Review of Chapter 5

Short-term Investments
Accounts receivable
Estimating bad debts Allowance method:
- Percentage of sales
- Aging or percentage of Accounts
receivable
Writing off and recovery of Accounts receivable
Direct write off method
Ratios: Current, Acid-test and Days sales in A/R

Question #1 Review of A/R

Accounts receivable has a debit balance of $2,300,
and the Allowance for Uncollectible accounts
has a credit balance of $200. An $80 account
receivable is written off. What is the amount of
net receivables after the write-off?
a.
b.
c.
d.

$2,100
$2,220
$2,020
$2,180

Inventory and
Cost of Goods Sold
Chapter 6

Inventory, Cost of Goods Sold & Gross Profit

Inventory

Cost of goods sold

Gross profit

Computing the cost of Inventory

Cost
Cost of
of inventory
inventory on
on hand
hand
== Number
Number of
of units
units on
on hand
hand unit
unit cost
cost

Cost
Cost of
of goods
goods sold
sold
== Number
Number of
of units
units sold
sold unit
unit cost
cost

Accounting for Inventory

Balance Sheet (partial)
Current assets:
Cash
$ XXX
Accounts receivable
XXX
Inventory
$22,000
Prepaid expenses
XXX

Income Statement (partial)

Sales revenue
$54,000
Cost of goods sold
44,000
Gross profit
$10,000

Learning Objective 1
Account for inventory using the
perpetual and periodic
inventory systems.

Inventory Accounting Systems

Two main types of inventory accounting systems
are:
1) Perpetual inventory system
2) Periodic inventory system

Inventory Accounting Systems

Periodic
Periodic systems
systems do
do not
not keep
keep aa
continuous
continuous record
record of
of inventory
inventory on
on hand.
hand.
Perpetual
Perpetual systems
systems maintain
maintain aa running
running record
record
to
to show
show the
the inventory
inventory on
on hand
hand at
at all
all times.
times.
Both
Both methods
methods count
count inventory
inventory once
once aa year.
year.

Inventory Accounting Systems

Perpetual Inventory

Periodic Inventory

Record inventory bought:

Dr
Inventory
Cr
Cash or Acct.Pay

Record inventory bought:

Dr
Purchases
Cr
Cash or Acct.Pay.

Record freight fee:

Dr
Inventory
Cr Accounts payable

Record freight fee:

Dr
Freight-in
Cr
Accounts payable

Returned goods:
Dr
Accounts payable
Cr Inventory

Returned goods:
Dr
Accounts payable
Cr
Purchase returns

Inventory Accounting Systems

Perpetual Inventory

Periodic Inventory

Record purchase allowance:

Dr
Accounts payable
Cr
Inventory

Record purchase allowance:

Dr
Accounts payable
Cr
Purchase allowance

To record purchase discount:

Dr
Accounts payable
Cr
Inventory

To record purchase discount:

Dr
Accounts payable
Cr
Purchase discount

To record payment:
Dr
Accounts payable
Cr
Cash

To record payment:
Dr
Accounts payable
Cr
Cash

Inventory Accounting Systems

Perpetual Inventory

Periodic Inventory

To record sales:
Dr
Cash or Accts.Rec.
Cr
Sales Revenue
Dr
Cost of goods sold
Cr
Inventory

To record sales:
Dr
Cash or Accts.Rec.
Cr
Sales Revenue

Perpetual Method: Reporting in the

Financial Statements
Net
Net Purchases
Purchases
of
of inventory
inventory

== Purchase
Purchase price
price of
of inventory
inventory
++ Freight-in
Freight-in
Purchase
Purchase returns
returns &
& allowances
allowances
Purchases
Purchases discount
discount

Net
Net sales
sales

== Sales
Sales revenue
revenue
Sales
Sales returns
returns &
& allowances
allowances
Sales
Sales discounts
discounts

Reporting in the Income Statement

Perpetual Method
Net Sales Revenue
Cost of goods sold
Gross profit

Periodic Method
Net Sales revenue
Cost of goods sold:
Beginning inventory
Net purchases
Cost of goods available for sale
Ending inventory
Cost of goods sold
Gross profit

Reporting in the Balance Sheet

Perpetual Method
Current assets:
Cash
Short-term investments
Accounts receivable
Inventory
Prepaid expenses

Periodic Method
Current assets:
Cash
Short-term investments
Accounts receivable
Inventory
Prepaid expenses

Learning Objective 2
Explain and apply three
inventory costing methods.

What Goes Into Inventory Cost?

The cost of any asset, such as inventory,
is the sum of all the costs incurred to
bring the asset to its intended use.
Generally accepted inventory costing methods:
Specific unit cost
First-in, first-out (FIFO)

Weighted-average cost

Illustrative Data

Beginning inventory (10 units @ $15)

$150
Jan.10- purchase (20 units @ $18 per unit) 360
Jan 15 - Sale of 15 units @ $20
Jan.20 purchase: 10 units @ $20 per unit 200

Specific Unit Cost

Specific Unit Cost is also called the specific
identification method
Some businesses deal in unique inventory items.
These businesses cost their inventories at the
specific cost of the particular unit

Specific Unit Cost

5 Units @ $15
Cost of Goods Sold
$ 75
180
$255
Ending inventory$455

10 Units @ $18

Illustration of Weighted Average

and FIFO Costing
The big accounting questions are:
1. What is the cost of goods sold for the income
statement?
2. What is the cost of ending inventory for the
balance sheet?

Weighted-Average Periodic

Cost of goods sold =

Ending inventory =

Weighted-average Perpetual

Cost of goods sold =

Ending inventory =
6 - 23

First-In, First-Out
Periodic and Perpetual
Cost of Goods Sold
$150
90
$240

First-In, First-Out
Periodic and Perpetual

Jan. 10 purchase:
Jan. 20 purchase:
Ending inventory

Income Effects of
Inventory Methods
Ending Inventory
Specific unit
$455.00
Weighted-average $443.75
FIFO
$470.00

Cost of Goods Sold

Specific unit
$255.00
Weighted-average $266.25
FIFO
$240.00

Income Effects of
Inventory Methods
Assumed
Sales
Revenue

Specific unit cost

Weighted-average
FIFO

$500
$500
$500

Cost of
Goods
Sold

255.00
266.25
240.00

Gross
Profit

=$245.00
=$233.75
=$260.00

When inventory costs are

INCREASING
Weighted average cost of goods sold is highest because it is
based on the average of the costs for the period
Gross profit is the lowest
FIFO cost of goods sold is lowest because it is
based on the oldest costs.
Gross profit is the highest

Question #2
The periodic inventory system is used:
Units
Unit Cost
Beginning inventory
8,000
$11
Purchase, June 19
13,000
$12
Purchase, Nov 8
5,000
$13
What is the cost of ending inventory using FIFO if 9,000
units are left over.
a. $100,000
d. $209,000

b. $113,000

c. $196,000

Learning Objective 3

Explain how accounting

standards
apply to inventory

Accounting Standards and

Inventory
Comparability (including consistency)
states that businesses should use the same
accounting methods and procedures from
period to period
Disclosure
holds that a companys financial statements
should report enough information for outsiders
to make informed decisions about a company

Accounting Standards and

Inventory
Lower-of-Cost-and-Net Realizable Value
(LCNRV)
requires that inventory be reported in the
financial statements at whichever is lower
inventorys cost or its net realizable value

Learning Objective 4
Analyze and evaluate
gross profit and
inventory turnover

Analyzing Financial Statements

Investors, creditors and managers use two key
decision aids for inventory:
1) Gross profit percentage
2) Inventory turnover

Analyzing Financial Statements

Gross profit percentage =

Gross profit
Net sales revenue

It measures the ability of a company to sell

inventory at a profit

Analyzing Financial Statements

Inventory Turnover = Cost of goods sold
Average inventory
Days Sales in Inventory = 365 days
Inv. Turnover
It indicates how rapidly inventory is sold

Learning Objective 5

Use the cost-of-goods-sold

(COGS) model to make
management decisions.

Estimating Inventory
Estimating ending inventory by the gross profit
method is based on the cost-of-goods sold
model:
Beginning inventory
+ Net Purchases
= Goods available for sale
- Ending inventory
= Cost of goods sold

Estimating Inventory
Rearranging ending inventory and cost of goods
sold makes the model useful for estimating
ending inventory:
Beginning inventory
+ Net purchases
= Goods available for sale
- Cost of goods sold
= Ending inventory

Learning Objective 6
Analyze how inventory errors
affect the financial
statements.

Effects of Inventory Errors

An error in the ending inventory
creates errors for cost of goods
sold and gross profit.
The current years ending inventory
is next years beginning inventory.

Effects of Inventory Errors

Period 1
Ending
Inventory
Overstated
by $5,000

Period 2
Beginning
Inventory
Overstated
by $5,000

Period 3
Correct

Sales revenue
$100,000
$100,000
$100,000
Cost of goods sold:
Beg. inventory
$10,000
$15,000
$10,000
Purchases
50,000
50,000
50,000
Cost of goods
available for sale $60,000
$65,000
$60,000
Ending inventory (15,000)
(10,000)
(10,000)
Cost of goods sold
45,000
55,000
50,000
Gross profit
$ 55,000
$ 45,000
$ 50,000

Effects of Inventory Errors

Ending Inventory: COGS
Net income/GP
Overstated
Understated
Overstated
Understated
Overstated
Understated
Beg. inventory:
Overstated
Understated

COGS
Overstated
Understated

Net income/GP
Understated
Overstated

Question #3
An overstatement of ending inventory in one period
results in:
a. No effect on net income of the next period
b. An overstatement of net income of the next
period
c. An understatement of net income of the next
period
d. An understatement of the beginning inventory of
the next period

Ethical Considerations
Managers of companies whose profits
do not meet shareholder expectations
are sometimes tempted to cook the
books to increase reported income.

1. Overstating ending inventory

2. Creating fictitious sales revenue

Reporting Inventory Transactions

on the Cash Flow Statement
Inventory transactions are operating activities
because the purchase and sale of merchandise
drives a companys operations.
The purchase of inventory requires a cash
payment, and the sale a cash receipt.

Question #4
ABC Ltd had a $24,000 beginning inventory and a
$26,000 ending inventory. Net sales were
$160,000; purchases, $86,000; purchase returns
and allowances, $5,000; and freight-in, $6,000.
Cost of goods sold for the period is:
a) $69,000
b) $49,000
c) $81,000
d) $85,000

End of Chapter 6