Accounting for the

Merchandising Firm

Chapter 7
 Chapter Outline
• Applications to people within and outside the firm
• What is inventory?
• Costs of goods sold
• Inventory costing methods
• Perpetual versus periodic systems
• Evaluating inventory
• Application of accounting concepts
• International issues
APPLICATIONS TO PEOPLE WITHIN
AND OUTSIDE THE FIRM

• A merchandising firm earns income by buying

products at wholesale prices and selling them at
higher, retail prices.
• Internal users: Accounting for cost of goods sold
and inventory is relevant to several people within
a merchandising firm.
• External users: Investors and lenders are
interested in cost of goods sold because it affects
gross profit & net income.
 WHAT IS INVENTORY?

• Inventory includes all of the goods or

products that are available for sale to
customers.
• Since the cost of inventory is a
merchandising firm's biggest expense,
keeping track of inventory is critical to
successful business operations.
 Inventory

Different types of businesses carry different

types of inventory (Exhibit 7.2):
• Service firm – no inventory
• Merchandiser – merchandise inventory
• Manufacturer – raw material, work-in-
progress, and finished goods
 Inventory

• Once merchandise is sold, it is removed

from the inventory list and its cost is added
to cost of goods sold.
• Merchandise on hand at the end of an
accounting period is called ending
inventory.
 Inventory example

• Home Depot buys 10 lawnmowers for $800 each and sells them
for $1,000. Home Depot’s statements:
Balance Sheet (partial) Income Statement (partial)
Current Assets: Sales Revenue: $7,000
Cash $ xxx (7 mowers @ $1,000)
A/R xxx Cost of Goods Sold: 5,600
Inventory 2,400 (7 mowers @ $800)
(3 mowers @ $800) Gross Profit $
1,400
 COST OF GOODS SOLD

Costs of goods sold is the cost of the

inventory that a company sells to its
customers.
 Computing costs of goods sold

• Determining the cost per unit of inventory is not

simple because inventory may be purchased at
different prices throughout the year.
• The computation of cost of goods sold involves
three specific amounts:
Beginning inventory - the cost of inventory on hand at
the start of the period.
Purchases of inventory made throughout the period.
Ending inventory - the cost of inventory on hand at the
end of the period.
 Computing COG example (Exhibit 7.3)
Beginning Inventory: Ending Inventory:
3 x $100 = $300 5 x $100 = $500
Cost of Goods
Available for sale:
Purchases: $2,300 Cost of Goods Sold:
20 x $100 = $2,000 18 x $100 = $1,800

Cost of Goods Sold:

Beginning inventory $ 300
+ Purchases 2,000
= Cost of goods available for sale 2,300
- Ending inventory (500)
= Cost of goods sold $ 1,800
 Cost of goods sold
on the income statement
Wal-Mart’s income statement (Exhibit 6.4):
2003 2002
(in billions)Net Sales 245
2006
218
2005
 Net Sales Cost of Goods Sold
Gross Profit
(192)
53
312
(172)
46
285
Other incomeOperating Expenses
Operating Income
Non-Operating Expenses
(41)
12
4
10 3
(36)

3
3
Cost of Goods Sold
Net Income 8
(240)7
(220)
Gross Profit 75 68
Operating Expenses (57) (51)
Operating Income 18 17
Non-Operating Expenses 7 7
Net Income 11 10
 Cost of goods sold
on the income statement

• Net Sales - Cost of Goods Sold = Gross Profit

• Gross Profit - Operating Expenses = Operating Income.

• Operating Income - Non-operating Expenses = Net Income

Gross profit is also referred to as gross margin.

 INVENTORY COSTING
METHODS

• Four inventory costing methods are available for

determining the cost of ending inventory and the
cost of goods sold.
• Each method is approved under GAAP.
• The business manager selects which accounting
method to use.
• When the unit costs of inventory vary, each
method can result in different amounts for ending
inventory and cost of goods sold.
 1. Specific Identification Method

For this inventory costing method…

• A company is required to keep track of the cost of
individual inventory items.
• Inventory is valued according to the specific cost
of each inventory unit.
• A common use is for inventory items that have
unique characteristics, such as cars and real estate.
 2. First-In, First-Out (FIFO)

For this inventory costing method…

• The cost of the first inventory unit is the first cost
to be transferred out to cost of goods sold.

• The cost of the units remaining in ending

inventory is based on the cost of the last units
purchased.
 Inventory costing example (Exhibit 7.5)

Beginning inventory and purchases:

Beginning inventory (20 units @ $15 ea) $ 300
Purchases: No. 1 (20 units @ $22 ea) $ 440
No. 2 (20 units @ $35 ea) 700 1,140
Cost of goods available for sale (60 units) 1,440

Ending inventory (15 units) ?

Cost of goods sold (45 units) ?
 Example using FIFO (Exhibit 7.6)

Cost of goods available for sale (60 units) $ 1,440

Ending inventory (last 15 units): (525)
15 units from purchase No. 2, $35 ea
Cost of goods sold (first 45 units):
20 units from beg. Inventory; $15 ea $ 300
20 units from purchase No. 1; $22 ea 440
5 units from purchase No. 2; $35 ea 175
Cost of Goods sold $ 915
 3. Last-In, First-Out (LIFO)

For this inventory costing method…

• The cost of the last unit added to inventory is the
first cost to be transferred out to cost of goods
sold.

• The cost of the units remaining in ending

inventory is based on the cost of the earliest units.
 Example using LIFO (Exhibit 7.7)

Cost of goods available for sale (60 units) $ 1,440

Ending inventory (first 15 units): (225)
15 units from beg. inventory, $15 ea
Cost of goods sold (last 45 units):
20 units from purchase No. 2; $35 ea $ 700
20 units from purchase No. 1; $22 ea 440
5 units from beg. inventory; $15 ea 75
Cost of Goods sold $ 1,215
 4. Weighted Average

For this inventory costing method…

• Inventory cost is based on the weighted average
cost of inventory during the period.
• Weighted avg. cost per unit =
cost of goods available / units available
• Cost of ending inventory =
No. of units on hand x Weighted avg. cost
 Example using weighted average cost

Cost of goods available for sale (60 units) $

1,140
($1,440 / 60 units = $24 avg. cost ea.)
Ending inventory (15 units @ $24 ea)
(360)
Cost of Goods sold (45 units @ $24 ea) $
1,080

(Exhibit. 6.8)
 Example Summary (Exhibit 7.9)
Impact of inventory methods on gross profit

FIFO LIFO Weighted Average

Net Sales $2,000 $2,000 $2,000
Cost of Goods Sold:
Goods available for sale $1,440 $1,440 $1,440
Ending inventory (525) (225) (360)
Cost of Goods Sold 915 1,215 1,080
Gross Profit $1,085 $785 $925
 Profit and tax considerations
for inventory costing methods

If inventory costs increase during a period…

• FIFO - Ending inventory is high. Cost of goods
sold is low because it includes the initial lower
unit costs. Result: higher gross profit.
• LIFO - Ending inventory is low. Cost of goods
sold is high because it includes the recent higher
unit costs. Result: lower gross profit.
• Weighted average - Produces values between the
FIFO and LIFO.
 Profit and tax considerations (cont.)

The inventory method producing the highest gross

profit will also produce the highest net income and
tax expense.
Weighted
FIFO LIFO Average
Gross Profit 1085 785 920
Operating Expenses 700 700 700
Income Before Tax 385 85 220
Income Tax Expense (.40) 154 34 88
Net Income 231 51 132

Exhibit 6.10
 Profit and tax considerations (cont.)

• Management decides what is more important -

reducing income tax payments or showing a
higher profit.
• FIFO is the most popular method because it
results in a higher net income, which affects stock
prices.
• About one-third of all firms employ LIFO because
it reduces income tax expense.
Percentage of Companies Using Various Inventory Methods

Other
Weighted 4%
Average
20% LIFO
32%

FIFO
44%

Exhibit 7.11
 Income statement vs balance sheet

• LIFO produces a more realistic costs of goods

sold on the income statement because the most
recent unit costs are used; this results in a better
picture of the actual cost to replace the units sold.
• LIFO produces a less realistic value for inventory
on the balance sheet because the older unit costs
are used to compute ending inventory.
• FIFO is the opposite; it results in a better balance
sheet presentation but a worse income statement.
 Ethics & inventory management
• Business managers may be tempted to use LIFO to
manipulate net income.
• To reduce net income in order to lower tax expense, large
quantities of high-priced inventory may be purchased
near year-end.
• To raise net income, inventory purchases may be
postponed until the next year. LIFO liquidation occurs
when inventory on hand declines below the quantity of
the prior period.
• Timing transactions for the purpose of misleading
investors and users of financial statements is unethical.
 PERIODIC VS PERPETUAL
SYSTEMS

• Periodic inventory system: inventory is accounted

for at the end of the period.
• Cost of goods sold is determined at the end of the
period, following the physical count of inventory.
• Perpetual inventory system: inventory is
accounted for continuously.
• A journal entry is made to the Cost of Goods Sold
account every time a sales transaction occurs.
 Recording transactions under the
Periodic inventory system

Journal entries: (Exh. 7.12)

1. Purchase on account:
Purchases 2,000
Accounts payable 2,000

2. Sale on account:
Accounts receivable 2,700
Sales revenue 2,700
 Recording transactions under the
Periodic inventory system
Adjusting entries at end of period to update inventory and
record cost of goods sold. (Exhibit 7.12)
1. Transfer cost of beg. inventory to cost of goods sold:
Cost of goods sold 300
Inventory (beginning) 300
2. Set up ending inventory based on physical count:
Inventory (ending) 500
Cost of goods sold 500
3. Transfer cost of purchases to cost of goods sold:
Cost of goods sold 2,000
Purchases 2,000
 Recording transactions under the
Perpetual inventory system
Journal entries: (Exhibit 7.13)
1. Purchase on account:
Inventory 2,000
Accounts payable 2,000

2. Sale on account:
• Accounts receivable 2,700
Sales revenue 2,700
• Cost of goods sold 1,800
Inventory 1,800
Terms of sale and product returns

When a company sells its products, the

seller and buyer agree to terms of the sale
such as when payment is to be made and
who pays delivery or freight costs.
 Sales discounts

• Payment terms vary among industries.

– For example, payment might be due 30 days from the
date on the invoice. The invoice would be printed with
terms “n/30.”

• In order to improve liquidity, a company offers a

sales discount to promote early customer payment.
– A common sales discount is “2/10, n/30.” The customer
receives a 2% discount by paying within 10 days, or
can wait 30 days and pay the full amount.
 Freight costs
• Freight-In Expense refers to the cost of shipping
goods “in” from suppliers.
• Freight-Out Expense refers to the cost of shipping
goods “out” to customers.
• Either the buyer or seller can pay delivery costs.
– FOB shipping point means the seller puts the product
“free on board” at the point of origin and ownership
transfers to the buyer. The seller does not pay delivery
costs (the buyer pays).
– FOB destination means the seller pays for delivery to
the destination and retains title until then.
 Purchases returns & allowances

• A purchase return is a reduction in the cost of

purchases, which occurs when the buyer returns
products to the seller.
• A purchase allowance is a reduction in the cost of
purchases, which occurs when the seller grants
the buyer a deduction from the amount owed.
 Net purchases

• The accounts used to compute net purchases are:

Purchases
- Purchase discounts
- Purchase returns and allowances
+ Freight-in
Net purchases
 Sales returns & allowances

• If a buyer returns products, the seller records this

as a sales return.
• A sales allowance is a deduction given by the
seller to the buyer on the amount owed.
• The accounts used to compute net sales are:
Sales revenue
- Sales discounts
- Sales returns and allowances
Net sales
 EVALUATING INVENTORY

• Managing inventory successfully is a key to

profitability.

• Inventory is significant in terms of quantity,

cost, and its effect on a company’s financial
ratios.
The amount of inventory to purchase

To determine the quantity of inventory to buy:

Start with. . . Add. . . Subtract. . . Equals. . .
Budgeted cost Budgeted Actual Amount
of ending beginning to
goods sold inventory inventory purchase

1. The budgeted cost of goods sold is based on an

estimate of future sales.
2. The budgeted ending inventory is the amount
of inventory needed to start the next period.
 Financial ratios

• Financial ratios help keep track of inventory.

• Financial ratios show the proportionate values of

financial statement items relative to other items.

Financial ratios presented in the following slides are:

inventory turnover ratio and gross profit margin.
 Inventory turnover ratio

• Inventory turnover is a measure of how fast

inventory is selling.
• Inventory turnover = Cost of goods sold /
Average inventory
• Note: Average inventory can be calculated by
taking beginning inventory of the period, adding
the ending inventory, and dividing by two.
 Gross profit margin

• Gross profit margin indicates the firm's capacity to

sell its inventory at a profit.
• Gross profit margin = Gross profit / Net sales revenue
• Example:
Wal-Mart’s gross profit margin is 21.7%.
This means that every one-dollar of sales results in a
gross profit of 21.7 cents.
 Just-in-Time inventory

• The just-in-time inventory system purchases

inventory just as the company needs it.
• This system enables a company to minimize
costs associated with keeping inventory on
hand.
 Estimating inventory using
the gross profit method

• The gross profit method is an effective approach

to estimate the cost of ending inventory.
• To use the gross profit method, the following is
needed:
– Beginning inventory
– Purchases
– Net sales
– Gross profit margin.
 Example using
the gross profit method

Beginning inventory $ 50,000

Purchases 430,000
Cost of Goods Available for Sale 480,000
Cost of goods sold:
Net sales revenue $ 500,000
Less estimated gross profit (21.7%) 108,500
Estimated cost of goods sold 391,500
Estimated ending inventory 88,500
 APPLICATION OF
ACCOUNTING CONCEPTS

• Accounting for business transactions, including

inventory transactions, must follow GAAP.
• Five principles for inventory include:
1. Neutrality
2. Lower of cost or market
3. Full disclosure principle
4. Materiality in accounting
5. Comparability
 1. Neutrality

• Fairly represent financial data using the

best information available.
• The concept of neutrality requires
companies to remain unbiased when
making decisions related to presenting
financial data.
 2. Lower of cost or market

• Lower of cost or market mandates that inventory

be shown on the financial statements at the lower
of its historical cost or its market value.
• When the replacement cost of inventory drops
below its cost, the firm is required to decrease
value of inventory to its market value.
 Example (Exhibit 7.14)
Impact of LCM on income statement

Sales revenue $ 180,000

Cost of goods sold:
Beginning inventory (LCM = cost) $ 45,000
Purchases 100,000
Cost of goods available for sale 145,000
Ending inventory:
Cost = $50,000;
Market value = $42,000; LCM = (42,000)
Cost of goods sold 103,000
Gross Profit $ 77,000
 Example (Exhibit 7.14)
Impact of LCM on balance sheet

Current Assets:
Cash $ xxx
Accounts receivable xxx
Inventory, at LCM 42,000
(Cost = $50,000; Market = $42,000)
Prepaid expenses xxx
Total Current Assets xxx
 3. Full disclosure principle

• Rrequires that financial reports include

sufficient information for readers to make
informed decisions about the firm.
• With regard to inventory, the firm must report
what inventory costing method is used.
 Full disclosure principle (cont.)

Example: Excerpt of note regarding merchandise inventories

from J.C. Penney's financial statements: (Exhibit 7.15)

 Merchandise Inventories
Inventories for Department Stores and Catalog are
valued primarily at the lower of cost (using the
last-in, first-out or "LIFO" method) or market,
determined by the retail method for department
stores and average cost for catalog.
 4. Materiality in accounting

• Materiality in accounting requires that a business

firm rigidly adhere to GAAP only for items that
are significant or material to the firm.
– An item is material if knowing about it would
influence the decisions of financial statement users.

• If an item is immaterial, then accountants do not

have to meticulously follow GAAP.
 5. Comparability

• Comparability requires that companies apply

the same accounting procedures and methods
from one time period to the next.
• A company can change an accounting
procedure if it can justify a reason for the
change and disclose that the change was made.
 INTERNATIONAL ISSUES

• In the United States, companies may use FIFO, LIFO, or

weighted average method of inventory costing.
• In many other countries, LIFO is not acceptable.
• Generally accepted accounting principles are not the
same in all countries.
• The International Accounting Standards Board (IASB)
provides guidance on accounting for inventory.
• The IASB requires that inventories be stated at the lower
of cost and net realizable value.