Chapter 6 Merchandise Inventory and Cost of Goods Sold

1
Chapter 6Merchandise Inventory and Cost of Goods
Sold
2
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

3
Accounting for Inventory

• Sales revenue is based on sale price.
• Cost of goods sold is based on cost.
• Inventory on the balance sheet is based on cost.
• Gross profit (gross margin) is sales revenue less
  cost of goods sold.

4
Accounting for Inventory
Inventory (balance sheet)
Number of units of inventory on hand
Cost per unit of inventory

X
Cost of Goods Sold (income statement)
Number of units of inventory sold
Cost per unit of inventory

X
5
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.

6
Perpetual System

• Cost of inventory is net purchases calculated as
• Purchase price of the inventory
• Freight-in
• - Purchase returns
• - Purchase allowances
• - Purchase discounts
• Net purchases of inventory

7
Perpetual System
Entry to record a sale under a perpetual system
1 Accounts Receivable 900,000
Sales Revenue 900,000
Sold inventory on account
2 Cost of Goods Sold 540,000
Inventory 540,000
Recorded cost of goods sold
8
Inventory Costing

• Specific unit cost
• Average cost
• First-in, first-out (FIFO) cost
• Last-in, first-out (LIFO) cost

9
Average Costing
Cost of Goods Available
Average Cost per unit

Number of units available
Inventory (at average cost)
Beg Bal (10 units _at_ 10) 100
Purchases
25 units _at_ 14 350
Cost of goods sold (40 units _at_ average cost of
15 per unit 600
25 units _at_ 18 450
Ending Bal (20 units _at_ average cost of 15 per
unit 300
10
FIFO
First costs into inventory are first costs
assigned to cost of goods sold.
Inventory (at FIFO cost)
Beg Bal (10 units _at_ 10) 100
Purchases
Cost of goods sold (40 units) (10 units _at_ 10
100) (25 units _at_ 14 350) ( 5 units _at_ 18
90) 540
25 units _at_ 14 350
25 units _at_ 18 450
Ending Bal (20 units _at_ 18) 360
11
LIFO
Last costs into inventory are first costs
assigned to cost of goods sold.
Inventory (at LIFO cost)
Beg Bal (10 units _at_ 10) 100
Purchases
25 units _at_ 14 350
Cost of goods sold (40 units) (25 units _at_ 18
450) (15 units _at_ 14 210) 660
25 units _at_ 18 450
Ending Bal (10 units _at_ 10 100) (10 units _at_
14 140) 240
12
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.

13
Other Issues

• Tax advantages of LIFO in periods of rising
  prices
• LIFO liquidation and managing income
• International issue LIFO not allowed in some
  countries

14
Accounting Principles

• Consistency principle
• Disclosure principle
• Accounting conservatism
• Lower-of-Cost-or-Market rule (LCM)
• To record a 1,000 decline in inventory value

Cost of Goods Sold 1,000
Inventory 1,000
Wrote inventory down to market value
15
Ratios
Gross Profit
Gross Profit Percentage

Net Sales Revenue
Cost of goods sold
Inventory Turnover

Average Inventory
16
Cost of Goods Sold Model

• Cost of goods sold
• Beginning inventory 1,200
• Purchases 6,300
• Goods available 7,500
• - Ending inventory (1,500)
• Cost of goods sold 6,000

17
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.

18
Gross Profit Method

• Cost of goods sold
• Beginning inventory 1,000
• Purchases 6,000
• Goods available 7,000
• - Cost of goods sold (5,000)
• Ending inventory 2,000

19
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

20
Inventory Errors

• Each inventory error affects
• Inventory
• Cost of goods sold
• Gross profit
• Net income

21
Inventory Errors
22
End of Chapter 6