Problem 4-13A Ten-Column Work Sheet and Financial Statements (Appendix)

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1 55231_04_c04_p qxd 7/21/08 9:41 AM Page Chapter 4 Income Measurement and Accrual Accounting Forever Green Landscaping Unadjusted Trial Balance August 31, 2008 Cash $ 6,460 Accounts Receivable 23,400 Supplies on Hand 1,260 Prepaid Insurance 3,675 Equipment 28,800 Accumulated Depreciation Equipment $ 9,200 Buildings 72,000 Accumulated Depreciation Buildings 16,800 Accounts Payable 10,500 Notes Payable 10,000 Capital Stock 40,000 Retained Earnings 42,100 Service Revenue 14,200 Advertising Expense 1,200 Gasoline and Oil Expense 1,775 Wage and Salary Expense 4,230 Totals $142,800 $142, Enter the unadjusted trial balance in the first two columns of a ten-column work sheet. 2. Enter the necessary adjustments in the appropriate columns of the work sheet for each of the following: a. A count of the supplies on hand at the end of August reveals a balance of $730. b. The company paid $4,200 in cash on May 1, 2008, for a two-year insurance policy. c. The equipment has a four-year estimated useful life and no salvage value. d. The buildings have an estimated useful life of 30 years and no salvage value. e. The company leases space in its building to another company. The agreement requires the tenant to pay Forever Green $700 on the 10th of each month for the previous month s rent. f. Wages and salaries earned by employees at the end of August but not yet paid amount to $3,320. g. The company signed a six-month promissory note on August 1, Interest at an annual rate of 12% and the principal amount of $10,000 are due on February 1, Complete the remaining columns of the work sheet. 4. Assume that Forever Green closes its books at the end of each month before preparing financial statements. Prepare the necessary closing entries at August 31, H O M E W O R K LO5,6,8 Problem 4-13A Ten-Column Work Sheet and Financial Statements (Appendix) The following unadjusted trial balance is available for Tenfour Trucking Company on January 31, 2008: Tenfour Trucking Company Unadjusted Trial Balance January 31, 2008 Cash $ 27,340 Accounts Receivable 41,500 Prepaid Insurance 18,000 Warehouse 40,000 Accumulated Depreciation Warehouse $ 21,600 Truck Fleet 240,000 Accumulated Depreciation Truck Fleet 112,500 Land 20,000 Accounts Payable 32,880 Notes Payable 50,000 Interest Payable 4,500 Customer Deposits 6,000 Capital Stock 100,000 Retained Earnings 40,470 Freight Revenue 165,670 Gas and Oil Expense 57,330 Maintenance Expense 26,400 Wage and Salary Expense 43,050 Dividends 20,000 Totals $533,620 $533,620

2 55231_04_c04_p qxd 7/21/08 9:41 AM Page 199 Integrative Problem Enter the unadjusted trial balance in the first two columns of a ten-column work sheet. 2. Enter the necessary adjustments in the appropriate columns of the work sheet for each of the following: a. Prepaid insurance represents the cost of a 24-month policy purchased on January 1, b. The warehouse has an estimated useful life of 20 years and an estimated salvage value of $4,000. c. The truck fleet has an estimated useful life of six years and an estimated salvage value of $15,000. d. The promissory note was signed on January 1, Interest at an annual rate of 9% and the principal of $50,000 are due on December 31, e. The customer deposits represent amounts paid in advance by new customers. A total of $4,500 of the balance in Customer Deposits was earned during January f. Wages and salaries earned by employees at the end of January but not yet paid amount to $8,200. g. Income taxes are accrued at a rate of 30% at the end of each month. 3. Complete the remaining columns of the work sheet. 4. Prepare in good form the following financial statements: a. Income statement for the month ended January 31, 2008 b. Statement of retained earnings for the month ended January 31, 2008 c. Balance sheet at January 31, Compute Tenfour s current ratio. What does this ratio tell you about the company s liquidity? 6. Compute Tenfour s profit margin. What does this ratio tell you about the company s profitability? SOLUTIONS TO KEY TERMS QUIZ 15 Recognition 22 Historical cost 8 Current value 18 Cash basis 11 Accrual basis 2 Revenues 14 Revenue recognition principle 20 Matching principle 23 Expenses 3 Adjusting entries 9 Straight-line method 21 Contra account INTEGRATIVE PROBLEM 10 Deferral 16 Deferred expense 5 Deferred revenue 12 Accrual 19 Accrued liability 7 Accrued asset 24 Accounting cycle 1 Work sheet 6 Real accounts 17 Nominal accounts 4 Closing entries 13 Interim statements Completing Financial Statements, Computing Ratios, Comparing Accrual versus Cash Income, and Evaluating the Company s Cash Needs Mountain Home Health Inc. provides home nursing services in the Great Smoky Mountains of Tennessee. When contacted by a client or referred by a physician, nurses visit the patient and discuss needed services with the physician. Mountain Home Health earns revenue from patient services. Most of the revenue comes from billing insurance companies, the state of Tennessee, or the Medicare program. Amounts billed are recorded in the Billings Receivable account. Insurance companies, states, and the federal government do not fully fund all procedures. For example, the state of Tennessee pays an average H O M E W O R K

3 55231_04_c04_p qxd 7/21/08 9:41 AM Page Chapter 4 Income Measurement and Accrual Accounting 78% of billed amounts. Mountain Home Health has already removed the uncollectible amounts from the Billings Receivable account and reports it and Medical Services Revenue at the net amount. Services provided but not yet recorded totaled $16,000, net of allowances for uncollectible amounts. The firm earns a minor portion of its total revenue directly from patients in the form of cash. Employee salaries, medical supplies, depreciation, and gasoline are the major expenses. Employees are paid every Friday for work performed during the Saturday-to-Friday pay period. Salaries amount to $800 per day. In 2008, December 31 falls on a Wednesday. Medical supplies (average use of $1,500 per week) are purchased periodically to support health-care coverage. The inventory of supplies on hand on December 31 amounted to $8,653. The firm owns five automobiles (all purchased at the same time) that average 50,000 miles per year and are replaced every three years. They typically have no residual value. The building has an expected life of 20 years with no residual value. Straight-line depreciation is used on all of the firm s assets. Gasoline costs, which are a cash expenditure, average $375 per day. The firm purchases a three-year extended warranty contract to cover maintenance costs. The contract costs $9,000. (Assume equal use each year.) On December 29, 2008, Mountain Home Health declared a dividend of $10,000, payable on January 15, The firm makes annual mortgage payments of principal and interest each June 30. The interest rate on the mortgage is 6%. The following unadjusted trial balance is available for Mountain Home Health on December 31, 2008: Mountain Home Health, Inc. Unadjusted Trial Balance December 31, 2008 Debit Credit H O M E W O R K Cash $ 77,400 Billings Receivable (net) 151,000 Medical Supplies 73,000 Extended Warranty 3,000 Automobiles 90,000 Accumulated Depreciation Automobiles $ 60,000 Building 200,000 Accumulated Depreciation Building 50,000 Accounts Payable 22,000 Dividend Payable 10,000 Mortgage Payable 100,000 Capital Stock 100,000 Additional Paid-In Capital 50,000 Retained Earnings 99,900 Medical Services Revenue 550,000 Salary and Wages Expense $ 288,000 Gasoline Expense 137,500 Utilities Expense 12,000 Dividends 10,000 Totals $1,041,900 $1,041, Set up T accounts for each of the accounts listed on the trial balance. Based on the information provided, set up any other T accounts that will be needed to prepare adjusting entries. 2. Post the year-end adjusting entries directly to the T accounts but do not bother to put the entries in journal format first. 3. Prepare a statement of income and a statement of retained earnings for Mountain Home Health for the year ended December 31, Prepare a balance sheet for Mountain Home Health as of December 31, Compute the following as of December 31, 2008: (a) Working capital and (b) Current ratio. 6. Which adjusting entries could cause a difference between cash- and accrual-based income? 7. Mary Francis, controller of Mountain Home, became concerned about the company s cash flow after talking to a local bank loan officer. The firm tries to maintain a seven-week supply of cash to meet the demands of payroll, medical supply purchases, and gasoline. Determine the amount of cash Mountain Home needs to meet the seven-week supply.

4 55231_04_c04_p qxd 7/21/08 9:41 AM Page 201 Answers to POD Reviews 201 ANSWERS TO POD REVIEWS LO1 LO2 LO3 LO4 LO5 LO6 LO7 LO8 1. b 2. a 1. c 2. b 1. a 2. d 1. b 2. c 1. a 2. c 1. c 2. a 1. b 2. a 1. a 2. b H O M E W O R K

5 55231_05_c05_p qxd 7/21/08 7:57 AM Page 202 C H A P T E R 5 Inventories and Cost of Goods Sold Learning Outcomes After studying this chapter, you should be able to: LO1 LO2 LO3 LO4 LO5 LO6 LO7 Identify the forms of inventory held by different types of businesses and the types of costs incurred. Show that you understand how wholesalers and retailers account for sales of merchandise. Show that you understand how wholesalers and retailers account for cost of goods sold. Use the gross profit ratio to analyze a company s ability to cover its operating expenses and earn a profit. Explain the relationship between the valuation of inventory and the measurement of income. Apply the inventory costing methods of specific identification, weighted average, FIFO, and LIFO by using a periodic system. Analyze the effects of the different costing methods on inventory, net LO8 LO9 LO10 LO11 LO12 LO13 income, income taxes, and cash flow. Analyze the effects of an inventory error on various financial statement items. Apply the lower-of-cost-or-market rule to the valuation of inventory. Explain why and how the cost of inventory is estimated in certain situations. Analyze the management of inventory. Explain the effects that inventory transactions have on the statement of cash flows. Explain the differences in the accounting for periodic and perpetual inventory systems and apply the inventory costing methods using a perpetual system (Appendix). Study Links... A Look at the Previous Chapter Chapter 4 completed our introduction to the accounting model. That chapter examined the role of adjusting entries in an accrual accounting system. A Look at This Chapter Starting in this chapter, we move beyond the basic accounting model to consider the accounting for the various elements in the financial statements. We start by looking at how companies that sell a product account for their inventories and the eventual sale of them. A Look at the Upcoming Chapter Each of the remaining chapters in this section of the book examine other assets of a company. Chapter 6 considers the most liquid of all assets, cash, and looks at the ways in which companies maintain control over it and other valuable assets.

6 55231_05_c05_p qxd 7/21/08 7:57 AM Page 203 Gap Inc. M A K I N G B U S I N E S S D E C I S I O N S Billing itself as one of the world s largest specialty retailers, Gap Inc. had its humble beginning when Doris and Don Fisher opened their first store in San Francisco in From that single store, the company has grown to operate more than 3,100 stores and to generate revenue that exceeded $15.9 billion in fiscal It counts among its brands some of the most recognizable in the world of apparel: Gap, Banana Republic, Old Navy, and Piperlime. As a retailer, Gap Inc. measures success in terms of what it earns from buying and selling jeans and other clothing apparel. The statements of income shown here provide an accounting of the company s success in this regard. Net sales have remained relatively steady in each of the last three years, amounting to about $16 billion annually. As is evident from the income statements, the cost that a retailer pays for the merchandise that it sells is the most important factor in determining whether the company is profitable. For Gap Inc., Cost of goods sold and occupancy expenses amounted to approximately $10 billion in each year. One of the biggest challenges a retailer faces is controlling the cost of its inventory while at the same time ensuring the quality of its merchandise. Besides being important for retailers to control the cost of what they sell, it is also imperative that they minimize the amount of stock they carry at any one time. The cost of carrying inventory, including storage and insurance, can be significant. Gap Inc. must minimize the amount of inventory on hand, but at the same time make sure it has enough merchandise to meet customers demands. The significance of inventory as an asset to Gap Inc. is indicated by the partial balance sheet shown here. This chapter looks at the accounting for inventories and cost of goods sold and shows how closely connected they are. We will answer the following important questions: AP Photo/Paul Sakuma When the company makes a sale, how does it determine the amount to assign to the cost of the product sold? (See pp ) How can the relationship between the company s sales and the cost of those sales be used to help assess the company s performance? (See pp ) How can the relationship between Gap Inc. s sales on its income statement and its inventory on the balance sheet be used to assess how well it is managing its inventory? (See pp ) How does Gap Inc. keep track of the cost of its inventory? (See pp ) (continued) 203

7 55231_05_c05_p qxd 7/21/08 7:57 AM Page Chapter 85 Operating Inventories Assets: and Cost Property, of Goods Plant, Soldand Equipment, Natural Resources, and Intangibles Gap, Inc. Consolidated Statements of Income ($ in millions except per share 53 Weeks Ended 52 Weeks Ended 52 Weeks Ended Net sales have amounted to amounts, shares in thousands) February 3, 2007 January 28, 2006 January 29, 2005 about $16 billion in each of Net sales the last three years. $ 15,943 $ 16,023 $ 16,267 Cost of goods sold and 10,294 10,154 9,886 occupancy expenses Gross profit Cost of sales and occupancy expenses have been about $10 billion. 5,649 5,869 6,381 Operating expenses 4,475 4,124 4,296 Loss on early retirement of 105 debt Interest expense Interest income (131) (93) (59) Earnings before income taxes 1,264 1,793 1,872 Income taxes Net earnings $ 778 $ 1,113 $ 1,150 Weighted average number of 831, , ,357 shares basic Weighted average number of 835, , ,122 shares diluted Earnings per share basic $ 0.94 $ 1.26 $ 1.29 Earnings per share diluted $ 0.93 $ 1.24 $ 1.21 See Notes to the Consolidated Financial Statements Gap, Inc. Consolidated Balance Sheets (Partial) ($ In millions, except per value, shares in thousands) February 3, 2007 January 28, 2006 Assets Current assets: Cash and cash equivalents $ 2,030 $ 2,035 Short-term investments Restricted cash The company s inventory on hand increased Merchandise inventory during the year and represents over one 1,796 1,696 Other current assets third of the current assets Total current assets 5,029 5,239 Source: Gap Inc s annual report. The Nature of Inventory LO1 Identify the forms of inventory held by different types of businesses and the types of costs incurred. This chapter discusses accounting by companies that sell products, or what accountants call inventory. Companies that sell inventory can be broadly categorized into two types: Retailers and wholesalers purchase inventory in finished form and hold it for resale. For example, as a retailer Gap Inc. buys clothes directly from other companies and then offers them for sale to consumers. In contrast, manufacturers transform raw materials into a finished product prior to sale. A good example of a manufacturing company is IBM. It buys all of the various materials that are needed to make computers and then sells the finished product to its customers.

8 55231_05_c05_p qxd 7/21/08 7:57 AM Page 205 The Nature of Inventory 205 Whether a company is a wholesaler, retailer, or manufacturer, its inventory is an asset that is held for resale in the normal course of business. The distinction between inventory and an operating asset is the intent of the owner. For example, some of the computers that IBM owns are operating assets because they are used in various activities of the business, such as the payroll and accounting functions. Many more of the computers IBM owns are inventory, however, because the company makes them and intends to sell them. This chapter is concerned with the proper valuation of inventory and the related effect on cost of goods sold. THREE TYPES OF INVENTORY COST AND THREE FORMS OF INVENTORY It is important to distinguish between the types of inventory costs incurred and the form the inventory takes. Wholesalers and retailers incur a single type of cost, the purchase price, of the inventory they sell. On the balance sheet, they use a single account for inventory, titled Merchandise Inventory. Wholesalers and retailers buy merchandise in finished form and offer it for resale without transforming the product in any way. Merchandise companies typically have a relatively large dollar amount in inventory. For example, on its February 3, 2007, balance sheet, Gap Inc. reported merchandise inventory of $1,796 million and total assets of $8,544 million. It is not unusual for inventories to account for half the total assets of a merchandise company. The cost of inventory to a merchandiser is limited to the product s purchase price, which may include other costs mentioned soon. Conversely, three distinct types of costs are incurred by a manufacturer direct materials, direct labor, and manufacturing overhead. Each is explained here. 1. Direct materials, also called raw materials, are the ingredients used in making a product. The costs of direct materials used in making a pair of shoes include the costs of fabric, plastic, and rubber. 2. Direct labor consists of the amounts paid to workers to manufacture the product. The hourly wage paid to an assembly line worker is a primary ingredient in the cost to make the shoes. 3. Manufacturing overhead includes all other costs that are related to the manufacturing process but cannot be directly matched to specific units of output. Depreciation of a factory building and the salary of a supervisor are two examples of overhead costs. Accountants have developed various techniques to assign, or allocate, these manufacturing overhead costs to specific products. Merchandise Inventory The account wholesalers and retailers use to report inventory held for resale. Raw materials The inventory of a manufacturer before the addition of any direct labor or manufacturing overhead. Alternate term: Direct materials. In addition to the three types of costs incurred in a production process, the inventory of a manufacturer takes three distinct forms. The three forms or stages in the development of inventory raw materials, work in process, and finished goods are discussed next. 1. Direct materials or raw materials enter a production process in which they are transformed into a finished product by the addition of direct labor and manufacturing overhead. 2. At any time, including the end of an accounting period, some of the materials have entered the process and some labor costs have been incurred but the product is not finished. The cost of unfinished products is appropriately called work in process or work in progress. 3. Inventory that has completed the production process and is available for sale is called finished goods. Finished goods are the equivalent of merchandise inventory for a retailer or wholesaler in that both represent the inventory of goods held for sale. Work in process The cost of unfinished products in a manufacturing company. Alternate term: Work in progress. Finished goods A manufacturer s inventory that is complete and ready for sale.

9 55231_05_c05_p qxd 7/21/08 7:57 AM Page Chapter 5 Inventories and Cost of Goods Sold Many manufacturers disclose the dollar amounts of the various forms of inventory in their annual report. For example, IBM disclosed on p. 79 of its 2006 annual report the following amounts, stated in millions of dollars: Inventories: at December 31 Millions Finished goods $ 506 Work in process and raw materials 2,304 $2,810 As you can see, finished goods make up less than 20% of IBM s total inventories. However, this may not be the case for other types of businesses, where finished goods are more significant. For example, consider the following excerpt from Caterpillar Inc. s 2006 annual report: December 31 (In millions) Raw materials $2,182 Work in process 977 Finished goods 2,915 Supplies 277 Total inventories $6,351 As the company that makes construction machinery and other related products, Caterpillar has nearly one-half of its inventory in finished products. Exhibit 5-1 summarizes the relationships between the types of costs incurred and the forms of inventory for different types of businesses. POD REVIEW 5.1 LO1 Identify the forms of inventory held by different types of businesses and the types of costs incurred. Inventory is a current asset held for resale in the normal course of business. The nature of inventory held depends on whether a business is a reseller of goods (wholesaler or retailer) or a manufacturer. Resellers incur a single cost to purchase inventory held for sale. Manufacturers incur costs that can be classified as raw materials, direct labor, and manufacturing overhead. QUESTIONS 1. The inventory of a retailer is limited to a single type of cost, the purchase price of the inventory it sells. The three distinct types of cost to a manufacturer are a. direct materials, direct labor, and work in process. b. direct materials, direct labor, and manufacturing overhead. c. direct labor, manufacturing overhead, and finished goods. d. none of the above. 2. The three forms or states in the development of inventory for a manufacturer are a. direct materials, direct labor, and finished goods. b. direct materials, direct labor, and manufacturing overhead. c. direct materials, work in process, and finished goods. d. none of the above.

10 55231_05_c05_p qxd 7/21/08 7:57 AM Page 207 Net Sales of Merchandise 207 EXHIBIT 5-1 Relationships between Types of Businesses and Inventory Costs Type of Business Inventory Costs Included in Inventory Retailer/Wholesaler Manufacturer Merchandise inventory Raw materials Work in process Finished goods Cost to purchase Cost of materials before entered into production Costs of direct materials used, direct labor, and overhead in unfinished items Cost of completed but unsold items Net Sales of Merchandise A condensed multiple-step income statement for Daisy s Running Depot is presented in Exhibit 5-2. First note the period covered by the statement: for the year ended December 31, Daisy s ends its fiscal year on December 31; however, many merchandisers end their fiscal year on a date other than December 31. Retailers often choose a date toward the end of January because the busy holiday shopping season is over and time can be devoted to closing the records and preparing financial statements. For example, Gap Inc. ends its fiscal year on the Saturday closest to the end of January. We will concentrate on the first two items on Daisy s statement: net sales and cost of goods sold. The major difference between this income statement and one for a service company is the inclusion of cost of goods sold. Because a service company does not sell a product, it does not report cost of goods sold. On the income statement of a merchandising company, cost of goods sold is deducted from net sales to arrive at gross profit or gross margin. The first section of Daisy s income statement is presented in Exhibit 5-2. Two deductions for sales returns and allowances and sales discounts are made from sales revenue to arrive at net sales. Sales revenue, or sales, is a representation of the inflow of assets, either cash or accounts receivable, from the sale of a product during the period. LO2 Show that you understand how wholesalers and retailers account for sales of merchandise. Gross profit Net sales less cost of goods sold. Alternate term: Gross margin. Net sales Sales revenue less sales returns and allowances and sales discounts. Sales revenue A representation of the inflow of assets. Alternate term: Sales. EXHIBIT 5-2 Condensed Income Statement for a Merchandiser Daisy s Running Depot Income Statement For the Year Ended December 31, 2008 Net sales $100,000 Cost of goods sold 60,000 Gross profit $ 40,000 Selling and administrative expenses 29,300 Net income before tax $ 10,700 Income tax expense 4,280 Net income $ 6,420

11 55231_05_c05_p qxd 7/21/08 7:57 AM Page Chapter 5 Inventories and Cost of Goods Sold Sales Returns and Allowances Contra-revenue account used to record refunds to customers and reductions of their accounts. Study Tip Recall Accumulated Depreciation, a contra account introduced in Chapter 4. It reduces a long-term asset. In other cases, such as this one involving sales, a contra account reduces an income statement account. Sales Discounts A contra-revenue account used to record discounts given to customers for early payment of their accounts. SALES RETURNS AND ALLOWANCES The cornerstone of marketing is to satisfy the customer. Most companies have standard policies that allow the customer to return merchandise within a stipulated period of time. Nordstrom, the Seattle-based retailer, has a very liberal policy regarding returns. That policy has, in large measure, fueled its growth. A company s policy might be that a customer who is not completely satisfied can return the merchandise anytime within 30 days of purchase for a full refund. Alternatively, the customer may be given an allowance for spoiled or damaged merchandise that is, the customer keeps the merchandise but receives a credit for a certain amount in the account balance. Typically, a single account, Sales Returns and Allowances, is used to account for both returns and allowances. If the customer has already paid for the merchandise, either a cash refund is given or the credit amount is applied to future purchases. CREDIT TERMS AND SALES DISCOUNTS Most companies have a standard credit policy. Special notation is normally used to indicate a particular firm s policy for granting credit. For example, credit terms of n/30 mean that the net amount of the selling price (i.e., the amount determined after deducting any returns or allowances) is due within 30 days of the date of the invoice. Net, 10 EOM means that the net amount is due anytime within ten days after the end of the month in which the sale took place. Another common element of the credit terms offered to customers is sales discounts, a reduction from the selling price given for early payment. For example, assume that Daisy s offers a customer credit terms of 1/10, n/30. This means that the customer can deduct 1% from the selling price if the bill is paid within ten days of the date of the invoice. Normally the discount period begins the day after the invoice date. If the customer does not pay within the first 10 days, the full invoice amount is due within 30 days. Finally, note that the use of n for net in this notation is a misnomer. Although the amount due is net of any returns and allowances, it is the gross amount that is due within 30 days. That is, no discount is given if the customer does not pay early. How valuable to the customer is a 1% discount for payment within the first ten days? Assume that a $1,000 sale is made. If the customer pays at the end of ten days, the cash paid will be $990 rather than $1,000, a net savings of $10. The customer has saved $10 by paying 20 days earlier than required by the 30-day term. If we assume 360 days in a year, there are 360/20, or 18, periods of 20 days each in a year. Thus, a savings of $10 for 20 days is equivalent to a savings of $10 times 18, or $180 for the year. An annual return of $180/$990, or 18.2%, would be difficult to match with any other type of investment. In fact, a customer might want to consider borrowing the money to pay off the account early. The Sales Discounts account is a contra-revenue account and thus reduces sales as shown on the income statement in Exhibit 5-3. EXHIBIT 5-3 Net Sales Section of the Income Statement Daisy s Running Depot Partial Income Statement For the Year Ended December 31, 2008 Sales revenue $103,500 Less: Sales returns and allowances 2,000 Sales discounts 1,500 Net sales $100,000

12 55231_05_c05_p qxd 7/21/08 7:57 AM Page 209 The Cost of Goods Sold 209 Hot Topics Hot Topics AP Photo/Paul Sakuma Some Work and Some Don t Not every marketing idea pans out for companies and certainly not in the fashion-conscious retail sector. Gap Inc. discovered this recently when it decided to close its 19 Forth & Towne stores. The marketing concept was started as a pilot program in 2005 but did not sustain the type of growth necessary to become a full-fledged member of the family, which includes the well-known Gap, Banana Republic, and Old Navy brand names. The brunt of the accounting implications for closure of the Forth & Towne stores was felt during the 2007 fiscal year. The loss for the first half of 2007 amounted to approximately $54 million. In the end, Gap made a difficult business decision to cut its losses and to invest in its existing brands as well as to provide support for other projects with the potential to be around for the long haul. Source: POD REVIEW 5.2 LO2 Show that you understand how wholesalers and retailers account for sales of merchandise. Net sales represents sales less deductions for discounts and merchandise returned (returns and allowances) and is a key figure on the income statement. Sales discounts are given to customers who pay their bills promptly. Returns and allowances have the same effect on sales that sales discounts do; that is, they reduce sales. QUESTIONS 1. Net sales is equal to a. sales revenue less sales returns and allowances and sales discounts. b. sales revenue less cost of goods sold. c. sales revenue less selling and administrative expenses. d. none of the above. 2. What type of account is Sales Discounts? a. contra-asset b. revenue c. contra-revenue d. expense The Cost of Goods Sold The cost of goods sold section of the income statement for Daisy s is shown in Exhibit 5-4. Let s take a look at the basic model for cost of goods sold. THE COST OF GOODS SOLD MODEL The recognition of cost of goods sold as an expense is an excellent example of the matching principle. Sales revenue represents the inflow of assets, in the form of cash and LO3 Show that you understand how wholesalers and retailers account for cost of goods sold.

13 55231_05_c05_p qxd 7/21/08 7:57 AM Page Chapter 5 Inventories and Cost of Goods Sold EXHIBIT 5-4 Cost of Goods Sold Section of the Income Statement Daisy s Running Depot Partial Income Statement For the Year Ended December 31, 2008 Cost of goods sold: Inventory, January 1, 2008 $15,000 Purchases $65,000 Less: Purchase returns and allowances 1,800 Purchase discounts 3,700 Net purchases $59,500 Add: Transportation-in 3,500 Cost of goods purchased 63,000 Cost of goods available for sale $78,000 Less: Inventory, December 31, ,000 Cost of goods sold $60,000 Cost of goods available for sale Beginning inventory plus cost of goods purchased. accounts receivable, from the sale of products during the period. Likewise, cost of goods sold represents the outflow of an asset, inventory, from the sale of those same products. The company needs to match the revenue of the period with one of the most important costs necessary to generate the revenue, the cost of the merchandise sold. It may be helpful in understanding cost of goods sold to realize what it is not. Cost of goods sold is not necessarily equal to the cost of purchases of merchandise during the period. Except in the case of a new business, a merchandiser starts the year with a certain stock of inventory on hand, called beginning inventory. For Daisy s, beginning inventory is the dollar cost of merchandise on hand on January 1, During the year, Daisy s purchases merchandise. When the cost of goods purchased is added to beginning inventory, the result is cost of goods available for sale. Just as the merchandiser starts the period with an inventory of merchandise on hand, a certain amount of ending inventory is usually on hand at the end of the year. For Daisy s, this is its inventory on December 31, As shown in Exhibit 5-5, think of cost of goods available for sale as a pool of costs to be distributed between what was sold and what was not sold. If we subtract from the pool the cost of what did not sell, the ending inventory, we will have the amount that did EXHIBIT 5-5 The Cost of Goods Sold Model Beginning inventory Purchases of merchandise Cost of Goods Available for Sale Ending Inventory (amount not sold) Cost of Goods Sold (amount sold)

14 55231_05_c05_p qxd 7/21/08 7:57 AM Page 211 The Cost of Goods Sold 211 sell, the cost of goods sold. Cost of goods sold is simply the difference between the cost of goods available for sale and the ending inventory. Cost of goods sold Cost of goods available for sale minus ending inventory. Beginning inventory Cost of goods purchased Cost of goods available for sale Ending inventory Cost of goods sold What is on hand to start the period What was acquired for resale during the period The pool of costs to be distributed What was not sold during the period and therefore is on hand to start the next period What was sold during the period The cost of goods sold model for a merchandiser is illustrated in Exhibit 5-6. The amounts used for the illustration are taken from the cost of goods sold section of Daisy s income statement as shown in Exhibit 5-4. Notice that ending inventory exceeds beginning inventory by $3,000. That means that the cost of goods purchased exceeds cost of goods sold by that same amount. Indeed, a key point for stockholders, bankers, and other users is whether inventory is building up, that is, whether a company is not selling as much inventory during the period as it is buying. A buildup may indicate that the company s products are becoming less desirable or that prices are becoming uncompetitive. INVENTORY SYSTEMS: PERPETUAL AND PERIODIC Before looking more closely at the accounting for cost of goods sold, you need to understand the difference between the periodic and the perpetual inventory systems. All businesses use one of these two distinct approaches to account for inventory. With the perpetual system, the Inventory account is updated perpetually, or after each sale or purchase of merchandise. Conversely, with the periodic system, the Inventory account is updated only at the end of the period. In a perpetual system, every time goods are purchased, the Inventory account is increased with a debit, with a corresponding credit for an increase in Accounts Payable for a credit purchase or a credit for a decrease in the Cash account for a cash purchase. In addition to recognizing the increases in Accounts Receivable or Cash and in Sales Revenue when goods are sold, the accountant also records an entry to recognize the cost of the goods sold and the decrease in the cost of inventory on hand. Perpetual system A system in which the Inventory account is increased at the time of each purchase and decreased at the time of each sale. Periodic system A system in which the Inventory account is updated only at the end of the period. EXHIBIT 5-6 The Cost of Goods Sold Model: Example for a Merchandiser Description Item Amount Merchandise on hand to start the period Beginning inventory $15,000 Acquisitions of merchandise during the period Pool of merchandise available for sale during the period Merchandise on hand at end of period Cost of goods purchased Cost of goods available for sale Ending inventory 63,000 $78,000 (18,000) A $3,000 excess of ending inventory over beginning inventory means that the company bought $3,000 more than it sold ($63,000 bought versus $60,000 sold). Expense recognized on the income statement Cost of goods sold $60,000

15 55231_05_c05_p qxd 7/21/08 7:57 AM Page Chapter 5 Inventories and Cost of Goods Sold Assume for example that Daisy s sells a pair of running shoes that costs the company $70. In addition to the entry to record the sale, Daisy s would also record this entry: Cost of Goods Sold 70 Inventory 70 To record the sale of inventory under perpetual system. Balance Sheet Income Statement ASSETS LIABILITIES STOCKHOLDERS EQUITY REVENUES EXPENSES Inventory (70) Cost of Goods Sold (70) Real World Practice 5-1 Understanding Gap Inc. s Inventory System Given the nature of its products, would you expect that Gap Inc. uses a perpetual or a periodic inventory system? Explain your answer. Thus, at any point during the period, the inventory account is up to date. It has been increased for the cost of purchases during the period and reduced for the cost of the sales. Why don t all companies use the procedure just described, the perpetual system? Depending on the volume of inventory transactions (i.e., purchases and sales of merchandise), a perpetual system can be extremely costly to maintain. Historically, businesses with a relatively small volume of sales at a high unit price have used perpetual systems. For example, dealers in automobiles, furniture, appliances, and jewelry normally use a perpetual system. Each purchase of a unit of merchandise, such as an automobile, can be easily identified and an increase recorded in the Inventory account. For instance, when an auto is sold, the dealer can determine the cost of the particular car sold by looking at a perpetual inventory record. However, can you imagine a similar system for a supermarket or a hardware store? Consider a checkout stand in a grocery store. Through the use of a cash register tape, the sales revenue for that particular stand is recorded at the end of the day. Because of the tremendous volume of sales of various items of inventory, from cans of vegetables to boxes of soap, it may not be feasible to record the cost of goods sold every time a sale takes place. This illustrates a key point in financial information: the cost of the information should never exceed its benefit. If a store manager had to stop and update the records each time a can of Campbell s soup was sold, the retailer s business would be disrupted. To a certain extent, the ability of mass merchandisers to maintain perpetual inventory records has improved with the advent of point-of-sale terminals. When a cashier runs a can of corn over the sensing glass at the checkout stand and the bar code is read, the company s computer receives a message that a can of corn has been sold. In some companies, however, an update of the inventory record is in units only and is used as a means to determine when a product needs to be reordered. The company still relies on a periodic system to maintain the dollar amount of inventory. The remainder of this chapter limits its discussion to the periodic system. The perpetual system is discussed in more detail in the appendix to this chapter. BEGINNING AND ENDING INVENTORIES IN A PERIODIC SYSTEM In a periodic system, the Inventory account is not updated each time a sale or purchase is made. Throughout the year, the Inventory account contains the amount of merchandise on hand at the beginning of the year. The account is adjusted only at the end of the year. A company using the periodic system must physically count the units of inventory on hand at the end of the period. The number of units of each product is then multiplied by the cost per unit to determine the dollar amount of ending inventory. Refer to Exhibit 5-4 for Daisy s Running Depot. The procedure just described was used to determine its ending inventory of $18,000. Because one period s ending inventory is the next period s beginning inventory, the beginning inventory of $15,000 was based on the count at the end of the prior year. In summary, the ending inventory in a periodic system is determined by counting the merchandise, not by looking at the Inventory account at the end of the period. The periodic system results in a trade-off. Use of the periodic system reduces record keeping but at the expense of a certain degree of control. Losses of merchandise due to theft, breakage, spoilage, or other reasons may go undetected in a periodic system because management may assume that all merchandise not on hand at the end of the year was sold. In a retail

16 55231_05_c05_p qxd 7/21/08 7:57 AM Page 213 The Cost of Goods Sold 213 EXHIBIT 5-7 Cost of Goods Purchased Daisy s Running Depot Partial Income Statement For the Year Ended December 31, 2008 Purchases $65,000 Less: Purchase returns and allowances 1,800 Purchase discounts 3,700 Net purchases $59,500 Add: Transportation-in 3,500 Cost of goods purchased $63,000 store, some of the merchandise may have been shoplifted rather than sold. In contrast, with a perpetual inventory system, a count of inventory at the end of the period serves as a control device. For example, if the Inventory account shows a balance of $45,000 at the end of the year but only $42,000 of merchandise is counted, management is able to investigate the discrepancy. No such control feature exists in a periodic system. In addition to the loss of control, the use of a periodic system presents a dilemma when a company wants to prepare interim financial statements. Because most companies that use a periodic system find it cost-prohibitive to count the entire inventory more than once a year, they use estimation techniques to determine inventory for monthly or quarterly statements. These techniques are discussed later in this chapter. THE COST OF GOODS PURCHASED The cost of goods purchased section of Daisy s income statement is shown in Exhibit 5-7. The company purchased $65,000 of merchandise during the period. Two amounts are deducted from purchases to arrive at net purchases: purchase returns and allowances of $1,800 and purchase discounts of $3,700. The cost of $3,500 incurred by Daisy s to ship the goods to its place of business is called transportation-in and is added to net purchases of $59,500 to arrive at the cost of goods purchased of $63,000. Another name for transportation-in is freight-in. Purchases Assume that Daisy s buys shoes on account from Nike at a cost of $4,000. Purchases is the temporary account used in a periodic inventory system to record acquisitions of merchandise. The journal entry to record the purchase is as follows: Transportation-in An adjunct account used to record freight costs paid by the buyer. Alternate term: Freight-in. Feb. 8 Purchases 4,000 Accounts Payable 4,000 To record the purchase of merchandise on account. Balance Sheet Income Statement ASSETS LIABILITIES STOCKHOLDERS EQUITY REVENUES EXPENSES Accounts Payable 4,000 Purchases (4,000) It is important to understand that Purchases is not an asset account. It is included in the income statement as an integral part of the calculation of cost of goods sold and is therefore shown as a reduction of owners equity in the accounting equation. Because Purchases is a temporary account, it is closed at the end of the period. Purchase Returns and Allowances Returns and allowances were discussed earlier in the chapter from the seller s point of view. From the standpoint of the buyer, purchase returns and allowances are reductions in the cost to purchase merchandise. Rather than record these reductions directly in the Purchases account, the accountant uses a separate account. The account, Purchase Returns and Allowances, is a contra account to Purchases. Because Purchases has a normal debit balance, the normal balance in Purchase Returns and Allowances is a credit balance. The use of a contra Purchases An account used in a periodic inventory system to record acquisitions of merchandise. Purchase Returns and Allowances A contra-purchases account used in a periodic inventory system when a refund is received from a supplier or a reduction is given in the balance owed to a supplier.

17 55231_05_c05_p qxd 7/21/08 7:57 AM Page Chapter 5 Inventories and Cost of Goods Sold account allows management to monitor the amount of returns and allowances. For example, a large number of returns during the period relative to the amount purchased may signal that the purchasing department is not buying from reputable sources. Suppose that Daisy s returns $850 of merchandise to Nike for credit on Daisy s account. The return decreases both liabilities and purchases. Note that because a return reduces purchases, it actually increases net income and thus also increases owners equity. The journal entry is as follows: Sept. 6 Accounts Payable 850 Purchase Returns and Allowances 850 To record the return of merchandise for credit to account. Balance Sheet Income Statement ASSETS LIABILITIES STOCKHOLDERS EQUITY REVENUES EXPENSES Accounts Payable (850) Purchases Returns and Allowances 850 The entry to record an allowance for merchandise retained rather than returned is the same as the entry for a return. Purchase Discounts Discounts were discussed earlier in the chapter from the seller s viewpoint. Merchandising companies often purchase inventory on terms that allow for a cash discount for early payment, such as 2/10, net 30. To the buyer, a cash discount is called a purchase discount and results in a reduction of the cost to purchase merchandise. Management must monitor the amount of purchase discounts taken as well as those opportunities missed by not taking advantage of the discounts for early payment. Assume a purchase of merchandise on March 13 for $500, with credit terms of 1/10, net 30. The entry at the time of the purchase is as follows: Mar. 13 Purchases 500 Accounts Payable 500 To record purchase on account, terms 1/10, net 30. Balance Sheet Income Statement ASSETS LIABILITIES STOCKHOLDERS EQUITY REVENUES EXPENSES Accounts Payable 500 Purchases (500) If the company does not pay within the discount period, the accountant simply makes an entry to record the payment of $500 cash and the reduction of accounts payable. However, assume that the company does pay its account on March 23, within the discount period. The following entry would be made: Mar. 23 Accounts Payable 500 Cash 495 Purchase Discounts 5 To record payment on account. Balance Sheet Income Statement ASSETS LIABILITIES STOCKHOLDERS EQUITY REVENUES EXPENSES Cash (495) Accounts Payable (500) Purchases Discounts 5 Purchase Discounts A contra-purchases account used to record reductions in purchase price for early payment to a supplier. The Purchase Discounts account is contra to the Purchases account and thus increases owners equity, as shown in the previous accounting equation. Also note in Exhibit 5-7 that purchase discounts are deducted from purchases on the income statement. Finally, note that the effect on the income statement is the same as illustrated earlier for a purchase return: because purchases are reduced, net income is increased.

18 55231_05_c05_p qxd 7/21/08 7:57 AM Page 215 The Cost of Goods Sold 215 Shipping Terms and Transportation Costs The cost principle governs the recording of all assets. All costs necessary to prepare an asset for its intended use should be included in its cost. The cost of an item to a merchandising company is not necessarily limited to its invoice price. For example, any sales tax paid should be included in computing total cost. Any transportation costs incurred by the buyer should likewise be included in the cost of the merchandise. The buyer does not always pay to ship the merchandise. This depends on the terms of shipment. Goods are normally shipped either FOB destination point or FOB shipping point; FOB stands for free on board. When merchandise is shipped FOB destination point, it is the responsibility of the seller to deliver the products to the buyer. Thus, the seller either delivers the product to the customer or pays a trucking firm, the railroad, or another carrier to transport it. Alternatively, the agreement between the buyer and the seller may provide for the goods to be shipped FOB shipping point. In this case, the merchandise is the responsibility of the buyer as soon as it leaves the seller s premises. When the terms of shipment are FOB shipping point, the buyer incurs transportation costs. Refer to Exhibit 5-7. Transportation-in represents the freight costs Daisy s paid for inbound merchandise. These costs are added to net purchases, as shown in the exhibit, and increase the cost of goods purchased. Assume that on delivery of a shipment of goods, Daisy s pays an invoice for $300 from Rocky Mountain Railroad. The terms of shipment are FOB shipping point. The entry on the books of Daisy s follows. FOB destination point Terms that require the seller to pay for the cost of shipping the merchandise to the buyer. FOB shipping point Terms that require the buyer to pay for the shipping costs. May 10 Transportation-in 300 Cash 300 To record the payment of freight costs. Balance Sheet Income Statement ASSETS LIABILITIES STOCKHOLDERS EQUITY REVENUES EXPENSES Cash (300) Transportation-in (300) The total of net purchases and transportation-in is called the cost of goods purchased. Transportation-in will be closed at the end of the period. In summary, cost of goods purchased consists of the following: Purchases Less: Purchase returns and allowances Purchase discounts Equals: Net purchases Add: Transportation-in Equals: Cost of goods purchased How should the seller account for the freight costs it pays when the goods are shipped FOB destination point? This cost, sometimes called transportation-out, is not an addition to the cost of purchases of the seller; instead, it is one of the costs necessary to sell the merchandise. Transportation-out is classified as a selling expense on the income statement. Shipping Terms and Transfer of Title to Inventory Terms of shipment take on additional significance at the end of an accounting period. It is essential that a company establish a proper cutoff at year-end. For example, what if Daisy s purchases merchandise that is in transit at the end of the year? To whom does the inventory belong, Daisy s or the seller? The answer depends on the terms of shipment. If goods are shipped FOB destination point, they remain the legal property of the seller until they reach their destination. Alternatively, legal title to goods shipped FOB shipping point passes to the buyer as soon as the seller turns the goods over to the carrier. The example in Exhibit 5-8 is intended to summarize the discussion about shipping terms and ownership of merchandise. Assume that Nike sells running shoes to Daisy s toward the end of the year and that the merchandise is in transit at the end of the year. Nike, the seller of the goods, pays the transportation charges only if the terms are FOB destination point. However, Nike records a sale for goods in transit at year-end only if

19 55231_05_c05_p qxd 7/21/08 7:57 AM Page Chapter 5 Inventories and Cost of Goods Sold EXHIBIT 5-8 Shipping Terms and Transfer of Title to Inventory FACTS Assume that on December 28, 2008, Nike ships running shoes to Daisy s Running Depot. The trucking company delivers the merchandise to Daisy s on January 2, Daisy s fiscal year-end is December 31. If Merchandise Is Shipped FOB Company Destination Point Shipping Point Nike Pay freight costs? Yes No (seller) Record sale in 2008? No Yes Include inventory on balance sheet at December 31, 2008? Yes No Daisy s Pay freight costs? No Yes (buyer) Record purchase in 2008? No Yes Include inventory on balance sheet at December 31, 2008? No Yes POD REVIEW 5.3 the terms of shipment are FOB shipping point. If Nike does not record a sale because the goods are shipped FOB destination point, the inventory appears on its December 31 balance sheet. Daisy s, the buyer, pays freight costs only if the goods are shipped FOB shipping point. Only in this situation does Daisy s record a purchase of the merchandise and include it as an asset on its December 31 balance sheet. LO3 Show that you understand how wholesalers and retailers account for cost of goods sold. The cost of goods sold represents goods sold, as opposed to the inventory purchased during the year. Cost of goods sold is matched with the sales of the period. The cost of goods sold in any one period is equal to: Beginning inventory Purchases Ending inventory. Under the perpetual method, the inventory account is updated after each sale or purchase of merchandise. In contrast, under the periodic method, the inventory account is updated only at the end of the period. The cost of goods purchased includes any costs necessary to acquire the goods less any purchase discounts, returns, and allowances. Transportation-in is the cost to ship goods to a company and is typically classified as part of cost of goods purchased. QUESTIONS 1. Cost of goods available for sale is equal to a. cost of goods sold less beginning inventory. b. beginning inventory less ending inventory. c. beginning inventory less cost of goods sold. d. none of the above. 2. The type of inventory system in which the Inventory account is updated at the time of each sale is called a. a periodic system. b. a perpetual system. c. an accrual system. d. none of the above.

20 55231_05_c05_p qxd 7/21/08 7:57 AM Page 217 The Gross Profit Ratio 217 The Gross Profit Ratio The first three lines on Daisy s income statement in Exhibit 5-2 are as follows: Net sales $100,000 Cost of goods sold 60,000 Gross profit $ 40,000 The relationship between gross profit and net sales as measured by the gross profit ratio is one of the most important measures used by managers, investors, and creditors to assess the performance of a company. LO4 Use the gross profit ratio to analyze a company s ability to cover its operating expenses and earn a profit. Gross profit ratio Gross profit divided by net sales. Gross Profit Ratio Formula Gross Profit Net Sales For Daisy Sporting Goods $40,000 $100,000 40% A 40% gross profit ratio says that for every dollar of sales, Daisy has a gross profit of 40 cents. In other words, after deducting 60 cents for the cost of the product, the company has 40 cents on the dollar to cover its operating costs and to earn a profit. We will now apply the ratio decision model to analyze this ratio for Gap Inc. USING THE RATIO DECISION MODEL: ANALYZING THE GROSS PROFIT RATIO Use the following Ratio Decision Model to evaluate the gross profit ratio for Gap Inc. or any other public company. 1. Formulate the Question The gross profit ratio tells us how many cents on every dollar are available to cover expenses other than cost of goods sold and to earn a profit. How much of the sales revenue is used for the cost of the products? Thus, how much is left to cover other expenses and to earn net income? 2. Gather the Information from the Financial Statements Both gross profit and net sales are reported on Gap Inc. s income statement for its 2006 fiscal year: Net sales: From the Income Statement for the Year Gross profit: From the Income Statement for the Year 3. Calculate the Ratio Gross Profit Ratio Gross Profit Net Sales (continued)