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Chapter 5
• Service business earns fees
– Revenues recorded
• Merchandising business sells inventory
– Revenue from sales
– Expense of Inventory Cost
• Cost of Goods Sold.
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• The Cost of Goods Sold
– An expense
– Treated differently on Income Statement
• Sales Revenue - Cost of Goods Sold
• Two Inventory Systems
– Periodic Inventory System
– Perpetual Inventory System
– Gross Profit or Gross Margin
– Reported at the top of an income statement.
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• 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.
• 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
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• Perpetual Inventory System
– Company always keeps track of COGS & Inventory
– Still need physical inventory
• End of year.
• Any discrepancy with books - theft and spoilage
• When you purchase inventory with cash:
D. Merchandise Inventory
Cr.
$5,000
Cash
$5,000
– 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.
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• When you purchase inventory on credit:
D.
Merchandise Inventory
Cr.
• Purchase Returns & Allowances
– You return inventory purchased (Purchases
Return)
$5,000
Accounts Payable
$5,000
• Reverse purchase
– Supplier reduces price of merchandise after
the sale (Purchases Allowance)
• Write down Inventory to amount paid
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• The receipt of $1,000 allowance on $5,000
purchase
• A return of entire $5,000 purchase:
D.
Accounts Payable
Cr. Merchandise Inventory
$5,000
D.
$5,000
Accounts Payable
Cr.
Merchandise Inventory
$1,000
$1,000
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• 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
• "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
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Invoice says FOB Detroit
You pay shipping costs
You own car during shipment.
Something goes wrong – Your problem
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• "FOB destination“
• Transportation Costs on purchases
– Seller transfers title to inventory when
delivered
– Part of cost of inventory
– Called “Freight in” or “Transportation In”
– Under perpetual inventory system – increase
cost of the inventory:
• At buyer’s place of business
– Seller pays shipping costs
– E.g., you order car from Ford
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Invoice says FOB Los Angeles
Ford pays shipping costs
Ford owns car during shipment
If something goes wrong – Ford’s problem
D.
Merchandise Inventory
Cr. Accounts Payable/Cash
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• Transportation Costs on sales
• Purchases Discounts
– An expense
Freight Out
Cr.
Accounts Payable/Cash
$150
– We buy inventory
– Seller offers credit terms to encourage us to
pay quickly
– Called purchase discounts.
– When we are seller – Called sales discounts
• Called “Transportation Out” or “Freight
Out”:
D.
$150
$150
$150
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• Examples
• If seller does not wish to offer discount
– 2/10 n/30 (“two-ten, net thirty”)
– Invoice says when payment is due
– n/30
• If buyer pays whole invoice within 10 days
– Gets 2% off
• Otherwise, entire bill due in 30 days
• No discount
• Entire Invoice due in 30 days
– 1/10 EOM
• If buyer pays whole invoice during 1st 10 days of
next month
– n/10 EOM
• Entire invoice due in first 10 days of next month
– Gets 1% off
• Otherwise, entire bill due by end of next month.
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• 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.
• You buy inventory for $3,500
• Supplier offers you 2/10 n/30
• When you receive inventory
– Ignore potential discount
D.
Merchandise Inventory
Cr.
$3,500
Accounts Payable
$3,500
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• If payment made during discount period
• If payment not made during discount
period
– Show A/P is discharged in full
– Show amount paid
– Write down Inventory to price actually paid
D. Accounts Payable
Cr. Cash
Merchandise Inventory
D.
Accounts Payable
Cr. Cash
$3,500
$3,500
$3,500
$3,430
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• Cash sale - revenue side of transaction:
• Credit sale - revenue side of transaction:
D.
D.
Cash
Cr.
$2,200
Sales Revenue
$2,200
• Cash sale - cost side of transaction:
D.
Cost of Goods Sold
Cr. Merchandise Inventory
Accounts Receivable
Cr.
$2,200
Sales Revenue
$2,200
• Credit sale - cost side of transaction:
D.
$1,400
Cost of Goods Sold
Cr. Merchandise Inventory
$1,400
$1,400
$1,400
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• Customer returns merchandise – you undo
sale.
• Undo revenue side of transaction:
– Debit Sales Returns & Allowances
D.
• 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
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Sales Returns & Allowances
Cr.
$2,200
Accounts Receivable
$2,200
• Undo cost side of transaction:
D.
Merchandise Inventory
Cr. Cost of Goods Sold
$1,400
$1,400
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• 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
• When sale is made
– Ignore potential sales discount
D. Accounts Receivable
Cr.
Sales/Sales Revenue
$3,500
$3,500
– Contra Revenue account
• Reduces Sales Revenue
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• 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)
D. Cash
Sales Discounts
Cr.
Accounts Receivable
• If payment received after discount period:
D. Cash
$3,500
Cr. Accounts Receivable
$3,500
$3,430
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$3,500
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• Trade Discounts
• Net Sales is Sales Revenue reduced by
the contra-revenue accounts:
– 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.
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• Single-step Income Statement
– One Revenues section - lists all revenues
– One Expenses section - lists all expenses
• Multiple-step Income Statement
– Contains many subcategories
Sales Revenue
Less: Sales Returns and Allowances
Sales Discounts
Credit Card Discounts (if treated as a
contra-revenue account)
Net Sales
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-8,000
-6,000
$454,000
Income Statement
For Year Ending December 31, 20XX
Net Sales
Less:
$480,000
-12,000
$460,000
Cost of Goods Sold
-316,000
Gross Margin/Profit
$144,000
Less:
-114,000
Operating Expenses
Income From Operations
Other Revenue & Gains
Less:
Other Expenses & Losses
Income Before Income Taxes
Less:
Income Tax Expense
Net Income
$30,000
3,600
-2,000
$31,600
-10,100
$21,500
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• 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.
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• 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?
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• Income From Operations
– Gross Margin - Operating Expenses
• Other Revenues and Expenses
– Nonoperating revenues & gains
• dividends income
• interest income
• gains from sales of assets
• Considered very important
– Represents major operations
– Good indication of future performance
• Typically viewed as sustainable in the future
– Less nonoperating expenses & losses
• interest expense
• losses from sales of assets
• Follows Income From Operations
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• 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
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Shafer Auto Parts Corporation
Income Statement
For the Year Ended December 31, 20XX
Revenues from Sales
$289,656
Cost of Goods Sold
-181,260
Gross Margin from Sales
$108,396
Operating Expenses
Selling Expenses
General and Administrative Expenses
$ 54,780
34,504
Total Operating Expenses
-89,284
Income from Operations
$19,112
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Shafer Auto Parts Corporation
Income Statement
For the Year Ended December 31, 20XX
Income from Operations
Shafer Auto Parts Corporation
Income Statement
For the Year Ended December 31, 20XX
Revenues
$19,112
Other Revenues and Expenses
Net Sales
$289,656
Interest Income
Interest Income
$1,400
Total Revenues
Less: Interest Expense
-2,631
Costs & Expenses
Excess of Other Expenses over Other
Revenues
Income Before Income Taxes
Income Taxes
-1,231
$17,881
-3,381
Net Income
$14,500
Earnings per share
$ 2.90
$1,400
$291,056
Cost of Goods Sold
$181,260
Selling Expenses
54,780
General and Administrative Expenses
34,504
Interest Expense
2,631
Income Tax Expense
1,231
Total Costs and Expenses
-276,556
Net Income
$14,500
Earnings per share
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$ 2.90
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• Gross Profit Rate
– Also called Gross Profit/Margin Percentage
– Gives Gross Profit/Margin in terms that are
not influenced by size
• Profit Margin Ratio
Net Income
---------------Net Sales
Gross Profit/Margin
------------------------------------Net Sales
• This ratio allows you to compare
profitability among firms of different sizes
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• Operating Expenses To Sales Ratio
– Focuses on management’s ability to control
operating expenses:
Operating Expenses
------------------------------------Net Sales
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