1. Merchandise Inventory,
Cost of Goods Sold, and
Gross Profit
Chapter 6

2. Merchandising Company General Motors Corporation
Income Statements
Service revenue $XXX
Expenses
Salary expense X
Depreciation expense X
Income tax expense X
Net income $ X
Service Company
Century 21 Real Estate
Income Statement
Year Ended December 31, 20xx
Sales revenue $185
Cost of goods sold
Gross profit
Operating expenses:
Salary expense X
Depreciation expense X
Income tax expense $ X
Net income $ 4
Merchandising Company
General Motors Corporation
Income Statement
Year Ended December 31, 20xx

3. Merchandising Company General Motors Corporation
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
Year Ended December 31, 20xx
Current assets:
Cash $ X
Short-term investments X
Accounts receivable, net X
Inventory
Prepaid expenses X
Merchandising Company
General Motors Corporation
Balance Sheet
Year Ended December 31, 20xx

4. Accounting for Inventory
Current assets:
Cash $ XXX
Short-term
investments XXX
Accounts receivable XXX
Inventory (1 truck
@$15,000) $15,000
Prepaid expenses XXX
General Motors Corporation
Balance Sheet (partial)
Sales revenue
(2 $20,000) $40,000
Cost of goods sold
(2 $15,000) 30,000
Gross profit $10,000
General Motors Corporation
Income Statement (partial)

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

6. Use the cost-of-goods-
sold model.

7. 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

8. 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

9. How Much Inventory Should Be Purchased?EI
-BI
+COGS 6000 =P

10. What is EI or what is COGS?BI +P
-EI
=COGS BI +P
-COGS
=EI
OR…

11. Account for inventory
transactions.

12. 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.

13. 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

14. Recording Transactions in the Perpetual System
Purchase price of the inventory $600,000
+ Freight-in ,000
– Purchase returns – 25,000
– Purchase allowances – 5,000
– Purchase discounts – 14,000
= Net purchases of inventory $560,000

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

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

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

18. Reporting in the Financial Statements
Income Statement (partial)
Sales revenue $900,000
Cost of goods sold ,000
Gross profit $360,000
Ending Balance Sheet (partial)
Current assets:
Cash $ XXX
Short-term investments XXX
Accounts receivable, net XXX
Inventory ,000
Prepaid expenses XXX

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

20. Analyze the various
inventory methods.

21. 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)

22. Illustrative Data Beginning inventory (10 units @ $10) $100
No. 1 (25 $14 per unit) $350
No. 2 (25 $18 per unit
Total purchases
Cost of goods available for sale $900
Ending inventory: 20 units
Cost of goods sold: 40 units

23. Specific Unit Cost 5 Units @ $10 Cost of Goods Sold $ 50 350 180 $580
$ 50
350
180
$580
25 $14
10 $18

24. Weighted-Average $900 total cost ÷ 60 units = $15/unit
Cost of goods sold = 40 × $15 = $600

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

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

27. Income Effects of Inventory Methods
Cost of Goods Sold
Specific unit cost $580.00
Weighted-average $600.00
FIFO $540.00
LIFO $660.00

28. Income Effects of Inventory Methods
Ending Inventory
Specific unit cost $320.00
Weighted-average $300.00
FIFO $360.00
LIFO $240.00

29. Income Effects of Inventory Methods
Assumed
Sales
Revenue
Cost of
Goods
Sold
Gross
Profit
Specific unit cost $1,000 – = $420
Weighted-average $1,000 – = $400
FIFO $1,000 – = $460
LIFO $1,000 – = $340

30. Income Effects – Inventory Costs Are Increasing
Gross profit, and net income
FIFO
Weighted-
average
LIFO

31. Income Effects – Inventory Costs Are Decreasing
Gross profit, and net income
LIFO
Weighted-
average
FIFO

32. Identify the income and
the tax effects of the
inventory methods.

33. The Tax Advantage of LIFO
Gross profit $460 $340
Operating expenses
Income before taxes $200 $ 80
Income tax expense (40%) $ $ 32
FIFO LIFO
The most attractive feature of LIFO
is low income tax payments.

34. Comparison of Inventory Methods
FIFO produces inventory profits
during periods of inflation.
LIFO liquidation occurs when inventory
quantities fall below the pervious level
resulting in higher
net income and increased taxes.

35. 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 disclose the
effects of the change on net income.

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

37. Accounting Principles and Inventories
Materiality Concept
An item is material if it has the potential
to alter a statement user’s decision
to invest in the stock of the company.
Materiality is different
For different firms.

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

39. 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.

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

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

42. 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 profit
$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

43. Ethical Considerations
Managers of companies whose profits
do not meet stockholder 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

44. percentage and inventory
Use the gross profit
percentage and inventory
turnover to evaluate
business.

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

46. Gross Profit on $1 of Sales for Two Merchandisers
$1.00 —
$0.75 —
$0.50 —
$0.25 —
$0.00
Gross
profit $0.21
Gross
profit
$0.61
Cost of
goods sold
$0.79
Cost of
goods sold
$0.39
General
Motors
Pepsi Co.

47. End of Chapter 6