Chapter 8
Chapter 8
Merchandise Inventory
In this chapter you will learn how merchandise inventory affects businesses, how it is controlled, accounted for, and reported in financial statements.
What Is Merchandise Inventory?
The products merchandising (retailing) companies buy and sell to individuals and/or other companies are called merchandise inventory. Wal-Mart's merchandise inventory includes food, clothing, home appliances, gardening supplies, and toys, to name just a few items. Like other merchandising companies, Wal-Mart buys products (merchandise inventory) from other companies, displays the products in stores and on the internet, and sells them to customers. The key element of merchandise inventory is it is a resource the merchandising company can use. Merchandise inventory is purchased to be sold to customers at a greater price than paid by the merchandising company. Through buying merchandise and selling it to customers at higher prices, merchandising companies increase their resources (assets) over time.
In terms of the accounting equation, merchandise inventory is an asset, as shown below. The numbers in parentheses refer to the chapters in which the items are discussed.
|Assets |= |Liabilities |+ |Stockholders' Equity |
|Current Assets | | | |Revenues |
|Cash and cash equivalents (6) | | | |Sales (7) |
|Accounts receivable (7) | | | |Sales Returns & Allow. (7) |
|Allow. for Uncoll. Accts. (7) | | | |Operating Expenses |
|Merchandise inventory (8) | | | |Uncollect. Accts. Exp. (7) |
| | | | |Bank Service Expense (6) |
| | | | |Other Revenues & Expenses |
| | | | |Interest Revenue (6) |
| | | | |Interest Expense (6) |
The amount of merchandise inventory differs from company to company and from year to year within a given company. Exhibit 8-1 presents inventory for three merchandising companies and compares it to the companies' total assets. As the data show, there are many differences among the companies. For example, Target maintained approximately 17% of its total assets in merchandise inventory, while Wal-Mart's inventory was over 22% of total assets.
|Exhibit 8-1 |
|Merchandise Inventory ($ millions) |
|January 31, 2007 |
|Company |Inventory |Total Assets |Percent |
|Federated Department Stores |$5,317 |$29,559 |18.0 |
|Target |$6,254 |$37,349 |16.7 |
|Wal-Mart |$33,685 |$151,193 |22.3 |
Merchandising: An Overview
The following paragraphs briefly describe how merchandise inventory affects merchandising companies by discussing one part of the operations of the Matthew Sporting Goods Company. As you may remember from Chapter 7, the Matthew Sporting Goods Company sells sporting equipment and supplies to youth organizations. The following paragraphs are restricted to only that part of the company's operations relating to the sale of customized baseball shirts. Each shirt is imprinted with a team's name and logo. As shown in Exhibit 8-2, there are four steps involved with the company’s merchandise inventory (baseball shirts): (1) the purchase of merchandise from suppliers, (2) the sale of merchandise to customers, (3) the collection of cash from customers, and (4) the payment of cash to suppliers. As will be shown, the Matthew Sporting Goods Company attempts to increase its resources through these four steps.
Exhibit 8-2
Matthew Sporting Goods Company
Merchandising Operations
Step 1: the purchase of merchandise from suppliers In order to sell baseball shirts to customers, the Matthew Sporting Goods Company must purchase the shirts from other companies. These other companies could also be merchandising companies or they could be companies that make the shirts, called manufacturers. Although the Matthew Sporting Goods Company does purchase some products by paying cash, the vast majority of its purchases are on credit. That is, the company buys merchandise by promising to pay for it in the near future, often within 30 days. As a result of buying merchandise on credit, the company's resources (assets) increase, as shown in Exhibit 8-2 by the arrow indicating resources coming into the company (Step 1). Since the source of these resources was creditors, the company's liabilities, called accounts payable, also increase. If the company buys 100 shirts at a cost of $24 per shirt, the effects of step 1, the purchase of merchandise from suppliers, can be summarized as follows.
| | | | | | | |Sources of Management |
| | | |Sources of Borrowed | |Sources of | |Generated |
| |Total Resources |= |Resources |+ |Owner Invested Resources |+ |Resources |
| |Assets |= |Liabilities |+ |Stockholders' Equity |
|Step 1: purchase | | | | | | | |
|of merchandise on credit |+ $2,400 |= |+ $2,400 | | | | |
| |Assets |= |Liabilities |+ |Stockholders' Equity |
|Step 1: purchase | | | | | | | |
|of merchandise on credit |+ $2,400 |= |+ $2,400 | | | | |
|Step 2A: flow of merchandise | | | | | | | |
|to customers (expense) |- $2,400 |= | | | | |- $2,400 |
The flow of promises (accounts receivable) from customers At the same time the Matthew Sporting Goods Company’s customers receive the shirts, they must give something in return to the company. Usually customers give either cash or promises of cash. Thus, the company receives either cash or accounts receivable. In either case, the obvious effect is an increase in the company’s resources, as shown in Exhibit 8-2 by the arrow indicating resources coming into the company (Step 2, part 2B). Consistent with our treatment of resources in previous chapters, this increase may be viewed as a result of management generating resources. The resources (cash or accounts receivable) were not borrowed from creditors nor invested by owners. The resources were generated by management in the performance of management’s responsibility for operating the company. When management generates resources in the operation of the company, such generations are reported as revenues. Remember the discussion of providing services to customers in previous chapters. As customers were serviced, the result was reported as an increase in cash or accounts receivable and an increase in fees revenue. Similarly with the sale of products to customers, the receipt of cash or accounts receivable from customers is reported as an increase in cash or accounts receivable and an increase in a revenue called sales. Since revenues increase stockholders’ equity, the ultimate result of the receipt of cash or accounts receivable from customers is an increase in resources (assets) and an equal increase in stockholders’ equity (through the closing process). If the 100 shirts of the Matthew Sporting Goods Company were sold to its customers on credit, at a price of $37 each, the effects can be summarized as presented as step 2B below. The resource increase and the stockholders’ equity increase (through the revenue increase) are $3,700 (100 x $37).
| | | | | | | |Sources of Management |
| | | |Sources of Borrowed | |Sources of | |Generated |
| |Total Resources |= |Resources |+ |Owner Invested Resources |+ |Resources |
| |Assets |= |Liabilities |+ |Stockholders' Equity |
|Step 1: purchase | | | | | | | |
|of merchandise on credit |+ $2,400 |= |+ $2,400 | | | | |
|Step 2A: flow of merchandise | | | | | | | |
|to customers (expense) |- $2,400 |= | | | | |- $2,400 |
|Step 2B: flow of accounts | | | | | | | |
|receivable from customers | | | | | | | |
|(revenue) |+ $3,700 |= | | | | |+ $3,700 |
Step 3: the collection of cash from customers Within a very short time, often 30 days or less, the Matthew Sporting Goods Company collects cash from customers to whom it sold shirts on credit. As a result, as cash increases and accounts receivable decrease, the company’s resources increase and decrease by the same dollar amount, as shown in Exhibit 8-2 by the arrows at Step 3. If the Matthew Sporting Goods Company collects all of its accounts receivable from its customers ($3,700), the effects can be summarized as presented in step 3 below.
| | | | | | | |Sources of Management |
| | | |Sources of Borrowed | |Sources of | |Generated |
| |Total Resources |= |Resources |+ |Owner Invested Resources |+ |Resources |
| |Assets |= |Liabilities |+ |Stockholders' Equity |
|Step 1: purchase | | | | | | | |
|of merchandise on credit |+ $2,400 |= |+ $2,400 | | | | |
|Step 2A: flow of merchandise | | | | | | | |
|to customers (expense) |- $2,400 |= | | | | |- $2,400 |
|Step 2B: flow of accounts | | | | | | | |
|receivable from customers | | | | | | | |
|(revenue) |+ $3,700 |= | | | | |+ $3,700 |
|Step 3: collection of cash | | | | | | | |
|from credit customers |+ $3,700 | | | | | | |
| |- $3,700 | | | | | | |
Step 4: paying cash to suppliers for purchases made on credit Similar to collecting cash from its credit customers, the Matthew Sporting Goods Company pays cash to its suppliers from whom it purchased the shirts on credit. The obvious effect of the flow of cash out of the company is the company’s resources decrease, as shown in Exhibit 8-2 by the arrow indicating resources going out of the company (Step 4). Inasmuch as the cash is paid to creditors, the other effect is to reduce liabilities (accounts payable). If the Matthew Sporting Goods Company pays all its accounts payable ($2,400), the effects can be summarized as presented in step 4 below.
| | | | | | | |Sources of Management |
| | | |Sources of Borrowed | |Sources of | |Generated |
| |Total Resources |= |Resources |+ |Owner Invested Resources |+ |Resources |
| |Assets |= |Liabilities |+ |Stockholders' Equity |
|Step 1: purchase | | | | | | | |
|of merchandise on credit |+ $2,400 |= |+ $2,400 | | | | |
|Step 2A: flow of merchandise | | | | | | | |
|to customers (expense) |- $2,400 |= | | | | |- $2,400 |
|Step 2B: flow of accounts | | | | | | | |
|receivable from customers | | | | | | | |
|(revenue) |+ $3,700 |= | | | | |+ $3,700 |
|Step 3: collection of cash | | | | | | | |
|from credit customers |+ $3,700 | | | | | | |
| |- $3,700 | | | | | | |
|Step 4: payment of cash to | | | | | | | |
|suppliers for purchases on |- $2,400 |= |- $2,400 | | | | |
|credit | | | | | | | |
Result of four merchandising steps As shown above, the result of the four merchandising steps is the Matthew Sporting Goods Company increased its resources and sources of resources by $1,300. This increase in resources came about because the company was able to charge its customers $13 ($37 - $24) more per shirt than it cost the company to buy each shirt from its suppliers. Since the company sold 100 shirts, the company’s resources increased by $1,300 (100 x $13). Stockholders’ equity increased by $1,300 because management generated the $1,300. This process of increasing resources by charging customers more for products than it cost the company to buy the products is the basis of merchandising. This process is the foundation of merchandising companies and is repeated by them hundreds or thousands of times. Furthermore, this increase in resources through the operation of the company is the key function of management. Management’s primary responsibility is to take resources they have been entrusted with and use them to generate additional resources. The additional resources generated can then be used by the company for many purposes. For example, the additional resources can be used to generate more resources, they may be distributed to owners as dividends, they may be given to employees as additional salaries or wages, or they can be contributed to various charitable organizations.
Management’s ability to generate additional resources by charging customers more than it cost the company to buy the products from its suppliers is reported on the income statement as gross profit or gross margin. As shown in the Matthew Sporting Goods Company’s August income statement in Exhibit 8-3, gross profit is the difference between sales (the dollar amount customers are charged) and the cost of goods sold (the dollar amount charged by suppliers). You should also note in Exhibit 8-3, while the cost of goods sold is the largest expense for the company, there are other expenses, specifically operating expenses and income taxes expense. As you would probably expect, operating expenses include such costs as employees’ salaries and wages, advertising, rent, and insurance.
|Exhibit 8-3 |
|Matthew Sporting Goods Company |
|Income Statement |
|for the Month Ended August 31 |
|Sales |$70,000 |
|Cost of Goods Sold |$42,000 |
|Gross Profit |$28,000 |
|Operating Expenses |$18,900 |
|Income from Operations |$9,100 |
|Other Revenues and (Expenses) |($100) |
|Income Before Taxes |$9,000 |
|Income Taxes Expense |$3,600 |
|Net Income |$5,400 |
Gross profit is a very important statistic for managers. Companies must be able to charge enough for their products so they can pay for the products and all other expenses, and still have enough to result in an increase in resources. If a company cannot charge its customers enough, the company's resources will decrease. If this continues long enough, the company will go out of business. One reason companies may not be able to charge customers enough is they may not be selling products customers want. In other words, a low gross profit could be the result of the company trying to sell undesirable products. Another reason for a low gross profit could be poor product pricing policies: the company may simply be charging too little for the products. In addition to calculating the dollar amount of gross profit, it is common for companies to calculate the gross profit percentage. The gross profit percentage measures the relationship between gross profit and net sales revenue, as follows:
|Gross profit percentage |= |Gross profit |
| | |Net sales revenue |
Using the information from the Matthew Sporting Goods Company presented in Exhibit 8-3, the company's gross profit percentage for August would be 40% ($28,000 / $70,000). For most companies, the gross profit percentage remains fairly constant from year to year. Sudden changes in this percentage are quickly investigated to determine if they indicate a major change in customer demand for the company's products. Gross profit is so important to companies the gross profit percentage is not only calculated for the whole company, but it is often calculated for each major product line.
** You now have the background to do exercises 8.1 and 8.2.
Sources of Merchandise Inventory
Merchandise inventory is obtained when a merchandising company purchases products. Purchases can be made from other merchandising companies or from manufacturing companies. When a company purchases merchandise, it records an increase in its resources for the items purchased and an equal increase in liabilities for the amount owed for the merchandise or an equal decrease in resources for the amount of cash paid. Continuing the illustration of the Matthew Sporting Goods Company, if the company were to purchase, on credit, 150 soccer shirts at a cost of $22 each, the $3,300 (150 x $22 = $3,300) effect on the company would be as follows.
| | |Sources of Borrowed | |Sources of | |Sources of |
|Total | |Resources | |Owner Invested Resources | |Management Generated |
|Resources |= | |+ | |+ |Resources |
|Assets |= |Liabilities |+ |Stockholders' Equity |
|+ $3,300 |= |+ $3,300 | | |
|Oct. 2 |Merchandise Inventory |131 |3,300 | |
| |Accounts Payable |211 | |3,300 |
| |Purchase from Mercurio Inc. | | | |
Uses of Merchandise Inventory
When companies purchase merchandise, they usually carefully check it to see if it is the merchandise that was ordered. This process of checking purchased items is called inspection. Inspection occurs before the company records the inventory through the above journal entry. If the merchandise is unacceptable, it is returned to the supplier and the preceding journal entry is not made. However, once merchandise is accepted and the journal entry is made to record the purchase, the company's management has three reasonable actions to take with regard to the merchandise. One option is to return the merchandise to the suppliers, even though the merchandise passed the company's inspection process. A second option is to sell the merchandise to customers. The third option is to keep the merchandise in the company for sale to customers in the next accounting period. Each of these possible options will be examined in the following paragraphs.
Returning purchased merchandise Occasionally, companies find it necessary to return to their suppliers some of the merchandise purchased from them and recorded through the previous entry. Such merchandise may need to be returned, for example, simply because the company ordered too much. Other merchandise may need to be returned because it came back from a customer who discovered a flaw in the item. (Remember the discussion of sales returns in Chapter 7?) When a company returns merchandise to its supplier, the company's resources (merchandise inventory) decrease. Its liabilities also decrease if the merchandise had been purchased on credit because the company will not have to pay for the merchandise it returned. Continuing the illustration of the Matthew Sporting Goods Company, if the company were to return, for credit, 4 soccer shirts purchased at a cost of $22 each, the $88 (4 x $22 = $88) effect on the company would be as follows.
| | |Sources of Borrowed | |Sources of | |Sources of |
|Total | |Resources | |Owner Invested Resources | |Management Generated |
|Resources |= | |+ | |+ |Resources |
|Assets |= |Liabilities |+ |Stockholders' Equity |
|- $88 |= |- $88 | | |
|Oct. 9 |Accounts Payable |211 |88 | |
| |Merchandise Inventory |131 | |88 |
| |Return to Mercurio Inc. | | | |
It is important for companies to keep aware of merchandise returned to suppliers. Such merchandise, if it had been sold to customers and returned by them, could damage the company's reputation for selling quality merchandise. Even if the company's reputation is not hurt, returning merchandise takes time and effort better spent elsewhere. Because of the importance of knowing about merchandise returned to suppliers, it has been common to record such returns in an account called purchases returns and allowances rather than directly in the merchandise inventory account as shown above. The speed and power of modern computer systems is changing this practice. Using a separate account to record purchases returns and allowances does, however, slightly complicate the accounting for merchandise inventory. Those students who enroll in additional accounting courses will probably have the opportunity to examine some of these complications.
Selling merchandise to customers The most important use of merchandise inventory is its sale to customers. Hopefully, merchandise is used to generate revenues that exceed the cost of obtaining the merchandise and getting it to customers. Through this process, merchandising companies increase their resources over time.
When merchandise is sold to customers, one part of the process results in a decrease in the company's resources as the merchandise flows out of the company into the hands of customers. Since the resources did not go to the company's creditors or owners, but were used up through the company's interaction with its customers, the result is a decrease in stockholders' equity through the recording of the cost of goods sold expense. If the Matthew Sporting Goods Company were to sell 135 of its soccer shirts, each of which cost the company $22, the $2,970 (135 x $22 = $2,970) effect on the company would be as follows.
| | |Sources of Borrowed | |Sources of | |Sources of |
|Total | |Resources | |Owner Invested Resources | |Management Generated |
|Resources |= | |+ | |+ |Resources |
|Assets |= |Liabilities |+ |Stockholders' Equity |
|- $2,970 |= | | | |
|Oct. 12 |Cost of Goods Sold |515 |2,970 | |
| |Merchandise Inventory |131 | |2,970 |
| |Soccer shirts sold | | | |
In accounting for merchandising companies, the cost of goods sold is by far the largest expense. For example, for the three-year period ended January 31, 2007, Wal-Mart's cost of goods sold was approximately four times as large as all its other expenses combined! Because of the financial significance of the cost of goods sold, it is imperative you understand it.
When merchandise is sold to customers, the second part of the process results in an increase in the company's resources as cash or a promise of cash (accounts receivable) flows into the company from customers. Since the resources resulted from management selling merchandise to customers, the result is an increase in stockholders' equity through the recording of sales revenue. If the Matthew Sporting Goods Company were to sell, on credit, 135 soccer shirts, each at a price of $36, the $4,860 (135 x $36 = $4,860) effect on the company would be as follows.
| | |Sources of Borrowed | |Sources of | |Sources of |
|Total | |Resources | |Owner Invested Resources | |Management Generated |
|Resources |= | |+ | |+ |Resources |
|Assets |= |Liabilities |+ |Stockholders' Equity |
|+ $4,860 |= | | | |
|Oct. 12 |Accounts Receivable |121 |4,860 | |
| |Sales |415 | |4,860 |
| |Soccer shirts sold | | | |
Keeping merchandise on hand The third use of merchandise inventory is to keep it on hand to be used for sale to customers in the next accounting period. Think about the necessity of maintaining inventory. Have you ever gone shopping and been unable to find the item you wanted at your favorite store? What did you do if the item was not there? Did you look elsewhere? Because customers often have many stores at which they can shop, merchandising companies must maintain enough inventory at the end of each accounting period to allow them to satisfy customers in the next period until the company can purchase additional merchandise.
From an accounting standpoint, maintaining items in inventory does not affect the accounting equation and does not require a journal entry. The merchandise inventory on hand is a result of three journal entries presented earlier: (1) the purchase of merchandise, (2) the return of merchandise, and (3) the sale of merchandise, as can be seen in the merchandise inventory T account below.
|Merchandise Inventory |
|Beginning inventory | |
| | |
|(1) Purchases | |
| |Purchases returns (2) |
| | |
| |Cost of goods sold (3) |
| | |
|Ending inventory | |
The beginning inventory and the ending inventory are debit balances in the T account because most assets have debit balances. Purchases are debited to the T account because assets increase with debits. Purchases returns and the cost of goods sold are credits because assets decrease with credits.
If the Matthew Sporting Goods Company began the period with merchandise inventory of $220, purchased additional merchandise of $3,300, returned $88 of merchandise, and sold $2,970 of merchandise, the company's merchandise inventory on hand (ending inventory) would be $462, as can be seen below.
|Merchandise Inventory |
|Beginning inventory |220 | | |
| | | | |
|Purchases |3,300 | | |
| | |88 |Purchases returns |
| | | | |
| | |2,970 |Cost of goods sold |
| | | | |
|Ending inventory |462 | | |
The amounts in the above T account show the several items affecting merchandise inventory. These items are often summarized as follows.
|Beginning merchandise inventory |$220 |
|Plus: purchases |3,300 |
|Less: purchases returns |88 |
|Merchandise available for sale |$3,432 |
|Less: cost of goods sold |2,970 |
|Ending merchandise inventory |$462 |
There are two important issues highlighted by the above table. First, the merchandise available for sale subtotal ($3,432) represents the total cost of merchandise inventory the company could have sold in the current period. This subtotal is important because it represents the maximum amount of merchandise management could have sold this period. Second, the table shows the direct relationship between the cost of goods sold and the ending merchandise inventory. Once merchandise available for sale is known, if the company knows its cost of goods sold, it can determine its ending merchandise inventory ($462) by subtracting the cost of goods sold ($2,970) from the merchandise available for sale ($3,432). Similarly, once the merchandise available for sale is known, if the company knows its ending merchandise inventory, it can determine its cost of goods sold ($2,970) by subtracting the ending merchandise inventory ($462) from the merchandise available for sale ($3,432). These calculations are logical when viewed in terms of what actions management can take once it has decided not to return merchandise to suppliers. The only two reasonable courses of action management can take with the merchandise available for sale are to sell the merchandise (in which case the cost of the items becomes the cost of goods sold) or keep the items for sale next period (in which case the cost of the items remains as ending merchandise inventory).
In fact, this relationship between the cost of goods sold and ending merchandise inventory is very important in accounting because, as mentioned previously, the cost of goods sold is the largest expense for merchandising companies. All information necessary to calculate the cost of merchandise available for sale is readily available in the accounting system. Remember, the beginning inventory dollar amount is known because it is carried over from the previous accounting period: the previous period's ending inventory is the current period's beginning inventory. The dollar amount of purchases is known because it comes from invoices received from companies that supplied the merchandise. The purchases returns dollar amount is known because it is the cost of the merchandise returned to suppliers. Thus, the only unknown items relating to merchandise inventory are the cost of goods sold and the ending inventory. It is quite useful to know that if the cost of goods sold can be determined, the ending merchandise inventory can be easily determined by subtraction. Conversely, if the ending merchandise inventory can be determined, the cost of goods sold can be easily determined by subtraction. Even more importantly, if both the cost of goods sold and the ending merchandise inventory can be determined, the reasonableness of the calculated amounts can be checked by comparing their total to the cost of merchandise available for sale.
** You now have the background to do exercises 8.3, 8.4, 8.5, 8.6, 8.7, and 8.8.
Accounting for Merchandise Inventory
As mentioned several times earlier, determining the cost of goods sold is very important because it is the largest expense reported on income statements of merchandising companies. Similarly, determining the cost of ending merchandise inventory is important because merchandise inventory is a large asset reported on merchandising companies' balance sheets. When a merchandising company's unit costs remain constant, determining the cost of goods sold and the ending merchandise inventory is quite easy. The cost of goods sold is simply the number of units sold multiplied by the cost per unit. Similarly, the ending merchandise inventory is just the number of units on hand multiplied by the cost per unit. Remember the Matthew Sporting Goods Company example presented earlier. The company's soccer shirts cost of goods sold of $2,970 was calculated by multiplying the 35 units sold by the $22 cost per unit. The company's soccer shirts $462 ending merchandise inventory was calculated by multiplying the 21 units on hand by the $22 cost per unit.
In actual business, unit costs do not remain constant. For some products, rising costs may be common. For other products, falling costs may occur. For still other products, unit costs may vary, increasing at times and decreasing at other times. Any merchandising company experiencing changing unit costs faces a decision in determining its cost of goods sold and the cost of its ending merchandise inventory. Which unit costs should be used in calculating cost of goods sold? Which unit costs should be used in calculating ending merchandise inventory?
As an illustration of the issues involved with changing product costs, consider the Matthew Sporting Goods Company's purchase and sale of football jerseys in the month of May. Assume the company began May's operation with 20 jerseys on hand, each of which cost the company $31. On May 6, the company sold 16 jerseys at a sales price of $50 each. On May 11, the company purchased 30 additional jerseys at a cost of $32 each. On May 15, the company sold 25 jerseys at a sales price of $50 each. On May 22, the company purchased 40 additional jerseys at a cost of $34 each. On May 27, the company sold 33 jerseys at a sales price of $50 each. Thus, during May the company's cost of football jerseys increased from $31 to $34 each. Some effects on the company's inventory of football jerseys can be seen by examining the company's perpetual inventory records shown below.
|Football jerseys |
| | |Increases |Decreases |Balance |
| | |
|Date |Des. |
The company's May 6 sale of 16 football jerseys is simple to account for because the jerseys had to come from the 20 on hand at the beginning of May. Thus, the cost of goods sold for the May 6 sale must have been $496 (16 jerseys x $31 each). According to the perpetual inventory records, on May 15 the company had available for sale 4 units @ $31 each and 30 units @ $32 each. On May 15, the company sold 25 jerseys? Which unit costs should be assigned to these jerseys? Did 4 of them cost $31 each and the other 21 cost $32 each? Did they all cost $32 each? Was there some other combination of $31 and $32 unit costs? The answers to questions such as these confront every merchandising company whose product costs change.
Over the last several decades, especially with the influence of tax rules enforced by the Internal Revenue Service, several different methods of assigning unit costs to inventory have become commonly accepted by companies in the United States. Two such methods will be examined in the following paragraphs: the first-in, first-out method (FIFO) and the last-in, first-out perpetual method (LIFO perpetual).
First-in, first-out (FIFO) As the name suggests, the FIFO inventory costing method takes the first unit costs that come into the company and assigns them to the cost of products sold (remember products sold are those products that have gone out of the company to customers). FIFO is based on the idea that the first merchandise purchased is the first merchandise sold. An example of a business whose units would flow on a FIFO basis would be a grocery store. It is very important for grocery stores to sell their first units first, otherwise many products could become worthless because they could spoil. Once again, according to the perpetual inventory records, on May 15, before 25 units were sold, the company had available for sale 4 units @ $31 each and 30 units @ $32 each. Using the FIFO method, the Matthew Sporting Goods Company's cost of goods sold for the 25 units sold on May 15 would be calculated as follows:
|Units | |Unit Cost | |Total |
|4 | |$31 (from the 4 units left from the May beginning | | |
| | |inventory after 16 units were sold on May 6) | |$124 |
|21 | |$32 (from the 30 units purchased on May 11) | |$672 |
|25 | | | |$796 |
Similarly, since FIFO assigns the first cost in to the first units sold, those units remaining on hand must be assigned the company's most recent costs. In the case of the Matthew Sporting Goods Company, the 9 units on hand on May 15 would be assigned the most recent costs of $32 from the May 11 purchase. Thus, the company's football jersey inventory at the end of May 15 would be $288 (9 units at a unit cost of $32).
The complete effects of applying the FIFO inventory costing method to the company's May activities can be seen in the perpetual inventory record shown below. You should carefully examine the perpetual inventory record, particularly noting the effects of selling 33 units on May 27. According to the perpetual inventory records, on May 27, before 33 units were sold, the company had available for sale 9 units @ $32 each and 40 units @ $40 each.
|Football jerseys |
| | |Increases |Decreases |Balance |
| | | |Unit | | |Unit | | |Unit | |
|Date |Des. |Quantity |Cost |Total |Quantity |Cost |Total |Quantity |Cost |Total |
|May 1 |B | | | | | | |20 |$31 |$620 |
|6 |S | | | |16 |$31 |$496 |4 |$31 |$124 |
|15 |S | | | |4 |$31 |$124 | | | |
| | | | | |21 |$32 |$672 |9 |$32 |$288 |
|27 |S |
Based on the Decreases Total column in its perpetual inventory records, the company's FIFO cost of goods sold for May is $ 2,396 ($496 + $124 + $672 + $288 + 816) and its football jersey inventory at the end of May is $544. Remembering the relationship between merchandise available for sale, the cost of goods sold, and ending inventory, the reasonableness of the calculations can be checked as follows.
|Beginning merchandise inventory |$620 |
|Plus: purchases |2,320 |
|Merchandise available for sale |$2,940 |
|Less: cost of goods sold |2,396 |
|Ending merchandise inventory |$544 |
For purposes of illustrating the income statement effects of the FIFO method only, if we make some very simple assumptions about the Matthew Sporting Goods Company, its income statement for May could appear as shown in Exhibit 8-6.
|Exhibit 8-6 |
|Matthew Sporting Goods Company |
|Income Statement |
|For the Month Ended May 31 |
|Sales (74 units at $50 each) |$3,700.00 |
|Cost of Goods Sold (FIFO) |$2,396.00 |
|Gross Profit |$1,304.00 |
|Operating Expenses (assumed) |$900.00 |
|Income from Operations |$404.00 |
|Other Revenues and (Expenses) (assumed) |($20.00) |
|Income Before Taxes |$384.00 |
|Income Taxes Expense (40% rate assumed) |$153.60 |
|Net Income |$230.40 |
Two parts of the above income statement are especially worth noting. First, the cost of goods sold is the largest expense. Second, since income taxes expense is related to income before taxes, the cost of goods sold, like all other expenses, reduces income taxes expense by reducing income before taxes. For those companies interested in minimizing their income taxes expense, inventory costing methods, such as FIFO, are very important because they can significantly affect the cost of good sold.
** You now have the background to do exercise 8.9.
Last-in, first-out perpetual (LIFO perpetual) Another common inventory costing method is LIFO. To assist your understanding of perpetual inventory systems, the LIFO inventory method examined in this chapter is the LIFO perpetual inventory method. You should note, however, the LIFO periodic method is very common. As the name suggests, the LIFO perpetual inventory costing method takes the last unit costs that come into the company and assigns them to the cost of products sold (again, remember products sold are those products that have gone out of the company to customers). LIFO is based on the idea that the last merchandise purchased is the first merchandise sold. An example of a business whose units flow on a LIFO basis is a stone and gravel company. Because the stone and gravel products are usually stored outside in large piles, the last units purchased by the company are the first units sold simply because the first units purchased are at the bottom of the piles! Once again, according to the perpetual inventory records, on May 15, before 25 units were sold, the company had available for sale 4 units @ $31 each and 30 units @ $32 each. Using the LIFO perpetual method, the Matthew Sporting Goods Company's cost of goods sold for the 25 units sold on May 15 would be calculated as follows:
|Units | |Unit Cost | |Total |
|25 | |$32 (from the 30 units purchased on May 11) | |$800 |
Similarly, since LIFO perpetual assigns the last cost in to the first units sold, those units on hand must be assigned the company's first costs. In the case of the Matthew Sporting Goods Company, the 9 units on hand on May 15 would be assigned the following costs.
|Units | |Unit Cost | |Total |
|4 | |$31 (from the 4 units left from the May beginning | | |
| | |inventory after 16 units were sold on May 6) | |$124 |
|5 | |$32 (from the 30 units purchased on May 11) | |$160 |
|9 | | | |$284 |
The complete effects of applying the LIFO perpetual inventory costing method to the company's May activities can be seen in the perpetual inventory record shown below. You should carefully examine the perpetual inventory record, particularly noting the effects of selling 33 units on May 27. According to the perpetual inventory records, on May 27, before 33 units were sold, the company had available for sale 4 units @ $31 each, 5 units @ $32 each, and 40 units @ $34 each.
|Football jerseys |
| | |Increases |Decreases |Balance |
| | |
|Date |Des. |
Based on the Decreases Total column in its perpetual inventory records, the company's LIFO perpetual cost of goods sold for May is $ 2,418 ($496 + $800 + $1,122) and its football jersey inventory at the end of May is $522 ($124 + $160 + $238). Again, remembering the relationship between merchandise available for sale, the cost of goods sold, and ending inventory, the reasonableness of the calculations can be checked as follows.
|Beginning merchandise inventory |$620 |
|Plus: purchases |2,320 |
|Merchandise available for sale |$2,940 |
|Less: cost of goods sold |2,418 |
|Ending merchandise inventory |$522 |
For purposes of illustrating the income statement effects of the LIFO perpetual method only, if we again make some very simple assumptions about the Matthew Sporting Goods Company, its income statement for May could appear as shown in Exhibit 8-7.
|Exhibit 8-7 |
|Matthew Sporting Goods Company |
|Income Statement |
|for the Month Ended May 31 |
|Sales (74 units at $50 each) |$3,700.00 |
|Cost of Goods Sold (LIFO perpetual) |$2,418.00 |
|Gross Profit |$1,282.00 |
|Operating Expenses (assumed) |$900.00 |
|Income from Operations |$382.00 |
|Other Revenues and (Expenses) (assumed) |($20.00) |
|Income Before Taxes |$362.00 |
|Income Taxes Expense (40% rate assumed) |$144.80 |
|Net Income |$217.20 |
Again, there are parts of the above income statement worth noting. First, the cost of goods sold is the largest expense. Second, since income taxes expense is related to income before taxes, the cost of goods sold, like all other expenses, reduces income taxes expense by reducing income before taxes. For those companies interested in minimizing their income taxes expense, inventory costing methods, such as LIFO perpetual, are very important because they can significantly affect the cost of good sold.
** You now have the background to do exercise 8.10.
FIFO and LIFO perpetual compared Exhibit 8-8 presents a comparison of the Matthew Sporting Goods Company's income statement in which the FIFO method was used to calculate the cost of goods sold (Exhibit 6) to the company's income statement using the LIFO perpetual method (Exhibit 7). A review of Exhibit 8-8 should make it easier to see the importance of knowing about the effects of different inventory costing methods, such as FIFO and LIFO perpetual.
|Exhibit 8-8 |
|Matthew Sporting Goods Company |
|Income Statements |
|for the Month Ended May 31 |
| | |LIFO |FIFO-LIFO |
| |FIFO |Perpetual |Perpetual |
|Sales (74 units at $50 each) |$3,700.00 |$3,700.00 |$0 |
|Cost of Goods Sold |$2,396.00 |$2,418.00 |- $22.00 |
|Gross Profit |$1,304.00 |$1,282.00 |+ $22.00 |
|Operating Expenses |$900.00 |$900.00 |$0 |
|Income from Operations |$404.00 |$382.00 |+ $22.00 |
|Other Revenues and (Expenses) |($20.00) |($20.00) |$0 |
|Income Before Taxes |$384.00 |$362.00 |+ $22.00 |
|Income Taxes Expense (40%) |$153.60 |$144.80 |+ $8.80 |
|Net Income |$230.40 |$217.20 |+ $13.20 |
Exhibit 8-8 shows that as inventory costing methods (FIFO and LIFO perpetual) affect the cost of goods sold, several income statement items are also affected, specifically, gross profit, income from operations, income before taxes, income taxes expense, and net income. Of particular importance to managers are the effects on income taxes expense and net income. Income taxes expense is important to managers because it requires a cash outlay for the company. Remember, income taxes must be paid, which requires cash! Net income is important to managers because it is often the primary measure on which their performance is evaluated.
In order to reduce income taxes payments, managers must reduce income before taxes. One way to reduce income before taxes is to increase expenses. Remember, as expenses increase, income decreases. In the case of merchandise inventory, to decrease income before taxes managers must increase the cost of goods sold. By choosing the appropriate inventory costing method, it is possible to increase the cost of goods sold, which in turn will reduce income before taxes and, thus, reduce income taxes expense. A reduced income taxes expense results in less cash flowing out of the company for taxes.
As shown in Exhibit 8-8, in the case of the Matthew Sporting Goods Company's May operations, if the company had used FIFO, its cash payments required for income taxes would have been $153.60. Using LIFO perpetual, the company's required cash payments would have been $144.80. Thus, by choosing LIFO perpetual, the company could have reduced its cash payments for income taxes by $8.80. Rather than paying the $8.80 for taxes, the company could use it for other purposes, such as investing to generate additional resources.
Consider the effects of the Matthew Sporting Goods Company’s investing $8.80 in a project that would earn the company a 10% return before taxes. By investing in such a project, the company would earn $.88 ($8.80 x .10). If the company pays federal and state income taxes of approximately 40%, the company would pay income taxes of $.35 ($.88 x .40) on the $.88 earnings. Thus, the company would get to keep $.53 ($.88 - $.35). This $.53 represents additional resources the company generated by (1) choosing LIFO perpetual instead of FIFO and (2) investing the cash not paid for taxes ($8.80) at a 10% rate of return before taxes. Although the $.53 additional resources seems very small, remember in the simple case of the Matthew Sporting Goods Company, there was only a $22 difference between the FIFO and LIFO perpetual cost of goods sold (see Exhibit 8). However, for many large companies, the annual differences between inventory methods can be significant, often millions of dollars. For example, as of January 31, 2007, through careful use of inventory methods, Wal-Mart postponed approximately $600 million of tax payments. If Wal-Mart’s managers can use the $600 million in projects similar to prior Wal-Mart projects, they will be able to generate approximately $45 million of additional resources per year. As you can imagine, additional resources generated through the intelligent choice of inventory costing methods by companies such as Wal-Mart have been quite large over the years.
Managers must also be aware when inventory costing methods reduce taxes by increasing the cost of goods sold, another effect is net income is reduced. Note in Exhibit 8-8 although the LIFO perpetual method resulted in $8.80 less income taxes expense, it also resulted in $13.20 less net income. Under certain conditions, managers may not want to report lower net income, even though lower income results in lower taxes. It may be important for management to report high income in order to borrow resources from financial institutions, to get additional resources through owners' investments, or simply to keep owners satisfied. It may also be important for managers to report high income in order for them to get themselves larger bonuses or promotions.
In short, inventory costing techniques, like FIFO and LIFO perpetual, directly affect company income statements. Under conditions of changing unit costs of purchases, such techniques, by affecting the cost of goods sold, can affect a company's net income and cash payments required for income taxes.
A few final notes about inventory costing methods. First, in the Matthew Sporting Goods Company example presented above, the company's product costs were increasing. As a result, the LIFO perpetual method resulted in higher cost of goods sold, lower income taxes expense, and lower net income. As you might expect, if product costs had been declining, the FIFO method would have resulted in higher cost of goods sold, lower income taxes expense, and lower net income. Since the effects of the methods depend upon the direction of unit cost changes (and other factors, too), it would be logical for companies to switch inventory costing methods from time to time, depending upon what is happening to unit costs. Fortunately, the accounting profession is aware of this possibility and does not allow it. There is an accounting concept, called consistency, which requires accounting principles followed in preparation of accounting data be the same from period to period unless the resulting data would be misleading for people trying to use it. In the case of inventory costing methods, the consistency concept prohibits companies from frequently changing from FIFO to LIFO perpetual or any other inventory costing method just to affect tax payments or net income.
A second important point to note is only two inventory techniques, FIFO and LIFO perpetual, were examined above. There are other common methods, such as specific identification, weighted average, and lower-of-cost-or-market. The mechanics of these methods are different than FIFO and LIFO perpetual, but they all result in dollar amounts for the cost of goods sold and merchandise ending inventory. When you enroll in additional accounting courses, you may be exposed to these other inventory techniques.
Finally, many companies use more than one inventory method. FIFO is used for some products, LIFO for others, and other methods for still other products. Furthermore, some of the methods are used in combination with one another, such as, lower-of-cost-or-market and LIFO. There is a wealth of literature available on inventory methods!
Tax planning versus tax evasion The tax benefits available through proper choice of inventory methods are examples of good tax planning followed by the vast majority of large U. S. companies. The Internal Revenue Service allows companies to choose among various inventory methods because such choices are in the long-run best interests of citizens and the government. On the other hand, the IRS does not condone tax evasion, which is the willful violation of tax laws. Choosing among inventory methods to postpone tax payments is not tax evasion as long as the inventory method followed is allowable by the IRS. Companies take great care to understand the tax laws in order to make sure the accounting methods they use, such as their inventory methods, are acceptable to the IRS.
** You now have the background to do exercise 8.11 and problems 8.1 and 8.2.
Financial Statement Reporting of Merchandise Inventory
Merchandise inventory is reported as an asset on the balance sheet as shown below.
|Assets | | |
|Current Assets | | |
|Cash | |$18,330 |
|Accounts Receivable |$75,000 | |
|Less: Allowance for Uncollectible Accounts |$1,500 |$73,500 |
|Merchandise Inventory | |$210,000 |
The cost of goods sold is reported on the income statement, usually appearing separately as the largest expense.
|Sales | |$400,000 |
|Cost of Goods Sold | |$160,000 |
|Gross Profit | |$240,000 |
|Operating Expenses | | |
|Salaries Expense |$73,000 | |
|Wages Expense |$40,000 | |
|Supplies Expense |$3,000 | |
|Utilities Expense |$9,000 | |
|Rent and Insurance Expense |$14,000 | |
|Uncollectible Accounts Expense |$1,000 | |
|Total Operating Expenses | |$140,000 |
|Income from Operations | |$100,000 |
|Other Revenues and (Expenses) | |($1,000) |
|Income Before Taxes | |$99,000 |
|Income Taxes Expense | |$34,650 |
|Net Income | |$64,350 |
Chapter 8 Critical Points
• Products purchased by merchandising companies to be sold to their customers are called merchandise inventory.
• By buying products and selling them to customers at higher prices, merchandising companies increase their resources.
• One of the two parts of sales of products is the flow of products to customers. This outflow of products results in a decrease in the company's resources (merchandise inventory) and a decrease in stockholders' equity through the recognition of the cost of goods sold (expense).
• The second part of sales of products is the flow of cash or accounts receivable into the company. This inflow results in an increase in the company's resources (cash or accounts receivable) and an increase in stockholders' equity through the recognition of sales (revenue).
• The cost of goods sold is the largest expense reported on merchandising companies' income statements.
• Gross profit is the difference between sales revenue and the cost of goods sold.
• The gross profit percentage is calculated by dividing gross profit by net sales (sales less sales returns and allowances).
• Merchandise inventory comes from the purchase of products from other companies.
• The most important use of merchandise inventory is its sale to customers, in which case the merchandise inventory becomes the cost of goods sold.
• Another important use of merchandise inventory is some is kept on hand to be available for sale to customers next period.
• Merchandise inventory is reported as a current asset on the balance sheet.
• Inventory costing methods, like FIFO and LIFO, can significantly affect merchandising companies' net income by affecting the cost of goods sold.
• Inventory costing methods, like FIFO and LIFO, can significantly affect merchandising companies' cash payments for income taxes by affecting the cost of goods sold.
• The following major topics have been examined so far.
|Assets |= |Liabilities |+ |Stockholders' Equity |
|Current Assets | | | |Revenues |
|Cash and cash equivalents (6) | | | |Sales (7) |
|Accounts receivable (7) | | | |Sales Returns & Allow. (7) |
|Allow. for Uncoll. Accts. (7) | | | |Cost of Goods Sold (8) |
|Merchandise inventory (8) | | | |Operating Expenses |
| | | | |Uncollect. Accts. Exp. (7) |
| | | | |Bank Service Expense (6) |
| | | | |Other Revenues & Expenses |
| | | | |Interest Revenue (6) |
| | | | |Interest Expense (6) |
Chapter Eight Questions
1. Define the term merchandise inventory.
2. Identify three examples of merchandise inventory.
3. What is the major difference between merchandising and manufacturing?
4. Identify four major steps involved with merchandise inventory.
5. What is the primary objective of the four merchandise inventory steps you identified in question 4?
6. How is gross profit calculated?
7. Why is gross profit important to merchandising companies?
8. State the formula for calculating the gross profit percentage.
9. How often are merchandise inventory records updated in a perpetual inventory system?
10. How does a perpetual inventory system differ from a periodic inventory system?
11. What is the reason merchandising companies inspect merchandise they purchase?
12. What is the most important use merchandising companies make of their merchandise inventory?
13. Why do merchandising companies maintain some merchandise inventory at the end of each accounting period?
14. After a merchandising company purchases merchandise, what are the three most important actions the company can take with the merchandise?
15. After a merchandising company purchases merchandise, inspects it, and returns any unwanted items, what are the two most important actions the company can take with the remaining merchandise?
16. What is the relationship between a company's cost of goods sold and its ending merchandise inventory?
17. Identify the name of the largest expense on the income statement of most merchandising companies.
18. What does a FIFO inventory system do with the first unit costs coming into a merchandising company?
19. What does a FIFO inventory system do with the last unit costs coming into a merchandising company?
20. What does a LIFO inventory system do with the first unit costs coming into a merchandising company?
21. What does a LIFO inventory system do with the last unit costs coming into a merchandising company?
22. What is the difference between tax planning and tax evasion?
23. In what section of the balance sheet is merchandise inventory reported?
24. On which financial statement and in which section is the cost of goods sold reported?
Chapter Eight Exercises
Exercise 8.1: Merchandising Income
The Chang Corporation began operations on September 1. During September, the company purchased 1,000 pairs of gloves at a cost of $30 per pair. By the end of September, the company had sold all the gloves for $42 per pair. The company's operating expenses for September were $8,000 and its effective income tax rate was 40%.
1. Determine the company's September sales revenue.
2. Determine the company's September cost of goods sold.
3. Determine the company's September gross profit.
4. Determine the company's September income before taxes.
5. Determine the company's September income taxes expense.
6. Determine the company's September net income.
7. If the Chang Corporation paid cash for its September purchases, operating expenses, and income taxes expense, by what dollar amount did the company's resources increase in September as a result of buying and selling merchandise?
Exercise 8.2: Gross Profit Percentage
The following information is from the records of the Masse Corporation.
| |Year 3 |Year 2 |Year 1 |
|Sales |$22,959 |$22,384 |$22,145 |
|Cost of Goods Sold |$17,405 |$17,109 |$17,079 |
|Gross Profit |$5,554 |$5,275 |$5,066 |
|Operating Expenses |$4,805 |$4,601 |$4,418 |
|Income from Operations |$749 |$674 |$648 |
|Other Revenues and (Expenses) |($328) |($390) |($475) |
|Income Before Taxes |$421 |$284 |$173 |
|Income Taxes Expense |$152 |$113 |$72 |
|Net Income |$269 |$171 |$101 |
1. Calculate the Masse Corporation's gross profit percentage for Year 3.
2. Calculate the Masse Corporation's gross profit percentage for Year 2.
3. Calculate the Masse Corporation's gross profit percentage for Year 1.
4. Comment on the trend you see in the company's gross profit percentage.
Exercise 8.3: Beginning Merchandise Inventory
During February, the Reeney Corporation purchased $56,000 of merchandise inventory and returned $4,000 of the merchandise. The company sold to customers merchandise that cost the company $42,000. At the end of February, the company had $15,000 of merchandise on hand.
Calculate the cost of merchandise inventory the Reeney Corporation had on hand at the beginning of February.
Exercise 8.4: Merchandise Purchases
At the beginning of March, the Chandran Corporation had merchandise inventory of $8,000 on hand. During March, the Chandran Corporation returned $3,000 of the merchandise it purchased in March. The company sold to customers merchandise that cost the company $24,000. At the end of March, the company had $11,000 of merchandise on hand.
Calculate the cost of merchandise inventory the Chandran Corporation purchased during March.
Exercise 8.5: Purchases Returns
At the beginning of April the Damron Corporation had merchandise inventory of $19,000 on hand. During April, the Damron Corporation purchased $63,000 of merchandise inventory. The company sold to customers merchandise that cost the company $71,000. At the end of April, the company had $6,000 of merchandise on hand.
Calculate the cost of merchandise the Damron Corporation returned during April.
Exercise 8.6: Cost of Goods Sold
At the beginning of May, the Dumais Corporation had merchandise inventory of $7,000 on hand. During May, the Dumais Corporation purchased $36,000 of merchandise inventory. The company returned merchandise that cost the company $2,000. At the end of May, the company had $4,000 of merchandise on hand.
Calculate the cost of merchandise the Dumais Corporation sold to its customers during May.
Exercise 8.7: Ending Merchandise Inventory
At the beginning of June, the Pierce Corporation had on hand merchandise that cost $27,000. During June, the company purchased $106,000 of merchandise inventory and returned $18,000 of the merchandise. The company sold to customers merchandise that cost the company $96,000.
Calculate the cost of merchandise inventory the Pierce Corporation had on hand at the end of June.
Exercise 8.8: Merchandising Journal Entries
Prepare the journal entries required to record the following transactions of the Katsikas Corporation. Before you prepare each entry, determine the transaction's effects on the company's resources and sources of resources.
July 1: Purchased $15,000 of merchandise on account.
| | |Sources of Borrowed | |Sources of | |Sources of |
|Total |= |Resources |+ |Owner Invested Resources |+ |Management Generated Resources |
|Resources | | | | | | |
|Assets |= |Liabilities |+ |Stockholders' Equity |
| | | | | | | |
| | |Posting | | |
|Date |Description |Ref. |Debits |Credits |
|July 1 | | | | |
| | | | | |
| | | | | |
July 5: Sold on account $3,500 of merchandise to customers for $5,900.
| | |Sources of Borrowed | |Sources of Owner Invested | |Sources of |
|Total |= |Resources |+ |Resources |+ |Management Generated |
|Resources | | | | | |Resources |
|Assets |= |Liabilities |+ |Stockholders' Equity |
| | | | | | | |
| | | | | | | |
| | |Posting | | |
|Date |Description |Ref. |Debits |Credits |
|July 5 | | | | |
| | | | | |
| | | | | |
| | | | | |
| | | | | |
| | | | | |
| | | | | |
July 9: Returned for credit $800 of merchandise purchased on July 1.
| | |Sources of Borrowed | |Sources of | |Sources of |
|Total |= |Resources |+ |Owner Invested Resources |+ |Management Generated Resources |
|Resources | | | | | | |
|Assets |= |Liabilities |+ |Stockholders' Equity |
| | | | | | | |
| | |Posting | | |
|Date |Description |Ref. |Debits |Credits |
|July 9 | | | | |
| | | | | |
| | | | | |
July 14: Paid cash for $9,000 of additional merchandise.
| | |Sources of Borrowed | |Sources of | |Sources of |
|Total |= |Resources |+ |Owner Invested Resources |+ |Management Generated Resources |
|Resources | | | | | | |
|Assets |= |Liabilities |+ |Stockholders' Equity |
| | | | | | | |
| | |Posting | | |
|Date |Description |Ref. |Debits |Credits |
|July 14 | | | | |
| | | | | |
| | | | | |
July 18: Sold $4,800 of merchandise to customers for $8,000 cash.
| | |Sources of Borrowed | |Sources of | |Sources of |
|Total |= |Resources |+ |Owner Invested Resources |+ |Management Generated Resources |
|Resources | | | | | | |
|Assets |= |Liabilities |+ |Stockholders' Equity |
| | | | | | | |
| | | | | | | |
| | |Posting | | |
|Date |Description |Ref. |Debits |Credits |
|July 18 | | | | |
| | | | | |
| | | | | |
| | | | | |
| | | | | |
| | | | | |
| | | | | |
July 21: Purchased $12,000 of merchandise on account.
| | |Sources of Borrowed | |Sources of | |Sources of |
|Total |= |Resources |+ |Owner Invested Resources |+ |Management Generated Resources |
|Resources | | | | | | |
|Assets |= |Liabilities |+ |Stockholders' Equity |
| | | | | | | |
| | |Posting | | |
|Date |Description |Ref. |Debits |Credits |
|July 21 | | | | |
| | | | | |
| | | | | |
July 25: Sold on account $6,500 of merchandise to customers for $11,000.
| | |Sources of Borrowed | |Sources of | |Sources of |
|Total |= |Resources |+ |Owner Invested Resources |+ |Management Generated Resources |
|Resources | | | | | | |
|Assets |= |Liabilities |+ |Stockholders' Equity |
| | | | | | | |
| | | | | | | |
| | |Posting | | |
|Date |Description |Ref. |Debits |Credits |
|July 25 | | | | |
| | | | | |
| | | | | |
| | | | | |
| | | | | |
| | | | | |
| | | | | |
July 27: Paid $6,000 as partial payment for merchandise purchased on July 1.
| | |Sources of Borrowed | |Sources of | |Sources of |
|Total |= |Resources |+ |Owner Invested Resources |+ |Management Generated Resources |
|Resources | | | | | | |
|Assets |= |Liabilities |+ |Stockholders' Equity |
| | | | | | | |
| | |Posting | | |
|Date |Description |Ref. |Debits |Credits |
|July 27 | | | | |
| | | | | |
| | | | | |
July 30: Returned for credit $1,200 of merchandise purchased on July 21.
| | |Sources of Borrowed | |Sources of | |Sources of |
|Total |= |Resources |+ |Owner Invested Resources |+ |Management Generated Resources |
|Resources | | | | | | |
|Assets |= |Liabilities |+ |Stockholders' Equity |
| | | | | | | |
| | |Posting | | |
|Date |Description |Ref. |Debits |Credits |
|July 30 | | | | |
| | | | | |
| | | | | |
Exercise 8.9: FIFO Inventory Costing
The Lord Corporation began July with 15 units of merchandise inventory on hand. Each unit had cost the company $22. During July, the company made the following purchases: July 7, 18 units at $25 each; July 19, 23 units at $27 each; and July 27, 24 units at $29 each. The company made the following sales in July: July 12, 17 units at $50 each; July 21, 22 units at $50 each; and July 29, 27 units at $50 each. The company uses the FIFO inventory method.
1. Calculate the company’s July cost of goods sold
2. Calculate the company’s cost of the merchandise inventory on hand on July 31.
Exercise 8.10: LIFO Perpetual Inventory Costing
The Connors Corporation began July with 15 units of merchandise inventory on hand. Each unit had cost the company $22. During July, the company made the following purchases: July 7, 18 units at $25 each; July 19, 23 units at $27 each; and July 27, 24 units at $29 each. The company made the following sales in July: July 12, 17 units at $50 each; July 21, 22 units at $50 each; and July 29, 27 units at $50 each. The company uses the LIFO perpetual inventory method.
1. Calculate the company’s July cost of goods sold
2. Calculate the company’s cost of the merchandise inventory on hand on July 31.
Exercise 8.11: FIFO Versus LIFO Inventory Costing
The Garnick Company reported annual sales of $20,000,000. If the company used the FIFO inventory method, its cost of goods sold would have been $11,000,000. The cost of goods sold under LIFO would have been $11,500,000. Operating expenses for the company were $6,000,000 during the year. The company estimates its income taxes expense to be approximately 40% of income before taxes.
1. Calculate the company’s net income under the FIFO inventory method.
2. Calculate the company’s net income under the LIFO inventory method.
3. Calculate the income tax advantage the company would realize if it were to use the LIFO inventory method.
Chapter Eight Problem
Problem 8.1: Inventory Costing: FIFO, LIFO Perpetual
The Braucher Merchandising Corporation, which is owned by Matthew Braucher, began May operations with merchandise inventory of 12 units, each of which cost $58. During May, Braucher Merchandising made the following purchases: (1) May 4, 24 units @ $59 per unit, (2) May 15, 36 units @ $61 per unit, (3) May 26, 28 units @ $64 per unit. During May the Company sold the following units at a sales price of $105 per unit: May 6, 21 units, May 20, 27 units, May 28, 27 units. Operating expenses in May were $2,600. The Company estimates its income taxes expense will be approximately 35% of income before taxes.
You have been asked by Matthew Braucher to assist him in deciding which inventory costing method to use in accounting for the Braucher Merchandising Corporation's May activity.
1. Determine the following for the Braucher Merchandising Corporation:
| | |LIFO |
| |FIFO |Perpetual |
|Inventory dollar amount on May 1 |$__________ |$__________ |
|Dollar amount of purchases made in May |$__________ |$__________ |
|Cost of goods available for sale during May |$__________ |$__________ |
|Cost of goods sold during May |$__________ |$__________ |
|Inventory dollar amount on May 31 |$__________ |$__________ |
2. Calculate the Braucher Merchandising Corporation's May net income using the FIFO and LIFO perpetual cost flow assumptions. Round all calculations to the nearest dollar.
|Braucher Merchandising Corporation |
|Income Statements |
|For the Month Ended May 31 |
| | |LIFO |
| |FIFO |Perpetual |
|Sales |$___________ |$___________ |
|Cost of Goods Sold |$___________ |$___________ |
|Gross Profit |$___________ |$___________ |
|Operating Expenses |$___________ |$___________ |
|Income Before Taxes |$___________ |$ 661 |
|Income Taxes Expense |$___________ |$___________ |
|Net Income |$ 504 |$___________ |
3. How much more cash would the Braucher Merchandising Corporation have available if it uses LIFO perpetual instead of FIFO? $_______________
-----------------------
Step 1
Purchase merchandise
on credit from suppliers
Step 2
Sell merchandise on
credit to customers
Step 4
Pay cash
to suppliers
Step 3
Collect cash
from customers
Resources
2B
2A
................
................
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