1. Accounting Principles Second Canadian Edition Prepared by: Carole Bowman, Sheridan College Weygandt · Kieso · Kimmel · Trenholm

2. ACCOUNTING FOR MERCHANDISING OPERATIONS CHAPTER 5

3. An accounting information system (AIS) involves collecting and processing data and disseminating financial information to interested parties. An AIS may either be manual or computerized. Accounting Information System

4. PRINCIPLES OF AN EFFICIENT AND EFFECTIVE ACCOUNTING INFORMATION SYSTEM CostsBenefits The accounting system must be cost effective. Benefits of information must outweigh the cost of providing it. The accounting system must be cost effective. Benefits of information must outweigh the cost of providing it.

5. PRINCIPLES OF AN EFFICIENT AND EFFECTIVE ACCOUNTING INFORMATION SYSTEM It must be relevant! It must be reliable! It must be accurate! It must be timely! Balance Sheet Income Statement Other Financial Reports

6. PRINCIPLES OF AN EFFICIENT AND EFFECTIVE ACCOUNTING INFORMATION SYSTEM Government Regulation and Deregulation Organizational Growth Increased Competition Changing Accounting Principles Technological Advances

7. PHASES IN THE DEVELOPMENT OF AN ACCOUNTING SYSTEM Analysis Follow upDesign Implementation Planning and identifying information needs and sources Evaluating and monitoring effectiveness and efficiency and correcting any weaknesses Creating forms, documents, procedures, job descriptions, and reports Installing the system, training personnel, and making the system operational

8. A subsidiary ledger is a group of accounts with a common characteristic, such as customer accounts. The subsidiary ledger is assembled to facilitate the recording process by freeing the general ledger from details concerning individual balances. Two common subsidiary ledgers are the Accounts Receivable Ledger and the Accounts Payable Ledger. SUBSIDIARY LEDGERS

9. The general ledger account that summarizes subsidiary ledger data is called a control account. Each general ledger control account balance must equal the composite balance of the individual accounts in the subsidiary ledger. CONTROL ACCOUNT

10. RELATIONSHIP OF GENERAL LEDGERS AND SUBSIDIARY LEDGERS Accounts receivable controls a subsidiary ledger of many different customers. General Ledger Subsidiary Ledgers Cash Owner’s Capital Accounts Receivable Accounts Payable Customer A Customer B Customer C Accounts payable controls a subsidiary ledger of many different creditors. Creditor X Creditor Y Creditor Z

11. Advantages of using subsidiary ledgers are that they: 1. Show transactions affecting one customer or one creditor in a single account. 2. Free the general ledger of excessive details. 3. Help locate errors in individual accounts by reducing the number of accounts combined in one ledger and by using controlling accounts. 4. Create a division of labour in posting by allowing one employee to post to the general ledger and a different employee to post to the subsidiary ledger. SUBSIDIARY LEDGERS

12. Special journals are used to group similar types of transactions. If a transaction cannot be recorded in a special journal, it is recorded in the general journal. Special journals permit greater division of labour and reduce time necessary to complete the posting process. SPECIAL JOURNALS

13. USE OF SPECIAL JOURNALS AND THE GENERAL JOURNAL Sales Journal Cash Receipts Journal Purchases Journal Cash Payments Journal General Journal Used for: All sales of merchan- dise on account Used for: All cash received (including cash sales) Used for: All purchases of merchan- dise on account Used for: All cash paid (including cash purchases) Used for: Transactions that cannot be entered in a special journal, including correcting, adjusting, and closing entries The types of special journals used depend largely on the types of transactions that occur frequently in a business enterprise.

14. A merchandising company is an enterprise that buys and sells goods to earn a profit. 1. Wholesalers sell to retailers. 2. Retailers sell to consumers. A merchandiser’s primary source of revenue is sales, whereas a service company’s primary source of revenue is service revenue. MERCHANDISING COMPANY

15. OPERATING CYCLES FOR A SERVICE COMPANY AND A MERCHANDISING COMPANY Accounts Receivable Cash Service Company Cash Merchandising Company Receive Cash Perform Services Sell Inventory Accounts Receivable Receive Cash Buy Inventory Merchandise Inventory

16. Perpetual vs. Periodic Inventory Accounting Perpetual Updates inventory and cost of goods sold after every purchase and sales transaction Periodic Delays updating of inventory and cost of goods sold until end of the period Misstates inventory during the period

17. INVENTORY SYSTEMS Merchandising entities may use either (or both) of the following inventory systems: 1. Perpetual – where detailed records of each inventory purchase and sale are maintained. Cost of goods sold is calculated at the time of each sale. 2. Periodic – detailed records are not maintained. Cost of goods sold is calculated only at the end of the accounting period. Majority of companies today use the perpetual method.

18. When merchandise is purchased for resale to customers, the account, Merchandise Inventory, is debited for the cost of the goods. Merchandise may be purchased for cash or on account (credit). The purchase is normally recorded by the purchaser when the goods are received from the seller. (FOB Destination) RECORDING COST OF GOODS PURCHASED PERPETUAL INVENTORY METHOD

19. PURCHASES OF MERCHANDISE For purchases on account, Merchandise Inventory is debited and Accounts Payable is credited. For cash purchases, Merchandise Inventory is debited and Cash is credited.

20. FREIGHT COSTS The sales agreement should indicate whether the seller or the buyer is to pay the cost of transporting the goods to the buyer’s place of business. FOB (Free on Board) Destination 1. Ownership of the merchandise transfers to the purchaser once it reaches the purchaser's location. The seller should continue to record the merchandise in their inventory while the inventory is in transit (on its way to the purchaser) 2. Seller pays freight costs from shipping point to destination 3. Delivery Expense (or Freight Out) is debited by the seller for the amount of the freight cost

21. FREIGHT COSTS cont'd FOB (Free on Board) Shipping Point 1. Ownership of the merchandise transfers to the purchaser at the point of sale (the seller's location). The purchaser should include the merchandise in their inventory while it is in transit (on it's way to the purchaser). 2. Buyer pays freight costs from shipping point to destination 3. Merchandising Inventory is debited by the buyer for the amount of the freight cost

22. Seller Buyer Public Carrier Co. Ownership passes to buyer here Ownership passes to buyer here FOB Shipping Point FOB Destination Point TERMS OF SALE Public Carrier Co. Buyer Seller

23. When the purchaser directly incurs the freight costs, the account Merchandise Inventory is debited and Cash is credited. ACCOUNTING FOR FREIGHT COSTS

24. Under a consignment arrangement, the holder of the goods (called the consignee) does not own the goods. Ownership remains with the shipper of the goods (consignor) until the goods are actually sold to a customer. Consigned goods should be included in the consignor’s inventory, not the consignee’s inventory. Consignee Company DETERMINING OWNERSHIP OF CONSIGNED GOODS Owned by a consignor; do not count in our (consignee) inventory

25. A purchaser may be dissatisfied with merchandise received because the goods 1. are damaged or defective, 2. are of inferior quality, or 3. are not in accord with the purchaser’s specifications. PURCHASE RETURNS AND ALLOWANCES

26. For purchases returns and allowances that were originally made on account, Accounts Payable is debited and Merchandise Inventory is credited. For cash returns and allowances, Cash is debited and Merchandise Inventory is credited.

27. QUANTITY DISCOUNTS Volume purchase terms may permit the buyer to claim a quantity discount. The merchandise inventory is simply recorded at the discounted cost. E.g. Buy 1 pay $100 per item DR Merchandise Inventory 100 CR Cash100 E.g. Buy 10 pay $95 per item DR Merchandise Inventory950 CR Cash950

28. PURCHASES JOURNAL PERPETUAL SYSTEM In a perpetual system, each entry results in a debit to Merchandise Inventory and a credit to Accounts Payable. Postings are made daily to the accounts payable subsidiary journal and monthly to the general ledger. In a perpetual system, each entry results in a debit to Merchandise Inventory and a credit to Accounts Payable. Postings are made daily to the accounts payable subsidiary journal and monthly to the general ledger.  Karns Wholesale Supply Purchases Journal

29. PROVING THE ACCURACY OF THE ACCOUNTS PAYABLE SUBSIDIARY LEDGER To prove the ledgers it is necessary to determine that the sum of the subsidiary ledger balances equals the balance in the control account. Accounts Payable Subsidiary Ledger Eaton and Howe, Inc. $19,800 Fabor and Son 15,600 Jasper Manufacturing Inc. 28,500 $63,900 General Ledger Merchandise Inventory$63,900 (Asset) Accounts Payable $63,900 (Liability)

30. In a computer-based accounting system, subsidiary ledger accounts and general ledger accounts are all posted automatically as transactions are recorded. In addition, the computer automatically reconciles the subsidiary ledgers with the controlling accounts. SUBSIDIARY LEDGERS in a Computerized Environment

31. CLASSIFIED BALANCE SHEET On the balance sheet, merchandise inventory is reported as a current asset and appears immediately below accounts receivable. This is because current assets are listed in the order of their liquidity.

32. In the balance sheet of merchandising and manufacturing companies, inventory is frequently the most significant current asset. INVENTORY BASICS

33. Sales Revenue Cost of Goods Sold Cost of Goods Sold Less INCOME MEASUREMENT PROCESS FOR A MERCHANDISING COMPANY Gross Profit Gross Profit Equals Operating Expenses Less Net Income (Loss) Equals

34. In the income statement, inventory is vital in determining the results of operations for a particular period. Gross profit (net sales - cost of goods sold) is closely watched by management, owners, and other interested parties. INVENTORY BASICS

35. Revenues are reported when earned in accordance with the revenue recognition principle. In a merchandising company. revenues are earned when the goods are transferred from seller to buyer. SALES TRANSACTIONS

36. Using Perpetual Inventory Method SALES TRANSACTIONS Using Perpetual Inventory Method 1. The first entry records the sale of goods to a customer at the retail (selling) price. 2. The second entry releases the goods from inventory at cost and charges the goods to cost of goods sold.

37. CALCULATION OF GROSS PROFIT Gross profit is often expressed as a percentage of sales. Gross profit is calculated by deducting cost of goods sold from sales as follows:

38. CALCULATION OF NET INCOME Net income is the “bottom line” of a company’s income statement. Net income is calculated by deducting operating expenses from gross profit as follows:

39. Under a perpetual inventory system, one entry at selling price in the Sales Journal results in a debit to Accounts Receivable and a credit to Sales. Another entry at cost results in a debit to Cost of Goods Sold and a credit to Merchandise Inventory. Postings are made monthly to the general ledger and daily to the accounts receivable subsidiary ledger. Under a perpetual inventory system, one entry at selling price in the Sales Journal results in a debit to Accounts Receivable and a credit to Sales. Another entry at cost results in a debit to Cost of Goods Sold and a credit to Merchandise Inventory. Postings are made monthly to the general ledger and daily to the accounts receivable subsidiary ledger. JOURNALIZING THE SALES JOURNAL – PERPETUAL INVENTORY SYSTEM Karns Wholesale Supply Sales Journal S1

40. PROVING THE ACCURACY OF THE ACCOUNTS RECEIVABLE SUBSIDIARY LEDGER To prove the accuracy of the ledgers it is necessary to determine whether the sum of the accounts receivable subsidiary ledger balances equals the balance in the general ledger’s Accounts Receivable control account. General Ledger Accounts Receivable $90,230 Accounts Receivable Subsidiary Ledger Abbot Sisters$26,000 Babson Co. 25,920 Carson Bros. 7,800 Deli Co. 30,510 $90,230

41. Only transactions that cannot be recorded in a special journal are recorded in the general journal. When the entry involves both control and subsidiary accounts: 1. In journalizing, control and subsidiary accounts must be identified, and 2. In posting there must be a dual posting (to the control account and subsidiary ledger). GENERAL JOURNAL ENTRIES

42. JOURNALIZING AND POSTING THE GENERAL JOURNAL

43. ILLUSTRATION 5-14 This is the format of a multi-step income statement that has both operating and non- operating activities. As shown, the non- operating activities are reported immediately after the company’s primary operating activities.

44. SALES TAXES Sales tax is expressed as a percentage of the sales price on selected goods sold to customers by a retailer. They are collected on most revenues, and paid on many costs. Sales taxes may include the federal goods and services tax (GST) and the provincial sales tax (PST), if any. These two taxes have been combined into one harmonized sales tax (HST) in some provinces (such as Ontario and the Atlantic Provinces).

45. SALES TAXES ON REVENUES The retailer collects the tax from the customer when the sale occurs, and periodically (usually monthly) remits the collections to the Receiver General. Sales taxes are not revenue but are a current liability until remitted. DRCash (or A/R) 113 CRRevenue 100 CRSales Tax Payable 13

46. PURCHASE DISCOUNTS Credit terms may permit the buyer to claim a cash discount for the prompt payment of a balance due. The buyer calls this discount a purchase discount. A purchase discount is based on the invoice cost less any returns and allowances granted.

47. Sales Returns occur when customers are dissatisfied with merchandise and are allowed to return the goods to the seller for credit or a refund. Sales Allowances occur when customers are dissatisfied, and the seller allows a deduction from the selling price. SALES RETURNS AND ALLOWANCES

48. The normal balance of Sales Returns and Allowances is a debit. Sales Returns and Allowances is a contra revenue account to the Sales account. SALES RETURNS AND ALLOWANCES

49. STATEMENT PRESENTATION OF SALES REVENUE SECTION As contra revenue accounts, sales returns and allowances (and sales discounts, if any) are deducted from sales in the income statement to arrive at Net Sales.

50. RECORDING SALES RETURNS AND ALLOWANCES PERPETUAL INVENTORY METHOD RECORDING SALES RETURNS AND ALLOWANCES PERPETUAL INVENTORY METHOD 1. The first entry reduces the balance owed by the customer and records the goods returned at retail price. 2. The second entry records the physical return of goods to inventory at cost and removes the goods from the cost of goods sold account.

51. RECORDING SALES RETURNS AND ALLOWANCES PERIODIC INVENTORY METHOD RECORDING SALES RETURNS AND ALLOWANCES PERIODIC INVENTORY METHOD The normal balance of Sales Returns and Allowances is a debit. Sales Returns and Allowances is a contra revenue account to the Sales account.

52. A quantity discount is the offer of a cash discount to a customer in return for a volume sale. Quantity discounts result in a sales price reduction. They are not separately journalized. Instead the sale is recorded at the reduced price. QUANTITY DISCOUNTS

53. A sales discount is the offer of a cash discount to a customer in exchange for the prompt payment of a balance due. Similar to Sales Returns and Allowances, Sales Discounts is also a contra revenue account with a normal debit balance. SALES DISCOUNTS

54. STATEMENT PRESENTATION OF SALES REVENUE SECTION As contra revenue accounts, sales returns and allowances and sales discounts, are deducted from sales in the income statement to arrive at Net Sales.

55. RECORDING SALES DISCOUNTS PERPETUAL OR PERIODIC INVENTORY METHOD RECORDING SALES DISCOUNTS PERPETUAL OR PERIODIC INVENTORY METHOD The normal balance of Sales Discounts is a debit. Sales Discounts is a contra revenue account to the Sales account.

56. PURCHASES OF MERCHANDISE UNDER THE PERIODIC INVENTORY METHOD For purchases on account, Purchases is debited and Accounts Payable is credited. For cash purchases, Purchases is debited and Cash is credited.

57. PURCHASE RETURNS AND ALLOWANCES PERIODIC INVENTORY METHOD PURCHASE RETURNS AND ALLOWANCES PERIODIC INVENTORY METHOD For purchases returns and allowances that were originally made on account, Accounts Payable is debited and Purchase Returns and Allowances is credited. The Purchase Returns and Allowances account is a contra account.

58. When the purchaser directly incurs the freight costs, the account Freight In is debited and Cash is credited. ACCOUNTING FOR FREIGHT COSTS PERIODIC INVENTORY METHOD ACCOUNTING FOR FREIGHT COSTS PERIODIC INVENTORY METHOD

59. Only one entry is required to record a sale under a periodic method. SALES TRANSACTIONS PERIODIC INVENTORY METHOD SALES TRANSACTIONS PERIODIC INVENTORY METHOD

60. The multi-step income statement under the periodic system requires more detail in the cost of goods sold section, as shown above.

61. ACCOUNTING FOR MERCHANDISING OPERATIONS CHAPTER 9

62. ALLOCATION OF INVENTORIABLE COSTS Beginning Inventory (e.g. $50,000) Goods Purchased during the year (e.g. $70,000) Cost of Goods Available for Sale (e.g. $120,000) Ending Inventory (Current Asset on the Balance Sheet at cost price) (e.g. $25,000) Cost of Goods Sold (Income Statement) (e.g. $95,000) Not sold Sold $ amount is based on the actual amount paid for the goods How do you determine the cost factor to value the inventory sold? How do you determine the cost factor to value the inventory left on hand?

63. INVENTORY COSTING METHODS When receiving merchandise inventory the amount debited to inventory is the amount that you paid for it (i.e. The Cost Principle)

64. INVENTORY COSTING METHODS When inventory is sold, there are a variety of inventory costing methods that can be used to determine the amount that will be debited to Costs of Good Sold. Perpetual Method

65. INVENTORY COSTING METHODS Or for the Periodic method, the costing factor used to determine the value of the ending inventory. Cost of goods sold: Inventory, January 1 $ 36,000 Purchases $ 325,000 Less: Purchase returns and allowances 17,200 Net purchases $ 307,800 Add: Freight in 12,200 Cost of goods purchased 320,000 Cost of goods available for sale $ 356,000 Inventory, December 31 40,000 Cost of goods sold $ 316,000

66. USING ACTUAL PHYSICAL FLOW COSTING The specific identification method tracks the actual physical flow of the goods. Each item of inventory is marked, tagged, or coded with its specific unit cost. It is most frequently used when the company sells a limited variety of high unit-cost items.

67. USING ASSUMED COST FLOW METHODS Other cost flow methods are allowed since specific identification is often impractical. These methods assume flows of costs that may be unrelated to the physical flow of goods. Cost flow assumptions: 1. First-in, first-out (FIFO). 2. Last-in, first-out (LIFO). 3.Average cost.

68. FIFOFIFO The FIFO method assumes that the earliest goods purchased are the first to be sold. Often reflects the actual physical flow of merchandise. The costs of the earliest goods purchased are the first to be recognized as cost of goods sold. The costs of the most recent goods purchased are recognized as the ending inventory.

69. FIFO method assumes earliest goods purchased are the first to be sold

70. LIFO The LIFO method assumes that the latest goods purchased are the first to be sold. Seldom coincides with the actual physical flow of inventory. The costs of the most recent goods purchased are recognized as the cost of goods sold. The costs of the earliest goods purchased are the first to be recognized as ending inventory. Rarely used in Canada.

71. LIFO method assumes latest goods purchased are the first to be sold Inventory

72. AVERAGE COST The average cost method assumes that the goods available for sale are homogeneous. The allocation of the cost of goods available for sale is made on the basis of the weighted average unit cost incurred. The weighted average unit cost is then applied to the units sold to determine the cost of goods sold and to the units on hand to determine the ending inventory.

73. Allocation of the cost of goods available for sale in average cost method is made on the basis of the weighted average unit cost

74. Average cost method assumes that goods available for sale are homogeneous

75. INCOME STATEMENT EFFECTS OF INVENTORY COSTING METHODS In periods of rising prices, FIFO reports the highest net income, LIFO the lowest and average cost falls in the middle. The reverse is true when prices are falling. When prices are constant, all cost flow methods will yield the same results.

76. FIFO produces the best balance sheet valuation since the inventory costs are closer to their current, or replacement, costs. BALANCE SHEET EFFECTS

77. USING INVENTORY COST FLOW METHODS CONSISTENTLY A company needs to use its chosen cost flow method consistently from one accounting period to another. Such consistent application enhances the comparability of financial statements over successive time periods. When a company adopts a different cost flow method, the change and its effects on net income should be disclosed in the financial statements.

78. Both beginning and ending inventories appear on the income statement. The ending inventory of one period automatically becomes the beginning inventory of the next period. Inventory errors affect the determination of cost of goods sold and net income. INVENTORY ERRORS - INCOME STATEMENT EFFECTS

79. FORMULA FOR COST OF GOODS SOLD FORMULA FOR COST OF GOODS SOLD + = Beginning Inventory Cost of Goods Purchased Ending Inventory Cost of Goods Sold _ The effects on cost of goods sold can be determined by entering the incorrect data in the above formula and then substituting the correct data.

80. EFFECTS OF INVENTORY ERRORS ON CURRENT YEAR’S INCOME STATEMENT An error in ending inventory of the current period will have a reverse effect on net income of the next accounting period. Understate beginning inventory Understated Overstated Overstate beginning inventory Overstated Understated Understate ending inventory Overstated Understated Overstate ending inventory Understated Overstated

81. The effect of ending inventory errors on the balance sheet can be determined by using the basic accounting equation: Assets = Liabilities + Owner’s Equity ENDING INVENTORY ERROR – BALANCE SHEET EFFECTS Overstated Overstated None Overstated Understated Understated None Understated

82. When the value of inventory is lower than the cost, the inventory is written down to its market value. This is known as the lower of cost and market (LCM) method. Market is defined as replacement cost or net realizable value. VALUING INVENTORY AT THE LOWER OF COST AND MARKET

83. ALTERNATIVE LOWER OF COST AND MARKET (LCM) RESULTS The common practice is to use total inventory rather than individual items or major categories in determining the LCM valuation.

84. COMPLETING THE ACCOUNTING CYCLE A merchandising company requires the same types of adjusting entries as a service company, with one additional adjustment for inventory to ensure the recorded inventory amount agrees with the actual quantity on hand. A physical count is an important control feature since a perpetual system indicates what should be there but a count will determine what is actually there.

85. COMPLETING THE ACCOUNTING CYCLE A merchandising company also requires the same types of closing entries as a service company. The additional accounts that need to be closed out in a merchandising company include Sales, Sales Returns and Allowances, Cost of Goods Sold, and Freight Out. Merchandise Inventory is an asset account and is not closed at the end of the period.

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