Module 4: Accounting for merchandising activities

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1 Course Schedule Course Modules Review and Practice Exam Preparation Resources Module 4: Accounting for merchandising activities Overview In the first three modules, you studied how to determine income for service companies such as WestJet (as illustrated in Appendix I, pages I-22 to I-50 in the text), where net income was determined by subtracting expenses incurred (using the matching principle) from service revenues (applying the revenue recognition principle). In this module, you study accounting for merchandising companies. These companies purchase goods (merchandise inventory) and resell them for a profit. Examples of merchandisers are clothing stores such as Danier Leather (illustrated in Appendix I, pages I-1 to I-21 in the text), and grocery stores such as Save-On-Foods or Sobeys. Accounting for merchandisers is somewhat more complex than that for service industries. This is because there is additional information that merchandisers need to keep track of: the company s purchase of and payment for the merchandise inventory. Merchandisers must keep track of the amount of inventory on hand and the cost of the amounts sold. This latter expense is known as cost of goods sold expense, or simply, cost of goods sold. Test your knowledge Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the depth of study required. Learning objectives 4.1 Merchandising companies Explain merchandising activities and analyze their effects on financial statements. (Level 2) 4.2 Merchandise purchases Perpetual inventory system Determine the cost of merchandise inventory purchases using a perpetual inventory accounting system. (Level 1) 4.3 An ethics application Cash discounts Explain the ethical issues related to cash discounts. (Level 1) 4.4 Revenue from sales and cost of goods sold Perpetual inventory system Record the revenue from merchandise sales, the collection of payment, and accompanying cost of the goods sold. (Level 1) 4.5 Additional merchandising issues Record adjustments for a merchandiser. (Level 1) 4.6 Alternative income statement formats, work sheet, and closing entries Prepare income statements in alternative formats and prepare closing entries for a merchandising company. (Level 1) 4.7 Periodic and perpetual inventory systems Determine the ending merchandise inventory and cost of goods sold using both a periodic and a perpetual inventory accounting system. (Level 2) 4.8 Using the information Gross profit ratio Calculate the gross profit ratio and interpret and apply this ratio in decision-making scenarios including using the ratio to determine a merchandiser's profitability before operating expenses. (Level 2) FA1 - Module 4 Page 1 of 60

2 Module summary Print this module Assignment reminder: Assignment #1 (see Module 5) is due at the end of week 5 (see Course Schedule). You may wish to take a look at it now in order to familiarize yourself with the requirements and to prepare for any necessary work in advance. Assignment #2 (see Module 7) is due at the end of week 7 (see Course Schedule). You may wish to take a look at it now in order to familiarize yourself with the requirements and to prepare for any necessary work in advance. FA1 - Module 4 Page 2 of 60

3 Course Schedule Course Modules Review and Practice Exam Preparation Resources Module 4 Test your knowledge a. Which of the following statements about inventory losses (inventory shrinkage) is true? 1. Inventory losses can be calculated under a periodic inventory system. 2. Inventory losses can be calculated under a perpetual inventory system. 3. Inventory losses can be calculated under neither a perpetual nor a periodic inventory system. 4. Inventory losses can be calculated under both a perpetual and a periodic inventory system. b. The following information relates to Quality Transoms for the year ended December 31, 20X1. Beginning inventory $70,000 Ending inventory $15,000 Purchase returns and allowances $3,000 Transportation in $17,000 Sales returns $12,000 Purchases $300,000 What was the cost of goods sold for the year ended December 31, 20X1? 1. $359, $369, $375, $390,000 c. Which of the following statements is correct with respect to the calculation of net sales? 1. Net sales = gross sales + sales returns and allowances sales discounts 2. Net sales = gross sales sales returns and allowances sales discounts 3. Net sales = gross sales sales returns and allowances + sales discounts 4. Net sales = gross sales sales returns and allowances sales discounts transportation-in d. Demill Ltd. uses a perpetual inventory system. During the month, Demill purchased $50,000 worth of inventory, paid transportation costs of $2,000, and took advantage of a $50 purchase discount. All of the inventory purchased was sold. What would the cost of goods sold be for the month, assuming that beginning inventory was zero? 1. $47, $49, $50, $51,950 FA1 - Module 4 Page 3 of 60

4 e. During the second half of June 20X1, Erudite Books Co. purchased $80,000 of inventory items from Region Publishers Ltd. on credit. Region gives its customers terms of 2/15, n/45. By June 30, Erudite had paid Region for half of the $80,000 purchased during the month. None of the inventory purchased from Region was sold by month end. What would be the impact of this activity on the general ledger accounts of Erudite, given that the company uses a perpetual inventory system? 1. Cost of goods sold amount would be $80, Inventory amount would be $79, Accounts payable amount would be $79, Accounts payable amount would be $80,000. Solutions FA1 - Module 4 Page 4 of 60

5 Course Schedule Course Modules Review and Practice Exam Preparation Resources Module 4 Test your knowledge solutions a. 1. Incorrect. Under a periodic inventory system, year-end adjusting entries compute the goods available for sale, subtract the cost of ending inventory, and defines the cost of goods sold as the resulting difference. Shrinkage is implicitly included in the Cost of goods sold account but not separately determined. 2. Correct. Under a perpetual inventory system, a physical count is performed at least once annually. This is compared to the recorded quantity of inventory to compute shrinkage. The amount of the difference is debited to Cost of goods sold and credited to Inventory. 3. Incorrect. A perpetual system incorporates a physical count in order to determine shrinkage. 4. Incorrect. Shrinkage can only be determined under a perpetual system. b. 1. Incorrect. Cost of goods sold = beginning inventory + (purchases purchase returns and allowances + transportation-in) ending inventory. 369,000 = 70,000 + (300,000 3, ,000) 15, Correct. Cost of goods sold = beginning inventory + (purchases purchase returns and allowances + transportation-in) ending inventory. 369,000 = 70,000 + (300,000 3, ,000) 15, Incorrect. Cost of goods sold = beginning inventory + (purchases purchase returns and allowances + transportation-in) ending inventory. 369,000 = 70,000 + (300,000 3, ,000) 15, Incorrect. Cost of goods sold = beginning inventory + (purchases purchase returns and allowances + transportation-in) ending inventory. 369,000 = 70,000 + (300,000 3, ,000) 15,000. c. 1. Incorrect. The Sales returns and allowances account is a contra revenue account, not a contra expense account. 2. Correct. The Sales returns and allowances account is a contra revenue account deducted from the Sales account when computing net sales. The Sales discount account is also a contra revenue account. 3. Incorrect. The Sales discount account is a contra revenue account, not a contra expense account. 4. Incorrect. Transportation-in are costs associated with the purchase of inventory. The cost principle requires this item to be included in the cost of inventory. They are not deducted from gross sales. d. 1. Incorrect. Transportation costs increase, not decrease, the amount of net FA1 - Module 4 Page 5 of 60

6 purchases. 2. Incorrect. Net purchases must include transportation costs, not just deduct the purchase discount. 3. Incorrect. All of the inventory purchased during the month was sold. Therefore, cost of goods sold must equal the net cost of purchases in this situation. Transportation costs increase the purchase cost, while purchase discounts decrease it. Net purchase cost = 50, , = 51,950. Cost of goods sold must also equal 51, Correct. Transportation costs are added to the cost of inventory purchased, while purchase discounts are deducted. Cost of goods sold = (beginning inventory) + (net purchases) (ending inventory). 51,950 = [0 + (50, ,000 50) 0] e. 1. Incorrect. No inventory purchased by Erudite was sold by month end, therefore no cost of goods sold was recognized. 2. Correct. 79,200 = [80,000 (2% 50% 80,000)] 3. Incorrect. Only half of the $80,000 outstanding invoice amount was paid. The 2% purchase discount does not affect the Accounts payable account. Accounts payable was decreased by $40, Incorrect. Only half of the $80,000 outstanding invoice amount was paid. Accounts payable was decreased by $40,000. FA1 - Module 4 Page 6 of 60

7 Course Schedule Course Modules Review and Practice Exam Preparation Resources 4.1 Merchandising companies Learning objective Explain merchandising activities and analyze their effects on financial statements. (Level 2) Required reading LEVEL 2 Chapter 6, pages Merchandising companies Service enterprises usually charge a commission or a fee for a service performed while a merchandiser s primary business activity is to buy goods from a manufacturer or supplier and resell them for profit. This difference between how service companies and merchandisers earn income is contrasted in Exhibit 6.1 on page 253. Pages provide more details on merchandise companies and distinguish between wholesale and retail operations. Note that revenue from selling merchandise is called sales and the expense of buying and preparing merchandise inventory sold is cost of goods sold. This accounting treatment is illustrated in the condensed income statement for Z-Mart in Exhibit 6.2 on page 254. By analyzing the income statement in Exhibit 6.2, two common equations used in the reporting of merchandising activities are visible: Net sales Cost of goods sold = Gross profit (also known as Gross margin) Gross profit Operating expenses +/- other revenues and expenses = Net income (or Net loss) In a merchandising company, net sales equals sales less sales discounts and sales returns and allowances. This is discussed further in Topic 4.4. Merchandise inventory represents the cost of the goods held for resale. In reviewing Exhibit 6.3 on page 254, note that merchandise inventory is reported as a current asset. Merchandise inventory is a current asset because you expect to sell it within the next 12 months. Observe also how the general format and the types of accounts presented in the classified balance sheet are much the same as for a service company. Periodic and perpetual inventory systems Some businesses update merchandise inventory records periodically while others do it on a daily basis. Both methods are acceptable under GAAP. A periodic inventory system provides current inventory and cost of goods sold data only when inventory is counted (for example, at year end). This differs from the perpetual inventory system, which provides inventory and cost of goods sold data on a continuous basis. FA1 - Module 4 Page 7 of 60

8 Periodic inventory systems used to be the norm because it was costly to continually update the merchandise inventory records. Advances in technology have changed all this, however, and most businesses now use a perpetual inventory system. The reason is simple companies need timely information in order to properly manage their business. Regardless of the system chosen, a physical inventory count is normally conducted at year end. For periodic systems, this count is necessary to determine the remaining inventory, and from that, the cost of goods sold for the year. For perpetual systems, the focus is slightly different it can check that the inventory records agree to what is actually on hand and account for any differences. Textbook activities Checkpoint Questions 1 to 3 on page 257 (Solutions on page 278) Quick Study 6-1 to 6-4 on pages (Solutions) FA1 - Module 4 Page 8 of 60

9 Quick Study 6-1 A B C D E Net sales... $14,000 $102,000 $68,000 $540,000 $398,000 Cost of goods sold... 8,000 64,000 31, , ,000 Gross profit from sales... $ 6,000 $ 38,000 $37,000 $220,000 $183,000 Operating expenses... 9,000 31,000 22, , ,000 Net income (loss)... $ (3,000) $ 7,000 $15,000 $(41,000) $ 77,000 Quick Study 6-2 a. Periodic AND perpetual inventory systems b. Perpetual inventory systems c. Perpetual inventory systems d. Periodic inventory systems e. Perpetual inventory systems Quick Study 6-3 a. This information reflects a perpetual inventory system = 430 Cost of Goods Sold (credit to Merchandise Inventory and debit to Cost of Goods Sold) b. This information reflects a periodic inventory system = 430 Cost of Goods Sold Quick Study 6-4 a. This information reflects a periodic inventory system = 750 Cost of goods sold b. This information reflects a perpetual inventory system , = 1,125 Cost of Goods Sold FA1 - Module 4 Page 9 of 60

10 Course Schedule Course Modules Review and Practice Exam Preparation Resources 4.2 Merchandise purchases Perpetual inventory system Learning objective Determine the cost of merchandise inventory purchases using a perpetual inventory accounting system. (Level 1) Required reading LEVEL 1 Chapter 6, pages In order for a merchandiser to sell products, it must first acquire those items from a supplier. The purchase of merchandise from suppliers involves a number of activities. Gross purchases Page 257 starts off by illustrating the purchase of inventory by a merchandising company. The $1,200 in the example is the gross purchase price. This amount usually needs to be adjusted for a number of factors that include purchase returns and allowances, trade discounts, purchase discounts, and transportation-in costs. These adjustments result in the cost of inventory differing somewhat from the gross purchase price. The details of how these various elements are accounted for, and the impact on the recorded inventory value, are set out on pages Additional commentary follows. Purchase discounts It is important to distinguish between trade and purchase discounts. A purchase discount is a cash discount that is applied against an amount of merchandise inventory on hand. It is offered by the supplier to encourage early payment. Review the November 12 entry in the middle of page 260. Note that when a purchaser takes advantage of a cash discount, the discount is credited to the Merchandise inventory account under the perpetual inventory system. This reduces the cost of the inventory to the actual amount paid, which is an application of the cost principle. The method described previously of recording the discount only when realized is known as the gross method. If a cash discount is lost due to late payment, the gross method causes merchandise inventory to be slightly overstated, because the discount is not deducted from the recorded cost of the goods. As a result, the lost discount may not come to the attention of management and other users of the financial statements. The net method of recording purchases enters the amount of discounts lost due to late payment. This method is considered to be theoretically superior because inventory is recorded at its lowest available cash price. For example, if $1,200 of merchandise is purchased on November 2 with terms 2/10, n/30 and paid on November 30, the purchaser would record the following entries under the net method: FA1 - Module 4 Page 10 of 60

11 The Purchase discounts lost account is a cost of financing that is included in the operating expense section of the income statement. It is not a component of cost of goods sold. This module and related materials will emphasize the gross method, but you should be aware that for many accounting issues, alternatives are available. The net method is not examinable. Textbook activities Checkpoint Questions 4, 5, and 6 on page 263 (Solutions on page 278) Quick Study 6-5, 6-6, and 6-7 on page 300 (Solutions) FA1 - Module 4 Page 11 of 60

12 Quick Study 6-5 May 1 Merchandise Inventory... 1,200 Accounts Payable... 1,200 To record purchase of merchandise; terms 1/10, n30. Quick Study Accounts Payable... 1,200 Cash... 1,200 To record payment of credit purchase. 15 Merchandise Inventory... 3,000 Accounts Payable... 3,000 To record purchase of merchandise; terms 2/15, n Accounts Payable... 3,000 Merchandise Inventory Cash... 2,940 To record payment of credit purchase within discount period; $3,000 x 2% = $60 discount. Aug. 2 Merchandise Inventory... 14,000 Accounts Payable... 14,000 To record purchase of merchandise; terms 1/5, n15. 4 Accounts Payable... 1,500 Merchandise Inventory... 1,500 To record allowance regarding August 2 credit purchase. 17 Accounts Payable... 12,500 Cash... 12,500 To record payment of credit purchase less allowance; 14,000 1,500 = 12,500. FA1 - Module 4 Page 12 of 60

13 Quick Study 6-7 Mar. 5 Merchandise Inventory... 2,000 Accounts Payable... 2,000 To record purchase of merchandise; (500 $5) 80% = $2,000 7 Accounts Payable Merchandise Inventory To record purchase return; (50/500) $2,000 = $ Accounts Payable... 1,800 Cash... 1,764 Merchandise Inventory To record payment within discount period; $2,000 $200 = $1,800; $1,800 ($1,800 2%) = $1,764 FA1 - Module 4 Page 13 of 60

14 Course Schedule Course Modules Review and Practice Exam Preparation Resources 4.3 An ethics application Cash discounts Learning objective Explain the ethical issues related to cash discounts. (Level 1) Required reading LEVEL 1 Chapter 6, page 261 Cash discounts can give rise to some interesting ethical issues. Some guidance for the practising accountant can be found in CGA-Canada s Code of Ethical Principles and Rules of Conduct. For example, Rule 101 states: A member shall not permit the member s firm name or the member s name to be used with, participate in, or knowingly provide services to any practice, pronouncement, or act that would be of a nature to discredit the profession. 1 Textbook activity Judgement Call on page 261 Detailed analysis 1 Code of Ethical Principles and Rules of Conduct (Vancouver: CGA-Canada, 2010), 6. FA1 - Module 4 Page 14 of 60

15 Course Schedule Course Modules Review and Practice Exam Preparation Resources Analysis of the Accounts Payable Manager case Your dilemma is whether to comply with the current policy or to create a new policy so as not to abuse the contracts with the company s suppliers. Although occasional late payments might happen, it would appear that the system for deliberate lateness is inappropriate and could risk the company s ability to obtain additional credit. Your first step should be to contact your superior to find out if the automatic late payment is indeed the policy and, if so, what rationale supports it. After all, it is possible that the outgoing employee lost his job because of this behaviour. If it is the policy to pay late, then you will have to struggle with your own sense of right and wrong to determine what to do. As a professional accountant, you are expected to act with integrity. You are also to be guided by the fundamental principles of the CGA Code of Ethical Principles and Rules of Conduct. One of the fundamental principles is that CGAs are not to be associated with deceptive information. How do you feel about the practice of blaming someone else (the mailroom staff, for example) for the delay in payment? Professional accounting codes of ethics have provisions that would preclude their members from acting in a manner that discredits the profession. Some people would argue that deliberately holding up payments is unethical and should be discontinued. If creditors are willing to accept late payments, then it would be best to negotiate the terms and make payments as agreed. From another perspective, the late payment may not be objectionable. In some markets, the attempt to take discounts even though payments are late may be accepted as nothing more than a continued phase of the price negotiation process. After all, the creditors can bill the company for the discounts that should not have been taken because the payments were late. For these reasons, some may conclude that the late payment practices in this case do not involve an ethical issue. You may well be asking which answer is right: (1) Is it right to delay payments past the stated due date? or (2) Is this just wrong? There is a general moral principle that can help you decide the circumstances in which either (1) or (2) is the appropriate response. That principle is the idea of reciprocity. People appeal to the idea of reciprocity in the Golden Rule: Do unto others as you would have them do unto you ; and in the so-called Copper Rule: Do not do to others as you would not want done to you. Stable markets depend on there being a significant amount of reciprocity in particular, that people generally keep their agreements with each other; that is, people treat each other reciprocally or fairly. With respect to payment on time or late payments, it is perfectly possible to have a stable and fair market under either condition. So if the general practice in a particular market is that people pay their bills on time, it would be taking unfair advantage of others to deliberately make a practice of late payments. That is, (2) would be your answer it is just wrong to delay payments because late payment would violate legitimate reciprocal expectations. However, if the general norm were for creditors to pay a few days after the due date, then it would be acceptable to follow practice (1) that is, to delay payments. In this case, there is fair treatment because creditors will factor this into their pricing when billing, expecting payment past the due date. FA1 - Module 4 Page 15 of 60

16 Course Schedule Course Modules Review and Practice Exam Preparation Resources 4.4 Revenue from sales and cost of goods sold Perpetual inventory system Learning objective Record the revenue from merchandise sales, the collection of payment, and the accompanying cost of the goods sold. (Level 1) Required reading LEVEL 1 Chapter 6, pages As already mentioned in topic 4.1, for a business engaged in a merchandising activity revenue takes the form of sales. Review Exhibit 6.11 on page 263. The $321,000 is gross sales or sales before subtracting sales discounts and sales returns and allowances. Net sales ($314,700) results after subtracting sales discounts and sales returns and allowances. Gross sales revenue from cash and credit sales is recorded when earned, which is usually when title to the goods changes hands. This occurs when the goods are physically transferred from the seller to the buyer. The entry to record the sale of merchandise on credit under a perpetual inventory system requires two entries, as follows: Recall that under the perpetual inventory system, any transactions affecting the cost of goods sold or merchandise inventory are recorded immediately. Pages explain the nature and accounting for sales discounts and sales returns and allowances. Additional commentary follows. Sales discounts The Sales discount account is a contra revenue account an offset to the Sales account. If the terms are 2/10, n/30 it means the buyer is being offerend a 2% discount if the payment is made within 10 days and the net amount is due within 30 days. So for a $100 purchase, the buyer saves $2 by paying 20 days early. A payment of $98 eliminates the debt of $100. If payment is not made within the discount period, it is equivalent to borrowing $2 on a base amount of $98 (2.04%) for a 20-day period. Because there are twenty-day periods in a year (that is, ), the annual effective rate of missing the discount is about 45% [(1.0204) = 44.6%]! Therefore, the buyer should try to take advantage of available discounts for early payment. If they do not have the cash available, they should borrow the money provided the cost of borrowing is lower than the annual effective rate of missing this discount. Textbook activities FA1 - Module 4 Page 16 of 60

17 Checkpoint Questions 7, 8, and 9 on page 266 (Solutions on page 278) Quick Study 6-8 to 6-10 on page 301 (Solutions) Mid-Chapter Demonstration Problem on page 267 FA1 - Module 4 Page 17 of 60

18 Quick Study 6-8 Sept. 1 Accounts Receivable JenAir... 6,000 Sales... 6,000 To record sale; terms 2/10, n30. Quick Study Cost of Goods Sold... 4,200 Merchandise Inventory... 4,200 To record cost of sales. 14 Cash... 6,000 Accounts Receivable JenAir... 6,000 To record collection from credit customer. 15 Accounts Receivable Dennis Leval... 1,800 Sales... 1,800 To record sale; terms 2/10, n Cost of Goods Sold... 1,500 Merchandise Inventory... 1,500 To record cost of sales. 25 Cash... 1,764 Sales Discounts Accounts Receivable Dennis Leval... 1,800 To record collection within discount period; $1,800 x 2% = $36 discount. Oct. 15 Accounts Receivable Leslie Garth Sales To record sale; terms 1/5, n Cost of Goods Sold Merchandise Inventory To record cost of sales. 16 Sales Returns and Allowances Accounts Receivable Leslie Garth To record allowance. 25 Cash Accounts Receivable Leslie Garth To record collection; = 800. FA1 - Module 4 Page 18 of 60

19 Quick Study 6-10 Apr. 1 Accounts Receivable... 2,000 Sales... 2,000 To record credit sale. 1 Cost of Goods Sold... 1,400 Merchandise Inventory... 1,400 To record cost of sale. 4 Sales Returns and Allowances Accounts Receivable To record sales return. 4 Merchandise Inventory Cost of Goods Sold To restore goods to inventory. 11 Cash... 1,470 Sales Discounts Accounts Receivable... 1,500 To record payment on account; $2,000 $500 = $1,500; $1,500 98% = $1,470. FA1 - Module 4 Page 19 of 60

20 Course Schedule Course Modules Review and Practice Exam Preparation Resources 4.5 Additional merchandising issues Learning objective Record adjustments for a merchandiser. (Level 1) Required reading LEVEL 2 Shrinkage Chapter 6, pages Inventory losses that occur as a result of theft or deterioration are known as inventory shrinkage. Shrinkage is measured differently under the perpetual and periodic inventory systems. LEVEL 1 Under the perpetual inventory system, shrinkage is calculated by comparing a physical inventory count to the unadjusted balance in the merchandise inventory account. Under the periodic inventory system, only the cost of goods on hand and the cost of goods sold are calculated and a direct measure of shrinkage is not provided. The cost of goods sold figure includes the actual cost of goods sold plus the cost of goods stolen or destroyed. Summary of merchandising cost flows Regardless of whether a perpetual or periodic inventory system is in place, the transactions affecting Cost of goods sold on the income statement and Merchandise inventory on the balance sheet are identical. Under both systems, the ending merchandise inventory of one accounting period is the beginning merchandise inventory of the next period. Exhibit 6.5 on page 255 provides a summary of inventory cost flows from beginning inventory to cost of goods sold. Exhibit 6.13 on page 269 summarizes the effects on Merchandise inventory and Cost of goods sold of the purchase and sale issues in the preceding topics, assuming a perpetual inventory system. These same transactions can be summarized through the following equations, which apply under either a perpetual or periodic inventory system: Beginning Merchandise inventory + Net Purchases = Cost of goods available for sale Ending Merchandise inventory = Cost of Goods Sold Where Net purchases equals: Purchases Purchase discounts Purchase returns and allowances + Transportation-in FA1 - Module 4 Page 20 of 60

21 = Net Purchases * Under a perpetual inventory system, shrinkage the difference between ending merchandise inventory per the physical count and ending merchandise inventory per the accounting records is subtracted from ending inventory and added to cost of goods sold as an adjustment at the end of the accounting period. Under a periodic system, ending inventory is determined based on a physical count; therefore, both ending inventory and the resulting cost of goods sold are inclusive of shrinkage. Example 4-1 illustrates the relationship between Cost of goods sold and Merchandise inventory through an analysis of transactions that affect these accounts. Textbook activities Checkpoint Question 10 on page 268 (Solution on page 278) Quick Study on 6-12 on page 301 (Solution) FA1 - Module 4 Page 21 of 60

22 Course Schedule Course Modules Review and Practice Exam Preparation Resources Example 4-1 Effects of transactions on COGS and merchandise inventory Selected information extracted from a company s income statement is shown as follows: Sales $ 300,000 Sales returns 15,000 Sales discounts 4,500 Gross profit from sales 105,000 Net income 55,000 Supplemental records show the following additional information: Beginning inventory 25,000 Purchases 180,000 Purchase returns and allowances 6,000 Purchase discounts 3,600 Transportation-in 11,000 Ending inventory 32,900 A physical count of merchandise inventory at the end of the period revealed an actual balance on hand of $30,900. Required: Calculate the balances for: Solution a. Total operating expenses b. Cost of goods sold c. Ending inventory a. Total operating expenses: Total operating expenses = Gross profit from sales net income = $105,000 $55,000 = $50,000 b. Cost of goods sold: Net sales = Sales sales returns sales discounts = $300,000 $15,000 $4,500 = $280,500 Cost of goods sold = Net sales gross profit from sales = $280,500 $105,000 = $175,500 c. Ending inventory can be confirmed through the following calculations: FA1 - Module 4 Page 22 of 60

23 Goods available for sale = Beginning inventory + purchases returns discounts + transportation-in = $25,000 + $180,000 $6,000 $3,600 + $11,000 = $206,400 Ending inventory = Goods available for sale cost of goods sold = $206,400 $175,500 = $30,900 The calculation of cost of goods sold can also be determined using T-accounts for Merchandise inventory and Cost of goods sold, as follows: Source: Adapted from Larson, Jensen, and Carroll, Fundamental Accounting Principles, 10 th edition, Exercise 6-22, page 306. FA1 - Module 4 Page 23 of 60

24 Quick Study 6-12 July 31 Cost of Goods Sold... 1,900 Merchandise Inventory... 1,900 $34,800 $32,900 = $1,900 Gross profit from sales = Net sales Cost of goods sold = (157,200 1,700 3,500) (102, ,900) = 152, ,900 = 48,100 FA1 - Module 4 Page 24 of 60

25 Course Schedule Course Modules Review and Practice Exam Preparation Resources 4.6 Alternative income statement formats, work sheet, and closing entries Learning objective Prepare income statements in alternative formats and prepare closing entries for a merchandising company. (Level 1) Required reading Chapter 6, pages LEVEL 1 While IFRS does not require that companies use a specific format to present financial statements, IFRS companies are encouraged to separate expenses on the income statement based either on their nature or their function. If a company chooses to present expenses grouped by function, additional information regarding the nature of the expenses must be disclosed. Currently Canadian companies classify expenses using a mix of function and nature with appropriate disclosures. 1 The common types of statements (classified multiple-step, multiple-step, and single-step) are set out in Exhibits 6.15 to 6.16 on pages , with an explanation of their respective merits. For external reporting the multiple-step format is acceptable and if not specified, this is the format that should be used in exams and assignments. Look closely at the work sheet in Exhibit 6.14 on page 270 and observe how the income statement accounts have been carried forward to the various statements. Note that all three statements arrive at the same net income. This is because the information given is the same; only the formatting is different. LEVEL 2 Work sheet for a merchandiser The work sheet for a merchandising company in Exhibit 6.14 on page 270 differs slightly from that for a service business Exhibit 6.14 includes accounts for Merchandise inventory, Sales (rather than Revenues), Sales returns and allowances, Sales discounts, and Cost of goods sold (see bold fonts). The merchandise inventory appearing in the unadjusted trial balance is the unadjusted inventory prior to adjustment for shrinkage. Shrinkage is an additional expense added to cost of goods sold on the income statement. Since cost of goods sold is an expense, any item that increases cost of goods sold will be extended to the income statement s debit column. The adjusted merchandise inventory balance appears on the balance sheet as a current asset and is entered in the balance sheet s debit column. The Sales, Sales returns and allowances, Sales discounts, and Cost of goods sold accounts are extended to the income statement columns. Note how the contra accounts (returns and allowances, discounts) are in the debit column. Do not make the mistake of putting these contra accounts in the credit column with Sales. Remember that both Sales returns and allowances and Sales discounts are debit balance accounts. Textbook activities FA1 - Module 4 Page 25 of 60

26 Closing entries Checkpoint Question 11 on page 274 (Solution on page 278) Quick Study 6-13 on page 302 (Solution) Referring back to page 199 and the first two closing entries for Vertically Inclined Rock Gym, a service business, brought revenue and expense accounts to zero balances. The same is accomplished for a merchandising company by crediting those accounts that appear on the work sheet in the income statement s debit column (including Sales returns and allowances, Sales discounts, and Cost of goods sold) and by debiting those accounts that appear on the work sheet in the income statement s credit column (including Sales). Exhibit 6.21 on page 276 demonstrates the closing entries for a merchandising business. Textbook activities Checkpoint Questions 13 and 14 on page 277 (Solutions on page 278) Quick Study 6-15 on page 302 (Solution) Demonstration Problem with solution on pages This problem provides additional practice in the preparation of merchandising income statements as well as journalizing closing entries for a merchandising company. Pay close attention to "Planning the Solution" on page 280. Remember that the Sales discounts and Sales returns and allowances accounts are contra-revenue accounts. 1 IAS 1, 2010, par. 99 and 100 FA1 - Module 4 Page 26 of 60

27 Quick Study 6-13 a. Classified Multi-Step Income Statement JETCO Income Statement For Year Ended December 31, 2011 Sales... $100 Less: Sales discounts... 4 Net sales... $ 96 Cost of goods sold Gross profit from sales... $ 36 Operating expenses: Selling expenses: Sales salaries expense... $ 15 Advertising expense... 6 Total selling expenses... $ 21 General and administrative expenses: Office salaries expense... $ 10 Office supplies expense... 3 Total general and administrative expenses Total operating expenses Income from operations... $ 2 Other revenues/expenses: Interest revenue... 5 Net income... $ 7 b. Single-Step Income Statement JETCO Income Statement For Year Ended December 31, 2011 Revenues: Net sales... $ 96 Interest revenue... 5 Total revenues... $101 Expenses: Cost of goods sold... $ 60 Selling expenses General and administrative expenses Total expenses Net income... $ 7 FA1 - Module 4 Page 27 of 60

28 Quick Study 6-15 Dec. 31 Sales Income Summary To close Sales. 31 Income Summary Sales Discounts... 3 Sales Returns and Allowances... 4 Cost of Goods Sold Depreciation Expense... 2 Advertising Expense... 7 To close income statement accounts with debit balances. 31 Income Summary Tony Ingram, Capital To close income summary account to capital. 31 Tony Ingram, Capital... 1 Tony Ingram, Withdrawals... 1 To close withdrawals account to capital. FA1 - Module 4 Page 28 of 60

29 Course Schedule Course Modules Review and Practice Exam Preparation Resources 4.7 Periodic and perpetual inventory systems Learning objective Determine the ending merchandise inventory and cost of goods sold using both a periodic and a perpetual inventory accounting system. (Level 2) Required reading LEVEL 2 Appendix 6A, pages The periodic inventory system is seldom used anymore. In today s global marketplace, managers need up-todate, accurate information to stay competitive. Nevertheless, some topical coverage is included here because this system has historical significance and is still used in isolated cases. Appendix 6A on pages contrasts the two types of inventory systems. Note that under a periodic system, the inventory account remains unchanged during the year. Inventory purchases are debited to a temporary expense account Purchases. Related accounts are Purchase returns and allowances (a contra expense account), Purchase discounts (a contra expense account), and Transportation-in (an expense account). Using a periodic system, total cost of goods sold is calculated as Cost of goods sold = Cost of merchandise on hand (beginning inventory) + Net cost of merchandise purchased during period Cost of merchandise on hand (ending inventory) Study the contrasting entries to record Purchases, Purchase returns and allowances, Purchase discounts, Transportation-in, Sales, and Sales returns on pages Note the differences in the unadjusted trial balances in Exhibit 6A.2 on page 285. Compare the income statement in Exhibit 6A.4 on page 289 to that illustrated in Exhibit 6.15 on page 272. In particular, note that cost of goods sold for both is $230,400; the difference between the two is in how the entries were recorded to arrive at that value. Finally, review the differences (bolded in red) in the closing entries between the periodic and perpetual inventory systems in Exhibit 6A.5 on page 290. The cost of goods sold under a periodic system is calculated from a physical count of merchandise inventory on hand and not continuously tracked as with a perpetual inventory system. For example, if a new business was using a periodic system and bought six computers for resale and two computers remain on hand, the units sold would be calculated as 6 2 = 4; four must have been sold (or stolen). The next period starts with two computers, and so on. A periodic system does not provide data about lost units that may result from shrinkage, spoilage, or shoplifting. These losses are hidden in the cost of goods sold figure. Exhibit 4-1 compares the accounting entries for the periodic and perpetual inventory systems and summarizes the differences between the two. FA1 - Module 4 Page 29 of 60

30 Exhibit 6.13 on page 269 shows the flow of entries through the merchandise inventory and COGS accounts. Textbook activities Checkpoint Questions 15 and 16 on page 285 and questions on page 292 (Solutions on page 297) Quick Study 6-16 to 6-19 on pages (Solutions) Mid-appendix Demonstration Problem on page 286 FA1 - Module 4 Page 30 of 60

31 Course Schedule Course Modules Review and Practice Exam Preparation Resources Exhibit 4-1 Comparison of the accounting entries for periodic and perpetual inventory systems FA1 - Module 4 Page 31 of 60

32 Summary of differences Periodic Perpetual Purchases, Purchase returns, and Transportationin accounts are used. All returns and transportation-in costs are recorded as changes to the merchandise inventory account. There is no Cost of goods sold account (instead, the amount is derived from the income statements, using the merchandise inventory or cost of goods sold equation). A Cost of goods sold account is maintained. The merchandise inventory account is unchanged, except by closing entries. The current merchandise inventory balance is always up-to-date. An entry is required to set up ending merchandise inventory. FA1 - Module 4 Page 32 of 60

33 *Quick Study 6-16 a. QS6-5 Periodic May 1 Purchases... 1,200 Accounts Payable... 1,200 To record purchase; terms 1/10, n30. b. QS6-6 Periodic 14 Accounts Payable... 1,200 Cash... 1,200 To record payment of credit purchase. 15 Purchases... 3,000 Accounts Payable... 3,000 To record purchase; terms 2/15, n Accounts Payable... 3,000 Purchase Discounts Cash... 2,940 To record payment within discount period; $3,000 x 2% = $60 discount. Aug. 2 Purchases... 14,000 Accounts Payable... 14,000 To record purchase; terms 1/5, n15. 4 Accounts Payable... 1,500 Purchase Returns and Allowances... 1,500 To record allowance. 17 Accounts Payable... 12,500 Cash... 12,500 To record payment less allowance. FA1 - Module 4 Page 33 of 60

34 *Quick Study 6-16 (concluded) c. QS6-7 Periodic Mar. 5 Purchases... 2,000 Accounts Payable... 2,000 (500 $5) 80% = $2,000 *Quick Study 6-17 a. QS6-8 Periodic 7 Accounts Payable Purchase Returns and Allowances (50/500) $2,000 = $ Accounts Payable... 1,800 Cash... 1,764 Purchase Discounts $1,800 ($1,800 2%) = $1,764 Sept. 1 Accounts Receivable JenAir... 6,000 Sales... 6,000 To record sale; terms 2/10, n Cash... 6,000 Accounts Receivable JenAir... 6,000 To record collection from credit customer. 15 Accounts Receivable Dennis Leval... 1,800 Sales... 1,800 To record sale; terms 2/10, n Cash... 1,764 Sales Discounts Accounts Receivable Dennis Leval... 1,800 To record collection within discount period; $1,800 x 2% = $36 discount. FA1 - Module 4 Page 34 of 60

35 *Quick Study 6-17 (concluded) b. QS6-9 Periodic Oct. 15 Accounts Receivable Leslie Garth Sales To record sale; terms 1/5, n Sales Returns and Allowances Accounts Receivable Leslie Garth To record sales allowance. 25 Cash Accounts Receivable Leslie Garth To record payment less allowance. c. QS Periodic Apr. 1 Accounts Receivable... 2,000 Sales... 2,000 To record sale; terms 2,10, EOM. 4 Sales Returns and Allowances Accounts Receivable To record sales return; returned to inventory. 11 Cash... 1,470 Sales Discounts Accounts Receivable... 1,500 To record payment less return and discount. *Quick Study 6-18 Merchandise inventory, January 1, $ 40,000 Purchases... $180,000 Less: Purchase discounts... 1,400 Add: Transportation-in... 14,000 Net Purchases ,600 Cost of Goods Available for Sale... $232,600 Less: Merchandise inventory, December 31, ,000 Cost of Goods Sold... $210,600 FA1 - Module 4 Page 35 of 60

36 *Quick Study 6-19 Dec 31 Sales ,000 Purchase Discounts... 1,400 Merchandise Inventory... 22,000 Income Summary ,400 To close all credit balance temporary accounts. 31 Income Summary ,000 Merchandise Inventory... 40,000 Sales Returns and Allowances... 27,000 Purchases ,000 Transportation-In... 14,000 Salaries Expense ,000 Depreciation Expense... 31,000 To close all debit balance temporary accounts. 31 Income Summary... 61,400 Kay Bondar, Capital... 61,400 To close the income summary to capital. 31 Kay Bondar, Capital... 65,000 Kay Bondar, Withdrawals... 65,000 To close the withdrawals account to capital. FA1 - Module 4 Page 36 of 60

37 Course Schedule Course Modules Review and Practice Exam Preparation Resources 4.8 Using the information Gross profit ratio Learning objective Calculate the gross profit ratio and interpret and apply this ratio in decision-making scenarios including using the ratio to determine a merchandiser's profitability before operating expenses. (Level 2) Required reading LEVEL 2 You have learned that: Chapter 6, page 274 Net sales Cost of goods sold = Gross profit (or Gross margin) Gross profit Operating expenses +/- other revenues and expenses = Net income For a merchandising company, cost of goods sold is the largest expense. It is therefore useful to understand the profit available after the sale of goods to ensure operating expenses can be covered. The gross profit ratio, also known as the gross margin ratio, helps with this analysis. Gross profit ratio = Gross profit Net sales Example 4-2 illustrates how the gross profit ratio is calculated. Textbook activities Checkpoint Question 12 on page 274 (Solution on page 278) Quick Study 6-11 on page 301, 6-14 on page 302 and 6-20 on page 303 (Solutions) FA1 - Module 4 Page 37 of 60

38 Course Schedule Course Modules Review and Practice Exam Preparation Resources Example 4-2 Gross profit ratio The following account balances were taken from the income statements of three cases. Case X Case Y Case Z Sales $ 8,000 $ 9,100 $ 1,100 Sales discounts Cost of goods sold 4,750 7, The gross profit ratios are calculated as follows: Case X Case Y Case Z Net sales $ 7,750 $ 9,000 $ 1,100 Gross profit (Net sales COGS) $ 3,000 $ 2,000 $ 600 Gross profit ratio (gross profit/net sales) 38.71% 22.22% 54.55% FA1 - Module 4 Page 38 of 60

39 Quick Study 6-11 (a) (b) (c) (d) Sales... $130,000 $512,000 $35,700 $245,700 Sales discounts... (4,200) (16,500) (400) (3,500) Sales returns and allowances... (17,000) (5,000) (5,000) (700) Net sales... $108,800 $490,500 $30,300 $241,500 Cost of goods sold... (76,600) (326,700) (21,300) (125,900) Gross profit from sales... $ 32,200 $163,800 $ 9,000 $115,600 Gross profit ratio % % % % 4 Gross profit ratio calculations*: 1. ($32,200/$108,800) x 100 = 29.60% 2. ($163,800/$490,500)) x 100 = 33.39% 3. ($9,000/$30,300) x 100 = 29.70% 4. ($115,600/$241,500) x 100 = 47.87% *rounded to two decimal places Quick Study 6-14 ($248,000 $114,080)/$248,000 = 0.54 or 54% This means that Willaby realizes a gross margin of 54 for each $1 of sales. Willaby s gross profit ratio of 54% is favourable in comparison to the industry average of 53%, or 53 for each $1 of sales. *Quick Study 6-20 a b c d Sales... $ 130,000 $ 512,000 $ 35,700 $ 245,700 Sales discounts... (4,200) (16,500) (400) (3,500) Net Sales... $125,800 $495,500 $35,300 $242,200 Merchandise inventory, Jan. 1, ,000 21,000 1,500 4,300 Purchases , ,000 29, ,000 Purchase returns and allowances... (4,000) (14,000) (750) (3,100) Cost of goods available for sale... $ 124,000 $ 357,000 $ 29,750 $ 132,200 Merchandise inventory, Dec. 31, (7,500) (22,000) (900) (4,100) Cost of goods sold , ,000 28, ,100 Gross profit from sales... $ 9,300 $160,500 $ 6,450 $114,100 Gross profit ratio % % % % 4 FA1 - Module 4 Page 39 of 60

40 Calculations*: 1. 9,300/125,800 x 100 = 7.39% ,500/495,500 x 100 = 32.39% 3. 6,450/35,300 x 100 = 18.27% ,100/242,200 x 100 = 47.11% *Rounded to two decimal places FA1 - Module 4 Page 40 of 60

41 Course Schedule Course Modules Review and Practice Exam Preparation Resources Module 4 summary Accounting for merchandising activities Explain merchandising activities and analyze their effects on financial statements. Merchandisers purchase merchandise inventory from a wholesaler or directly from a manufacturer and then sell the product to customers. Accounting for merchandising includes revenue from sales, cost of goods sold, and merchandise inventory. For a service enterprise, net income is simply determined by subtracting expenses incurred from service revenues. A merchandiser purchases goods or merchandise and then sells them for the purpose of generating profit. Therefore, the accounting procedures involve accounts additional to those used for service companies. Determine the cost of inventory purchases using a perpetual inventory accounting system. Service enterprise and merchandising company A merchandiser manages inventory by using either a perpetual or a periodic inventory system. Under a perpetual system, Merchandise inventory and Cost of goods sold are updated immediately upon the purchase, sale, and return of any item and adjusted at the end of the period based on a physical inventory count. Under a periodic system, all purchases are debited to a Purchases account rather than merchandise inventory. Merchandise inventory and Cost of goods sold are not updated until the end of the accounting period when a physical count is performed. Merchandise purchases Perpetual inventory system In determining the amount to record as a purchase, trade discounts are subtracted from list prices to calculate the invoice price; this amount is debited to Merchandise inventory. Purchases, purchase discounts, purchase returns and allowances, and transportation-in are all recorded as adjustments to the Merchandise inventory account. Explain the ethical issues related to cash discounts. Dealing with cash discounts can give rise to ethical issues. For example, it is not proper to claim a discount when you pay an invoice after the specified discount date. Guidance on dealing with ethical issues for the practising accountant can be found in CGA- Canada s Code of Ethical Principles and Rules of Conduct. Record the revenue from merchandise sales, the collection of payment, and the accompanying cost of goods sold. In determining the amount to record as a sale, trade discounts are subtracted from list prices to FA1 - Module 4 Page 41 of 60

42 calculate the invoice price; the corresponding cost of goods sold amount is credited to Merchandise inventory. Sales, sales returns and allowances, and sales discounts are recorded in separate accounts. Sales returns that are returned to inventory are all recorded in Merchandise inventory at the cost of the goods sold under a perpetual inventory system. Sales discounts and sales returns and allowances are subtracted from sales to calculate net sales. Cost of goods sold is subtracted from net sales to arrive at gross profit. Under both a perpetual and periodic inventory system, cost of goods sold can be calculated by subtracting the ending inventory from the cost of goods available for sale. The beginning inventory plus net purchases equals the cost of goods available for sale. Record adjustments for a merchandiser. To account for any difference between the physical merchandise inventory count performed at the end of the accounting period and the merchandise inventory account balance in the general ledger, a shrinkage adjustment is recorded by debiting Cost of goods sold and crediting Merchandise inventory. Prepare income statements in alternative formats and prepare closing entries for a merchandising company. Alternative income statement formats include the following: Work sheet Single-step income statement lists cost of goods sold as an operating expense. Multiple-step income statement omits detailed computation of net sales; it combines selling expenses with general and administrative expenses. Classified, multiple-step income statement shows a detailed computation of net sales; operating expenses are classified as to selling expenses or general and administrative expenses. These statements illustrate current convention using a mix of function and nature when classifying expenses with appropriate disclosure. The work sheet for a merchandising company is completed in the same manner as for a service enterprise except that there are additional accounts to include: Sales, Sales returns and allowances, Sales discounts, and Cost of goods sold. Closing entries The closing process for a merchandiser is also similar to a service company, debiting all credit accounts in the income statement columns of the worksheet and crediting all debit accounts in the income statement columns. Determine the ending inventory and cost of goods sold using both a periodic and a perpetual inventory accounting system. Periodic and perpetual inventory systems Under a periodic system, the Merchandise inventory account is not updated until a physical count is performed. In contrast, under a perpetual system, Merchandise inventory is continually updated. Under a periodic inventory system, Cost of Goods sold is not maintained on an ongoing basis; rather, it is determined at year end. A physical count of inventory is required at the end of the accounting period to determine the closing inventory. Cost of goods sold FA1 - Module 4 Page 42 of 60

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