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68 BOOKKEEPING AND ACCOUNTING
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Goods available for sale Ending inventory = Cost of goods sold it can be seen that if the ending inventory is overstated then the cost of goods sold will be understated and net pro t overstated. Likewise, if in ventory is understated then cost of goods sold will be overstated and net pro t understated. Clearly, the method chosen for inventory computation can have a marked effect upon the pro t of a company. There is no one method that is the best, but the rm must consider the following factors to help make the decision: 1. The effect on the income statement and the balance sheet. 2. The effect on taxable income. 3. The effect on the selling price. The following evaluations can be made concerning the three valua tion methods: FIFO 1. Yields the lowest amount of cost of goods sold (COGS) 2. Yields the highest amount of gross pro t 3. Yields the highest amount of ending inventory
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During a period of in ation or rising prices, the use of FIFO will have these effects, but in a declining economy the results will be reversed.
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LIFO 1. Yields the highest amount of COGS 2. Yields the lowest amount of gross pro t 3. Yields the lowest amount of ending inventory Weighted Average Yields results between FIFO and LIFO for all three concepts being re viewed.
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CHAPTER 10: Costing Merchandise Inventory
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Determining Inventory: Estimation
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Although a physical inventory is taken once a year, there are occasions when the value of the inventory must be known during the year. When interim nancial statements are requested, an inventory amount must be estimated. If no physical count is taken, the amount of inventory must be estimated. Also, in the event of re or any other casualty, an amount must be reported as a loss. Two of the most popular methods of estimating in ventory are the gross pro t method and the retail method. Gross Pro t Method This method rearranges the Cost of Goods Sold section of the income statement. As stated before, the cost of goods sold formula is: Beginning Inventory + Net Purchases Goods Available For Sale Ending Inventory Cost of Goods Sold Note that when you subtract ending inventory from the goods avail able for sale, the cost of goods sold is determined. Conversely, if you sub tract the estimated cost of goods sold from the goods available for sale, the value of the ending inventory will result. The estimated cost of goods sold gure is arrived at by using the past year s gross pro t percentage and subtracting the resulting amount from sales. For example, during the past ve years, a company s gross pro t av eraged 30 percent of sales. If the sales for this interim period are $70,000, the inventory at the beginning of the period is $30,000, and the net pur chases are $50,000, you would estimate the ending inventory under the gross pro t method as follows: Beginning Inventory Add: Net Purchases Goods Available For Sale Sales Estimated Gross Pro t (30%) Estimated Cost of Goods Sold Estimated Ending Inventory $30,000 50,000 $80,000 $70,000 21,000 49,000 $31,000
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70 BOOKKEEPING AND ACCOUNTING
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This method of estimating ending inventory is also useful for deter mining casualty losses such as res, ood, or theft, when such a calami ty destroys a company s inventory. It is obvious that a dollar amount must be assigned to the inventory lost before any insurance claim can be made. Although this may appear to be an impossible task, it is possible to build up to the inventory gure. Retail Inventory Method The retail inventory method of inventory costing is used by retail businesses, particularly department stores. Department stores usually determine gross pro t monthly but only take a physical inventory on an annual basis. The retail inventory method permits a determination of inventory at any time of the year and also produces a comparison of the estimated end ing inventory with the physical inventory ending inventory, both at retail prices. This will help to identify any inventory shortages resulting from theft or other causes. This method, similar to the gross pro t method, is used to estimate the dollar cost of the ending inventory when a physical count cannot be done, such as in the case of re. The procedure for determination under this method is as follows: 1. Beginning inventory and purchases must be recorded at both cost and selling prices. 2. Total goods available for sale are then computed on both bases. 3. Sales for the period are deducted from the goods available for sale at selling price. 4. Ending inventory at selling price is the result of step 3. This amount is then converted to ending inventory at cost by multiplying by the appropriate markup ratio. The procedure is illustrated in the example below: Cost Step 1. Beginning inventory $280,000 + Net Purchases for period 110,000 Step 2. Goods available for sale $390,000 Step 3. Net sales for period Ending inventory @ selling price Selling Price $400,000 180,000 $580,000 340,000 $240,000
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CHAPTER 10: Costing Merchandise Inventory Step 4. Cost to selling price ratio ($390,000 / $580,000) = 67% Ending inventory @ cost ($240,000 67%) = $160,800
In the above example, the cost percentage is 67%, which means that the inventory and purchases are marked up to yield a gross pro t margin of 33%. Certainly not all items in the goods available for sale are marked up by exactly the same percentage, but it is the average. In other words, the retail method will use a percentage that represents an average of markup cost. Summary Comparison The major difference between the gross pro t method and the retail method is that the former uses the historical gross pro t rates, and the lat ter uses the percentage markup from the current period. The gross pro t method uses past experience as a basis, whereas the retail method uses current experience. The gross pro t method is usually less reliable, because past situa tions may be different from current ones. Remember that both methods are useful because they allow the accountant to prepare interim nancial statements more frequently without taking the time to physically count the inventory. However, the annual physical count is necessary.
Summary
1. When inventory is physically counted at the end of an accounting period, we have the ________ method. 2. The _______ inventory method is most commonly used in retail establishments. 3. In a rising market, net income under ______ would be smaller, thus producing a smaller tax. 4. The inventory method based on the concept that the unit of cost of merchandise sold is the average of all expenditures for inventory is known as ________. 5. Of the two methods of estimation, the _______ is less reliable as an indicator of the inventory. Answers: 1. periodic; 2. periodic; 3. LIFO; 4. weighted average; 5. gross pro t method
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