Accounting for Inventory Transactions: Purchase and Sales, Perpetual and Periodic Systems, Lecture notes of Financial Accounting

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Introductory Financial Accounting – Cataldo (WCU ACC201) Page 1 Chapter 41 Accounting for Merchandising Firms Learning Objectives • Define and describe merchandising activities. • Describe income components for a merchandising firm. • Identify and illustrate your understanding of inventory, an asset, and the cost flow assumptions applied to a merchandising company. • Describe purchase returns, purchase discounts, and purchase allowances accounts and how they interact with gross and net purchases. • Explain how transportation-in or freight-in accounts interact with gross and net purchases. • Describe sales discounts, sales returns, and sales allowances accounts and how they interact with gross and net sales. • Prepare adjusting journal entries and close nominal or temporary accounts for a merchandising firm. • Prepare, define, explain and distinguish between single-step and multiple-step income statements. • Compute and describe the value associated with the computation of the acid-test ratio with respect to asset liquidity. • Compute and describe the value associated with the computation of the gross margin ratio with respect to the assessment of profitability assessment. • Analyze and record inventory transactions for a merchandising company – purchases and sales – using both perpetual and periodic inventory systems. 1 Acknowledgement: An earlier version of this chapter was provided to all accounting faculty on January 21, 2015, for review notes, comments, and recommendations for improvement. Work on this text began in early 2014. The completion of this text was made possible through a spring 2015 sabbatical from West Chester University. Introductory Financial Accounting – Cataldo (WCU ACC201) Page 2 No, it is not an elephant. Professor Cataldo and his wife, Holley, hold a stingray at Stingray City Antigua on December 31, 2014. They are large, but the crew feeds them, so they are very friendly. Introductory Financial Accounting – Cataldo (WCU ACC201) Page 5 Inventory Systems Cost of goods sold is the cost of merchandise inventory sold during a period. It is usually the largest single expense item on a merchandiser’s income statement. Cost of goods sold or the cost of sales is computed, as follows: Beginning Inventory plus: Net Purchases equals: Merchandise Available for Sale less: Ending Inventory equals: Cost of Goods Sold Introductory Financial Accounting – Cataldo (WCU ACC201) Page 6 Merchandise available for sale equals the beginning inventory plus (net) purchases of additional inventory during the period. This merchandise available for sale is either sold (cost of goods sold) or remains in ending inventory. In terms of the balance sheet and income statement, beginning inventory and ending inventory amounts represent amounts at a beginning and ending point in time, and are reflected in the beginning and ending balance sheets. The cost of goods sold or cost of sales are matched to the relevant period of time. Beginning Inventory __________________________________ Ending Inventory Beginning Balance Sheet Ending Balance Sheet (Point in Time) (Point in Time) Cost of Goods Sold or Cost of Sales Income Statement (Period of Time) Inventory Alternatives Two alternatives are available to account for inventory: the perpetual and periodic systems. Perpetual systems continuously update records for inventory sales and the cost of these sales (cost of goods sold), as sales occur. Periodic systems periodically update records for inventory sales and the cost of these sales, usually at the end of an accounting period (e.g., month, quarter, semi-annual or annual period). Hybrid systems are common, where a retail store, for example, accounts for some inventory classes or departments perpetually and others, periodically. Regardless of whether a firm uses perpetual or periodic inventory systems, a physical count is likely to be conducted annually, to verify perpetual and/or periodic balances maintained in the firms records. An Example of Perpetual Inventory Today, when you purchase an item at a retail outlet, the item is scanned at the checkout counter. This represents an example of a perpetual inventory system. When scanned at checkout, the item is immediately deleted from inventory in the firm’s recorded merchandise inventory balance. The sale, revenue or retail price is immediately “matched” to the cost of goods sold, as the cost of this item is removed from inventory available for sale. The gross margin is immediately available (revenue less cost of goods sold equals gross margin), and can be accessed by the firm’s management, online and real-time. The same could be said for sales returns. These items, when scanned, are returned or added back to inventory balances. The inventory account is increased and cost of goods sold is decreased for the cost of merchandise returned by the buyer. Introductory Financial Accounting – Cataldo (WCU ACC201) Page 7 Merchandise purchases and the cost of merchandise purchased for resale is recorded (debited) to merchandise inventory, a current asset account. For example, assume that Flynn Enterprises made a $1,000 cash purchase of merchandise on February 15, as follows: Feb. 15 Merchandise Inventory $1,000 Cash $1,000 Purchase discounts, returns, allowances are contra accounts (credits). Freight-in or transportation-in are additional costs (debits). When combined or netted with gross purchases, all of these measures equal net purchases. Typical balances of accounts follows: Gross Purchases Debit less: Purchase Discounts Credit less: Purchase Returns Credit less: Purchase Allowances Credit plus: Transportation-In Debit Credit equals: Net Purchases Debit Notice that purchase discounts, returns and allowances are accounted for in a “grossed- up” fashion and not netted. This is to allow management to monitor and investigate (1) the impact of discounts they offer or take advantage of, (2) returns of merchandise, to track them to specific items or suppliers, and (3) allowances, the frequency of which might help to identify problem delivery services or products. If these separate accounts were not maintained, the seller or purchaser might not otherwise become aware of problems with merchandise, adversely impacting relations with their customers or suppliers and their business. Purchase discount is a contra account. A discount is provided as an incentive to the customer to buy early and pay quickly, to improve the selling firm’s sales and cash inflows. Terms may vary. For example, n/10 EOM means “pay the net amount 10 days after end of month,” n/30 means “pay within 30 days of the invoice date,” and 2/10, n/60 means “full payment is due in 60 days, but you may deduct 2 percent of the invoice amount if paid within 10 days of the invoice.” Other alternatives are possible. Assume that Flynn Enterprises, in the above example, made the same $1,000 purchase, but on credit. The terms were 2/10, n/60: Feb. 15 Merchandise Inventory $1,000 Accounts Payable $1,000 If Flynn Enterprises pays the entire amount on February 25: Introductory Financial Accounting – Cataldo (WCU ACC201) Page 10 Gross Purchases Debit less: Purchase Discounts Credit less: Purchase Returns Credit less: Purchase Allowances Credit plus: Transportation-In Debit Credit equals: Net Purchases Debit Transportation Cost and Transfer of Ownership Buyers and sellers must agree on transportation costs and related risks. At what point does ownership transfer from the buyer to the seller? The point in time when ownership transfers is referred to as the FOB (free on board). This point determines who bears the cost of transportation and merchandise insurance against the risk of damage or loss. There are two alternatives: 1. FOB shipping point or FOB factory means the buyer accepts ownership and all related risks when merchandise leave the seller’s place of business. Merchandise-related shipping costs and insurance costs and risk of damage while in transit are the buyer’s responsibility. Ownership transfers and the merchandise becomes part of the buyer’s inventory when departing the seller’s location. Similarly, the merchandise is presumed to have been sold, from the seller’s perspective, once the merchandise leaves their location. 2. FOB destination means the buyer accepts ownership and all related risks after merchandise arrives, undamaged. Merchandise-related shipping costs and insurance costs and risk of damage while in transit are the seller’s responsibility. Ownership transfers and the merchandise becomes part of the buyer’s inventory once it has arrived and is accepted by the buyer. Similarly, the merchandise is presumed to have been sold, from the seller’s perspective, only once the merchandise is accepted at its destination. If the buyer agrees to pay the transportation cost for merchandise inventory, this transportation cost is added to the cost of merchandise inventory, as follows: Merchandise Inventory $xxx Cash $xxx Alternatively, a separate account could be established to maintain data on the amount of transportation-in or freight-in charges included in merchandise inventory: Transportation-In $xxx Cash $xxx Introductory Financial Accounting – Cataldo (WCU ACC201) Page 11 If the seller pays the cost of transportation or delivery, they would record the cost in a Delivery Expense or Transportation-Out or Freight-Out account. Therefore, from the buyer’s perspective, Net Purchases is used for the computation of Cost of Goods Sold, and can be summarized, as follows: Gross Purchases less: Purchase Discounts less: Purchase Returns less: Purchase Allowances plus: Transportation-In equals: Net Purchases Beginning Inventory plus: Net Purchases equals: Merchandise Available for Sale less: Ending Inventory equals: Cost of Goods Sold Alternatively, Beginning Inventory $ xxx Gross Purchases $ xxx Purchase Discounts $(xxx) Purchase Returns $(xxx) Purchase Allowances $(xxx) Transportation-In $ xxx Net Purchases $ xxx Merchandise Available for Sale $ xxx Ending Inventory $(xxx) Cost of Goods Sold $ xxx Tracking Merchandise Purchases In today’s world, it is common for the buyer to be able to “track” items as their purchase orders are filled and shipped for delivery. Both buyer and seller use identifying tracking identification numbers and may be notified by email of the progress as the merchandise proceeds from its shipping point to its destination. Merchandise Sales The price received by a seller of merchandise is recorded (credited) to sales (or revenues). For example, assume that the Oehlers Corporation made a $1,500 cash sale on March 15, as follows: Introductory Financial Accounting – Cataldo (WCU ACC201) Page 12 If the sale was a cash sale, it would be recorded, as follows: Mar. 15 Cash $1,500 Sales $1,500 If the sale was a credit sale, it would be recorded, as follows: Mar. 15 Accounts Receivable $1,500 Sales $1,500 Whether a cash sale or a credit sale, the cost of the merchandise inventory sold must be recorded as a reduction in the available inventory, expensed as cost of goods sold and “matched” to the revenue or sales, as follows: Mar. 15 Cost of Goods Sold $1,000 Merchandise Inventory $1,000 Therefore, this single sale of $1,000 in merchandise at $1,500 produces a gross profit of $500, as follows: Gross Sales $1,500 less: Cost of Goods Sold 1,000 equals: Gross Profit $500 If the sale was made on credit, the cash collection of the accounts receivable, on March 20, would be recorded, as follows: Mar. 20 Cash $1,500 Accounts Receivable $1,500 After collecting cash, in the case of the credit sale, the accounts receivable account will show a zero balance, as follows: Sales Accounts Receivable Cash Mar. 15 $1,500 Mar. 15 $1,500 Mar. 20 $1,500 Mar. 20 $1,500 Balance $-0- Sales discounts, returns, allowances are contra accounts (debits). When combined or netted with gross sales, all of these measures equal net sales. Typical balances of sales and related contra accounts follows: Introductory Financial Accounting – Cataldo (WCU ACC201) Page 15 refund, but, also, does not want to pay the full price. Assume the sale occurred at $500 and both agree to a $50 sales allowance on March 25: Mar. 25 Sales allowance $500 Accounts receivable $500 Sales discounts, sales returns, and sales allowances can be set up as separate accounts and monitored, as follows: Gross Sales $120 less: Sales Discounts $5 less: Sales Returns $7 less: Sales Allowances $8 20 equals: Net Sales $100 Both sales and purchases, in an expanded or grossed-up form, are outlined below: Gross Sales $ xxx Sales Discounts $(xxx) Sales Returns $(xxx) Sales Allowances $(xxx) Net Sales $ xxx Beginning Inventory $ xxx Gross Purchases $ xxx Purchase Discounts $(xxx) Purchase Returns $(xxx) Purchase Allowances $(xxx) Transportation-In $ xxx Net Purchases $ xxx Merchandise Available for Sale $ xxx Ending Inventory $(xxx) Cost of Goods Sold $ xxx Gross Margin $ xxx Adjusting and Closing Entries for Merchandising Firms In addition to sales and other revenue accounts, contra revenue accounts (i.e., sales discounts, sales returns, and sales allowances) must be closed to the income summary. In addition to cost of goods sold and other expense accounts, contra expense accounts (i.e., purchase discounts, purchase returns, and purchases allowances) must be closed to the income summary. Introductory Financial Accounting – Cataldo (WCU ACC201) Page 16 Financial Statement Formats Generally accepted accounting principles (GAAP) permit different formats to be used for financial statements. Two common income statement formats are described in this section: multiple-step and single-step. Multiple-Step Income Statement The multiple-step income statement for the Oehlers Corporation is presented below. This statement provides for measures of (1) gross profit, (2) income from operations (gross profit less operating expenses), and (3) income and expense items not associated with operations (non-operating items, like gain and losses and interest revenues and expenses). Oehlers Corporation Income Statement For Year Ended December 31, 2015 Sales $1,000,000 Cost of Goods Sold $550,000 Gross Profit $450,000 Operating Expenses General, selling & administrative expenses Advertising expense $20,000 Depreciation expense $5,000 Insurance expense $7,500 Office supplies expense $12,500 Rent expense $120,000 Salaries expense $235,000 Total general, selling & administrative expenses $400,000 Income from Operations $50,000 Other revenues and expenses Interest revenue $1,000 Gain on sale of building $3,500 Interest expense ($1,500) Loss on sale of land ($500) Total Other revenues and expenses $2,500 Net Income $52,500 • Sales, in the above, are net sales. Recall that gross sales, less sales discounts, sales returns, and sales allowances are netted to arrive at net sales. • Cost of goods sold is computed by adding net purchases to beginning inventory and subtracting ending inventory. • Recall that gross purchases, less purchase discounts, purchase returns, and purchase allowances, and adding freight-in or transportation-in, before these measures are netted to arrive at net purchases. • General, selling & administrative expenses might be separated into components (e.g., selling separated from general & administrative), if preferred. In these cases, Introductory Financial Accounting – Cataldo (WCU ACC201) Page 17 certain expenses might have to be allocated. If allocated, some systematic and rational approach will be developed to allocate expenses (e.g., rent expense might be allocated between selling and general & administrative based on the square footage consumed by each). • Operating expenses might be arranged or sequenced alphabetically, as they have been in the above case, or from larger amounts to lesser amounts. Single-Step Income Statement The single-step income statement for Oehlers Corporation is presented below. Note that this presentation alternative may prove to be less useful. Measures of gross profit and income from operations are not immediately available. Oehlers Corporation Income Statement For Year Ended December 31, 2015 Revenues Sales $1,000,000 Interest revenue $1,000 Gain on sale of building $3,500 Total revenues $1,004,500 Expenses Cost of Goods Sold $550,000 Total general, selling & administrative expenses $400,000 Interest expense $1,500 Loss on sale of land $500 $952,000 Net Income $52,500 Classified Balance Sheet – Current Assets The classified balance sheet for a merchandising firm reports merchandise inventory as an asset. Assets are organized in order of liquidity, with cash first, followed by accounts receivable, soon to be received in cash, and inventory, which must be sold on cash or credit terms and will either become an accounts receivable or paid in cash. Office supplies inventory and store supplies inventory are for consumption during operations and, unlike merchandise inventory, are not held for resale. Prepaid expenses can include prepaid rent, utilities, insurance and a variety of operating expense. Introductory Financial Accounting – Cataldo (WCU ACC201) Page 20 Appendix B Gross Margin Ratio Frequently, the strength of a firm is determined by its ability to maintain gross margins. For example, a higher gross margin ratio suggests that the firm has industry leadership and/or cost efficiencies and/or the ability to maintain a relatively high price for its product or service, relative to competitors. The computation of the gross margin ratio follows: Gross Margin Ratio = [Net Sales – Cost of Goods Sold] ÷ Net Sales The below has been extracted from a story that appeared in mid-February 2015, with respect to Apple’s (NASDAQ: AAPL) gross margins Apple reported gross margin of 39.9% in the most recent quarter, which was up from 38.0% in the September quarter. This is favorable news, and the maintenance (or improvement) in gross margin ratio tends to have a favorable impact on the firm’s stock price. Below is a 1 year, split- adjusted chart of Apple’s stock price through February 13, 2015: Introductory Financial Accounting – Cataldo (WCU ACC201) Page 21 Appendix C Perpetual v. Periodic Inventory There are two broad categories of accounting for inventory: periodic and perpetual. Periodic inventory accounting systems require that inventory items be accounted for periodically. Perpetual systems account for inventory in real time, after each and every transaction. Note, in the below, that the only difference between periodic and perpetual systems involve the use of (1) purchases, (2) purchase discount, (3) purchase return, (4) purchase allowance, and (5) freight-in or transportation-in accounts for periodic inventory accounting systems, all of which are replaced by the merchandise inventory account under a perpetual inventory accounting system. PERIODIC PERPETUAL Purchases $ xx Merchandise inventory $ xx Accounts payable $ xx Accounts payable $ xx Accounts payable $ xx Accounts payable $ xx Purchase discount $ xx Merchandise inventory $ xx Cash $ xx Cash xx Accounts payable $ xx Accounts payable $ xx Purchase return $ xx Merchandise inventory $ xx Accounts payable $ xx Accounts payable $ xx Purchase allowance $ xx Merchandise inventory $ xx Transportation-in $ xx Merchandise inventory $ xx Cash $ xx Cash $ xx Just think of any retail outlet check-out counter, where an item is scanned. The scanner is connected to a computer that adjusts inventory balances, in real time or perpetually. Introductory Financial Accounting – Cataldo (WCU ACC201) Page 22 In the case of sales, the only difference between periodic inventory and perpetual inventory systems is that cost of goods sold and inventory balances are updated, in real time, in the case of the perpetual inventory system. Again, you can think of any retail outlet check-out counter and scanner, where both retail price and cost of goods sold are stored in the store computer. Effectively, these systems can compute gross margins on each and every sale, in real time. PERIODIC PERPETUAL Accounts receivable $ xx Accounts receivable $ xx Sales $ xx Sales $ xx Cost of goods sold $ xx Merchandise inventory $ xx Cash $ xx Cash $ xx Sales discounts $ xx Sales discounts $ xx Accounts receivable $ xx Accounts receivable $ xx Merchandise inventory $ xx Cost of goods sold $ xx Sales returns $ xx Sales returns $ xx Accounts receivable $ xx Accounts receivable $ xx Merchandise inventory $ xx Cost of goods sold $ xx Sales allowances $ xx Sales allowances $ xx Accounts receivable $ xx Accounts receivable $ xx