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CHAPTER NINETEEN. ACCOUNTING FOR MERCHANDISE INVENTORY. INVENTORY ERRORS. Errors in inventory will cause errors on: Income Statement, Statement of Owner’s Equity and Balance Sheet For the current and the next year. EFFECT OF INVENTORY ERRORS. INCOME STATEMENT. 20 - 1. 20 - 2. Sales. 80.

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Chapter nineteen

CHAPTER NINETEEN

ACCOUNTING FOR MERCHANDISEINVENTORY


Inventory errors

INVENTORY ERRORS

  • Errors in inventory will cause errors on:

    • Income Statement, Statement of Owner’s Equity and Balance Sheet

      • For the current and the next year


Effect of inventory errors

EFFECT OF INVENTORY ERRORS

INCOMESTATEMENT

20-1

20-2

Sales

80

Cost of Goods Sold:

Beginning Merch. Inventory

20

Add Purchases (net)

40

Cost of Goods Available for Sale

60

Less: Ending Merch. Inventory

20

Let’s first look at the Income

Statement with the ending inventory

correctly stated at $20.


Effect of inventory errors1

EFFECT OF INVENTORY ERRORS

INCOMESTATEMENT

20-1

20-2

Sales

80

Cost of Goods Sold:

Beginning Merch. Inventory

20

Add Purchases (net)

40

Cost of Goods Available for Sale

60

Less: Ending Merch. Inventory

20

(40)

Cost of Goods Sold

Gross Profit

40

Operating Expenses

(10)

Net Income

30

Now let’s look at the other financial statements.


Effect of inventory errors2

EFFECT OF INVENTORY ERRORS

STMT OF OWNER’S EQUITY

20-1

20-2

Erv Bultman, capital, January 1

100

Net Income

30

Erv Bultman, capital, December 31

130

BALANCE SHEET (partial)

Current Assets:

Merchandise Inventory

20

Owner’s Equity:

Erv Bultman, Capital

130


Effect of inventory errors3

EFFECT OF INVENTORY ERRORS

INCOMESTATEMENT

20-1

20-2

Sales

80

80

Cost of Goods Sold:

Beginning Merch. Inventory

20

20

Add Purchases (net)

40

Cost of Goods Available for Sale

60

Less: Ending Merch. Inventory

20

(40)

Cost of Goods Sold

Gross Profit

40

20-1’s ending inventory becomes

20-2’s beginning inventory.

Operating Expenses

(10)

Net Income

30


Effect of inventory errors4

EFFECT OF INVENTORY ERRORS

INCOMESTATEMENT

20-1

20-2

Sales

80

80

Cost of Goods Sold:

Beginning Merch. Inventory

20

20

Add Purchases (net)

40

40

Cost of Goods Available for Sale

60

60

Less: Ending Merch. Inventory

20

20

(40)

(40)

Cost of Goods Sold

Gross Profit

40

40

Operating Expenses

(10)

(10)

Net Income

30

30


Effect of inventory errors5

EFFECT OF INVENTORY ERRORS

STMT OF OWNER’S EQUITY

20-1

20-2

Erv Bultman, capital, January 1

100

130

Net Income

30

30

Erv Bultman, capital, December 31

130

160

BALANCE SHEET (partial)

Current Assets:

Merchandise Inventory

20

20

Owner’s Equity:

Erv Bultman, Capital

130

160


Effect of inventory errors6

EFFECT OF INVENTORY ERRORS

What would be the effect on the financial statements for 20-1 & 20-2 if the 12/31/-1 inventory was reported as $15 instead of $20?

Ending inventory 20-1

& Beginning inventory 20-2

UNDERSTATED


Effect of inventory errors7

EFFECT OF INVENTORY ERRORS

INCOMESTATEMENT

20-1

20-2

Sales

80

Cost of Goods Sold:

Beginning Merch. Inventory

20

Add Purchases (net)

40

Cost of Goods Available for Sale

60

Less: Ending Merch. Inventory

15

(45)

Cost of Goods Sold

Gross Profit

35

Operating Expenses

(10)

Net Income

25

Understated Ending Inventory results in understated Net Income.


Effect of inventory errors8

EFFECT OF INVENTORY ERRORS

STMT OF OWNER’S EQUITY

20-1

20-2

Erv Bultman, capital, January 1

100

Net Income

25

Erv Bultman, capital, December 31

125

BALANCE SHEET (partial)

Understated Net Income results in

understated Owner’s Equity.

Current Assets:

Merchandise Inventory

Owner’s Equity:

Erv Bultman, Capital


Effect of inventory errors9

EFFECT OF INVENTORY ERRORS

STMT OF OWNER’S EQUITY

20-1

20-2

Erv Bultman, capital, January 1

100

Net Income

25

Erv Bultman, capital, December 31

125

BALANCE SHEET (partial)

Current Assets:

Merchandise Inventory

15

Owner’s Equity:

Erv Bultman, Capital

125

Assets and Owner’s Equity will be understated.


Effect of inventory errors10

EFFECT OF INVENTORY ERRORS

INCOMESTATEMENT

20-1

20-2

Sales

80

80

Cost of Goods Sold:

Beginning Merch. Inventory

20

15

Add Purchases (net)

40

40

Cost of Goods Available for Sale

60

55

Less: Ending Merch. Inventory

15

20

(45)

(35)

Cost of Goods Sold

Gross Profit

35

45

Operating Expenses

(10)

(10)

Net Income

25

35

Understated Beginning Inventory results in overstated Net Income.


Effect of inventory errors11

EFFECT OF INVENTORY ERRORS

STMT OF OWNER’S EQUITY

20-1

20-2

Erv Bultman, capital, January 1

100

125

Net Income

25

35

Erv Bultman, capital, December 31

125

160

BALANCE SHEET (partial)

Current Assets:

Merchandise Inventory

15

Owner’s Equity:

Erv Bultman, Capital

125

Owner’s Equity is correct by the end of 20-2.


Effect of inventory errors12

EFFECT OF INVENTORY ERRORS

STMT OF OWNER’S EQUITY

20-1

20-2

Erv Bultman, capital, January 1

100

125

Net Income

25

35

Erv Bultman, capital, December 31

125

160

BALANCE SHEET (partial)

Current Assets:

Merchandise Inventory

15

20

Owner’s Equity:

Erv Bultman, Capital

125

160

Assets and Owner’s Equity

will be correct.


Effect of inventory errors13

EFFECT OF INVENTORY ERRORS

What would be the effect on the financial statements for 20-1 & 20-2 if the 12/31/-1 inventory was reported as $25 instead of $20?

Ending inventory 20-1

& Beginning inventory 20-2

OVERSTATED


Effect of inventory errors14

EFFECT OF INVENTORY ERRORS

INCOMESTATEMENT

20-1

20-2

Sales

80

Cost of Goods Sold:

Beginning Merch. Inventory

20

Add Purchases (net)

40

Cost of Goods Available for Sale

60

Less: Ending Merch. Inventory

25

(35)

Cost of Goods Sold

Gross Profit

45

Operating Expenses

(10)

Net Income

35

Overstated Ending Inventory results in overstated Net Income.


Effect of inventory errors15

EFFECT OF INVENTORY ERRORS

STMT OF OWNER’S EQUITY

20-1

20-2

Erv Bultman, capital, January 1

100

Net Income

35

Erv Bultman, capital, December 31

135

BALANCE SHEET (partial)

Current Assets:

Merchandise Inventory

Overstated Net Income results in

overstated Owner’s Equity.

Owner’s Equity:

Erv Bultman, Capital


Effect of inventory errors16

EFFECT OF INVENTORY ERRORS

STMT OF OWNER’S EQUITY

20-1

20-2

Erv Bultman, capital, January 1

100

Net Income

35

Erv Bultman, capital, December 31

135

BALANCE SHEET (partial)

Current Assets:

Merchandise Inventory

25

Owner’s Equity:

Erv Bultman, Capital

135

Assets and Owner’s Equity will be overstated.


Effect of inventory errors17

EFFECT OF INVENTORY ERRORS

INCOMESTATEMENT

20-1

20-2

Sales

80

80

Cost of Goods Sold:

Beginning Merch. Inventory

20

25

Add Purchases (net)

40

40

Cost of Goods Available for Sale

60

65

Less: Ending Merch. Inventory

25

20

(35)

(45)

Cost of Goods Sold

Gross Profit

45

35

Operating Expenses

(10)

(10)

Net Income

35

25

Overstated Beginning Inventory results in understated Net Income.


Effect of inventory errors18

EFFECT OF INVENTORY ERRORS

STMT OF OWNER’S EQUITY

20-1

20-2

Erv Bultman, capital, January 1

100

135

Net Income

35

25

Erv Bultman, capital, December 31

135

160

BALANCE SHEET (partial)

Current Assets:

Merchandise Inventory

25

Owner’s Equity:

Erv Bultman, Capital

135

Owner’s Equity is correct by the end of 20-2.


Effect of inventory errors19

EFFECT OF INVENTORY ERRORS

STMT OF OWNER’S EQUITY

20-1

20-2

Erv Bultman, capital, January 1

100

135

Net Income

35

25

Erv Bultman, capital, December 31

135

160

BALANCE SHEET (partial)

Current Assets:

Merchandise Inventory

25

20

Owner’s Equity:

Erv Bultman, Capital

135

160

Assets and Owner’s Equity

will be correct.


Recording purchases

PERIODIC METHOD

Merch. Inv. account balance = most recent physical inventory

Purchases account used for all merchandise purchases

Current inventory and cost of goods sold only computed at end of period

PERPETUAL METHOD

Merch. Inv. Account reflects current inventory

Purchases are debited to Merch. Inv., cost of sales are credited to Merch. Inv.

Generally no need for end of year adjustments

RECORDING PURCHASES


Comparing entries under periodic and perpetual systems

COMPARING ENTRIES UNDER PERIODIC AND PERPETUAL SYSTEMS

Example: Purchased $100 of merchandise on account


Periodic system

PERIODIC SYSTEM

DATE

DESCRIPTION

DEBIT

PR

CREDIT

Purchases

100 00

1

Accts Payable

2

100 00

3

4

Periodic system uses a

“Purchases” account.

5

6

7

8

9

10

11


Perpetual system

PERPETUAL SYSTEM

DATE

DESCRIPTION

DEBIT

PR

CREDIT

Merchandise Inventory

100 00

1

Accts Payable

2

100 00

3

4

Perpetual system records purchases

directly in the Merchandise Inventory account.

5

6

7

8

9

10

11


Comparing entries under periodic perpetual systems

COMPARING ENTRIES UNDER PERIODIC & PERPETUAL SYSTEMS

Example: Paid freight charges $30


Periodic system1

PERIODIC SYSTEM

DATE

DESCRIPTION

DEBIT

PR

CREDIT

Frieight-In

30 00

1

Cash

2

30 00

3

4

5

Periodic system separates

freight charges in to their own account.

6

7

8

9

10

11


Perpetual system1

PERPETUAL SYSTEM

DATE

DESCRIPTION

DEBIT

PR

CREDIT

Merchandise Inventory

30 00

1

Cash

2

30 00

3

4

5

Perpetual system considers freight charges

part of the cost of merchandise

and includes them in the inventory account.

6

7

8

9

10

11


Chapter nineteen

COMPARING ENTRIES UNDER PERIODIC & PERPETUAL SYSTEMS

Example: Sold merchandise on account, $80. The cost of the merchandise was $50.


Periodic system2

PERIODIC SYSTEM

DATE

DESCRIPTION

DEBIT

PR

CREDIT

Accounts Receivable

80 00

1

Sales

2

80 00

3

4

5

Periodic system only records the selling

price of merchandise sold.

No attempt is made to reduce the

inventory account for items sold.

6

7

8

9

10

11


Perpetual system2

PERPETUAL SYSTEM

DATE

DESCRIPTION

DEBIT

PR

CREDIT

Accounts Receivable

80 00

1

Sales

2

80 00

3

4

5

Perpetual system also records

the selling price of merchandise sold.

6

7

8

9

10

11


Perpetual system3

PERPETUAL SYSTEM

DATE

DESCRIPTION

DEBIT

PR

CREDIT

Accounts Receivable

80 00

1

Sales

2

80 00

3

Cost of Goods Sold

4

50 00

Merchandise Inventory

50 00

5

6

In addition, the perpetual system removes

the cost of merchandise sold from inventory.

7

8

9

10

11


Chapter nineteen

COMPARING ENTRIES UNDER PERIODIC & PERPETUAL SYSTEMS

Example: Merchandise costing $10 was returned to the supplier.


Periodic system3

PERIODIC SYSTEM

DATE

DESCRIPTION

DEBIT

PR

CREDIT

Accounts Payable

10 00

1

Purchases Ret. & Allow.

2

10 00

3

4

5

Periodic system maintains a

separate account for returns.

6

7

8

9

10

11


Perpetual system4

PERPETUAL SYSTEM

DATE

DESCRIPTION

DEBIT

PR

CREDIT

Accounts Payable

80 00

1

Merchandise Inventory

2

80 00

3

4

5

Since the merchandise was recorded

in the inventory account when purchased,

it is removed from the account when returned.

6

7

8

9

10

11


Chapter nineteen

COMPARING ENTRIES UNDER PERIODIC & PERPETUAL SYSTEMS

Example: Customers returned merchandise sold for $20. The cost of the merchandise was $15.


Periodic system4

PERIODIC SYSTEM

DATE

DESCRIPTION

DEBIT

PR

CREDIT

Sales Returns & Allow.

20 00

1

Accounts Receivable

2

20 00

3

4

5

Periodic system maintains a

separate account for returns.

6

7

8

9

10

11


Perpetual system5

PERPETUAL SYSTEM

DATE

DESCRIPTION

DEBIT

PR

CREDIT

Sales Returns & Allow.

20 00

1

Accounts Receivable

2

20 00

3

4

5

Perpetual system records the returned sale.

It also must adjust the “Cost of Goods Sold”

and “Merchandise Inventory” accounts.

6

7

8

9

10

11


Perpetual system6

PERPETUAL SYSTEM

DATE

DESCRIPTION

DEBIT

PR

CREDIT

Sales Returns & Allow.

20 00

1

Accounts Receivable

2

20 00

3

Merchandise Inventory

4

15 00

Cost of Goods Sold

15 00

5

6

7

8

9

10

11


Chapter nineteen

COMPARING ENTRIES UNDER PERIODIC & PERPETUAL SYSTEMS

Example: Paid for merchandise costing $100. The supplier granted a 2% discount for prompt payment.


Periodic system5

PERIODIC SYSTEM

DATE

DESCRIPTION

DEBIT

PR

CREDIT

Accounts Payable

100 00

1

Purchases Discounts

2

2 00

Cash

3

98 00

4

Discounts are recorded in a

separate account.

5

6

7

8

9

10

11


Perpetual system7

PERPETUAL SYSTEM

DATE

DESCRIPTION

DEBIT

PR

CREDIT

Sales Returns & Allow.

20 00

1

Accounts Receivable

2

20 00

3

4

5

Perpetual system records the returned sale.

It also must adjust the “Cost of Goods Sold”

and “Merchandise Inventory” accounts.

6

7

8

9

10

11


Chapter nineteen

COMPARING ENTRIES UNDER PERIODIC & PERPETUAL SYSTEMS

Example: Adjusting entries made at the end of the accounting period.


Periodic system6

PERIODIC SYSTEM

DATE

DESCRIPTION

DEBIT

PR

CREDIT

Income Summary

1

XX

Merchandise Inventory

2

XX

3

4

Removing the old balance

from the inventory account

5

6

7

8

9

10

11


Periodic system7

PERIODIC SYSTEM

DATE

DESCRIPTION

DEBIT

PR

CREDIT

Income Summary

1

XX

Merchandise Inventory

2

XX

3

Merchandise Inventory

4

XX

Income Summary

XX

5

6

7

Recording new balance

in the inventory account

8

9

10

11


Perpetual system8

PERPETUAL SYSTEM

DATE

DESCRIPTION

DEBIT

PR

CREDIT

1

2

No entry needed if physical inventory

agrees with amount reported

in inventory account.

3

4

5

6

7

8

9

10

11


Taking a physical inventory

TAKING A PHYSICAL INVENTORY

  • Counting the goods on hand at the end of the period

    • used in the PERIODIC system to allocate merchandise costs between sold and unsold goods

    • in the PERPETUAL system it is compared to the accounting records to determine if what is actually held agrees with the records

    • done after regular business hours

    • ideally when inventory on hand is at its lowest level

      • fiscal year that starts and ends when inventory is at its lowest level is called “natural business year”


Taking a physical inventory1

TAKING A PHYSICAL INVENTORY

  • Two special situations:

    • Goods held for sale on CONSIGNMENT

      • Goods held on consignment remain the property of the shipper (Consignor)

    • Goods in TRANSIT

      • if FOB Shipping point - goods belong to the BUYER while in transit

      • if FOB Destination- goods belong to the SELLER while in transit


Computing the cost of ending inventory

COMPUTING THE COST OF ENDING INVENTORY

EXAMPLE: A physical inventory found 50 bicycles (Model ZX007) on hand. All of this model bicycle were purchased for $60 each.

Number of bikes on hand

Cost per unit

Ending Inventory

X

=

50

$60

$3000

=

X

Computing ending inventory is simple

if all purchases were made at the same price.


Computing the cost of ending inventory1

COMPUTING THE COST OF ENDING INVENTORY

What if each time we restocked this bicycle the price had changed?

Units

Unit Price

Total Cost

On hand at start of period

40

$62

$2,480

Purchased during period:

3,900

1st purchase

60

65

2nd purchase

80

67

5,360

3rd purchase

70

68

4,760

$16,500

250

No. of units available for sale

On hand at end of period

50

Cost of these 200 sold?

No. of units sold during period

200


Computing the cost of ending inventory2

COMPUTING THE COST OF ENDING INVENTORY

What if each time we restocked this bicycle the price had changed?

Units

Unit Price

Total Cost

Depends on inventory

method used

On hand at start of period

40

$62

$2,480

Purchased during period:

3,900

1st purchase

60

65

2nd purchase

80

67

5,360

3rd purchase

70

68

4,760

$16,500

250

No. of units available for sale

On hand at end of period

50

No. of units sold during period

200


Inventory methods

INVENTORY METHODS

Method #1 - Specific Identification Method

  • Used when each unit of inventory can be specifically identified

    • examples: cars, motorcycles, furniture, appliances, fine jewelry

  • Only practical for businesses in which sales volume is low and inventory unit value is high

Let’s apply this method

to the bicycle example.


Computing the cost of goods sold

COMPUTING THE COST OF GOODS SOLD

Inventory was maintained using the Specific Identification Method. The 200 bikes sold are as follows:

Units

Unit Price

Total Cost

30 of these were sold

On hand at start of period

40

$62

$2,480

Purchased during period:

3,900

1st purchase

60

65

2nd purchase

80

67

5,360

3rd purchase

70

68

4,760

$16,500

250

No. of units available for sale

On hand at end of period

50

No. of units sold during period

200


Computing the cost of goods sold1

COMPUTING THE COST OF GOODS SOLD

Inventory was maintained using the Specific Identification Method. The 200 bikes sold are as follows:

Units

Unit Price

Total Cost

On hand at start of period

40

$62

$2,480

Purchased during period:

50 of these were sold

3,900

1st purchase

60

65

2nd purchase

80

67

5,360

3rd purchase

70

68

4,760

$16,500

250

No. of units available for sale

On hand at end of period

50

No. of units sold during period

200


Computing the cost of goods sold2

COMPUTING THE COST OF GOODS SOLD

Inventory was maintained using the Specific Identification Method. The 200 bikes sold are as follows:

Units

Unit Price

Total Cost

On hand at start of period

40

$62

$2,480

Purchased during period:

3,900

1st purchase

60

65

60 of these were sold

2nd purchase

80

67

5,360

3rd purchase

70

68

4,760

$16,500

250

No. of units available for sale

On hand at end of period

50

No. of units sold during period

200


Computing the cost of goods sold3

COMPUTING THE COST OF GOODS SOLD

Inventory was maintained using the Specific Identification Method. The 200 bikes sold are as follows:

Units

Unit Price

Total Cost

On hand at start of period

40

$62

$2,480

Purchased during period:

3,900

1st purchase

60

65

2nd purchase

80

67

5,360

60 of these were sold

3rd purchase

70

68

4,760

$16,500

250

No. of units available for sale

On hand at end of period

50

No. of units sold during period

200


Computing the cost of goods sold4

COMPUTING THE COST OF GOODS SOLD

Units Sold

Unit Price

Total Cost

From beginning inventory

30

$62

$1,860

1st purchase

50

65

3,250

2nd purchase

60

67

4,020

3rd purchase

60

68

4,760

Total

200

$13,210

Cost of goods (the 200 bikes) sold


Computing the ending inventory

COMPUTING THE ENDING INVENTORY

Units Remaining

Unit Price

Total Cost

From beginning inventory

10

$62

$620

1st purchase

10

65

650

2nd purchase

20

67

1,340

3rd purchase

10

68

680

Total

50

$3,290

This ending inventory will be

reported on the Income Statement

and the Balance Sheet.


Inventory methods1

INVENTORY METHODS

Method #2 - First-In, First-Out (FIFO) Method

  • Assumes the first goods purchased were the first goods sold

    • Leaving the most recently purchased goods in ending inventory

  • Follows the natural flow of goods

    • especially true of grocery stores, fresh fruit stands, and computer software businesses

Let’s apply this method

to the bicycle example.


Computing the cost of goods sold5

COMPUTING THE COST OF GOODS SOLD

Inventory was maintained using the FIFO method. The identity of the 200 bikes sold is as follows:

Units

Unit Price

Total Cost

All of these - assumed sold

On hand at start of period

40

$62

$2,480

Purchased during period:

3,900

1st purchase

60

65

2nd purchase

80

67

5,360

3rd purchase

70

68

4,760

$16,500

250

No. of units available for sale

On hand at end of period

50

No. of units sold during period

200


Computing the cost of goods sold6

COMPUTING THE COST OF GOODS SOLD

Inventory was maintained using the FIFO method. The identity of the 200 bikes sold is as follows:

Units

Unit Price

Total Cost

On hand at start of period

40

$62

$2,480

Purchased during period:

All of these - assumed sold

3,900

1st purchase

60

65

2nd purchase

80

67

5,360

3rd purchase

70

68

4,760

$16,500

250

No. of units available for sale

On hand at end of period

50

No. of units sold during period

200


Computing the cost of goods sold7

COMPUTING THE COST OF GOODS SOLD

Inventory was maintained using the FIFO method. The identity of the 200 bikes sold is as follows:

Units

Unit Price

Total Cost

On hand at start of period

40

$62

$2,480

Purchased during period:

All of these - assumed sold

3,900

1st purchase

60

65

2nd purchase

80

67

5,360

3rd purchase

70

68

4,760

$16,500

250

No. of units available for sale

On hand at end of period

50

No. of units sold during period

200


Computing the cost of goods sold8

COMPUTING THE COST OF GOODS SOLD

Inventory was maintained using the FIFO method. The identity of the 200 bikes sold is as follows:

Units

Unit Price

Total Cost

On hand at start of period

40

$62

$2,480

Purchased during period:

40

3,900

1st purchase

60

65

60

2nd purchase

80

67

5,360

80

180

considered

3rd purchase

70

68

4,760

sold so far

$16,500

250

No. of units available for sale

On hand at end of period

50

No. of units sold during period

200


Computing the cost of goods sold9

COMPUTING THE COST OF GOODS SOLD

Inventory was maintained using the FIFO method. The identity of the 200 bikes sold is as follows:

Units

Unit Price

Total Cost

On hand at start of period

40

$62

$2,480

Purchased during period:

3,900

1st purchase

60

65

2nd purchase

80

20 of these - assumed sold

67

5,360

3rd purchase

70

68

4,760

$16,500

250

No. of units available for sale

On hand at end of period

50

No. of units sold during period

200


Computing the cost of goods sold10

COMPUTING THE COST OF GOODS SOLD

Units Sold

Unit Price

Total Cost

All of the beginning inventory

40

$62

$2,480

All of the 1st purchase

60

65

3,900

All of the 2nd purchase

80

67

5,360

3rd purchase

20

The remaining units from this

purchase are the 50 units in

ending inventory.


Computing the cost of goods sold11

COMPUTING THE COST OF GOODS SOLD

Units Sold

Unit Price

Total Cost

All of the beginning inventory

40

$62

$2,480

All of the 1st purchase

60

65

3,900

All of the 2nd purchase

80

67

5,360

3rd purchase

20

68

1,360

Total

200

$13,100

Cost of goods (the 200 bikes) sold


Computing the ending inventory1

COMPUTING THE ENDING INVENTORY

Units Remaining

Unit Price

Total Cost

From beginning inventory

0

$62

$ 0

1st purchase

0

65

0

2nd purchase

0

67

0

3rd purchase

50

68

3,400

Total

50

$3,400

This ending inventory will be

reported on the Income Statement

and the Balance Sheet.


Inventory methods2

INVENTORY METHODS

Method #3 - Weighted -Average Method

  • Computes an average cost per unit using the following formula:

    • Total cost of units available for sale divided by the units available for sale

Let’s apply this method

to the bicycle example.


Computing the cost of goods sold12

COMPUTING THE COST OF GOODS SOLD

Inventory was maintained using the Weighted-Average method.

Units

Unit Price

Total Cost

On hand at start of period

40

$62

$2,480

Purchased during period:

3,900

1st purchase

60

65

2nd purchase

80

67

5,360

3rd purchase

70

68

4,760

$16,500

250

No. of units available for sale

On hand at end of period

50

$16,500

= $66/unit

No. of units sold during period

200

250


Weighted average method

WEIGHTED-AVERAGE METHOD

Cost of goods sold

200

units @ $66 =

$13,200

units @ $66 =

Ending Inventory

50

3,300

One of the advantages of the

Weighted-Average method

is its simplicity.


Inventory methods3

INVENTORY METHODS

Method #4 - Last-In, First-Out Method

  • Assumes that the sales in the period were made from the most recently purchased goods.

    • While oldest goods remain in inventory

  • Use of this method is justified because:

    • LIFO is the actual physical flow of goods in some businesses

    • it matches the most current costs of items purchased against the current sales revenue


Computing the cost of goods sold13

COMPUTING THE COST OF GOODS SOLD

Inventory was maintained using the LIFO method. The identity of the 200 bikes sold is as follows:

Units

Unit Price

Total Cost

On hand at start of period

40

$62

$2,480

Purchased during period:

3,900

1st purchase

60

65

2nd purchase

80

All of these - assumed sold

67

5,360

3rd purchase

70

68

4,760

$16,500

250

No. of units available for sale

On hand at end of period

50

No. of units sold during period

200


Computing the cost of goods sold14

COMPUTING THE COST OF GOODS SOLD

Inventory was maintained using the LIFO method. The identity of the 200 bikes sold is as follows:

Units

Unit Price

Total Cost

On hand at start of period

40

$62

$2,480

Purchased during period:

3,900

1st purchase

60

All of these - assumed sold

65

2nd purchase

80

67

5,360

3rd purchase

70

68

4,760

$16,500

250

No. of units available for sale

On hand at end of period

50

No. of units sold during period

200


Computing the cost of goods sold15

COMPUTING THE COST OF GOODS SOLD

Inventory was maintained using the LIFO method. The identity of the 200 bikes sold is as follows:

Units

Unit Price

Total Cost

On hand at start of period

40

$62

$2,480

Purchased during period:

3,900

1st purchase

60

65

70

2nd purchase

80

67

5,360

80

3rd purchase

70

68

4,760

150

considered

$16,500

250

No. of units available for sale

sold so far

On hand at end of period

50

No. of units sold during period

200


Computing the cost of goods sold16

COMPUTING THE COST OF GOODS SOLD

Inventory was maintained using the LIFO method. The identity of the 200 bikes sold is as follows:

Units

Unit Price

Total Cost

On hand at start of period

40

$62

$2,480

Purchased during period:

50 of these - assumed sold

3,900

1st purchase

60

65

2nd purchase

80

67

5,360

3rd purchase

70

68

4,760

$16,500

250

No. of units available for sale

On hand at end of period

50

No. of units sold during period

200


Computing the cost of goods sold17

COMPUTING THE COST OF GOODS SOLD

Units Sold

Unit Price

Total Cost

None of the beginning inventory

0

$62

$ 0

1st purchase

50

65

3,250

All of the 2nd purchase

80

67

5,360

All of the 3rd purchase

70

68

4,760

200

$13,370


Computing the ending inventory2

COMPUTING THE ENDING INVENTORY

Units Remaining

Unit Price

Total Cost

From beginning inventory

40

$62

$2,480

1st purchase

10

65

650

2nd purchase

0

67

0

3rd purchase

0

68

0

Total

50

$3,130

This ending inventory will be

reported on the Income Statement

and the Balance Sheet.


Comparison of methods

COMPARISON OF METHODS

  • Assumed cost flows (FIFO, Weighed-Average, and LIFO) do not have to match the actual physical movement of goods.

  • Any one of the methods may be used under any set of physical flow conditions.


Comparison of methods1

COMPARISON OF METHODS

Specific Identification

FIFO

Sales

$18,000

$18,000

Cost of Goods Sold:

Beg. Inventory

$ 2,480

$ 2,480

Purchases

14,020

14,020

Goods Avail. for Sale

$16,500

$16,500

Goods Available for Sale is the same

for all four methods!


Comparison of methods2

COMPARISON OF METHODS

FIFO

Weigthed-Average

LIFO

$18,000

$18,000

$18,000

$ 2,480

$ 2,480

$ 2,480

14,020

14,020

14,020

$16,500

$16,500

$16,500


Comparison of methods3

COMPARISON OF METHODS

Specific Identification

FIFO

Sales

$18,000

$18,000

Cost of Goods Sold:

Beg. Inventory

$ 2,480

$ 2,480

Purchases

14,020

14,020

Goods Avail. for Sale

$16,500

$16,500

Less ending inventory

3,290

3,400

Cost of goods sold

13,210

13,100

Ending Inventory & Cost of Goods Sold

differ with each method.


Comparison of methods4

COMPARISON OF METHODS

FIFO

Weigthed-Average

LIFO

$18,000

$18,000

$18,000

$ 2,480

$ 2,480

$ 2,480

14,020

14,020

14,020

$16,500

$16,500

$16,500

3,400

3,300

3,130

13,100

13,200

13,370


Comparison of methods5

COMPARISON OF METHODS

Specific Identification

FIFO

Sales

$18,000

$18,000

Cost of Goods Sold:

Beg. Inventory

$ 2,480

$ 2,480

Purchases

14,020

14,020

Goods Avail. for Sale

$16,500

$16,500

Less ending inventory

3,290

3,400

Cost of goods sold

13,210

13,100

Gross Profit

$ 4,790

$ 4,900


Comparison of methods6

COMPARISON OF METHODS

FIFO

Weigthed-Average

LIFO

$18,000

$18,000

$18,000

$ 2,480

$ 2,480

$ 2,480

14,020

14,020

14,020

$16,500

$16,500

$16,500

3,400

3,300

3,130

13,100

13,200

13,370

$ 4,900

$ 4,800

$ 4,630

When prices are rising (as with the bikes)

FIFO results in the largest Gross Profit.


Comparison of methods7

COMPARISON OF METHODS

FIFO

Weigthed-Average

LIFO

$18,000

$18,000

$18,000

$ 2,480

$ 2,480

$ 2,480

14,020

14,020

14,020

$16,500

$16,500

$16,500

3,400

3,300

3,130

13,100

13,200

13,370

$ 4,900

$ 4,800

$ 4,630

LIFO results in the smallest Gross Profit,

therefore creating the smallest tax liability.


Perpetual system9

PERPETUAL SYSTEM

  • Merchandise Inventory is a controlling account.

    • Subsidiary ledger maintained for each product

  • Costs can be assigned on a FIFO, moving-average or LIFO basis.


Perpetual fifo method

PERPETUAL FIFO METHOD

Let’s return to the example of the 200 bicycles sold.

Purchases

Cost of Goods Sold

Date

Cost/

Cost/

Cumulative

Units

Unit

Total

Units

Unit

CGS

CGS

Jan. 1 (BI)

There were 40 bicycles in inventory

at the beginning of the year.


Perpetual fifo method1

PERPETUAL FIFO METHOD

Let’s return to the example of the 200 bicycles sold.

Cost of Goods Sold

Inventory on Hand

Cost/

Cumulative

Cost/

Layer

Units

Unit

CGS

CGS

Layer

Units

Unit

Cost

Total

(1)

40

$62

$2,480

$2,480

Each of the 40 units were

purchased at $62.


Perpetual fifo method2

PERPETUAL FIFO METHOD

Let’s return to the example of the 200 bicycles sold.

Purchases

Cost of Goods Sold

Date

Cost/

Cost/

Cumulative

Units

Unit

Total

Units

Unit

CGS

CGS

Jan. 1 (BI)

Feb. 15

30

$ 62

The 30 bikes sold came from the

$62 bikes in beginning inventory.


Perpetual fifo method3

PERPETUAL FIFO METHOD

Let’s return to the example of the 200 bicycles sold.

Purchases

Cost of Goods Sold

Date

Cost/

Cost/

Cumulative

Units

Unit

Total

Units

Unit

CGS

CGS

Jan. 1 (BI)

Feb. 15

30

$ 62

$ 1,860

$ 1,860


Perpetual fifo method4

PERPETUAL FIFO METHOD

Let’s return to the example of the 200 bicycles sold.

Cost of Goods Sold

Inventory on Hand

Cost/

Cumulative

Cost/

Layer

Units

Unit

CGS

CGS

Layer

Units

Unit

Cost

Total

(1)

40

$62

$2,480

$2,480

(1)

30

$ 62

$ 1,860

$ 1,860

10

$62

620

$ 620


Perpetual fifo method5

PERPETUAL FIFO METHOD

Let’s return to the example of the 200 bicycles sold.

Purchases

Cost of Goods Sold

Date

Cost/

Cost/

Cumulative

Units

Unit

Total

Units

Unit

CGS

CGS

Jan. 1 (BI)

Feb. 15

30

$ 62

$ 1,860

$ 1,860

Mar. 1

60

$ 65

$ 3,900


Perpetual fifo method6

PERPETUAL FIFO METHOD

Let’s return to the example of the 200 bicycles sold.

Cost of Goods Sold

Inventory on Hand

Cost/

Cumulative

Cost/

Layer

Units

Unit

CGS

CGS

Layer

Units

Unit

Cost

Total

(1)

40

$62

$2,480

$2,480

(1)

30

$ 62

$ 1,860

$ 1,860

10

$62

620

$ 620

(1)

10

620

$62

(2)

60

65

3,900

$4,520

Now there are two layers in inventory…

10 bikes from the beginning inventory

and the 60 bikes just purchased.


Perpetual fifo method7

PERPETUAL FIFO METHOD

Let’s return to the example of the 200 bicycles sold.

Purchases

Cost of Goods Sold

Date

Cost/

Cost/

Cumulative

Units

Unit

Total

Units

Unit

CGS

CGS

Jan. 1 (BI)

Feb. 15

30

$ 62

$ 1,860

$ 1,860

Mar. 1

60

$ 65

$ 3,900

April 1

On April 1, 40 units

were sold.


Perpetual fifo method8

PERPETUAL FIFO METHOD

Let’s return to the example of the 200 bicycles sold.

Cost of Goods Sold

Inventory on Hand

Cost/

Cumulative

Cost/

Layer

Units

Unit

CGS

CGS

Layer

Units

Unit

Cost

Total

(1)

40

$62

$2,480

$2,480

(1)

30

$ 62

$ 1,860

$ 1,860

10

$62

620

$ 620

(1)

10

620

$62

(2)

60

65

3,900

$4,520

FIFO assumes the first-in are the first sold….

40 sold = 10 from the beginning inventory

and the 30 from the 3/1 purchase.


Perpetual fifo method9

PERPETUAL FIFO METHOD

Let’s return to the example of the 200 bicycles sold.

Purchases

Cost of Goods Sold

Date

Cost/

Cost/

Cumulative

Units

Unit

Total

Units

Unit

CGS

CGS

Jan. 1 (BI)

Feb. 15

30

$ 62

$ 1,860

$ 1,860

Mar. 1

60

$ 65

$ 3,900

April 1

10

$ 62

$ 620

$ 4,430

30

65

1,950


Perpetual fifo method10

PERPETUAL FIFO METHOD

Let’s return to the example of the 200 bicycles sold.

Cost of Goods Sold

Inventory on Hand

Cost/

Cumulative

Cost/

Layer

Units

Unit

CGS

CGS

Layer

Units

Unit

Cost

Total

(1)

40

$62

$2,480

$2,480

(1)

30

$ 62

$ 1,860

$ 1,860

10

$62

620

$ 620

(1)

10

620

$62

(2)

60

65

3,900

$4,520

10

$ 62

$ 620

(2)

30

$65

1,950

30

65

1,950

$ 4,430

$1,950


Perpetual fifo method11

PERPETUAL FIFO METHOD

Let’s return to the example of the 200 bicycles sold.

Purchases

Cost of Goods Sold

Date

Cost/

Cost/

Cumulative

Units

Unit

Total

Units

Unit

CGS

CGS

Jan. 1 (BI)

Feb. 15

30

$ 62

$ 1,860

$ 1,860

Mar. 1

60

$ 65

$ 3,900

April 1

10

$ 62

$ 620

$ 4,430

30

65

1,950

May15

80

$ 67

$ 5,360


Perpetual fifo method12

PERPETUAL FIFO METHOD

Let’s return to the example of the 200 bicycles sold.

Cost of Goods Sold

Inventory on Hand

Cost/

Cumulative

Cost/

Layer

Units

Unit

CGS

CGS

Layer

Units

Unit

Cost

Total

(1)

40

$62

$2,480

$2,480

(1)

30

$ 62

$ 1,860

$ 1,860

10

$62

620

$ 620

(1)

10

620

$62

(2)

60

65

3,900

$4,520

10

$ 62

$ 620

(2)

30

$65

1,950

30

65

1,950

$ 4,430

$1,950

(2)

30

$65

1,950

(3)

80

67

5,360

$7,310


Perpetual fifo method13

PERPETUAL FIFO METHOD

Let’s return to the example of the 200 bicycles sold.

Purchases

Cost of Goods Sold

Date

Cost/

Cost/

Cumulative

Units

Unit

Total

Units

Unit

CGS

CGS

May 15

80

$ 67

$ 5,360

June 30

On June 30, 90 units were sold.


Perpetual fifo method14

PERPETUAL FIFO METHOD

Let’s return to the example of the 200 bicycles sold.

Cost of Goods Sold

Inventory on Hand

Cost/

Cumulative

Cost/

Layer

Units

Unit

CGS

CGS

Layer

Units

Unit

Cost

Total

(2)

30

1,950

$65

(3)

80

67

5,360

$7,310

90 bikes sold = 30 (layer 2) + 60 (layer 3)


Perpetual fifo method15

PERPETUAL FIFO METHOD

Let’s return to the example of the 200 bicycles sold.

Purchases

Cost of Goods Sold

Date

Cost/

Cost/

Cumulative

Units

Unit

Total

Units

Unit

CGS

CGS

May 15

80

$ 67

$ 5,360

June 30

30

$65

1,950

60

67

4,020

$ 10,400


Perpetual fifo method16

PERPETUAL FIFO METHOD

Let’s return to the example of the 200 bicycles sold.

Cost of Goods Sold

Inventory on Hand

Cost/

Cumulative

Cost/

Layer

Units

Unit

CGS

CGS

Layer

Units

Unit

Cost

Total

(2)

30

1,950

$65

(3)

80

67

5,360

$7,310

30

$65

1,950

20

67

1,340

(3)

$1,340

60

67

4,020

$ 10,400


Perpetual fifo method17

PERPETUAL FIFO METHOD

Let’s return to the example of the 200 bicycles sold.

Purchases

Cost of Goods Sold

Date

Cost/

Cost/

Cumulative

Units

Unit

Total

Units

Unit

CGS

CGS

May 15

80

$ 67

$ 5,360

June 30

30

$65

1,950

60

67

4,020

$ 10,400

Aug. 28

70

$ 68

$ 4,760


Perpetual fifo method18

PERPETUAL FIFO METHOD

Let’s return to the example of the 200 bicycles sold.

Cost of Goods Sold

Inventory on Hand

Cost/

Cumulative

Cost/

Layer

Units

Unit

CGS

CGS

Layer

Units

Unit

Cost

Total

(2)

30

1,950

$65

(3)

80

67

5,360

$7,310

30

$65

1,950

20

$67

1,340

(3)

$1,340

60

67

4,020

$ 10,400

(3)

20

1,340

$67

(4)

70

68

$6,100

4,760


Perpetual fifo method19

PERPETUAL FIFO METHOD

Let’s return to the example of the 200 bicycles sold.

Purchases

Cost of Goods Sold

Date

Cost/

Cost/

Cumulative

Units

Unit

Total

Units

Unit

CGS

CGS

May 15

80

$ 67

$ 5,360

June 30

30

$65

1,950

60

67

4,020

$ 10,400

Aug. 28

70

$ 68

$ 4,760

Oct. 30

40 units were sold on Oct. 30.


Perpetual fifo method20

PERPETUAL FIFO METHOD

Let’s return to the example of the 200 bicycles sold.

Cost of Goods Sold

Inventory on Hand

Cost/

Cumulative

Cost/

Layer

Units

Unit

CGS

CGS

Layer

Units

Unit

Cost

Total

(2)

30

1,950

$65

(3)

80

67

5,360

$7,310

30

$65

1,950

20

$67

1,340

(3)

$1,340

60

67

4,020

$ 10,400

(3)

20

1,340

$67

(4)

70

68

$6,100

4,760

40 units sold =

20 (layer 3) + 20 (layer 4)


Perpetual fifo method21

PERPETUAL FIFO METHOD

Let’s return to the example of the 200 bicycles sold.

Purchases

Cost of Goods Sold

Date

Cost/

Cost/

Cumulative

Units

Unit

Total

Units

Unit

CGS

CGS

May 15

80

$ 67

$ 5,360

June 30

30

$65

$1,950

60

67

4,020

$ 10,400

Aug. 28

70

$ 68

$ 4,760

20

$67

$1,340

Oct. 30

20

68

1,360

$ 13,100


Perpetual fifo method22

PERPETUAL FIFO METHOD

Let’s return to the example of the 200 bicycles sold.

Cost of Goods Sold

Inventory on Hand

Cost/

Cumulative

Cost/

Layer

Units

Unit

CGS

CGS

Layer

Units

Unit

Cost

Total

(2)

30

1,950

$65

(3)

80

67

5,360

$7,310

30

$65

1,950

20

$67

1,340

(3)

$1,340

60

67

4,020

$ 10,400

(3)

20

1,340

$67

(4)

70

68

$6,100

4,760

20

$1,340

(4)

50

$68

3,400

$67

20

68

1,360

$ 13,100

$3,400

Cost of Goods Sold for the year


Perpetual fifo method23

PERPETUAL FIFO METHOD

Let’s return to the example of the 200 bicycles sold.

Cost of Goods Sold

Inventory on Hand

Cost/

Cumulative

Cost/

Layer

Units

Unit

CGS

CGS

Layer

Units

Unit

Cost

Total

(2)

30

1,950

$65

(3)

80

67

5,360

$7,310

30

$65

1,950

20

$67

1,340

(3)

$1,340

60

67

4,020

$ 10,400

(3)

20

1,340

$67

(4)

70

68

$6,100

4,760

20

$1,340

(4)

50

$68

3,400

$67

20

68

1,360

$ 13,100

$3,400

Ending Inventory


Physical inventory

PHYSICAL INVENTORY

  • Perpetual system does not eliminate the need for a physical inventory.

  • Records are compared with the physical inventory.

    • If a difference is found, an adjusting entry must be prepared

    • differences are recorded in “Inventory Short and Over” account


Physical inventory1

PHYSICAL INVENTORY

Example: A physical inventory shows $3,710 worth of merchandise, but the inventory account has a balance of $3,840.

$130 short


General journal

GENERAL JOURNAL

DATE

DESCRIPTION

DEBIT

PR

CREDIT

1

Dec

31

Inventory Short and Over

130

2

Merchandise Inventory

130

3

To adjust inventory per

4

physical count

5

If physical count had

shown $3,900…

$60 overage

6

7

8

9

10

11


General journal1

GENERAL JOURNAL

DATE

DESCRIPTION

DEBIT

PR

CREDIT

1

Dec

31

Merchandise Inventory

60

2

Inventory Short and Over

60

3

To adjust inventory per

4

physical count

5

6

7

8

9

10

11


Conservatism principle

CONSERVATISM PRINCIPLE

  • Assets that increase in value while being held….

    • No formal entry of the gain is made until asset is sold

  • Assets that decrease in value while being held….

    • An entry is made to recognize the loss

  • We never anticipate gains, but we should always anticipate and account for losses.


Lower of cost or market

LOWER OF COST OR MARKET

  • If the value of inventory declines while it is being held, the loss should be recognized in the period of the decline.

  • “Cost”

    • the dollar amount calculated using one of the four costing methods

  • “Market”

    • the cost to replace the inventory


Lower of cost or market1

LOWER OF COST OR MARKET

Recorded Purchase Cost

End-of-Period Market Value

Lower-of-Cost-or-Market

Item

1

2

3

This company sells three products.


Lower of cost or market2

LOWER OF COST OR MARKET

Recorded Purchase Cost

End-of-Period Market Value

Lower-of-Cost-or-Market

Item

1

$ 8,000

2

3

The inventory of product #1

cost $8,000.


Lower of cost or market3

LOWER OF COST OR MARKET

Recorded Purchase Cost

End-of-Period Market Value

Lower-of-Cost-or-Market

Item

1

$ 8,000

$ 7,000

2

3

But the price has fallen,

it now could be replaced

for $7,000.


Lower of cost or market4

LOWER OF COST OR MARKET

Recorded Purchase Cost

End-of-Period Market Value

Lower-of-Cost-or-Market

Item

1

$ 8,000

$ 7,000

$ 7,000

2

3

“Market” is the lowest


Lower of cost or market5

LOWER OF COST OR MARKET

Recorded Purchase Cost

End-of-Period Market Value

Lower-of-Cost-or-Market

Item

1

$ 8,000

$ 7,000

$ 7,000

2

9,000

9,000

10,000

3

7,000

6,500

6,500

$22,500

$23,500

$24,000

Two ways to calculate

Lower-of-Cost-or-Market


Lower of cost or market6

LOWER OF COST OR MARKET

Recorded Purchase Cost

End-of-Period Market Value

Lower-of-Cost-or-Market

Item

1

$ 8,000

$ 7,000

$ 7,000

2

9,000

9,000

10,000

3

7,000

6,500

6,500

$22,500

$23,500

$24,000

#1 - Applied to Total Inventory

The lower of all items at their

cost or all items at their market value


Lower of cost or market7

LOWER OF COST OR MARKET

Recorded Purchase Cost

End-of-Period Market Value

Lower-of-Cost-or-Market

Item

1

$ 8,000

$ 7,000

$ 7,000

2

9,000

9,000

10,000

3

7,000

6,500

6,500

$22,500

$23,500

$24,000

#2 - Applied to Each Item

Each item is evaluated,

lowest amount is selected for each item


Lower of cost or market8

LOWER OF COST OR MARKET

Recorded Purchase Cost

End-of-Period Market Value

Lower-of-Cost-or-Market

Item

1

$ 8,000

$ 7,000

$ 7,000

2

9,000

9,000

10,000

3

7,000

6,500

6,500

$22,500

$23,500

$24,000

Let’s assume it was applied to Total Inventory.

A journal entry is needed to reduce

Merchandise Inventory to $23,500.


General journal2

GENERAL JOURNAL

Expense

DATE

DESCRIPTION

DEBIT

PR

CREDIT

1

Loss on Write-Down of Inventory

500

2

Merchandise Inventory

500

3

To recognize loss in value of

4

inventory held

5

6

7

8

9

10

11


Estimating inventory

ESTIMATING INVENTORY

  • Not needed under Perpetual system

  • Used in a Periodic system when a physical inventory is not practical

    • monthly, quarterly financial statements

  • Two Methods

    • Gross Profit method

    • Retail Inventory method


Gross profit method

GROSS PROFIT METHOD

A business’s normal gross profit (Net Sales - Cost of Goods Sold) is used to estimate the cost of goods sold and ending inventory.

3 steps


Gross profit method1

GROSS PROFIT METHOD

Example:

Inventory, start of period

$80,000

Net Purchases, first month

$70,000

Net Sales, first month

$110,000

Normal gross profit as a percentage of sales

40%

Step #1 Compute the cost of goods available for sale.

Inventory, start of period

$80,000

Net Purchases, first month

70,000

Cost of Goods Available for Sale

$150,000


Gross profit method2

GROSS PROFIT METHOD

Example:

Inventory, start of period

$80,000

Net Purchases, first month

$70,000

Net Sales, first month

$110,000

Normal gross profit as a percentage of sales

40%

Step #2 Estimate cost of goods sold by deducting the normal gross profit from net sales.

Net Sales

$110,000

Normal Gross Profit

44,000

$110,000 x 40%


Gross profit method3

GROSS PROFIT METHOD

Example:

Inventory, start of period

$80,000

Net Purchases, first month

$70,000

Net Sales, first month

$110,000

Normal gross profit as a percentage of sales

40%

Step #2 Estimate cost of goods sold by deducting the normal gross profit from net sales.

Net Sales

$110,000

Normal Gross Profit

44,000

Estimated cost of goods sold

66,000


Gross profit method4

GROSS PROFIT METHOD

Example:

Inventory, start of period

$80,000

Net Purchases, first month

$70,000

Net Sales, first month

$110,000

Normal gross profit as a percentage of sales

40%

Step #3 Estimate the ending inventory by deducting cost of goods sold from the cost of goods available for sale.

Cost of goods available for sale

$150,000

Estimated cost of goods sold

66,000

$ 84,000

Estimated end-of-month inventory


Retail inventory method

RETAIL INVENTORY METHOD

Used by many retail businesses. Requires keeping records of both the cost and selling (retail) prices of all goods purchased.

5 steps


Gross profit method5

GROSS PROFIT METHOD

Step #1 Compute the cost of goods available for sale at cost and retail.

COST

RETAIL

Inventory, start of period

$ 60,000

$ 85,000

126,000

163,000

Net purchases during period

$ 248,000

Goods available for sale

$ 186,000


Gross profit method6

GROSS PROFIT METHOD

Step #2 Compute the ending inventory at retail by subtracting sales at retail from goods available for sale at retail.

COST

RETAIL

Inventory, start of period

$ 60,000

$ 85,000

126,000

163,000

Net purchases during period

$ 248,000

Goods available for sale

$ 186,000

Less net sales for period

180,000

Inventory, end of period, at retail

$ 68,000


Gross profit method7

GROSS PROFIT METHOD

Step #3 Compute the cost-to-retail ratio by dividing the cost of goods available for sale by retail value of goods available for sale.

COST

RETAIL

Inventory, start of period

$ 60,000

$ 85,000

126,000

163,000

Net purchases during period

$ 248,000

Goods available for sale

$ 186,000

Less net sales for period

180,000

Inventory, end of period, at retail

$ 68,000

Ratio ($186,000 ÷ $248,000)

75%


Gross profit method8

GROSS PROFIT METHOD

Step #4 Estimate the cost of ending inventory by multiplying the ending inventory at retail by the cost-to-retail ratio.

COST

RETAIL

Inventory, start of period

$ 60,000

$ 85,000

126,000

163,000

Net purchases during period

$ 248,000

Goods available for sale

$ 186,000

Less net sales for period

180,000

Inventory, end of period, at retail

$ 68,000

Ratio ($186,000 ÷ $248,000)

75%

Inventory, end of period,

at cost ($68,000 x 75%)

$ 51,000


Gross profit method9

GROSS PROFIT METHOD

Step #5a Estimate cost of goods sold by multiplying sales at retail by the cost-to-retail ratio.

COST

RETAIL

Inventory, start of period

$ 60,000

$ 85,000

126,000

163,000

Net purchases during period

$ 248,000

Goods available for sale

$ 186,000

Less net sales for period

180,000

Inventory, end of period, at retail

$ 68,000

Ratio ($186,000 ÷ $248,000)

75%

Inventory, end of period,

at cost ($68,000 x 75%)

$ 51,000

Estimated cost of goods sold

$ 135,000


Gross profit method10

GROSS PROFIT METHOD

Step #5b Estimate cost of goods sold by subtracting the estimated ending inventory from the cost of goods available for sale.

COST

RETAIL

Inventory, start of period

$ 60,000

$ 85,000

126,000

163,000

Net purchases during period

$ 248,000

Goods available for sale

$ 186,000

Less net sales for period

180,000

Inventory, end of period, at retail

$ 68,000

Ratio ($186,000 ÷ $248,000)

75%

Inventory, end of period,

at cost ($68,000 x 75%)

$ 51,000

$ 135,000

Estimated cost of goods sold


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