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Financial accounting the impact on decision makers 9e chapter 5

Chapter 5
Inventories and Cost
of Goods Sold

Inventory Types
Finished inventory: held by retailers and wholesalers
 Merchandise inventory
 Materials inventory: held by manufacturers
 Raw materials
 Work-in-progress
 Finished goods

LO 1

Types of Manufacturing Costs
Direct materials: also called raw materials
 Ingredients used in making a product
 Direct labor: amounts paid to workers to manufacture

the product
 Manufacturing overheads: all other costs that are
related to the manufacturing process but cannot be
directly matched to specific units of output
 Example: depreciation of building and salary of

Three Forms of Inventory
Direct materials
 The inventory of a manufacturer before the addition
of any direct labor or manufacturing overhead
 Work in process
 Cost of unfinished products in a manufacturing
 Finished goods
 A manufacturer’s inventory that is complete and
ready for sale

Exhibit 5.1 Relationships between Types of
Businesses and Inventory Costs

Account for Sales of Merchandise

Sales revenue: representation of the inflow of assets,
either cash or accounts receivable, from the sale of a
product during the period

Sales Return and
Net Sales = Sales −
− Sales Discount
Gross Profit = Net Sales − Cost of Goods Sold

LO 2

Exhibit 5.3—Net Sales Section of
the Income Statement

Sales Returns and Allowances
Sales returns and allowances: contra-revenue account
used to record refunds to customers and reductions of
their accounts
 Sales discounts: contra-revenue account used to
record discounts given to customers for early payment
of their accounts
 Credit terms: firm’s policy for granting credit
 Example: n/30; Net, 10 EOM; 1/10, n/30

Credit Terms and Sales Discounts

Credit terms: firm’s policy for granting credit
 n/30: the

net amount of the selling price is due
within 30 days of the date of the invoice
 Net, 10 EOM: the net amount is due anytime within
ten days after the end of the month
 1/10, n/30: the customer can deduct 1% from the
selling price if the bill is paid within ten days

Sales discounts: contra-revenue account used to
record discounts given to customers for early
payment of their accounts

Cost of Goods Sold
Recognition of cost of goods sold as an expense is an
excellent example of matching principle
 Sales revenue: inflow of assets, cash or accounts
 Cost of goods sold: outflow of asset, inventory
 Cost of goods available for sale

Beginning inventory + Cost of goods purchased
 Cost of goods sold
Cost of goods available for sale − Ending inventory
LO 3

Exhibit 5.4—Cost of Goods Sold
Section of the Income Statement

Exhibit 5.5—Cost of Goods Sold

Inventory Systems: Perpetual and

Example 5.3—Recording Cost of Goods
Sold in a Perpetual System

Daisy’s sells a pair of running shoes that costs $70. In
addition to the entry to record the sale, Daisy’s would
also record an adjustment as follows:

Exhibit 5.6—Cost of Goods

Example 5.4—Recording Purchase
in a Periodic System

Daisy’s buys shoes from Nike at a cost of $4,000. The
effect is to increase liabilities and increase cost of
goods sold, which is an expense

Example 5.5—Recording Purchase
Returns in a Periodic System

Daisy’s returns $850 of merchandise to Nike for credit
on Daisy’s account. The return decreases both
liabilities and purchases. Because a return reduces
purchases, it has the effect of reducing expenses and
increasing net income and stockholders’ equity

Example 5.6—Recording Purchase
Discounts in a Periodic System

On March 13,there is a purchase of merchandise for
$500, with credit terms of 1/10, n/30

Example 5.6—Recording Purchase
Discounts in a Periodic System (continued)

Purchase Discounts

A contra-purchases account used to record reductions
in purchase price for early payment to a supplier

Shipping Terms and Transportation
Cost principle: All costs necessary to prepare an asset
for its intended use should be included in its cost
 FOB destination point: seller incurs the transportation
 FOB shipping point: buyer incurs the transportation
 FOB stands for ‘‘free on board’’

Example 5.7—Recording
Transportation-In in a Periodic System

Assume that on delivery of a shipment of goods,
Daisy’s pays an invoice for $300 from Rocky
Mountain Railroad. The terms of shipment are
FOB shipping point

Example 5.8—Determining the Effect of
Shipping Terms on Purchases and Sales

The Gross Profit Ratio
Important measure of profitability
 Indicates a company’s ability to cover operating
expenses and earn a profit
 Relationship between gross profit and net sales—
measured by the gross profit ratio—one of the most
important measures to assess the performance of a

Gross Profit Ratio =

Gross Profit
Net Sales
LO 4

The Ratio Analysis Model


How much of the sales revenue is used for the cost
of the products, and thus, how much remains to
cover other expenses and to earn net income?
Gather the information about net sales and cost of
goods sold
Calculate the gross profit ratio
Compare the ratio with prior years and with
Interpret the ratios—showing increase or decrease

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