Merchandise Inventory, Cost of Goods Sold, and Gross Margin Chapter 6

Income Statements Revenue $758 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

Merchandising Company 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 Inventory 229 Prepaid expenses X Merchandising Company The Foranzi Group Ltd. Balance Sheet January 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 Canada Balance Sheet (partial) Sales revenue (2 Impalas @ $27,000) $54,000 Cost of goods sold (2 Impalas @ $22,000) 44,000 Gross margin $10,000 General Motors of Canada Income Statement (partial)

Gross Margin (Gross Profit) Sales revenues – Cost of goods sold = Gross margin (before operating expenses) Gross margin – Operating expenses = Net income

Computing Cost Balance Sheet Cost of inventory on hand = Number of units on hand × unit cost Balance Sheet Cost of goods sold = Number of units sold × unit cost Income Statement

Use the cost-of-goods- Learning Objective 1 Use the cost-of-goods- sold model.

Cost of Goods Sold Model Beginning inventory $20 Ending inventory $30 Cost of goods sold $90 Cost of goods available for sale $120 Purchases $100

How Much Inventory Should Be Purchased? Budgeted cost of goods sold $6,000 + Budgeted ending inventory 1,500 = Budgeted cost of goods available for sale $7,500 – Actual beginning inventory 1,200 = Budgeted purchases $6,300

Learning Objective 2 Account for inventory transactions.

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.

Recording Transactions in the Perpetual System Debit Inventory Credit Cash or Accounts Payable Debit Cash or Accounts Receivable Credit Sales Revenue Debit Cost of Goods Sold Credit Inventory

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

Recording Transactions and the T-Accounts Inventory 560,000 Accounts Payable 560,000 Purchased inventory on account Beg. 100,000 560,000 Inventory Accounts Payable 560,000

Recording Transactions and the T-Accounts Sale on account $900,000 (cost $540,000): Accounts Receivable 900,000 Sales Revenue 900,000 Cost of Goods Sold 540,000 Inventory 540,000

Recording Transactions and the T-Accounts Inventory Cost of Goods Sold 540,000 Beg. 100,000 560,000 120,000 540,000

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

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

Learning Objective 3 Analyze the various inventory methods.

What Goes Into Inventory Cost? The cost of any asset, such as inventory, is the sum of all the costs incurred to bring the asset to its intended use. Generally accepted inventory costing methods: Specific unit cost Weighted-average cost First-in, first-out (FIFO) Last-in, first-out (LIFO)

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: 20 units Cost of goods sold: 40 units

Specific Unit Cost 5 Units @ $10 Cost of Goods Sold $ 50 350 180 $580 $ 50 350 180 $580 25 Units @ $14 10 Units @ $18 $900 – $580 = $320

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

First-In, First-Out Ending inventory cost 60 units Less units sold 40 Ending inventory 20 units 20 units × $18 per unit = $360

First-In, First-Out 10 Units @ $10 Cost of Goods Sold $100 350 90 $540

Last-In, First-Out Ending inventory cost 60 units Less units sold 40 Ending inventory 20 units 10 units × 10 = $100 10 units × 14 = 140 Total $240

Last-In, First-Out 25 Units @ $18 Cost of Goods Sold $450 210 $660

Income Effects of Inventory Methods Ending Inventory Specific unit cost $320 Weighted-average $300 FIFO $360 LIFO $240

Income Effects of Inventory Methods Cost of Goods Sold Specific unit cost $580 Weighted-average $600 FIFO $540 LIFO $660

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

Income Effects – Inventory Costs Are Increasing Ending inventory, gross margin, and net income FIFO Weighted- average LIFO

Income Effects – Inventory Costs Are Decreasing Ending inventory, gross margin, and net income LIFO Weighted- average FIFO

Learning Objective 4 Identify the income effects of the inventory methods.

Use of the Various Inventory Methods

Comparison of Inventory Methods FIFO produces inventory profits during periods of inflation. LIFO allows managers to manipulate net income. LIFO liquidation occurs when inventory quantities fall below the level of the previous period resulting in higher net income.

International Perspective LIFO is not allowed for tax purposes in Canada. Almost no Canadian companies use LIFO.

Accounting Principles and Inventories Consistency Principle 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.

Accounting Principles and Inventories Disclosure Principle The financial statements should report enough information to enable an outsider to make informed decisions about the company.

Accounting Principles and Inventories Materiality Concept An item is material if it has the potential to alter a statement user’s decision. Materiality is specific to the entity being evaluated.

Accounting Principles and Inventories Conservatism Err on the side of caution when reporting any item in the financial statements.

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.

Show how inventory errors affect cost of goods sold Objective 5 Show how inventory errors affect cost of goods sold and income.

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

Effects of Inventory Errors Period 1 Ending Inventory Overstated by $5,000 Period 1 Beginning Inventory Overstated by $5,000 Period 1 Correct 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

percentage and inventory Learning Objective 6 Use the gross margin percentage and inventory turnover to evaluate business.

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

Gross Margin on $1 of Sales for Two Merchandisers $1.00 — $0.75 — $0.50 — $0.25 — $0.00 Gross margin $0.17 Gross margin $0.61 Cost of goods sold $0.83 Cost of goods sold $0.39 Magna Int’l Inc. Pepsi Co.

Reporting Inventory Transactions on the Cash Flow Statement Inventory transactions are operating activities because the purchase and sale of merchandise drives a company’s operations. The purchase of inventory requires a cash payment, and the sale a cash receipt.

Estimate inventory by the gross margin method and the retail method. Learning Objective 7 Estimate inventory by the gross margin method and the retail method.

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

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

Estimating Inventory Step 1 Step 2 + = – = Beginning inventory Net purchases + Goods available for sale = Cost of goods sold – Ending inventory = Step 2 Goods available for sale

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

Ethical Considerations Managers of companies whose profits do not meet shareholder expectations are sometimes tempted to “cook the books” to increase reported income. What are some possibilities? 1. Overstating ending inventory 2. Creating fictitious sales revenue

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.

End of Chapter 6