 Hello, and welcome to this session. This is Professor Farhad in which we would look at the gross profit method for estimating ending inventory. So simply put, this method is a way to estimate ending inventory, the gross profit method. Now, when do we use this method? Is it always acceptable? And the answer, it's not always acceptable. It's used at interim financial reporting and interim is something less than a year. Usually what we're looking at is quarterly reportings, fire, catastrophe, destruction of property where we need to estimate ending inventory for insurance purposes or to basically rebuild our record. Any reason we need to estimate inventory, we can use this method. This is not acceptable for year end. So for the year end, you cannot use this method, the gross profit method. You have to count the inventory. The gross profit method relies on some formulas, on some prior knowledge. What are the, what's the required prior knowledge? Well, first thing you need to know how to compute the gross profit because it's called the gross profit method. How do we compute the gross profit? It's the sales minus cost of goods sold. Will give us the gross profit or the gross margin, gross profit or gross margin. Then we need to understand how to compute the gross margin percentage or the gross margin ratio, which is taking the gross margin, dividing the gross margin by sales. We're going to come up with the gross margin ratio. So if we are talking about $100 in sales, $60 in cost, the gross profit is $40, $40 divided by $100 will give us a gross margin ratio of 40% for this company. That's the first thing you need to know about this method is how to compute the gross margin percentage. Also you need to understand how to compute something called goods available for sale or goods to be accounted for. We will take beginning inventory, which usually that's giving to us. Let's assume that's $10 in beginning inventory. We add to those purchases. Let's assume purchases is $100. So beginning inventory is 10. We purchased 100 worth of inventory. The goods available for sale is $110. Now goods available for sale will have to be split between two accounts. So simply put, you have $110 worth of merchandise inventory. Goods available for sale. At the end of the period, some of it you will have, which ending inventory, it means it's not sold. And let's assume for the sake of this illustration, you have $20 in ending inventory. This means the remaining is cost of goods sold and the remaining must have been $90 because 90 plus 20 equal to 110. Now the best way to illustrate this concept is to actually look at a complete example. Before we look at an example, I would like to make an announcement about my company, farhat-lectures.com. Farhat accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions as well as exercises. Go ahead, start your free trial today. No obligation, no credit card required. Adam has a beginning inventory of $70,000, purchases of $210, freight in worth $10,000. Adam received a discount of $5,000, simply put the vendor gave Adam discounts of $5,000, sales at selling prices amounted to $200, the customer returned $4,000 at selling prices and the gross profit for Adam company is 30%. Can we estimate our ending inventory? How do we do so given this information? Well, let's start. We started with $70,000 of beginning inventory at cost. Then we purchased $210,000 that's also at cost. We know this. How do we know beginning ending inventory? This was last year ending. For the prior year, we assume we counted the inventory. How do we know $210,000 and purchases? We have a record of it. Freight worth $10,000. This is how much freight. Freight is added to your cost. Freight is added. It's transportation and purchase discount. The vendor gave you a discount. You must have paid early. You deduct the discount from your purchases because they lower your price. All in all, goods available for sale is $285,000. We put, those three figures gives us net purchases because we paid $210,000 for the cost of the merchandise. We add to it the freight. We deduct from it. They purchase discount. If there's any return, we deduct, so on and so forth. You have to know how to compute net purchases. Selling at selling price, sales at selling price were $200,000, $200,000. Returns return were $4,000, therefore net sales was $196,000. We know that we sold $196,000 from our sales record because we keep track of our sales record. What do we know about this company? We know that Adam Company earns 30% of gross profit. What does that mean? It means this amount, $196,000, 30% of it is profit, and guess what, 70% of it is cost. Let's compute the profit. The profit is $196,000 times 30%, and let me just double check the math. I believe that's correct, but it's good to double check, $196 times 0.3, so the profit is $58,800. Obviously, the sales at cost is $137,200. This is the cost, and this is the profit. Now, we know we had $285,000 in total, goods available for sale, and now we know of that amount $137,200 was sold at, this is $200,000 were sold, but of this $200,000, some of it is profit, some of it is cost, and we determined the cost happens to be $137,200. To simply put, that $285, we need to deduct from it $137,200 to find out how much of it is left, and we find out what's left of it is $147,800, and let me double check my math. If I take those two, $137,200, $137,200 plus $147,800, I come up with $285, exactly. I reconciled. It means I go back to $285, simply put, the $285 is split between ending inventory and cost of sales. So this is the cost of goods sold, and what's left, and this is an estimate, $147,800. Now we might have less, if there's any theft, any shrinkage, we're not aware of it, but approximately our inventory should be $147,800. This is how you compute ending inventory using the gross profit, and the information is going to be given to you as markup on cost, markup on cost, or markup on retail. So rather than giving you this straightforward 30%, they'll give you the percentage in a different way. I'll have a quick recording about this. What should you do now? Go to farhatlectures.com and work through false multiple choice exercises that's going to help you understand this concept. Invest in yourself. Good luck, study hard, and of course, stay safe.