1 Chapter 5

2 Service business earns fees –Revenues recorded Merchandising business sells inventory –Revenue from sales –Expense of Inventory Cost Cost of Goods Sold.

3 The Cost of Goods Sold –An expense –Treated differently on Income Statement Sales Revenue - Cost of Goods Sold –Gross Profit or Gross Margin –Reported at the top of an income statement.

4 Two Inventory Systems –Periodic Inventory System –Perpetual Inventory System

5 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.

6 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

7 Perpetual Inventory System –Company always keeps track of COGS & Inventory –Still need physical inventory End of year. Any discrepancy with books - theft and spoilage –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.

8 D.Merchandise Inventory$5,000 Cr.Cash$5,000 When you purchase inventory with cash:

9 D.Merchandise Inventory$5,000 Cr.Accounts Payable$5,000 When you purchase inventory on credit:

10 Purchase Returns & Allowances –You return inventory purchased (Purchases Return) Reverse purchase –Supplier reduces price of merchandise after the sale (Purchases Allowance) Write down Inventory to amount paid

11 D.Accounts Payable$5,000 Cr.Merchandise Inventory$5,000 A return of entire $5,000 purchase:

12 D.Accounts Payable$1,000 Cr.Merchandise Inventory$1,000 The receipt of $1,000 allowance on $5,000 purchase

13 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

14 "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 Invoice says FOB Detroit You pay shipping costs You own car during shipment. Something goes wrong – Your problem

15 "FOB destination“ –Seller transfers title to inventory when delivered At buyer’s place of business –Seller pays shipping costs –E.g., you order car from Ford Invoice says FOB Los Angeles Ford pays shipping costs Ford owns car during shipment If something goes wrong – Ford’s problem

16 D.Merchandise Inventory$150 Cr.Accounts Payable/Cash$150 Transportation Costs on purchases –Part of cost of inventory –Called “Freight in” or “Transportation In” –Under perpetual inventory system – increase cost of the inventory:

17 D.Freight Out$150 Cr.Accounts Payable/Cash$150 Transportation Costs on sales –An expense Called “Transportation Out” or “Freight Out”:

18 Purchases Discounts –We buy inventory –Seller offers credit terms to encourage us to pay quickly –Called purchase discounts. –When we are seller – Called sales discounts

19 Examples –2/10 n/30 (“two-ten, net thirty”) If buyer pays whole invoice within 10 days –Gets 2% off Otherwise, entire bill due in 30 days –1/10 EOM If buyer pays whole invoice during 1 st 10 days of next month –Gets 1% off Otherwise, entire bill due by end of next month.

20 If seller does not wish to offer discount –Invoice says when payment is due –n/30 No discount Entire Invoice due in 30 days –n/10 EOM Entire invoice due in first 10 days of next month

21 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.

22 D.Merchandise Inventory$3,500 Cr.Accounts Payable$3,500 You buy inventory for $3,500 Supplier offers you 2/10 n/30 When you receive inventory –Ignore potential discount

23 D.Accounts Payable$3,500 Cr.Cash$3,430 Merchandise Inventory70 If payment made during discount period –Show A/P is discharged in full –Show amount paid –Write down Inventory to price actually paid

24 D.Accounts Payable$3,500 Cr.Cash$3,500 If payment not made during discount period

25 D.Cash$2,200 Cr.Sales Revenue$2,200 D.Cost of Goods Sold$1,400 Cr.Merchandise Inventory$1,400 Cash sale - revenue side of transaction: Cash sale - cost side of transaction:

26 D.Accounts Receivable$2,200 Cr.Sales Revenue$2,200 D.Cost of Goods Sold$1,400 Cr.Merchandise Inventory$1,400 Credit sale - revenue side of transaction: Credit sale - cost side of transaction:

27 Customer returns merchandise – you undo sale. –Debit Sales Returns & Allowances 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

28 D.Sales Returns & Allowances$2,200 Cr.Accounts Receivable$2,200 D.Merchandise Inventory$1,400 Cr.Cost of Goods Sold$1,400 Undo revenue side of transaction: Undo cost side of transaction:

29 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 –Contra Revenue account Reduces Sales Revenue

30 D.Accounts Receivable$3,500 Cr.Sales/Sales Revenue$3,500 When sale is made –Ignore potential sales discount

31 D.Cash$3,430 Sales Discounts70 Cr.Accounts Receivable$3,500 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)

32 D.Cash$3,500 Cr.Accounts Receivable$3,500 If payment received after discount period:

33 Trade Discounts –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.

34 Sales Revenue$480,000 Less:Sales Returns and Allowances-12,000 Sales Discounts-8,000 Credit Card Discounts (if treated as a contra-revenue account)-6,000 Net Sales$454,000 Net Sales is Sales Revenue reduced by the contra-revenue accounts:

35 Single-step Income Statement –One Revenues section - lists all revenues –One Expenses section - lists all expenses Multiple-step Income Statement –Contains many subcategories

36 Income Statement For Year Ending December 31, 20XX Net Sales$460,000 Less:Cost of Goods Sold-316,000 Gross Margin/Profit$144,000 Less:Operating Expenses-114,000 Income From Operations$30,000 Other Revenue & Gains3,600 Less:Other Expenses & Losses-2,000 Income Before Income Taxes$31,600 Less:Income Tax Expense-10,100 Net Income$21,500

37 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.

38 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?

39 Income From Operations – Gross Margin - Operating Expenses Considered very important –Represents major operations –Good indication of future performance Typically viewed as sustainable in the future

40 Other Revenues and Expenses –Nonoperating revenues & gains dividends income interest income gains from sales of assets –Less nonoperating expenses & losses interest expense losses from sales of assets Follows Income From Operations

41 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

42 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 $ 54,780 General and Administrative Expenses34,504 Total Operating Expenses-89,284 Income from Operations $19,112

43 Shafer Auto Parts Corporation Income Statement For the Year Ended December 31, 20XX Income from Operations $19,112 Other Revenues and Expenses Interest Income$1,400 Less:Interest Expense-2,631 Excess of Other Expenses over Other Revenues -1,231 Income Before Income Taxes$17,881 Income Taxes-3,381 Net Income$14,500 Earnings per share$ 2.90

44 Shafer Auto Parts Corporation Income Statement For the Year Ended December 31, 20XX Revenues Net Sales$289,656 Interest Income$1,400 Total Revenues$291,056 Costs & Expenses Cost of Goods Sold$181,260 Selling Expenses 54,780 General and Administrative Expenses34,504 Interest Expense2,631 Income Tax Expense1,231 Total Costs and Expenses-276,556 Net Income$14,500 Earnings per share$ 2.90

45 Gross Profit Rate –Also called Gross Profit/Margin Percentage –Gives Gross Profit/Margin in terms that are not influenced by size Gross Profit/Margin Net Sales

46 Operating Expenses To Sales Ratio –Focuses on management’s ability to control operating expenses: Operating Expenses Net Sales