Have you ever shopped for outdoor gear at an REI (Recreational Equipment Incorporated) store? If so, you might have been surprised if a salesclerk asked if you were a member. A member? What do you mean a member? You soon realize that REI might not be your typical store. In fact, there's a lot about REI that makes it different.
REI is a consumer cooperative, or “co-op” for short. To figure out what that means, consider this quote from the company's annual report:
As a cooperative, the Company is owned by its members. Each member is entitled to one vote in the election of the Company's Board of Directors. Since January 1, 2008, the nonrefundable, nontransferable, one-time membership fee has been $20 dollars. As of December 31, 2010, there were approximately 10.8 million members.
Voting rights? Now that's something you don't get from shopping at Wal-Mart. REI members get other benefits as well, including sharing in the company's profits through a dividend at the end of the year, which can be used for purchases at REI stores during the next two years. The more you spend, the bigger your dividend.
Since REI is a co-op, you might wonder whether management's incentives might be a little different. For example, is management still concerned about making a profit? The answer is yes, as it ensures the long-term viability of the company. At the same time, REI's members want the company to be run efficiently, so that prices remain low. In order for its members to evaluate just how well management is doing, REI publishes an audited annual report, just like publicly traded companies do. So, while profit maximization might not be the ultimate goal for REI, the accounting and reporting issues are similar to those of a typical corporation.
How well is this business model working for REI? Well, it has consistently been rated as one of the best places to work in the United States. It was ranked 8th on Fortune's 2012 list. Also, REI had sustainable business practices long before social responsibility became popular at other companies. The CEO's Stewardship Report states “we reduced the absolute amount of energy we use despite opening four new stores and growing our business; we grew the amount of FSC-certified paper we use to 58.4 percent of our total paper footprint—including our cash register receipt paper; we facilitated 2.2 million volunteer hours and we provided $3.7 million to more than 330 conservation and recreation nonprofits.”
So, while REI, like other retailers, closely monitors its financial results, it also strives to succeed in other areas. And, with over 10 million votes at stake, REI's management knows that it has to deliver.
Preview of Chapter 5
Merchandising is one of the largest and most influential industries in the United States. It is likely that a number of you will work for a merchandiser. Therefore, understanding the financial statements of merchandising companies is important. In this chapter, you will learn the basics about reporting merchandising transactions. In addition, you will learn how to prepare and analyze a commonly used form of the income statement—the multiple-step income statement. The content and organization of the chapter are as follows.
REI, Wal-Mart, and Amazon.com are called merchandising companies because they buy and sell merchandise rather than perform services as their primary source of revenue. Merchandising companies that purchase and sell directly to consumers are called retailers. Merchandising companies that sell to retailers are known as wholesalers. For example, retailer Walgreens might buy goods from wholesaler McKesson. Retailer Office Depot might buy office supplies from wholesaler United Stationers. The primary source of revenues for merchandising companies is the sale of merchandise, often referred to simply as sales revenue or sales. A merchandising company has two categories of expenses: cost of goods sold and operating expenses.
Cost of goods sold is the total cost of merchandise sold during the period. This expense is directly related to the revenue recognized from the sale of goods. Illustration 5-1 shows the income measurement process for a merchandising company. The items in the two blue boxes are unique to a merchandising company; they are not used by a service company.
The operating cycle of a merchandising company ordinarily is longer than that of a service company. The purchase of merchandise inventory and its eventual sale lengthen the cycle. Illustration 5-2 shows the operating cycle of a service company.
Illustration 5-3 shows the operating cycle of a merchandising company.
Note that the added asset account for a merchandising company is the Inventory account. Companies report inventory as a current asset on the balance sheet.
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 5-4 describes these relationships. Companies use one of two systems to account for inventory: a perpetual inventory system or a periodic inventory system.
In a perpetual inventory system, companies keep 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 Kroger 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.
Helpful Hint For control purposes, companies take a physical inventory count under the perpetual system, even though it is not needed to determine cost of goods sold.
In a periodic inventory system, companies do not keep detailed inventory records of the goods on hand throughout the period. Instead, 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.
Illustration 5-5 graphically compares the sequence of activities and the timing of the cost of goods sold computation under the two inventory systems.
Companies that sell merchandise with high unit values, such as automobiles, furniture, and major home appliances, have traditionally used perpetual systems. The growing use of computers and electronic scanners has enabled many more companies to install perpetual inventory systems. The perpetual inventory system is so named because the accounting records continuously—perpetually—show the quantity and cost of the inventory that should be on hand at any time.
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 the subsidiary records, a computerized system can minimize this cost. Much of Amazon.com's success is attributed to its sophisticated inventory system.
Some businesses find it either unnecessary or uneconomical to invest in a sophisticated, computerized perpetual inventory system such as Amazon's. Many small merchandising businesses find that basic computerized accounting packages provide some of the essential benefits of a perpetual inventory system. Also, managers of some small businesses still find that they can control their merchandise and manage day-to-day operations using a periodic inventory system.
Because of the widespread use of the perpetual inventory system, we illustrate it in this chapter. Appendix 5B describes the journal entries for the periodic system.
INVESTOR INSIGHT
Morrow Snowboards Improves Its Stock Appeal
Investors are often eager to invest in a company that has a hot new product. However, when snowboard-maker Morrow Snowboards, Inc. issued shares of stock to the public for the first time, some investors expressed reluctance to invest in Morrow because of a number of accounting control problems. To reduce investor concerns, Morrow implemented a perpetual inventory system to improve its control over inventory. In addition, it stated that it would perform a physical inventory count every quarter until it felt that the perpetual inventory system was reliable.
If a perpetual system keeps track of inventory on a daily basis, why do companies ever need to do a physical count? (See page 270.)
Companies purchase inventory using cash or credit (on account). They normally record purchases when they receive the goods from the seller. Every purchase should be supported by business documents that provide written evidence of the transaction. Each cash purchase should be supported by a canceled check or a cash register receipt indicating the items purchased and amounts paid. Companies record cash purchases by an increase in Inventory and a decrease in Cash.
A purchase invoice should support each credit purchase. This invoice 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 a copy of the sales invoice sent by the seller. In Illustration 5-6 (page 222), for example, Sauk Stereo (the buyer) uses as a purchase invoice the sales invoice prepared by PW Audio Supply (the seller).
Sauk Stereo makes the following journal entry to record its purchase from PW Audio Supply. The entry increases (debits) Inventory and increases (credits) Accounts Payable.
Helpful Hint To better understand the contents of this invoice, identify these items:
1. Seller
2. Invoice date
3. Purchaser
4. Salesperson
5. Credit terms
6. Freight terms
7. Goods sold: catalog number, description, quantity, price per unit
8. Total invoice amount
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.
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. For example, the sales invoice in Illustration 5-6 indicates FOB shipping point. Thus, the buyer (Sauk Stereo) pays the freight charges. Illustration 5-7 (on the next page) illustrates these shipping terms.
When the buyer incurs the transportation costs, these costs are considered part of the cost of purchasing inventory. Therefore, the buyer debits (increases) the Inventory account. For example, if Sauk Stereo (the buyer) pays Public Carrier Co. $150 for freight charges on May 6, the entry on Sauk Stereo's books is:
Thus, any freight costs incurred by the buyer are part of the cost of merchandise purchased. The reason: Inventory cost should include all costs to acquire the inventory, including freight necessary to deliver the goods to the buyer. Companies recognize these costs as cost of goods sold when inventory is sold.
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). For example, if the freight terms on the invoice in Illustration 5-6 had required PW Audio Supply (the seller) to pay the freight charges, the entry by PW Audio Supply would be:
When the seller pays the freight charges, the seller will usually establish a higher invoice price for the goods to cover the shipping expense.
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 an allowance (deduction) from 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 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.
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.
Helpful Hint The term net in “net 30” means the remaining amount due after subtracting any sales returns and allowances and partial payments.
Credit terms specify the amount of the cash discount and time period in which it is offered. They also indicate the time period in which the purchaser is expected to pay the full invoice price. In the sales invoice in Illustration 5-6 (page 222), credit terms are 2/10, n/30, which is read “two-ten, net thirty.” This means that the buyer may take a 2% cash discount 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 invoice 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 the buyer pays an invoice within the discount period, the amount of the discount decreases Inventory. Why? Because companies record inventory at cost and, by paying within the discount period, the buyer has reduced its 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 $70 ($3,500 × 2%), and Sauk Stereo pays $3,430 ($3,500 − $70). 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.
If Sauk Stereo failed to take the discount, and instead made full payment of $3,500 on June 3, it would debit Accounts Payable and credit Cash for $3,500 each.
A merchandising company usually should take all available discounts. Passing up the discount may be viewed as paying interest for use of the money. For example, passing up the discount offered by PW Audio Supply would be comparable to Sauk Stereo paying an interest rate of 2% for the use of $3,500 for 20 days. This is the equivalent of an annual interest rate of approximately 36.5% (2% × 365/20). Obviously, it would be better for Sauk Stereo to borrow at prevailing bank interest rates of 6% to 10% than to lose the discount.
The following T-account (with transaction descriptions in red) 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.
DO IT!
Purchase Transactions
On September 5, De La Hoya Company buys merchandise on account from Junot Diaz Company. The selling price of the goods is $1,500, and the cost to Diaz Company was $800. On September 8, De La Hoya returns defective goods with a selling price of $200. Record the transactions on the books of De La Hoya Company.
Action Plan
Purchaser records goods at cost.
When goods are returned, purchaser reduces Inventory.
Solution
Related exercise material: BE5-2, BE5-4, E5-2, E5-3, E5-4, and DO IT! 5-1.
In accordance with the revenue recognition principle, companies record sales revenue when the performance obligation is satisfied. Typically, the performance obligation is satisfied when the goods transfer from the seller to the buyer. At this point, the sales transaction is complete and the sales price established.
Sales may be made on credit or for cash. A business document should support every sales transaction, to provide written evidence of the sale. Cash register documents provide evidence of cash sales. A sales invoice, like the one shown in Illustration 5-6 (page 222), provides support for a credit 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. The first entry records the sale: The seller increases (debits) Cash (or Accounts Receivable, if a credit sale) and also increases (credits) Sales Revenue. The second entry records the cost of the merchandise sold: The seller increases (debits) Cost of Goods Sold and also decreases (credits) Inventory for the cost of those goods. 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 its May 4 sale of $3,800 to Sauk Stereo (see Illustration 5-6) as follows (assume the merchandise cost PW Audio Supply $2,400).
For internal decision-making purposes, merchandising companies may use more than one sales account. For example, PW Audio Supply may decide to keep separate sales accounts for its sales of TV sets, DVD recorders, and microwave ovens. REI might use separate accounts for camping gear, children's clothing, and ski equipment—or it might have even more narrowly defined accounts. By using separate sales accounts for major product lines, rather than a single combined sales account, company management can more closely monitor sales trends and respond more strategically to changes in sales patterns. For example, if TV sales are increasing while microwave oven sales are decreasing, PW Audio Supply might reevaluate both its advertising and pricing policies on these items to ensure they are optimal.
On its income statement presented to outside investors, a merchandising company normally would provide only a single sales figure—the sum of all of its individual sales accounts. This is done for two reasons. First, providing detail on all of its individual sales accounts would add considerable length to its income statement. Second, companies do not want their competitors to know the details of their operating results. However, Microsoft recently expanded its disclosure of revenue from three to five types. The reason: The additional categories enabled financial statement users to better evaluate the growth of the company's consumer and Internet businesses.
Ethics Note
Many companies are trying to improve the quality of their financial reporting. For example, General Electric now provides more detail on its revenues and operating profits.
ANATOMY OF A FRAUD1
Holly Harmon was a cashier at a national superstore for only a short while when she began stealing merchandise using three methods. Under the first method, her husband or friends took UPC labels from cheaper items and put them on more expensive items. Holly then scanned the goods at the register. Using the second method Holly scanned an item at the register but then voided the sale and left the merchandise in the shopping cart. A third approach was to put goods into large plastic containers. She scanned the plastic containers but not the goods within them. One day, Holly did not call in sick or show up for work. In such instances, the company reviews past surveillance tapes to look for suspicious activity by employees. This enabled the store to observe the thefts and to identify the participants.
Total take: $12,000
THE MISSING CONTROLS
Human resource controls. A background check would have revealed Holly's previous criminal record. She would not have been hired as a cashier.
Physical controls. Software can flag high numbers of voided transactions or a high number of sales of low-priced goods. Random comparisons of video records with cash register records can ensure that the goods reported as sold on the register are the same goods that are shown being purchased on the video recording. Finally, employees should be aware that they are being monitored.
Source: Adapted from Wells, Fraud Casebook (2007), pp. 251–259.
At the end of “Anatomy of a Fraud” stories, which describe some recent real-world frauds, we discuss the missing control activity that would likely have prevented or uncovered the fraud.
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 the buyer (a return) or grants a reduction in the purchase price (an allowance) so 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 (assuming that the goods were not defective).
If Sauk Stereo returns goods because they are damaged or defective, then PW Audio Supply's entry to Inventory and Cost of Goods Sold should be for the fair value of the returned goods, rather than their cost. For example, if the returned goods were defective and had a fair value of $50, PW Audio Supply would debit Inventory for $50 and credit Cost of Goods Sold for $50.
What happens if the goods are not returned but the seller grants the buyer an allowance by reducing the purchase price? In this case, the seller debits Sales Returns and Allowances and credits Accounts Receivable for the amount of the allowance. An allowance has no impact on Inventory or Cost of Goods Sold.
As mentioned above, Sales Returns and Allowances is a contra revenue account to Sales Revenue. This means that 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 may suggest problems—inferior merchandise, inefficiencies in filling orders, errors in billing customers, or delivery or shipment mistakes. 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.
ACCOUNTING ACROSS THE ORGANIZATION
Should Costco Change Its Return Policy?
In most industries, sales returns are relatively minor. But returns of consumer electronics can really take a bite out of profits. Recently, the marketing executives at Costco Wholesale Corp. faced a difficult decision. Costco has always prided itself on its generous return policy. Most goods have had an unlimited grace period for returns. A new policy will require that certain electronics must be returned within 90 days of their purchase. The reason? The cost of returned products such as high-definition TVs, computers, and iPods cut an estimated 8¢ per share off Costco's earnings per share, which was $2.30.
Source: Kris Hudson, “Costco Tightens Policy on Returning Electronics,” Wall Street Journal (February 27, 2007), p. B4.
If a company expects significant returns, what are the implications for revenue recognition? (See page 270.)
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. For example, PW Audio Supply makes the following entry to record the cash receipt on May 14 from Sauk Stereo within the discount period.
Like Sales Returns and Allowances, Sales Discounts is a contra revenue account to Sales Revenue. Its normal balance is a debit. PW Audio Supply uses this account, instead of debiting Sales Revenue, to disclose the amount of cash discounts taken by customers. If Sauk Stereo 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.
The following T-accounts summarize the three sales-related transactions and show their combined effect on net sales.
PEOPLE, PLANET, AND PROFIT INSIGHT
Selling Green
Here is a question an executive of PepsiCo was asked: Should PepsiCo market green? The executive indicated that the company should, as he believes it's the No. 1 thing consumers all over the world care about. Here are some of his thoughts on this issue:
“Sun Chips are part of the food business I run. It's a ‘healthy snack.’ We decided that Sun Chips, if it's a healthy snack, should be made in facilities that have a net-zero footprint. In other words, I want off the electric grid everywhere we make Sun Chips. We did that. Sun Chips should be made in a facility that puts back more water than it uses. It does that. And we partnered with our suppliers and came out with the world's first compostable chip package.
Now, there was an issue with this package: It was louder than the New York subway, louder than jet engines taking off. What would a company that's committed to green do: walk away or stay committed? If your people are passionate, they're going to fix it for you as long as you stay committed. Six months later, the compostable bag has half the noise of our current package.
So the view today is: we should market green, we should be proud to do it … it has to be a 360-degree process, both internal and external. And if you do that, you can monetize environmental sustainability for the shareholders.”
Source: “Four Problems—and Solutions,” Wall Street Journal (March 7, 2011), p. R2.
What is meant by “monetize environmental sustainability” for shareholders? (See page 270.)
DO IT!
Sales Transactions
On September 5, De La Hoya Company buys merchandise on account from Junot Diaz Company. The selling price of the goods is $1,500, and the cost to Diaz Company was $800. On September 8, De La Hoya returns defective goods with a selling price of $200 and a fair value of $30. Record the transactions on the books of Junot Diaz Company.
Action Plan
Seller records both the sale and the cost of goods sold at the time of the sale.
When goods are returned, the seller records the return in a contra account, Sales Returns and Allowances, and reduces Accounts Receivable.
Any goods returned increase Inventory and reduce Cost of Goods Sold. Defective or damaged inventory is recorded at fair value (scrap value).
Solution
Related exercise material: BE5-2, BE5-3, E5-3, E5-4, E5-5, and DO IT! 5-2.
Up to this point, we have illustrated the basic entries for transactions relating to purchases and sales in a perpetual inventory system. Now we consider the remaining steps in the accounting cycle for a merchandising company. Each of the required steps described in Chapter 4 for service companies apply to merchandising companies. Appendix 5A to this chapter shows use of a worksheet by a merchandiser (an optional step).
A merchandising company generally has the same types of adjusting entries as a service company. However, a merchandiser using a perpetual system will require one additional adjustment to make the records agree with the actual inventory on hand. Here's why: At the end of each period, for control purposes, a merchandising company that uses a perpetual system will take a physical count of its goods on hand. The company's unadjusted balance in Inventory usually does not agree with the actual amount of inventory on hand. The perpetual inventory records may be incorrect due to recording errors, theft, or waste. Thus, the company needs to adjust the perpetual records to make the recorded inventory amount agree with the inventory on hand. This involves adjusting Inventory and Cost of Goods Sold.
For example, suppose that PW Audio Supply has an unadjusted balance of $40,500 in Inventory. Through a physical count, PW Audio Supply determines that its actual merchandise inventory at year-end is $40,000. The company would make an adjusting entry as follows.
A merchandising company, like a service company, closes to Income Summary all accounts that affect net income. In journalizing, the company credits all temporary accounts with debit balances, and debits all temporary accounts with credit balances, as shown below for PW Audio Supply. Note that PW Audio Supply closes Cost of Goods Sold to Income Summary.
Helpful Hint The easiest way to prepare the first two closing entries is to identify the temporary accounts by their balances and then prepare one entry for the credits and one for the debits.
After PW Audio Supply has posted the closing entries, all temporary accounts have zero balances. Also, Owner's Capital has a balance that is carried over to the next period.
Illustration 5-8 summarizes the entries for the merchandising accounts using a perpetual inventory system.
DO IT!
Closing Entries
The trial balance of Celine's Sports Wear Shop at December 31 shows Inventory $25,000, Sales Revenue $162,400, Sales Returns and Allowances $4,800, Sales Discounts $3,600, Cost of Goods Sold $110,000, Rent Revenue $6,000, Freight-Out $1,800, Rent Expense $8,800, and Salaries and Wages Expense $22,000. Prepare the closing entries for the above accounts.
Action Plan
Close all temporary accounts with credit balances to Income Summary by debiting these accounts.
Close all temporary accounts with debit balances, except drawings, to Income Summary by crediting these accounts.
Solution
Related exercise material: BE5-5, BE5-6, E5-6, E5-7, E5-8, and DO IT! 5-3.
Merchandising companies widely use the classified balance sheet introduced in Chapter 4 and one of two forms for the income statement. This section explains the use of these financial statements by merchandisers.
The multiple-step income statement is so named because it shows several steps in determining net income. Two of these steps relate to the company's principal operating activities. A multiple-step statement also distinguishes between operating and nonoperating activities. Finally, the statement also highlights intermediate components of income and shows subgroupings of expenses.
The multiple-step income statement begins by presenting sales revenue. It then deducts contra revenue accounts—sales returns and allowances, and sales discounts—from sales revenue to arrive at net sales. Illustration 5-9 presents the sales revenues section for PW Audio Supply, using assumed data.
From Illustration 5-1, you learned that companies deduct cost of goods sold from sales revenue to determine gross profit. For this computation, companies use net sales (which takes into consideration Sales Returns and Allowances and Sales Discounts) as the amount of sales revenue. On the basis of the sales data in Illustration 5-9 (net sales of $460,000) and cost of goods sold under the perpetual inventory system (assume $316,000), PW Audio Supply's gross profit is $144,000, computed as follows.
Alternative Terminology Gross profit is sometimes referred to as gross margin.
We also can express a company's gross profit as a percentage, called the gross profit rate. To do so, we divide the amount of gross profit by net sales. For PW Audio Supply, the gross profit rate is 31.3%, computed as follows.
Analysts generally consider the gross profit rate to be more useful than the gross profit amount. The rate expresses a more meaningful (qualitative) relationship between net sales and gross profit. For example, a gross profit of $1,000,000 may sound impressive. But if it is the result of a gross profit rate of only 7%, it is not so impressive. The gross profit rate tells how many cents of each sales dollar go to gross profit.
Gross profit represents the merchandising profit of a company. It is not a measure of the overall profitability because operating expenses are not yet deducted. But managers and other interested parties closely watch the amount and trend of gross profit. They compare current gross profit with amounts reported in past periods. They also compare the company's gross profit rate with rates of competitors and with industry averages. Such comparisons provide information about the effectiveness of a company's purchasing function and the soundness of its pricing policies.
Operating expenses are the next component in measuring net income for a merchandising company. They are the expenses incurred in the process of earning sales revenue. These expenses are similar in merchandising and service companies. At PW Audio Supply, operating expenses were $114,000. The company determines its net income by subtracting operating expenses from gross profit. Thus, net income is $30,000, as shown below.
The net income amount is the so-called “bottom line” of a company's income statement.
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.” Illustration 5-13 lists examples of each.
Ethics Note
Companies manage earnings in various ways. ConAgra Foods recorded a non-recurring gain for $186 million from the sale of Pilgrim's Pride stock to help meet an earnings projection for the quarter.
Merchandising companies report the nonoperating activities in the income statement immediately after the company's operating activities. Illustration 5-14 shows these sections for PW Audio Supply, using assumed data.
The distinction between operating and nonoperating activities is crucial to many external users of financial data. These users view operating income as sustainable and many nonoperating activities as non-recurring. Therefore, when forecasting next year's income, analysts put the most weight on this year's operating income, and less weight on this year's nonoperating activities.
ETHICS INSIGHT
Disclosing More Details
After Enron, increased investor criticism and regulator scrutiny forced many companies to improve the clarity of their financial disclosures. For example, IBM began providing more detail regarding its “Other gains and losses.” It had previously included these items in its selling, general, and administrative expenses, with little disclosure.
Disclosing other gains and losses in a separate line item on the income statement will not have any effect on bottom-line income. However, analysts complained that burying these details in the selling, general, and administrative expense line reduced their ability to fully understand how well IBM was performing. For example, previously if IBM sold off one of its buildings at a gain, it would include this gain in the selling, general and administrative expense line item, thus reducing that expense. This made it appear that the company had done a better job of controlling operating expenses than it actually had.
As another example, when eBay recently sold the remainder of its investment in Skype to Microsoft, it reported a gain in “Other revenues and gains” of $1.7 billion. Since eBay's total income from operations was $2.4 billion, it was very important that the gain from the Skype sale not be buried in operating income.
Why have investors and analysts demanded more accuracy in isolating “Other gains and losses” from operating items? (See page 270.)
Another income statement format 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.
In a single-step statement, all data are classified into two categories: (1) revenues, which include both operating revenues and other revenues and gains; and (2) expenses, which include cost of goods sold, operating expenses, and other expenses and losses. Illustration 5-15 shows a single-step statement for PW Audio Supply.
There are two primary reasons for using the single-step format. (1) A company does not realize any type of profit or income until total revenues exceed total expenses, so it makes sense to divide the statement into these two categories. (2) The format is simpler and easier to read. For homework problems, however, you should use the single-step format only when specifically instructed to do so.
In the balance sheet, merchandising companies report inventory as a current asset immediately below accounts receivable. Recall from Chapter 4 that companies generally list current asset items in the order of their closeness to cash (liquidity). Inventory is less close to cash than accounts receivable because the goods must first be sold and then collection made from the customer. Illustration 5-16 presents the assets section of a classified balance sheet for PW Audio Supply.
Helpful Hint The $40,000 is the cost of the inventory on hand, not its expected selling price.
Financial Statement Classifications
You are presented with the following list of accounts from the adjusted trial balance for merchandiser Gorman Company. Indicate in which financial statement and under what classification each of the following would be reported.
Accounts Payable | Interest Payable |
Accounts Receivable | Inventory |
Accumulated Depreciation—Buildings | Land |
Accumulated Depreciation—Equipment | Notes Payable (due in 3 years) |
Advertising Expense | Owner's Capital (beginning balance) |
Buildings | Owner's Drawings |
Cash | Property Taxes Payable |
Depreciation Expense | Salaries and Wages Expense |
Equipment | Salaries and Wages Payable |
Freight-Out | Sales Returns and Allowances |
Gain on Disposal of Plant Assets | Sales Revenue |
Insurance Expense | Utilities Expense |
Interest Expense |
Action Plan
Review the major sections of the income statement: sales revenues, cost of goods sold, operating expenses, other revenues and gains, and other expenses and losses.
Add net income and investments to beginning capital and deduct drawings to arrive at ending capital in the owner's equity statement.
Review the major sections of the balance sheet, income statement, and owner's equity statement.
Solution
Related exercise material: BE5-7, BE5-8, BE5-9, E5-9, E5-10, E5-12, E5-13, E5-14, and DO IT! 5-4.
The adjusted trial balance columns of Falcetto Company's worksheet for the year ended December 31, 2014, are as follows.
Action Plan
Remember that the key components of the income statement are net sales, cost of goods sold, gross profit, total operating expenses, and net income (loss). Report these components in the right-hand column of the income statement.
Put nonoperating items after income from operations.
Instructions
Prepare a multiple-step income statement for Falcetto Company.
Solution to Comprehensive DO IT!
1 Identify the differences between service and merchandising companies. Because of inventory, a merchandising company has sales revenue, cost of goods sold, and gross profit. To account for inventory, a merchandising company must choose between a perpetual and a periodic inventory system.
2 Explain the recording of purchases under a perpetual inventory system. The company debits the Inventory account for all purchases of merchandise and freight-in, and credits it for purchase discounts and purchase returns and allowances.
3 Explain the recording of sales revenues under a perpetual inventory system. When a merchandising company sells inventory, it debits Accounts Receivable (or Cash) and credits Sales Revenue for the selling price of the merchandise. At the same time, it debits Cost of Goods Sold and credits Inventory for the cost of the inventory items sold. Sales Returns and Allowances and Sales Discounts are debited and are contra revenue accounts.
4 Explain the steps in the accounting cycle for a merchandising company. Each of the required steps in the accounting cycle for a service company applies to a merchandising company. A worksheet is again an optional step. Under a perpetual inventory system, the company must adjust the Inventory account to agree with the physical count.
5 Distinguish between a multiple-step and a single-step income statement. A multiple-step income statement shows numerous steps in determining net income, including nonoperating activities sections. A single-step income statement classifies all data under two categories, revenues or expenses, and determines net income in one step.
Contra revenue account An account that is offset against a revenue account on the income statement. (p. 228).
Cost of goods sold The total cost of merchandise sold during the period. (p. 218).
FOB destination Freight terms indicating that the seller places the goods free on board to the buyer's place of business, and the seller pays the freight. (p. 222).
FOB shipping point Freight terms indicating that the seller places goods free on board the carrier, and the buyer pays the freight costs. (p. 222).
Gross profit The excess of net sales over the cost of goods sold. (p. 233).
Gross profit rate Gross profit expressed as a percentage, by dividing the amount of gross profit by net sales. (p. 233).
Income from operations Income from a company's principal operating activity; determined by subtracting cost of goods sold and operating expenses from net sales. (p. 234).
Multiple-step income statement An income statement that shows several steps in determining net income. (p. 232).
Net sales Sales revenue less sales returns and allowances and less sales discounts. (p. 233).
Nonoperating activities Various revenues, expenses, gains, and losses that are unrelated to a company's main line of operations. (p. 234).
Operating expenses Expenses incurred in the process of earning sales revenue. (p. 234).
Other expenses and losses A nonoperating-activities section of the income statement that shows expenses and losses unrelated to the company's main line of operations. (p. 234).
Other revenues and gains A nonoperating-activities section of the income statement that shows revenues and gains unrelated to the company's main line of operations. (p. 234).
Periodic inventory system An inventory system under which the company does not keep detailed inventory records throughout the accounting period but determines the cost of goods sold only at the end of an accounting period. (p. 220).
Perpetual inventory system An inventory system under which the company keeps detailed records of the cost of each inventory purchase and sale, and the records continuously show the inventory that should be on hand. (p. 219).
Purchase allowance A deduction made to the selling price of merchandise, granted by the seller so that the buyer will keep the merchandise. (p. 223).
Purchase discount A cash discount claimed by a buyer for prompt payment of a balance due. (p. 224).
Purchase invoice A document that supports each credit purchase. (p. 221).
Purchase return A return of goods from the buyer to the seller for a cash or credit refund. (p. 223).
Sales discount A reduction given by a seller for prompt payment of a credit sale. (p. 228).
Sales invoice A document that supports each credit sale.(p. 226).
Sales returns and allowances Purchase returns and allowances from the seller's perspective. See Purchase return and Purchase allowance, above. (p. 227).
Sales revenue (Sales) The primary source of revenue in a merchandising company. (p. 218).
Single-step income statement An income statement that shows only one step in determining net income. (p. 236).
As indicated in Chapter 4, a worksheet enables companies to prepare financial statements before they journalize and post adjusting entries. The steps in preparing a worksheet for a merchandising company are the same as for a service company (see pages 163–165). Illustration 5A-1 shows the worksheet for PW Audio Supply (excluding nonoperating items). The unique accounts for a merchandiser using a perpetual inventory system are in red.
Data for the trial balance come from the ledger balances of PW Audio Supply at December 31. The amount shown for Inventory, $40,500, is the year-end inventory amount from the perpetual inventory system.
A merchandising company generally has the same types of adjustments as a service company. As you see in the worksheet, adjustments (b), (c), and (d) are for insurance, depreciation, and salaries. Pioneer Advertising Agency, as illustrated in Chapters 3 and 4, also had these adjustments. Adjustment (a) was required to adjust the perpetual inventory carrying amount to the actual count.
After PW Audio Supply enters all adjustments data on the worksheet, it establishes the equality of the adjustments column totals. It then extends the balances in all accounts to the adjusted trial balance columns.
The adjusted trial balance shows the balance of all accounts after adjustment at the end of the accounting period.
Next, the merchandising company transfers the accounts and balances that affect the income statement from the adjusted trial balance columns to the income statement columns. PW Audio Supply shows Sales Revenue of $480,000 in the credit column. It shows the contra revenue accounts Sales Returns and Allowances $12,000 and Sales Discounts $8,000 in the debit column. The difference of $460,000 is the net sales shown on the income statement (Illustration 5-14, page 235).
Finally, the company totals all the credits in the income statement column and compares those totals to the total of the debits in the income statement column. If the credits exceed the debits, the company has net income. PW Audio Supply has net income of $30,000. If the debits exceed the credits, the company would report a net loss.
The major difference between the balance sheets of a service company and a merchandiser is inventory. PW Audio Supply shows the ending inventory amount of $40,000 in the balance sheet debit column. The information to prepare the owner's equity statement is also found in these columns. That is, the Owner's Capital account is $83,000. Owner's Drawings are $15,000. Net income results when the total of the debit column exceeds the total of the credit column in the balance sheet columns. A net loss results when the total of the credits exceeds the total of the debit balances.
6 Prepare a worksheet for a merchandising company. The steps in preparing a worksheet for a merchandising company are the same as for a service company. The unique accounts for a merchandiser are Inventory, Sales Revenue, Sales Returns and Allowances, Sales Discounts, and Cost of Goods Sold.
As described in this chapter, companies may use one of two basic systems of accounting for inventories: (1) the perpetual inventory system or (2) the periodic inventory system. In the chapter, we focused on the characteristics of the perpetual inventory system. In this appendix, we discuss and illustrate the periodic inventory system. One key difference between the two systems is the point at which the company computes cost of goods sold. For a visual reminder of this difference, refer back to Illustration 5-5 (on page 220).
Explain the recording of purchases and sales of inventory under a periodic inventory 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, as shown in Illustration 5B-1.
Another difference between the two approaches is that the perpetual system directly adjusts the Inventory account for any transaction that affects inventory (such as freight costs, returns, and discounts). The periodic system does not do this. Instead, it creates different accounts for purchases, freight costs, returns, and discounts. These various accounts are shown in Illustration 5B-2, which presents the calculation of cost of goods sold for PW Audio Supply using the periodic approach.
Helpful Hint The far right column identifies the primary items that make up cost of goods sold of $316,000. The middle column explains cost of goods purchased of $320,000. The left column reports contra purchase items of $17,200.
Note that the basic elements from Illustration 5B-1 are highlighted in Illustration 5B-2. You will learn more in Chapter 6 about how to determine cost of goods sold using the periodic system.
The use of the periodic inventory system does not affect the form of presentation in the balance sheet. As under the perpetual system, a company reports inventory in the current assets section.
In a periodic inventory system, companies record revenues from the sale of merchandise when sales are made, just as in a perpetual system. Unlike the perpetual system, however, companies do not attempt on the date of sale to record the cost of the merchandise sold. Instead, they take a physical inventory count at the end of the period to determine (1) the cost of the merchandise then on hand and (2) the cost of the goods sold during the period. And, under a periodic system, companies record purchases of merchandise in the Purchases account rather than the Inventory account. Also, in a periodic system, purchase returns and allowances, purchase discounts, and freight costs on purchases are recorded in separate accounts.
To illustrate the recording of merchandise transactions under a periodic inventory system, we will use purchase/sale transactions between PW Audio Supply and Sauk Stereo, as illustrated for the perpetual inventory system in this chapter.
On the basis of the sales invoice (Illustration 5-6, shown on page 222) and receipt of the merchandise ordered from PW Audio Supply, Sauk Stereo records the $3,800 purchase as follows.
Helpful Hint Be careful not to debit purchases of equipment or supplies to a Purchases account.
Purchases is a temporary account whose normal balance is a debit.
When the purchaser directly incurs the freight costs, it debits the account Freight-In (or Transportation-In). For example, if Sauk Stereo pays Public Carrier Co. $150 for freight charges on its purchase from PW Audio Supply on May 6, the entry on Sauk Stereo's books is:
Alternative Terminology Freight-In is also called Transportation-In.
Like Purchases, Freight-In is a temporary account whose normal balance is a debit. Freight-In is part of cost of goods purchased. The reason is that cost of goods purchased should include any freight charges necessary to bring the goods to the purchaser. Freight costs are not subject to a purchase discount. Purchase discounts apply only to the invoice cost of the merchandise.
Sauk Stereo returns $300 of goods to PW Audio Supply and prepares the following entry to recognize the return.
Purchase Returns and Allowances is a temporary account whose normal balance is a credit.
On May 14, Sauk Stereo pays the balance due on account to PW Audio Supply, taking the 2% cash discount allowed by PW Audio Supply for payment within 10 days. Sauk Stereo records the payment and discount as follows.
Purchase Discounts is a temporary account whose normal balance is a credit.
The seller, PW Audio Supply, records the sale of $3,800 of merchandise to Sauk Stereo on May 4 (sales invoice No. 731, Illustration 5-6, page 222) as follows.
To record the returned goods received from Sauk Stereo on May 8, PW Audio Supply records the $300 sales return as follows.
On May 14, PW Audio Supply receives payment of $3,430 on account from Sauk Stereo. PW Audio Supply honors the 2% cash discount and records the payment of Sauk Stereo's account receivable in full as follows.
Illustration 5B-3 summarizes the periodic inventory entries shown in this appendix and compares them to the perpetual-system entries from the chapter. Entries that differ in the two systems are shown in color.
For a merchandising company, like a service company, all accounts that affect the determination of net income are closed to Income Summary. Data for the preparation of closing entries may be obtained from the income statement columns of the worksheet. In journalizing, all debit column amounts are credited, and all credit columns amounts are debited. To close the merchandise inventory in a periodic inventory system:
1. The beginning inventory balance is debited to Income Summary and credited to Inventory.
2. The ending inventory balance is debited to Inventory and credited to Income Summary.
The two entries for PW Audio Supply are:
After posting, the Inventory and Income Summary accounts will show the following.
Often, the closing of inventory is included with other closing entries, as shown below for PW Audio Supply.
Helpful Hint Except for merchandise inventory, the easiest way to prepare the first two closing entries is to identify the temporary accounts by their balances and then prepare one entry for the credits and one for the debits.
Helpful Hint Close inventory with other accounts in homework problems unless stated otherwise.
After the closing entries are posted, all temporary accounts have zero balances. In addition, Owner's Capital has a credit balance of $98,000: beginning balance + net income − drawings ($83,000 + $30,000 − $15,000).
As indicated in Chapter 4, a worksheet enables companies to prepare financial statements before journalizing and posting adjusting entries. The steps in preparing a worksheet for a merchandising company are the same as they are for a service company (see pages 163–165).
Data for the trial balance come from the ledger balances of PW Audio Supply at December 31. The amount shown for Inventory, $36,000, is the beginning inventory amount from the periodic inventory system.
A merchandising company generally has the same types of adjustments as a service company. As you see in the worksheet in Illustration 5B-5, adjustments (a), (b), and (c) are for insurance, depreciation, and salaries and wages. These adjustments were also required for Pioneer Advertising Agency, as illustrated in Chapters 3 and 4. The unique accounts for a merchandiser using a periodic inventory system are shown in capital red letters. Note, however, that the worksheet excludes nonoperating items.
After all adjustment data are entered on the worksheet, the equality of the adjustment column totals is established. The balances in all accounts are then extended to the adjusted trial balance columns.
Next, PW Audio Supply transfers the accounts and balances that affect the income statement from the adjusted trial balance columns to the income statements columns. The company shows Sales Revenue of $480,000 in the credit column. It shows the contra revenue accounts, Sales Returns and Allowances of $12,000 and Sales Discounts of $8,000 in the debit column. The difference of $460,000 is the net sales shown on the income statement (Illustration 5-9, page 233). Similarly, Purchases of $325,000 and Freight-In of $12,200 are extended to the debit column. The contra purchase accounts, Purchase Returns and Allowances of $10,400 and Purchase Discounts of $6,800, are extended to the credit columns.
The worksheet procedures for the Inventory account merit specific comment. The procedures are:
1. The beginning balance, $36,000, is extended from the adjusted trial balance column to the income statement debit column. From there it can be added in reporting cost of goods available for sale in the income statement.
2. The ending inventory, $40,000, is added to the worksheet by an income statement credit and a balance sheet debit. The credit makes it possible to deduct ending inventory from the cost of goods available for sale in the income statement to determine cost of goods sold. The debit means the ending inventory can be reported as an asset on the balance sheet.
These two procedures are specifically illustrated below:
The computation for cost of goods sold, taken from the income statement column in Illustration 5B-5, is as follows.
Helpful Hint In a periodic system, cost of goods sold is a computation—it is not a separate account with a balance.
Finally, PW Audio Supply totals all the credits in the income statement column and compares these totals to the total of the debits in the income statement column. If the credits exceed the debits, the company has net income. PW Audio Supply has net income of $30,000. If the debits exceed the credits, the company would report a net loss.
The major difference between the balance sheets of a service company and a merchandising company is inventory. PW Audio Supply shows ending inventory of $40,000 in the balance sheet debit column. The information to prepare the owner's equity statement is also found in these columns. That is, the Owner's Capital account is $83,000. Owner's Drawings are $15,000. Net income results when the total of the debit column exceeds the total of the credit column in the balance sheet columns. A net loss results when the total of the credits exceeds the total of the debit balances.
__________
1The “Anatomy of a Fraud” stories in this textbook are adapted from Fraud Casebook: Lessons from the Bad Side of Business, edited by Joseph T. Wells (Hoboken, NJ: John Wiley & Sons, Inc., 2007). Used by permission. The names of some of the people and organizations in the stories are fictitious, but the facts in the stories are true.