Download Chapter 5

Accounting
Principles
Second Canadian Edition
Weygandt · Kieso · Kimmel · Trenholm
Prepared by:
Carole Bowman, Sheridan College
CHAPTER
5
ACCOUNTING FOR
MERCHANDISING
OPERATIONS
Accounting Information System


An accounting information system (AIS)
involves collecting and processing data and
disseminating financial information to
interested parties.
An AIS may either be manual or
computerized.
PRINCIPLES OF AN
EFFICIENT AND EFFECTIVE
ACCOUNTING INFORMATION SYSTEM
The accounting
system must be
cost effective.
Benefits of
information must
outweigh the cost
of providing it.
Costs
Benefits
PRINCIPLES OF AN
EFFICIENT AND EFFECTIVE
ACCOUNTING INFORMATION SYSTEM
It must be
relevant!
It must
be
reliable!
Balance
Sheet
Income
Statement
Other
Financial
Reports
It must
be
timely!
It must be
accurate!
PRINCIPLES OF AN
EFFICIENT AND EFFECTIVE
ACCOUNTING INFORMATION SYSTEM
Technological
Advances
Government
Regulation and
Deregulation
Changing
Accounting
Principles
PHASES IN THE DEVELOPMENT
OF AN ACCOUNTING SYSTEM
Analysis
Follow up
Evaluating and
monitoring effectiveness
and efficiency and
correcting any
weaknesses
Planning and
identifying
information needs
and sources
Implementation
Installing the system,
training personnel, and
making the system
operational
Design
Creating forms,
documents, procedures,
job descriptions, and
reports
SUBSIDIARY LEDGERS



A subsidiary ledger is a group of accounts with a
common characteristic, such as customer
accounts.
The subsidiary ledger is assembled to facilitate
the recording process by freeing the general
ledger from details concerning individual
balances.
Two common subsidiary ledgers are the
Accounts Receivable Ledger and the Accounts
Payable Ledger.
CONTROL ACCOUNT


The general ledger account that
summarizes subsidiary ledger data is
called a control account.
Each general ledger control account
balance must equal the composite balance
of the individual accounts in the subsidiary
ledger.
RELATIONSHIP OF GENERAL LEDGERS
AND SUBSIDIARY LEDGERS
Accounts receivable controls
a subsidiary ledger of many
different customers.
General
Ledger
Subsidiary
Ledgers
Cash
Accounts
Receivable
Accounts payable controls a
subsidiary ledger of many
different creditors.
Accounts
Payable
Owner’s
Capital
Customer Customer Customer
A
B
C
Creditor
X
Creditor
Y
Creditor
Z
SUBSIDIARY LEDGERS
Advantages of using subsidiary ledgers are that they:
1. Show transactions affecting one customer or one
creditor in a single account.
2. Free the general ledger of excessive details.
3. Help locate errors in individual accounts by
reducing the number of accounts combined in one
ledger and by using controlling accounts.
4. Create a division of labour in posting by allowing
one employee to post to the general ledger and a
different employee to post to the subsidiary ledger.
SPECIAL JOURNALS
Special journals are used to group similar
types of transactions.
 If a transaction cannot be recorded in a
special journal, it is recorded in the
general journal.
 Special journals permit greater division of
labour and reduce time necessary to
complete the posting process.

USE OF SPECIAL JOURNALS AND
THE GENERAL JOURNAL
Sales
Journal
Used for:
All sales
of
merchandise on
account
Cash
Cash
Purchases
Payments
Receipts
Journal
Journal
Journal
General
Journal
Used for:
Used for:
Used for:
All cash
received
(including
cash
sales)
Used for:
All
All cash
purchases
paid
of
merchan- (including
cash
dise on
account purchases)
Transactions
that cannot
be entered
in a special
journal,
including
correcting,
adjusting, and
closing entries
The types of special journals used depend largely on the
types of transactions that occur frequently in a business
enterprise.
MERCHANDISING COMPANY


A merchandising company is an enterprise
that buys and sells goods to earn a profit.
1. Wholesalers sell to retailers.
2. Retailers sell to consumers.
A merchandiser’s primary source of
revenue is sales, whereas a service
company’s primary source of revenue is
service revenue.
OPERATING CYCLES FOR A
SERVICE COMPANY AND A
MERCHANDISING COMPANY
Service Company
Receive
Cash
Cash
Perform
Services
Accounts
Receivable
Merchandising Company
Receive
Cash
Cash
Buy
Inventory
Sell Inventory
Accounts
Receivable
Merchandise
Inventory
Perpetual vs. Periodic
Inventory Accounting


Perpetual
• Updates inventory and cost of goods sold
after every purchase and sales transaction
Periodic
• Delays updating of inventory and cost of
goods sold until end of the period
• Misstates inventory during the period
INVENTORY SYSTEMS
Merchandising entities may use either (or both)
of the following inventory systems:
1. Perpetual – where detailed records of each
inventory purchase and sale are maintained.
Cost of goods sold is calculated at the time of
each sale.
2. Periodic – detailed records are not
maintained. Cost of goods sold is calculated
only at the end of the accounting period.
Majority of companies today use the
perpetual method.
RECORDING COST OF GOODS
PURCHASED
PERPETUAL INVENTORY METHOD



When merchandise is purchased for resale
to customers, the account, Merchandise
Inventory, is debited for the cost of the
goods.
Merchandise may be purchased for cash
or on account (credit).
The purchase is normally recorded
by the purchaser when the goods
are received from the seller.
•
(FOB Destination)
PURCHASES OF
MERCHANDISE
General Journal
Date Account Title and Explanation Ref
May 4 Merchandise Inventory
Accounts Payable
To record goods purchased on
account, terms n/30.
Debit
3,800
For purchases on account, Merchandise
Inventory is debited and Accounts Payable is
credited. For cash purchases, Merchandise
Inventory is debited and Cash is credited.
J1
Credit
3,800
FREIGHT COSTS


The sales agreement should indicate whether the seller
or the buyer is to pay the cost of transporting the
goods to the buyer’s place of business.
FOB (Free on Board) Destination
1. Ownership of the merchandise transfers to the
purchaser once it reaches the purchaser's location.
The seller should continue to record the
merchandise in their inventory while the inventory
is in transit (on its way to the purchaser)
2. Seller pays freight costs from shipping point to
destination
3. Delivery Expense (or Freight Out) is debited by
the seller for the amount of the freight cost
FREIGHT COSTS cont'd

FOB (Free on Board) Shipping Point
1. Ownership of the merchandise transfers to the
purchaser at the point of sale (the seller's location). The
purchaser should include the merchandise in their
inventory while it is in transit (on it's way to the
purchaser).
2. Buyer pays freight costs from shipping
point to destination
3. Merchandising Inventory is debited by the buyer for
the amount of the freight cost
TERMS OF SALE
FOB Shipping Point
FOB Destination Point
Seller
Seller
Ownership
passes to
buyer here
Public
Carrier
Co.
Buyer
Ownership
passes to
buyer here
Public
Carrier
Co.
Buyer
ACCOUNTING FOR
FREIGHT COSTS
General Journal
Date Account Title and Explanation
May 4 Merchandise Inventory
Cash
To record payment of freight.
Ref
Debit
150
J1
Credit
When the purchaser directly incurs the freight
costs, the account Merchandise Inventory is
debited and Cash is credited.
150
DETERMINING OWNERSHIP OF
CONSIGNED GOODS



Under a consignment arrangement, the
holder of the goods (called the consignee)
does not own the goods.
Ownership remains with the shipper of the
goods (consignor) until the goods are
actually sold to a customer.
Consigned goods should be included in the
consignor’s inventory, not the consignee’s
inventory.
Owned by a consignor; do not
count in our (consignee) inventory
Consignee Company
PURCHASE RETURNS AND
ALLOWANCES

A purchaser may be dissatisfied with
merchandise received because the goods
1. are damaged or defective,
2. are of inferior quality, or
3. are not in accord with the
purchaser’s specifications.
PURCHASE RETURNS AND
ALLOWANCES
General Journal
Date Account Title and Explanation
May 8 Accounts Payable
Merchandise Inventory
To record return of goods.
Ref
Debit
300
J1
Credit
For purchases returns and allowances that were
originally made on account, Accounts Payable is
debited and Merchandise Inventory is credited.
For cash returns and allowances, Cash is debited
and Merchandise Inventory is credited.
300
QUANTITY DISCOUNTS
• Volume purchase terms may permit the
buyer to claim a quantity discount.
• The merchandise inventory is simply
recorded at the discounted cost.
E.g. Buy 1 pay $100 per item
DR Merchandise Inventory 100
CR Cash
100
E.g. Buy 10 pay $95 per item
DR Merchandise Inventory 950
CR Cash
950
PURCHASES JOURNAL
PERPETUAL SYSTEM
Karns Wholesale Supply
Purchases Journal
Date
May 6
10
14
19
26
29
 In
Account Credited
Jasper Manufacturing Inc.
Eaton and Howe Inc.
Fabor and Son
Jasper Manufacturing Inc.
Fabor and Son
Eaton and Howe Inc.
Terms
n/20
n/20
n/20
n/20
n/20
n/20
Ref.






Merchandise
Inventory Dr.
Accounts Payable Cr.
11,000
7,200
6,900
17,500
8,700
12,600
63,900
a perpetual system, each entry results in a debit to
Merchandise Inventory and a credit to Accounts Payable.
 Postings are made daily to the accounts payable subsidiary
journal and monthly to the general ledger.
PROVING THE ACCURACY OF THE
ACCOUNTS PAYABLE SUBSIDIARY
LEDGER
General Ledger
Merchandise Inventory $63,900
(Asset)
Accounts Payable
(Liability)
$63,900
Accounts Payable
Subsidiary Ledger
Eaton and Howe, Inc.
$19,800
Fabor and Son
15,600
Jasper Manufacturing Inc. 28,500
$63,900
To prove the ledgers it is necessary to determine that
the sum of the subsidiary ledger balances equals the
balance in the control account.
SUBSIDIARY LEDGERS in a
Computerized Environment
In a computer-based accounting system, subsidiary
ledger accounts and general ledger accounts are all
posted automatically as transactions are recorded.
In addition, the computer automatically reconciles the
subsidiary ledgers with the controlling accounts.
CLASSIFIED BALANCE SHEET
HIGHPOINT ELECTRONIC
Balance Sheet (partial)
December 31, 2002
Assets
On the balance sheet,
Current assets
merchandise inventory is
Cash
reported as a current asset
Accounts receivable
and appears immediately
Merchandise inventory
below accounts receivable.
Prepaid insurance
This is because current
assets are listed in the
Total current assets
order of their liquidity.
Capital assets
Store equipment
$ 80,000
Less: Accumulated amortization
24,000
Total assets
$
9,500
16,100
40,000
1,800
67,400
56,000
$ 123,400
INVENTORY BASICS

In the balance sheet of merchandising and
manufacturing companies, inventory is
frequently the most significant current asset.
INCOME MEASUREMENT PROCESS
FOR A MERCHANDISING COMPANY
Sales
Revenue
Less
Equals
Cost of
Goods Sold
Gross
Profit
Less
Equals
Operating
Expenses
Net
Income
(Loss)
INVENTORY BASICS


In the income statement, inventory is vital in
determining the results of operations for a
particular period.
Gross profit (net sales - cost of goods sold)
is closely watched by management,
owners, and other interested parties.
SALES TRANSACTIONS

Revenues are reported when earned in
accordance with the revenue recognition
principle. In a merchandising company.
revenues are earned when the goods are
transferred from seller to buyer.
SALES TRANSACTIONS
Using Perpetual Inventory Method
General Journal
Date Account Title and Explanation
May 4 Accounts Receivable
Sales
To record credit sale.
May 4 Cost of Goods Sold
Merchandise Inventory
To record cost of merchandise
sold.
Ref
Debit
3,800
J1
Credit
3,800
2,400
2,400
1. The first entry records the sale of goods to a
customer at the retail (selling) price.
2. The second entry releases the goods from inventory
at cost and charges the goods to cost of goods sold.
CALCULATION OF GROSS PROFIT
Gross profit is calculated by deducting cost of
goods sold from sales as follows:
Net
sales
Sales
Cost
Cost of
of goods
goods sold
sold
Gross
Gross profit
profit
$$ 460,000
460,000
316,000
316,000
$ 144,000
144,000
100%
69%
31%
Gross profit is often expressed as a
percentage of sales.
CALCULATION OF NET INCOME
Net income is calculated by deducting operating
expenses from gross profit as follows:
Gross profit
Operating expenses
Net income
$ 144,000
114,000
$ 30,000
Net income is the “bottom line” of a
company’s income statement.
JOURNALIZING THE SALES JOURNAL –
PERPETUAL INVENTORY SYSTEM
Karns Wholesale Supply
Sales Journal
Date
Ref
Accts Receivable Dr
Sales Cr
Cost of Goods Sold Dr
Merchandise Inventory Cr
101

10,600
6,360
Babson Co.
102

11,350
7,370
14
Carson Bros.
103

7.800
5,070
19
Deli Co.
104

9,300
6,510
21
Abbot Sisters
105

15,400
10,780
24
Deli Co.
106

21,210
15,900
27
Babson Co.
107

14,570
10,200
90,230
62,190
7

Invoice
#
Abbot Sisters
May 3

Account
Debited
S1
Under a perpetual inventory system, one entry at selling price in the Sales
Journal results in a debit to Accounts Receivable and a credit to Sales. Another
entry at cost results in a debit to Cost of Goods Sold and a credit to
Merchandise Inventory.
Postings are made monthly to the general ledger and daily to the accounts
receivable subsidiary ledger.
PROVING THE ACCURACY OF THE
ACCOUNTS RECEIVABLE
SUBSIDIARY LEDGER
Accounts Receivable
Subsidiary Ledger
General Ledger
Accounts Receivable
$90,230
Abbot Sisters
Babson Co.
Carson Bros.
Deli Co.
$26,000
25,920
7,800
30,510
$90,230
To prove the accuracy of the ledgers it is necessary to determine
whether the sum of the accounts receivable subsidiary ledger
balances equals the balance in the general ledger’s Accounts
Receivable control account.
GENERAL JOURNAL
ENTRIES
Only transactions that cannot be recorded
in a special journal are recorded in the
general journal.
 When the entry involves both control and
subsidiary accounts:
1. In journalizing, control and subsidiary
accounts must be identified, and
2. In posting there must be a dual posting
(to the control account and subsidiary
ledger).

JOURNALIZING AND POSTING THE
GENERAL JOURNAL
General Journal
Date
Account Title and Explanation
31-May Accounts Payable-Fabor and Sons
Merchandise Inventory
Record goods returned.
Date
2002
May 14
24
26
31
Fabor and Son
Ref
Debit
Credit
P1
CP1
P1
G1
6,900
6,900
8,700
500
Balance
6,900
8,700
8,200
Ref
Debit
500
J1
Credit
500
General Ledger
Merchandise Inventory
Date Ref
Debit
Credit
2002
May 31 S1
62,190
31 CR1
2,930
31 P1
63,900
31 CP1
4,500
31 G1
500
120
Balance
(62,190)
(65,120)
(1,220)
3,280
2,780
Accounts Payable
201
Date Ref
Debit
Credit
Balance
2002
May 31 P1
63,900
63,900
31 CP1
42,600
21,300
31 G1
500
20,800
ILLUSTRATION
5-14
This is the format
of a multi-step
income statement
that has both
operating and nonoperating
activities.
As shown, the nonoperating activities
are reported
immediately after
the company’s
primary operating
activities.
HIGHPOINT ELECTRONIC
Income Statement
For the Year Ended December 31, 2002
Sales
Cost of goods sold
Gross profit
Operating expenses
Selling expenses
Salaries expense
$
Advertising expense
Amortization expense
Freight out
Total selling expenses
Administrative expenses
Rent expense
$
Utilities expense
Insurance expense
Total administrative expenses
Total operating expenses
Income from operations
Other revenue and gains
Interest revenue
$
Gain on sale of equipment
Total non-operating revenue and gain
Other expenses and losses
Interest on expense
$
Casualty loss from vandalism
Total non-operating expense and loss
Net non-operating revenue
Net income
$
$
45,000
16,000
8,000
7,000
$
76,000
19,000
17,000
2,000
38,000
$
3,000
600
$
3,600
1,800
200
2,000
$
SALES TAXES
•
•
Sales tax is expressed as a percentage of the sales
price on selected goods sold to customers by a
retailer. They are collected on most revenues, and
paid on many costs.
Sales taxes may include the federal goods and
services tax (GST) and the provincial sales tax
(PST), if any. These two taxes have been combined
into one harmonized sales tax (HST) in some
provinces (such as Ontario and the Atlantic
Provinces).
SALES TAXES ON REVENUES
• The retailer collects the tax from the
customer when the sale occurs, and
periodically (usually monthly) remits the
collections to the Receiver General.
• Sales taxes are not revenue but are a current
liability until remitted.
DR
Cash (or A/R)
113
CR
Revenue
100
CR
Sales Tax Payable
13
PURCHASE DISCOUNTS



Credit terms may permit the buyer to claim
a cash discount for the prompt payment of a
balance due.
The buyer calls this discount a
purchase discount.
A purchase discount is based on
the invoice cost less any returns
and allowances granted.
SALES RETURNS AND
ALLOWANCES


Sales Returns occur when customers are
dissatisfied with merchandise and are
allowed to return the goods to the seller for
credit or a refund.
Sales Allowances occur when
customers are dissatisfied, and the
seller allows a deduction from
the selling price.
SALES RETURNS AND
ALLOWANCES
The normal balance of Sales Returns
and Allowances is a debit.
 Sales Returns and Allowances is a contra
revenue account to the Sales account.

STATEMENT PRESENTATION OF
SALES REVENUE SECTION
As contra revenue accounts, sales returns and
allowances (and sales discounts, if any) are
deducted from sales in the income statement to
arrive at Net Sales.
HIGHPOINT ELECTRONIC
Income Statement (Partial)
For the Year Ended December 31, 2002
Sales revenue
Sales
$ 480,000
Less: Sales returns and allowances
20,000
Net sales
$ 460,000
RECORDING SALES RETURNS
AND ALLOWANCES
PERPETUAL INVENTORY METHOD
General Journal
Date Account Title and Explanation
May 8 Sales Returns and Allowances
Accounts Receivable
To record returned goods.
May 8 Merchandise Inventory
Cost of Goods Sold
To record cost of goods
returned.
Ref
Debit
300
J1
Credit
300
140
140
1. The first entry reduces the balance owed by the customer
and records the goods returned at retail price.
2. The second entry records the physical return of goods to
inventory at cost and removes the goods from the cost
of goods sold account.
RECORDING SALES RETURNS
AND ALLOWANCES
PERIODIC INVENTORY METHOD
General Journal
Date Account Title and Explanation
May 8 Sales Returns and Allowances
Accounts Receivable
To record returned goods.
Ref
Debit
300
J1
Credit
The normal balance of Sales Returns and
Allowances is a debit. Sales Returns and
Allowances is a contra revenue account to the
Sales account.
300
QUANTITY DISCOUNTS
• A quantity discount is the offer of a cash
discount to a customer in return for a volume
sale.
• Quantity discounts result in a sales price
reduction. They are not separately journalized.
Instead the sale is recorded at the reduced
price.
SALES DISCOUNTS


A sales discount is the offer of a cash discount
to a customer in exchange for the prompt
payment of a balance due.
Similar to Sales Returns and Allowances,
Sales Discounts is also a contra revenue
account with a normal debit balance.
STATEMENT PRESENTATION OF
SALES REVENUE SECTION
As contra revenue accounts, sales returns and
allowances and sales discounts, are deducted
from sales in the income statement to arrive at
Net Sales.
HIGHPOINT ELECTRONIC
Income Statement (Partial)
For the Year Ended December 31, 2002
Sales revenue
Sales
$ 480,000
Less: Sales returns and allowances
20,000
Less: Sales discounts
10,000
Net sales
$ 450,000
RECORDING SALES DISCOUNTS
PERPETUAL OR PERIODIC
INVENTORY METHOD
General Journal
Date Account Title and Explanation
May 8 Sales Discounts
Accounts Receivable
To record discount taken
Ref
Debit
150
J1
Credit
150
The normal balance of Sales Discounts is a debit.
Sales Discounts is a contra revenue account to the
Sales account.
PURCHASES OF MERCHANDISE
UNDER THE PERIODIC INVENTORY
METHOD
General Journal
Date Account Title and Explanation Ref
May 4 Purchases
Accounts Payable
To record goods purchased on
account, terms n/30.
Debit
3,800
J1
Credit
For purchases on account, Purchases is debited
and Accounts Payable is credited. For cash
purchases, Purchases is debited and Cash is
credited.
3,800
PURCHASE RETURNS AND
ALLOWANCES
PERIODIC INVENTORY METHOD
General Journal
Date Account Title and Explanation
May 8 Accounts Payable
Purchase Returns and Allowances
To record return of goods
Ref
Debit
300
J1
Credit
300
For purchases returns and allowances that were
originally made on account, Accounts Payable is debited
and Purchase Returns and Allowances is credited. The
Purchase Returns and Allowances account is a contra
account.
ACCOUNTING FOR FREIGHT COSTS
PERIODIC INVENTORY METHOD
General Journal
Date Account Title and Explanation
May 4 Freight In
Cash
To record payment of freight.
Ref
Debit
150
J1
Credit
When the purchaser directly incurs the freight
costs, the account Freight In is debited and
Cash is credited.
150
SALES TRANSACTIONS
PERIODIC INVENTORY METHOD
General Journal
Date Account Title and Explanation
May 4 Accounts Receivable
Sales
To record credit sale.
Ref
Debit
3,800
Only one entry is required to record a sale
under a periodic method.
J1
Credit
3,800
HIGHPOINT ELECTRONICS
Income Statement
For the Year Ended December 31, 2002
Sales revenue
Sales
Less: Sales returns and allowances
Net sales
Cost of goods sold
Inventory, January 1
Purchases
Less: Purchase returns and allowances
Net purchases
Add: Freight in
Cost of goods purchased
Cost of goods available for sale
Inventory, December 31
Cost of goods sold
Gross profit
Operating expenses
Salaries expense
Rent expense
Utilities expense
Advertising expense
Amortization expense
Freight out
Insurance expense
Total operating expenses
Net income
$
$
$
$
$
480,000
20,000
460,000
$
316,000
144,000
36,000
325,000
17,200
307,800
12,200
320,000
$ 356,000
40,000
$
45,000
19,000
17,000
16,000
8,000
7,000
2,000
The multi-step income statement under the periodic
system requires more detail in the cost of goods sold
section, as shown above.
$
114,000
30,000
CHAPTER
9
ACCOUNTING FOR
MERCHANDISING
OPERATIONS
ALLOCATION OF
INVENTORIABLE COSTS
How do you
determine the
cost factor to
value the
inventory left
on hand?
Beginning
Inventory
(e.g. $50,000)
Ending Inventory
(Current Asset on the
Balance Sheet at cost
price)
(e.g. $25,000)
Cost of Goods
Available for Sale
(e.g. $120,000)
Goods
Purchased
during the year
(e.g. $70,000)
$ amount is
based on the
actual amount
paid for the
goods
Not
sold
How do you
determine the
cost factor to
value the
inventory
sold?
Sold
Cost of Goods
Sold (Income
Statement)
(e.g. $95,000)
INVENTORY COSTING
METHODS

When receiving merchandise inventory the
amount debited to inventory is the amount
that you paid for it (i.e. The Cost Principle)
General Journal
Date Account Title and Explanation Ref
May 4 Merchandise Inventory
Accounts Payable
To record goods purchased on
account, terms n/30.
Debit
3,800
J1
Credit
3,800
INVENTORY COSTING
METHODS

When inventory is sold, there are a variety of
inventory costing methods that can be used
to determine the amount that will be debited
to Costs of Good Sold.
Perpetual Method
General Journal
Date Account Title and Explanation Ref
May 1 Cost of Goods Sold
Merchandise Inventory
To record cost of merchandise
sold.
Debit
2,400
J1
Credit
2,400
INVENTORY COSTING
METHODS

Or for the Periodic method, the costing
factor used to determine the value of the
ending inventory.
Cost of goods sold:
Inventory, January 1
Purchases
Less: Purchase returns and allowances
Net purchases
Add: Freight in
Cost of goods purchased
Cost of goods available for sale
Inventory, December 31
Cost of goods sold
$
$
$
36,000
325,000
17,200
307,800
12,200
$
$
320,000
356,000
40,000
316,000
USING ACTUAL PHYSICAL
FLOW COSTING



The specific identification method tracks the
actual physical flow of the goods.
Each item of inventory is marked, tagged, or
coded with its specific unit cost.
It is most frequently used when the company
sells a limited variety of high unit-cost items.
USING ASSUMED COST
FLOW METHODS



Other cost flow methods are allowed since
specific identification is often impractical.
These methods assume flows of costs that
may be unrelated to the physical flow of
goods.
Cost flow assumptions:
1. First-in, first-out (FIFO).
2. Last-in, first-out (LIFO).
3. Average cost.
FIFO




The FIFO method assumes that the earliest
goods purchased are the first to be sold.
Often reflects the actual physical flow of
merchandise.
The costs of the earliest goods purchased
are the first to be recognized as cost of
goods sold.
The costs of the most recent goods
purchased are recognized as the ending
inventory.
FIFO method assumes earliest goods
purchased are the first to be sold
LIFO





The LIFO method assumes that the latest
goods purchased are the first to be sold.
Seldom coincides with the actual physical
flow of inventory.
The costs of the most recent goods
purchased are recognized as the cost of
goods sold.
The costs of the earliest goods purchased are
the first to be recognized as ending
inventory.
Rarely used in Canada.
LIFO method assumes latest goods
purchased are the first to be sold
Inventory
AVERAGE COST



The average cost method assumes that the
goods available for sale are homogeneous.
The allocation of the cost of goods
available for sale is made on the basis of
the weighted average unit cost incurred.
The weighted average unit cost is then
applied to the units sold to determine the
cost of goods sold and to the units on hand
to determine the ending inventory.
Allocation of the cost of goods
available for sale in average cost
method is made on the basis of the
weighted average unit cost
Average cost method assumes that
goods available for sale are
homogeneous
INCOME STATEMENT EFFECTS OF
INVENTORY COSTING METHODS



In periods of rising prices, FIFO reports the
highest net income, LIFO the lowest and
average cost falls in the middle.
The reverse is true when prices are
falling.
When prices are constant, all cost flow
methods will yield the same results.
BALANCE SHEET EFFECTS
FIFO produces the best balance sheet
valuation since the inventory costs are closer
to their current, or replacement, costs.
USING INVENTORY COST FLOW
METHODS CONSISTENTLY



A company needs to use its chosen cost
flow method consistently from one
accounting period to another.
Such consistent application enhances the
comparability of financial statements over
successive time periods.
When a company adopts a different cost
flow method, the change and its effects on
net income should be disclosed in the
financial statements.
INVENTORY ERRORS INCOME STATEMENT EFFECTS



Both beginning and ending inventories appear
on the income statement.
The ending inventory of one period
automatically becomes the beginning
inventory of the next period.
Inventory errors affect the
determination of cost of goods
sold and net income.
FORMULA FOR
COST OF GOODS SOLD
Beginning
Inventory
+
Cost of
Goods
Purchased
_
Ending
Inventory
=
Cost of
Goods
Sold
The effects on cost of goods sold can be
determined by entering the incorrect data
in the above formula and then substituting
the correct data.
EFFECTS OF INVENTORY
ERRORS ON CURRENT YEAR’S
INCOME STATEMENT
Inventory Error
Cost of
Goods Sold
Understate beginning inventory Understated
Overstate beginning inventory
Overstated
Understate ending inventory
Overstated
Overstate ending inventory
Understated
Net Income
Overstated
Understated
Understated
Overstated
An error in ending inventory of the current period
will have a reverse effect on net income of the next
accounting period.
ENDING INVENTORY ERROR –
BALANCE SHEET EFFECTS
The effect of ending inventory errors on the
balance sheet can be determined by using the
basic accounting equation:
Assets = Liabilities + Owner’s Equity
Ending Inventory
Error
Overstated
Understated
Assets
Overstated
Understated
Liabilities
None
None
Owner’s Equity
Overstated
Understated
VALUING INVENTORY AT THE
LOWER OF COST AND MARKET



When the value of inventory is lower than
the cost, the inventory is written down to
its market value.
This is known as the lower of cost and
market (LCM) method.
Market is defined as replacement cost or
net realizable value.
ALTERNATIVE LOWER OF COST
AND MARKET (LCM) RESULTS
Cost
Television sets
Consoles
$
Portables
Total
Video equipment
Recorders
Movies
Total
Total inventory
$
Market
60,000
45,000
105,000
$
48,000
15,000
63,000
168,000
45,000
14,000
59,000
$ 166,000
LCM
55,000
52,000
107,000
$ 166,000
The common practice is to use total inventory
rather than individual items or major categories in
determining the LCM valuation.
COMPLETING THE
ACCOUNTING CYCLE


A merchandising company requires the same
types of adjusting entries as a service company,
with one additional adjustment for inventory to
ensure the recorded inventory amount agrees
with the actual quantity on hand.
A physical count is an important control feature
since a perpetual system indicates what should
be there but a count will determine what is
actually there.
COMPLETING THE
ACCOUNTING CYCLE



A merchandising company also requires the
same types of closing entries as a service
company.
The additional accounts that need to be closed
out in a merchandising company include Sales,
Sales Returns and Allowances, Cost of Goods
Sold, and Freight Out.
Merchandise Inventory is an asset account and
is not closed at the end of the period.
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