Chapter 6

Inventory and
Merchandising
Operations

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 Chapter 5 Review
• Balance revenues with cost of not being able to
collect
– Bad Debt Expense
– Allowance of Uncollectible Accounts
• Steps related to bad debts
1) Record Bad Debt Expense & Allowance
2) Write off bad debts
3) Calculate how much allowance is needed
– Aging method
2
 Chapter 6
• Objective 1
– Understanding the nature of inventory
• Objective 2
– Recording inventory-related transactions
• Objective 3
– Determine inventory and cost of goods sold
• Objective 4
– Use gross profit percentage and inventory turnover to
evaluate operations

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Understand the nature of inventory
LEARNING OBJECTIVE 1

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 Inventory, Supplies, Equipment
• To clarify, these assets are all different
– Merchandise Inventories
• Assets purchased with the intent of selling
them to customers
– Supplies are assets purchased to be used
• Short-term assets, consumed when used
– Equipment are assets purchased to be used
• Usually included in long-term assets, consumed
when used, but depreciated

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 Accounting For Inventory
Balance Sheet (partial)
Current assets:
Cash $$$$
Accounts receivable $$$$
Inventory (1 shirts @ cost of $30) $30

Income Statement (partial)

Sales (2 shirts @ $50 selling price) $100
Cost of goods sold (2 shirts @ $30 cost) 60
Gross profit $40

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 The cost of The cost of inventory
inventory on hand that’s been sold
= Inventory = Cost of Goods Sold

Asset on the Balance Expense on the

Sheet Income Statement

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 GROSS PROFIT

SALES REVENUE

COST OF GOODS SOLD

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 Cost of Goods Sold
• Direct costs attributable to the production of the goods
– Cost of the materials used in creating products
– Direct labor costs

• Exclude indirect costs

– Distribution costs 
– Utility costs
– CEO Salary

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 Number of units
• Determined from accounting records
• Evidenced by physical count at year end
• Consigned goods:
– Does not include those held for another company
– Does include those out on consignment(sell or return)
• In transit goods
– Depends on shipping terms

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 Cosigned Goods
• Merchandise that is not owned by the party in
possession of the goods
– A craftsperson might have produced 100 ornate
wood items. Local merchant to take 5 items on
consignment.
– Who owns the 5 items?

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 Shipping terms
FOB means Free-On-Board or Freight-On-Board

FOB Shipping Point FOB Destination

• Legal title passes to buyers • Legal title passes to buyers
when items leave seller’s when items arrive at buyers’
place of business place of business
• Buyers own good while in • Seller owns goods while in
transit transit
– Included in buyers’ inventory – Included in seller’s inventory
count count
• Buyers pay transportation • Seller pays transportation
costs costs

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Recording inventory-related transactions
LEARNING OBJECTIVE 2

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 Inventory Systems
Perpetual Periodic
Used for all types of goods Used for inexpensive goods
Keeps a running total of all Does not keep a running
goods bought, sold and on total of all goods bought,
hand sold and on hand
Inventory counted at least Inventory counted at least
once a year once a year

Must count inventory at least once a year

under both systems
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 Perpetual Inventory
• Bar codes on products provide information to
record
– Sale of item
– Update of inventory record

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 Perpetual Inventory
• Two entries needed for each sale
– Record revenue and asset received (cash or
receivables)
– Record cost of sale and reduction of inventory

• In this class, assume Perpetual Inventory

unless otherwise specified!

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 Recording Inventory (Amounts Assumed)
JOURNAL
Date Accounts and explanation Debit Credit
Inventory 560,000
Accounts payable 560,000
1. Purchased inventory on account

Accounts receivable 900,000

Sales Revenue 900,000
2. Sold inventory on account

Cost of goods sold 540,000

Inventory 540,000
3. Recorded cost of goods sold
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 Recording Inventory (Amounts Assumed)
Inventory
Beginning balance $100,000
Purchases
Ending balance

Cost of Goods Sold

Cost of goods sold

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 Exercise 1
• Summer Kluxon, Inc., purchased inventory
costing $120,000 and sold 75% of the goods
for $150,000. All purchases and sales were on
account. Kluxon later collected 30% of the
accounts receivable.

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• Journalize these transactions for Kluxon,
which uses the perpetual inventory system.

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• For these transactions, show what Kluxon will
report for inventory, revenues, and expenses
on its financial statements. Report gross profit
on the appropriate statement.

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 Cost of Net Purchases (Buyer
Perspective)
• Purchases and Inventory includes related direct
costs, including:
– Freight-in is the cost of delivery paid by the buyer
(carriage inwards)
– Returns are reduction in inventory for sending goods
back to seller
– Allowances are reduction in price granted for certain
purchases(trade discounts)
– Discounts are reduction in price, often for paying on
time(cash discounts)
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 Recording Inventory
JOURNAL
Date Accounts and explanation Debit Credit
Inventory 500,000
Freight-inwards 60,000
Accounts Payable 560,000
Purchase of inventory, including $60,000 freight costs

Inventory 60,000
Freight-inwards 60,000
Transfer of freight-inwards to inventory cost

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 Return defective inventory

Accountants Payable 10,000

Inventory 10,000
Returned defective inventory to vendor

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Reporting in the Financial Statements
Balance Sheet (partial)
Current assets:
Cash $$$$
Accounts receivable $$$$
Inventory $70,000

Income Statement (partial)

Sales $900,000
Cost of goods sold 540,000
Gross profit $360,000

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 Purchase Payment Terms
• Inventory purchases often specify payment terms
that include:

– Discount

– Discount period

– Net due period

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• Example 1, payment terms of 3/5, n/30 means:
– 3% discount
– If paid within 5 days
– Net amount due within 30 days

• Example 2, payment terms of 2/10, n/eom

– 2 % discount
– If paid within 10 days
– Net amount due by the end of the month

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 Net Sales (Seller Perspective)
• Sales are adjusted for Sales revenue
returns, allowances,
and discounts - Sales returns and
allowance
• Sales do not include
shipping, even if paid - Sales discounts
by seller
=Net sales
– Separate category
called shipping expense
or delivery expense Reduces Sales Revenue!

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Determine inventory and cost of goods sold based
on various inventory cash flow assumptions.
LEARNING OBJECTIVE THREE

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Question about ZARA

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• Trousers that cost Zara $10 in January may
cost $14 in June and $18 in October.

• Zara sells 1,000 pairs of trousers in November.

• How many of those cost $10, $14, and $18?

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Inventory Methods (Assumptions)

Specific Average
unit cost

First-in, Last-in,
first-out first-out
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Specific Unit (Specific Identification)
• Used different inventory methods for different
inventory items
– Automobiles, fine jewelry, real estate
• Inventory expensed at specific price of the
particular unit
• Limitation : Too expensive for inventories with
common characteristics

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 First-in, First-out (FIFO)
• Oldest items assumed to be sold first
• Ending inventory consists of most recent
purchase costs
Inventory (at FIFO Cost)

Beg bal (10 units @ $10) $100

Purchases: Cost of goods sold (40 units):
No. 1 (25 units @ $14) 350 (10 units @ $10) 100
No. 2 (25 units @ $18) 450 (25 units @ $14) 350
(5 units @ $18) 90
Ending
Balance(20 units @ $18) 360

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 Last-in, First-out (LIFO)
• Most recent items purchased are assumed to
be sold first
• Oldest costs in ending inventory
Inventory (at LIFO Cost)

Beg bal (10 units @ $10) $100

Purchases: Cost of goods sold (40 units):
No. 1 (25 units @ $14) 350 (25 units @ $18) 450
No. 2 (25 units @ $18) 450 (15 units @ $14) 210

Ending (10 units @ $10) 240

Balance (10 units @ $14)
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Average Cost (Weighted Average)
Average cost Cost of goods available *
per unit
Number of units available*

*Goods available = Beginning inventory + Purchases

Cost of Number of Average cost
goods sold units sold per unit

Ending Number of Average cost

inventory units on hand per unit

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 Average Cost
Inventory (at Average Cost)

Beg bal (10 units @ $10) $100

Purchases:
No. 1 (25 units @ $14) 350 Cost of goods sold (40 units @
No. 2 (25 units @ $18) 450 average cost of $15 per unit) 600

Ending (20 units @ average 300

Balance cost of $15 per unit)

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 Financial Statements Effects of the FIFO, LIFO
and Average Cost Inventory Methods

FIFO LIFO Average

Sales revenue (assumed) $1,000 $1,000 $1,000
Cost of goods sold
Gross profit
Inventory (on balance sheet)

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 Exercise 2
Coca Cola
Units Unit Total Units
Cost Cost Sold
Beginning inventory 15 $5 $75
Purchase on Mar 25 40 8 320
Purchase on Dec 13 10 9 90
Sales 40 ? ?

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• Coca Cola uses a FIFO inventory system. Cost
of goods sold for the period is

a. $360
b. $298
c. $275
d. $330

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• Coca Cola’s LIFO cost of ending inventory
would be

a. $187
b. $155
c. $210
d. $200

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• Coca Cola’s average cost of ending inventory is

a. $210
b. $155
c. $187
d. $200

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Impact of Inventory Methods on Financial
Statements

Increasing inventory prices

Cost of goods sold Ending inventory
FIFO Lowest because Highest because
based on older costs, based on more recent
which are less and expensive costs
expensive

LIFO Highest because Lowest because based

based on more recent on older costs, which
costs, which are more are less expensive
expensive

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 Impact of Inventory Methods on
Financial Statements
Decreasing inventory prices
Cost of goods sold Ending inventory

FIFO Highest because based Lowest because based

on older costs, which on more recent, less
are more expensive expensive costs

LIFO Lowest because based Highest because based

on more recent costs on older, more
which are less expensive costs
expensive
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45
Comparison of Inventory Methods
COST OF GOODS SOLD ENDING INVENTORY
• LIFO provides a more • FIFO provides a more
realistic net income up-to-date inventory
figure cost
– More recent costs – More recent costs on the
included in Cost of Balance Sheet
Goods Sold

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Principles Related to Inventories

Comparability
Principle Net Realizable
Value
(consistency)

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 Comparability Principle
• Business should use the same accounting
methods from year-to-year
• Allows investors to compare financial
statements from one period to the next
• Companies are permitted to change methods
– Must disclose effect on net income

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 Exercise
• HollyFrontier Corporation changed from FIFO
to LIFO in 2009.

• Pre-tax income will decrease by US$ 180

million

• Why?

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 LIFO is not allowed under IFRS
• Inventory is recognized at amounts bearing
little relationship to cost level inventories

• Conceptual Framework favors ?

• LIFO distorts income

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 Net Realizable Value
• Inventory is reported at the lower of
– Cost, or
– Net realizable value (NRV)

• Net the estimated costs necessary to make the

realizable value is the estimated selling price in
the ordinary course of business less the
estimated costs of completion and sale.

• If NRV is lower, inventory is written down

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 Zara again…
• Zara paid $3,000 for inventory on September
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• By January 31, $2,000 of the inventory has
been sold
• Some inventories are damaged
• Net realizable value of inventory is $400
• What is the journal entry?

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 Net Realizable Value
• If NRV is lower, inventory is written down
JOURNAL
Date Accounts and explanation Debit Credit
Cost of goods sold 600
Inventory 600
Wrote down inventory to market

• If the NRV of inventory had been above cost, it

would have made no adjustment for NRV.
– report the inventory at cost, which is the lower of cost and
NRV

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Use gross profit percentage and inventory turnover
to evaluate operations.
LEARNING OBJECTIVE FOUR

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 Gross Profit Percentage

Key indicator of a company’s ability to sell inventory at a profit

Gross profit

Net sales revenue

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 Gross Profit Percentage
• Gross profit percentage = 59 % means?
– each dollar generates almost 60 cents of gross
profit
– cost of goods sold = 40 cents of each sales dollar

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 Inventory Turnover
How quickly inventory is sold

Cost of Goods Sold

Average Inventory

(Beginning inventory + Ending inventory)/2

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 Inventory Turnover
• How many times the company sold its average
level of inventory during the year

– Days inventory on hand= ?

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60
Rearranging the Cost of Goods Sold Model

Cost of goods sold (based on plan for next period)

+ Ending inventory (based on plan for next period)

= Goods available as planned

- Beginning inventory (actual amount)

= Purchases (amount manager should buy)

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 Exercise 3
• J R Company began May with inventory of
$47,500. The business made net
purchases of $30,900 and had net sales of
$62,100 before a fire destroyed the
company’s inventory. For the past several
years, J R’s gross profit percentage has
been 35%.
• Estimate the cost of the inventory
destroyed by the fire.
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 Exercise 3

Beginning inventory
Purchases
Goods available for sale
Estimated cost of goods sold:
Net sales revenue
Less estimated gross profit
Estimated cost of goods sold
Estimated cost of ending inventory

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