Copyright ©2004 Pearson Education Canada Inc. 6 - 1 Merchandise Inventory, Cost of Goods Sold, and...

6 - 1Copyright ©2004 Pearson Education Canada Inc.

Merchandise Inventory,

Cost of Goods Sold, and

Gross Margin

Chapter 6


Income Statements

Service revenue $XXXExpenses Operating and

administrative expense X Amortization expense X Income tax expense XNet income $ X

Service CompanyCentury 21 Real Estate

Income StatementFor the Year Ended December 31, 2002

Revenue $758Cost of goods sold 498Gross margin 260Operating expenses: Operating and

administrative expense X Amortization expense X Income tax expense $ XNet income $ 4

Merchandising CompanyThe Foranzi Group Ltd.

Income StatementFor the Year Ended January 27, 2002


Balance Sheets

Current assets: Cash $X Short-term investments X Accounts receivable, net X Prepaid expenses X

Service CompanyCentury 21 Real Estate

Balance SheetDecember 31, 2002

Current assets: Cash $ X Short-term investments X Accounts receivable, net X Inventory 229 Prepaid expenses X

Merchandising CompanyThe Foranzi Group Ltd.

Balance SheetJanuary 27, 2002


Accounting for Inventory

Current assets: Cash $ XXX Short-term investments XXX Accounts receivable XXX Inventory (1 Impala @$22,000) $22,000 Prepaid expenses XXX

General Motors of CanadaBalance Sheet (partial)

Sales revenue (2 Impalas @ $27,000) $54,000Cost of goods sold (2 Impalas @ $22,000) 44,000Gross margin $10,000

General Motors of CanadaIncome Statement (partial)


Sales revenues – Cost of goods sold= Gross margin (before operating expenses)

Sales revenues – Cost of goods sold= Gross margin (before operating expenses)

Gross margin – Operating expenses= Net income

Gross margin – Operating expenses= Net income

Gross Margin (Gross Profit)


Computing Cost

Cost of inventory on hand= Number of units on hand × unit cost

Cost of inventory on hand= Number of units on hand × unit cost

Cost of goods sold= Number of units sold × unit cost

Cost of goods sold= Number of units sold × unit cost


Learning Objective 1

Use the cost-of-goods-

sold model.


Cost of Goods Sold Model

Beginninginventory

$20

Purchases$100

Cost of goodsavailablefor sale$120

Endinginventory

$30

Cost ofgoods sold

$90


How Much InventoryShould Be Purchased?

Budgeted cost of goods sold $6,000

+ Budgeted ending inventory 1,500

– Actual beginning inventory 1,200

= Budgeted purchases $6,300

= Budgeted cost of goods available for sale $7,500



Account for inventory

transactions.


Perpetual systems maintain a running recordto show the inventory on hand at all times.

Perpetual systems maintain a running recordto show the inventory on hand at all times.

Periodic systems do not keep acontinuous record of inventory on hand.

Periodic systems do not keep acontinuous record of inventory on hand.

Inventory Accounting Systems


Debit Cash or Accounts ReceivableCredit Sales Revenue

Debit Cash or Accounts ReceivableCredit Sales Revenue

Debit Cost of Goods SoldCredit Inventory

Debit Cost of Goods SoldCredit Inventory

Recording Transactionsin the Perpetual System

Debit InventoryCredit Cash or Accounts Payable

Debit InventoryCredit Cash or Accounts Payable


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

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

Accounts Payable560,000Beg. 100,000

560,000

Inventory

Inventory 560,000Accounts Payable 560,000

Purchased inventory on account

Inventory 560,000Accounts Payable 560,000

Purchased inventory on account



Sale on account $900,000 (cost $540,000):Sale on account $900,000 (cost $540,000):

Accounts Receivable 900,000Sales Revenue 900,000

Cost of Goods Sold 540,000Inventory 540,000

Accounts Receivable 900,000Sales Revenue 900,000

Cost of Goods Sold 540,000Inventory 540,000



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 margin $360,000 Ending Balance Sheet (partial)Current assets: Cash $ XXX Short-term investments XXX Accounts receivable, net XXX Inventory 120,000 Prepaid expenses XXX


Net sales = Sales revenue– Sales returns & allowances– Sales discounts

Net sales = Sales revenue– Sales returns & allowances– Sales discounts

Reporting in theFinancial Statements

Net purchases = Purchases+ Freight-in– Purchase returns & allowances– Purchases discount

Net purchases = Purchases+ Freight-in– Purchase returns & allowances– Purchases discount



Analyze the various

inventory methods.


The cost of any asset, such as inventory,is the sum of all the costs incurred to

bring the asset to its intended use.

What Goes Into Inventory Cost?

Generally accepted inventory costing methods:

Specific unit cost Weighted-average cost

First-in, first-out (FIFO) Last-in, first-out (LIFO)


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 $900Ending inventory: 20 unitsCost of goods sold:40 units

Illustrative Data


Cost of Goods Sold$ 50 350 180$580

Specific Unit Cost

5 Units @ $10

25 Units @ $14

10 Units @ $18$900 – $580 = $320


Weighted-Average

$900 total cost ÷ 60 units = $15/unit

Cost of goods sold = 40 × $15 = $600

Ending inventory = 20 × $15 = $300


60 units Less units sold 40 Ending inventory 20 units

First-In, First-Out

20 units × $18 per unit = $360


Cost of Goods Sold$100 350 90$540

First-In, First-Out

10 Units @ $10

25 Units @ $14

5 Units @ $18


60 units Less units sold 40 Ending inventory 20 units

Last-In, First-Out

10 units × 10 = $10010 units × 14 = 140Total $240


Cost of Goods Sold$450 210$660

Last-In, First-Out

25 Units @ $18

15 Units @ $14


Ending InventorySpecific unit cost $320Weighted-average $300FIFO $360LIFO $240

Income Effects ofInventory Methods


Cost of Goods SoldSpecific unit cost $580Weighted-average $600FIFO $540LIFO $660




Specific unit cost $1,000 – 580 = $420Weighted-average $1,000 – 600 = $400FIFO $1,000 – 540 = $460LIFO $1,000 – 660 = $340

AssumedSales

Revenue

Cost ofGoodsSold

GrossMargin


Income Effects – InventoryCosts Are Increasing

Ending inventory, gross margin, and net income

LIFO

Weighted-average

FIFO


Income Effects – InventoryCosts Are Decreasing

Ending inventory, gross margin, and net income

LIFOWeighted-

averageFIFO



Identify the income

effects of the

inventory methods.


Use of the VariousInventory Methods

Other4%

Average52%

LIFO2%

FIFO42%


Comparison of Inventory Methods

LIFO liquidation occurs when inventory quantities fall below the

level of the previous period resulting in higher net income.

FIFO produces inventory profitsduring periods of inflation.

LIFO allows managers tomanipulate net income.


International Perspective

LIFO is not allowed for taxpurposes in Canada.

Almost no Canadian companiesuse LIFO.


Businesses should use the sameaccounting methods and procedures

from one period to the next.

Businesses should use the sameaccounting methods and procedures

from one period to the next.

A company may change inventorymethods, but it must apply the

new method retroactively, per GAAP.

A company may change inventorymethods, but it must apply the

new method retroactively, per GAAP.

Accounting Principlesand Inventories


The financial statements shouldreport enough information toenable an outsider to make

informed decisionsabout the company.

The financial statements shouldreport enough information toenable an outsider to make

informed decisionsabout the company.




An item is material if it has the potentialto alter a statement user’s decision.

An item is material if it has the potentialto alter a statement user’s decision.

Materiality is specific tothe entity being evaluated.

Materiality is specific tothe entity being evaluated.


Err on the sideof caution when

reporting any item inthe financial statements.

Err on the sideof caution when

reporting any item inthe financial statements.



Lower-of-Cost-or-Market Rule

Inventory is reported at thelower of its historical cost

or market (replacement) value.

If the replacement cost falls below itshistorical cost, the business must write

down the value of its inventory.


Show how inventory errors

affect cost of goods soldand income.

Objective 5


Effects of Inventory Errors

The current year’s ending inventoryis next year’s beginning inventory.

An error in the ending inventorycreates errors for cost of goods

sold and gross margin.


Effects of Inventory Errors

Sales revenueCost of goods sold: Beg. inventory Purchases Cost of goods available for sale Ending inventory Cost of goods soldGross margin

$100,000

$10,000 50,000

$60,000(15,000)

45,000$ 55,000

$100,000

$15,000 50,000

$65,000(10,000)

55,000$ 45,000

$100,000

$10,000 50,000

$60,000(10,000)

50,000$ 50,000

Period 1Ending

InventoryOverstatedby $5,000

Period 1BeginningInventoryOverstatedby $5,000

Period 1

Correct



Use the gross margin

percentage and inventory

turnover to evaluate

business.


Inventory turnover= Cost of goods sold÷ Average inventory

Inventory turnover= Cost of goods sold÷ Average inventory

Gross margin percentage= Gross margin

÷ Net sales revenue

Gross margin percentage= Gross margin

÷ Net sales revenue

Using the Financial Statementsfor Decision Making


Gross Margin on $1 of Salesfor Two Merchandisers

Grossmargin $0.17

Grossmargin$0.61

Cost ofgoods sold

$0.83 Cost ofgoods sold

$0.39

$1.00 —

$0.75 —

$0.50 —

$0.25 —

$0.00 Magna

Int’l Inc.Pepsi Co.


Reporting Inventory Transactions on the Cash Flow Statement

Inventory transactions are operating activitiesbecause the purchase and sale of merchandise

drives a company’s operations.

The purchase of inventory requires a cashpayment, and the sale a cash receipt.



Estimate inventory by the gross margin method and

the retail method.


Estimating Inventory

The gross margin method of estimatingending inventory is based on the

cost-of-goods-sold model.

Beginning inventory+ Purchases= Cost of goods available for sale– Ending inventory= Cost of goods sold



Rearranging ending inventory andcost of goods sold makes the model

useful for estimating ending inventory.

Beginning inventory+ Purchases= Cost of goods available for sale– Cost of goods sold= Ending inventory



Beginninginventory

Netpurchases+

Goodsavailablefor sale

Goodsavailablefor sale

=

Endinginventory=

Cost ofgoodssold

–



Beginning inventory $14,000Purchases 66,000Cost of goods available for sale 80,000Cost of goods sold: Net sales revenue $100,000 Less estimated gross margin of 42% – 42,000 Estimated cost of goods sold 58,000Estimated cost of ending inventory $22,000


Ethical Considerations

Managers of companies whose profitsdo not meet shareholder expectationsare sometimes tempted to “cook thebooks” to increase reported income.

1. Overstating ending inventory

2. Creating fictitious sales revenue


Appendix: Periodic System

All purchases are recorded with a debitto Purchases, an expense account.

A physical count of inventory at the end of theaccounting period will be needed to update

the accounting records.


End of Chapter 6

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