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

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Presentation on theme: "Copyright ©2004 Pearson Education Canada Inc. 6 - 1 Merchandise Inventory, Cost of Goods Sold, and Gross Margin Chapter 6."— Presentation transcript:

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2 Copyright ©2004 Pearson Education Canada Inc Merchandise Inventory, Cost of Goods Sold, and Gross Margin Chapter 6

3 Copyright ©2004 Pearson Education Canada Inc Income Statements Service revenue$XXX Expenses Operating and administrative expense X Amortization expense X Income tax expense X Net income$ X Service Company Century 21 Real Estate Income Statement For the Year Ended December 31, 2002 Revenue$758 Cost of goods sold 498 Gross margin 260 Operating expenses: Operating and administrative expense X Amortization expense X Income tax expense$ X Net income$ 4 Merchandising Company The Foranzi Group Ltd. Income Statement For the Year Ended January 27, 2002

4 Copyright ©2004 Pearson Education Canada Inc Balance Sheets Current assets: Cash$X Short-term investments X Accounts receivable, net X Prepaid expenses X Service Company Century 21 Real Estate Balance Sheet December 31, 2002 Current assets: Cash$ X Short-term investments X Accounts receivable, net X Inventory229 Prepaid expenses X Merchandising Company The Foranzi Group Ltd. Balance Sheet January 27, 2002

5 Copyright ©2004 Pearson Education Canada Inc Accounting for Inventory Current assets: Cash$ XXX Short-term investments XXX Accounts receivable XXX Inventory (1 Prepaid expenses XXX General Motors of Canada Balance Sheet (partial) Sales revenue (2 $27,000) $54,000 Cost of goods sold (2 $22,000) 44,000 Gross margin$10,000 General Motors of Canada Income Statement (partial)

6 Copyright ©2004 Pearson Education Canada Inc 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)

7 Copyright ©2004 Pearson Education Canada Inc 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

8 Copyright ©2004 Pearson Education Canada Inc Learning Objective 1 Use the cost-of-goods- sold model.

9 Copyright ©2004 Pearson Education Canada Inc Cost of Goods Sold Model Beginning inventory $20 Purchases $100 Cost of goods available for sale $120 Ending inventory $30 Cost of goods sold $90

10 Copyright ©2004 Pearson Education Canada Inc How Much Inventory Should 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

11 Copyright ©2004 Pearson Education Canada Inc Learning Objective 2 Account for inventory transactions.

12 Copyright ©2004 Pearson Education Canada Inc Perpetual systems maintain a running record to show the inventory on hand at all times. Perpetual systems maintain a running record to show the inventory on hand at all times. Periodic systems do not keep a continuous record of inventory on hand. Periodic systems do not keep a continuous record of inventory on hand. Inventory Accounting Systems

13 Copyright ©2004 Pearson Education Canada Inc Debit Cash or Accounts Receivable Credit Sales Revenue Debit Cash or Accounts Receivable Credit Sales Revenue Debit Cost of Goods Sold Credit Inventory Debit Cost of Goods Sold Credit Inventory Recording Transactions in the Perpetual System Debit Inventory Credit Cash or Accounts Payable Debit Inventory Credit Cash or Accounts Payable

14 Copyright ©2004 Pearson Education Canada Inc 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 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

15 Copyright ©2004 Pearson Education Canada Inc Recording Transactions and the T-Accounts Accounts Payable 560,000Beg.100, ,000 Inventory Inventory560,000 Accounts Payable560,000 Purchased inventory on account Inventory560,000 Accounts Payable560,000 Purchased inventory on account

16 Copyright ©2004 Pearson Education Canada Inc Recording Transactions and the T-Accounts Sale on account $900,000 (cost $540,000): Accounts Receivable900,000 Sales Revenue900,000 Cost of Goods Sold540,000 Inventory540,000 Accounts Receivable900,000 Sales Revenue900,000 Cost of Goods Sold540,000 Inventory540,000

17 Copyright ©2004 Pearson Education Canada Inc Recording Transactions and the T-Accounts Cost of Goods Sold 540,000 Inventory Beg.100, , , ,000

18 Copyright ©2004 Pearson Education Canada Inc Reporting in the Financial Statements Income Statement (partial) Sales revenue$900,000 Cost of goods sold 540,000 Gross 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

19 Copyright ©2004 Pearson Education Canada Inc Net sales= Sales revenue – Sales returns & allowances – Sales discounts Net sales= Sales revenue – Sales returns & allowances – Sales discounts Reporting in the Financial Statements Net purchases= Purchases + Freight-in – Purchase returns & allowances – Purchases discount Net purchases= Purchases + Freight-in – Purchase returns & allowances – Purchases discount

20 Copyright ©2004 Pearson Education Canada Inc Learning Objective 3 Analyze the various inventory methods.

21 Copyright ©2004 Pearson Education Canada Inc 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 costWeighted-average costFirst-in, first-out (FIFO)Last-in, first-out (LIFO)

22 Copyright ©2004 Pearson Education Canada Inc 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:20 units Cost of goods sold:40 units Illustrative Data

23 Copyright ©2004 Pearson Education Canada Inc Cost of Goods Sold $ $580 Specific Unit Cost 5 $10 25 $14 10 $18 $900 – $580 = $320

24 Copyright ©2004 Pearson Education Canada Inc Weighted-Average $900 total cost ÷ 60 units = $15/unit Cost of goods sold = 40 × $15 = $600 Ending inventory = 20 × $15 = $300

25 Copyright ©2004 Pearson Education Canada Inc units Less units sold40 Ending inventory20 units First-In, First-Out 20 units × $18 per unit = $360

26 Copyright ©2004 Pearson Education Canada Inc Cost of Goods Sold $ $540 First-In, First-Out 10 $10 25 $14 5 $18

27 Copyright ©2004 Pearson Education Canada Inc units Less units sold40 Ending inventory20 units Last-In, First-Out 10 units × 10 =$ units × 14 = 140 Total$240

28 Copyright ©2004 Pearson Education Canada Inc Cost of Goods Sold $ $660 Last-In, First-Out 25 $18 15 $14

29 Copyright ©2004 Pearson Education Canada Inc Ending Inventory Specific unit cost$320 Weighted-average$300 FIFO$360 LIFO$240 Income Effects of Inventory Methods

30 Copyright ©2004 Pearson Education Canada Inc Cost of Goods Sold Specific unit cost$580 Weighted-average$600 FIFO$540 LIFO$660 Income Effects of Inventory Methods

31 Copyright ©2004 Pearson Education Canada Inc Income Effects of Inventory Methods Specific unit cost $1,000 –580 =$420 Weighted-average $1,000 – 600 =$400 FIFO $1,000 – 540 =$460 LIFO $1,000 – 660 =$340 Assumed Sales Revenue Cost of Goods Sold Gross Margin

32 Copyright ©2004 Pearson Education Canada Inc Income Effects – Inventory Costs Are Increasing Ending inventory, gross margin, and net income LIFO Weighted- average FIFO

33 Copyright ©2004 Pearson Education Canada Inc Income Effects – Inventory Costs Are Decreasing Ending inventory, gross margin, and net income LIFO Weighted- average FIFO

34 Copyright ©2004 Pearson Education Canada Inc Learning Objective 4 Identify the income effects of the inventory methods.

35 Copyright ©2004 Pearson Education Canada Inc Use of the Various Inventory Methods

36 Copyright ©2004 Pearson Education Canada Inc 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 profits during periods of inflation. LIFO allows managers to manipulate net income.

37 Copyright ©2004 Pearson Education Canada Inc International Perspective LIFO is not allowed for tax purposes in Canada. Almost no Canadian companies use LIFO.

38 Copyright ©2004 Pearson Education Canada Inc Businesses should use the same accounting methods and procedures from one period to the next. Businesses should use the same accounting methods and procedures from one period to the next. A company may change inventory methods, but it must apply the new method retroactively, per GAAP. A company may change inventory methods, but it must apply the new method retroactively, per GAAP. Accounting Principles and Inventories

39 Copyright ©2004 Pearson Education Canada Inc The financial statements should report enough information to enable an outsider to make informed decisions about the company. The financial statements should report enough information to enable an outsider to make informed decisions about the company. Accounting Principles and Inventories

40 Copyright ©2004 Pearson Education Canada Inc Accounting Principles and Inventories An item is material if it has the potential to alter a statement users decision. An item is material if it has the potential to alter a statement users decision. Materiality is specific to the entity being evaluated. Materiality is specific to the entity being evaluated.

41 Copyright ©2004 Pearson Education Canada Inc Err on the side of caution when reporting any item in the financial statements. Err on the side of caution when reporting any item in the financial statements. Accounting Principles and Inventories

42 Copyright ©2004 Pearson Education Canada Inc Lower-of-Cost-or-Market Rule Inventory is reported at the lower of its historical cost or market (replacement) value. If the replacement cost falls below its historical cost, the business must write down the value of its inventory.

43 Copyright ©2004 Pearson Education Canada Inc Show how inventory errors affect cost of goods sold and income. Objective 5

44 Copyright ©2004 Pearson Education Canada Inc Effects of Inventory Errors The current years ending inventory is next years beginning inventory. An error in the ending inventory creates errors for cost of goods sold and gross margin.

45 Copyright ©2004 Pearson Education Canada Inc Effects of Inventory Errors Sales revenue Cost of goods sold: Beg. inventory Purchases Cost of goods available for sale Ending inventory Cost of goods sold Gross 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 1 Ending Inventory Overstated by $5,000 Period 1 Beginning Inventory Overstated by $5,000 Period 1 Correct

46 Copyright ©2004 Pearson Education Canada Inc Learning Objective 6 Use the gross margin percentage and inventory turnover to evaluate business.

47 Copyright ©2004 Pearson Education Canada Inc 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 Statements for Decision Making

48 Copyright ©2004 Pearson Education Canada Inc Gross Margin on $1 of Sales for Two Merchandisers Gross margin $0.17 Gross margin $0.61 Cost of goods sold $0.83 Cost of goods sold $0.39 $1.00 $0.75 $0.50 $0.25 $0.00 Magna Intl Inc. Pepsi Co.

49 Copyright ©2004 Pearson Education Canada Inc Reporting Inventory Transactions on the Cash Flow Statement Inventory transactions are operating activities because the purchase and sale of merchandise drives a companys operations. The purchase of inventory requires a cash payment, and the sale a cash receipt.

50 Copyright ©2004 Pearson Education Canada Inc Learning Objective 7 Estimate inventory by the gross margin method and the retail method.

51 Copyright ©2004 Pearson Education Canada Inc Estimating Inventory The gross margin method of estimating ending 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

52 Copyright ©2004 Pearson Education Canada Inc Estimating Inventory Rearranging ending inventory and cost 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

53 Copyright ©2004 Pearson Education Canada Inc Estimating Inventory Beginning inventory Net purchases + Goods available for sale Goods available for sale = Ending inventory = Cost of goods sold –

54 Copyright ©2004 Pearson Education Canada Inc Estimating Inventory Beginning inventory$14,000 Purchases 66,000 Cost of goods available for sale 80,000 Cost of goods sold: Net sales revenue$100,000 Less estimated gross margin of 42% – 42,000 Estimated cost of goods sold 58,000 Estimated cost of ending inventory$22,000

55 Copyright ©2004 Pearson Education Canada Inc Ethical Considerations Managers of companies whose profits do not meet shareholder expectations are sometimes tempted to cook the books to increase reported income. 1. Overstating ending inventory 2. Creating fictitious sales revenue

56 Copyright ©2004 Pearson Education Canada Inc Appendix: Periodic System All purchases are recorded with a debit to Purchases, an expense account. A physical count of inventory at the end of the accounting period will be needed to update the accounting records.

57 Copyright ©2004 Pearson Education Canada Inc End of Chapter 6


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