©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren 1 Merchandise Inventory, Cost of Goods Sold, and Gross Profit Chapter

1©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Merchandise Inventory, Cost of Goods Sold, and Gross Profit

Chapter 6

Income Statements

Service revenue $XXXExpenses Salary expense X Depreciation expense X Income tax expense XNet income $ X

Service CompanyCentury 21 Real Estate

Income StatementYear Ended December 31, 20xx

Sales revenue $185Cost of goods sold 146Gross profit 39Operating expenses: Salary expense X Depreciation expense X Income tax expense $ XNet income $ 4

Merchandising CompanyGeneral Motors Corporation

Income StatementYear Ended December 31, 20xx

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Balance Sheets

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

Service CompanyCentury 21 Real Estate

Balance SheetYear Ended December 31, 20xx

Current assets: Cash $ X Short-term investments X Accounts receivable, net X Inventory 11 Prepaid expenses X

Merchandising CompanyGeneral Motors Corporation

Balance SheetYear Ended December 31, 20xx



Gross Profit (Gross Margin)

Sales Revenue

- Gross Profit

- Operating Expenses

Net Income


Learning Objective 1

Account for inventory transactions.


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.

Inventory Accounting Systems


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

General Journal

Date Accounts and Explanations PR Debit Credit

Recording Transactionsand the T-Accounts

Accounts Payable560,000Beg. 100,000

560,000

Inventory

Inventory 560,000

Accounts Payable 560,000Purchased inventory on account



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

General Journal

Date Accounts and Explanations PR Debit Credit

Accounts Receivable 900,000

Sales Revenue 900,000Cost of Goods Sold 540,000

Inventory 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 profit $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 salesSales revenue– Sales returns & allowances– Sales discounts

Reporting in theFinancial Statements

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



Analyze the various inventory methods.


What Goes Into Inventory Cost?

Sum of all costs incurred to bring asset to its intended use

Inventory costing methods:Specific unit costWeighted-average costFirst-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 $ 900

Ending inventory: 20 unitsCost of goods sold: 40 units

Illustrative Data


Cost of Goods Sold$ 50 350 180$580

Specific Unit Cost

$900 – $580 = $320

25 Units @ $14

10 Units @ $18

5 Units @ $10


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

Ending Inventory Cost:

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

Ending Inventory Cost:

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

Income Effects ofInventory Methods

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

AssumedSales

Revenue

Cost ofGoodsSold

GrossProfit




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


The Tax Advantage of LIFO

Gross profit $460 $340Operating expenses 260 260Income before taxes $200 $ 80Income tax expense (40%) $ 80 $ 32

FIFO LIFO

The most attractive feature of LIFO is low income tax payments when prices are

increasing.


Use of the VariousInventory Methods

Other3%

Average20%

LIFO31% FIFO

46%


Comparison of Inventory MethodsFIFO produces inventory profits

during periods of inflationLIFO allows managers to

manipulate net incomeLIFO liquidation


Consistency Principle

Use the same accounting methods and procedures from one period to the next

May change inventory methods, but must disclose the effects of the change on net income


Disclosure Principle

Financial statements should report enough information to enable an outsider to make knowledgeable decisions about the company.


Conservatism

The least favorable figures are presented in the financial statements.


Lower-of-Cost-or-Market Rule

Report inventory at the lower of its historical cost or market (replacement) value

If the replacement cost falls below its historical cost, write down the value of the inventory



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


Inventory turnover= Cost of goods sold÷ Average inventory

Gross profit percentage= Gross profit

÷ Net sales revenue

Using the Financial Statementsfor Decision Making



Estimate inventory by the gross profit method.


Estimating Inventory

Gross profit method - based on computation of cost-of-goods-sold

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


Objective 6

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 profit.

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


Reporting Inventory Transactions on the Statement of Cash Flows

Inventory transactions are operating activities

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


End of Chapter 6

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©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren 1 Merchandise Inventory, Cost of Goods Sold, and Gross Profit Chapter