Week 5: Chapter 4 & 5

Inventories and Cost of Sales

Wild and Shaw

Financial and Managerial Accounting
8th Edition

Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 Chapter 4 Learning Objectives
CONCEPTUAL
C1 Describe merchandising activities and identify income components for a merchandising
company.
C2 Identify and explain the inventory asset and cost flows of a merchandising company.

PROCEDURAL
P1 Analyze and record transactions for merchandise purchases using a perpetual system.
P2 Analyze and record transactions for merchandise sales using a perpetual system.
P3 Prepare adjustments and close accounts for a merchandising company.

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• Lesson 4

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 Learning Objective C1

Describe merchandising
activities and identify income
components for a
merchandising company.

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 Reporting Income for a Service
Organization
Service organizations sell service
time to earn revenue.

Examples: Accounting firms, law firms,

and plumbing services

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Learning Objective C1: Describe merchandise activities and identify income components for a merchandising company.
 Reporting Income for a
Merchandiser
Merchandising companies sell products to
earn revenue.
Examples: sporting goods, clothing, and auto parts stores

Exhibit
4.2

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Learning Objective C1: Describe merchandise activities and identify income components for a merchandising company.
 Learning Objective C2

Identify and explain the

inventory asset and cost flows
of a merchandising company.

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 Operating Cycle for
a Merchandiser
Begins with the purchase of merchandise and
ends with the collection of cash from the sale
of merchandise.
Exhibit
4.3

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Learning Objective C2: Identify and explain the inventory asset and cost flows of a merchandising company.
 The Operating Cycle, Figure 6-1
Cash XXX
Account receivable XXX
Cash
Receive payment Manufacture or
purchase inventory

Inventory XXX
Accounts Cash XXX
Inventory
Receivable (or account payable)
Cost of Goods Sold XXX
Inventory XXX Sales to customers
Account receivable XXX
Sales Revenue XXX
 The Flow of Inventory Costs
BALANCE SHEET

Purchase costs (or

Asset
manufacturing Inventory
costs)
as goods are
INCOME STATEMENT sold

Revenue
Cost of goods sold
Gross profit
Expenses
Net income
 Inventory System
 Perpetual system: continually update accounting records
for merchandising transactions
– More effective inventory management
– Allow company to detect the amount of inventory loss incurred
due to waste, theft or other loss
– Used for all types of goods.

 Periodic system: accounting records relating to

merchandise transactions are updated only at the end of
the accounting period
– Does not keep a running record of all goods bought and sold. Hard
to detect inventory shrinkage (e.g., theft, spoilage) as well as
management fraud.
– Used for inexpensive goods.
 Cost of Goods Sold
• Selling merchandise introduces a new and
major cost of doing business: the cost incurred
by merchandising companies to acquire the
inventory they sold to customers. We call it
Cost of goods sold.

• Cost of Goods Sold is presented as a separate

expense item on the income statement.
 Merchandising Company
• How do a merchandiser’s financial statements differ from
the statement of a service business?
• Balance sheet:
– Merchandiser has inventory, an asset.
– Service business has no inventory
• Income statement:
Merchandiser: Service business:
Sales revenue Service revenue
-Cost of goods sold - Expenses
=Gross profit = Net income
-Operation Expenses
=Net income
The Relative Size of Inventories
 Inventory Systems: Graphic

Exhibit
4.4

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Learning Objective C2: Identify and explain the inventory asset and cost flows of a merchandising company.
 Learning Objective P1

Analyze and record

transactions for merchandise
purchases using a perpetual
system.

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 Purchases without Cash Discounts
On November 2, Z-Mart purchased $500 of
merchandise inventory for cash.

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Learning Objective P1: Analyze and record transactions for merchandise purchases using a perpetual system.
 Trade Discounts
Used by manufacturers and wholesalers
to offer better prices for greater
quantities purchased.

Example
Z-Mart offers a 30% trade
discount for orders of 1,000
units or more on its popular
product Racer. Each
Racer has a list price of $5.25.
 Purchases with Cash Discounts
On November 2, Z-Mart purchased $500 of
merchandise inventory on account; credit
terms are 2/10, n/30.

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Learning Objective P1: Analyze and record transactions for merchandise purchases using a perpetual system.
 Purchase Discounts

2/10, n/30
Number of
Otherwise,
Discount Days Credit
Net (or All)
Percent Discount Is Period
Is Due in 30
Available
Days
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Learning Objective P1: Analyze and record transactions for merchandise purchases using a perpetual system.
 Credit Terms
A deduction from the invoice price granted
to induce early payment of the amount due.

Exhibit
4.5

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Learning Objective P1: Analyze and record transactions for merchandise purchases using a perpetual system.
 Invoice Exhibit
4.6

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Learning Objective P1: Analyze and record transactions for merchandise purchases using a perpetual system.
 Payment within Discount
Period: Journal Entry
On November 12, Z-Mart paid the amount
due on the purchase of November 2.

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Learning Objective P1: Analyze and record transactions for merchandise purchases using a perpetual system.
 Payment within Discount
Period: Ledger Accounts
After we post these entries, the accounts
involved look like these:

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Learning Objective P1: Analyze and record transactions for merchandise purchases using a perpetual system.
 Payment after Discount Period
On December 2, Z-Mart paid the amount
due on the purchase of November 2.

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Learning Objective P1: Analyze and record transactions for merchandise purchases using a perpetual system.
 Purchases with Returns and
Allowances
Purchase Return:
Merchandise returned by the purchaser to the
supplier.
Cash flow/ flow of goods
Purchase Allowance:
A price reduction to the buyer of defective or
unacceptable merchandise.
Cash flow
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Learning Objective P1: Analyze and record transactions for merchandise purchases using a perpetual system.
 Purchases Allowances
On November 5, Z-Mart (buyer) issues a $30
debit memorandum for an allowance from
Trex for defective merchandise.

© McGraw-Hill Education 
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Learning Objective P1: Analyze and record transactions for merchandise purchases using a perpetual system.
 Purchases Returns
Z-Mart purchases $250 of merchandise on June 1 with terms 2/10,
n/60. On June 3, Z-Mart returns $50 of goods before paying the
invoice. When Z-Mart pays on June 11, it takes the 2% discount
only on the $200 remaining balance.

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Learning Objective P1: Analyze and record transactions for merchandise purchases using a perpetual system.
 Purchases and Transportation Costs
Exhibit
4.7

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Learning Objective P1: Analyze and record transactions for merchandise purchases using a perpetual system.
 Transportation Costs
Z-Mart purchased merchandise on terms of
FOB shipping point. The transportation
charge is $75.

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Learning Objective P1: Analyze and record transactions for merchandise purchases using a perpetual system.
 Itemized Costs of Purchases
Exhibit
4.8

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Learning Objective P1: Analyze and record transactions for merchandise purchases using a perpetual system.
 Learning Objective P2

Analyze and record

transactions for merchandise
sales using a perpetual system.

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 Accounting for Merchandise
Sales
Exhibit
4.9

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Learning Objective P2: Analyze and record transactions for merchandise sales using a perpetual system.
 Sales of Merchandise
Each sales transaction for a seller of
merchandise involves two parts:

Revenue received
Recognition of the
in the form of an
cost of merchandise
asset from a
sold to a customer.
customer.
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Learning Objective P2: Analyze and record transactions for merchandise sales using a perpetual system.
 Sales without Cash Discounts
Z-Mart sold $1,000 of merchandise on credit. The
merchandise has a cost basis to Z-Mart of $300.
Revenue side journal entry:

Cost side journal entry:

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Learning Objective P2: Analyze and record transactions for merchandise sales using a perpetual system.
 Sales Discounts
Sales discounts on credit sales can benefit a seller by
decreasing the delay in receiving cash and reducing future
collection efforts.

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Learning Objective P2: Analyze and record transactions for merchandise sales using a perpetual system.
 Sales with Cash Discounts
Z-Mart completes a $1,000 credit sale with terms of 2/10, n/45.

Buyer pays within discount period:

Buyer pays after discount period:

© McGraw-Hill Education 
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Learning Objective P2: Analyze and record transactions for merchandise sales using a perpetual system.
 Sales Returns and Allowances
Sales returns and allowances usually involve
dissatisfied customers and the possibility of
lost future sales.

Sales returns refer Sales allowances

to merchandise that refer to reductions in
customers return to the selling price of
the seller after a merchandise sold to
sale. customers.
© McGraw-Hill Education 
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Learning Objective P2: Analyze and record transactions for merchandise sales using a perpetual system.
 Sales with Returns and Allowances
Customer returns merchandise which sold
for $15 and cost $9.

Returned Goods - Not Defective:

Returned Goods - Are Defective:

© McGraw-Hill Education 
Learning Objective P2: Analyze and record transactions for merchandise sales using a perpetual system. 39
 Buyer Granted Allowances
Assume that $40 of the merchandise Z-Mart
sold on November 12 is defective but the
buyer decides to keep it because Z-Mart
offers a $10 price reduction.

© McGraw-Hill Education 
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Learning Objective P2: Analyze and record transactions for merchandise sales using a perpetual system.
:-) Journal Entries: Buyer vs. Seller

41
 Learning Objective P3

Prepare adjustments and close

accounts for a merchandising
company.

© McGraw-Hill Education 
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 Merchandising Cost Flow in the
Accounting Cycle Exhibit
4.10

© McGraw-Hill Education 

Learning Objective P3: Prepare adjustments and close accounts for a merchandising company. 43
Adjusting Entries for Merchandisers
A merchandiser using a perpetual inventory system is
usually required to make an adjustment to update the
Merchandise Inventory account to reflect any loss of
merchandise, including theft and deterioration.

Z-Mart’s Merchandise Inventory account at the end of

year 2017 has a balance of $21,250, but a physical
count reveals that only $21,000 of inventory exists.
Closing Entries for Merchandisers Exhibit
4.11

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Learning Objective P3: Prepare adjustments and close accounts for a merchandising company.
End of Chapter 4

© McGraw-Hill Education 
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 Chapter 5 Learning Objectives
CONCEPTUAL
C1 Identify the items making up merchandise inventory.
C2 Identify the costs of merchandise inventory.

ANALYTICAL
A1 Analyze the effects of inventory methods for both financial and tax reporting.
A2 Analyze the effects of inventory errors on current and future financial statements.
.

PROCEDURAL
P1 Compute inventory in a perpetual system using the methods of specific
identification, FIFO, LIFO, and weighted average.

© McGraw-Hill Education 47
 Learning Objective C1

Identify the items making up

merchandise inventory.

© McGraw-Hill Education 48
 DEFINITION OF INVENTORY
• "Inventories" are assets:
– held for sale in the ordinary course of
business;
– in the process of production for such sale; or
– in the form of materials or supplies to be
consumed in the production process or in the
rendering of services.

• HKAS 2 prescribes the accounting

 Accounting for Inventory
Management decisions in accounting for inventory
involve the following:
1. Items included in inventory and their costs.
2. Costing method (specific identification, FIFO, LIFO,
or weighted average).
3. Inventory system (perpetual or periodic).
4. Use of market values or other estimates.
5. Impact of inventory errors on financial statement
 Determining Inventory Items
Merchandise inventory includes all goods that a
company owns and holds for sale, regardless of where
the goods are located when inventory is counted.

Items requiring special attention include:

Goods
Goods in
Damaged or
Transit
Goods on Obsolete
Consignment

Learning Objective C1: Identify the items making up merchandise inventory © McGraw-Hill Education 51
 Goods in Transit

• FOB shipping point – goods included in buyer’s

inventory when shipped.
• FOB destination – goods included in buyer’s
inventory after arrival at destination.

© McGraw-Hill Education 52
Learning Objective C1: Identify the items making up merchandise inventory
 Goods on Consignment
• Consignor: owner of goods.
• Consignee: sells goods for the owner.
• Merchandise is included in the inventory of the
consignor.
• Consignee never reports consigned goods in
inventory.

Learning Objective C1: Identify the items making up merchandise inventory © McGraw-Hill Education 53
 Goods Damaged or Obsolete
• Damaged or obsolete goods are not reported in
inventory if they cannot be sold.
• Damaged or obsolete goods which can be sold
are included in inventory at net realizable value.
• Net realizable value: the estimated selling price in
the ordinary course of business less the
estimated costs of completion and the estimated
costs necessary to make the sale.
• Loss is recorded when damage or obsolescence
occurs.
Learning Objective C1: Identify the items making up merchandise inventory © McGraw-Hill Education 54
Learning Objective C2

Identify the costs of

merchandise inventory.

© McGraw-Hill Education 55
 Determining Inventory Costs
Include all expenditures necessary to bring an item to
a salable condition and location.

Minus
Discounts Invoice Plus
Insurance
and Cost
Allowances

Plus
Import Plus
Plus Storage
Duties Freight
 Internal Controls and Taking a Physical Count
 Most companies take a  When the physical count
physical count of does not match the
Merchandise Inventory
inventory at least once account, an adjustment must
each year. be made.
COGS
Good internal controls over count include:
1. Pre-numbered inventory tickets.
2. Counters have no inventory responsibility.
3. Counters confirm existence, amount, and
condition of inventory.
4. Second count is taken by a different counter.
5. Manager confirms all items counted only once.
© McGraw-Hill Education 57
Learning Objective C2: Identify the costs of merchandise inventory
 Which Unit Did We Sell?
When identical units of inventory have different unit costs, a
question naturally arises as to which of these costs should be
used in recording a sale of inventory.
 Inventory Subsidiary Ledger
A separate subsidiary account is maintained for
each item in inventory.

How can we determine the unit cost for the Sept. 10 sale?
 Inventory Costing Methods
Four methods are used
to assign costs to inventory and
to cost of goods sold:

1. Specific identification
2. First-in, First-out (FIFO)
3. Last-in, First-out (LIFO)
4. Weighted average

© McGraw-Hill Education 60
Learning Objective C2: Identify the costs of merchandise inventory
 SPECIFIC IDENTIFICATION

• Each time a sale occurs, the actual invoice cost

of the units sold is identified and charged to
cost of goods sold. This method requires to
identify which items were sold and when.

• If each unit is unique, specific identification

method should be chosen.
• Tag RFID
 Cost Flow Assumptions
• If the items in inventory are homogenous in
nature, companies normally adopt a more
convenient practice of using a cost flow
assumption to determine cost of goods sold
and the ending inventory account balance.

• The actual physical flow of inventory need not

correspond to these assumptions.
Inventory Cost Flow Assumptions
First-In, First-Out The Earliest costs to COGS, leaving
(FIFO) costs of most recent purchases in
inventory.
Last-In, First-Out Most recent costs to COGS, leaving
(LIFO) costs of earliest purchases in
inventory.

Weighted Each time a sale occurs, the weighted

Average average cost per unit is determined
the average cost of each unit in
inventory is assigned to COGS and
ending inventory.
 Cost Flow of Inventory

Learning Objective C2: Identify the costs of merchandise inventory © McGraw-Hill Education 64
 Learning Objective P1

Compute inventory in a perpetual

system using the methods of
specific identification, FIFO, LIFO
and Weighted Average

© McGraw-Hill Education 65
 Inventory Costing under
a Perpetual System

Balance Income
Inventory Statement:
Sheet:
affects Cost of
Ending Goods Sold
Inventory
Physical flow does not
need to follow cost
flow.

Learning Objective P1: Compute inventory in a perpetual system using specific identification, FIFO, LIFO and © McGraw-Hill Education 66
weighted average
 Inventory Costing Illustration:
Perpetual System Exhibit
5.3

Here is information about the mountain bike inventory of Trekking

for the month of August.

Learning Objective P1: Compute inventory in a perpetual system using specific identification, FIFO, LIFO and © McGraw-Hill Education 67
weighted average
 Specific Identification:
Exhibit
Perpetual 5.4

Learning Objective P1: Compute inventory in a perpetual system using specific identification, FIFO, LIFO and © McGraw-Hill Education 68
weighted average
 First-In, First-Out (FIFO):
Definition Perpetual
Oldest Cost of
Costs Goods Sold

Recent Ending
Costs Inventory

Learning Objective P1: Compute inventory in a perpetual system using specific identification, FIFO, LIFO © McGraw-Hill Education 69
and weighted average
 First-In, First-Out (FIFO):
Exhibit
Perpetual 5.5

Learning Objective P1: Compute inventory in a perpetual system using specific identification, FIFO, LIFO and © McGraw-Hill Education 70
weighted average
 Last-In, First-Out (LIFO):
Definition Perpetual
Recent Cost of
Costs Goods Sold

Oldest Ending
Costs Inventory

Learning Objective P1: Compute inventory in a perpetual system using specific identification, FIFO, LIFO and © McGraw-Hill Education 71
weighted average
 Last-In, First-Out (LIFO):
Exhibit
Perpetual 5.6

Learning Objective P1: Compute inventory in a perpetual system using specific identification, FIFO, LIFO © McGraw-Hill Education 72
and weighted average
 Weighted Average:
Perpetual
When a unit is sold, the average cost of
each unit in inventory is assigned to cost
of goods sold.
Units on hand
Cost of Goods
Available for Sale
÷ on the date of
sale

Learning Objective P1: Compute inventory in a perpetual system using specific identification, FIFO, LIFO and © McGraw-Hill Education 73
weighted average
 Weighted Average: Perpetual Part 1

On August 14, 20 bikes are sold. To determine the cost of the

units sold, we first, need to compute the weighted average cost
per unit of items in inventory.

The cost of goods sold for the August 14 sale is $2,000. After
this sale, there are five $100 units in inventory totaling $500.
Learning Objective P1: Compute inventory in a perpetual system using specific identification, FIFO, LIFO and © McGraw-Hill Education 74
weighted average
 Weighted Average: Perpetual Part 2

After the August 14 sale, there are 5 units in inventory totaling $500.
On August 17, 20 units are purchased for $2,300.
($2,300+500) / 25 = $2,800 / 25 = $112 per unit.
Learning Objective P1: Compute inventory in a perpetual system using specific identification, FIFO, LIFO and © McGraw-Hill Education 75
weighted average
 :-) Inventory costing methods
specific identification
Laker Company reported the following January purchases and sales data for its only product.

Date Activities Units Acquired at Cost Units sold at Retail

Jan. 1 Beginning inventory 140 units @ $6.00 = $840
Jan. 10 Sales 100 units @ $15.00 = $1,500
Jan. 20 Purchase 60 units @ $5.00 = 300
Jan. 25 Sales 80 units @ $15.00 = $1,200
Jan. 30 Purchase 180 units @ $4.50 = 810
380 units $1,950 180 units $2,700

Laker uses a perpetual inventory system. Determine the cost assigned to cost of goods sold using specific
identification, weighted average, FIFO, and LIFO. For specific identification, ending inventory consists of 200 units,
where 180 are from the January 30 purchase, 5 are from the January 20 purchase, and 15 are from beginning
inventory.

1. Determine the cost assigned to ending inventory and to cost of goods sold using specific identification.
For specific identification, ending inventory consists of 200 units, where 180 are from the January 30 purchase,
5 are from the January 20 purchase, and 15 are from beginning inventory.

76
 Inventory costing methods
weighted average
Laker Company reported the following January purchases and sales data for its only product.

Date Activities Units Acquired at Cost Units sold at Retail

Jan. 1 Beginning inventory 140 units @ $6.00 = $840
Jan. 10 Sales 100 units @ $15.00 = $1,500
Jan. 20 Purchase 60 units @ $5.00 = 300
Jan. 25 Sales 80 units @ $15.00 = $1,200
Jan. 30 Purchase 180 units @ $4.50 = 810
380 units $1,950 180 units $2,700

Laker uses a perpetual inventory system. Determine the cost assigned to cost of goods sold using specific
identification, weighted average, FIFO, and LIFO. For specific identification, ending inventory consists of 200 units,
where 180 are from the January 30 purchase, 5 are from the January 20 purchase, and 15 are from beginning
inventory.

2. Determine the cost assigned to ending inventory and to cost of goods sold using weighted average.

77
 Inventory costing methods
perpetual FIFO.
Laker Company reported the following January purchases and sales data for its only product.

Date Activities Units Acquired at Cost Units sold at Retail

Jan. 1 Beginning inventory 140 units @ $6.00 = $840
Jan. 10 Sales 100 units @ $15.00 = $1,500
Jan. 20 Purchase 60 units @ $5.00 = 300
Jan. 25 Sales 80 units @ $15.00 = $1,200
Jan. 30 Purchase 180 units @ $4.50 = 810
380 units $1,950 180 units $2,700

Laker uses a perpetual inventory system. Determine the cost assigned to cost of goods sold using specific
identification, weighted average, FIFO, and LIFO. For specific identification, ending inventory consists of 200 units,
where 180 are from the January 30 purchase, 5 are from the January 20 purchase, and 15 are from beginning
inventory.

3. Determine the cost assigned to ending inventory and to cost of goods sold using perpetual FIFO.

78
 Inventory costing methods
perpetual LIFO
Laker Company reported the following January purchases and sales data for its only product.

Date Activities Units Acquired at Cost Units sold at Retail

Jan. 1 Beginning inventory 140 units @ $6.00 = $840
Jan. 10 Sales 100 units @ $15.00 = $1,500
Jan. 20 Purchase 60 units @ $5.00 = 300
Jan. 25 Sales 80 units @ $15.00 = $1,200
Jan. 30 Purchase 180 units @ $4.50 = 810
380 units $1,950 180 units $2,700

Laker uses a perpetual inventory system. Determine the cost assigned to cost of goods sold using specific
identification, weighted average, FIFO, and LIFO. For specific identification, ending inventory consists of 200 units,
where 180 are from the January 30 purchase, 5 are from the January 20 purchase, and 15 are from beginning
inventory.

4. Determine the cost assigned to ending inventory and to cost of goods sold using perpetual LIFO.

79
 Learning Objective A1

Analyze the effects of inventory

methods for both financial and tax
reporting.

© McGraw-Hill Education 80
 Financial Statement Effects
of Costing Methods
First-In, Last-In, Weighted
First-Out First-Out Average

Cost of goods sold

Ending inventory on income
Smoothes out
approximates statement
price changes.
current cost. approximates its
current costs.

© McGraw-Hill Education 81
Learning Objective A1: Analyze the effects of inventory methods for both financial and tax reporting
 Financial Statement Effects of
Inventory Costing Methods: Exhibit
Perpetual Method 5.8
Because prices change, inventory methods nearly always assign
different cost amounts.

© McGraw-Hill Education 82
Learning Objective A1: Analyze the effects of inventory methods for both financial and tax reporting
 FINANCIAL STATEMENT EFFECTS
OF COSTING METHODS
• When inventory costs are increasing (inflation)
– LIFO cost of goods sold is highest, gross profit is
lowest.
– FIFO cost of goods sold is lowest, gross profit is
highest.
• When inventory costs are decreasing
– FIFO cost of goods sold is highest.
– LIFO cost of goods sold is lowest.
 The Tax Advantage of LIFO
FIFO LIFO
Gross profit $460 $340
Operating expenses 260 260
Income before taxes $200 $ 80
Income tax expense (40%) $ 80 $ 32
The most attractive feature of LIFO is low
income tax payments when prices are
increasing. (LIFO is not allowed in HK)
The Internal Revenue Service (IRS) requires that when
LIFO is used for tax reporting, it must also be used for
financial reporting: LIFO conformity rule.
 Consistency in Using Costing Methods

The consistency principle requires a

company to use the same accounting
methods period after period so that financial
statements are comparable across periods.

May change inventory methods, but must

disclose the effects of the change on net income
 Learning Objective P2

Compute the lower of cost or

market amount of inventory

© McGraw-Hill Education 86
 LOWER OF COST AND NRV
• Inventories are recorded at their cost. However, if
inventory declines in value below its original cost, a
major departure from the historical cost principle
occurs. Inventory must be reported at NRV when NRV
is lower than cost.

• The term net realizable value (NRV) refers to the net

amount that a company expects to realize from the
sale of inventory.
– Specifically, net realizable value is the estimated
selling price in the normal course of business less
estimated costs to complete and estimated costs to
make a sale.
 lower of cost and NRV
Inventory must be reported at NRV
when NRV is lower than cost.

Consistent with Can be applied two ways:

the conservatism (1) separately to each
individual item.
principle. (2) to major categories of
assets.
 lower of cost and NRV
A motor sports retailer has the following
items in inventory:
 lower of cost and NRV
Here is how to compute lower of cost
and NRV for individual inventory
items.
 US GAAP vs. IFRS
Topic IFRS US GAAP
Method for determining LIFO is prohibited. LIFO is permitted
inventory cost
Use of cost formulas The same formula must be The same formula does not
applied to all inventories that need to be applied to all
have a similar nature and use inventories that have a
to the entity similar nature and use to the
entity

Measuring of carrying Lower of cost and net Lower of cost and market
amount realizable value (i.e. current replacement
cost)
Reversal of write-downs Required, if certain criteria Prohibited
are met
 A

Learning Objective A2

Analyze the effects of inventory

errors on current and future
financial statements.

© McGraw-Hill Education 92
 Inventory Errors: An Example
Period 1 Period 2 Period 3
Ending Inventory Beginning Inventory
Overstated Overstated
by 5,000 by 5,000 Correct
Sales Revenue 100,000 100,000 100,000
Cost of goods sold
Beginning inventory 10,000 15,000 10,000
Net purchases 50,000 50,000 50,000
Cost of goods available for
sale 60,000 65,000 60,000
Ending inventory (15,000) (10,000) (10,000)
Cost of goods sold 45,000 55,000 50,000
Gross profit 55,000 45,000 50,000

ote: The correct gross profit is 50,000 for each period

 :-) Analysis of inventory errors
Vibrant Company had $850,000 of sales in each of three consecutive years 2017–2019, and it purchased
merchandise costing $500,000 in each of those years. It also maintained a $250,000 physical inventory from
the beginning to the end of that three-year period. In accounting
for inventory, it made an error at the end of year 2017 that caused its year-end 2017 inventory to appear on its
statements as $230,000 rather than the correct $250,000.

1. Determine the correct amount of the company's gross profit in each of the years 2017 - 2019.

2. Prepare comparative income statements to show the effect of this error on the company's cost of goods sold and gross
profit for each of the year 2017 - 2019.

95
 Appendix 6B:
Inventory Estimation Methods
Inventory sometimes requires estimation for interim statements or
if some casualty such as fire or flood makes taking a physical
count impossible.

Retail Inventory Method Gross Profit Method

Four Important Inventory Issues
End of Chapter 5

© McGraw-Hill Education 98