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Chapter Four. Accounting for Merchandising Businesses. 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

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Chapter Four

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Chapter four

Chapter Four

Accounting for Merchandising Businesses


Inventory

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


Inventory cost

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”.


Inventory cost1

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.


Income statement change

Net Sales 7,500

Less: Cost of goods sold -3,000

Gross Profit Margin 4,500

Income Statement Change

Because of Cost of Goods Sold, the format for the Income Statement is modified:


Product costs versus selling and administrative costs

Product Costs

Selling & Admin. Costs

Costs that are included in inventory.

Costs that are not included in inventory. They are sometimes called period costs.

Product Costs Versus Selling and Administrative Costs


Cost of goods sold

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.


Cost of goods sold1

Beginning inventory

Add: Purchases (net)

Cost of Goods Available for Sale

Deduct: Ending inventory

Cost of goods sold

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.


Allocation of inventory cost between asset and expense accounts

Allocation of Inventory Cost Between Asset and Expense Accounts

Merchandise Inventory (Balance Sheet)

Cost of Goods Available for Sale

Cost of Goods Sold (Income Statement)

5-9


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Purchase $4,000 of Office Supplies

Date Account Title Debit Credit

Jan. 6 Supplies4,000

Cash 4,000

Post from General Journal to the General Ledger

Supplies

Cash

4,000

4,000


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$1,000 of Supplies left over at the end of the month

Date Account Title Debit Credit

Jan. 30 Supplies Expense3,000

Supplies 3,000

Record use of $3,000 of Supplies

Post from General Journal to the General Ledger

Supplies Expense

Supplies

3,000

3,000


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Purchase 1,000 units of Inventory for $4,000

Date Account Title Debit Credit

Jan. 6 Inventory4,000

Cash 4,000

Purchase 1,000 units @ $4.00 each

Post from General Journal to the General Ledger

Inventory

Cash

4,000

4,000


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$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

Cost of Goods Sold

Inventory

3,000

3,000


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$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

Cash

Sales Revenue

7,500

7,500


Cash discounts

Terms

Time

Due

Discount Period

Credit Period

Full amount

less discount

Full amount due

Purchase or Sale

Cash Discounts

A deduction from the invoice price granted to induce early payment of the amount due.


Terms of sales purchases

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.


Cash discounts1

Cash Discounts

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


Terms of sales purchases1

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.


Fob shipping and fob destination

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).


Who pays for fob

Who Pays for FOB?

Shipping Point

Supplier

Destination

Destination –

Supplier pays

Business

Shipping Pt – Business pays

Shipping Point

Destination –

Business pays

Destination

Shipping Pt –

Customer pays

Customer


Purchased 1000 units for 4 each on account terms 2 10 n 30

Purchased 1000 units for $4 each on account.(Terms: 2/10, n/30)

Asset Source

Transaction


1 journalize post the purchase

1. Journalize & Post the purchase.


Paid a trucking company 500 to deliver the purchased units to our warehouse

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


2 journalize post the transportation cost

2. Journalize & Post the transportation cost


3 sold 620 units on account for 6 each terms 1 10 n 30

3.Sold 620 units on account for $6 each. (Terms 1/10, n/30)

3a. Record the Sales Revenue and

related Receivable.

$6 sales price x 620 units = $3720

Asset Source

Transaction


3a journalize and post the sale

3a. Journalize and Post the sale.


3b record the cost of the goods sold and their removal from inventory

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

620 units sold x $4.50 cost each = $2790


3b record the cost of the goods sold and their removal from inventory1

3b. Record the Cost of the Goods Sold and their removal from inventory.

620 units sold x $4.50 cost each = $2790

Cost of goods sold

Asset Use

Transaction


3b journalize and post the cost of the sale

3b. Journalize and Post the cost of the sale.


4 the customer in transaction 3a returned 20 units for credit

4.The customer in Transaction #3A returned 20 units for credit.

4a. Remove the previously recorded Sales Revenue and related Account Receivable.

A separate “Sales Return” contra-revenue account may be used.

$6 sales price x 20 units = $120

Asset Use

Transaction


4a journalize and post the sales return

4a. Journalize and Post the sales return.


Chapter four

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.)

Reduction in “Cost of Goods Sold”.

$4.50 x 20 units = $90

Asset Source

Transaction


4b journalize and post the return to inventory

4b. Journalize and Post the return to inventory.


Chapter four

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


5a journalize and post the 1 sales discount

5a. Journalize and Post the 1% Sales Discount.


5b the transaction 3a customer paid within the ten day discount period record the cash collection

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


5b journalize and post the cash collection

5b. Journalize and Post the cash collection.


Chapter four

Returned 50 units to our supplier who granted us credit for the cost of the items but not for any transportation costs.

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.

Technically, this LOSS should be reported in the operating expense section of the income statement. However, this loss is usually NOTMATERIAL, so most companies record it as an increase in the COST OF GOODS SOLD expense account.

That’s what we’ll do here.


Chapter four

6. Returned 50 units to our supplier who granted us credit for the cost of the items but not for any transportation costs.


7 a physical inventory count shows 340 units on hand indicating 10 units have been lost

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 inventory350

  • Actual ending inventory from count(340)

  • = Units missing 10

  • x $4.50 cost per unit$45.00


7 a physical inventory count shows 340 units on hand indicating 10 units have been lost1

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.


7 a physical inventory count shows 340 units on hand indicating 10 units have been lost2

7. A physical inventory count shows 340 units on-hand, indicating 10 units have been lost.


Chapter four

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.


Chapter four

8a. Paid within discount period, so record the discount on the $4000 Tr. #1 purchase less $200 Tr. #6 return.


Chapter four

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


8b paid the remaining balance on the transaction 1 inventory purchase 4000 200 76 3724 to pay

8b. Paid the remaining balance on the Transaction #1 inventory purchase. ($4000-200-76=$3724 to pay)


Chapter four

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).


Chapter four

9. The Sale recorded in Transaction #3a was made with terms of F.O.B. destination. Record payment of the $340 shipping cost.


Clock company ending balances of ledger accounts

Clock CompanyEnding Balances of LEDGER Accounts


Timing is everything

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


Perpetual inventory systems

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.


Perpetual inventory systems1

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.


Periodic inventory system separate accounts used

Let’s look at another Inventory system.

Periodic Inventory SystemSeparate Accounts Used

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 systems

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 Inare all separate TEMPORARY accounts that must be closed out at the end of the period.)


Periodic inventory system purchases and purchase returns and allowances

Periodic Inventory SystemPurchases 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.

  • ThePurchase Returns and Allowancesaccount 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


Periodic inventory system purchase discounts

Periodic Inventory SystemPurchase Discounts

When using the Periodic systemPurchase Discounts are recordedin a separate account. This helps managers keep track of the company’s performance in taking advantage of discounts.


Periodic inventory systems1

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


Gross margin percentage

Gross Margin

Net Sales

Gross Margin Percentage

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.


Ratios gross margin percentage

Ratios: Gross Margin Percentage

  • Gross margin %:

    • Gross margin as a percent of sales

    • Net sales – CGSgross margin

      Net sales net sales

=


Ratios gross margin percentage1

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.


Return on sales

Net Income

Net Sales

Return on 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.


Ratios return on sales

Ratios: Return on sales

  • Return on sales =

    Net income

    Net sales

    Revenues - expenses

    Net sales


Ratios return on sales1

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


Income statement formats

Single Step -

with details

Single Step -

condensed

Multi-step -

with details

Multi-step -

condensed

Income Statement Formats

Let’s look at examples…..


Income statement formats1

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

Income Statement Formats

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. 21Operating Income 19

Non-Operating Rev. (Exp.)

Interest Expense (1)

Income before tax 18

Income Tax expense 3

Net Income 15


Income statement formats2

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

The multi-step INCOME Statement format classifies interest as a NON-operating item. But, interest is still an OPERATING ACTIVITY on the CASHFLOW Statement.

Income Statement Formats

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. 21Operating Income 19

Non-Operating Rev. (Exp.)

Interest Expense (1)

Income before tax 18

Income Tax expense 3

Net Income 15


Income statement formats3

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

Income Statement Formats

Single-step with details

Single-step: condensed

Net Sales 100

Less Expenses:

Cost of goods sold 60

Selling 10

Administrative 11

Interest Expense1

Income Tax Expense 3

Total Expenses 85

Net Income 15


Income statement formats4

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

Income Statement Formats

Single-step with details

Single-step: condensed

A common modification of the single-step method is to have the income tax expense separated out.

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


Common size income statement

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


Comparative common size income statements

Comparative Common-size Income Statements

20132012

Net Sales $3,000 $2,000

Cost of Goods Sold 2,0001,200

Gross Profit 1,000 800

Operating Expenses:

Selling Expenses 600 400

Administrative Exp. 700300

Total Oper. Exp. 1,300700

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


Income statement trend analysis

Income Statement Trend Analysis

Trend Analysisshows 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%)


Income statement trend analysis1

Income Statement Trend Analysis

20132012

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. 700300

Total Oper. Exp. 1,300700

Net Income ($300)$100

$ inc.(dec.)

$1,000

800

200

200

400

600

($400)

% inc.(dec)

50.0

66.7

25.0

50.0

133.3

85.7

(400.0)


How about analyzing the balance sheet

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.


End of chapter 4

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!


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