Merchandise Inventory, Cost of Goods Sold, and Gross Profit. Pr. Zoubida SAMLAL

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1 Merchandise Inventory, Cost of Goods Sold, and Gross Profit Pr. Zoubida SAMLAL 1

2 Accounting for Inventory Inventory (balance sheet) = Number of units of inventory on hand X Cost per unit of inventory Cost of Goods Sold (income statement) = Number of units of inventory sold X Cost per unit of inventory

3 Recording Transactions and the T-Accounts General Journal Date Accounts and Explanations PR Debit Credit Inventory 560,000 Accounts Payable 560,000 Purchased inventory on account Inventory Beg. 100, ,000 Accounts Payable 560,000

4 Recording Transactions and 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 900,000 Cost of Goods Sold 540,000 Inventory 540,000

5 Recording Transactions and the T-Accounts Inventory Cost of Goods Sold Beg. 100, , , , ,000

6 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

7 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

8 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 2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

9 Gross Profit (Gross Margin) Sales Revenue - Gross Profit - Operating Expenses Net Income 9

10 Learning Objective 1 Account for inventory transactions. 10

11 Inventory Accounting Systems Periodic systems do not keep a continuous record of inventory on hand. Perpetual systems maintain a running record to show the inventory on hand at all times. 11

12 Recording Transactions in 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 12

13 Recording Transactions and the T-Accounts General Journal Date Accounts and Explanations PR Debit Credit Inventory 560,000 Accounts Payable 560,000 Purchased inventory on account Inventory Beg. 100, ,000 Accounts Payable 560,000

14 Recording Transactions and the T-Accounts Sale on account $900,000 (cost $540,000): General Journal Date Accounts and Explanations PR Debit Credit Accounts Receivable 900,000 Sales Revenue 900,000 Cost of Goods Sold 540,000 Inventory 540,000

15 Recording Transactions and the T-Accounts Inventory Beg. 100, , , ,000 Cost of Goods Sold 540,000 15

16 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 16

17 Reporting in the Financial Statements Net purchases Purchases + Freight-in Purchase returns & allowances Purchases discount Net sales Sales revenue Sales returns & allowances Sales discounts 17

18 Learning Objective 2 Analyze the various inventory methods. 18

19 What Goes Into Inventory Cost? Sum of all costs incurred to bring asset to its intended use Inventory costing methods: Specific unit cost Weighted-average cost First-in, first-out (FIFO) Last-in, first-out (LIFO) 19

20 Illustrative Data Beginning inventory (10 $10) $ 100 No. 1 (25 $14 per unit) $350 No. 2 (25 $18 per unit) 450 Total purchases 800 Cost of goods available for sale $ 900 Ending inventory: Cost of goods sold: 20 units 40 units 20

21 Specific Unit Cost Cost of Goods Sold $ $580 $900 $580 = $320 5 $10 25 $14 10 $18 21

22 Weighted-Average $900 total cost 60 units = $15/unit Ending inventory = 20 $15 = $300 Cost of goods sold = 40 $15 = $600 22

23 First-In, First-Out Ending Inventory Cost: 60 units Less units sold 40 Ending inventory 20 units 20 units $18 per unit = $360 23

24 First-In, First-Out Cost of Goods Sold $ $ $10 25 $14 5 $18 24

25 Last-In, First-Out Ending Inventory Cost: 60 units Less units sold 40 Ending inventory 20 units 10 units 10 = $ units 14 = 140 Total $240 25

26 Last-In, First-Out Cost of Goods Sold $ $ $18 15 $14 26

27 Income Effects of Inventory Methods Assumed Sales Revenue Cost of Goods Sold Gross Profit Specific unit cost $1, = $420 Weighted-average $1, = $400 FIFO $1, = $460 LIFO $1, = $340

28 Learning Objective 3 Identify the income and the tax effects of the inventory methods. 28

29 The Tax Advantage of LIFO FIFO LIFO Gross profit $460 $340 Operating expenses Income before taxes $200 $ 80 Income tax expense (40%) $ 80 $ 32 The most attractive feature of LIFO is low income tax payments when prices are increasing. 29

30 Use of the Various Inventory Methods LIFO 31% FIFO 46% Average 20% Other 3% 30

31 Comparison of Inventory Methods FIFO produces inventory profits during periods of inflation LIFO allows managers to manipulate net income LIFO liquidation 31

32 Consistency Principle Use the same accounting methods and procedures from one period to the next May change inventory methods, but must disclose the effects of the change on net income 32

33 Disclosure Principle Financial statements should report enough information to enable an outsider to make knowledgeable decisions about the company. 33

34 Conservatism The least favorable figures are presented in the financial statements. 34

35 Lower-of-Cost-or-Market Rule Report inventory at the lower of its historical cost or market (replacement) value If the replacement cost falls below its historical cost, write down the value of the inventory 35

36 Learning Objective 4 Use the gross profit percentage and inventory turnover to evaluate business. 36

37 Using the Financial Statements for Decision Making Gross profit percentage = Gross profit Net sales revenue Inventory turnover = Cost of goods sold Average inventory 37

38 Learning Objective 5 Estimate inventory by the gross profit method. 38

39 Estimating Inventory Gross profit method - based on computation of cost-of-goods-sold Beginning inventory + Purchases = Cost of goods available for sale - Ending Cost of inventory goods sold = = Cost Ending of goods inventory sold 39

40 Objective 6 Show how inventory errors affect cost of goods sold and income. 40

41 Effects of Inventory Errors An error in the ending inventory creates errors for cost of goods sold and gross profit. The current year s ending inventory is next year s beginning inventory. 41

42 Reporting Inventory Transactions on the Statement of Cash Flows Inventory transactions are operating activities The purchase of inventory requires a cash payment, and the sale a cash receipt 42

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