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The accounting treatment of purchase returns, purchase discounts, and purchase allowances, as well as sales discounts, sales returns, and sales allowances. It also discusses the computation of cost of goods sold and the differences between perpetual and periodic inventory systems.
Typology: Lecture notes
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Chapter 4^1
Learning Objectives
(^1) Acknowledgement: An earlier version of this chapter was provided to all accounting
faculty on January 21, 2015, for review notes, comments, and recommendations for improvement. Work on this text began in early 2014. The completion of this text was made possible through a spring 2015 sabbatical from West Chester University.
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No, it is not an elephant.
Professor Cataldo and his wife, Holley, hold a stingray at Stingray City Antigua on December 31, 2014. They are large, but the crew feeds them, so they are very friendly.
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Merchandising firms generate net income by buying and selling merchandise. They can be wholesalers or retailers. The wholesaler purchases goods from the manufacturer and sells to the retailer. A retailer purchases goods from a wholesaler and sells to the consumer.
Manufacturer
Wholesaler
Retailer
Consumer
Merchandising Income Service firms differ from merchandisers. Service firms (e.g., CPA firms or law firms) generate revenues or sales from the sale of services. Merchandisers generate revenues or sales from the sale of merchandise or what might be referred to as cost of goods sold or cost of sales. The gross profit or gross margin is net sales less cost of goods sold or cost of sales.
Service Merchandising Revenues $100 Net Sales $ less: Cost of Goods Sold $ equals: Gross Profit $ less: Expenses $80 less: Expenses $ equals: Net Income $20 equals: Net Income $
Merchandise Inventory (or simply inventory) is a current asset included on a merchandiser’s balance sheet. The cost of merchandise inventory includes the costs incurred to buy the goods, ship them to the store, and prepare them for sale.
A Merchandiser’s Operating Cycle includes the (1) purchase goods or merchandise for inventory, (2) providing merchandise inventory available for sale, and (3) sell merchandise. The sale can be a cash sale, resulting in an immediate cash receipt, or a credit sale. If credit is extended to the buyer, an (4) account receivable is created and (5) a cash receipt or collection leads to the completion of the cycle, which is repeated. Merchandisers try to accelerate or shorten these operating cycles, since each inventory “turn” or cycle results in the generation of additional gross profit or gross margin. It is, of course, possible for cash collections from customers to occur before and/or after cash payments are made to vendors.
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Inventory Systems Cost of goods sold is the cost of merchandise inventory sold during a period. It is usually the largest single expense item on a merchandiser’s income statement. Cost of goods sold or the cost of sales is computed, as follows:
Beginning Inventory plus: Net Purchases equals: Merchandise Available for Sale less: Ending Inventory equals: Cost of Goods Sold
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Merchandise purchases and the cost of merchandise purchased for resale is recorded (debited) to merchandise inventory, a current asset account. For example, assume that Flynn Enterprises made a $1,000 cash purchase of merchandise on February 15, as follows:
Feb. 15 Merchandise Inventory $1, Cash $1,
Purchase discounts, returns, allowances are contra accounts (credits). Freight-in or transportation-in are additional costs (debits). When combined or netted with gross purchases, all of these measures equal net purchases. Typical balances of accounts follows:
Gross Purchases Debit less: Purchase Discounts Credit less: Purchase Returns Credit less: Purchase Allowances Credit plus: Transportation-In Debit Credit equals: Net Purchases Debit
Notice that purchase discounts, returns and allowances are accounted for in a “grossed- up” fashion and not netted. This is to allow management to monitor and investigate (1) the impact of discounts they offer or take advantage of, (2) returns of merchandise, to track them to specific items or suppliers, and (3) allowances, the frequency of which might help to identify problem delivery services or products. If these separate accounts were not maintained, the seller or purchaser might not otherwise become aware of problems with merchandise, adversely impacting relations with their customers or suppliers and their business.
Purchase discount is a contra account. A discount is provided as an incentive to the customer to buy early and pay quickly, to improve the selling firm’s sales and
cash inflows. Terms may vary. For example, n/10 EOM means “pay the net
amount 10 days after end of month,” n/30 means “pay within 30 days of the
invoice date,” and 2/10, n/60 means “full payment is due in 60 days, but you may deduct 2 percent of the invoice amount if paid within 10 days of the invoice.” Other alternatives are possible.
Assume that Flynn Enterprises, in the above example, made the same $1, purchase, but on credit. The terms were 2/10, n/60:
Feb. 15 Merchandise Inventory $1, Accounts Payable $1,
If Flynn Enterprises pays the entire amount on February 25:
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Feb. 25 Accounts Payable $1, Merchandise Inventory $ Cash $
After these transactions, the merchandise inventory account will reflect the net cost and the accounts payable account will show a zero balance. Both of these accounts are shown in T-account form, below:
Merchandise Inventory Accounts Payable Feb. 15 $1,000 Feb. 15 $1, Feb. 25 $20 Feb. 25 $1, Balance $980 Balance $-0-
Purchase Discounts and the Implied Annual Interest Rate Most buyers take advantage of these types of discounts. To understand why, compute
the implied annual interest rate.
The firm can pay the full amount in 60 days or take advantage of the 2% discount by paying in 10 days. Therefore, waiting 50 days costs the firm 2%.
Assuming a 30 day month and 360 day year, there are approximately 7.2 50 day periods in a calendar year. Therefore, taking advantage of the 2% discount is comparable to generating an annual return of approximately 14.4% on these purchase discounts. If a firm can borrow at 10% to save 14.4%, they are reducing costs and improving their profitability – a strategy that would be perceived by external parties as superior management.
Purchase Discount If paid in Savings 60 days 0% less: 10 days 2% equals: 50 days 2% 360 days divided by: 50 days equals: 7.2 times multiplied by: 2% equals: 14.4%
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Gross Purchases Debit less: Purchase Discounts Credit less: Purchase Returns Credit less: Purchase Allowances Credit plus: Transportation-In Debit Credit equals: Net Purchases Debit
Transportation Cost and Transfer of Ownership Buyers and sellers must agree on transportation costs and related risks. At what point does ownership transfer from the buyer to the seller? The point in time when ownership transfers is referred to as the FOB (free on board). This point determines who bears the cost of transportation and merchandise insurance against the risk of damage or loss. There are two alternatives:
If the buyer agrees to pay the transportation cost for merchandise inventory, this transportation cost is added to the cost of merchandise inventory, as follows:
Merchandise Inventory $xxx Cash $xxx
Alternatively, a separate account could be established to maintain data on the amount of transportation-in or freight-in charges included in merchandise inventory:
Transportation-In $xxx Cash $xxx
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If the seller pays the cost of transportation or delivery, they would record the cost in a
Delivery Expense or Transportation-Out or Freight-Out account.
Therefore, from the buyer’s perspective, Net Purchases is used for the computation of
Cost of Goods Sold, and can be summarized, as follows:
Gross Purchases less: Purchase Discounts less: Purchase Returns less: Purchase Allowances plus: Transportation-In equals: Net Purchases
Beginning Inventory plus: Net Purchases equals: Merchandise Available for Sale less: Ending Inventory equals: Cost of Goods Sold
Alternatively,
Beginning Inventory $ xxx Gross Purchases $ xxx Purchase Discounts $(xxx) Purchase Returns $(xxx) Purchase Allowances $(xxx) Transportation-In $ xxx Net Purchases $ xxx Merchandise Available for Sale $ xxx Ending Inventory $(xxx) Cost of Goods Sold $ xxx
Tracking Merchandise Purchases In today’s world, it is common for the buyer to be able to “track” items as their purchase orders are filled and shipped for delivery. Both buyer and seller use identifying tracking identification numbers and may be notified by email of the progress as the merchandise proceeds from its shipping point to its destination.
Merchandise Sales The price received by a seller of merchandise is recorded (credited) to sales (or revenues). For example, assume that the Oehlers Corporation made a $1,500 cash sale on March 15, as follows:
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Gross Sales Credit less: Sales Discounts Debit less: Sales Returns Debit less: Sales Allowances Debit Debit equals: Net Sales Credit
Note that, with the exception of the transportation-in or freight-in account, the computations from gross sales to net sales and the computations from gross purchases to net purchases are comparable.
Gross Purchases Debit less: Purchase Discounts Credit less: Purchase Returns Credit less: Purchase Allowances Credit plus: Transportation-In Debit Credit equals: Net Purchases Debit
Sales discount is a contra account. Just as was the case for purchase discounts, sales discounts are provided to the buyer as an incentive to buy early and pay quickly, to improve the selling firm’s sales and cash inflows. The same terms may apply and
can vary. Recall that n/10 EOM means “pay the net amount 10 days after end of
month,” n/30 means “pay within 30 days of the invoice date,” and 2/10, n/60 means “full payment is due in 60 days, but you may deduct 2% of the invoice amount if paid within 10 days of the invoice.” Again, other alternatives are possible.
Assume that Oehlers Corporation, in the above example, made the same $1, purchase, but on credit. The terms were 2/10, n/60:
Mar. 15 Accounts receivable $1, Sales $1,
If Oehlers Corporation pays the entire amount on March 20:
Mar. 20 Cash $1, Sales discount (^) $ Accounts receivable $1,
After these transactions, the merchandise inventory account will reflect the net cost and the accounts payable account will show a zero balance. Both of these accounts are shown in T-account form, below:
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Sales Accounts Receivable $1,500 Feb.15 Feb. 15 $1, $1, $1,500 Balance $-0- $-0-
Cash Sales Discount $1,470 $
As was the case for purchase discounts, purchase returns, and purchase allowances, a firm might have sales discounts, sales returns, and sales allowances.
Sales return is a contra account. The sales returns account is increased (debited) and cash or accounts receivable is decreased (credited) for the selling price of any merchandise inventory returned by the buyer. In addition, a sales return must be returned to inventory.
For example, assume that Oehlers Corporation sold merchandise that cost $500 for $1,000. There was nothing wrong with the merchandise, but Oehlers has a 100%, 30 day refund or return policy. A customer returned the item 1 week after it was purchased, as follows, for the sale:
Mar. 15 Accounts receivable $1, Sales $1,
Mar. 15 Cost of goods sold $ Inventory $
Accounting for the return, 1 week later, on March 21:
Mar. 21 Sales return $1, Accounts receivable $1,
Mar. 21 Inventory $ Cost of goods sold $
Sales allowance is also a contra account. A sales allowance is issued for damaged merchandise, when the customer and the merchant mutually agree that a discount is preferable to a return. Assume that Oehlers offers a 10% allowance to a customer for some damaged merchandise that the customer likes, does not really want to return for a
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Financial Statement Formats Generally accepted accounting principles (GAAP) permit different formats to be used for financial statements. Two common income statement formats are described in this section: multiple-step and single-step.
Multiple-Step Income Statement The multiple-step income statement for the Oehlers Corporation is presented below. This statement provides for measures of (1) gross profit, (2) income from operations (gross profit less operating expenses), and (3) income and expense items not associated with operations (non-operating items, like gain and losses and interest revenues and expenses).
Oehlers Corporation Income Statement For Year Ended December 31, 2015 Sales $1,000, Cost of Goods Sold $550, Gross Profit $450, Operating Expenses General, selling & administrative expenses Advertising expense $20, Depreciation expense $5, Insurance expense $7, Office supplies expense $12, Rent expense $120, Salaries expense $235, Total general, selling & administrative expenses $400, Income from Operations $50, Other revenues and expenses Interest revenue $1, Gain on sale of building $3, Interest expense ($1,500) Loss on sale of land ($500) Total Other revenues and expenses $2, Net Income $52,
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certain expenses might have to be allocated. If allocated, some systematic and rational approach will be developed to allocate expenses (e.g., rent expense might be allocated between selling and general & administrative based on the square footage consumed by each).
Single-Step Income Statement The single-step income statement for Oehlers Corporation is presented below. Note that this presentation alternative may prove to be less useful. Measures of gross profit and income from operations are not immediately available.
Oehlers Corporation Income Statement For Year Ended December 31, 2015 Revenues Sales $1,000, Interest revenue $1, Gain on sale of building $3, Total revenues $1,004, Expenses Cost of Goods Sold $550, Total general, selling & administrative expenses $400, Interest expense $1, Loss on sale of land $500 $952, Net Income $52,
Classified Balance Sheet – Current Assets The classified balance sheet for a merchandising firm reports merchandise inventory as an asset. Assets are organized in order of liquidity, with cash first, followed by accounts receivable, soon to be received in cash, and inventory, which must be sold on cash or credit terms and will either become an accounts receivable or paid in cash.
Office supplies inventory and store supplies inventory are for consumption during operations and, unlike merchandise inventory, are not held for resale. Prepaid expenses can include prepaid rent, utilities, insurance and a variety of operating expense.
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Appendix A
Chapter 3, Appendix B, introduced the Current Ratio , as follows:
A firm’s ability to pay near-term debts or liabilities is quickly and easily assessed by computing their current ratio , as follows:
Current Ratio = Current Assets ÷ Current Liabilities
Suppliers and creditors would use this ratio to formulate a decision with respect to the firm’s credit worthiness. They would compute and use this measure to assist them in deciding whether they might decide to extend credit to the firm.
The acid-test ratio (or quick ratio ) represents a more liquid modification of the current ratio, as follows:
Acid-Test Ratio = [Current Assets – Prepaid Expenses – Inventory] ÷ Current Liabilities
Note that inventory and prepaid expenses are both excluded from the numerator, providing for a higher standard of liquidity, when compared to the current ratio. Recall that inventory must first be sold before any credit sales result in accounts receivable, as follows:
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Appendix B
Frequently, the strength of a firm is determined by its ability to maintain gross margins. For example, a higher gross margin ratio suggests that the firm has industry leadership and/or cost efficiencies and/or the ability to maintain a relatively high price for its product or service, relative to competitors.
The computation of the gross margin ratio follows:
Gross Margin Ratio = [Net Sales – Cost of Goods Sold] ÷ Net Sales
The below has been extracted from a story that appeared in mid-February 2015, with respect to Apple’s (NASDAQ: AAPL) gross margins
Apple reported gross margin of 39.9% in the most recent quarter, which was up from 38.0% in the September quarter.
This is favorable news, and the maintenance (or improvement) in gross margin ratio tends to have a favorable impact on the firm’s stock price. Below is a 1 year, split- adjusted chart of Apple’s stock price through February 13, 2015: