Sales DiscountsA sales discountis an incentive the seller offers in exchange for prompt payment on credit sales. Sales discounts are recorded in another centrarevenue account, enabling management to monitor the effectiveness of the company's discount policy. Invoices generally includecredit terms, which specify when the customer must pay and define the sales discount if one is available. For example, the credit terms on the invoice below are 2/10, n/30, which is read twoten, net thirty.

The terms 2/10, n/30 mean the customer may take a two percent discount on the outstanding balance (original invoice amount less any returns and allowances) if payment occurs within ten days of the invoice date. If the customer chooses not to take the discount, the outstanding balance is due within thirty days. An abbreviation that sometimes appears in the credit terms section of an invoice isEOM, which stands forend of month. The terms n/15 EOM indicate that the outstanding balance is due fifteen days after the end of the month in which the invoice is dated.If Music World returns merchandise worth $100 after receiving a $1,000 order, they still owe Music Suppliers, Inc., $900. Assuming the credit terms are 2/10, n/30 and Music World pays the invoice within ten days, the payment equals $882, an amount calculated by subtracting $18 (2% of $900) from the outstanding balance. To record this payment from Music World, Music Suppliers, Inc., makes a compound journal entry that increases (debits) cash for $882, increases (debits) sales discounts for $18, and decreases (credits) accounts receivable for $900.

Net SalesNet salesis calculated by subtracting sales returns and allowances and sales discounts from sales. Suppose Music Suppliers, Inc., sells merchandise worth $116,500 during June and, in conjunction with these sales, handles $9,300 in returns and allowances and $1,200 in sales discounts. The company's net sales for June equal $106,000.

Music Suppliers, Inc. Calculation of Net Sales For the Month Ended June 30, 20X3Sales$116,500

Less: Sales Returns and Allowances$9,300

Sales Discounts1,20010,500

Net Sales$106,000

Cliff's NotesInventory SystemsThere are two systems to account for inventory: the perpetual system and the periodic system. With theperpetual system, the inventory account is updated after every inventory purchase or sale. Before computers became widely available, only companies that sold a relatively small number of highpriced items used this system. Under theperiodic system, a careful evaluation of inventory occurs only at the end of each accounting period. At that time, each product available for sale is counted and multiplied by its per unit cost, and the total of all such calculations equals the value of inventory.

Cliff's Notes I love watching TV court shows, and would enjoy them more if I understood some of the legal jargon, likeex post facto.What does that mean? Which U.S. presidents also served in the House of Representatives?More Study HelpRecording PurchasesUnder the periodic system, a temporary expense account namedmerchandise purchases, or simplypurchases, is used to record the purchase of goods intended for resale. The source documents used to journalize merchandise purchases include the seller's invoice, the company's purchase order, and a receiving report that verifies the accuracy of the inventory quantities. When Music World receives a shipment of merchandise worth $1,000 on account from Music Suppliers, Inc., Music World increases (debits) the purchases account for $1,000 and increases (credits) accounts payable for $1,000.

For reference purposes, the journal entry's description usually includes the invoice number.When a seller pays to ship merchandise to a purchaser, the seller records the cost as a delivery expense, which is considered an operating expense and, more specifically, a selling expense. When a purchaser pays the shipping fees, the purchaser considers the fees to be part of the cost of the merchandise. Instead of recording such fees directly in the purchases account, however, they are recorded in a separate expense account namedfreightinortransportationin, which provides management with a way to monitor these shipping costs.If Music World pays a shipping company $30 for delivering the merchandise from Music Suppliers, Inc., Music World increases (debits) freightin for $30 and decreases (credits) cash for $30.

Freight terms, which indicate whether the purchaser or seller pays the shipping fees, are often specified with the abbreviations FOB shipping point or FOB destination.FOBmeansfree on board.FOB shipping pointmeans the purchaser pays the shipping fees and gains title to the merchandise at the shipping point (the seller's place of business).FOB destinationmeans the seller pays the shipping fees and maintains title until the merchandise reaches its destination (the purchaser's place of business).More Study HelpReturns and AllowancesWhen a purchaser receives defective, damaged, or otherwise undesirable merchandise, the purchaser prepares adebit memorandumthat identifies the items in question and the cost of those items. The purchaser uses the debit memorandum to inform the seller about the return and to prepare a journal entry that decreases (debits) accounts payable and increases (credits) an account namedpurchases returns and allowances, which is a contraexpense account. Contraexpense accounts normally have credit balances. On the income statement, the purchases returns and allowances account is subtracted from purchases.

If Music World discovers $100 worth of defective merchandise in the shipment from Music Suppliers, Inc., Music World prepares a debit memorandum, returns the merchandise, and makes a journal entry that decreases (debits) accounts payable for $100 and that increases (credits) purchases returns and allowances for $100.

For reference purposes, the journal entry's description may include the debit memorandum number and the seller's invoice number.Accounting InventoryAlthough the accounting cycle and the basic accounting principles are the same for companies that sell merchandise and companies that provide services, merchandising companies use several accounts that service companies do not use. The balance sheet includes an additional current asset calledmerchandise inventory, or simplyinventory, which records the cost of merchandise held for resale. On balance sheets, the inventory account usually appears just below accounts receivable because inventory is less liquid than accounts receivable.

Music World Partial Balance Sheet June 30, 20X3ASSETS

Current Assets

Cash$10,000

Accounts Receivable2,000

Inventory37,000

Supplies1,000

Prepaid Insurance2,000

Total Current Assets$52,000

Merchandising companies also have several specific income statement accounts designed to provide detailed information about revenues and expenses associated with salable merchandise.Purchases DiscountsCompanies that take advantage of sales discounts usually record them in an account namedpurchases discounts, which is another contraexpense account that is subtracted from purchases on the income statement. If Music Suppliers, Inc., offers the terms 2/10, n/30 and Music World pays the invoice's outstanding balance of $900 within ten days, Music World takes an $18 discount. To record this payment to Music Suppliers, Inc., Music World makes a compound journal entry that decreases (debits) accounts payable for $900, decreases (credits) cash for $882, and increases (credits) purchases discounts for $18.

Recording SalesSales invoicesare source documents that provide a record for each sale. For control purposes, sales invoices should be sequentially prenumbered to help the accounting department determine the disposition of every invoice.Sales revenuesequal the selling price of all products that are sold. In accordance with the revenue recognition principle, sales revenue is recognized when a customer receives title to the merchandise, regardless of when the money changes hands. If a customer purchases merchandise at a sales counter and takes possession of the goods immediately, the sales invoice or cash register receipt is the only source document needed to record the sale. However, if merchandise is shipped to the customer, a delivery record or shipping document is matched with the invoice to prove that the merchandise has been shipped to the customer.

Suppose a company named Music Suppliers, Inc., sells merchandise worth $1,000 on account to a retail store named Music World. Music Suppliers, Inc., records the sale with the journal entry below.

For reference purposes, the journal entry's description often includes the invoice number.Net Purchases and Goods PurchasedNet purchasesis found by subtracting the credit balances in the purchases returns and allowances and purchases discounts accounts from the debit balance in the purchases account Thecost of goods purchasedequals net purchases plus the freightin account's debit balance.

Sales Returns and AllowancesAlthough sales returns and sales allowances are technically two distinct types of transactions, they are generally recorded in the same account.Sales returnsoccur when customers return defective, damaged, or otherwise undesirable products to the seller.Sales allowancesoccur when customers agree to keep such merchandise in return for a reduction in the selling price.

If Music World returns merchandise worth $100, Music Suppliers, Inc., prepares acredit memorandumto account for the return. This credit memorandum becomes the source document for a journal entry that increases (debits) the sales returns and allowances account and decreases (credits) accounts receivable.

A $100 allowance requires the same entry.In the sales revenue section of an income statement, the sales returns and allowances account is subtracted from sales because these accounts have the opposite effect on net income. Therefore, sales returns and allowances is considered acontrarevenue account, which normally has a debit balance. Recording sales returns and allowances in a separate contrarevenue account allows management to monitor returns and allowances as a percentage of overall sales. High return levels may indicate the presence of serious but correctable problems. For example, improved packaging might minimize damage during shipment, new suppliers might reduce the amount of defective merchandise, or better methods for recording and packaging orders might eliminate or reduce incorrect merchandise shipments. The first step in identifying such problems is to carefully monitor sales returns and allowances in a separate, contrarevenue account.The Cost of Goods Available and SoldThecost of goods available for saleequals the beginning value of inventory plus the cost of goods purchased. Thecost of goods soldequals the cost of goods available for sale less the ending value of inventory.

Gross ProfitGross profit,which is also calledgross margin,represents the company's profit from selling merchandise before deducting operating expenses such as salaries, rent, and delivery expenses. Gross profit equals net sales minus the cost of goods sold.

The statement of owner's equity and the statement of cash flows are the same for merchandising and service companies. Except for the inventory account, the balance sheet is also the same. But a merchandising company's income statement includes categories that service enterprises do not use. A singlestep income statement for a merchandising company lists net sales under revenues and the cost of goods sold under expenses.

Music World Income Statement For the Year Ended June 30,20X3Revenues

Net Sales$1,172,000

Interest Income7,500

Gain on Sale of Equipment1,500

Total Revenues1,181,000

Expenses

Cost of Goods Sold$596,600

Selling Expenses177,000

General and Administrative Expenses152,900

Interest Expense18,000

Total Expenses944,500

Net Income$ 236.500

Although the singlestep format is easier to read than the multiplestep format, most companies produce a multiplestep income statement, which clearly identifies each step in the calculation of net income or net loss.Music World Income Statement For the Year Ended June 30,20X3

Sales$1,240,000

Less: Sates Returns and Allowances$65,000

Sales Discounts3,00068,000

Net Sates1,172,000

Cost of Goods Sold

Inventory, July 1,20X237,000

Purchases$610,000

Less: Purchases Returns and Allowances$9,000

Purchases Discounts8,00017,000

Net Purchases593,000

Add: Freight-In5,600

Cost of Goods Purchased598,600

Cost of Goods Available for Sate635,600

Less: Inventory, June 30,20X339,000

Cost of Goods Sold596,600

Gross Profit575,400

Operating Expenses

Selling Expenses

Sales Salaries Expense120,000

Sales Commission Expense21,000

Delivery Expense15,000

Store Rent Expense12,000

Depredation Expense-Store Equipment9,000

Total Selling Expenses177,000

General and Administrative Expenses

Office Salaries Expense140,000

Insurance Expense6,000

Depredation Expense-Office Equipment5,000

Office Rent Expense1,200

Office Supplies Expense700

Total General and Administrative Expenses152,900

Total Operating Expenses329,900

Operating Income245,500

Other Income/(Expense), Net

Interest Income7,500

Gain on Sate of Equipment1,500

Interest Expense(18,000)

Other Income/(Expense), Net(9,000)

Net Income$236,500

Key Topics to Know Note: The same example transactions are presented for Purchase Transactions and Sales Transactions to highlight the differences between cost and selling price. Purchase Transactions When companies purchase goods they intend to sell to customers, the transaction is recorded in the Merchandise Inventory account, a current asset. Inventory is recorded at cost, which includes the price paid for the goods plus all necessary costs of getting the inventory to the companys place of business and ready to sell. The rules of FOB determine whether freight costs are included in the cost of inventory. Example 1: $800 of inventory is purchased for cash, FOB shipping point. In a separate transaction, the purchaser pays $100 of shipping charges to the shipping company, which are added to the cost of the inventory. Therefore the total cost of the inventory purchased is $800 purchase price + $100 shipping charges: Merchandise Inventory 800 Cash 800 Merchandise Inventory 100 Cash 100 $200 of merchandise purchased is returned prior to payment: Cash 200 Merchandise Inventory 200 Example 2: $800 of inventory is purchased on account, FOB shipping point. The seller pays $100 to the shipping company on behalf of the buyer, which is added to the sellers invoice. The credit terms offered by the seller are 2/10, n/30. Therefore the total cost of the inventory purchased is $800 purchase price + $100 shipping charges: Merchandise Inventory 900 A/P 900 $200 of merchandise purchased is returned prior to payment. A/P 200 Merchandise Inventory 200 Revised Fall 2012 Page 6 of 25 When the invoice is paid within the discount period $800 purchase - $200 return = $600 merchandise * 2% = $12 discount $700 owed ($600 + $100 shipping) - $12 discount = $688 paidA/P 700 Cash 688 Merchandise Inventory 12 Example 3: $800 of inventory is purchased on account, FOB destination. In a separate transaction, the seller pays $100 of shipping charges to the shipping company. The buyer records only the cost of the merchandise. The credit terms offered by the seller are 2/10, n/30. Therefore the total cost of the inventory purchased is $800 purchase price. Merchandise Inventory 800 A/P 800 $200 of merchandise purchased is returned prior to payment. A/P 200 Merchandise Inventory 200 When the invoice is paid within the discount period assuming credit terms of 2/10, n/30: $800 purchase - $200 return = $600 merchandise * 2% = $12 discount $600 owed - $12 discount = $588 paid A/P 500 Cash 490 Merchandise Inventory 10 Practice Problem #1 Journalize the following purchase related transactions: a. Jingle Co. purchased $4,000 worth of merchandise on account, terms 2/10, n/30, FOB shipping point. Prepaid transportation charges of $200 were added to the invoice. b. Returned $500 of merchandise purchased in (a). c. Paid on account for purchases in (a), less return (b) and discount. Revised Fall 2012 Page 7 of 25 Sales Transactions When companies sell merchandise inventory, the transaction requires two journal entries: the first entry records the revenue from the sale at the selling price and the second entry decreases the inventory account and records the expense of the sale at cost. Revenue (sales) is recorded at the time the transaction occurs, regardless of whether payment is received from the buyer. Revenue is always greater the cost of the goods being sold. Inventory is decreased for the cost of the inventory sold, which includes the price paid for the goods plus all necessary costs of getting the inventory to the companys place of business and ready to sell as noted above. The rules of FOB determine whether freight costs are recorded as transportation out, a selling expense. The seller would record the examples in Purchase Transactions above as follows. Note that the seller had a gross margin ratio of 20%. Example 1: Inventory is sold for $800 cash (FOB shipping point. In a separate transaction, the purchaser pays $100 of shipping charges to the shipping company. The total cost of the inventory when purchased was $640 (800 ( 20% * 800)): Cash 800 Sales 800 Cost of Goods Sold 640 Merchandise Inventory 640 $200 of merchandise purchased is returned by the customer prior to payment: Sales returns and Allowances 200 Cash 200 Merchandise Inventory 160 Cost of Goods Sold 160 Example 2: $800 of inventory is sold on account, FOB shipping point. The seller pays $100 to the shipping company on behalf of the buyer, which is added to the sellers invoice. The credit terms offered by the seller are 2/10, n/30. Therefore the total account receivable is $900 selling price + $100 shipping charges. The total cost of the inventory when purchased was $640 (800 (20% * 800)):A/R 900 Sales 800 Cash 100 Cost of Goods Sold 640 Merchandise Inventory 640 $200 of merchandise purchased is returned prior to payment. Sales Returns and Allowances 200 A/R 200 Merchandise Inventory 160 Cost of Goods Sold 160 When the invoice is paid within the discount period $800 purchase - $200 return = $600 merchandise * 2% = $12 discount $700 owed ($600 + $100 shipping) - $12 discount = $688 paid Cash 688 Sales Discounts 12 A/R 700 Example 3: $800 of inventory is sold on account, FOB shipping point. In a separate transaction, the seller pays $100 to the shipping company. Therefore the total account receivable is $800 selling price. The total cost of the inventory when purchased was $640 (800 20% * 800): A/R 800 Sales 800 Cost of Goods Sold 640 Merchandise Inventory 640 Transportation Out 100 Cash 100 $200 of merchandise purchased is returned prior to payment. Sales Returns and Allowances 200 A/R 200 Merchandise Inventory 160 Cost of Goods Sold 160 When the invoice is paid within the discount period $800 purchase - $200 return = $600 merchandise * 2% = $12 discount$600 owed - $12 discount = $588 paid Cash 588 Sales Discounts 12 A/R 600 Practice Problem #2 Journalize the following sales related transactions. a) Sold merchandise on account to Jangle Co., $5,000, terms FOB Shipping Point, 2/10, n/30. The cost of the merchandise sold was $3,000. Paid transportation charges of $200, which were added to the invoice. b) Sold merchandise on account to Comet Co., $10,000, terms FOB Destination, 1/10, n/30. The cost of the merchandise was $6,000. c) Paid transportation charges of $400 for delivery of merchandise sold to Comet Co. d) Issued credit memorandum for $2,000 to Comet Co. for merchandise returned from sale in (b). The cost of the merchandise was $1,200. e) Received amount due from Jangle Co. within the discount period. f) Received amount due, less return and discount from Comet Co.g) Sold merchandise on account to Jangle Co., $5,000, terms FOB Shipping Point, 2/10, n/30. The cost of the merchandise sold was $3,000. Paid transportation charges of $200, which were added to the invoice. h) Sold merchandise on account to Comet Co., $10,000, terms FOB Destination, 1/10, n/30. The cost of the merchandise was $6,000. i) Paid transportation charges of $400 for delivery of merchandise sold to Comet Co. j) Issued credit memorandum for $2,000 to Comet Co. for merchandise returned from sale in (b). The cost of the merchandise was $1,200. k) Received amount due from Jangle Co. within the discount period. l) Received amount due, less return and discount from Comet Co.Practice Problem #2 a) Accounts Receivable/Jangle 5,200 Sales 5,000 Cash 200 Cost of Merchandise Sold 3,000 Merchandise Inventory 3,000 b) Accounts Receivable/Comet 10,000 Sales 10,000 Cost of Merchandise Sold 6,000 Merchandise Inventory 6,000 c) Transportation Out 400 Cash 400 d) Sales Returns & Allowances 2,000 Accounts Receivable/Comet 2,000 Merchandise Inventory 1,200 Cost of Merchandise Sold 1,200 e) Cash 5,100 Sales Discounts 100 Accounts Receivable/Jangle 5,200 $5,000 sale * 2% = $100 discount$5,200 owed ($5,000 + $200 shipping) - $100 discount = $5,100 received Cash 7,920 Sales Discounts 80 Accounts Receivable/Comet 8,000 $10,000 sale - $2,000 return = $8,000 owed$8,000 * 1% = $80 discount $8,000 owed - $80 discount = $7,920 receivedInventory Shrinkage When a company takes a physical count of its inventory, should it reasonably expect to find all of the inventory items present and accounted for? Unfortunately, this is not always the case. Inventory could have been stolen (e.g. shoplifting) or damaged, disposed of and not reported as such (e.g. the inventory fell off the shelf in the warehouse, was damaged by the fall and was disposed of by the cleaning crew). Although companies try to protect their inventory through proper internal controls, inventory losses or shrinkage still occur. Under the matching principle, these losses are recorded as expenses in the period in which they occur to match them against the revenue earned. Although the text suggests that they should be recorded as cost of goods sold, in practice they may be recorded in a separate inventory shrinkage expense account reported within cost of goods sold. Example: The balance in the Merchandise Inventory account in the general ledger was $300,000 before adjustment. A Physical Inventory was taken and the value of the merchandise on hand was $294,000. Adjusting entry required: Cost of Merchandise Sold 6,000 Merchandise Inventory 6,000 Multi-Step Income Statement The Multi-Step Income statement provides a substantial amount of additional significant information to the user of the financial statements. It also incorporates revenues and expenses unique to the merchandising company versus a service provider. Key changes compared to the single-step income statement include: Gross-to-Net Sales to account for contra-revenue accounts Gross Profit to report the margin or profit remaining after covering the cost of merchandise sold that is available to cover operating expenses Separating Operating Expenses into selling expenses and administrative expenses to provide an additional level detail Income from Operations to report the profitability of the companys reason for being in business Other Income and Other Expense to identify the revenues and expenses not related to the companys reason for being in business Revised Fall 2012 Page 11 of 25 In real life, income tax expense would be reported between net other revenues and expenses and Net Income. It is excluded in this illustration and in the textbook for simplicity. Gross Sales $500,000 - Sales Returns & allow. $5,000 - Sales Discounts 3,000 8,000 Net Sales 492,000 Cost of Merchandise Sold 294,000 Gross Profit 198,000 Operating Expenses: Selling Expenses 50,000 Admin Expense 45,000 Total Operating Expenses 95,000 Income from Operations 103,000 Other Income: Interest Revenue 1,000 Other Expenses: Interest Expense 700 300 Net Income $102,700 Practice Problem #3 Using the format for the multi-step income statement, compute the following: a. Calculate Net Sales and Gross Profit if, Sales are $375,000, Sales Returns and Allowances are $32,000, Sales Discounts are $12,000 and Cost of Merchandise Sold is $255,000. b. Calculate Sales Returns and Allowances and Cost of Merchandise Sold if, Sales are $750,000, Sales Discounts are $9,000, Net Sales are $736,000 and Gross Profit is $310,000. c. Calculate Sales and Net Sales if, Sales Returns and Allowances are $25,000, Sales Discounts are $15,000, Cost of Merchandise Sold is $620,000 and Gross Profit is $185,000. Practice Problem #3 a) Sales $375,000 - Sales Returns & Allowances (32,000) - Sales Discounts (12,000) Net Sales 331,000 -Cost of Merchandise Sold (255,000) Gross Profit $76,000 b) Sales $750,000 750,000 x 9,000 = 736,000 - Sales Returns & Allowances x 741,000 x = 736,000 - Sales Discounts (9,000) x = 5,000 Net Sales 736,000 736,000 y = 310,000 - Cost of Merchandise Sold y y = 426,000 Gross Profit $310,000 c) Sales X x 25,000 15,000 = y - Sales Returns & Allowances (25,000) - Sales Discounts (15,000) y 620,000 = 185,000 Net Sales Y y = 805,000 - Cost of Merchandise Sold (620,000) x = 845,000 Gross Profit 185,00 Page 12 of 25 Practice Problem #4 Journalize the following related transactions. a) Purchased mdse on account from Blitzen Co., list price $20,000, trade discount 25%, terms FOB shipping point, 2/10, n/30, with prepaid transportation costs of $650 added to the invoice. b) Purchased merchandise on account from Cupid Co., $8,000, terms FOB destination, 1/10, n/30. c) Sold merchandise on account to Donner Co., $9,800, terms 2/10, n/30. The cost of the merchandise sold was $5,800. d) Returned $2,000 of merchandise purchased from Cupid Co. (b) e) Paid Blitzen Co. on account for purchase in (a) less discount. f) Received merchandise returned by Donner Co. from sale in (c), $1,800. The cost of the merchandise returned was $1,080. g) Paid Cupid Co. on account for purchase in (b) less return (d) and discount. h) Received cash on account from Donner Co. for sale in (c) less return (f) and discount. i) Perpetual inventory records indicate that $85,000 of merchandise should be on hand. The physical inventory indicates that $81,350 Practice Problem #4 a. Merchandise Inventory 15,650 Accounts Payable/Blitzen 15,650 (20,000 * 25%) = $5,000 discount (20,000 5,000 + 650 shipping) b. Merchandise Inventory 8,000 Accounts Payable/Cupid 8,000 c. Accounts Receivable/Donner 9,800 Sales 9,800 Cost of Merchandise Sold 5,800 Merchandise Inventory 5,800 d. Accounts Payable/Cupid 2,000 Merchandise Inventory 2,000 e. Accounts Payable/Blitzen 15,650 Cash 15,350 Merchandise Inventory 300 (15,000 mdse * 2% = $300 disc.) f. Sales Returns & Allowances 1,800 A/R Donner 1,800 Merchandise Inventory 1,080 Cost of Merchandise Sold 1,080 g. Accounts Payable/Cupid 6,000 Cash 5,940 Merchandise Inventory 60 (8,000 2,000 return = 6,000 bal.) (6,000 * 1% = $60 discount) h. Cash 7,840 Sales Discount 160 A/R Donner 8,000 (8,000 * 2% = $160 discount) (9,800 1,800 return = 8,000 bal.) i. Cost of Merchandise Sold 3,650 Merchandise Inventory 3,650 (85,000 81,350 = 3,650)oSOLUTIONS TO PRACTICE PROBLEMS Practice Problem #1 a) Merchandise Inventory 4,200 A/P 4,200 b) A/P 500 Merchandise Inventory 500 c) A/P 3,700 Cash 3,630 Merchandise Inventory 70f merchandise is on handCost of goods available for sale, cost of goods sold (COGS), gross margin, inventory; selling and administrative expenses; multi-step income statement and single-step income statement.1. Definition of inventoryWe have talked about businesses that provide services. However, there are other types of businesses and one of them is a merchandising company. Merchandising companies create a supply of goods that are delivered to customers. This supply is calledinventory:Inventoryis a current asset on a company's balance sheet. Inventory includes goods for resale, raw materials, spare parts, etc.Inventory usually includes goods that are being made (in the process of being produced) and goods that are finished and ready for sale.Merchandise inventoryis goods that are held for resale by a merchandising company.Inventory for resale is accounted for in the Merchandise Inventory account. This is an asset account shown in the assets section of the balance sheet.2. Inventory costs. Product and period costsAll costs related to acquiring goods and making them ready for sale are accumulated in theMerchandise Inventoryaccount. Such costs are associated with products and often calledproduct costs:Product costsare costs required to produce inventory and make it ready for sale. Such costs are directly associated with the inventory production.Product costs are expensed in the period when inventory is sold regardless of when the inventory was purchased or produced by a company.There are a few types of expenditures that cannot be directly traced to a specific product. Such costs include (but are not limited to) advertising, administrative salaries, insurance, etc. Such costs are calledselling and administrative expenses:Selling and administrative expensesare expenses of selling and administrative nature that are not directly traceable to a specific product. Examples are advertising, administrative salaries and insurance, among others.Because selling and administrative expenditures are expensed in the period in which they are incurred, they are labeledperiod costs:Period costsare costs associated with a specific period and not a specific product. Period costs include selling and administrative expenses.3. Cost of goods available for sale and cost of goods soldThe total inventory cost for a given accounting period is calculated by adding the beginning inventory account balance to the amount of inventory acquired during the period. The result of adding these two numbers is called acost of goods available for sale:Cost of goods available for saleis the cost of goods acquired during a period plus the cost of goods on hand at the beginning of the period. This cost represents all inventories available for sale during the period.The cost of goods available for sale is allocated between the Merchandise Inventory account and an expense account calledCost of Goods Sold. At a period end, inventory that was not sold during the period is shown as an asset on the balance sheet (Merchandise Inventory) and inventory that was sold is shown as an expense on the income statement (Cost of Goods Sold).Cost of goods sold (COGS)is the difference between the cost of goods available for sale and the cost of goods on hand at a period end. This cost represents the cost of goods sold by the company during the period.Gross marginis the difference between the sales revenue (i.e., revenue generated from sales) and the cost of goods sold. Gross margin shows what profit the company made after the cost of goods sold, but before any other expenses (selling and administrative, etc.).Operating incomeis the difference between the gross margin and selling and administrative expenses.Sales

Less: Cost of Goods Sold

Gross Margin

Less: Selling and Administrative Expenses

Operating Income

4. Perpetual and periodic inventory systemsThere are two inventory accounting systems -perpetualandperiodic:Perpetual inventory systemmeans that the Inventory account is adjusted perpetually. The Inventory account is affected each time inventory is sold or purchased.Periodic inventory systemonly adjusts the Inventory account at the end of an accounting period. Purchases and sales do not affect the Inventory account during the accounting period, but do affect at the period end.Although both systems have different approaches to inventory accounting, they are to provide the same results. The cost of goods sold amount and the sales amount should be the same regardless which system a company applies.5. First illustration of accounting for inventory (period 1)In our example, we will follow the rules of the perpetual inventory system. Under the perpetual inventory system sales and purchases of inventory are recorded directly to the Merchandise Inventory account when they take place. The accounting events below refer to a bookstore business called Dav's Books that was opened in 20X6:1. The owner contributed $3,000 ofinventoryand $9,000 cash to the business.2. $4,000 cash was paid to purchase additional inventory.3. $200 cash was paid for the inventory transportation (see Event No. 2) from the vendor to the bookstore.4. Inventory that cost $2,000 was sold for $5,500 cash.5. Transportation expenses of $300 to deliver the sold goods (see Event No. 4) were incurred and paid with cash.6. $400 of selling expenses were incurred and paid with cash.5.1. Analysis of capital contribution transactionEvent No. 1: The owner made a combinedcapital contributionthat consisted of cash and inventory. Cash ($9,000), Inventory ($3,000), and Contributed Capital (totally, $12,000) increase. This is an asset source transaction:Illustration 1: Effect of capital contributionEvent No.Balance SheetIncome StatementCash Flows

Cash+Inv.=Cont. Cap.+Ret. Earn.Rev.-Exp.=Net Inc.

Beg.$ 0+$ 0=$ 0+$ 0$ 0-$ 0=$ 0

19,000+3,000=12,000+n/an/a-n/a=n/a9,000FA

End.9,000+3,000=12,000+00-0=0

5.2. Analysis of inventory acquisition transactionEvent No. 2: TheMerchandise Inventoryaccount increased when the $4,000 inventory purchase was made. Inventory increased and cash decreased. This is an asset exchange transaction:Illustration 2: Effect of inventory acquisitionEvent No.Balance SheetIncome StatementCash Flows

Cash+Inv.=Cont. Cap.+Ret. Earn.Rev.-Exp.=Net Inc.

Beg.9,000+3,000=12,000+00-0=0

2(4,000)+4,000=n/a+n/an/a-n/a=n/a(4,000)OA

End.5,000+7,000=12,000+00-0=0

5.3. Analysis of transportation-in costsEvent No. 3: Recall that all expenses incurred to deliver goods and make them ready for sale are treated as part of inventory costs and recorded in the Merchandise Inventory account. So, the transportation costs related to the delivery of inventory from the vendor to the bookstore are recorded in theMerchandise Inventoryaccount. This transportation expense is calledtransportation-in:Transportation-in expendituresare costs incurred to deliver inventory from a vendor (supplier) to a company. Transportation-in costs are treated as part of the inventory costs (product costs).The transaction acts to increase merchandise inventory and to decrease cash. This is an asset exchange transaction:Illustration 3: Effect of transportation-in costsEvent No.Balance SheetIncome StatementCash Flows

Cash+Inv.=Cont. Cap.+Ret. Earn.Rev.-Exp.=Net Inc.

Beg.5,000+7,000=12,000+00-0=0

3(200)+200=n/a+n/an/a-n/a=n/a(200)OA

End.4,800+7,200=12,000+00-0=0

5.4. Analysis of inventory sale transactionEvent No. 4: This event is composed of two parts. The first one (4a in the table below) is the recognition of salesrevenue. Cash andRetained Earningsincrease by $5,500. Transaction 4a is an asset source transaction. The second part (4b) is designed to record the cost of goods sold. Remember that goods are only expensed at the point of sale (under the perpetual system). Accordingly, $2,000 should be removed from the Merchandise Inventory account and placed to the expense account calledCost of Goods Sold. Transaction 4b is an asset use transaction.Illustration 4: Effects of inventory saleEvent No.Balance SheetIncome StatementCash Flows

Cash+Inv.=Cont. Cap.+Ret. Earn.Rev.-Exp.=Net Inc.

Beg.4,800+7,200=12,000+00-0=0

4a5,500+n/a=n/a+5,5005,500-n/a=5,5005,500OA

4bn/a+(2,000)=n/a+(2,000)n/a-(2,000)=(2,000)

End.10,300+5,200=12,000+3,5005,500-(2,000)=3,500

5.5. Analysis of transportation-out expensesEvent No. 5: The cash expenditure made by the bookstore to deliver goods to the customer is calledtransportation-out:Transportation-out expendituresare expenses incurred to deliver products from a company to a customer. Transportation-out expenditures are treated as period costs and expensed in the period of incurrence.The company records transportation-out expenditures as an operating expense. This is an asset use transaction:Illustration 5: Effect of transportation-out expensesEvent No.Balance SheetIncome StatementCash Flows

Cash+Inv.=Cont. Cap.+Ret. Earn.Rev.-Exp.=Net Inc.

Beg.10,300+5,200=12,000+3,5005,500-(2,000)=3,500

5(300)+n/a=n/a+(300)n/a-(300)=(300)(300)OA

End.10,000+5,200=12,000+3,2005,500-(2,300)=3,200

5.6. Analysis of selling expenses transactionEvent No. 6: The $400 cash payment for selling expense has the same effect as operating expenses do. Cash andRetained Earningsdecrease. This is an asset use transaction:Illustration 6: Effect of selling expensesEvent No.Balance SheetIncome StatementCash Flows

Cash+Inv.=Cont. Cap.+Ret. Earn.Rev.-Exp.=Net Inc.

Beg.10,000+5,200=12,000+3,2005,500-(2,300)=3,200

6(400)+n/a=n/a+(400)n/a-(400)=(400)(400)OA

End.9,600+5,200=12,000+2,8005,500-(2,700)=2,800

. Comparison of the periodic and perpetual inventory systemsTheperiodic inventory systemis known to be used more frequently than the perpetual one. The reason is simple. It is easier to make a few period-end adjusting entries than to adjust accounting records every time a sale or purchase is made (for example, grocery store sales are very frequent). Under the periodic system the cost of goods sold is determined at the end of the period. Purchases or sales of inventory do not affect the inventory account during the period. When goods are purchased, the cost is recorded in the Purchases (Inventory Purchases) account. When goods are sold, a reduction in the Inventory account does not take place. Transportation-out expenditures, purchase returns, and allowances are recorded in separate accounts. The cost of goods sold is calculated by subtracting the amount of ending inventory from the total cost of goods available for sale (see the table below). The ending inventory is determined by performing a period end physical count.Theschedule of cost of goods soldhelps in performing these computations:Illustration 13: Schedule of cost of goods soldBeginning Inventory

Plus: Purchases

Plus: Transportation-in

Less: Purchase Returns and Allowances

Less: Purchase Discounts

Cost of Goods Available for Sale

Less: Ending Inventory

Cost of Goods Sold

However, there is one weak point about the periodic system which relates to lost, damaged, or stolen merchandise. Because the periodic system determines the cost of goods sold and the ending inventory at the end of the period, it is impossible, during the period, to figure out whether there were any goods stolen, damaged, or lost. It is rather difficult even at the period end because all goods not available at hand are considered sold.At the same time, it is quite easy to figure out damaged, lost, or stolen goods if a company employs theperpetual system. A simple comparison of the physically counted merchandise on hand at the end of the period and the book balance of the Merchandise Inventory account will do the job. If there is a difference between the two, then some goods were damaged, stolen, or lost. In such a case an adjusting entry is needed to record the goods not available any more. The adjusting entry acts to decrease assets and equity. The equity is decreased by increasing an expense account calledInventory Loss(or sometimes directly increasing the Cost of Goods Sold account). The assets are decreased by reducing the Inventory account.For example, let us assume a company applies the perpetual inventory system and has the book balance of the Merchandise Inventory account of $1,500. The physical count at the end of the period showed that only $1,300 of goods was on hand. The inventory loss of $200 ($1,500 - $1,300) should be recorded as follows:Illustration 14: Effect of recording inventory loss in the horizontal modelAssets=Liabilities+EquityRev.-Exp.=Net Inc.Cash Flow

(200)=n/a+(200)n/a-(200)=(200)n/a

The entry in the general journal looks like this:Illustration 15: Journal entry to record the inventory lossEvent NoAccount titlesDebitCredit

1Inventory Loss (Cost of Goods Sold)200

Inventory200

Perpetual vs. Periodic Inventory System Journal EntriesA. The Sale and Purchase of ProductsPerpetual inventory systems show all changes in inventory in the "Inventory" account. Purchase accounts are not used in a perpetual inventory system.Periodic inventory systems keep the inventory balance at the same value that it was at the beginning of the year. At year end, the inventory balance is adjusted to a physical count. To account for inventory purchases in a periodic inventory system, an account called "Purchases" is used rather than debiting "Inventory". Example: (Unit cost is held constant to avoid the necessity of a using a cost flow assumption)

Beginning inventory 100 units @ $6 = $ 600 Purchases 900 units @ $6 = $5,400 Sales 600 units @ $12 = $7,200 Ending inventory 400 units @ $6 = $2,400

Perpetual Inventory System | Periodic Inventory System ---------------------------------------------------------------------- 1. Beginning inventory 100 units at $600 ---------------------------------------------------------------------- Inventory account shows | Inventory account shows $600 in inventory. | $600 in inventory. ---------------------------------------------------------------------- 2. Purchase of 900 units at $6 per unit ---------------------------------------------------------------------- Inventory 5,400 | Purchases 5,400 Acc. Payable 5,400| Acc. Payable 5,400 ---------------------------------------------------------------------- 3. Sale of 600 units at a selling price of $12 per unit ---------------------------------------------------------------------- Acc. Receivable 7,200 | Acc. Receivable 7,200 Sales 7,200| Sales 7,200 | Cost of Goods Sold 3,600 | No entry Inventory 3,600| ---------------------------------------------------------------------- 4. End-of-period entry for inventory adjustment ---------------------------------------------------------------------- No entry needed. | Inventory 1,800 The ending balance of inventory | Cost of Goods Sold 3,600 shows $2,400. | Purchases 5,400 ---------------------------------------------------------------------- Note: The periodic inventory adjustment in transaction 4 adjusts inventory to the physical count, closes out any purchase accounts, and runs any difference through cost of goods sold.

B. Cost of Goods Sold in a Periodic Inventory SystemPerpetual inventory systems record cost of goods sold and keep inventory at its current balance throughout the year. Therefore, there is no need to do a year-end inventory adjustment unless the perpetual records disagree with the inventory count. In addition, a separate cost of goods sold calculation is unnecessary since cost of goods sold is recorded whenever inventory is sold.The inventory account in a periodic inventory system keeps its beginning balance until the end of period adjustment to the physical inventory count. Therefore, a separate cost of goods sold calculation is necessary. The following calculation shows the calculation for the preceding example. Beginning Inventory 600 Net Purchases 5,400 ------- Goods Available for Sale 6,000 Ending Inventory 2,400 ------- Cost of Goods Sold 3,600 =======C. Purchase Returns and Allowances and Purchase Discounts"Purchases" has a normal debit balance since it replaces the debit to "Inventory". It has two contra accounts known as "Purchase Discounts" (Purch. Disc.) and "Purchase Returns and Allowances" (Purch. R&A) that reduce it to determine "Net Purchases". The balance of these two contra accounts is a credit because "Purchases" is a debit. Remember that contra accounts always have a normal balance that is opposite to what they are contra to. Purchase-type accounts are temporary accounts (i.e., they are closed at year end) and only appear in a periodic inventory system. They simply serve to replace the corresponding inventory portion of an entry that exists in a perpetual inventory system. The following entries illustrate purchase returns and discounts in perpetual and periodic inventory systems:

Perpetual Inventory System | Periodic Inventory System ----------------------------------------------------------------------- 1. Ace Company returned $600 of damaged merchandise and received a price reduction allowance of $100 on the portion of the merchandise they retained. ----------------------------------------------------------------------- Acc. Payable 700 | Acc. Payable 700 Inventory 700 | Purch. R&A 700 ----------------------------------------------------------------------- 2. In a previous transaction, Ace purchased merchandise on account at a cost of $1,000. The credit terms were 2/10, n/30. Ace paid for the merchandise within the discount period. ----------------------------------------------------------------------- Acc. Payable 1,000 | Acc. Payable 1,000 Inventory 20 | Purch. Disc. 20 Cash 980 | Cash 980 -----------------------------------------------------------------------

D. Sales Returns and Allowances and Sales DiscountsSales has two contra accounts known as "Sales Discounts" (Sales Disc.) and "Sales Returns and Allowances" (Sales R&A) that reduce it. The normal balance for these two contra accounts is a debit. Sales and its contra accounts may appear with either a perpetual or periodic inventory system. The following entries illustrate the accounts in perpetual and periodic inventory systems. The entries assume the gross method.

Perpetual Inventory System | Periodic Inventory System ----------------------------------------------------------------------- 1. Sam Company received $600 of damaged merchandise from their customer Ace. They also gave Ace a $100 allowance for some of the damaged merchandise that Ace retained. The original cost of the merchandise returned to Sam was $400. ----------------------------------------------------------------------- Sales R&A 700 | Sales R&A 700 Acc. Receivable 700 | Acc. Receivable 700 | Inventory 400 | No entry Cost of Goods Sold 400 | ----------------------------------------------------------------------- 2. Sam received a customer payment for a prior sale on account of $1,000 subject to credit terms of 2/10, n/30. The customer made payment within the discount period. ----------------------------------------------------------------------- Cash 980 | Cash 980 Sales Disc. 20 | Sales Disc. 20 Acc. Receivable 1,000| Acc. Receivable 1,000 -----------------------------------------------------------------------Sales on the income statement should be shown net of its contra accounts. For example, if a company has $980,000 in sales, $3,400 in sales returns and allowances, and $2,200 in sales discounts; net sales would be $974,400.. The FIFO MethodThe FIFO method considers the oldest goods sold first. The ending inventory consists of the newer purchases. During times of rising prices, FIFO will result in a higher ending inventory value and a lower cost of goods sold (i.e., in comparision to LIFO).B. The LIFO MethodThe LIFO method considers the most recent purchases as being sold first. The ending inventory consists of the older purchases. During times of rising prices, LIFO will result in a lower ending inventory and a higher cost of goods sold (i.e., in comparison to FIFO)C. Computing Cost of Goods Sold in a Periodic Inventory SystemThe calculations can be broken down into three basic parts:(1) determine goods available for sale, (2) determine the value of ending inventory, and (3) determining cost of goods sold.

Example:

Beginning Inventory, Jan. 1 10 units @ $20 per unit

Purchases: Jan 10 8 units @ $21 per unit Jan 30 10 units @ $22 per unit

Sales: Jan 4 7 units Jan 22 4 units Jan 28 2 units

Step 1: Determine Goods Available for Sale

Units Cost Total ----- ----- ----- Beginning Inventory 10 x $20 = $200 Jan 10 Purchases 8 x $21 = $168 Jan 30 Purchases 10 x $22 = $220 ----- ----- Goods available for sale 28 $588 ===== =====

Step 2: Determine Ending Inventory (28 units available - 13 units sold = 15)

A. FIFO

Units Cost Total ----- ----- ----- 10 x $22 = $220 5 x $21 = $105 ----- ----- 15 $325 ===== ===== A. LIFO

Units Cost Total ----- ----- ----- 10 x $20 = $200 5 x $21 = $105 ----- ----- 15 $305 ===== =====

Step 3: Determine Cost of Goods Sold

FIFO LIFO ------ ------ Goods Available for Sale $588 $588 Less Ending Inventory 325 305 ------ ------ Cost of Goods Sold $263 $283 ====== ======