Merchandise Inventory,
Cost of Goods Sold, and
Gross Profit
Chapter 6
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Income Statements
Service Company
Century 21 Real Estate
Income Statement
Year Ended December 31, 20xx
Service revenue
Expenses
Salary expense
Depreciation expense
Income tax expense
Net income
$XXX
$
X
X
X
X
Merchandising Company
General Motors Corporation
Income Statement
Year Ended December 31, 20xx
Sales revenue
Cost of goods sold
Gross profit
Operating expenses:
Salary expense
Depreciation expense
Income tax expense
Net income
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$185
146
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X
X
$ X
$ 4
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, netX
Inventory
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Prepaid expenses
X
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Gross Profit (Gross Margin)
Sales Revenue
- Cost of Goods Sold
= Gross Profit
- Operating Expenses
= Net Income
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Learning Objective 1
Account for inventory
transactions.
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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.
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Recording Transactions
in the Perpetual System
Purchase price of the inventory
+ Freight-in
– Purchase returns
– Purchase allowances
– Purchase discounts
= Net purchases of inventory
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$600,000
4,000
– 25,000
– 5,000
– 14,000
$560,000
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Recording Transactions
and the T-Accounts
Date
General Journal
Accounts and Explanations
PR
Inventory
Debit
560,000
Accounts Payable
560,000
Purchased inventory on account
Inventory
Beg. 100,000
560,000
Credit
Accounts Payable
560,000
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Recording Transactions
and the T-Accounts
Sale on account $900,000 (cost
$540,000):
Date
General Journal
Accounts and Explanations
PR
Accounts Receivable
Debit
900,000
Sales Revenue
Cost of Goods Sold
Inventory
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Credit
900,000
540,000
540,000
Recording Transactions
and the T-Accounts
Inventory
Beg. 100,000 540,000
560,000
120,000
Cost of Goods Sold
540,000
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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
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Reporting in the
Financial Statements
Net purchases
Purchases
+ Freight-in
– Purchase returns & allowances
– Purchases discount
Net sales
Sales revenue
– Sales returns & allowances
– Sales discounts
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Learning Objective 2
Analyze the various inventory
methods.
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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)
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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:
Cost of goods sold:
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20 units
40 units
15
Specific Unit Cost
5 Units @ $10
Cost of Goods Sold
$ 50
350
180
$580
25 Units @ $14
10 Units @ $18
$900 – $580 = $320
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Weighted-Average
$900 total cost ÷ 60 units = $15/unit
Ending inventory = 20 × $15 = $300
Cost of goods sold = 40 × $15 = $600
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First-In, First-Out
Ending Inventory Cost:
Less units sold
Ending inventory
60 units
40
20 units
20 units × $18 per unit = $360
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First-In, First-Out
10 Units @ $10
Cost of Goods Sold
$100
350
90
$540
25 Units @ $14
5 Units @ $18
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Last-In, First-Out
Ending Inventory Cost:
Less units sold
Ending inventory
60 units
40
20 units
10 units × 10 =$100
10 units × 14 = 140
Total
$240
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Last-In, First-Out
Cost of Goods Sold
$450
210
$660
25 Units @ $18
15 Units @ $14
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Income Effects of
Inventory Methods
Assumed
Sales
Revenue
Specific unit cost
Weighted-average
FIFO
LIFO
$1,000
$1,000
$1,000
$1,000
Cost of
Goods
Sold
–
–
–
–
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580
600
540
660
Gross
Profit
=
=
=
=
$420
$400
$460
$340
Learning Objective 3
Identify the income and the tax
effects of the inventory
methods.
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The Tax Advantage of LIFO
FIFO
Gross profit
$460
Operating expenses
260
Income before taxes
$200
Income tax expense (40%) $ 80
LIFO
$340
260
$ 80
$ 32
The most attractive feature of LIFO is low
income tax payments when prices are
increasing.
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Use of the Various
Inventory Methods
LIFO
31%
Average
20%
FIFO
46%
Other
3%
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Comparison of Inventory
Methods
FIFO produces inventory profits
during periods of inflation
LIFO allows managers to
manipulate net income
LIFO liquidation
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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
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Disclosure Principle
Financial statements should
report enough information to
enable an outsider to make
knowledgeable decisions about
the company.
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Conservatism
The least favorable figures are
presented in the financial
statements.
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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
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Learning Objective 4
Use the gross profit percentage
and inventory turnover to
evaluate business.
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Using the Financial Statements
for Decision Making
Gross profit percentage
= Gross profit
÷ Net sales revenue
Inventory turnover
= Cost of goods sold
÷ Average inventory
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Learning Objective 5
Estimate inventory by the gross
profit method.
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Estimating Inventory
Gross profit method - based on
computation of cost-of-goodssold Beginning inventory
+
=
–=
Purchases
Cost of goods available for sale
Cost of inventory
goods sold
Ending
Cost
of goods
sold
Ending
inventory
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Objective 6
Show how inventory errors affect
cost of goods sold and income.
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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.
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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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End of Chapter 6
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