Chapter_1_Inventory_2 - CHAPTER-1 INVENTORIES Definition...

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CHAPTER -1 INVENTORIES Definition : - Inventories can be defined as merchandise held for sale in the normal course of business which is termed as merchandise inventory or materials in the process of production or held for production. Importance of inventories - It is the principal source of revenue for wholesale and retail businesses. - Cost of merchandise sold is the largest deduction from sells to determine net income. - A substantial part of merchandising firm’s resources is invested in inventory - It is the largest of the current assets on merchandisers businesses. Effect of Inventory Errors on Financial Statements Any error in the inventory count will affect both the balance sheet and the income statement. For example, an error in the physical inventory will misstate the ending inventory, current assets, and total assets on the balance sheet. This is because the physical inventory is the basis for recording the adjusting entry. Also an error in taking the physical inventory misstates the cost of goods sold, gross profit, and net income on the income statement. In addition, because net income is closed to the owner’s equity at the end of the period owner’s equity will also be misstated on the balance sheet. This misstatement of owner’s equity will equal the misstatement of the ending inventory, current asset and total assets. The effect of understatements and overstatements of merchandise inventory at the end of the period are demonstrated in the following three sets of condensed income statements and balance sheets. The first set of statements is based on a correct ending inventory of $60,000; The second set, on an incorrect ending inventory of 50,000; The third set, on an incorrect ending inventory of 70,000. In all three cases, net sales are 980,000, merchandise available for sale is $705,000, and operating expenses are $100,000. Income statement for the year Balance Sheet at the end of the year 1. Inventory at the end of the year correctly Stated $60,000 Net sales……………………..980,000 Merchandise inventory………. .$60,000 Cost of goods sold…………..645,000 Other asset……………………..340,000 Gross profit ………… ...... $335,000 Total asset ………………….400, 000 Expenses…………………….100,000 Liabilities………………………120,000 Net income ………………235,000 Owners equity…………………280,000 Total ………………………400,000 Page 1 of 14
2. Inventory at the end of period incorrectly stated at $50,000: (understated by 10,000). Net sales……………………..980,000 Merchandise inventory………. .$50,000 Cost of goods sold…………..655,000 Other asset…………………….340, 000 Gross profit ………… ...... $325,000 Total asset ……………...…. 390,000 Expenses…………………….100,000 Liabilities………………………120,000 Net income ………………225,000 Owners equity…………………270,000 Total ………………………390,000 3. Inventory at the end of period incorrectly stated at $70,000 (overstated by $10,000).

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