Chapter 06

Inventory and Cost of Goods Sold

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Inventory

o Includes items a company intends for sale to customers. For example, clothes at The Limited, shoes at Payless ShoeSource, building supplies at Home Depot, and so on.

o Also includes items that are not yet finished products. For instance, lumber at a cabinet manufacturer, and rubber at a tire manufacturer are part of inventory because the firm will use them to make a finished product for sale to customers.

o Includes items a company intends for sale to customers. For example, clothes at The Limited, shoes at Payless ShoeSource, building supplies at Home Depot, and so on.

o Also includes items that are not yet finished products. For instance, lumber at a cabinet manufacturer, and rubber at a tire manufacturer are part of inventory because the firm will use them to make a finished product for sale to customers.

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Part A

Understanding Inventory and Cost of Goods Sold

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LO1 Trace the flow of inventory costs from manufacturing companies to merchandising companies

Inventory

Merchandise companyMerchandise company Manufacturing companyManufacturing company

WholesalerWholesaler Retailer Retailer Raw material

Raw material

Work in progressWork in progress

Finished goods

Finished goods

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Merchandising Companies

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Manufacturing Companies

o These companies manufacture the inventories they sell, rather than buying them in finished form from suppliers.

o Manufacturers classify inventory into three categories:o Raw materials inventory: Includes the cost of components that

will become part of the finished product but have not yet been used in production.

o Work-in-process inventory: Refers to the products that have started the production process but are not yet complete at the end of the period.

o Finished goods inventory: It includes the cost of the units that have been completed by the end of the period but not yet sold.

o These companies manufacture the inventories they sell, rather than buying them in finished form from suppliers.

o Manufacturers classify inventory into three categories:o Raw materials inventory: Includes the cost of components that

will become part of the finished product but have not yet been used in production.

o Work-in-process inventory: Refers to the products that have started the production process but are not yet complete at the end of the period.

o Finished goods inventory: It includes the cost of the units that have been completed by the end of the period but not yet sold.

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Types of Companies and Flow of Inventory Costs

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LO2 Calculate cost of goods sold

Beginning inventory+ Purchases

Cost of goods available for sale- Ending inventory

Cost of goods sold6-8

Relationship between Inventory and Cost of Goods Sold

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LO3 Determine the cost of goods sold and ending inventory using different inventory cost methods

Inventory cost method

Specific Identification

Specific Identification

First in,first out(FIFO)

First in,first out(FIFO)

Last in,first out(LIFO)

Last in,first out(LIFO)

Average Cost

Average Cost

Specific Identification Method Specific Identification Method

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o It has 100 units of inventory at the beginning of the year and then makes two purchases during the year—one on April 25 and one on October 19.

o There are 1,000 game cartridges available for sale.o During the year, it sells 800 video game cartridges for $15 each.

This means that 200 cartridges remain in ending inventory at the end of the year.

o It has 100 units of inventory at the beginning of the year and then makes two purchases during the year—one on April 25 and one on October 19.

o There are 1,000 game cartridges available for sale.o During the year, it sells 800 video game cartridges for $15 each.

This means that 200 cartridges remain in ending inventory at the end of the year.

Inventory Transactions for Mario’s Game Shop

Date TransactionNumber of

Units Unit cost Total J an. 1 Beginning inventory 100 $7 $700 Apr. 25 Purchase 300 9 2,700Oct. 19 Purchase 600 11 6,600

Total goods available for sale 1,000 $10,000

Total sales to customers 800Ending Inventory 200

J an. 1 – Dec. 31 Dec. 31

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First-In, First-Out (FIFO)

First units purchased are the first ones sold. Beginning inventory sells first, followed by the inventory from the first purchase during the year, followed by the inventory from the second purchase during the year, and so on.

o Mario’s Game Shop, which 800 units were sold?

o They were the first 800 units purchased, and that all other units remain in ending inventory.

First units purchased are the first ones sold. Beginning inventory sells first, followed by the inventory from the first purchase during the year, followed by the inventory from the second purchase during the year, and so on.

o Mario’s Game Shop, which 800 units were sold?

o They were the first 800 units purchased, and that all other units remain in ending inventory.

=

Cost of goods sold +

Ending inventory

Purchases Number x Unit = Total of units cost Cost

Jan. 1 100 $7 $700 Apr. 25 $9 $2,700

400 $11 $4,400 200 $11 $2,200 Not Sold $2,200

$10,000 = $7,800 + $2,200

Inventory Transactions for Mario’s Game Shop—FIFO METHOD

Cost of goods available for sale

$700

1,000

300 $2,700

Oct. 19$4,400

Sold first 800 units

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Last units purchased are the first ones sold.

o If Mario sold 800 units, we assume all the 600 units purchased on October 19 (the last purchase) were sold, along with 200 units from the April 25 purchase. That leaves 100 of the units from the April 25 purchase and all 100 units from beginning inventory assumed to remain in ending inventory.

Last units purchased are the first ones sold.

o If Mario sold 800 units, we assume all the 600 units purchased on October 19 (the last purchase) were sold, along with 200 units from the April 25 purchase. That leaves 100 of the units from the April 25 purchase and all 100 units from beginning inventory assumed to remain in ending inventory.

Last-In, First-Out (LIFO)

Cost of Endinggoods sold inventory

Numb Unit Total of cost cost100 $7 $700 Not Sold $700

100 $9 $900 $900

200 $9 $1,800

600 $11 $6,600 $10,000 = $8,400 + $1,600

Jan. 1

$1,800

Inventory Transactions for Mario’s Game Shop—LIFO METHOD

=

+Cost of goods available for sale

=

Purchases x

Apr. 25Sold last 800 units

Oct. 19 $6,600 1,000

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Weighted-Average Cost

o Both cost of goods sold and ending inventory consist of a random mixture of all the goods available for sale.

o Each unit of inventory has a cost equal to the weighted-average cost of all inventory items.

o Both cost of goods sold and ending inventory consist of a random mixture of all the goods available for sale.

o Each unit of inventory has a cost equal to the weighted-average cost of all inventory items.

Number Unit Total of units cost cost

Jan. 1 Beginning inventory 100 $7 $700 Apr. 25 Purchase 300 $9 2,700 Oct. 19 Purchase 600 $11 6,600

1,000 $10,000

$10,000 1,000 units

Cost of goods sold = 800 sold X $10 $8,000 Ending inventory = 200 not sold X $10 2,000

$10,000

Cost of goods available for sale

Inventory Transactions for Mario’s Game Shop—WEIGHTED-AVERAGE COST METHOD

Date Transaction x =

Weighted-average unit cost = = 10 per unit

Weighted-average unit cost =Number of units available for sale

Cost of goods available for sale

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A company begins the year with one unit, purchases three units and sells two units.

o FIFO: Inventory is sold in the order purchased.o LIFO: Inventory is sold in the opposite order that we purchased it. o Weighted-average cost: Inventory is sold using an average of all

inventory purchased.

A company begins the year with one unit, purchases three units and sells two units.

o FIFO: Inventory is sold in the order purchased.o LIFO: Inventory is sold in the opposite order that we purchased it. o Weighted-average cost: Inventory is sold using an average of all

inventory purchased.

Comparison of Cost of Goods Sold Under the Three Inventory Cost Flow Assumptions

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LO4 Explain the financial statement effects and tax effects of inventory cost flow assumptions

Effects of Managers’ Choice of Inventory Reporting Methods

Effects of Managers’ Choice of Inventory Reporting Methods

Why Choose LIFO?

o Results in tax savings when inventory costs are rising.o Has an income statement focus.

Why Choose LIFO?

o Results in tax savings when inventory costs are rising.o Has an income statement focus.

Why Choose FIFO?

o Matches physical flow for most companies.o Results in higher assets and net income when inventory costs are rising.o Has a balance sheet focus.

Why Choose FIFO?

o Matches physical flow for most companies.o Results in higher assets and net income when inventory costs are rising.o Has a balance sheet focus.

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Comparison of Inventory Cost Flow Assumptions When Prices Are Rising

A comparison of FIFO, LIFO, and average cost for Mario’s Game Shop is provided below.

A comparison of FIFO, LIFO, and average cost for Mario’s Game Shop is provided below.

FIFO LIFO AverageBalance sheet:

Ending inventory $2,200 $1,600 $2,000

Income statement:Sales (800 x $15) $12,000 $12,000 $12,000 Cost of goods 7,800 8,400 8,000

Gross Profit $4,200 $3,600 $4,000

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Reporting the LIFO Difference

o Choice between FIFO and LIFO results in different amounts for ending inventory and cost of goods sold.

o It complicates the investment decisions of stockholders. o Due to financial statement effects of different inventory

methods, companies that choose LIFO must report what’s called their LIFO difference.o LIFO difference is the additional amount of inventory a

company would report if it used FIFO instead of LIFO. o Companies that have been using LIFO for a long time or that

have seen dramatic increases in inventory costs, the LIFO difference can be substantial.

o LIFO difference reported by Rite Aid Corporation which uses LIFO to account for most of its inventory follows.

o Choice between FIFO and LIFO results in different amounts for ending inventory and cost of goods sold.

o It complicates the investment decisions of stockholders. o Due to financial statement effects of different inventory

methods, companies that choose LIFO must report what’s called their LIFO difference.o LIFO difference is the additional amount of inventory a

company would report if it used FIFO instead of LIFO. o Companies that have been using LIFO for a long time or that

have seen dramatic increases in inventory costs, the LIFO difference can be substantial.

o LIFO difference reported by Rite Aid Corporation which uses LIFO to account for most of its inventory follows.

($ in millions) 2009 2008Reported inventory under LIFO $3,509 $3,937LIFO difference 746 563

Inventory assuming FIFO $4,255 $4,500

RITE AID CORPORATIONNotes to the Financial Statements (partial)

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Part B

Recording Inventory Transactions

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Perpetual inventory system and Periodic inventory system

Perpetual Inventory System

Perpetual Inventory System

It maintains a continual—that is,perpetual—tracking of inventory.

It maintains a continual—that is,perpetual—tracking of inventory.

A continual tracking helps a company to better manage its inventory

levels.

A continual tracking helps a company to better manage its inventory

levels.

Periodic Inventory System

Periodic Inventory System

It does not continually modify inventory amounts,

but instead periodically adjusts for purchases and sales of inventory at the

end of the reporting period based on a physical count

of inventory on hand.

It does not continually modify inventory amounts,

but instead periodically adjusts for purchases and sales of inventory at the

end of the reporting period based on a physical count

of inventory on hand.

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LO5 Record inventory transactions using a perpetual inventory system.

To see how to record inventory transactions using a perpetual inventory system, we will look again at the inventory transactions for Mario’s Game Shop.

To see how to record inventory transactions using a perpetual inventory system, we will look again at the inventory transactions for Mario’s Game Shop.

Date Transaction DetailsTotal Cost

Total Revenue

Jan. 1 Beginning inventory 100 units for $7 each $700Apr. 25 Purchase 300 units for $9 each 2,700Jul. 17 Sale 300 units for $15 each $4,500Oct. 19 Purchase 600 units for $11 each 6,600Dec. 15 Sale 500 units for $15 each 7,500

Totals $10,000 $12,000

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Inventory Purchases

!April 25 Debit CreditInventory ..................................................................................... 2,700

Accounts Payable ............................................................ 2,700(Purchase inventory on account )

Common Retained NetAssets = Liabilities + Stock + Earnings Revenues + Expenses = Income

+2,700 = +2,700

Stockholders' EquityBalance Sheet Income Statement

To record the purchase of new inventory, we debit inventory (an asset) to show that the company’s balance of this asset account has increased. At the same time, if the purchase was paid in cash, we credit cash. Or more likely, if the company made the purchase on account, we credit accounts payable, increasing total liabilities. Thus, Mario records the first purchase of 300 units for $2,700 on April 25 as:

To record the purchase of new inventory, we debit inventory (an asset) to show that the company’s balance of this asset account has increased. At the same time, if the purchase was paid in cash, we credit cash. Or more likely, if the company made the purchase on account, we credit accounts payable, increasing total liabilities. Thus, Mario records the first purchase of 300 units for $2,700 on April 25 as:

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On July 17, Mario sold 300 units of inventory on account for $15 each, resulting in total sales of $4,500. We make two entries to record the sale:

(1) The first entry shows an increase to the asset account (in this case, Accounts Receivable) and an increase in sales revenue.

(2) The second entry adjusts the Inventory and Cost of Goods Sold accounts.

On July 17, Mario sold 300 units of inventory on account for $15 each, resulting in total sales of $4,500. We make two entries to record the sale:

(1) The first entry shows an increase to the asset account (in this case, Accounts Receivable) and an increase in sales revenue.

(2) The second entry adjusts the Inventory and Cost of Goods Sold accounts.

Inventory Sales

July 17 Debit CreditAccounts Receivable .............................................................4,500

Sales Revenue …....................................................... 4,500(Sell inventory on account)($4,500 = 300 units x $15 )

Cost of Goods Sold ................................................................2,500Inventory .................................................................... 2,500

(Record cost of inventory sold )($2,500 = [100 units x $7] ÷ [200 units x $9])

Common Retained NetAssets = Liabilities + Stock + Earnings Revenues - Expenses = Income

+4,500 = +2,000 +4,500 - +2,500 +2,000-2,500

+2,000

Stockholders' EquityIncome StatementBalance Sheet

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Other inventory transactions

Jan. 1 Beginning 700Apr. 25 Purchase 2,700 2,500 Jul. 17 SaleOct. 19 Purchase 6,600 5,300 Dec. 15 Sale

10,000 7,800Dec. 31 Ending FIFO amount Bal. 2,200

Inventory

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Simple Adjustment from FIFO to LIFO.

Mario’s ending balance of inventory using FIFO is $2,200. Under LIFO, it is only $1,600. As a result, if Mario wants to adjust its FIFO inventory records to LIFO for preparing financial statements, it needs to adjust inventory downward by $600 (decreasing the balance in ending inventory from $2,200 to $1,600).

Mario’s ending balance of inventory using FIFO is $2,200. Under LIFO, it is only $1,600. As a result, if Mario wants to adjust its FIFO inventory records to LIFO for preparing financial statements, it needs to adjust inventory downward by $600 (decreasing the balance in ending inventory from $2,200 to $1,600).

December 31 Debit CreditCost of Goods Sold………………………………………….. 600

Inventory …………………………………………………. 600(Record the LIFO adjustment)

Jan. 1 Beginning 700Apr. 25 Purchase 2,700 2,500 Jul. 17 SaleOct. 19 Purchase 6,600 5,300 Dec. 15 Sale

10,000 7,800

FIFO amount 2,200600 LIFO Adjustment

Bal. 1,600

Inventory

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Additional Inventory Transactions – Freight Charges

April 25 Debit CreditInventory .................................................................... 300

Cash …………..…................................................ 300(Pay freight-in charges)

Mario pays $300 for freight charges associated with the purchase of inventory on April 25

Mario pays $300 for freight charges associated with the purchase of inventory on April 25

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Additional Inventory Transactions – Purchase Discounts.

Mario on April 30, pays for the units purchased on April 25, less a 2% purchase discount.

Mario on April 30, pays for the units purchased on April 25, less a 2% purchase discount.

April 30 Debit CreditAccounts Payable ................................................................. 2,700

Inventory …………..…....................................................... 54Cash …………..…............................................................. 2,646

(Pay on account with a 2% purchase discount of $54 )($54 = $2,700 x 2% )

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Additional Inventory Transactions – Purchase Returns.

Mario decides on October 22 to return 50 defective units from the 600 units purchased on October 19 for $11 each

Mario decides on October 22 to return 50 defective units from the 600 units purchased on October 19 for $11 each

October 22 Debit CreditAccounts Payable ................................................................. 550

Inventory …………..…....................................................... 550(Return inventory previously purchased on account)($550 = 50 defective units x $11)

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o For merchandising companies, sales and purchases of inventory are most important set of transactions , companies report revenues and expenses from these separately from other revenues and expenses.

o It makes easier for investors and other financial statement users to determine the profitability of a company’s inventory transactions.

o Use the information for Mario's Game Shop to calculate gross profit on the sale and purchase of inventory.

o For merchandising companies, sales and purchases of inventory are most important set of transactions , companies report revenues and expenses from these separately from other revenues and expenses.

o It makes easier for investors and other financial statement users to determine the profitability of a company’s inventory transactions.

o Use the information for Mario's Game Shop to calculate gross profit on the sale and purchase of inventory.

LO6 Prepare a multiple-step income statement

Net sales 12,000$ Cost of goods sold 8,046

Gross profit 3,954 Selling expenses 950 MultipleGeneral and administrative expenses 804 levels

Operating income 2,200 ofNonoperating revenues 100 profitNonoperating expenses (300)

Income before income taxes 2,000 Income tax expense 800

Net income 1,200$

For the year ended December 31, 2012Multiple-Step Income Statement

MARIO’S GAME SHOP

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Part C

LOWER-OF-COST-OR-MARKET METHOD

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LO7 Apply the lower-of-cost-or-market method for inventories

o When the value of inventory falls below its cost, companies are required to report inventory at the lower market value. And it is considered to be the replacement cost.

o Once it has determined both the cost and market value of inventory, the company reports ending inventory in the balance sheet at the lower of the two amounts.

o When the value of inventory falls below its cost, companies are required to report inventory at the lower market value. And it is considered to be the replacement cost.

o Once it has determined both the cost and market value of inventory, the company reports ending inventory in the balance sheet at the lower of the two amounts.

Lower-of-Cost- Total Lower-Inventory Cost Market or-Market of-Cost-or-

items per unit per unit per Unit Quantity Market

FunStation 2 $300 $200 $200 15 = $3,000

FunStation 3 400 450 400 20 = 8,000

Reported ending inventory = $11,000

Which is lower?

OR

Report inventory at cost

(specific identification, FIFO, Cost Market Value

(and report an expense)Report inventory at market

Then:If:

Market < Cost

Cost < Market

(replacement cost)LIFO or weighted-average cost)

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Calculating the Lower of Cost or Market1 Mario’s reports the FunStation 2 in ending inventory at market value. 2 The 15 FunStation 2s were originally reported in inventory at their cost. 3 To reduce the inventory from that original cost to lower market value, Mario

records the following year-end adjustment.

December 31, 2012 Debit Credit

Cost of Goods Sold .............................................................. 1,500Inventory ...................................................................... 1,500

(Adjust inventory down to market value)

Common Retained NetAssets = Liabilities + Stock + Earnings Revenues - Expenses = Income

-1,500 = -1,500 +1,500 = -1,500

Stockholders' EquityIncome StatementBalance Sheet

Balance before 12,500LCM Adjustment

1,500 LCM adjustmentEnding Balance Bal. 11,000

Inventory

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LO8 Analyze management of inventory using the inventory turnover ratio and gross profit ratio

Inventory turnover ratio =Cost of goods sold

Average inventory

Average days in inventory =365

Inventory turnover ratio

o If managers purchase too much inventory, the company runs the risk of the inventory becoming obsolete and market value falling below cost.

o Analysts as well as managers often use the inventory turnover ratio to evaluate a company’s effectiveness in managing its investment in inventory.

o Investors often rely on the gross profit ratio to determine the core profitability of a company’s operations.

o If managers purchase too much inventory, the company runs the risk of the inventory becoming obsolete and market value falling below cost.

o Analysts as well as managers often use the inventory turnover ratio to evaluate a company’s effectiveness in managing its investment in inventory.

o Investors often rely on the gross profit ratio to determine the core profitability of a company’s operations.

Inventory turnover ratio shows the number of times the firm sells its average inventory balance during a reporting period.

Average days in inventory indicates the approximate number of days the average inventory is held.

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o We can analyze the inventory of Best Buy and Radio Shack Corporation by calculating these ratios for both companies.

o Best Buy sells a large volume of commonly purchased products.

o Radio Shack sells a variety of high-end specialty products, including electronics, toys and other home and personal care products that typically are not carried by most other retailers.

o Below are relevant amounts for each company.

o We can analyze the inventory of Best Buy and Radio Shack Corporation by calculating these ratios for both companies.

o Best Buy sells a large volume of commonly purchased products.

o Radio Shack sells a variety of high-end specialty products, including electronics, toys and other home and personal care products that typically are not carried by most other retailers.

o Below are relevant amounts for each company.

Analyze the inventory of Best Buy and Radio Shack Corporation

($ in millions)Cost of goods

soldBeginning inventory

Ending inventory

Best Buy $34,017 $4,708 $4,753 Radio Shack 2,302 705 636

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Computation of the Inventory Turnover Ratio

The turnover ratio is more than twice as high for Best Buy. On average, it takes Radio Shack an additional 56 days to sell its inventory.

$4,708 + $4,753

2

$705 + $636

2

$34,017 365$4,730.5 7.5

$2,302 365$670.5 3.0

= 3.0 timesRadio Shack = 107 days

Inventory turnover ratio Average Days in Inventory

Best Buy = 7.5 times = 51 days

Radio Shack Average inventory

= = $670.5

Best Buy Average inventory

= = $4,730.5

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Computation of Gross Profit Ratio

Gross profit ratio: Important indicator of the company’s successful management of inventory.

Gross profit ratio =Gross profit

Net sales

1. Measures the amount by which the sale price of inventory exceeds its cost per dollar of sales.

2. Higher the ratio, higher is the “markup” a company is able to achieve on its inventories.

($ in millions) Net sales −Cost of

goods sold =Gross profit

Best Buy $45,015 $34,017 $10,998

Radio Shack 4,225 2,302 1,923

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Calculation of Gross Profit Ratio for Best buy and Radio Shack

Gross = Profit Ratio

Best Buy = 24%Radio Shack = 46%

Gross Profit/Net Sales

$10,998/$45,015$1,923/$4,225

For Best Buy, this means that for every $1 of sales revenue, the company spends $0.76 on inventory, resulting in a gross profit of $0.24. In contrast, the gross profit ratio for Radio Shack is 46%.

For Best Buy, this means that for every $1 of sales revenue, the company spends $0.76 on inventory, resulting in a gross profit of $0.24. In contrast, the gross profit ratio for Radio Shack is 46%.

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LO9 Record inventory transactions using a periodic inventory system.

Recall that under a perpetual inventory system we maintain a continual—or perpetual —record of inventory purchased and sold. In contrast, using a periodic inventory system we do not continually modify inventory amounts. Instead, we periodically adjust for purchases and sales of inventory at the end of the reporting period, based on a physical count of inventory on hand.

Recall that under a perpetual inventory system we maintain a continual—or perpetual —record of inventory purchased and sold. In contrast, using a periodic inventory system we do not continually modify inventory amounts. Instead, we periodically adjust for purchases and sales of inventory at the end of the reporting period, based on a physical count of inventory on hand.

Date Transaction DetailsTotal Cost

Total Revenue

Jan. 1 Beginning inventory 100 units for $7 each $700Apr. 25 Purchase 300 units for $9 each 2,700Jul. 17 Sale 300 units for $15 each $4,500Oct. 19 Purchase 600 units for $11 each 6,600Dec. 15 Sale 500 units for $15 each 7,500

Totals $10,000 $12,000

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Comparing Perpetual and Periodic inventory system – Inventory Purchase and Sales

April 25 - PurchasesInventory 2,700 Purchases 2,700

Accounts Payable 2,700 Accounts Payable 2,700

July 17 - SalesAccounts Receivable 4,500 Accounts Receivable 4,500

Sales Revenue 4,500 Sales Revenue 4,500

Cost of Goods Sold 2,500Inventory 2,500 No entry for cost of goods sold

October 19 - PurchasesInventory 6,600 Purchases 6,600

Accounts Payable 6,600 Accounts Payable 6,600

December 15 - SalesAccounts Receivable 7,500 Accounts Receivable 7,500

Sales Revenue 7,500 Sales Revenue 7,500

Cost of Goods Sold 5,300Inventory 5,300 No entry for cost of goods sold

Perpetual System Periodic System

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Comparing Perpetual and Periodic inventory system – Freight charges, Purchase discounts and returns

April 25 - Freight ChargesInventory 300 Freight-in 300

Cash 300 Cash 300

April 30 - Purchase DiscountsAccounts Payable 2,700 Accounts Payable 2,700

Inventory 54 Purchase Discounts 54Cash 2,646 Cash 2,646

October 22 - Purchase ReturnsAccounts Payable 550 Accounts Payable 550

Inventory 550 Purchase Returns 550

Perpetual System Periodic System

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Comparing Perpetual and Periodic inventory system – Period-End Adjustment

A period-end adjustment is needed only under the periodic system.• Adjusts the balance of inventory to its proper ending

balance.• Records the cost of goods sold for the period, to match

inventory costs with the related revenues.• Closes (or zeros out) the temporary purchases accounts

(Purchases, Freight-in, Purchase Discounts, and Purchase Returns).

A period-end adjustment is needed only under the periodic system.• Adjusts the balance of inventory to its proper ending

balance.• Records the cost of goods sold for the period, to match

inventory costs with the related revenues.• Closes (or zeros out) the temporary purchases accounts

(Purchases, Freight-in, Purchase Discounts, and Purchase Returns).

No entry Inventory (ending) 1,650Cost of Goods Sold 8,046Purchase Discounts 54Purchase Returns 550

Purchases 9,300Freight-In 300Inventory (beginning) 700

Perpetual System Periodic System

Temporaryaccountsclosed

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Inventory Errorso Errors can unknowingly occur in inventory amounts if there are

mistakes in a physical count of inventory or in the pricing of inventory quantities.

o The formula for cost of goods sold, follows

Inventory Errorso Errors can unknowingly occur in inventory amounts if there are

mistakes in a physical count of inventory or in the pricing of inventory quantities.

o The formula for cost of goods sold, follows

LO10 Determine the financial statement effects of inventory errors

Beginnig Inventory+ Purchases- Ending Inventory Asset; Balance sheet

Cost of Goods Sold Expense; Income statement

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Summary of Effects of Inventory Error in the Current Year.Relationship between Cost of Goods Sold in the Current Year and the Following Year

Summary of Effects of Inventory Error in the Current Year.Relationship between Cost of Goods Sold in the Current Year and the Following Year

Determine the financial statement effects of inventory errors

Inventory Error Ending Inventory Cost of Goods Sold Gross ProfitOverstate ending inventory Overstate Understate OverstateUnderstate ending inventory Understate Overstate Understate

Year 1 Year 2Beginning Inventory Beginning Inventory

+ Purchases + Purchases- Ending Inventory - Ending Inventory= Cost of Goods Sold = Cost of Goods Sold

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Inventory Amounts

2012 2013Correct Inventory Beginning Inventory $600 $500Amounts + Purchases + 3,000 + 4,000

- Ending Inventory - 500 - 800Cost of Goods Sold $3,100 $3,700

$6,800

2012 2013Incorrect Inventory Beginning Inventory $600 $400Amounts + Purchases + 3,000 + 4,000

- Ending Inventory - 400 - 800Cost of Goods Sold $3,200 $3,600

$6,800

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End of chapter 06

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