CHAPTER 5 Solutions THE OPERATING CYCLE AND MERCHANDISING OPERATIONS

CHAPTER 5 Solutions THE OPERATING CYCLE AND MERCHANDISING OPERATIONS Chapter 5, SE 1. 1. 2. 3. 4. d c a b Chapter 5, SE 2. Financial ratios computed Current Assets = $ 5,000 + $2,000 + $1,000 + $6,000 = $14,000 Working Capital = Current Assets Current Liabilities = $14,000 = $7,500 $6,500 Current Ratio = Current Assets Current Liabilities = $14,000 = $6,500 2.15 Chapter 5, SE 3. Days to sell inventory Add days to collect for the sale Less creditors' payment terms Financing period 40 25 (33) 32 252

Chapter 5, SE 4. List price Less 40 percent trade discount Dealer price Shipping cost Cost of tooling machine Less sales discount ( $7,200 2% Net cost of tooling machine ) $12,000 4,800 $ 7,200 700 $ 7,900 144 $ 7,756 Chapter 5, SE 5. Merchandise value: Discount: Payment: $2,500 $2,075 $2,075 $425 = 2% = $41.50 = $2,075 $41.50 $2,033.50 Chapter 5, SE 6. T accounts set up and entries posted Accounts Payable Freight-In 8/10 970* 8/7 180 8/2 1,150 8/3 105 Bal.** 970 8/10 970 8/3 105 Bal. 105 1,150 1,255 Bal. 105 Merchandise Inventory 8/2 1,150 8/7 180 1,150 180 Bal. 970 * $1,150 $180 = $970 ** The balance of is a credit because there are no data about the beginning balance and only one entry has been posted to the credit side of the account. 253

Chapter 5, SE 7. T accounts set up and entries posted Accounts Payable Freight-In 8/10 970* 8/7 180 8/2 1,150 8/3 105 Bal.** 970 8/10 970 8/3 105 Bal. 105 1,150 1,255 Bal. 105 8/2 Bal. Purchases Purchases Returns and Allowances 1,150 8/7 180 1,150 Bal. 180 * $1,150 $180 = $970 ** The balance of is a credit because there are no data about the beginning balance and only one entry has been posted to the credit side of the account. Chapter 5, SE 8. T accounts set up and entries posted 5/2 Bal. Accounts Payable Freight-In 5/10 1,455* 5/7 270 5/2 1,725 5/3 158 Bal.** 1,455 5/10 1,455 5/3 158 Bal. 158 1,725 1,883 Merchandise Inventory 1,725 5/7 270 1,725 270 1,455 Bal. 158 * $1,725 $270 = $1,455 ** The balance of is a credit because there are no data about the beginning balance and only one entry has been posted to the credit side of the account. 254

Chapter 5, SE 9. T accounts set up and entries posted Accounts Payable Freight-In 5/10 1,455* 5/7 270 5/2 1,725 5/3 158 Bal.** 1,455 5/10 1,455 5/3 158 Bal. 158 1,725 1,883 Bal. 158 5/2 Bal. Purchases Returns Purchases and Allowances 1,725 5/7 270 1,725 Bal. 270 * ** $1,725 $270 = $1,455 The balance of is a credit because there are no data about the beginning balance and only one entry has been posted to the credit side of the account. Chapter 5, SE 10. Purchases: $282,900 ($273,700 + $50,600 $13,800 + $10,350 $37,950) Cost of goods sold Merchandise inventory, September 30, 2011 Purchases Less purchases returns and allowances Net purchases Freight-in Net cost of purchases Cost of goods available for sale $282,900 10,350 $272,550 13,800 $ 37,950 286,350 $324,300 Less merchandise inventory, October 31, 2011 50,600 Cost of goods sold $273,700 255

Chapter 5, SE 11. T accounts set up and entries posted Accounts Receivable Delivery Expense 8/4 2,520 8/4 2,520 8/9 735 8/5 231 Bal. 2,520 9/3 1,785 Bal. 231 2,520 2,520 Bal. 9/3 Bal. Returns and Allowances 1,785* 8/5 231 8/9 735 1,554 Bal. 735 * $2,520 $735 = $1,785 Chapter 5, SE 12. 1. 2. 3. 4. 5. 6. 7. f d g e a c b Chapter 5, SE 13. 1. 2. 3. 4. d b a c 256

Chapter 5, E 1. 1. 2. 3. 4. Yes, a company can have a negative financing period if its merchandise is held for a very short time, if its sales are mostly for cash, or if it has long terms to pay its suppliers. Because the exchange rate for the dollar is declining as it relates to the euro, the dollar can buy more euros. Therefore, you would want the eventual payment to be made in dollars. Management has the ultimate responsibility for safeguarding a company s assets with a system of internal control. You would want the terms to be FOB destination because the loss of merchandise would be the responsibility of the shipper. If the terms were FOB shipping point, the merchandise would belong to you when it left the shipper and would be your loss. Chapter 5, E 2. 1. 2. 3. 4. The balance would be wrong if an error were made in updating the account or if merchandise had been lost or stolen. Under the periodic inventory system, a physical inventory is needed to determine the cost of goods sold and the resulting amount of ending inventory. Under the perpetual inventory system, a physical inventory is required to verify the inventory as shown in the accounting records. Merchandise Inventory would be assigned a higher level of risk because there is a greater risk of human error in recording the large number of transactions involved and because there is a greater risk of theft. It is important because until there is a written record of the cash, there is no accountability. This is why some stores offer a reward to customers who report having made a purchase without receiving a receipt. Chapter 5, E 3. 1. 2. 3. 4. 5. 6. d a b c d a 257

Chapter 5, E 4. Date of purchase: Cost of machine in dollars: Date of payment: Amount of payment: Exchange loss: Chapter 5, E 5. 1. Working capital computed 150,000 $1.00 = 150,000 $1.25 = $187,500 $150,000 = $150,000 $187,500 $37,500 Current Assets Marketable Securities Notes Receivable (90 days) Accounts Receivable Merchandise Inventory Prepaid Insurance Supplies Total Current Assets Current Liabilities Notes Payable (90 days) Accounts Payable Current Portion of Long-Term Debt Salaries Payable Property Taxes Payable Unearned Revenue Total Current Liabilities Working Capital $ 1,200 10,080 20,800 8,160 20,320 320 280 $12,000 13,280 8,000 680 1,000 600 $61,160 35,560 $25,600 2. Current ratio computed Current Assets $61,160 Current Ratio = = = Current Liabilities $35,560 Chapter 5, E 6. List price Less 30% trade discount Dealer price Shipping cost Cost of pool Less sales discount ($3,500 2%) Net cost of pool 1.72 $5,000 1,500 $3,500 $3,500 70 $3,430 258

Chapter 5, E 7. Mar. 1 Accounts Receivable 2,000 Sold merchandise on credit to Sun Company, terms 2/10, n/30, FOB shipping point 3 Returns and Allowances 800 Accounts Receivable Accepted a return from Sun Company for full credit 10 1,176 Discounts 24 Accounts Receivable Received payment from Sun Company for the sale, less the return and discount Accounts Receivable: $2,000 $800 = $1,200 Discount: $1,200 2% = $24 Payment: $1,200 $24 = $1,176 11 Accounts Receivable 3,200 Sold merchandise on credit to Sun Company, terms 2/10, n/30, FOB shipping point 31 3,200 Accounts Receivable Received payment for amount due from Sun Company for the sale of March 11 2,000 800 1,200 3,200 3,200 The total amount received from Sun Company (debits to the account): $1,176 + $3,200 = $4,376 259

Chapter 5, E 8. July 2 Merchandise Inventory 2,000 Accounts Payable Purchased merchandise on credit from Lucas Company, terms n/20, FOB destination, invoice dated July 1 6 Accounts Payable 250 Merchandise Inventory Returned some merchandise to Lucas Company for full credit 11 Accounts Payable 1,750 Paid Lucas Company for purchase of July 2 less return Accounts Payable: $2,000 $250 = $1,750 14 Merchandise Inventory 2,250 Accounts Payable Purchased merchandise on credit from Lucas Company, terms n/20, FOB destination, invoice dated July 12 31 Accounts Payable 2,250 Paid amount owed Lucas Company for purchase of July 14 2,000 250 1,750 2,250 2,250 The total amount paid to Lucas Company (credits to the account): $1,750 + $2,250 = $4,000 260

Chapter 5, E 9. Parties, Etc. Income Statement For the Year Ended December 31, 2011 Net sales Less sales returns and allowances Net sales Cost of goods sold* Gross margin Operating expenses Selling expenses General and administrative expenses Total operating expenses Income before income taxes Income taxes Net income *Cost of goods sold includes freight-in: $142,000 + $7,350 = $149,350 $21,500 43,500 $249,000 11,750 $237,250 149,350 $ 87,900 65,000 $ 22,900 6,000 $ 16,900 261

Chapter 5, E 10. T accounts set up and entries posted Merchandise Inventory a. c. d. Bal. 5,000 2,800 4,800 12,600 11,600 e. 1,000 1,000 Accounts Payable b. 270 e. 1,000 a. 5,000 b. 270 f. 5,000 f. 5,000 c. 2,800 d. 400 g. 5,200 g. 5,200 d. 5,200 Bal. 670 h.* 1,800 h. 1,800 Bal.** 12,270 13,000 13,000 Bal. Freight-In * $2,800 $1,000 = $1,800 ** The balance of is a credit because there are no data about the beginning balance and entries have been posted only to the credit side of the account. 262

Chapter 5, E 11. T accounts set up and entries posted 6/25 Bal. 6/15 Bal. 6/20 2,000* 6/15 2,600 2,000 Bal. Returns 2,600 Accounts Receivable and Allowances 2,600 6/20 600 6/20 600 6/25 2,000 Bal. 600 2,600 2,600 Merchandise Inventory Cost of Goods Sold 350 6/15 1,500 6/15 1,500 6/20 350 350 1,500 1,500 350 Bal.** 1,150 Bal. 1,150 * ** $2,600 $600 = $2,000 The balance of Merchandise Inventory is a credit because there are no data about the beginning balance and a larger amount has been posted to the credit side of the account. 263

Chapter 5, E 12. Handy General Store Income Statement For the Year Ended December 31, 2011 Net sales Less sales returns and allowances Net sales Cost of goods sold Merchandise inventory, December 31, 2010 Purchases $57,400 Less purchases returns and allowances 3,500 Net purchases $53,900 Freight-in 2,800 Net cost of purchases Cost of goods available for sale Less merchandise inventory, December 31, 2011 Cost of goods sold Gross margin Operating expenses Selling expenses General and administrative expenses Total operating expenses Income before income taxes Income taxes Net income $14,000 56,700 $70,700 10,500 $28,200 18,600 $154,500 7,600 $146,900 60,200 $ 86,700 46,800 $ 39,900 9,000 $ 30,900 264

Chapter 5, E 13. (in thousands) returns and allowances Net sales Merchandise inventory, beginning Purchases Purchases returns and allowances Freight-in Net cost of purchases Cost of goods available for sale Merchandise inventory, ending Cost of goods sold Gross margin Selling expenses General and administrative expenses Total operating expenses Income before income taxes Income taxes Net income 2011 2010 2009 $349 (p) $336 (h) $286 24 19 20 (a) 325 (q) 317 266 (b) 33 (r) 42 (i) 38 192 169 139 (c) 31 28 (j) 17 28 (s) 29 22 189 170 (k) 144 (d) 222 212 182 39 33 (l) 42 183 (t) 179 140 (e) 142 138 (m) 126 91 (u) 78 66 (f) 39 50 (n) 33 130 128 99 (g) 12 (v) 10 (o) 27 3 2 5 9 (w) 8 22 265

Chapter 5, E 14. T accounts set up and entries posted Accounts Payable b. 270 e. 1,000 a. 5,000 a. 5,000 f. 5,000 f. 5,000 c. 2,800 c. 2,800 g. 5,200 g. 5,200 d. 5,200 d. 4,800 h.* 1,800 h. 1,800 Bal. ##### Bal.** 12,270 13,000 13,000 Bal. Purchases Freight-In b. 270 d. 400 Bal. 670 Purchases Returns and Allowances e. 1,000 Bal. 1,000 * $2,800 $1,000 = $1,800 ** The balance of is a credit because there are no data about the beginning balance and entries have been posted only to the credit side of the account. 266

Chapter 5, E 15. T accounts set up and entries posted 6/25 Bal. 2,000* 6/15 2,600 2,000 Bal. 2,600 Accounts Receivable Returns and Allowances 6/15 2,600 6/20 600 6/20 600 6/25 2,000 Bal. 600 2,600 2,600 Bal. * $2,600 $600 = $2,000 267

Chapter 5, E 16. 1. 2. 3. 4. The 30 percent increase represents about one additional employee on the payger has either added an unauthorized employee to the payroll or added a fictiroll (after accounting for the raises). It is possible that the branch office manatious employee to the payroll and then cashed the payroll checks himself or herself. The large increase in sales returns and allowances immediately following yearend probably means that to meet sales goals, the sales staff inflated the preapproval. Those goods were subsequently returned for credit in the first two vious year's sales by shipping unordered merchandise or by sending goods on months of 2011. All other things being equal, a decrease in both gross margin and ending in- ventory probably indicates the theft or pilferage of inventory by customers or employees. The cashier in question may be turning in and ringing up discount coupons available in the store and pocketing the cash for the coupons. Businesses often have extra coupons in the store for customers who request them. Chapter 5, E 17. 1. 2. 3. 4. b c a d Chapter 5, E 18. 1. 2. 3. 4. 5. g e a, c, f g b, c 268

Chapter 5, P 1. 1. Multistep income statement prepared Leonid's Delivery, Inc. Income Statement For the Year Ended August 31, 2011 Net sales Less sales returns and allowances Net sales Cost of goods sold* Gross margin Operating expenses Selling expenses Store salaries expense $65,650 Advertising expense 48,200 Store supplies expense 5,360 Depreciation expense store equipment 2,500 Total selling expenses $121,710 General and administrative expenses Office salaries expense Rent expense Insurance expense Utilities expense Office supplies expense Depreciation expense office equipment Total general and administrative expenses Total operating expenses Income before income taxes Income taxes Net income $25,750 4,800 2,400 3,120 2,350 1,600 40,020 $338,000 18,000 $320,000 127,400 $192,600 161,730 $ 30,870 4,000 $ 26,870 *Cost of goods sold includes freight-in ( $122,800 + $4,600 = $127,400 ) 269

Chapter 5, P 1. (Continued) 2. User Insight: Income statement discussed This question is meant to link the income statements in this chapter to the financial statement ratios prepared in the previous chapter. The income statement for Leonids Delivery, Inc., can be examined (1) as a whole, (2) in components, and (3) in relation to other information. First, overall, the statement shows net income of $26,870, which was earned on net sales of $320,000. This is a profit margin of 8.4 percent. Third, the net income, $26,870, can be compared with the total assets of the business to compute return on assets and with total stockholders' equity to compute return on equity. An analyst also would want to examine the balance sheet in rela- tion to the income statement. Second, the components of gross margin and operating expenses can be examined. The gross margin is $192,600, or 60.2 percent of net sales; the operating expenses are $161,730, or 50.5 percent of net sales. Net income can be improved by increasing the gross margin and/or by decreasing the operating expenses. When possible, an analysis would also include comparing the ratios above for Leonid's Delivery, Inc., to prior years and to other companies of similar size within the same industry for the same period of time. 270

Chapter 5, P 2. 1. Transactions recorded 2011 July 1 Accounts Receivable 1,050 Sold merchandise to Tina Lands, terms n/30, FOB shipping point 1 Cost of Goods Sold 630 Merchandise Inventory To transfer cost of merchandise sold to Cost of Goods Sold account 3 Merchandise Inventory 1,900 Accounts Payable Purchased merchandise from Livomax Company, terms n/30, FOB shipping point 5 Freight-In 145 Paid shipping charges to Team Freight 8 Merchandise Inventory 1,700 Freight-In 100 Accounts Payable Purchased merchandise from Arbor Supply Company, terms n/30, FOB shipping point; freight paid by supplier 12 Accounts Payable 300 Merchandise Inventory Returned some of merchandise purchased from Livomax Company 15 Accounts Receivable 600 Sold merchandise to John Nuzzo, terms n/30, FOB shipping point 15 Cost of Goods Sold 360 Merchandise Inventory To transfer cost of merchandise sold to Cost of Goods Sold account 1,050 630 1,900 145 1,800 300 600 360 271

Chapter 5, P 2. (Continued) 2011 July 17 500 Sold merchandise for cash 17 Cost of Goods Sold 300 Merchandise Inventory To transfer cost of merchandise sold to Cost of Goods Sold account 18 Returns and Allowances 100 Accounts Receivable Accepted return of merchandise for full credit from Tina Lands 18 Merchandise Inventory 60 Cost of Goods Sold To transfer cost of merchandise returned to Merchandise Inventory account 24 Accounts Payable 1,600 Made payment on account to Livomax Company $1,900 $300 = $1,600 25 950 Accounts Receivable Received payment on account from Tina Lands $1,050 $100 = $950 500 300 100 60 1,600 950 2. User Insight: Net sales discussed Net sales reflects gross sales adjusted for any sales discounts, sales returns, or allowances granted the buyer. When companies simply show "sales," it may mean that they have granted no discounts, returns, or allowances, or it may mean that any of these items granted were of an immaterial amount. In effect, "net sales" and "sales" are equivalent. 272

Chapter 5, P 3. 1. Income statement prepared Hill Sporting Equipment, Inc. Income Statement For the Year Ended September 30, 2011 Net sales Less sales returns and allowances Net sales Cost of goods sold Merchandise inventory, September 30, 2010 Purchases $110,593 Less purchases returns and allowances 15,119 Net purchases $ 95,474 Freight-in 5,039 Net cost of purchases Cost of goods available for sale Less merchandise inventory, September 30, 2011 Cost of goods sold Gross margin Operating expenses Selling expenses Store salaries expense $ 52,775 Advertising expense 10,100 Store supplies expense 232 Depreciation expense store equipment 900 Total selling expenses General and administrative expenses Office salaries expense $ 13,250 Rent expense 7,500 Insurance expense 1,100 Utilities expense 9,380 Office supplies expense 407 Depreciation expense office equipment 925 Total general and administrative expenses Total operating expenses Income before income taxes Income taxes Net income $ 40,611 100,513 $141,124 38,332 $ 64,007 32,562 $220,456 9,125 $211,331 102,792 $108,539 96,569 $ 11,970 2,500 $ 9,470 273

Chapter 5, P 3. (Continued) 2. User Insight: Income statement discussed Third, the net income, $9,470, can be compared with the total assets of the busi- ness to compute return on assets and with total stockholders' equity to compute return on equity. Therefore, an analyst also would want to examine the balance sheet in relation to the income statement. This question is meant to get the students thinking about how to analyze financial statements. Hill Sporting Equipment, Inc.'s income statement can be examined (1) as a whole, (2) in components, and (3) in relation to other information. Second, the components of gross margin and operating expenses can be examined. The gross margin is $108,539, or 51.4 percent of net sales; the operating ex- penses are $96,569, or 45.7 percent of net sales. Net income can be improved by increasing the gross margin and/or by decreasing the operating expenses. First, the statement shows the net income of Hill Sporting Equipment, Inc. The shop earned $9,470 on net sales of $211,331. This is a profit margin of 4.5 percent. When possible, an analysis would also include comparing the ratios above for Hill Sporting Equipment, Inc., to prior years and to other companies of similar size within the same industry for the same period of time. 274

Chapter 5, P 4. 1. Transactions recorded 2011 July 1 Accounts Receivable 1,050 Sold merchandise to Tina Lands, terms n/30, FOB shipping point 3 Purchases 1,900 Accounts Payable Purchased merchandise from Livomax Company, terms n/30, FOB shipping point 5 Freight-In 145 Paid shipping charges to Team Freight 8 Purchases Freight-In 1,700 100 Accounts Payable Purchased merchandise from Arbor Supply Company, terms n/30, FOB shipping point; freight paid by supplier 12 Accounts Payable 300 Purchase Returns and Allowances Returned some of merchandise purchased from Livomax Company 15 Accounts Receivable 600 Sold merchandise to John Nuzzo, terms n/30, FOB shipping point 17 500 Sold merchandise for cash 18 Returns and Allowances 100 Accounts Receivable Accepted return of merchandise for full credit from Tina Lands 1,050 1,900 145 1,800 300 600 500 100 275

Chapter 5, P 4. (Continued) 2011 July 24 Accounts Payable 1,600 Made payment on account to Livomax Company $1,900 $300 = $1,600 25 950 Accounts Receivable Received payment on account from Tina Lands $1,050 $100 = $950 1,600 950 2. User Insight: Net sales discussed Net sales reflects gross sales adjusted for any sales discounts, sales returns, or allowances granted the buyer. When companies simply show "sales," it may mean that they have granted no discounts, returns, or allowances, or it may mean that any of these items granted were of an immaterial amount. In effect, "net sales" and "sales" are equivalent. 276

Chapter 5, P 5. 1. Control activities identified 1. 2. 3. 4. 5. 6. 7. 8. 9. d c, f a c, d, f a, c, f a, f b, c, f c e 2. User Insight: New control activities explained Authorization Two major points of authorization have been put into the new system. First, the supplies clerk is routinely authorized to release a predetermined amount of supplies to each supervisor based on the job. Second, the purchasing clerk authorizes purchases of supplies based on purchase requisitions received from the supplies clerk. This is an improvement over the old system in that all releases of supplies and purchases of supplies have appropriate approval. Sulowest price for pervisors are discouraged from wasting supplies, and the company is paying the supplies. Recording transactions There is no major difference between the old and new systems regarding the recording of transactions. In both cases, the accounting department records the purchase of supplies. Additional inventory records are maintained, however, as explained in the next section. Physical controls Physical controls are established through the designation of a supplies storeroom. This new and essential control procedure protects the sup- plies from waste and theft and means that the supplies clerk can be held accountable for the inventory of supplies. Documents and records Several new documents and records were established by the new system. Requisitions by supervisors, purchase requisitions by the supplies clerk, purchase orders by the purchasing clerk, and receiving reports by the supplies clerk are new documents that establish controls over supplies. These documents are an improvement over the old system in that forms now document the responsibilities of each individual. New inventory records are kept by the accounting department. With these records, the inventory on hand can be verified by taking a physical inventory. This discourages employees from using too many supplies or stealing them. Periodic independent verification This control procedure is accomplished by having the warehouse manager take a physical inventory each month and match 277

Chapter 5, P 5. (Continued) it against the records maintained by the accounting department. This is a major improvement over the old system because employees are motivated not to waste or steal the supplies and because losses can be uncovered quickly. Sound personnel practices This is an area of apparent weakness in the new sys- tem. Many employees have new duties with more rigorous procedures to follow and more forms to complete than before. The case does not specify what steps, if any, were taken to train the employees in the new procedures and to motivate them to accept these procedures. The success of the new system will depend on the employees' understanding of and willingness to carry out their new roles. Some examples: The supplies clerk must be careful to release only the amount of supplies authorized for each job. The warehouse manager must take the physical inventory each month and do so accurately. The purchasing clerk must make a conscious effort to find the best prices for supplies. And access to the supplies storeroom must be limited to the supplies clerk. If anybody can walk into the storeroom, the control is lost. Separation of duties The new system represents a good example of the separation of duties. The supervisors and the supplies clerk, who have access to the supplies, can obtain them only through proper authorization as documented by the requisitions and the purchase orders. Authorization here is the responsibility of management, which sets the amount to be released to the supervisors, and of the purchasing clerk, who authorizes purchases. The accounting records, including the inventory records, are maintained by the accounting department. The independent verification is conducted by the warehouse supervisor. 278

Chapter 5, P 6. 1. Income statement prepared Joseph's Video Store, Inc. Income Statement For the Year Ended June 30, 2011 Net sales Less sales returns and allowances Net sales Cost of goods sold* Gross margin Operating expenses Selling expenses Store salaries expense $216,700 Advertising expense 36,400 Store supplies expense 3,328 Depreciation expense store equipment 3,600 Total selling expenses General and administrative expenses Office salaries expense Rent expense Insurance expense Utilities expense Office supplies expense Depreciation expense office equipment Total general and administrative expenses Total operating expenses Income before income taxes Income taxes Net income $ 53,000 28,000 5,600 18,320 3,628 3,700 $260,028 112,248 $870,824 25,500 $845,324 462,526 $382,798 372,276 $ 10,522 5,000 $ 5,522 *Cost of goods sold includes freight-in ($442,370 + $20,156 = $462,526) 279

Chapter 5, P 6. (Continued) 2. User Insight: Income statement discussed First, overall, the statement shows net income of $5,522, which was earned on net sales of $845,324. This is a profit margin of only 0.7 percent. Second, the components of gross margin and operating expenses can be examined. The gross margin is $382,798, or 45.3 percent of net sales. The operating expenses are $372,276, or 44.0 percent of net sales. Net income can be improved by increasing the gross margin and/or by decreasing the operating expenses. This question is meant to link the income statements in this chapter to the finan- cial statement ratios prepared in the previous chapter. The income statement for Joseph's Video Store, Inc., can be examined (1) as a whole, (2) in components, and (3) in relation to other information. Third, the net income, $5,522, can be compared with the total assets of the business to compute return on assets and with total stockholders' equity to compute return on equity. An analyst would want to examine the balance sheet in relation to the income statement. When possible, an analysis would also include comparing the ratios above for Joseph's Video Store, Inc., to prior years and to other companies of similar size within the same industry for the same period of time. 280

Chapter 5, P 7. 1. Transactions recorded 2011 Oct. 7 Accounts Receivable 3,000 Sold merchandise to Ron Moore, terms n/30, FOB shipping point 7 Cost of Goods Sold 1,800 Merchandise Inventory To transfer cost of merchandise sold to Cost of Goods Sold account 8 Merchandise Inventory 6,000 Accounts Payable Purchased merchandise from Lima Company, terms n/30, FOB shipping point 9 Freight-In 254 Paid shipping charges to Warta Company for October 8 purchase 10 Merchandise Inventory 9,000 Freight-In 600 Accounts Payable Purchased merchandise from Maria's Company, terms n/30, FOB shipping point; freight paid by supplier 14 Accounts Receivable 2,400 Sold merchandise to Kate Lang, terms n/30, FOB shipping point 14 Cost of Goods Sold 1,440 Merchandise Inventory To transfer cost of merchandise sold to Cost of Goods Sold account 14 Accounts Payable 600 Merchandise Inventory Returned damaged merchandise to Lima Company for credit 3,000 1,800 6,000 254 9,600 2,400 1,440 600 281

Chapter 5, P 7. (Continued) 2011 Oct. 17 3,000 Accounts Receivable Received payment on account from Ron Moore 19 1,800 Sold merchandise for cash 19 Cost of Goods Sold 1,080 Merchandise Inventory To transfer cost of merchandise sold to Cost of Goods Sold account 20 Accounts Payable 9,600 Made payment on account to Maria's Company for purchase of October 10 21 Accounts Payable 5,400 Made payment on account to Lima Company for purchase of October 8, net of return on October 14 $6,000 $600 = $5,400 24 Returns and Allowances 200 Accounts Receivable Accepted return from Kate Lang 24 Merchandise Inventory 120 Cost of Goods Sold To transfer cost of merchandise returned to Merchandise Inventory account 3,000 1,800 1,080 9,600 5,400 200 120 2. User Insight: rebates discussed rebates should not be recorded as revenue because doing so overstates revenues. (Some companies have gotten into trouble for following this practice.) rebates are properly treated as purchases discounts or allowances and deducted from gross purchases. 282

Chapter 5, P 8. 1. Income statement prepared Robert's Shop, Inc. Income Statement For the Year Ended March 31, 2011 Net sales Less sales returns and allowances Net sales Cost of goods sold Merchandise inventory, March 31, 2010 Purchases $70,200 Less purchases returns and allowances 2,600 Net purchases $67,600 Freight-in 2,300 Net cost of purchases Cost of goods available for sale Less merchandise inventory, March 31, 2011 Cost of goods sold Gross margin Operating expenses Selling expenses Store salaries expense $33,125 Advertising expense 23,800 Store supplies expense 2,880 Depreciation expense store equipment 1,050 Total selling expenses General and administrative expenses Office salaries expense $12,875 Rent expense 2,400 Utilities expense 1,560 Insurance expense 1,300 Office supplies expense 1,075 Depreciation expense office equipment 800 Total general and administrative expenses Total operating expenses Income before income taxes Income taxes Net income $ 38,200 69,900 $108,100 29,400 $ 60,855 20,010 $168,700 5,700 $163,000 78,700 $ 84,300 80,865 $ 3,435 1,000 $ 2,435 283

Chapter 5, P 8. (Continued) 2. User Insight: Income statement discussed This question is meant to get the students thinking about how to analyze finan- cial statements. The income statement for Robert's Shop, Inc., can be examined (1) as a whole, (2) in components, and (3) in relation to other information. First, the statement shows net income of $2,435, which was earned on net sales of $163,000. This is a profit margin of only 1.5 percent. Second, the components of gross margin and operating expenses can be examined. The gross margin is $84,300, or 51.7 percent of net sales; the operating expenses are $80,865, or 49.6 percent of net sales. Net income can be improved by increasing the gross margin and/or by decreasing the operating expenses. Third, the net income, $2,435, can be compared with the total assets of the business to compute return on assets and with total stockholders' equity to compute return on equity. An analyst would want to examine the balance sheet in relation to the income statement. When possible, an analysis would also include comparing the ratios above for Robert's Shop, Inc., to prior years and to other companies of similar size within the same industry for the same period of time. 284

Chapter 5, P 9. 1. Transactions recorded 2011 Oct. 7 Accounts Receivable 3,000 Sold merchandise to Ron Moore, terms n/30, FOB shipping point 8 Purchases 6,000 Accounts Payable Purchased merchandise from Lima Company, terms n/30, FOB shipping point 9 Freight-In 254 Paid freight charges to Warta Company 10 Purchases Freight-In 9,000 600 Accounts Payable Purchased merchandise from Maria's Company, terms n/30, FOB shipping point; freight paid by supplier 14 Accounts Receivable 2,400 Sold merchandise to Kate Lang, terms n/30, FOB shipping point 14 Accounts Payable 600 Purchases Returns and Allowances Returned damaged merchandise to Lima Company for credit 17 3,000 Accounts Receivable Received payment on account from Ron Moore 3,000 6,000 254 9,600 2,400 600 3,000 285

Chapter 5, P 9. (Continued) 2011 Oct. 19 1,800 Sold merchandise for cash 20 Accounts Payable 9,600 Made payment on account to Maria's Company for purchase of October 10 rebates should not be recorded as revenue because doing so overstates rev- enues. (Some companies have gotten into trouble for following this practice.) rebates are properly treated as purchases discounts or allowances and deducted from gross purchases. 21 Accounts Payable 5,400 Made payment on account to Lima Company for purchase of October 8, net of return on October 14 $6,000 $600 = $5,400 24 Returns and Allowances 200 Accounts Receivable Accepted return from Kate Lang 1,800 9,600 5,400 200 2. User Insight: rebates discussed 286

Chapter 5, P 10. 1. Significant internal control weaknesses To remedy both of these weaknesses in internal contol over purchases, the receiv- ing report and the purchase order should go to the accounting department to be compared with the invoices before payment is authorized. In addition, prior to payment, the invoice should be approved by the person who submitted the purchase requisition to ensure that he or she actually received the quantity and quality of goods requested. In this way, authorization (the purchasing agent) and custody (the receiving clerk) are separated from recordkeeping (the accounting department). sales One objective of internal control is to compare the records of assets with the existing assets at reasonable intervals. The comparison of the cash register tape with the cash in the cash drawer at the end of each day accomplishes this objective. However, the comparison should be made by someone other than the person who has custody of the assets. In this case, the salesclerk could misappropriate funds from the cash drawer and report the sales at less than actual. Purchases In this case, invoices are being paid before they are compared with the purchase order and receiving report. An invoice could be paid for goods that have not been properly authorized or for goods that have not been received. The pur- chasing agent, who has the responsibility to authorize purchases, also certifies that the invoice is correct. It would be possible for the purchasing agent to be involved in a kickback scheme with a supplier. 2. Recommended changes that would improve the system One way of overcoming the internal control weakness over cash sales is to have the salesclerk take the cash drawer to the cashier and count the cash in the pres- ence of the cashier. Another person, such as the manager, should remove the tape from the cash register for comparison with the amount turned in to the cashier. 287

Chapter 5, C 1. The operating cycle is the amount of time from the purchase of inventory until it is sold and payment is collected. Amazing Sound Source's operating cycle is 160 days (70 days plus 90 days). The financing period is the time needed for financing of inventory and receivables. For Amazing Sound Source, it is 140 days (160 days minus 20 days). Amazing Sound Source can improve its cash flow management in one or all of the following ways: 1. Reduce the inventory period. (Suggestions: Analyze inventory to reduce inventory on hand; try to get inventory on consignment.) 2. Reduce the receivable period. (Suggestions: Encourage customers to use credit cards instead of giving 90 days' credit; make arrangements with bank to provide credit to customers.) 3. Increase the payable period. (Suggestions: Pay suppliers at last possible time instead of when invoice is received; negotiate longer payment times.) Chapter 5, C 2. A principal advantage of the perpetual inventory system is that sales and inven- tory levels can be monitored on a day-by-day basis. Fast-selling books can be re- ordered quickly, and slow-selling books can be moved to other stores or returned to the publisher before they have to be offered at lower prices. In addition, financial statements can be prepared frequently, giving management constant feedback on how well the company is doing. Centralization of the records would mean that Note to the instructor: This case can be used for class discussion or as a writing exercise. It is also excellent for use with small groups, with the participants being asked to develop arguments for either the periodic inventory system or the perpetual inventory system. The Periodic Inventory System An advantage of the periodic inventory system is that it is usually less costly to administer. There may be some merit to the system of relying on the judgment of the store managers. Perhaps this system needs to be strengthened with a better training program for managers and a better system for monitoring sales within the stores. The patterns of sales in different neighborhoods do vary, and the store managers are probably the best people to monitor these trends. The disadvantage of the periodic inventory system is that little information about inventory is available except within each store. in the book business can fluctuate unexpectedly, and top management may not know when one store has run out of a title and another store has been unable to sell it. Another disadvantage of the periodic inventory system is that financial statements are prepared only when a physical inventory is taken (in this case, every six months). The Perpetual Inventory System 288

Chapter 5, C 2. (Continued) sales trends among the stores could be monitored, allowing inventory to be shifted from stores where sales have been slow to those where sales are better. A disadvantage of the perpetual inventory system is the cost to install and maintain it. Em- ployees must be trained to follow procedures in recording sales, purchases, and returns and in maintaining the records. This may be much more costly than hiring and training qualified store managers. Also, the centralization of the records takes considerable autonomy away from the individual store managers, who are in the best position to evaluate their own situations. A solution to this last disadvantage is to give the managers ready access to the perpetual inventory records and let them have a say in decisions about purchases. Note to the instructor: Many specialty store chains, including bookstores, use a perpetual inventory system like the one proposed for Books Unlimited. are monitored at the national or regional level, and individual store managers have little or no say in the titles or other products that are stocked. Chapter 5, C 3. A weak U.S. dollar means that one dollar may be exchanged for less than previously or, conversely, that one euro is now worth more in terms of dollars than it was before. Thus, when McDonald's prepares its financial statements in dollars, sales in Europe translate into more dollars than previously. Assume, for instance, that the company sold 12,000,000 worth of Big Macs in Europe in each of two years. Also assume that in the first year, one euro is worth $1.40 and in the second year, one euro is worth $1.60. In euros, sales appear to be equal from one year to the next, but in dollars, sales increased from $16,800,000 ( 12,000,000 $1.40) to $19,200,000 ( 12,000,000 $1.60). by McDonald's in the United States are not relevant to the discussion because these sales were in dollars and therefore were not affected by the changes in foreign exchange rates. 289

Chapter 5, C 4. The control activities that were likely violated in this case are as follows: a. b. c. d. Authorization: These expenditures were probably not authorized by a person who would understand their implications. Periodic independent verification: There was apparently no independent veriduties. fication that the work had been done. Separation of duties: It is likely that these expenditures were authorized by the employee who perpetrated the fraud, thus circumventing separation of Sound personnel practices: It is likely that sound personnel practices such as rotation of jobs, required vacations, and bonding were violated and enabled the employee to conceal the fraud. 290

Chapter 5, C 5. CVS's operating cycle described Date: To: From: Re: Today's Date Instructor's Name Student's Name CVS's Operating Cycle Memorandum The operating cycle is the length of time from the purchase of inventory until it is sold and the proceeds collected. The financing period is the operating cycle less the days of credit received to pay for the inventory. The relative importance of each component of the financing period is as follows: 1. 2. 3. Purchase of inventory: Maintaining an adequate merchandise inventory is very important to CVS's operating cycle. The company maintains about 45 days' inventory on hand at any one time. sales and collection on account: Accounts receivable are not as important to CVS as inventory because most of the company's sales are for cash, debit card, or credit card. Its days' receivable is 21. Payments on account: Because of the number of days' inventory on hand, the days' payable is very important to CVS in financing the inventory. Its days' payable is 19. In summary, the financing period for CVS is about 47 days (45 + 21 19). CVS needs to provide inventory financing for somewhat less than two months. Please let me know if you have any questions. 291

Chapter 5, C 6. (Dollars in millions) Net sales Cost of sales Gross margin Total operating expenses Income from operations Inventories CVS Walgreens 2009 % 2009 % $98,729 100.0% $63,335 100.0% 78,349 79.4% 45,722 72.2% $20,380 20.6% $17,613 27.8% 13,942 14.1% 14,366 22.7% $ 6,438 6.5% $ 3,247 5.1% $10,343 13.2% $ 6,789 14.8% These companies have very comparable operations. Walgreens has a higher gross margin than that of CVS, but has higher operating expenses that more than offset its advantage in gross margin. As a result, CVS is slightly more profitable because its income from operations is higher as a percentage of net sales than Walgreens'. Also, it appears that CVS manages its inventory better because of the lower percentage of inventories to cost of sales. 292

Chapter 5, C 7. 1. Cost of goods sold recomputed Beginning inventory Purchases Less purchases allowances Purchases Freight-in Net cost of purchases Cost of goods available for sale Less ending inventory Cost of goods sold 2011 $ 53,000 $ $200,000 $271,000 15,000 20,000 $185,000 $251,000 19,000 27,000 2010 204,000 278,000 $257,000 $278,000 32,000 53,000 $225,000 $225,000 An inventory loss of $25,000 appears to have occurred in 2011. The amount is the difference between the computed inventory level of $57,000 and the actual level of $32,000 shown by the physical inventory. If the actual inventory had been $57,000, the cost of goods sold for 2011 would have been $200,000 ($257,000 in cost of goods available for sale minus $57,000). Net income, therefore, would have been $50,000. The difference between 2010 and 2011 net income can be accounted for as follows: 2011 income before income taxes Manager's salary Inventory loss 2010 income before income taxes $25,000 $25,000 25,000 50,000 $75,000 293

Chapter 5, C 7. (Continued) 2. Possible reasons for the inventory loss suggested The inventory loss could have occurred as the result of embezzlement or theft. Inmanager may have failed to record sales of inventory and kept the money paid for ventory may have been stolen by shoplifters, by the manager, or by salesclerks. The the goods because sales declined by $25,000. Perry should take several actions: (1) assume a more active role in managing the original store, including being physically present on a random schedule; (2) institute controls over cash receipts to enprise counts (audits) of cash and sure that they are recorded at the time of sale; (3) establish controls over inventory to prevent customers from leaving the premises without paying; and (4) conduct sur- inventory. 294