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Merchandise Inventory, Cost of Goods Sold, and Gross Profit Chapter 6 Income Statements Service Company Century 21 Real Estate Income Statement Year Ended December 31, 20xx Merchandising Company General Motors Corporation Income Statement Year Ended December 31, 20xx

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income statements
Income Statements

Service Company

Century 21 Real Estate

Income Statement

Year Ended December 31, 20xx

Merchandising Company

General Motors Corporation

Income Statement

Year Ended December 31, 20xx

Service revenue $XXX

Expenses

Salary expense X

Depreciation expense X

Income tax expense X

Net income $ X

Sales revenue $185

Cost of goods sold 146

Gross profit 39

Operating expenses:

Salary expense X

Depreciation expense X

Income tax expense $ X

Net income $ 4

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

balance sheets
Balance Sheets

Service Company

Century 21 Real Estate

Balance Sheet

Year Ended December 31, 20xx

Merchandising Company

General Motors Corporation

Balance Sheet

Year Ended December 31, 20xx

Current assets:

Cash $X

Short-term investments X

Accounts receivable, net X

Prepaid expenses X

Current assets:

Cash $ X

Short-term investments X

Accounts receivable, net X

Inventory 11

Prepaid expenses X

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

gross profit gross margin
Gross Profit (Gross Margin)

Sales Revenue

- Gross Profit

- Operating Expenses

Net Income

learning objective 1
Learning Objective 1

Account for inventory transactions.

inventory accounting systems
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
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

recording transactions and the t accounts

Inventory

Accounts Payable

Beg. 100,000

560,000

560,000

Recording Transactionsand the T-Accounts

Inventory 560,000

Accounts Payable 560,000

Purchased inventory on account

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

recording transactions and the t accounts9
Recording Transactionsand 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

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

recording transactions and the t accounts10

Cost of Goods Sold

540,000

Recording Transactionsand the T-Accounts

Inventory

Beg. 100,000

560,000

120,000

540,000

reporting in the financial statements
Reporting in theFinancial Statements

Income Statement (partial)

Sales revenue $900,000

Cost of goodssold 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

reporting in the financial statements12
Reporting in theFinancial Statements

Net purchases

Purchases

+ Freight-in

– Purchase returns & allowances

– Purchases discount

Net sales

Sales revenue

– Sales returns & allowances

– Sales discounts

learning objective 2
Learning Objective 2

Analyze the various inventory methods.

what goes into inventory cost
What Goes Into Inventory Cost?
  • Sum of all costs incurred to bring asset to its intended use
  • Inventory costing methods:
    • Specific unit cost
    • Weighted-average cost
    • First-in, first-out (FIFO)
    • Last-in, first-out (LIFO)
illustrative data
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

25 Units @ $14

10 Units @ $18

Specific Unit Cost

Cost of Goods Sold

$ 50

350

180

$580

$900 – $580 = $320

weighted average
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
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 out19
First-In, First-Out

10 Units @ $10

Cost of Goods Sold

$100

350

90

$540

25 Units @ $14

5 Units @ $18

last in first out
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 out21
Last-In, First-Out

Cost of Goods Sold

$450

210

$660

25 Units @ $18

15 Units @ $14

income effects of inventory methods
Income Effects ofInventory Methods

Assumed

Sales

Revenue

Cost of

Goods

Sold

Gross

Profit

Specific unit cost $1,000 – 580 = $420

Weighted-average $1,000 – 600 = $400

FIFO $1,000 – 540 = $460

LIFO $1,000 – 660 = $340

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

learning objective 3
Learning Objective 3

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

the tax advantage of lifo

FIFO LIFO

Gross profit $460 $340

Operating expenses 260 260

Income before taxes $200 $ 80

Income tax expense (40%) $ 80 $ 32

The Tax Advantage of LIFO

The most attractive feature of LIFO is low

income tax payments when prices are

increasing.

comparison of inventory methods
Comparison of Inventory Methods
  • FIFO produces inventory profits during periods of inflation
  • LIFO allows managers to manipulate net income
  • LIFO liquidation
consistency principle
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
Disclosure Principle
  • Financial statements should report enough information to enable an outsider to make knowledgeable decisions about the company.
conservatism
Conservatism
  • The least favorable figures are presented in the financial statements.
lower of cost or market rule
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
learning objective 4
Learning Objective 4

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

using the financial statements for decision making
Using the Financial Statementsfor Decision Making

Gross profit percentage

= Gross profit

÷ Net sales revenue

Inventory turnover

= Cost of goods sold

÷ Average inventory

learning objective 5
Learning Objective 5

Estimate inventory by the gross profit method.

estimating inventory

Beginning inventory

+ Purchases

= Cost of goods available for sale

– Ending inventory

= Cost of goods sold

Estimating Inventory

Gross profitmethod - based on computation of cost-of-goods-sold

- Cost of goods sold

= Ending inventory

objective 6
Objective 6

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

effects of inventory errors
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
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
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