 Hello and welcome to this session in which we would look at this exercise. It looks like a puzzle but it illustrates various concepts that are critical for your understanding of basic as well as advanced accounting. So this exercise it's going to help us to learn how to compute the gross profit or the gross margin, how to compute cost of goods sold, the formula for cost of goods sold, and how to look at an income statement overall and be able to read an income statement. So when you look at this problem, basically those are three years, year one, year two, and year three. It looks pretty intimidating but you will see once you understand how the income statement and the formula for the cost of goods sold fits together, you will find this exercise very easy and very beneficial for your understanding. 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Let's go ahead and take a look at this exercise. So we are giving sales, we are not giving beginning inventory, we are not giving cost of goods sold, we are not giving operating expenses, we are not giving tax expense and we are not giving net income. So how would you solve this problem? How would you solve this problem? Well you need to know the relationship between these accounts. What can I do? Well I don't know, I can't find beginning inventory yet, but here's what I can find. I'm giving sales and I'm giving gross margin or gross profit, whatever you want to call it, gross margin or gross profit. I know that if I take my sales subtracted from cost of goods sold, it's going to give me gross margin. So simply put you need to know that sales minus cost of goods sold equal to gross profit or gross margin. This is an important formula. So knowing this formula you can immediately find cost of goods sold, which happens to be I need to deduct 36,000 and I found out cost of goods sold. Well I found out the first number. What can cost of goods sold gives me? Well if I can find cost of goods sold, I can find beginning inventory. How so? Well I need to know this formula by heart. If I'm an accounting student I need to know that beginning inventory plus purchases minus ending gives me cost of goods sold. And we gave, by the way, beginning inventory plus purchases, we call them, there's an intermediate term for them available for sale or goods available for sale. Now I know I don't have beginning inventory, but I know if I take some number x, let's call this x, x plus 20,050 minus 14,200 will give me 36,000. All what I have to do now is solve for x and x must be 30,150 and I just find out my beginning inventory. Good. Now I'm down to my gross margin, so I found sales minus cost of goods sold equal to gross margin. I'm not giving operating expenses, but I am told that income before expenses is 8,800. It means my operating expenses need to be deducted and I need to deduct 2000 and operating expenses. Now I have income before taxes. Well, I'm told my income tax rate is 40 percent. This means I have to pay in taxes 3,520 and therefore I have a net income, not a net loss of 5,280 and I found the missing numbers. Okay. Now using this information can you find year two? Well let's see. I don't have sales, I have beginning inventory, I have purchases, I don't have ending inventory, I have cost of goods sold and I have gross margin. Well, if I have cost of goods sold and I have gross margin, I can find sales. Sales is x minus 48,000 equal to 14,400. Sales must have been 62,400, so I just found sales. Now I am missing ending inventory. I know that beginning inventory plus purchases minus x minus ending inventory gives me 48,000. Well, I must have deducted 16,400 to get to 18,000. Now I'm not giving operating expenses and I'm not giving income before taxes. Okay. But I'm giving taxes, tax expense. Well, what does that mean? It means I took some number here. Income before taxes, I took some number multiplied by 0.4 gave me 2,560. Why 0.4? Because my tax rate is 0.4. Therefore my income before taxes must have been 6,400 and let's double check that. Let's get the calculator here and if my income, I guess my son was using my calculator because it's on a large scale. He likes to use a calculator. 6,400, 6,400 times 0.4 equal to 2,560. Now I am, now I'm still missing one component of this exercise and that's operating expenses. Well, I know my gross margin is 14,400. Then I have to deduct something from operating expenses, which will give me 6,400. That number must be 8,000. So notice how we filled out this all this information based on knowing the gross profit or gross margin formula, knowing the formula for cost of goods sold, knowing how to compute the taxes, knowing that gross margin minus operating expenses will give you income before taxes. So knowing the structure of an income statement, that's extremely important, especially the inventory formula, cost of goods sold. Let's take a look at the third year. In the third year, I'm giving sales. I'm giving beginning inventory. They're not told me how much I purchased. I am giving ending inventory. I am not giving cost of goods sold. I am giving gross margin. Well, let's start step by step. What can I do? Well, if I have sales and if I have gross margin, I can find cost of goods sold. Of course I can, because sales minus cost of goods sold, so 78,000 minus 60, 78,000 minus 60 will give me 18,000. Well, I got my cost of goods sold. I found out that number. Now, if I have my beginning inventory and I know if I add my purchases, which is X, I deduct my ending inventory, I should get cost of goods sold. All I have to do is sold for X. And in this situation, the purchases were, if I sold for X, 62,200. Now, let's keep going. I have gross margin. I have operating expenses. Well, that's easy. Gross margin minus operating expenses gives me income before taxes, which happens to be 12,000. Now, I have to pay 40% taxes on 12,000. That's 4,800. And from that number, I will deduct taxes from my income before taxes to get to net income. So my net income is 7,200. So notice how we completed this puzzle, which is a very interesting puzzle, knowing how to fill this information. Now, the other thing I want you to notice is this, because it's obvious, but maybe it may not be obvious for a lot of you, but I just want to let you know that always ending inventory becomes your beginning inventory of the of the of the following year. Ending inventory becomes beginning inventory, because sometime what they do is they give you ending inventory, and they will not give you 14,200, and they will not give you cost of goods. They will give you, they will give you to find beginning inventory and end ending inventory. I can't do that because, you know, I have missing two numbers. Well, always beginning inventory is the prior year ending inventory. So just in case that happens, you know how to deal with that scenario. Again, those exercises are extremely important in terms of understanding. You understand this formula, beginning inventory plus purchases, minus cost of goods sold, you will use it in financial accounting, intermediate accounting, advanced accounting, knowing the formula for cost of goods sold, you will use it in financial accounting, intermediate accounting, cost accounting, managerial accounting, and obviously all these concepts are tested on the CPA exam. Therefore, if you want a better understanding, if you're a CPA candidate, I strongly suggest you check out my website farhatlectures.com. I can help you do better on your CPA exam. I explain the material differently, maybe better, maybe not better, but at least differently from your CPA review course, which in turn will help you increase your understanding of your CPA review course, which in turn help you on the exam. Good luck, study hard, the CPA is worth it.