1.Chapter Four
Accounting for Merchandising Businesses
2.5- 2
Inventory
Inventory is tangible property that is held for resale or will be used in producing goods or services.
Inventory is reported on the balance sheet as an asset.
Types of inventory:
Merchandise inventory
Raw materials inventory
Work in process inventory
Finished goods inventory
manufacturer
3.5- 3
Inventory Cost
The cost principle requires that inventory be recorded for the price paid or the consideration given up.
What type of transaction is the purchase of inventory?
Asset Exchange if cash paid.
Asset Source if “on account”.
4.5- 4
Inventory Cost
The amount recorded for inventory should include:
Invoice price (minus purchase discounts), transportation-in costs (also called “freight-in”), inspection costs, and preparation costs.
The company should accumulate costs of purchases until raw materials are ready for use or until merchandise is ready for shipment to customers.
5.5- 5
Income Statement Change
Net Sales 7,500
Less: Cost of goods sold -3,000
Gross Profit Margin 4,500
Because of Cost of Goods Sold, the format for the Income Statement is modified:
6.5- 6
Product Costs Versus Selling and Administrative Costs
Product Costs
Costs that are included in inventory.
Selling & Admin. Costs
Costs that are not included in inventory. They are sometimes called period costs.
7.5- 7
Cost of Goods Sold
Cost of goods sold is calculated as the number of units sold during the period multiplied by their unit costs.
Cost of goods sold is a major expense item for most non-service businesses.
The measurement of cost of goods sold is an excellent example of the application of the matching principle Why?
The Cost of Goods Sold EXPENSE is recorded in the period the units are SOLD (REVENUE is recognized), regardless of when the units are paid for. So, the EXPENSE is MATCHED against the related REVENUE.
8.5- 8
Cost of Goods Sold
Beginning inventory
Add: Purchases (net)
Cost of Goods Available for Sale
Deduct: Ending inventory
Cost of goods sold
Cost of Goods Available for Sale expresses the total cost of what has been available for sale throughout a given time period.
9.5- 9
5-9
Allocation of Inventory Cost Between Asset and Expense Accounts
Cost of Goods Available for Sale
Merchandise Inventory (Balance Sheet)
Cost of Goods Sold (Income Statement)
10.5- 10
Purchase $4,000 of Office Supplies
Date Account Title Debit Credit
Jan. 6 Supplies 4,000
Cash 4,000
Post from General Journal to the General Ledger
4,000
4,000
Supplies
Cash
11.5- 11
$1,000 of Supplies left over at the end of the month
Date Account Title Debit Credit
Jan. 30 Supplies Expense 3,000
Supplies 3,000
Record use of $3,000 of Supplies
Post from General Journal to the General Ledger
3,000
3,000
Supplies Expense
Supplies
12.5- 12
Purchase 1,000 units of Inventory for $4,000
Date Account Title Debit Credit
Jan. 6 Inventory 4,000
Cash 4,000
Purchase 1,000 units @ $4.00 each
Post from General Journal to the General Ledger
4,000
4,000
Inventory
Cash
13.5- 13
$1,000 of Inventory left over at the end of the month
Date Account Title Debit Credit
Jan. 30 Cost of Goods Sold 3,000
Inventory 3,000
Record sale of 750 units of Inventory
Post from General Journal to the General Ledger
3,000
3,000
Cost of Goods Sold
Inventory
14.5- 14
$3,000 of Inventory was sold for $7,500 Cash
Date Account Title Debit Credit
Jan. 30 Cash 7,500
Revenue 7,500
Record sale of Inventory @ $10 each
Post from General Journal to the General Ledger
7,500
7,500
Cash
Sales Revenue
15.5- 15
A deduction from the invoice price granted to induce early payment of the amount due.
Terms
Time
Due
Discount Period
Full amount
less discount
Credit Period
Full amount due
Purchase or Sale
Cash Discounts
16.5- 16
Terms of Sales & Purchases
Discount Terms: 2/10, n/30 (for example)
2% discount if balance paid in ten days,
remainder to be paid within 30 days of sale
tells when and how much must be paid
There is a high interest cost of not taking purchase discounts when offered.
17.5- 17
2/10, n/30
Percentage of Discount
# of Days Discount Is Available
Otherwise, the Full Amount Is Due
# of Days when Full Amount Is Due
Cash Discounts
18.5- 18
Terms of Sales & Purchases
F. O. B. (Free On Board) shipping point or F.O.B. destination
tells who pays for the shipping and when ownership “title” passes from the seller to the buyer.
19.5- 19
FOB Shipping and FOB Destination
FOB Shipping Point: Buyer pays the shipping costs because ownership “title” transfers to buyer at the point the shipment starts on its journey.
FOB Destination: Seller pays shipping costs because title does not transfer to the buyer until the goods reach their destination (the buyer’s place of business).
20.Who Pays for FOB?
5- 20
Business
Supplier
Customer
Shipping Point
Shipping Point
Destination
Destination
Shipping Pt – Business pays
Shipping Pt –
Customer pays
Destination –
Business pays
Destination –
Supplier pays
21.5- 21
Purchased 1000 units for $4 each on account. (Terms: 2/10, n/30)
Asset Source
Transaction
22.5- 22
1. Journalize & Post the purchase.
23.5- 23
Paid a trucking company $500to deliver the purchased unitsto our warehouse.
Freight charges paid to get inventory to our place of business (called TRANSPORTATION IN) is part of the cost of the purchase. It is added to the Inventory account, thus increasing the asset value. It is NOT “expensed”.
Asset Exchange
Transaction
24.5- 24
2. Journalize & Post the transportation cost
25.5- 25
3. Sold 620 units on account for $6 each. (Terms 1/10, n/30)
$6 sales price x 620 units = $3720
3a. Record the Sales Revenue and
related Receivable.
Asset Source
Transaction
26.5- 26
3a. Journalize and Post the sale.
27.5- 27
620 units sold x $4.50 cost each = $2790
3b. Record the Cost of the Goods Sold and their removal from inventory.
What is the cost of each item in inventory?
$4.00 invoice price + $0.50 transportation
= $4.50 per unit
$500 transport / 1000 units
28.5- 28
620 units sold x $4.50 cost each = $2790
3b. Record the Cost of the Goods Sold and their removal from inventory.
Cost of goods sold
Asset Use
Transaction
29.5- 29
3b. Journalize and Post the cost of the sale.
30.5- 30
4. The customer in Transaction #3A returned 20 units for credit.
$6 sales price x 20 units = $120
4a. Remove the previously recorded Sales Revenue and related Account Receivable.
A separate “Sales Return” contra-revenue account may be used.
Asset Use
Transaction
31.5- 31
4a. Journalize and Post the sales return.
32.5- 32
4b. Put the cost of the 20 returned units back into inventory and out of Cost of Goods Sold. (Recall, the units were “costed out” of inventory and charged to Cost of Goods Sold at $4.50 each in Tr. #3b.)
$4.50 x 20 units = $90
Reduction in “Cost of Goods Sold”.
Asset Source
Transaction
33.5- 33
4b. Journalize and Post the return to inventory.
34.5- 34
5a. The Transaction #3a customer paid within the ten day discount period.Record the Sales Discount. (1/10, n/30)
Original Account Receivable (Transaction 3a) $3,720
Less: Sales Return (Transaction 4a) 120
Amount owed by customer before discount 3,600
x 1% sales discount 1%
Sales Discount $ 36
Asset Source
Transaction
35.5- 35
5a. Journalize and Post the 1% Sales Discount.
36.5- 36
5b. The Transaction #3a customer paid within the ten day discount period. Record the cash collection.
Original Account Receivable (Transaction 3a) $3,720
Less: Sales Return (Transaction 4a) (120)
Less: Sales Discount (Transaction 5a) (36)
Cash receipt that will satisfy the account $3,564
Asset Exchange
Transaction
37.5- 37
5b. Journalize and Post the cash collection.
38.5- 38
Returned 50 units to our supplier who granted us credit for the cost of the items but not for any transportation costs.
Technically, this LOSS should be reported in the operating expense section of the income statement. However, this loss is usually NOT MATERIAL, so most companies record it as an increase in the COST OF GOODS SOLD expense account.
That’s what we’ll do here.
Supplier cost was $4.00 per unit x 50 = $200. Transportation cost recorded when units were purchased was $0.50 per unit x 50 = $25.
39.5- 39
6. Returned 50 units to our supplier who granted us credit for the cost of the items but not for any transportation costs.
40.5- 40
7. A physical inventory count shows 340 units on-hand, indicating 10 units have been lost.
Units in Beginning Inventory 0
+ Units Purchased this period (1000- 50 purchase returns) 950
= Units Available for Sale 950
Units Sold (620 – 20 sales returns) (600)
= Units that should be in ending inventory 350
Actual ending inventory from count (340)
= Units missing 10
x $4.50 cost per unit $45.00
41.5- 41
7. A physical inventory count shows 340 units on-hand, indicating 10 units have been lost.
Technically, this LOSS should be reported in the operating expense section of the income statement. However, this loss is usually NOT MATERIAL, so most companies record it as an increase in the COST OF GOODS SOLD expense account.
That’s what we’ll do here.
42.5- 42
7. A physical inventory count shows 340 units on-hand, indicating 10 units have been lost.
43.5- 43
8a. Paid within discount period, so record the 2% discount on the $4000 Tran. #1 purchase less $200 Tran. #6 return.
Purchase (Transaction #1) $4000
Less Purchase Return (Trans. #6) 200
Amount owed 3800
X discount % 2%
Amount of Purchase Discount $ 76
This reduces the cost of the inventory and the amount we owe the supplier.
44.5- 44
8a. Paid within discount period, so record the discount on the $4000 Tr. #1 purchase less $200 Tr. #6 return.
45.5- 45
8b. Paid the remaining balance on the Transaction #1 inventory purchase. $4000 purchase (Trans. #1) - 200 purchase return (Trans. #6) - 76 purchase discount (Trans. #8a) $3724 remainder to pay supplier
46.5- 46
8b. Paid the remaining balance on the Transaction #1 inventory purchase. ($4000-200-76=$3724 to pay)
47.5- 47
9. The Sale recorded in Transaction #3a was made with terms of F.O.B. destination. Record payment of the $340 shipping cost.
Transportation charges on PURCHASES are added to the cost of the asset, INVENTORY. (Transportation IN)
Transportation charges to ship products TO CUSTOMERS are reported as operating expenses on the income statement. The appropriate account title is TRANSPORTATION OUT (or FREIGHT OUT or SHIPPING EXPENSE).
48.5- 48
9. The Sale recorded in Transaction #3a was made with terms of F.O.B. destination. Record payment of the $340 shipping cost.
49.5- 49
Clock CompanyEnding Balances of LEDGER Accounts
50.5- 50
Transaction Analysis
The following selected events occurred during 2004 at Clock Company which uses the PERPETUAL INVENTORY SYSTEM.
For each event:
Determine the effect on the financial statements.
Record the event in the journal and ledger.
51.5- 51
Lost, Damaged, or Stolen Inventory
Most merchandise companies experience some level of inventory shrinkage, a term that reflects decreases in inventory for reasons other than sales to customers.
52.5- 52
Lost, Damaged, or Stolen Inventory
Assume a company determined that $500 of inventory was lost through shrinkage. Here is how it would effect the statements:
In general journal form, the entry is as follows:
53.5- 53
Timing is EVERYTHING...
Recognize revenue when “earned”
earned when an exchange (seller to buyer) occurs
Three levels of the matching principle
Product costs (e.g., inventory costs): assets until produce revenue
direct cause & effect relationship between revenue and expense
Period costs: systematic & rational allocation
e.g., depreciation costs
Period costs: recognize as expense as incurred
e.g., advertising costs
54.5- 54
Perpetual Inventory Systems
The inventory account is continuously updated for the following events:
Purchases
Purchase Discounts Taken
Purchase Returns & Allowances
Sales (remove from inventory the COST of the units sold)
Sales Returns (add to inventory the COST of units returned)
The necessary detailed record-keeping required by the perpetual system has become much easier with current computer technology.
A physical count of the inventory is still required at the end of the accounting period to assure accurate inventory records in case of errors or theft.
55.5- 55
Perpetual Inventory Systems
Cost of Goods Sold . . .
Contains the cost of units that have been sold to customers.
Is a temporary account.
(It will be closed out at
the end of the period.)
Is an expense account.
56.5- 56
When using the Periodic system, inventory transactions are not recorded directly in the INVENTORY account. Instead, separate accounts are used for
PURCHASES
PURCHASE RETURNS & ALLOWANCES
PURCHASE DISCOUNTS
TRANSPORTATION IN
Periodic Inventory SystemSeparate Accounts Used
Let’s look at another Inventory system.
57.5- 57
Periodic Inventory Systems
Because entries are not made to the inventory account during the accounting period, the amount of inventory is not known until the end of the period when the inventory count is done.
The PERIODIC system is being used less and less due to advancements in technology that make the extra record keeping of the perpetual system easy and inexpensive.
Periodic inventory systems require more closing entries at the end of the period. (Purchases, Purchase Returns and Allowances, Purchase Discounts, and Transportation In are all separate TEMPORARY accounts that must be closed out at the end of the period.)
58.5- 58
Periodic Inventory System Purchases and Purchase Returns and Allowances
Purchases is an account that holds the current period’s inventory purchases (a debit balance) and is used in the calculation of Cost of Goods Sold on the Income Statement.
The Purchase Returns and Allowances account also is used to calculate Cost of Goods Sold on the income statement. It is a deduction from the cost of purchases in a periodic inventory system.
Bar codes/scanners
59.5- 59
When using the Periodic system Purchase Discounts are recorded in a separate account. This helps managers keep track of the company’s performance in taking advantage of discounts.
Periodic Inventory SystemPurchase Discounts
60.5- 60
Periodic Inventory Systems
The ending inventory is determined at the end of the period by taking a physical count of the goods remaining on hand.
Cost of goods sold is calculated at the end of the accounting period by subtracting the ending inventory (determined from the physical count) from the Cost of Goods Available for Sale.
Beginning Inventory $ 400 + Purchases, net 2000
= Goods Available for Sale 2400
Ending Inv. (from count) 500
= Cost of Goods Sold $1900
61.5- 61
Gross Margin Percentage
Gross Margin
Net Sales
This measure indicates how much
of each sales dollar is left after deducting the cost of goods sold to cover expenses and provide a profit.
Other things being equal, the company with the higher gross margin percentage is pricing its products higher.
62.5- 62
Ratios: Gross Margin Percentage
Gross margin %:
Gross margin as a percent of sales
Net sales – CGS gross margin
Net sales net sales
=
63.5- 63
Ratios: Gross Margin Percentage
Net sales – CGS = $1,000 – 400
Net sales $1,000
= $600___ = 60% or $.60
$1,000
This tells us that each dollar of sales
contributes 60 cents to the
Gross Margin.
64.5- 64
Return on Sales
Net Income
Net Sales
Net income expressed as a percentage of sales provides insight as to how much of each sales dollar is left as net income after all expenses are paid.
Other things being equal, the company with the higher return on sales percentage is doing a better job of controlling costs.
65.5- 65
Ratios: Return on sales
Return on sales =
Net income
Net sales
Revenues - expenses
Net sales
66.5- 66
Ratios: Return on sales
Return on sales =
Net income =
Net sales
$500___ = 50% or $.50
$1,000
Each dollar of sales is generating 50 cents of Net Income
67.5- 67
Income Statement Formats
Single Step -
with details
Single Step -
condensed
Multi-step -
with details
Multi-step -
condensed
Let’s look at examples…..
68.5- 68
Income Statement Formats
Net Sales 100
Less: Cost of goods sold 60
Gross Profit Margin 40
Operating Expenses:
Selling:
Sales Salaries 8
Advertising 2
Total Selling 10
Administrative:
Admin. Salaries 3
Building Rent 8
Total Adm. Exp. 11
Total Operating Exp. 21
Operating Income 19
Non-Operating Rev. (Exp.)
Interest Expense (1)
Income before tax 18
Income Tax expense 3
Net Income 15
Multi-step with details
Multi-step: condensed
Net Sales 100
Less: Cost of goods Sold 60
Gross Profit Margin 40
Operating Expenses:
Selling Expenses 10
Administrative Exp. 11
Total Operating Exp. 21 Operating Income 19
Non-Operating Rev. (Exp.)
Interest Expense (1)
Income before tax 18
Income Tax expense 3
Net Income 15
69.5- 69
Income Statement Formats
Net Sales 100
Less: Cost of goods sold 60
Gross Profit Margin 40
Operating Expenses:
Selling:
Sales Salaries 8
Advertising 2
Total Selling 10
Administrative:
Admin. Salaries 3
Building Rent 8
Total Adm. Exp. 11
Total Operating Exp. 21
Operating Income 19
Non-Operating Rev. (Exp.)
Interest Expense (1)
Income before tax 18
Income Tax expense 3
Net Income 15
Multi-step with details
Multi-step: condensed
Net Sales 100
Less: Cost of goods Sold 60
Gross Profit Margin 40
Operating Expenses:
Selling Expenses 10
Administrative Exp. 11
Total Operating Exp. 21 Operating Income 19
Non-Operating Rev. (Exp.)
Interest Expense (1)
Income before tax 18
Income Tax expense 3
Net Income 15
The multi-step INCOME Statement format classifies interest as a NON-operating item. But, interest is still an OPERATING ACTIVITY on the CASHFLOW Statement.
70.5- 70
Income Statement Formats
Net Sales 100
Less Expenses:
Cost of goods sold 60
Sales Salaries 8
Advertising 2
Admin. Salaries 3
Building Rent 8
Interest Expense 1
Income Tax Expense 3
Total Expenses 85
Net Income 15
Single-step with details
Single-step: condensed
Net Sales 100
Less Expenses:
Cost of goods sold 60
Selling 10
Administrative 11
Interest Expense 1
Income Tax Expense 3
Total Expenses 85
Net Income 15
71.5- 71
Income Statement Formats
Net Sales 100
Less Operating Exp.
Cost of goods sold 60
Sales Salaries 8
Advertising 2
Admin. Salaries 3
Building Rent 8
Interest Expense 1
Total Oper. Exp. 82
Income before taxes 18
Income Tax Expense 3
Net Income 15
Single-step with details
Single-step: condensed
Net Sales 100
Less Expenses:
Cost of goods sold 60
Selling 10
Administrative 11
Total Oper. Exp. 81
Income before taxes 19
Income Tax Expense 4
Net Income 15
A common modification of the single-step method is to have the income tax expense separated out.
72.5- 72
Common-size Income Statement
Each item on the income statement is expressed as a % of that year’s Net Sales.
Comparisons are made to:
Budget
Previous year(s)
Competitors
%
Net Sales 100.0
- Cost 60.0
=G.P 40.0
73.5- 73
Comparative Common-size Income Statements
2013 2012
Net Sales $3,000 $2,000
Cost of Goods Sold 2,000 1,200
Gross Profit 1,000 800
Operating Expenses:
Selling Expenses 600 400
Administrative Exp. 700 300
Total Oper. Exp. 1,300 700
Net Income ($300) $100
% of N.Sales
100.0
% of N.Sales
100.0
74.5- 74
Comparative Common-size Income Statements
2013 2012
Net Sales $3,000 $2,000
Cost of Goods Sold 2,000 1,200
Gross Profit 1,000 800
Operating Expenses:
Selling Expenses 600 400
Administrative Exp. 700 300
Total Oper. Exp. 1,300 700
Net Income ($300) $100
% of N.Sales
100.0
66.7
33.3
20.0
23.3
43.3
(10.0)
% of N.Sales
100.0
60.0
40.0
20.0
15.0
35.0
5.0
75.5- 75
Income Statement Trend Analysis
Trend Analysis shows both Dollar and % changes from one year to the next year for each item on the income statement.
Example:
From 2012 to 2013 Net Sales increased
from $2,000 to $3,000. So……
Net Sales increased $1,000 which is a 50% increase over 2012 Net Sales.
($1,000 incr./$2,000 Net Sales of 2012 = 50%)
76.5- 76
Income Statement Trend Analysis
2013 2012
Net Sales $3,000 $2,000
Cost of Goods Sold 2,000 1,200
Gross Profit 1,000 800
Operating Expenses:
Selling Expenses 600 400
Administrative Exp. 700 300
Total Oper. Exp. 1,300 700
Net Income ($300) $100
% inc.(dec)
50.0
66.7
25.0
50.0
133.3
85.7
(400.0)
$ inc.(dec.)
$1,000
800
200
200
400
600
($400)
77.5- 77
How about analyzing the Balance Sheet?
The same techniques are used to analyze the Balance Sheet.
Common-size Analysis:
Use the TOTAL ASSETS amount as the 100% figure. So, …….. Express each Balance Sheet item as a % of Total Assets.
Trend Analysis:
Same approach as used on the income statement.
1. Calculate the $ change for each bal. sheet item. 2. Express the $ change as a % of the previous
year’s (or base year’s) amount.
78.5- 78
End of Chapter 4
Remember,
Your objectives are to understand what you are doing and to be able to analyze the financial information.
Memorization without understanding
is meaningless!