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CHAPTER 6

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  1. CHAPTER 6 Accounting for Merchandising Inventory, Cost of Goods Sold, and the Gross Margin

  2. Opening Vignette - Huntington Galleries • Change in way Huntington accounts for inventory helped increase company’s net income • Significant because Huntington is a merchandisingcompany • Earns substantial portion of revenues selling products to customers • What is the relationship between inventory accounting and financial statements?

  3. Opening Vignette - Huntington Galleries • Inventory accounting decisions have “trickle-down” effect • Income statement - • Cost of goods sold • Balance sheet - • Inventory (asset) • Statement of cash flows • Cash flows from operating activities

  4. Chapter Learning Objectives 1. Account for inventory by the perpetual and periodic systems 2. Apply the inventory costing methods: specific unit cost, weighted-average cost, FIFO, and LIFO 3. Identify the income effects and the tax effects of the inventory costing methods 4. Apply the lower-of-cost-or-market rule to inventory

  5. Chapter Learning Objectives 5. Compute the effects of inventory errors on cost of goods sold and net income 6. Estimate inventory by the gross margin method 7. Use the gross margin percentage and the inventory turnover ratio to evaluate a business

  6. Chapter Objective 1 Account for inventory by the perpetual and periodic systems

  7. The Basic Concept of Inventory Accounting • Record amount and quantity of inventory on hand at end of accounting period

  8. The Basic Concept of Inventory Accounting • Record amount and quantity of inventory on hand at end of accounting period • Recognize cost of sales (an “expense”) to be matched against period sales revenues

  9. The Basic Concept of Inventory Accounting • Inventory is primary current asset for merchandising organization • Cost of goods sold (cost of sales) is organization’s primary expense • Refer to Lands’ End’s financial statements (textbook Chapter 1)

  10. COST OF GOODS SOLD $588,017,000 57 cents of every sales dollar earned goes to pay for cost of merchandise sold to customers by Lands’ End The Basic Concept of Inventory Accounting

  11. COST OF GOODS SOLD $588,017,000 57 cents of every sales dollar earned goes to pay for cost of merchandise sold to customers by Lands’ End INVENTORY $164,816,000 Comprises 74.2% of Lands’ End total current assets Comprises nearly 51% of total company assets The Basic Concept of Inventory Accounting

  12. Generally used for expensive merchandise items: trucks, jewelry, furniture Point-of-sale technology eases implementation Keeps perpetual (continuous) accounting records for every inventory item purchased and sold by company Inventory Accounting - Perpetual System

  13. Perpetual System Advantages • Allows quick determination of cost of goods sold and merchandise inventory from ledger account balances • Facilitates inventory resource management activities • Links to electronic document interchange (EDI) systems decrease inventory ordering time • Product managers perform multidimensional analyses of inventory/sales data • Managers make realtime changes to sales plans, purchasing budgets, etc.

  14. Perpetual System Advantages • Improves internal control over merchandise inventory • Physical counts should agree with amounts reported in records • Otherwise, adjust records for spoilage, theft, etc.

  15. Perpetual System Advantages • Improves internal control over merchandise inventory • Physical counts should agree with amounts reported in records • Otherwise, adjust records for spoilage, theft, etc. • Enhances customer service • Report up-to-date information to customers: quantity, expected delivery dates, etc.

  16. Entries Under the Perpetual System • Goods purchased debited to Inventory (orMerchandise Inventory) ledger account • Cash or A/P credited SITUATION: On November 14, Asian Art, Inc. purchases $43,000 of sculptures and watercolors on account for resale to customers.

  17. Entries Under the Perpetual System • How would you record this transaction? 11/14/xx Inventory $43,000 A/P $43,000 To record inventory purchased on account

  18. Entries Under the Perpetual System • How would you record this transaction? 11/14/xx Inventory $43,000 A/P $43,000 To record inventory purchased on account Inventory 11/14 $43,000

  19. Entries Under the Perpetual System • How would you record this transaction? 11/14/xx Inventory $43,000 A/P $43,000 To record inventory purchased on account Inventory Accounts Payable 11/14 $43,000 $43,000 11/14

  20. Entries Under the Perpetual System • Sales to customers captured through two journal entries • (1) record sales revenue • (2) reduce inventory and increase cost of goods sold

  21. Entries Under the Perpetual System • Sales to customers captured through two journal entries • (1) record sales revenue • (2) reduce inventory and increase cost of goods sold • How would Asian Art journalize a $7,000 sale on account on Nov. 29, assuming cost of goods sold is $2,900?

  22. Entries Under the Perpetual System 11/29/xx A/R $7,000 Sales Revenue $7,000 To record sale on account

  23. Entries Under the Perpetual System 11/29/xx A/R $7,000 Sales Revenue $7,000 To record sale on account Accounts Receivable 11/29 $7,000

  24. Entries Under the Perpetual System 11/29/xx A/R $7,000 Sales Revenue $7,000 To record sale on account Accounts Receivable Sales Revenue 11/29 $7,000 $7,000 11/29

  25. Entries Under the Perpetual System 11/29/xx Cost of Goods Sold $2,900 Inventory $2,900 To record cost of sales

  26. Entries Under the Perpetual System 11/29/xx Cost of Goods Sold $2,900 Inventory $2,900 To record cost of sales Cost of Goods Sold 11/29 $2,900

  27. Entries Under the Perpetual System 11/29/xx Cost of Goods Sold $2,900 Inventory $2,900 To record cost of sales Cost of Goods Sold Inventory 11/29 $2,900 $2,900 11/29

  28. Inventory Accounting - Periodic System • Accounting records do not continuously track on-hand inventory • At period end, physical count performed to determine proper ending inventory account balance • Inventory and cost of goods sold account balances adjusted before preparing financials INVENTORY COUNT SCHEDULE: March 31

  29. Periodic System Advantages • Fewer journal entries required during accounting period • Easy to use for small companies with rather homogenous goods • Although computerized accounting and sales systems make perpetual system just as easy to work with

  30. Entries Under the Periodic System • Goods purchased debited to Purchasesledger account • Cash or A/P credited SITUATION: On February 20, Ray’s Seafood Shack purchases $850 of shark, red snapper, and black grouper filets for the next week’s dinner specials.

  31. Entries Under the Periodic System • How would you record this transaction? 2/20/xx Purchases $850 A/P $850 To record inventory purchased on account

  32. Entries Under the Periodic System • How would you record this transaction? 2/20/xx Purchases $850 A/P $850 To record inventory purchased on account Purchases 2/20 $850

  33. Entries Under the Periodic System • How would you record this transaction? 2/20/xx Purchases $850 A/P $850 To record inventory purchased on account Purchases Accounts Payable 2/20 $850 $850 2/20

  34. Entries Under the Periodic System • Only entry necessary to capture Seafood Shack’s sales to customers is one to record sales revenues earned • REMEMBER: inventory and cost of goods sold adjusted at month-end only

  35. Entries Under the Periodic System • Textbook Exhibit 6-2 details adjusting entries used to update account balances

  36. Entries Under the Periodic System • Textbook Exhibit 6-2 details adjusting entries used to update account balances INVENTORY Beginning balance COST OF GOODS SOLD

  37. Entries Under the Periodic System • Textbook Exhibit 6-2 details adjusting entries used to update account balances INVENTORY Beginning balance COST OF GOODS SOLD Beginning bal.

  38. Entries Under the Periodic System • Textbook Exhibit 6-2 details adjusting entries used to update account balances INVENTORY Ending Beginning balance balance COST OF GOODS SOLD Beginning bal.

  39. Entries Under the Periodic System • Textbook Exhibit 6-2 details adjusting entries used to update account balances INVENTORY Ending Beginning balance balance COST OF GOODS SOLD Beginning bal. Ending bal.

  40. Entries Under the Periodic System • Textbook Exhibit 6-2 details adjusting entries used to update account balances INVENTORY PURCHASES Ending Beginning Net purchases balance balance during period COST OF GOODS SOLD Beginning bal. Ending balance

  41. Entries Under the Periodic System • Textbook Exhibit 6-2 details adjusting entries used to update account balances INVENTORY PURCHASES Ending Beginning Net purchases balance balance during period COST OF GOODS SOLD Beginning bal. Ending balance Net purchases

  42. Entries Under the Periodic System • Textbook Exhibit 6-2 details adjusting entries used to update account balances INVENTORY PURCHASES Ending Beginning Net purchases balance balance during period COST OF GOODS SOLD Beginning bal. Ending balance Net purchases Cost of goods sold

  43. Cost of Goods Sold (Cost of Sales) • Represents net purchase costs of inventory sold to customers during accounting period • Cost of goods sold = beginning inventory + net purchases - ending inventory

  44. Managers’ Use of theCost of Goods Sold Model • How do product managers and corporate buyers at Pier 1 Imports, Sears, or Williams-Sonoma decide how much inventory to buy for the upcoming year? • Want to have enough product on hand to meet customer demand • But not TOO much inventory - requiring company to discount sales prices to rid itself of excess merchandise!

  45. Managers’ Use of theCost of Goods Sold Model • Rearranging model allows managers to determine appropriate amount of inventory purchases Budgeted Cost of Goods Sold - budgeted ending inventory = cost of goods available for sale - actual beginning inventory = budgeted purchases

  46. Gross Margin (Gross Profit) • Difference between sales revenue and cost of sales

  47. Gross Margin (Gross Profit) • Difference between sales revenue and cost of sales • Revenues = $700,000

  48. Gross Margin (Gross Profit) • Difference between sales revenue and cost of sales • Revenues = $700,000 • Cost of sales = $450,000

  49. Gross Margin (Gross Profit) • Difference between sales revenue and cost of sales • Revenues = $700,000 • Cost of sales = $450,000 • Gross margin = $250,000

  50. Gross Margin (Gross Profit) • Difference between sales revenue and cost of sales • Revenues = $700,000 • Cost of sales = 450,000 • Gross margin = 250,000 • What is the significance of the gross margin?