Chapter 5

1. 1 Chapter 5

2. 2 • Service business earns fees • Revenues recorded • Merchandising business sells inventory • Revenue from sales • Expense of Inventory Cost • Cost of Goods Sold.

3. 3 • The Cost of Goods Sold • An expense • Treated differently on Income Statement • Sales Revenue - Cost of Goods Sold • Gross Profit or Gross Margin • Reported at the top of an income statement. 

4. 4 • Two Inventory Systems • Periodic Inventory System • Perpetual Inventory System

5. 5 • Periodic Inventory System • Company keeps track of Purchases during the period • Calculates COGS at end of year Beginning Inventory + Purchases Goods Available For Sale • Ending Inventory Cost of Goods Sold.

6. 6 • Periodic Inventory System • Assumes anything not there was sold • No information on theft or spoilage - Disadvantage • Company doesn’t know COGS until physical inventory taken - Disadvantage • Easy to maintain - Advantage

7. 7 • Perpetual Inventory System • Company always keeps track of COGS & Inventory • Still need physical inventory • End of year. • Any discrepancy with books - theft and spoilage • Used to be very expensive • With computers & scanners no longer true • Increasing in popularity • Previous class discussion is perpetual system • Will continue to use it in this chapter.

8. 8 • When you purchase inventory with cash:

9. 9 • When you purchase inventory on credit:

10. 10 • Purchase Returns & Allowances • You return inventory purchased (Purchases Return) • Reverse purchase • Supplier reduces price of merchandise after the sale (Purchases Allowance) • Write down Inventory to amount paid

11. 11 • A return of entire $5,000 purchase:

12. 12 • The receipt of $1,000 allowance on $5,000 purchase

13. 13 • Inventory cost includes: • Price paid (less discounts) • freight • insurance in transit • Taxes • Tariffs • Inspection costs • Preparation costs • Everything paid inventory to location & ready to sell

14. 14 • "FOB shipping point“ • Stands for Free On Board • Seller transfers title to inventory at the seller’s location. • Buyer pays shipping costs • E.g. you order car from Ford • Invoice says FOB Detroit • You pay shipping costs • You own car during shipment. • Something goes wrong – Your problem

15. 15 • "FOB destination“ • Seller transfers title to inventory when delivered • At buyer’s place of business • Seller pays shipping costs • E.g., you order car from Ford • Invoice says FOB Los Angeles • Ford pays shipping costs • Ford owns car during shipment • If something goes wrong – Ford’s problem

16. 16 • Transportation Costs on purchases • Part of cost of inventory • Called “Freight in” or “Transportation In” • Under perpetual inventory system – increase cost of the inventory:

17. 17 • Transportation Costs on sales • An expense • Called “Transportation Out” or “Freight Out”:

18. 18 • Purchases Discounts • We buy inventory • Seller offers credit terms to encourage us to pay quickly • Called purchase discounts. • When we are seller – Called sales discounts

19. 19 • Examples • 2/10 n/30 (“two-ten, net thirty”) • If buyer pays whole invoice within 10 days • Gets 2% off • Otherwise, entire bill due in 30 days • 1/10 EOM • If buyer pays whole invoice during 1st 10 days of next month • Gets 1% off • Otherwise, entire bill due by end of next month.

20. 20 • If seller does not wish to offer discount • Invoice says when payment is due • n/30 • No discount • Entire Invoice due in 30 days • n/10 EOM • Entire invoice due in first 10 days of next month

21. 21 • Passing up purchase discounts is very unwise • Interest cost for delaying payment for a few days is very high • E.g., 2/20 n/30 • Means you are paying 2% for a 20-day loan • Annualized rate of 36.5% per annum.

22. 22 • You buy inventory for $3,500 • Supplier offers you 2/10 n/30 • When you receive inventory • Ignore potential discount

23. 23 • If payment made during discount period • Show A/P is discharged in full • Show amount paid • Write down Inventory to price actually paid

24. 24 • If payment not made during discount period

25. 25 • Cash sale - revenue side of transaction: • Cash sale - cost side of transaction:

26. 26 • Credit sale - revenue side of transaction: • Credit sale - cost side of transaction:

27. 27 • Customer returns merchandise – you undo sale.  • Debit Sales Returns & Allowances • Contra-revenue account • It will be deducted from Sales Revenue • We keep track of this in separate account to gives management important information about company’s returns history • Otherwise, we could have just reduced Sales Revenue

28. 28 • Undo revenue side of transaction: • Undo cost side of transaction:

29. 29 • Sales Discounts • When we are seller • We can offer customers credit terms to encourage quick payment • Same notations as in Purchase Discounts • E.g., 2/10 n/30 • Contra Revenue account • Reduces Sales Revenue

30. 30 • When sale is made • Ignore potential sales discount

31. 31 • If payment received during discount period • Record the Cash received (reduced price) • Show A/R discharged in full (original price) • The Difference is Sales Discount (difference)

32. 32 • If payment received after discount period:

33. 33 • Trade Discounts • Offer customers cheaper prices • Not for paying quickly • An After Christmas Sale • E.g, Volume Discounts – If you buy 100, price drops • Record sale at cheaper price • no account for trade discounts.

34. 34 • Net Sales is Sales Revenue reduced by the contra-revenue accounts:

35. 35 • Single-step Income Statement • One Revenues section - lists all revenues • One Expenses section - lists all expenses • Multiple-step Income Statement • Contains many subcategories

36. 36

37. 37 • Gross Profit • Net Sales - Cost of Goods Sold • Also called Gross Margin • Gives you the mark-up on the goods sold • Merchandising profit • Gives information about market place • High gross margins – market isn’t very competitive • E.g., PC market in 1970s & 1980s - high gross margins • During 1990s, the PC market became competitive • Had shrinking gross margins.

38. 38 • Operating Expenses are: • sales expenses and • general & administrative expenses • Direct result of Management activities • Not like Gross Margin • Result from marketplace. • How good is the company in controlling its expenses?

39. 39 • Income From Operations • Gross Margin - Operating Expenses • Considered very important • Represents major operations • Good indication of future performance • Typically viewed as sustainable in the future

40. 40 • Other Revenues and Expenses • Nonoperating revenues & gains • dividends income • interest income • gains from sales of assets • Less nonoperating expenses & losses • interest expense • losses from sales of assets • Follows Income From Operations

41. 41 • Income Before Income Taxes • Income From Operations - Other Revenues and Expenses • Net Income • Income Before Income Taxes - Income Taxes • Earnings Per Share • Reported Below Net Income • Corporation’s Net Income earned for each share of common stock

42. 42

43. 43

44. 44

45. 45 • Gross Profit Rate • Also called Gross Profit/Margin Percentage • Gives Gross Profit/Margin in terms that are not influenced by size Gross Profit/Margin ------------------------------------- Net Sales

46. 46 • Operating Expenses To Sales Ratio • Focuses on management’s ability to control operating expenses: Operating Expenses ------------------------------------- Net Sales