ACG 2021

Financial Accounting

Merchandise Inventory and Cost
of Goods Sold
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
Inventory and Cost of Goods Sold
Inventory
Products purchased or manufactured for Sale to
Customers
Beginning Inventory
Quantities of Merchandise on hand
Purchases
New Purchases or Manufactured products
Available for Sale = Beginning Inventory +
Purchases
Most that a company can sell during an accounting
period
Ending Inventory
Remaining Unsold Merchandise
Cost of Goods Sold
Cost of Inventory Sold during accounting Period
Purchases consist of the following:
Purchase price of the inventory $600,000
+ Freight-in (delivery charges) 4,000
Purchase returns 25,000
Purchase allowances 5,000
Purchase discounts 14,000
= Net purchases of inventory $560,000
Calculation
Cost of Beginning
Inventory
+Cost of Purchases
___________________
=Cost of Goods
Available for Sale
- Cost of Ending
Inventory
___________________
=Cost of Goods Sold

Cost of Beginning
Inventory
+Cost of Purchases
___________________
=Cost of Goods
Available for Sale
- Cost of Goods Sold
___________________
=Cost of Ending
Inventory
Inventory vs Cost of Goods Sold
Inventory Cost of Goods Sold
Beginning
Purchases
Inventory Sold
Ending
Inventory Sold
As Inventory is Sold we remove its cost from the Asset side of A=L+E and
Insert its cost into an Expense on the Equity side of A = L + E

This property exists for all Assets: As they are used up or sold the cost
Transfers from the Balance Sheet as a Future Economic Resource (Asset)
To the Income Statement as an Expense incurred to generate Revenue
Relationship between Balance Sheet and
Income Statement
Income Statement Items:
Sales revenue is based on sale price of
Inventory sold.
Cost of goods sold is based on cost of
Inventory sold.
Gross profit (gross margin) is sales revenue
less cost of goods sold.
Balance Sheet Item:
Inventory on the balance sheet is based on
cost.
Income Statement Service Company
Balance Sheet Service Company
Income Statement Retail Company
Best Buy
Balance Sheet Retail Company
Best Buy
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.
Accounting for Inventory
Inventory
(balance sheet)
=
Number of units of
inventory on hand
X
Cost per unit
of inventory
Cost of Goods Sold
(income statement)
=
Number of units of
inventory sold
X
Cost per unit
of inventory

General Journal
Date Accounts and Explanations PR Debit Credit

Recording Transactions and the T-Accounts
Accounts Payable
560,000 Beg. 100,000
560,000
Inventory
Inventory 560,000
Accounts Payable 560,000
Purchased inventory on account
Recording Transactions
and the T-Accounts
Sale on account $900,000 of Inventory
which cost $540,000:

General Journal
Date Accounts and Explanations PR Debit Credit

Accounts Receivable 900,000
Sales Revenue 900,000
Cost of Goods Sold 540,000
Inventory 540,000
Recording Transactions
and the T-Accounts
Cost of Goods Sold
540,000
Inventory
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 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
ACG 2021
Financial Accounting
Inventory Cost Methods
Inventory Costing
Sum of all costs incurred to bring asset to
its intended use
Methods for determining per unit Inventory
Cost
Specific unit cost
Average cost
First-in, first-out (FIFO) cost
Last-in, first-out (LIFO) cost
Which Method will a Company Use?
Decision is up to Management
NOT based on Actual Inventory Movements
A tool for managing Earnings
A tool for managing Taxes
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
Illustrative Data
Specific Unit Cost
Identify each inventory unit and determine the
cost
Of the 20 Units left, how many came from the:
Of the 40 Units sold, how many came from the:
$10, $14, or $18 purchase
Multiply each unit by that specific units cost
For example if we assume:
Inventory: 10@10, 5@14 and 5@18
Inventory = $260
Cost of Goods Sold: 20@14 and 20@18
CGS = $640


Average Costing
Average Cost
per unit
=
Cost of Goods Available
Number of units available
Inventory (at average cost)
Beg Bal (10 units @ $10) 100
25 units @ $14 350
Purchases:
25 units @ $18 450
Cost of goods sold (40 units
@ average cost of $15
per unit 600
Ending Bal (20 units
@ average cost of $15
per unit 300
Weighted-Average
$900 total cost 60 units = $15/unit
Cost of goods sold = 40 $15 = $600
Ending inventory = 20 $15 = $300
FIFO
Inventory (at FIFO cost)
Beg Bal (10 units @ $10) 100
25 units @ $14 350
Purchases:
25 units @ $18 450
Cost of goods sold (40 units):
(10 units @ $10 = 100)
(25 units @ $14 = 350)
( 5 units @ $18 = 90) 540
Ending Bal
(20 units @ $18) 360
First costs into inventory are first costs assigned to cost of
goods sold.
LIFO
Inventory (at LIFO cost)
Beg Bal (10 units @ $10) 100
25 units @ $14 350
Purchases:
25 units @ $18 450
Cost of goods sold (40 units):
(25 units @ $18 = 450)
(15 units @ $14 = 210) 660
Ending Bal
(10 units @ $10 = 100)
(10 units @ $14 = 140) 240
Last costs into inventory are first costs assigned to cost of
goods sold.
Income Effects of
Inventory Methods
Specific unit cost $1,000 640 = $360
Weighted-average $1,000 600 = $400
FIFO $1,000 540 = $460
LIFO $1,000 660 = $340
Assumed
Sales
Revenue
Cost of
Goods
Sold
Gross
Profit
2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
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.
Other Issues
Tax advantages of LIFO in periods of
rising prices
Higher Cost of Goods Sold = Lower Net Income
= Lower Income Taxes
Inventory Method & managing income
International issue LIFO not allowed in
some countries
Inventory Errors
Each inventory error affects:
Inventory
Cost of goods sold
Gross profit
Net income
Inventory Errors
Period 1 Period 2

Inventory Error
Cost of
Goods Sold
Gross Profit
and Net Income
Cost of
Goods Sold
Gross Profit
and Net Income
Period 1 Ending
inventory overstated Understated Overstated Overstated Understated

Period 1 Ending
inventory understated Overstated Understated Understated Overstated

ACG 2021
Financial Accounting
More accounting Principles and
Concepts
Accounting Principles
Consistency principle
Same Accounting Methods from Period to Period
Accounting Changes must be disclosed
Effect of accounting Change must be disclosed
Disclosure principle
Enough information must be reported for stakeholders to make
informed decisions
Relevant, Reliable, and Comparable Information
Accounting conservatism
Anticipate or disclose all likely losses, but gains are not reported
until they occur
Assets are recorded as lowest reasonable amount
Liabilities are recorded at highest reasonable amount:
Lower of Cost or Market
Lower-of-Cost-or-Market rule (LCM)
Inventory is reported at the lowest value
Historical Cost
Or Market (Replacement Cost)
Inventory is below cost
Record an increase in Cost of Goods Sold (debit)
Record the reduction in Inventory (credit)

To record a $1,000 decline in inventory value
Cost of Goods Sold 1,000
Inventory 1,000
Wrote inventory down to market value
ACG 2021
Financial Accounting
Inventory Ratios
Ratios
Gross Profit
Percentage
=
Gross Profit
Net Sales Revenue
Inventory
Turnover
=
Cost of goods sold
Average Inventory
Ratios
Gross Profit
Profit indicator
Inventory Turnover Liquidity ratio
How quickly is Inventory Sold?
Best Buy
ACG 2021
Financial Accounting
Estimating Inventory and/or
Cost of Goods Sold using
Gross Profit
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.
Calculation
Cost of Beginning
Inventory
+Cost of Purchases
___________________
=Cost of Goods
Available for Sale
- Cost of Ending
Inventory
___________________
=Cost of Goods Sold

Cost of Beginning
Inventory
+Cost of Purchases
___________________
=Cost of Goods
Available for Sale
- Cost of Goods Sold
___________________
=Cost of Ending
Inventory
Calculation Continued
Sales Cost of Goods Sold = Gross Profit
Gross Profit% = Gross Profit / Sales
Cost of Goods Sold = Sales x (1- Gross Profit%)

Estimate CGS using GP%
We know Beginning Inventory = 14,000
We know Purchases = 66,000
We know Sales = 100,000
We know Gross Profit % = 43%

We Dont know Cost of Goods Sold
We Dont know Ending Inventory
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
End of Chapter 6