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13 Accounting for Merchandise Inventory

Learning Objective

Explain the impact of merchandise inventory on the financial statements.

Errors in inventory will cause errors on the: Income statement Statement of owner’s equity Balance sheet

Since this year’s ending inventory becomes next year’s beginning inventory, financial statements for the following year will also contain errors

Inventory Errors

Effect Of Inventory Errors

INCOME STATEMENT 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

Let’s first look at the income statement with the ending inventory correctly stated at $20.

Beginning merch. inventory 20 Add purchases (net) 40 Cost of goods available for sale 60

Less ending merch. inventory (20) Cost of goods sold (40)

Gross profit 40 Operating expenses (10) Net income 30 Now let’s look at

the other financial statements.

STMT. OF OWNER’S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 Net income Erv Bultman, capital, December 31

30 130

Current assets: Merchandise inventory

Owner’s equity: 20

Erv Bultman, capital

BALANCE SHEET (Partial)

Gross profit 40 Operating expenses (10) Net income 30

20-1’s ending inventory becomes 20-2’s beginning

inventory.

20 40 60

(20) (40) 40

(10) 30

130 30

130 160

What would be the effect on the financial statements for 20-1 and 20-2 if the ending inventory was reported as $15 instead of $20?

Cost of goods available for sale 60 Less ending merch. inventory (15)

Cost of goods sold (45) Gross profit 35 Operating expenses (10) Net income 25

Understated ending inventory

results in understated net

income.

25 125

BALANCE SHEET (Partial) Current assets:

Merchandise inventory Owner’s equity:

Erv Bultman, capital Understated net income results in understated

owner’s equity.

25 125

125 Current assets and owner’s equity will

be understated.

Cost of goods available for sale 60 Less ending merch. inventory (15)

15 40 55 20

(35) 45

(10) 35

Understated beginning inventory results in

overstated net income.

125 35

125 160

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

125 35

125 160

160 Current assets and

owner’s equity will be correct by the end of 20-2.

What would be the effect on the financial statements for 20-1 and 20-2 if the ending inventory was reported as $25 instead of $20?

Beginning merch. inventory 20 Add Purchases (net) 40 Cost of goods available for sale

60 Less ending merch. inventory (25)

Overstated ending inventory results in

overstated net income.

35 135

BALANCE SHEET (Partial) Current assets:

Merchandise inventory Owner’s equity:

Erv Bultman, capital Overstated net income results in overstated

owner’s equity.

STMT. OF OWNER’S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 Net income 35

owner’s equity will be overstated.

Erv Bultman, capital, December 31

25 40 65 20

(45) 35

(10) 25

Overstated beginning inventory results in

understated net income.

135 25

135 160

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

135 25

135 160

owner’s equity will be correct by the end of

Your Perspective - Sales Associate

Learning Objective

Describe the two principal systems of accounting for merchandise inventory—the periodic system and the perpetual system.

PERIODIC INVENTORY SYSTEM Merchandise inventory account balance = most recent physical inventory Purchases account used for all merchandise purchases Current inventory and cost of goods sold are only computed at the end of the period

Types Of Inventory Systems

PERPETUAL INVENTORY SYSTEM Merchandise inventory account reflects current inventory Purchases are debited to Merchandise Inventory and cost of goods sold are credited to Merchandise Inventory Generally, there is no need for end-of-year adjustments

Types Of Inventory Systems (cont.)

EXAMPLE: Purchased merchandise on account, $100.

Comparing Entries For Periodic And Perpetual Inventory Systems

DATE DESCRIPTION PR DEBIT CREDIT Purchases 1

2 3 4 5 6 7 8 9

Accounts Payable 100 00

Periodic System

The periodic system uses a purchases

account.

100 00

DATE DESCRIPTION PR DEBIT CREDIT Merchandise Inventory 1

2 3 4 5 6 7 8 9

Accounts Payable

Perpetual System

The perpetual system records purchases directly in the merchandise inventory account.

100 00 100 00

EXAMPLE: Paid freight charge, $30.

DATE DESCRIPTION PR DEBIT CREDIT Freight-In 1

2 3 4 5 6 7 8 9

30 00 Cash 30 00

The periodic system separates freight charges into their own

account.

Periodic System

DATE DESCRIPTION PR DEBIT CREDIT Merchandise Inventory 1

2 3 4 5 6 7 8 9

30 00 Cash 30 00

The perpetual system considers freight charges part of the cost of merchandise

and includes them in the inventory account.

Perpetual System

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

DATE DESCRIPTION PR DEBIT CREDIT Accounts Receivable 1

2 3 4 5 6 7 8 9

80 00 Sales 80 00

The periodic system only records the selling price of merchandise sold. No attempt is made to reduce the inventory account for items sold.

Periodic System

2 3 4 5 6 7 8 9

80 00 Sales 80 00

The perpetual system also records the selling price of merchandise

Perpetual System

2 3 4 5 6 7 8 9

80 00 Sales 80 00

In addition, the perpetual system removes the cost of merchandise sold from

inventory.

Perpetual System

Cost of Goods Sold Merchandise Inventory

50 00 50 00

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

DATE DESCRIPTION PR DEBIT CREDIT Accounts Payable 1

2 3 4 5 6 7 8 9

10 00 Purchases Ret. and Allow. 10 00

The periodic system maintains a separate account for returns.

Periodic System

2 3 4 5 6 7 8 9

10 00 Merchandise Inventory 10 00

Since the merchandise was recorded in the inventory account when purchased, it

is removed from the account when returned.

Perpetual System

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

DATE DESCRIPTION PR DEBIT CREDIT Sales Returns and Allowances 1

2 3 4 5 6 7 8 9

20 00 Accounts Receivable 20 00

The periodic system maintains a separate account for returns.

Periodic System

2 3 4 5 6 7 8 9

The perpetual system records the returned sale.

Perpetual System

2 3 4 5 6 7 8 9

Perpetual System

Merchandise Inventory 15 00 15 00 Cost of Goods Sold

It also must adjust the cost of goods sold and merchandise inventory

accounts.

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

2 3 4 5 6 7 8 9

Purchases Discounts 2 00

Discounts are recorded in a

separate account.

Periodic System

Cash 98 00

100 00

2 3 4 5 6 7 8 9

Merchandise Inventory

100 00

The perpetual system does not record discounts in a separate account. It

reduces Merchandise Inventory directly for the discount amount.

Perpetual System

Cash 2 00

Entries for Periodic and Perpetual Inventory Systems

Learning Objective

Compute the costs allocated to the ending inventory and cost of goods sold using different inventory methods.

A Broader View

Use of Inventory Methods

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 what is reported in the accounting records

Taking A Physical Inventory

Done after regular business hours The ideal time to count the goods is when the quantity on hand is at its lowest levels

A fiscal year that starts and ends when inventory is at its lowest level is known as natural business year

Taking A Physical Inventory (cont.)

Two special situations: Goods held for sale on CONSIGNMENT

Goods held on consignment remain the property of the shipper (consignor)

Goods IN TRANSIT If goods are shipped FOB shipping point, the BUYER pays for shipping and goods belong to the buyer as soon as they are shipped If goods are shipped FOB destination, the seller pays for shipping and the goods belong to the seller until they are received by the buyer

Taking A Physical Inventory (cont.)

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

Computing The Cost Of Ending Inventory

Number of bikes on hand

× Cost per unit

= Ending inventory

50 $60 × = $3,000

Computing ending inventory is simple if all purchases were made at the same price.

• 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:

1st purchase 60 2nd purchase 80 3rd purchase 70

No. of units available for sale 250 On hand at end of period 50 No. of units sold during period 200

65 67 68

3,900 5,360 4,760

$16,500 Cost of these

200 sold?

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

65 67 68

3,900 5,360 4,760

$16,500 Depends on

the inventory method used.

Method #1 – Specific Identification Method Used when each unit of inventory can be specifically identified

Examples: cars, motorcycles, furniture, appliances, and fine jewelry

Practical only for businesses in which sales volume is relatively low and inventory unit value is relatively high

Inventory Methods

Let’s apply this method to the bicycle example.

Computing The Cost Of Goods Sold • Inventory was maintained using the specific

identification method. The identity of the 200 bicycles sold is as follows: Units Unit Price Total Cost

On hand at start of period 40 $62 $ 2,480 Purchased during period:

65 67 68

3,900 5,360 4,760

$16,500 30 of the beginning inventory were sold

Computing The Cost Of Goods Sold

• Inventory was maintained using the specific identification method. The identity of the 200 bicycles sold is as follows: Units Unit Price Total Cost

On hand at start of period 40 $62 $ 2,480 Purchased during period:

65 67 68

3,900 5,360 4,760

$16,500 50 from the 1st purchase

were sold

65 67 68

3,900 5,360 4,760

$16,500 60 from the 2nd purchase

were sold

Inventory was maintained using the specific identification method. The identity of the 200 bicycles sold is as follows:

65 67 68

3,900 5,360 4,760

$16,500 60 from the 3rd purchase

were sold

Inventory was maintained using the specific identification method. The identity of the 200 bicycles sold is as follows:

Units Unit Price Total Beginning inventory 30 $62 $ 1,860 1st purchase 50 2nd purchase 60 3rd purchase 60 Total 200

65 67 68

3,250 4,020 4,080

$13,210

Cost of goods (the 200 bicycles) sold

Units Unit Price Total Beginning inventory 10 $62 $ 620 1st purchase 10 2nd purchase 20 3rd purchase 10 Total 50

65 67 68

650 1,340

680 $3,290

This ending inventory will be reported on the income statement and the balance sheet.

Computing The Ending Inventory

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

Assumes that the first goods purchased were the first goods sold

Therefore, the latest goods purchased remain in inventory

Follows the natural flow of goods Especially true of grocery stores, fresh fruit stands, and computer software businesses

Inventory Methods

65 67 68

3,900 5,360 4,760

$16,500

All of these were

assumed sold

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

65 67 68

3,900 5,360 4,760

$16,500

All of these were

assumed sold

65 67 68

3,900 5,360 4,760

$16,500

All of these were

assumed sold

65 67 68

3,900 5,360 4,760

$16,500

40 60 80

180 considered sold so far

65 67 68

3,900 5,360 4,760

$16,500

20 of these were

assumed sold

Units Unit Price Total Beginning inventory 40 $62 $2,480 1st purchase 60 2nd purchase 80 3rd purchase 20

3,900 5,360

The remaining units from the 3rd purchase are the 50 units

in ending inventory.

68 1,360

Units Unit Price Total Beginning inventory 40 $62 $ 2,480 1st purchase 60 2nd purchase 80 3rd purchase 20 Total 200

65 67 68

3,900 5,360 1,360

$13,100

Cost of goods (the 200 bicycles) sold

Units Unit Price Total Beginning inventory 0 $62 $ 0 1st purchase 0 2nd purchase 0 3rd purchase 50 Total 50

65 67 68

3,400 $3,400

This ending inventory will be reported on the income statement and the

balance sheet.

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

Inventory Methods

Inventory was maintained using the weighted-average method.

65 67 68

3,900 5,360 4,760

$16,500 $16,500

250 = $66/unit

Computing The Average Cost Per Unit

Weighted-Average Method

Cost of goods sold 200 units @ $66 = $13,200

Ending inventory 50 units @ $66 = 3,300

One of the advantages of the weighted-average

method is its simplicity.

Method #4 – Last-In, First-Out (LIFO) Method

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

Therefore, the earliest goods purchased remain in inventory

The use of this method is justified because: The actual physical flow of goods in some businesses is actually last-in, first-out It matches the most current costs of items purchased against the current sales revenue

Inventory Methods

65 67 68

3,900 5,360 4,760

$16,500

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

All of these were assumed

65 67 68

3,900 5,360 4,760

$16,500

All of these were assumed

65 67 68

3,900 5,360 4,760

$16,500

150 considered sold so far

65 67 68

3,900 5,360 4,760

$16,500

50 of these were assumed

Units Unit Price Total Beginning inventory 0 $62 $ 0 1st purchase 50 2nd purchase 80 3rd purchase 70

3,250 5,360

68 4,760 200 $13,370

Units Unit Price Total Beginning inventory 40 $62 $2,480 1st purchase 10 2nd purchase 0 3rd purchase 0 Total 50

65 67 68

$3,130

This ending inventory will be reported on the income statement

and the balance sheet.

The assumed cost flows (FIFO, weighted-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

Physical Flows And Cost Flows

Sales Cost of goods sold:

Beg. inventory Purchases Goods avail. for sale

$18,000

$ 2,480 14,020

$16,500

Specific Identification FIFO

$18,000

14,020 $16,500

$ 2,480

Goods available for sale is the same for all four

methods!

Comparison of Inventory Methods

$18,000

$ 2,480 14,020

$16,500

FIFO $18,000

14,020 $16,500

$ 2,480

Weighted-Average LIFO $18,000

$ 2,480 14,020

$16,500

Sales Cost of goods sold:

Beg. inventory Purchases Goods avail. for sale

$18,000

$ 2,480 14,020

$16,500

$18,000

14,020 $16,500

$ 2,480

Less ending inventory

3,290 3,400

Cost of goods sold 13,210 13,100

Ending inventory and cost of goods sold differ with each

method.

$18,000

$ 2,480 14,020

$16,500

FIFO $18,000

14,020 $16,500

$ 2,480

3,300 3,130 13,200 13,370

$ 2,480 14,020

$16,500 3,400

13,100

Sales Cost of goods sold: Beg. inventory Purchases Goods avail. for sale

$18,000

$ 2,480 14,020

$16,500

$18,000

14,020 $16,500

$ 2,480

Less ending inventory

3,290 3,400

Cost of goods sold 13,210 13,100

Gross profit $ 4,790 $ 4,900

$18,000

$ 2,480 14,020

$16,500

FIFO $18,000

14,020 $16,500

$ 2,480

3,300 3,130 13,200 13,370

$ 4,800 $ 4,630

$ 2,480 14,020

$16,500 3,400

13,100 $ 4,900

When prices are rising (as with the bicycles), FIFO results in the largest

gross profit.

$18,000

$ 2,480 14,020

$16,500

FIFO $18,000

14,020 $16,500

$ 2,480

3,300 3,130 13,200 13,370

$ 4,800 $ 4,630

$ 2,480 14,020

$16,500 3,400

13,100 $ 4,900

LIFO results in the smallest gross profit, therefore creating the

smallest tax liability.

Merchandise Inventory is a controlling account

A subsidiary ledger is maintained with an account for each type of merchandise

Goods sold are usually assigned cost on either a FIFO, moving-average, or LIFO basis

The Perpetual Inventory System

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

Cost of Goods Sold

Units Cost/ Unit CGS

Jan. 1 (BI)

Cumulative CGS Units Unit

Cost/ Purchases

There were 40 bicycles in inventory at the beginning of

the year.

Perpetual Inventory Record: FIFO Method

Units Cost/ Unit

Cost of Goods Sold

Inventory on Hand

Layer Units Unit Cost/ Layer

(1) 40 $62 $2,480

CGS Cumulative

Each of the 40 units were purchased at

$2,480

Date Purchases

Units Cost/ Unit Total

Cost of Goods Sold

Jan. 1 (BI)

Cumulative CGS

Feb. 15 30

The 30 bicycles sold came from the $62 bicycles in beginning

inventory.

Date Purchases

Cost of Goods Sold

Units CGS Jan. 1 (BI)

Cumulative CGS

Feb. 15 30 $62 $1,860 $ 1,860

Unit Cost/

Units Cost/ Unit

Cost of Goods Sold

Inventory on Hand

(1) 40 $62 $2,480

CGS Cumulative

$2,480

30 $62 $1,860 $ 1,860 (1) 10 $62 $ 620 $ 620

Date Purchases

Cost of Goods Sold

Jan. 1 (BI)

Cumulative CGS

Feb. 15 30 $62 $1,860 $ 1,860 Mar. 1

60 $65 $3,900

Units Cost/ Unit

Cost of Goods Sold

Inventory on Hand

(1) 40 $62 $2,480

CGS Cumulative

$2,480

30 $62 $1,860 $ 1,860 (1) 10 $62 $ 620 $ 620 (1) 10 $62 $ 620 (2) 60 65 3,900 $4,520

Now there are two layers in inventory…10 bicycles from the beginning inventory and the

60 bicycles just purchased.

Date Purchases

Cost of Goods Sold

Jan. 1 (BI)

Cumulative CGS

Feb. 15 30 $62 $1,860 $ 1,860 Mar. 1

60 $65 $3,900 April 1

On April 1, 40 units were sold.

Units Cost/ Unit

Cost of Goods Sold

Inventory on Hand

(1) 40 $62 $2,480

CGS Cumulative

$2,480

30 $62 $1,860 $ 1,860 (1) 10 $62 $ 620 $ 620 (1) 10 $62 $ 620 (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.

Date Purchases

Cost of Goods Sold

Jan. 1 (BI)

Cumulative CGS

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

Units Cost/ Unit

Cost of Goods Sold

Inventory on Hand

(1) 40 $62 $2,480

CGS Cumulative

$2,480

30 $62 $1,860 $ 1,860 (1) 10 $62 $ 620 $ 620 (1) 10 $62 $ 620 (2) 60 65 3,900 $4,520

10 $62 $ 620 30 65 1,950 $ 4,430

(2) 30 $65 $1,950 $1,950

Date Purchases

Cost of Goods Sold

Jan. 1 (BI)

Cumulative CGS

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 May 15

80 $67 $5,360

Units Cost/ Unit

Cost of Goods Sold

Inventory on Hand

(1) 40 $62 $2,480

CGS Cumulative

$2,480

30 $62 $1,860 $ 1,860 (1) 10 $62 $ 620 $ 620 (1) 10 $62 $ 620 (2) 60 65 3,900 $4,520

10 $62 $ 620 30 65 1,950 $ 4,430

(2) 30 $65 $1,950 $1,950

(2) 30 $65 $1,950 (3) 80 67 $5,360 $7,310

Date Purchases

Cost of Goods Sold

May 15

Cumulative CGS

80 $67 $5,360 June 30

On June 30, 90 units were sold.

Units Cost/ Unit

Cost of Goods Sold

Inventory on Hand

Cost CGS Cumulative

Total (2) 30 $65 $1,950 (3) 80 67 5,360 $7,310

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

Date Purchases

Cost of Goods Sold

May 15

Cumulative CGS

80 $67 $5,360 June 30 30 $65 $1,950

60 67 4,020 $10,400

Units Cost/ Unit

Cost of Goods Sold

Inventory on Hand

Cost CGS Cumulative

Total (2) 30 $65 $1,950

80 67 5,360 $7,310 30 $65 $1,950

60 67 4,020 $10,400

(3) (3) 20 $67 $1,340

$1,340

Date Purchases

Cost of Goods Sold

May 15

Cumulative CGS

80 $67 $5,360 June 30 30 $65 $1,950

60 67 4,020 $10,400 Aug. 28

70 $68 $4,760

Units Cost/ Unit

Cost of Goods Sold

Inventory on Hand

Cost CGS Cumulative

Total (2) 30 $65 $1,950

80 67 5,360 $7,310 30 $65 $1,950

60 67 4,020 $10,400

(3) (3) 20 $67 $1,340

$1,340 (3) 20 $67 $1,340 (4) 70 68 4,760 $6,100

Date Purchases

Cost of Goods Sold

May 15

Cumulative CGS

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.

Units Cost/ Unit

Cost of Goods Sold

Inventory on Hand

Cost CGS Cumulative

Total (2) 30 $65 $1,950

80 67 5,360 $7,310 30 $65 $1,950

60 67 4,020 $10,400

(3) (3) 20 $67 $1,340

$1,340 (3) 20 $67 $1,340 (4) 70 68 4,760 $6,100

40 units sold =

20 (layer 3) + 20 (layer 4)

Date Purchases

Cost of Goods Sold

May 15

Cumulative CGS

80 $67 $5,360 June 30 30 $65 $1,950

60 67 4,020 $10,400 Aug. 28

70 $68 $4,760 Oct. 30 20 $67 $1,340

20 68 1,360 $13,100

Units Cost/ Unit

Cost of Goods Sold

Inventory on Hand

Cost CGS Cumulative

Total (2) 30 $65 $1,950

80 67 5,360 $7,310 30 $65 $1,950

60 67 4,020 $10,400

(3) (3) 20 $67 $1,340

$1,340 (3) 20 $67 $1,340 (4) 70 68 4,760 $6,100

20 $67 $1,340 20 68 1,360 $13,100

(4) 50 $68 $3,400

$3,400

Cost of goods sold for the year

Units Cost/ Unit

Cost of Goods Sold

Inventory on Hand

Cost CGS Cumulative

Total (2) 30 $65 $1,950

80 67 5,360 $7,310 30 $65 $1,950

60 67 4,020 $10,400

(3) (3) 20 $67 $1,340

$1,340 (3) 20 $67 $1,340 (4) 70 68 4,760 $6,100

20 $67 $1,340 20 68 1,360 $13,100

(4) 50 $68 $3,400

$3,400 Ending inventory

An asset that increases in value while being held…

No formal entry of the gain is made on the books until asset is sold

An asset that decreases in value while being held…

An entry is made to recognize the loss

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

Conservatism Principle

Conservatism means that if the value of inventory declines while it is being held, the loss should be recognized in the period of the decline The purpose of the lower-of-cost-or-market method is to recognize such losses on the income statement and to report the lower inventory valuation on the balance sheet

Lower-of-cost-or-market Method

“Cost” The dollar amount calculated using one of the four inventory costing methods

“Market” The cost to replace the inventory

Lower-of-cost-or-market Method (cont.)

Item Recorded

Purchase Cost End-of-Period Market Value

This company sells three products.

Lower-of-Cost-or-Market

Item Recorded

1 $ 8,000

The inventory of product #1

cost $8,000.

Item Recorded

1 $ 7,000

3 But the price has fallen;

it now could be replaced

for $7,000.

$ 8,000

Item Recorded

1 $ 7,000

“Market” is the lowest.

Lower-of-Cost-or-Market $ 7,000 $ 8,000

Item Recorded

1 $ 7,000

Lower-of-Cost-or-Market $ 7,000

2 9,000 10,000 9,000

3 7,000 6,500 6,500 $24,000 $23,500 $22,500

There are two ways to calculate

the lower-of-cost-or-market.

$ 8,000

Item Recorded

1 $ 8,000 $ 7,000

2 9,000 10,000 9,000

3 7,000 6,500 6,500 $24,000 $23,500 $22,500

#1 – Applied to Total Inventory

The lower of all items at their

cost or all items at their market value

Item Recorded

1 $ 8,000 $ 7,000

2 9,000 10,000 9,000

3 7,000 6,500 6,500 $24,000 $23,500 $22,500

#2 – Applied to Each Item Each item is evaluated;

the lowest amount is selected for each item

Item Recorded

1 $ 8,000 $ 7,000

2 9,000 10,000 9,000

3 7,000 6,500 6,500 $24,000 $23,500 $22,500

Let’s assume it was applied to the total inventory. A journal entry is needed to reduce Merchandise Inventory

to $23,500.

DATE DESCRIPTION PR DEBIT CREDIT 1 2 3 4 5 6 7 8 9

Loss on Write-Down of Inventory 500 Merchandise Inventory 500

To recognize loss in value of inventory held

Expense

General Journal

Learning Objective

Estimate the ending inventory and cost of goods sold by using the gross profit and retail inventory methods.

Estimating inventory is not a problem for businesses using the perpetual inventory method

Unverified amounts are generally reliable estimates and can be used for “interim” monthly or quarterly financial statements

Businesses using the periodic inventory method must use other methods to estimate ending inventory and cost of goods sold

Two generally accepted methods: Gross profit method Retail inventory method

Estimating Inventory

A business’s normal gross profit (net sales – cost of goods sold) is used to estimate the cost of goods sold and ending inventory.

Gross Profit Method

3 STEPS

Gross Profit Method (cont.)

Example:

Inventory, start of period $80,000 Net purchases, first month $70,000

$110,000 Net sales, first month Normal gross profit as a percentage of sales

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 avail. for sale $150,000

Example:

Inventory, start of period Net purchases, first month Net sales, first month Normal gross profit as a percentage of sales

$80,000 $70,000

$110,000 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 × 40%

Gross Profit Method

Example: Inventory, start of period Net purchases, first month Net sales, first month Normal gross profit as a percentage of sales

$80,000 $70,000

$110,000 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 Estimated end-of-month inv. $ 84,000

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

Retail Inventory Method

5 STEPS

Inventory, start of period $ 60,000 $ 85,000 COST RETAIL

Net purchases during period 126,000 163,000 Goods available for sale $186,000 $248,000

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

Retail Inventory Method (cont.)

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

Net purchases during period 126,000 163,000 Goods available for sale $186,000 $248,000 Less net sales for period 180,000 Inventory, end of period, at retail $ 68,000

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

Net purchases during period 126,000 163,000 Goods available for sale $186,000 $248,000 Less net sales for period 180,000 Inventory, end of period, at retail $ 68,000 Cost to Retail Ratio ($186,000 ÷ $248,000) 75%

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

Net purchases during period 126,000 163,000 Goods available for sale $186,000 $248,000 Less net sales for period 180,000 Inventory, end of period, at retail $ 68,000 Cost to Retail Ratio ($186,000 ÷ $248,000) 75% Inventory, end of period,

$(51,000) at cost ($68,000 × 75%)

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

Net purchases during period 126,000 163,000 Goods available for sale $186,000 $248,000 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,

$(51,000) at cost ($68,000 × 75%) Estimated cost of goods sold $135,000

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