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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