# Chapter 5 Financial Accounting

OPERATING CYCLES
The operating cycle of a merchandising company ordinarily is longer than that of a service company. The purchase of inventory and its eventual sale lengthen the cycle. Illustration 5-2 contrasts the operating cycles of service and merchandising companies. Note that the added asset account for a merchandising company is the Inventory account.
FLOW OF COSTS
The flow of costs for a merchandising company is as follows. Beginning inventory plus the cost of goods purchased is the cost of goods available for sale. As goods are sold, they are assigned to cost of goods sold. Those goods that are not sold by the end of the accounting period represent ending inventory. Illustration 5-3 describes these relationships. Companies use one of two systems to account for inventory: a perpetual inventory system or a periodic inventory system.

Perpetual System: In a perpetual inventory system, companies maintain detailed records of the cost of each inventory purchase and sale. These records continuously—perpetually—show the inventory that should be on hand for every item. For example, a Ford dealership has separate inventory records for each automobile, truck, and van on its lot and showroom floor. Similarly, a grocery store uses bar codes and optical scanners to keep a daily running record of every box of cereal and every jar of jelly that it buys and sells. Under a perpetual inventory system, a company determines the cost of goods sold each time a sale occurs.

Periodic System: In a periodic inventory system, companies do not keep detailed inventory records of the goods on hand throughout the period. They determine the cost of goods sold only at the end of the accounting period—that is, periodically. At that point, the company takes a physical inventory count to determine the cost of goods on hand.
To determine the cost of goods sold under a periodic inventory system, the following steps are necessary:
1. Determine the cost of goods on hand at the beginning of the accounting period.
2. Add to it the cost of goods purchased.
3. Subtract the cost of goods on hand at the end of the accounting period.

Advantages of the Perpetual System: A perpetual inventory system provides better control over inventories than a periodic system. Since the inventory records show the quantities that should be on hand, the company can count the goods at any time to see whether the amount of goods actually on hand agrees with the inventory records. If shortages are uncovered, the company can investigate immediately. Although a perpetual inventory system requires additional clerical work and additional cost to maintain inventory records, a computerized system can minimize this cost. Much of Amazon.com’s success is attributed to its sophisticated inventory system.

Recording Purchases of Merchandise
Each purchase should be supported by a purchase invoice, which indicates the total purchase price and other relevant information. However, the purchaser does not prepare a separate purchase invoice. Instead, the purchaser uses as a purchase invoice the copy of the sales invoice sent by the seller.

Under the perpetual inventory system, companies record purchases of merchandise for sale in the Inventory account. Thus, REI would increase (debit) Inventory for clothing, sporting goods, and anything else purchased for resale to customers. Not all purchases are debited to Inventory, however. Companies record purchases of assets acquired for use and not for resale, such as supplies, equipment, and similar items, as increases to specific asset accounts rather than to Inventory. For example, to record the purchase of materials used to make shelf signs or for cash register receipt paper, REI would increase (debit) Supplies.

Freight Costs
The sales agreement should indicate who—the seller or the buyer—is to pay for transporting the goods to the buyer’s place of business. When a common carrier such as a railroad, trucking company, or airline transports the goods, the carrier prepares a freight bill in accord with the sales agreement.
Freight terms are expressed as either FOB shipping point or FOB destination. The letters FOB mean free on board. Thus, FOB shipping point means that the seller places the goods free on board the carrier, and the buyer pays the freight costs. Conversely, FOB destination means that the seller places the goods free on board to the buyer’s place of business, and the seller pays the freight.

Freight Costs Incurred by Buyer: When the buyer pays the transportation costs, these costs are considered part of the cost of purchasing inventory. As a result, the account Inventory is increased (debited).

Freight Costs Incurred by Seller: In contrast, freight costs incurred by the seller on outgoing merchandise are an operating expense to the seller. These costs increase an expense account titled Freight-Out (sometimes called Delivery Expense).

PURCHASE RETURNS AND ALLOWANCES
A purchaser may be dissatisfied with the merchandise received because the goods are damaged or defective, of inferior quality, or do not meet the purchaser’s specifications. In such cases, the purchaser may return the goods to the seller for credit if the sale was made on credit, or for a cash refund if the purchase was for cash. This transaction is known as a purchase return. Alternatively, the purchaser may choose to keep the merchandise if the seller is willing to grant a reduction of the purchase price. This transaction is known as a purchase allowance.
Assume that Sauk Stereo returned goods costing \$300 to PW Audio Supply on May 8. The following entry by Sauk Stereo for the returned merchandise decreases (debits) Accounts Payable and decreases (credits) Inventory. Because Sauk Stereo increased Inventory when the goods were received, Inventory is decreased (credited) when Sauk Stereo returns the goods.
Suppose instead that Sauk Stereo chose to keep the goods after being granted a \$50 allowance (reduction in price). It would reduce (debit) Accounts Payable and reduce (credit) Inventory for \$50.
PURCHASE DISCOUNTS
The credit terms of a purchase on account may permit the buyer to claim a cash discount for prompt payment. The buyer calls this cash discount a purchase discount. This incentive offers advantages to both parties. The purchaser saves money, and the seller is able to shorten the operating cycle by converting the accounts receivable into cash earlier.

The credit terms specify the amount of the cash discount and time period during which it is offered. They also indicate the length of time in which the purchaser is expected to pay the full invoice price. In the sales invoice in Illustration 5-5, credit terms are 2/10, n/30, which is read “two-ten, net thirty.” This means that a 2% cash discount may be taken on the invoice price, less (“net of”) any returns or allowances, if payment is made within 10 days of the invoice date (the discount period). Otherwise, the invoice price, less any returns or allowances, is due 30 days from the invoice date. Alternatively, the discount period may extend to a specified number of days following the month in which the sale occurs. For example, 1/10 EOM (end of month) means that a 1% discount is available if the invoice is paid within the first 10 days of the next month.

When the seller elects not to offer a cash discount for prompt payment, credit terms will specify only the maximum time period for paying the balance due. For example, the credit terms may state the time period as n/30, n/60, or n/10 EOM. This means, respectively, that the buyer must pay the net amount in 30 days, 60 days, or within the first 10 days of the next month.
When an invoice is paid within the discount period, the amount of the discount decreases Inventory. Why? Because the merchandiser records inventory at its cost and, by paying within the discount period, it has reduced that cost. To illustrate, assume Sauk Stereo pays the balance due of \$3,500 (gross invoice price of \$3,800 less purchase returns and allowances of \$300) on May 14, the last day of the discount period. The cash discount is , and the amount of cash Sauk Stereo paid is . The entry Sauk Stereo makes to record its May 14 payment decreases (debits) Accounts Payable by the amount of the gross invoice price, reduces (credits) Inventory by the \$70 discount, and reduces (credits) Cash by the net amount owed.

The following T-account (with transaction descriptions in blue) provides a summary of the effect of the previous transactions on Inventory. Sauk Stereo originally purchased \$3,800 worth of inventory for resale. It then returned \$300 of goods. It paid \$150 in freight charges, and finally, it received a \$70 discount off the balance owed because it paid within the discount period. This results in a balance in Inventory of \$3,580.
Recording Sales of Merchandise
Sales may be made on credit or for cash. Every sales transaction should be supported by a business document that provides written evidence of the sale. Cash register documents provide evidence of cash sales. A sales invoice, like the one that was shown in Illustration 5-5, provides support for each sale. The original copy of the invoice goes to the customer, and the seller keeps a copy for use in recording the sale. The invoice shows the date of sale, customer name, total sales price, and other relevant information.
The seller makes two entries for each sale. (1) It increases (debits) Accounts Receivable or Cash, as well as increases (credits) Sales Revenue. (2) It increases (debits) Cost of Goods Sold and decreases (credits) Inventory. As a result, the Inventory account will show at all times the amount of inventory that should be on hand.
To illustrate a credit sales transaction, PW Audio Supply records the sale of \$3,800 on May 4 to Sauk Stereo (see Illustration 5-5) as follows (assume the merchandise cost PW Audio Supply \$2,400).
SALES RETURNS AND ALLOWANCES
We now look at the “flip side” of purchase returns and allowances, which the seller records as sales returns and allowances. These are transactions where the seller either accepts goods back from a purchaser (a return) or grants a reduction in the purchase price (an allowance) so that the buyer will keep the goods. PW Audio Supply’s entries to record credit for returned goods involve (1) an increase (debit) in Sales Returns and Allowances (a contra account to Sales Revenue) and a decrease (credit) in Accounts Receivable at the \$300 selling price, and (2) an increase (debit) in Inventory (assume a \$140 cost) and a decrease (credit) in Cost of Goods Sold, as shown below. (We assumed that the goods were not defective. If they were defective, PW Audio Supply would make an entry to the Inventory account to reflect their decline in value.)

Sales Returns and Allowances is a contra revenue account to Sales Revenue, which means it is offset against a revenue account on the income statement. The normal balance of Sales Returns and Allowances is a debit. Companies use a contra account, instead of debiting Sales Revenue, to disclose in the accounts and in the income statement the amount of sales returns and allowances. Disclosure of this information is important to management. Excessive returns and allowances suggest problems—inferior merchandise, inefficiencies in filling orders, errors in billing customers, or mistakes in delivery or shipment of goods. Moreover, a decrease (debit) recorded directly to Sales Revenue would obscure the relative importance of sales returns and allowances as a percentage of sales. It also could distort comparisons between total sales in different accounting periods.

SALES DISCOUNTS
As mentioned in our discussion of purchase transactions, the seller may offer the customer a cash discount—called by the seller a sales discount—for the prompt payment of the balance due. Like a purchase discount, a sales discount is based on the invoice price less returns and allowances, if any. The seller increases (debits) the Sales Discounts account for discounts that are taken. The entry by PW Audio Supply to record the cash receipt on May 14 from Sauk Stereo within the discount period is:

Like Sales Returns and Allowances, Sales Discounts is a contra revenue account to Sales Revenue. Its normal balance is a debit. Sellers use this account, instead of debiting Sales Revenue, to disclose the amount of cash discounts taken by customers. If the customer does not take the discount, PW Audio Supply increases (debits) Cash for \$3,500 and decreases (credits) Accounts Receivable for the same amount at the date of collection.

Income Statement Presentation
Companies widely use two forms of the income statement. One is the single-step income statement. The statement is so named because only one step, subtracting total expenses from total revenues, is required in determining net income (or net loss).
In a single-step statement, all data are classified into two categories: (1) revenues, which include both operating revenues and nonoperating revenues and gains (for example, interest revenue and gain on sale of equipment); and (2) expenses, which include cost of goods sold, operating expenses, and nonoperating expenses and losses (for example, interest expense, loss on sale of equipment, or income tax expense). The single-step income statement is the form we have used thus far in the text.

The multiple-step income statement has three important line items: gross profit, income from operations, and net income. They are determined as follows.
1. Subtract cost of goods sold from net sales to determine gross profit.
2. Deduct operating expenses from gross profit to determine income from operations.
3. Add or subtract the results of activities not related to operations to determine net income.

SALES REVENUES
The income statement for a merchandising company typically presents gross sales revenues for the period. The company deducts sales returns and allowances and sales discounts (both contra accounts) from sales revenue in the income statement to arrive at net sales.
GROSS PROFIT
The excess of net sales over cost of goods sold is gross profit. It is determined by deducting cost of goods sold from sales revenue. As shown in Illustration 5-8, REI had a gross profit of \$729 million in 2010. This computation uses net sales, which takes into account sales returns and allowances and sales discounts.

It is important to understand what gross profit is—and what it is not. Gross profit represents the merchandising profit of a company. Because operating expenses have not been deducted, it is not a measure of the overall profit of a company. Nevertheless, management and other interested parties closely watch the amount and trend of gross profit. Comparisons of current gross profit with past amounts and rates and with those in the industry indicate the effectiveness of a company’s purchasing and pricing policies.

OPERATING EXPENSES
Operating expenses are the next component in measuring net income for a merchandising company. At REI, for example, operating expenses were \$613.5 million in 2010.
At PW Audio Supply, operating expenses were \$114,000. The firm determines its income from operations by subtracting operating expenses from gross profit. Thus, income from operations is \$30,000, as shown below.
NONOPERATING ACTIVITIES
Nonoperating activities consist of various revenues and expenses and gains and losses that are unrelated to the company’s main line of operations. When nonoperating items are included, the label “Income from operations” (or “Operating income”) precedes them. This label clearly identifies the results of the company’s normal operations, an amount determined by subtracting cost of goods sold and operating expenses from net sales. The results of nonoperating activities are shown in the categories “Other revenues and gains” and “Other expenses and losses.”
DETERMINING COST OF GOODS SOLD UNDER A PERIODIC SYSTEM
Determining cost of goods sold is different when a periodic inventory system is used rather than a perpetual system. As you have seen, a company using a perpetual system makes an entry to record cost of goods sold and to reduce inventory each time a sale is made. A company using a periodic system does not determine cost of goods sold until the end of the period. At the end of the period, the company performs a count to determine the ending balance of inventory. It then calculates cost of goods sold by subtracting ending inventory from the goods available for sale. Goods available for sale is the sum of beginning inventory plus purchases,
GROSS PROFIT RATE
A company’s gross profit may be expressed as a percentage by dividing the amount of gross profit by net sales. This is referred to as the gross profit rate. For PW Audio Supply, the gross profit rate is .
Analysts generally consider the gross profit rate to be more informative than the gross profit amount because it expresses a more meaningful (qualitative) relationship between gross profit and net sales. For example, a gross profit amount of \$1,000,000 may sound impressive. But if it was the result of sales of \$100,000,000, the company’s gross profit rate was only 1%. A 1% gross profit rate is acceptable in very few industries. Illustration 5-14 demonstrates that gross profit rates differ greatly across industries.
PROFIT MARGIN
The profit margin measures the percentage of each dollar of sales that results in net income. We compute this ratio by dividing net income by net sales (revenue) for the period.
How do the gross profit rate and profit margin differ? The gross profit rate measures the margin by which selling price exceeds cost of goods sold. The profit margin measures the extent by which selling price covers all expenses (including cost of goods sold). A company can improve its profit margin by either increasing its gross profit rate and/or by controlling its operating expenses and other costs. For example, at one time Radio Shack reported increased profit margins which it accomplished by closing stores and slashing costs. While its total sales have been declining, its profitability as measured by its profit margin has increased.

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