• Use the same accounting methods andprocedures from one period to the next
• May change inventory methods, but mustdisclose the effects of the change on netincome
• Use the same accounting methods andprocedures from one period to the next
• May change inventory methods, but mustdisclose the effects of the change on netincome
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Disclosure Principle
• Financial statements should report enoughinformation to enable an outsider to makeknowledgeable decisions about the company.
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Conservatism
• The least favorable figures are presented inthe financial statements.
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Lower-of-Cost-or-Market Rule
• Report inventory at the lower of its historicalcost or market (replacement) value
• If the replacement cost falls below itshistorical cost, write down the value of theinventory
• Report inventory at the lower of its historicalcost or market (replacement) value
• If the replacement cost falls below itshistorical cost, write down the value of theinventory
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Learning Objective 4
Use the gross profit percentage and inventoryturnover to evaluate business.
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Using the Financial Statementsfor Decision Making
Gross profit percentage= Gross profit
÷ Net sales revenue
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Inventory turnover= Cost of goods sold÷ Average inventory
Gross profit percentage= Gross profit
÷ Net sales revenue
Learning Objective 5
Estimate inventory by the gross profit method.
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Estimating Inventory
Gross profit method - based on computation ofcost-of-goods-sold
Beginning inventory+ Purchases= Cost of goods available for sale– Ending inventory= Cost of goods sold
Gross profit method - based on computation ofcost-of-goods-sold
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Beginning inventory+ Purchases= Cost of goods available for sale– Ending inventory= Cost of goods sold
- Cost of goods sold= Ending inventory
Objective 6
Show how inventory errors affect cost of goodssold and income.
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Effects of Inventory Errors
• An error in the ending inventory creates errorsfor cost of goods sold and gross profit.
• The current year’s ending inventory is nextyear’s beginning inventory.
• An error in the ending inventory creates errorsfor cost of goods sold and gross profit.
• The current year’s ending inventory is nextyear’s beginning inventory.
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Reporting Inventory Transactions onthe Statement of Cash Flows
• Inventory transactions are operating activities
• The purchase of inventory requires a cashpayment, and the sale a cash receipt
• Inventory transactions are operating activities
• The purchase of inventory requires a cashpayment, and the sale a cash receipt
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