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CHAPTER NINETEEN

CHAPTER NINETEEN. ACCOUNTING FOR MERCHANDISE INVENTORY. INVENTORY ERRORS. Errors in inventory will cause errors on: Income Statement, Statement of Owner’s Equity and Balance Sheet For the current and the next year. EFFECT OF INVENTORY ERRORS. INCOME STATEMENT. 20 - 1. 20 - 2. Sales. 80.

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CHAPTER NINETEEN

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  1. CHAPTER NINETEEN ACCOUNTING FOR MERCHANDISEINVENTORY

  2. INVENTORY ERRORS • Errors in inventory will cause errors on: • Income Statement, Statement of Owner’s Equity and Balance Sheet • For the current and the next year

  3. EFFECT OF INVENTORY ERRORS INCOMESTATEMENT 20-1 20-2 Sales 80 Cost of Goods Sold: Beginning Merch. Inventory 20 Add Purchases (net) 40 Cost of Goods Available for Sale 60 Less: Ending Merch. Inventory 20 Let’s first look at the Income Statement with the ending inventory correctly stated at $20.

  4. EFFECT OF INVENTORY ERRORS INCOMESTATEMENT 20-1 20-2 Sales 80 Cost of Goods Sold: Beginning Merch. Inventory 20 Add Purchases (net) 40 Cost of Goods Available for Sale 60 Less: Ending Merch. Inventory 20 (40) Cost of Goods Sold Gross Profit 40 Operating Expenses (10) Net Income 30 Now let’s look at the other financial statements.

  5. EFFECT OF INVENTORY ERRORS STMT OF OWNER’S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 Net Income 30 Erv Bultman, capital, December 31 130 BALANCE SHEET (partial) Current Assets: Merchandise Inventory 20 Owner’s Equity: Erv Bultman, Capital 130

  6. EFFECT OF INVENTORY ERRORS INCOMESTATEMENT 20-1 20-2 Sales 80 80 Cost of Goods Sold: Beginning Merch. Inventory 20 20 Add Purchases (net) 40 Cost of Goods Available for Sale 60 Less: Ending Merch. Inventory 20 (40) Cost of Goods Sold Gross Profit 40 20-1’s ending inventory becomes 20-2’s beginning inventory. Operating Expenses (10) Net Income 30

  7. EFFECT OF INVENTORY ERRORS INCOMESTATEMENT 20-1 20-2 Sales 80 80 Cost of Goods Sold: Beginning Merch. Inventory 20 20 Add Purchases (net) 40 40 Cost of Goods Available for Sale 60 60 Less: Ending Merch. Inventory 20 20 (40) (40) Cost of Goods Sold Gross Profit 40 40 Operating Expenses (10) (10) Net Income 30 30

  8. EFFECT OF INVENTORY ERRORS STMT OF OWNER’S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 130 Net Income 30 30 Erv Bultman, capital, December 31 130 160 BALANCE SHEET (partial) Current Assets: Merchandise Inventory 20 20 Owner’s Equity: Erv Bultman, Capital 130 160

  9. EFFECT OF INVENTORY ERRORS What would be the effect on the financial statements for 20-1 & 20-2 if the 12/31/-1 inventory was reported as $15 instead of $20? Ending inventory 20-1 & Beginning inventory 20-2 UNDERSTATED

  10. EFFECT OF INVENTORY ERRORS INCOMESTATEMENT 20-1 20-2 Sales 80 Cost of Goods Sold: Beginning Merch. Inventory 20 Add Purchases (net) 40 Cost of Goods Available for Sale 60 Less: Ending Merch. Inventory 15 (45) Cost of Goods Sold Gross Profit 35 Operating Expenses (10) Net Income 25 Understated Ending Inventory results in understated Net Income.

  11. EFFECT OF INVENTORY ERRORS STMT OF OWNER’S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 Net Income 25 Erv Bultman, capital, December 31 125 BALANCE SHEET (partial) Understated Net Income results in understated Owner’s Equity. Current Assets: Merchandise Inventory Owner’s Equity: Erv Bultman, Capital

  12. EFFECT OF INVENTORY ERRORS STMT OF OWNER’S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 Net Income 25 Erv Bultman, capital, December 31 125 BALANCE SHEET (partial) Current Assets: Merchandise Inventory 15 Owner’s Equity: Erv Bultman, Capital 125 Assets and Owner’s Equity will be understated.

  13. EFFECT OF INVENTORY ERRORS INCOMESTATEMENT 20-1 20-2 Sales 80 80 Cost of Goods Sold: Beginning Merch. Inventory 20 15 Add Purchases (net) 40 40 Cost of Goods Available for Sale 60 55 Less: Ending Merch. Inventory 15 20 (45) (35) Cost of Goods Sold Gross Profit 35 45 Operating Expenses (10) (10) Net Income 25 35 Understated Beginning Inventory results in overstated Net Income.

  14. EFFECT OF INVENTORY ERRORS STMT OF OWNER’S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 125 Net Income 25 35 Erv Bultman, capital, December 31 125 160 BALANCE SHEET (partial) Current Assets: Merchandise Inventory 15 Owner’s Equity: Erv Bultman, Capital 125 Owner’s Equity is correct by the end of 20-2.

  15. EFFECT OF INVENTORY ERRORS STMT OF OWNER’S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 125 Net Income 25 35 Erv Bultman, capital, December 31 125 160 BALANCE SHEET (partial) Current Assets: Merchandise Inventory 15 20 Owner’s Equity: Erv Bultman, Capital 125 160 Assets and Owner’s Equity will be correct.

  16. EFFECT OF INVENTORY ERRORS What would be the effect on the financial statements for 20-1 & 20-2 if the 12/31/-1 inventory was reported as $25 instead of $20? Ending inventory 20-1 & Beginning inventory 20-2 OVERSTATED

  17. EFFECT OF INVENTORY ERRORS INCOMESTATEMENT 20-1 20-2 Sales 80 Cost of Goods Sold: Beginning Merch. Inventory 20 Add Purchases (net) 40 Cost of Goods Available for Sale 60 Less: Ending Merch. Inventory 25 (35) Cost of Goods Sold Gross Profit 45 Operating Expenses (10) Net Income 35 Overstated Ending Inventory results in overstated Net Income.

  18. EFFECT OF INVENTORY ERRORS STMT OF OWNER’S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 Net Income 35 Erv Bultman, capital, December 31 135 BALANCE SHEET (partial) Current Assets: Merchandise Inventory Overstated Net Income results in overstated Owner’s Equity. Owner’s Equity: Erv Bultman, Capital

  19. EFFECT OF INVENTORY ERRORS STMT OF OWNER’S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 Net Income 35 Erv Bultman, capital, December 31 135 BALANCE SHEET (partial) Current Assets: Merchandise Inventory 25 Owner’s Equity: Erv Bultman, Capital 135 Assets and Owner’s Equity will be overstated.

  20. EFFECT OF INVENTORY ERRORS INCOMESTATEMENT 20-1 20-2 Sales 80 80 Cost of Goods Sold: Beginning Merch. Inventory 20 25 Add Purchases (net) 40 40 Cost of Goods Available for Sale 60 65 Less: Ending Merch. Inventory 25 20 (35) (45) Cost of Goods Sold Gross Profit 45 35 Operating Expenses (10) (10) Net Income 35 25 Overstated Beginning Inventory results in understated Net Income.

  21. EFFECT OF INVENTORY ERRORS STMT OF OWNER’S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 135 Net Income 35 25 Erv Bultman, capital, December 31 135 160 BALANCE SHEET (partial) Current Assets: Merchandise Inventory 25 Owner’s Equity: Erv Bultman, Capital 135 Owner’s Equity is correct by the end of 20-2.

  22. EFFECT OF INVENTORY ERRORS STMT OF OWNER’S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 135 Net Income 35 25 Erv Bultman, capital, December 31 135 160 BALANCE SHEET (partial) Current Assets: Merchandise Inventory 25 20 Owner’s Equity: Erv Bultman, Capital 135 160 Assets and Owner’s Equity will be correct.

  23. PERIODIC METHOD Merch. Inv. account balance = most recent physical inventory Purchases account used for all merchandise purchases Current inventory and cost of goods sold only computed at end of period PERPETUAL METHOD Merch. Inv. Account reflects current inventory Purchases are debited to Merch. Inv., cost of sales are credited to Merch. Inv. Generally no need for end of year adjustments RECORDING PURCHASES

  24. COMPARING ENTRIES UNDER PERIODIC AND PERPETUAL SYSTEMS Example: Purchased $100 of merchandise on account

  25. PERIODIC SYSTEM DATE DESCRIPTION DEBIT PR CREDIT Purchases 100 00 1 Accts Payable 2 100 00 3 4 Periodic system uses a “Purchases” account. 5 6 7 8 9 10 11

  26. PERPETUAL SYSTEM DATE DESCRIPTION DEBIT PR CREDIT Merchandise Inventory 100 00 1 Accts Payable 2 100 00 3 4 Perpetual system records purchases directly in the Merchandise Inventory account. 5 6 7 8 9 10 11

  27. COMPARING ENTRIES UNDER PERIODIC & PERPETUAL SYSTEMS Example: Paid freight charges $30

  28. PERIODIC SYSTEM DATE DESCRIPTION DEBIT PR CREDIT Frieight-In 30 00 1 Cash 2 30 00 3 4 5 Periodic system separates freight charges in to their own account. 6 7 8 9 10 11

  29. PERPETUAL SYSTEM DATE DESCRIPTION DEBIT PR CREDIT Merchandise Inventory 30 00 1 Cash 2 30 00 3 4 5 Perpetual system considers freight charges part of the cost of merchandise and includes them in the inventory account. 6 7 8 9 10 11

  30. COMPARING ENTRIES UNDER PERIODIC & PERPETUAL SYSTEMS Example: Sold merchandise on account, $80. The cost of the merchandise was $50.

  31. PERIODIC SYSTEM DATE DESCRIPTION DEBIT PR CREDIT Accounts Receivable 80 00 1 Sales 2 80 00 3 4 5 Periodic system only records the selling price of merchandise sold. No attempt is made to reduce the inventory account for items sold. 6 7 8 9 10 11

  32. PERPETUAL SYSTEM DATE DESCRIPTION DEBIT PR CREDIT Accounts Receivable 80 00 1 Sales 2 80 00 3 4 5 Perpetual system also records the selling price of merchandise sold. 6 7 8 9 10 11

  33. PERPETUAL SYSTEM DATE DESCRIPTION DEBIT PR CREDIT Accounts Receivable 80 00 1 Sales 2 80 00 3 Cost of Goods Sold 4 50 00 Merchandise Inventory 50 00 5 6 In addition, the perpetual system removes the cost of merchandise sold from inventory. 7 8 9 10 11

  34. COMPARING ENTRIES UNDER PERIODIC & PERPETUAL SYSTEMS Example: Merchandise costing $10 was returned to the supplier.

  35. PERIODIC SYSTEM DATE DESCRIPTION DEBIT PR CREDIT Accounts Payable 10 00 1 Purchases Ret. & Allow. 2 10 00 3 4 5 Periodic system maintains a separate account for returns. 6 7 8 9 10 11

  36. PERPETUAL SYSTEM DATE DESCRIPTION DEBIT PR CREDIT Accounts Payable 80 00 1 Merchandise Inventory 2 80 00 3 4 5 Since the merchandise was recorded in the inventory account when purchased, it is removed from the account when returned. 6 7 8 9 10 11

  37. COMPARING ENTRIES UNDER PERIODIC & PERPETUAL SYSTEMS Example: Customers returned merchandise sold for $20. The cost of the merchandise was $15.

  38. PERIODIC SYSTEM DATE DESCRIPTION DEBIT PR CREDIT Sales Returns & Allow. 20 00 1 Accounts Receivable 2 20 00 3 4 5 Periodic system maintains a separate account for returns. 6 7 8 9 10 11

  39. PERPETUAL SYSTEM DATE DESCRIPTION DEBIT PR CREDIT Sales Returns & Allow. 20 00 1 Accounts Receivable 2 20 00 3 4 5 Perpetual system records the returned sale. It also must adjust the “Cost of Goods Sold” and “Merchandise Inventory” accounts. 6 7 8 9 10 11

  40. PERPETUAL SYSTEM DATE DESCRIPTION DEBIT PR CREDIT Sales Returns & Allow. 20 00 1 Accounts Receivable 2 20 00 3 Merchandise Inventory 4 15 00 Cost of Goods Sold 15 00 5 6 7 8 9 10 11

  41. COMPARING ENTRIES UNDER PERIODIC & PERPETUAL SYSTEMS Example: Paid for merchandise costing $100. The supplier granted a 2% discount for prompt payment.

  42. PERIODIC SYSTEM DATE DESCRIPTION DEBIT PR CREDIT Accounts Payable 100 00 1 Purchases Discounts 2 2 00 Cash 3 98 00 4 Discounts are recorded in a separate account. 5 6 7 8 9 10 11

  43. PERPETUAL SYSTEM DATE DESCRIPTION DEBIT PR CREDIT Sales Returns & Allow. 20 00 1 Accounts Receivable 2 20 00 3 4 5 Perpetual system records the returned sale. It also must adjust the “Cost of Goods Sold” and “Merchandise Inventory” accounts. 6 7 8 9 10 11

  44. COMPARING ENTRIES UNDER PERIODIC & PERPETUAL SYSTEMS Example: Adjusting entries made at the end of the accounting period.

  45. PERIODIC SYSTEM DATE DESCRIPTION DEBIT PR CREDIT Income Summary 1 XX Merchandise Inventory 2 XX 3 4 Removing the old balance from the inventory account 5 6 7 8 9 10 11

  46. PERIODIC SYSTEM DATE DESCRIPTION DEBIT PR CREDIT Income Summary 1 XX Merchandise Inventory 2 XX 3 Merchandise Inventory 4 XX Income Summary XX 5 6 7 Recording new balance in the inventory account 8 9 10 11

  47. PERPETUAL SYSTEM DATE DESCRIPTION DEBIT PR CREDIT 1 2 No entry needed if physical inventory agrees with amount reported in inventory account. 3 4 5 6 7 8 9 10 11

  48. TAKING A PHYSICAL INVENTORY • Counting the goods on hand at the end of the period • used in the PERIODIC system to allocate merchandise costs between sold and unsold goods • in the PERPETUAL system it is compared to the accounting records to determine if what is actually held agrees with the records • done after regular business hours • ideally when inventory on hand is at its lowest level • fiscal year that starts and ends when inventory is at its lowest level is called “natural business year”

  49. TAKING A PHYSICAL INVENTORY • Two special situations: • Goods held for sale on CONSIGNMENT • Goods held on consignment remain the property of the shipper (Consignor) • Goods in TRANSIT • if FOB Shipping point - goods belong to the BUYER while in transit • if FOB Destination- goods belong to the SELLER while in transit

  50. COMPUTING THE COST OF ENDING INVENTORY EXAMPLE: A physical inventory found 50 bicycles (Model ZX007) on hand. All of this model bicycle were purchased for $60 each. Number of bikes on hand Cost per unit Ending Inventory X = 50 $60 $3000 = X Computing ending inventory is simple if all purchases were made at the same price.

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