ACG 2021 Financial Accounting

Merchandise Inventory and Cost of Goods Sold

Learning Objectives
 Account for inventory transactions  Analyze the various inventory methods  Identify the income and the tax effects of the inventory methods  Use the gross profit percentage and inventory turnover to evaluate a business  Estimate inventory by the gross profit method  Show 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 period

 Ending Inventory
 Remaining Unsold Merchandise

 Cost 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
Beginning Purchases Ending Inventory Sold

Cost of Goods Sold
Inventory Sold

As Inventory is Sold we remove it’s cost from the Asset side of A=L+E and Insert 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 cost Transfers 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 Statement
 Income Statement Items:
Sales revenue is based on sale price of Inventory sold. Cost of goods sold is based on cost 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 cost.

Income Statement – Service Company

Balance Sheet – Service Company

Income Statement – Retail Company
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Balance Sheet – Retail Company
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Inventory Accounting Systems
 Periodic system
Does not keep a running record of all goods bought and sold. Inventory counted at least once a year Used for inexpensive goods

 Perpetual system
Keeps 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 Cost per unit of inventory

=

X

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

X

Cost per unit of inventory

Recording Transactions and the T-Accounts
General Journal Accounts and Explanations PR

Date

Debit

Credit

Inventory Accounts Payable Purchased inventory on account

560,000 560,000

Inventory Beg. 100,000 560,000

Accounts Payable 560,000

Recording Transactions and the T-Accounts

Sale on account $900,000 of Inventory which cost $540,000:
Date General Journal Accounts and Explanations PR Accounts Receivable Debit 900,000 Credit

Sales Revenue Cost of Goods Sold Inventory 540,000

900,000

540,000

Recording Transactions and the T-Accounts

Inventory Beg. 100,000 540,000 560,000 120,000

Cost of Goods Sold 540,000

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

ACG 2021 Financial Accounting
Inventory Cost Methods

Inventory Costing
 Sum of all costs incurred to bring asset to its intended use  Methods for determining per unit Inventory Cost
Specific unit cost Average cost First-in, first-out (FIFO) cost Last-in, first-out (LIFO) cost

Which Method will a Company Use?
 Decision is up to Management
NOT based on Actual Inventory Movements

 A tool for managing Earnings  A tool for managing Taxes

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

Ending inventory: Cost of goods sold:

20 units 40 units

Specific Unit Cost
 Identify each inventory unit and determine the cost
 Of the 20 Units left, how many came from the:  Of the 40 Units sold, how many came from the:
 $10, $14, or $18 purchase

 Multiply each unit by that specific units cost

 For example if we assume:
 Inventory: 10@10, 5@14 and 5@18
 Inventory = $260

 Cost of Goods Sold: 20@14 and 20@18
 CGS = $640

Average Costing
Average Cost per unit Cost of Goods Available =

Number of units available

Inventory (at average cost)
Beg Bal (10 units @ $10) Purchases: 25 units @ $14 25 units @ $18 Ending Bal (20 units @ average cost of $15 per unit 100 350 450 Cost of goods sold (40 units @ average cost of $15 per unit 600

300

Weighted-Average

$900 total cost ÷ 60 units = $15/unit Ending inventory = 20 × $15 = $300 Cost of goods sold = 40 × $15 = $600

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

Inventory (at FIFO cost)
Beg Bal (10 units @ $10) Purchases: 25 units @ $14 25 units @ $18 Ending Bal (20 units @ $18) 100 350 450 Cost of goods sold (40 units): (10 units @ $10 = 100) (25 units @ $14 = 350) ( 5 units @ $18 = 90) 540

360

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

Inventory (at LIFO cost)
Beg Bal (10 units @ $10) Purchases: 25 units @ $14 25 units @ $18 Ending Bal (10 units @ $10 = 100) (10 units @ $14 = 140) 100 350 450 Cost of goods sold (40 units): (25 units @ $18 = 450) (15 units @ $14 = 210) 660

240

Income Effects of Inventory Methods
Assumed Sales Revenue Cost of Goods Sold

Gross Profit

Specific unit cost Weighted-average FIFO LIFO

$1,000 $1,000 $1,000 $1,000

– – – –

640 600 540 660

= = = =

$360 $400 $460 $340

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

Income Effects
 When inventory costs are increasing
LIFO 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 prices
Higher Cost of Goods Sold = Lower Net Income = Lower Income Taxes

 Inventory Method & managing income  International issue – LIFO not allowed in some countries

Inventory Errors
 Each inventory error affects:
Inventory Cost of goods sold Gross profit Net income

Inventory Errors
Period 1 Period 2 Cost of Gross Profit Cost of Gross Profit Goods Sold and Net Income Goods Sold and Net Income Understated Overstated Overstated Understated

Inventory Error Period 1 Ending inventory overstated Period 1 Ending inventory understated

Overstated

Understated

Understated

Overstated

ACG 2021 Financial 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 disclosed

 Disclosure principle
 Enough information must be reported for stakeholders to make informed decisions
 Relevant, 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 value
 Historical Cost  Or Market (Replacement Cost)

 Inventory is below cost
 Record 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 Inventory Wrote inventory down to market value

1,000

1,000

ACG 2021 Financial Accounting
Inventory Ratios

Ratios
Gross Profit Percentage

=

Gross Profit Net Sales Revenue

Inventory Turnover

=

Cost of goods sold Average Inventory

Ratios
 Gross Profit
Profit indicator

 Inventory Turnover – Liquidity ratio
How quickly is Inventory Sold?

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ACG 2021 Financial Accounting
Estimating Inventory and/or Cost 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 Profit Gross Profit% = Gross Profit / Sales Cost of Goods Sold = Sales x (1- Gross Profit%)

Estimate CGS using GP%
 We know Beginning Inventory = 14,000  We know Purchases = 66,000  We know Sales = 100,000  We know Gross Profit % = 43%  We Don’t know Cost of Goods Sold  We Don’t know Ending Inventory

Gross Profit Method
Beginning inventory $14,000 Purchases 66,000 Goods available 80,000 Cost of goods sold: Net sales revenue $100,000 Less estimated gross profit 43% (43,000) Estimated cost of goods sold 57,000 Estimated cost of ending inventory $23,000

End of Chapter 6

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