1. 5-1

2. 5-2 MERCHANDISING OPERATIONS AND THE MULTIPLE-STEP INCOME STATEMENT Accounting, Fifth Edition 5

3. 5-3 After studying this chapter, you should be able to: 1. 1.Identify the differences between a service company and a merchandising company. 2. 2.Explain the recording of purchases under a perpetual inventory system. 3. 3.Explain the recording of sales revenues under a perpetual inventory system. 4. 4.Distinguish between a single-step and a multiple-step income statement. 5. 5.Determine cost of goods sold under a periodic system. 6. 6.Explain the factors affecting profitability. 7. 7.Identify a quality of earnings indicator. Learning Objectives

4. 5-4 Preview of Chapter 5 Accounting Fifth Edition Kimmel Weygandt Kieso

5. 5-5 Merchandising Operations LO 1 Identify the differences between service and merchandising companies. Merchandising Companies Buy and Sell Goods WholesalerConsumer The primary source of revenues is referred to as sales revenue or sales. Retailer

6. 5-6 Merchandising Operations LO 1 Identify the differences between service and merchandising companies. Income Measurement Cost of goods sold is the total cost of merchandise sold during the period. Not used in a Service business. Net Income (Loss) Less Equals Sales Revenue Cost of Goods Sold Gross Profit Operating Expenses Illustration 5-1 Income measurement process for a merchandising company

7. 5-7 The operating cycle of a merchandising company ordinarily is longer than that of a service company. Illustration 5-2 LO 1 Identify the differences between service and merchandising companies. Operating Cycles Merchandising Operations

8. 5-8 Flow of Costs Companies use either a perpetual inventory system or a periodic inventory system to account for inventory. LO 1 Identify the differences between service and merchandising companies. Merchandising Operations Illustration 5-3

9. 5-9 Perpetual System LO 1 Identify the differences between service and merchandising companies. Merchandising Operations  Maintain detailed records of the cost of each inventory purchase and sale.  Records continuously show inventory that should be on hand for every item.  Company determines cost of goods sold each time a sale occurs. Flow of Costs

10. 5-10  Do not keep detailed records of the goods on hand.  Cost of goods sold determined by count at the end of the accounting period.  Calculation of Cost of Goods Sold: Beginning inventory$ 100,000 Add: Purchases, net800,000 Goods available for sale900,000 Less: Ending inventory125,000 Cost of goods sold$ 775,000 LO 1 Merchandising Operations Flow of Costs Periodic System

11. 5-11  Traditionally used for merchandise with high unit values.  Shows the quantity and cost of the inventory that should be on hand at any time.  Provides better control over inventories than a periodic system. LO 1 Identify the differences between service and merchandising companies. Merchandising Operations Flow of Costs Advantages of the Perpetual System

12. 5-12

13. 5-13  Made using cash or credit (on account). Recording Purchases of Merchandise LO 2 Explain the recording of purchases under a perpetual inventory system.  Normally record when goods are received from the seller.  Purchase invoice should support each credit purchase. Illustration 5-5

14. 5-14 Illustration: Sauk Stereo (the buyer) uses as a purchase invoice the sales invoice prepared by PW Audio Supply, Inc. (the seller). Prepare the journal entry for Sauk Stereo for the invoice from PW Audio Supply. Inventory3,800May 4 Accounts payable 3,800 LO 2 Explain the recording of purchases under a perpetual inventory system. Recording Purchases of Merchandise Illustration 5-5

15. 5-15 Illustration 5-6 Shipping terms Ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller. Ownership of the goods remains with the seller until the goods reach the buyer. Recording Purchases of Merchandise Freight Costs – Terms of Sale Freight costs incurred by the seller are an operating expense. LO 2

16. 5-16 Illustration: Assume upon delivery of the goods on May 6, Sauk Stereo pays Public Freight Company $150 for freight charges, the entry on Sauk Stereo’s books is: Inventory150 May 6 Cash 150 Recording Purchases of Merchandise LO 2 Explain the recording of purchases under a perpetual inventory system. Assume the freight terms on the invoice in Illustration 5-5 had required PW Audio Supply to pay the freight charges, the entry by PW Audio Supply would have been: Freight-out 150May 4 Cash 150

17. 5-17 Purchaser may be dissatisfied because goods are damaged or defective, of inferior quality, or do not meet specifications. Purchase Returns and Allowances Recording Purchases of Merchandise Return goods for credit if the sale was made on credit, or for a cash refund if the purchase was for cash. May choose to keep the merchandise if the seller will grant a reduction of the purchase price. Purchase Return Purchase Allowance LO 2 Explain the recording of purchases under a perpetual inventory system.

18. 5-18 Recording Purchases of Merchandise LO 2 Explain the recording of purchases under a perpetual inventory system. Illustration: Assume Sauk Stereo returned goods costing $300 to PW Audio Supply on May 8. Accounts payable300May 8 Inventory 300

19. 5-19 In a perpetual inventory system, a return of defective merchandise by a purchaser is recorded by crediting: a.Purchases b.Purchase Returns c.Purchase Allowance d.Inventory Recording Purchases of Merchandise LO 2 Explain the recording of purchases under a perpetual inventory system. Review Question

20. 5-20 Credit terms may permit buyer to claim a cash discount for prompt payment. Advantages:  Purchaser saves money.  Seller shortens the operating cycle by converting the accounts receivable into cash earlier. Purchase Discounts Recording Purchases of Merchandise Example: Credit terms may read 2/10, n/30. LO 2 Explain the recording of purchases under a perpetual inventory system.

21. 5-21 2% discount if paid within 10 days, otherwise net amount due within 30 days. 1% discount if paid within first 10 days of next month. 2/10, n/301/10 EOM Net amount due within the first 10 days of the next month. n/10 EOM LO 2 Explain the recording of purchases under a perpetual inventory system. Purchase Discounts - Terms Recording Purchases of Merchandise

22. 5-22 Accounts payable3,500 May 14 Cash 3,430 Recording Purchases of Merchandise Inventory 70 (Discount = $3,500 x 2% = $70) LO 2 Explain the recording of purchases under a perpetual inventory system. Illustration: Assume Sauk Stereo pays the balance due of $3,500 (gross invoice price of $3,800 less purchase returns and allowances of $300) on May 14, the last day of the discount period. Prepare the journal entry Sauk Stereo makes on May 14 to record the payment.

23. 5-23 Accounts payable3,500June 3 Recording Purchases of Merchandise Cash 3,500 LO 2 Explain the recording of purchases under a perpetual inventory system. Illustration: If Sauk Stereo failed to take the discount, and instead made full payment of $3,500 on June 3, the journal entry would be:

24. 5-24 Should discounts be taken when offered? Purchase Discounts Recording Purchases of Merchandise Example: 2% for 20 days = Annual rate of 36.5% $3,500 x 36.5% x 20 ÷ 365 = $70 LO 2 Explain the recording of purchases under a perpetual inventory system.

25. 5-25 $3,8008 th - Return$300 Balance 4 th - Purchase $3,580 7014 th - Discount Recording Purchases of Merchandise Summary of Purchasing Transactions 1506 th – Freight-in LO 2 Explain the recording of purchases under a perpetual inventory system.

26. 5-26  Made using cash or credit (on account).  Sales revenue, like service revenue, is recorded when the performance obligation is satisfied.  Performance obligation is satisfied when the goods are transferred from the seller to the buyer.  Sales invoice should support each credit sale. Recording Sales of Merchandise LO 3 Explain the recording of sales revenues under a perpetual inventory system. Illustration 5-5

27. 5-27 Journal Entries to Record a Sale Cash or Accounts receivableXXX Sales revenue XXX Recording Sales of Merchandise LO 3 Explain the recording of sales revenues under a perpetual inventory system. #1 Cost of goods soldXXX Inventory XXX #2 Selling Price Cost

28. 5-28 Recording Sales of Merchandise LO 3 Explain the recording of sales revenues under a perpetual inventory system. Accounts receivable3,800May 4 Sales revenue 3,800 Illustration: PW Audio Supply records the sale of $3,800 on May 4 to Sauk Stereo on account (Illustration 5-5) as follows (assume the merchandise cost PW Audio Supply $2,400). Cost of goods sold2,4004 Inventory 2,400

29. 5-29

30. 5-30  “Flip side” of purchase returns and allowances.  Contra-revenue account to Sales Revenue (debit).  Sales not reduced (debited) because: ► Would obscure importance of sales returns and allowances as a percentage of sales. ► Could distort comparisons. Sales Returns and Allowances Recording Sales of Merchandise LO 3 Explain the recording of sales revenues under a perpetual inventory system.

31. 5-31 Illustration: Prepare the entry PW Audio Supply would make to record the credit for returned goods that had a $300 selling price (assume a $140 cost). Assume the goods were not defective. Recording Sales of Merchandise LO 3 Explain the recording of sales revenues under a perpetual inventory system. Sales returns and allowances 300May 8 Accounts receivable300 Inventory 1408 Cost of goods sold140

32. 5-32 Recording Sales of Merchandise LO 3 Explain the recording of sales revenues under a perpetual inventory system. Sales returns and allowances 300 Accounts receivable300 Inventory 50 Cost of goods sold50 Illustration: Assume the returned goods were defective and had a scrap value of $50, PW Audio would make the following entries: May 8 8

33. 5-33 Recording Sales of Merchandise LO 3 Explain the recording of sales revenues under a perpetual inventory system. The cost of goods sold is determined and recorded each time a sale occurs in: a.periodic inventory system only. b.a perpetual inventory system only. c.both a periodic and perpetual inventory system. d.neither a periodic nor perpetual inventory system. Review Question

34. 5-34

35. 5-35  Offered to customers to promote prompt payment of the balance due.  Contra-revenue account (debit) to Sales Revenue. Sales Discount Recording Sales of Merchandise LO 3 Explain the recording of sales revenues under a perpetual inventory system.

36. 5-36 Recording Sales of Merchandise LO 3 Explain the recording of sales revenues under a perpetual inventory system. Cash3,430May 14 Accounts receivable3,500 Sales discounts70 * [($3,800 – $300) X 2%] * Illustration: Assume Sauk Stereo pays the balance due of $3,500 (gross invoice price of $3,800 less purchase returns and allowances of $300) on May 14, the last day of the discount period. Prepare the journal entry PW Audio Supply makes to record the receipt on May 14.

37. 5-37  Subtract total expenses from total revenues  Two reasons for using the single-step format: 1.Company does not realize any type of profit or income until total revenues exceed total expenses. 2.Form is simple and easy to read. Single-Step Income Statement Income Statement Presentation LO 4 Distinguish between a single-step and a multiple-step income statement.

38. 5-38 Illustration 5-7 LO 4 Income Statement Presentation Single- Step

39. 5-39  Highlights the components of net income.  Three important line items: 1) gross profit, 2) income from operations, and 3) net income. LO 4 Distinguish between a single-step and a multiple-step income statement. Income Statement Presentation Multiple-Step Income Statement

40. 5-40 Illustration 5-8 Income Statement Presentation Key Line Items Multiple- Step LO 4

41. 5-41 Key Items:  Net sales Multiple- Step Illustration 5-11 LO 4

42. 5-42 Key Items:  Net sales  Gross profit Multiple- Step Illustration 5-11 LO 4

43. 5-43 Key Items:  Net sales  Gross profit  Operating expenses Multiple- Step Illustration 5-11 LO 4

44. 5-44 Key Items:  Net sales  Gross profit  Operating expenses  Nonoperating activities Multiple- Step Illustration 5-11 LO 4

45. 5-45 Key Items:  Net sales  Gross profit  Operating expenses  Nonoperating activities Multiple- Step Illustration 5-11 LO 4

46. 5-46 Key Items:  Net sales  Gross profit  Operating expenses  Nonoperating activities  Net income Illustration 5-11 Multiple- Step LO 4

47. 5-47 The multiple-step income statement for a merchandiser shows each of the following features except: a.gross profit. b.cost of goods sold. c.a sales revenue section. d.investing activities section. LO 4 Distinguish between a single-step and a multiple-step income statement. Income Statement Presentation Review Question

48. 5-48

49. 5-49  No running account of changes in inventory.  Ending inventory determined by physical count.  Cost of goods sold not determined until the end of the period. LO 5 Determine cost of goods sold under a periodic system. Determining Cost of Goods Sold Under a Periodic System Income Statement Presentation

50. 5-50 LO 5 Income Statement Presentation Determining Cost of Goods Sold Under a Periodic System Illustration 5-13

51. 5-51 Aerosmith Company’s accounting records show the following at the yearend December 31, 2014. Purchase Discounts $ 3,400Freight-In 6,100 Purchases 162,500Beginning Inventory 18,000 Ending Inventory 20,000Purchase Returns and Allowances 5,200 Assuming that Aerosmith Company uses the periodic system, compute (a) cost of goods purchased and (b) cost of goods sold. LO 5 Determine cost of goods sold under a periodic system. Beginning Inventory $ 18,000 Purchases$ 162,500 Purchase Returns and Allowances- 5,200 Purchase Discounts- 3,400 Freight-In + 6,100 160,000 (a) Goods Available for Sale178,000 Ending Inventory- 20,000 Cost of Goods Sold $ 158,000 (b) Solution

52. 5-52 Evaluating Profitability May be expressed as a percentage by dividing the amount of gross profit by net sales. LO 6 Explain the factors affecting profitability. Gross Profit Rate A decline in the gross profit rate might have several causes. ► Selling products with a lower “markup.” ► Increased competition may result in a lower selling price. ► Company forced to pay higher prices to its suppliers without being able to pass these costs on to its customers.

53. 5-53 Evaluating Profitability LO 6 Explain the factors affecting profitability. Illustration 5-15 Why does REI’s gross profit rate differ so much from that of Dick’s Sporting Goods and the industry average? Gross Profit Rate

54. 5-54 Evaluating Profitability Measures the percentage of each dollar of sales that results in net income. LO 6 Explain the factors affecting profitability. Profit Margin Ratio How do the gross profit rate and profit margin ratio differ? ► Gross profit rate - measures the margin by which selling price exceeds cost of goods sold. ► Profit margin ratio - measures the extent by which selling price covers all expenses (including cost of goods sold).

55. 5-55 Evaluating Profitability LO 6 Explain the factors affecting profitability. Illustration 5-17 How does REI compare to its competitors? Its profit margin was lower than Dick’s in 2010 and was less than the industry average. Thus, its profit margin does not suggest exceptional profitability. Profit Margin Ratio

56. 5-56 Evaluating Profitability Earnings have high quality if they provide a full and transparent depiction of how a company performed. LO 7 Identify a quality of earnings indicator. ► A measure significantly less than 1 suggests that a company may be using more aggressive accounting techniques in order to accelerate income recognition. ► A measure significantly greater than 1 suggests that a company is using conservative accounting techniques which cause it to delay the recognition of income.

57. 5-57 Appendix 5A LO 8 Explain the recording of purchases and sales of inventory under a periodic inventory system.  Record revenues when sales are made.  Do not record cost of merchandise sold on the date of sale.  Physical inventory count determines: ► Cost of merchandise on hand and ► Cost of merchandise sold during the period.  Record purchases in Purchases account.  Purchase returns and allowances, Purchase discounts, and Freight costs are recorded in separate accounts. Recording Merchandise Transactions Periodic Inventory System

58. 5-58 Appendix 5A LO 8 Explain the recording of purchases and sales of inventory under a periodic inventory system. Illustration: On the basis of the sales invoice (Illustration 5-5) and receipt of the merchandise ordered from PW Audio Supply, Sauk Stereo records the $3,800 purchase as follows. Purchases3,800May 4 Accounts payable 3,800 Recording Purchases of Merchandise Periodic Inventory System

59. 5-59 Appendix 5A Illustration: If Sauk pays Public Freight Company $150 for freight charges on its purchase from PW Audio Supply on May 6, the entry on Sauk’s books is: Freight-in (Transportation-in)150May 6 Cash 150 LO 8 Explain the recording of purchases and sales of inventory under a periodic inventory system. Freight Costs Periodic Inventory System

60. 5-60 Appendix 5A Accounts payable300May 8 Purchase returns and allowances 300 Purchase Returns and Allowances LO 8 Explain the recording of purchases and sales of inventory under a periodic inventory system. Illustration: Sauk Stereo returns $300 of goods to PW Audio Supply and prepares the following entry to recognize the return. Periodic Inventory System

61. 5-61 Appendix 5A Accounts payable3,500May 14 Purchase discounts 70 Purchase Discounts Cash 3,430 LO 8 Explain the recording of purchases and sales of inventory under a periodic inventory system. Illustration: On May 14 Sauk Stereo pays the balance due on account to PW Audio Supply, taking the 2% cash discount allowed by PW Audio for payment within 10 days. Sauk Stereo records the payment and discount as follows. Periodic Inventory System

62. 5-62 Appendix 5A No entry is recorded for cost of goods sold at the time of the sale under a periodic system. Illustration: PW Audio Supply, records the sale of $3,800 of merchandise to Sauk Stereo on May 4 (sales invoice No. 731, Illustration 5-5) as follows. Accounts receivable3,800May 4 Sales revenue 3,800 LO 8 Explain the recording of purchases and sales of inventory under a periodic inventory system. Recording Sales of Merchandise Periodic Inventory System

63. 5-63 Appendix 5A Illustration: To record the returned goods received from Sauk Stereo on May 8, PW Audio Supply records the $300 sales return as follows. Sales returns and allowances300May 8 Accounts receivable 300 Sales Returns and Allowances LO 8 Explain the recording of purchases and sales of inventory under a periodic inventory system. Periodic Inventory System

64. 5-64 Appendix 5A Cash3,430May 14 Accounts receivable3,500 Sales discounts70 LO 8 Explain the recording of purchases and sales of inventory under a periodic inventory system. Periodic Inventory System Sales Discounts Illustration: On May 14, PW Audio Supply receives payment of $3,430 on account from Sauk Stereo. PW Audio honors the 2% cash discount and records the payment of Sauk’s account receivable in full as follows.

65. 5-65 Appendix 5A LO 8 Explain the recording of purchases and sales of inventory under a periodic inventory system. Periodic Inventory System Comparison of Entries

66. 5-66 Appendix 5A LO 8 Explain the recording of purchases and sales of inventory under a periodic inventory system. Periodic Inventory System Comparison of Entries

67. 5-67  Under both GAAP and IFRS, a company can choose to use either a perpetual or a periodic system.  Inventories are defined by IFRS as held-for-sale in the ordinary course of business, in the process of production for such sale, or in the form of materials or supplies to be consumed in the production process or in the providing of services. Key Points LO 9 Compare the procedures for the merchandising under GAAP and IFRS.

68. 5-68 Key Points  Under GAAP, companies generally classify income statement items by function. Classification by function leads to descriptions like administration, distribution, and manufacturing. Under IFRS, companies must classify expenses by either nature or function. Classification by nature leads to descriptions such as the following: salaries, depreciation expense, and utilities expense. If a company uses the functional-expense method on the income statement, disclosure by nature is required in the notes to the financial statements. LO 9 Compare the procedures for the merchandising under GAAP and IFRS.

69. 5-69 Key Points  Presentation of the income statement under GAAP follows either a single-step or multiple-step format. IFRS does not mention a single-step or multiple-step approach.  Under IFRS, revaluation of land, buildings, and intangible assets is permitted. The initial gains and losses resulting from this revaluation are reported as adjustments to equity, often referred to as other comprehensive income.  IAS 1, “Presentation of Financial Statements,” provides general guidelines for the reporting of income statement information. LO 9 Compare the procedures for the merchandising under GAAP and IFRS.

70. 5-70 Key Points  Similar to GAAP, comprehensive income under IFRS includes unrealized gains and losses (such as those on certain types of investment securities) that are not included in the calculation of net income.  IFRS requires that two years of income statement information be presented, whereas GAAP requires three years. LO 9 Compare the procedures for the merchandising under GAAP and IFRS.

71. 5-71 Looking to the Future The IASB and FASB are working on a project that would rework the structure of financial statements. Specifically, this project will address the issue of how to classify various items in the income statement. It will adopt major groupings similar to those currently used by the statement of cash flows (operating, investing, and financing), so that numbers can be more readily traced across statements. The new financial statement format was heavily influenced by suggestions from financial statement analysts. LO 9 Compare the procedures for the merchandising under GAAP and IFRS.

72. 5-72 Which of the following would not be included in the definition of inventory under IFRS? a)Photocopy paper held for sale by an office-supply store. b)Stereo equipment held for sale by an electronics store. c)Used office equipment held for sale by the human relations department of a plastics company. d)All of the above would meet the definition. IFRS Practice LO 9 Compare the procedures for the merchandising under GAAP and IFRS.

73. 5-73 Which of the following would not be a line item of a company reporting costs by nature? a)Depreciation expense. b)Salaries expense. c)Interest expense. d)Manufacturing expense. IFRS Practice LO 9 Compare the procedures for the merchandising under GAAP and IFRS.

74. 5-74 Which of the following would not be a line item of a company reporting costs by function? a)Administration. b)Manufacturing. c)Utilities expense. d)Distribution. IFRS Practice LO 9 Compare the procedures for the merchandising under GAAP and IFRS.

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