Perpetual Inventory System and Inventory Valuation Methods

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LEARNING OBJECTIVE 1

Identify the forms of business organization and the uses of accounting information. 

Suppose you graduate with a business degree and decide you want to start your own business. But what kind of business? You enjoy working with people, especially teaching them new skills. You also spend most of your free time outdoors, kayaking, backpacking, skiing, rock climbing, and mountain biking. You think you might be successful in opening an outdoor guide service where you grew up, in the Sierra Nevada mountains.

FORMS OF BUSINESS ORGANIZATION Your next decision is to determine the organizational form of your business. You have three choices—sole proprietorship, partnership, or corporation.

SOLE PROPRIETORSHIP

You might choose the sole proprietorship form for your outdoor guide service. A business owned by one person is a sole proprietorship. It is simple to set up and gives you control over the business. Small owner-operated businesses such as barber shops, law of�ices, and auto repair shops are often sole proprietorships, as are farms and small retail stores.

PARTNERSHIP

Another possibility is for you to join forces with other individuals to form a partnership. A business owned by two or more persons associated as partners is a partnership. Partnerships often are formed because one individual does not have enough economic resources to initiate or expand the business. Sometimes partners bring unique skills or resources to the partnership. You and your partners should formalize your duties and contributions in a written partnership agreement. Retail and service-type businesses, including professional practices (lawyers, doctors, architects, and certi�ied public accountants), often organize as partnerships.

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Alternative Terminology notes present synonymous terms that you may come across in practice.

CORPORATION

As a third alternative, you might organize as a corporation. A business organized as a separate legal entity owned by stockholders is a corporation. Investors in a corporation receive shares of stock to indicate their ownership claim. Buying stock in a corporation is often more attractive than investing in a partnership because shares of stock are easy to sell (transfer ownership). Selling a proprietorship or partnership interest is much more involved. Also, individuals can become stockholders by investing relatively small amounts of money. Therefore, it is easier for corporations to raise funds. Successful corporations often have thousands of stockholders, and their stock is traded on organized stock exchanges like the New York Stock Exchange. Many businesses start as sole proprietorships or partnerships and eventually incorporate.

Other factors to consider in deciding which organizational form to choose are taxes and legal liability. If you choose a sole proprietorship or partnership, you generally receive more favorable tax treatment than a corporation. However, proprietors and partners are personally liable for all debts and legal obligations of the business; corporate stockholders are not. In other words, corporate stockholders generally pay higher taxes but have no personal legal liability. We will discuss these issues in more depth in a later chapter.

Finally, while sole proprietorships, partnerships, and corporations represent the main types of business organizations, hybrid forms are now allowed in all states. These hybrid business forms combine the tax advantages of partnerships with the limited liability of corporations. Probably the most common among these hybrids types are limited liability companies (LLCs) and subchapter S corporations. These forms are discussed extensively in business law classes.

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The combined number of proprietorships and partnerships in the United States is more than �ive times the number of corporations. However, the revenue produced by corporations is eight times greater. Most of the largest businesses in the United States—for example, Coca-Cola, ExxonMobil, General Motors, Citigroup, and Microsoft—are corporations. Because the majority of U.S. business is done by corporations, the emphasis in this textbook is on the corporate form of organization.

ALTERNATIVE TERMINOLOGY

Stockholders are sometimes called shareholders.

USERS AND USES OF FINANCIAL INFORMATION The purpose of �inancial information is to provide inputs for decision-making. Accounting is the information system that identi�ies, records, and communicates the economic events of an organization to interested users. Users of accounting information can be divided broadly into two groups: internal users and external users.

Internal Users

Internal users of accounting information are managers who plan, organize, and run a business. These include marketing managers, production supervisors, �inance directors, and company of�icers. In running a business, managers must answer many important questions, as shown in Illustration 1-1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch01lo1#c01-�ig-0001) .

ILLUSTRATION 1-1 Questions that internal users ask

Accounting Across the Organization boxes show applications of accounting information in various business functions.

To answer these and other questions, you need detailed information on a timely basis. For internal users, accounting provides internal reports, such as �inancial comparisons of operating alternatives, projections of income from new sales campaigns, and forecasts of cash needs for the next year. In addition, companies present summarized �inancial information in the form of �inancial statements.

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 ACCOUNTING ACROSS THE ORGANIZATION 

Clif Bar & Company

Owning a Piece of the Bar

The original Clif Bar® energy bar was created in 1990 after six months of experimentation by Gary Erickson and his mother in her kitchen. Today, the company has almost 300 employees and is considered one of the leading Landor's Breakaway Brands®. One of Clif Bar & Company's proudest moments was the creation of an employee stock ownership plan (ESOP) in 2010. This plan gives its employees 20% ownership of the company. The ESOP also resulted in Clif Bar enacting an open-book management program, including the commitment to educate all employee-owners about its �inances. Armed with basic accounting knowledge, employees are more aware of the �inancial impact of their actions, which leads to better decisions.

What are the bene�its to the company and to the employees of making the �inancial statements available to all employees? (Go to WileyPLUS for this answer and additional questions.)

External Users

There are several types of external users of accounting information. Investors (owners) use accounting information to make decisions to buy, hold, or sell stock. Creditors such as suppliers and bankers use accounting information to evaluate the risks of selling on credit or lending money. Some questions that investors and creditors may ask about a company are shown in Illustration 1-2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch01lo1#c01-�ig-0002) .

ILLUSTRATION 1-2 Questions that external users ask

The information needs and questions of other external users vary considerably. Taxing authorities, such as the Internal Revenue Service, want to know whether the company complies with the tax laws. Customers are interested in whether a company like General Motors will continue to honor product warranties and

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otherwise support its product lines. Labor unions, such as the Major League Baseball Players Association, want to know whether the owners have the ability to pay increased wages and bene�its. Regulatory agencies, such as the Securities and Exchange Commission or the Federal Trade Commission, want to know whether the company is operating within prescribed rules. For example, Enron, Dynegy, Duke Energy, and other big energy-trading companies reported record pro�its at the same time as California was paying extremely high prices for energy and suffering from blackouts. This disparity caused regulators to investigate the energy traders to make sure that the pro�its were earned by legitimate and fair practices.

ACCOUNTING ACROSS THE ORGANIZATION

Spinning the Career Wheel

How will the study of accounting help you? A working knowledge of accounting is desirable for virtually every �ield of business. Some examples of how accounting is used in business careers include the following.

General management: Managers of Ford Motors, Massachusetts General Hospital, California State University– Fullerton, a McDonald's franchise, and a Trek bike shop all need to understand accounting data in order to make wise business decisions.

Marketing: Marketing specialists at Procter & Gamble must be sensitive to costs and bene�its, which accounting helps them quantify and understand. Making a sale is meaningless unless it is a pro�itable sale.

Finance: Do you want to be a banker for Citicorp, an investment analyst for Goldman Sachs, or a stock broker for Merrill Lynch? These �ields rely heavily on accounting knowledge to analyze �inancial statements. In fact, it is dif�icult to get a good job in a �inance function without two or three courses in accounting.

Real estate: Are you interested in being a real estate broker for Prudential Real Estate? Because a third party—the bank— is almost always involved in �inancing a real estate transaction, brokers must understand the numbers involved: Can the buyer afford to make the payments to the bank? Does the cash �low from an industrial property justify the purchase price? What are the tax bene�its of the purchase?

How might accounting help you? (Go to WileyPLUS for this answer and additional questions.)

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ETHICS IN FINANCIAL REPORTING People won't gamble in a casino if they think it is “rigged.” Similarly, people won't “play” the stock market if they think stock prices are rigged. At one time, the �inancial press was full of articles about �inancial scandals at Enron, WorldCom, HealthSouth, and AIG. As more scandals came to light, a mistrust of �inancial reporting in general seemed to be developing. One article in the Wall Street Journal noted that “repeated disclosures about questionable accounting practices have bruised investors' faith in the reliability of earnings reports, which in turn has sent stock prices tumbling.” Imagine trying to carry on a business or invest money if you could not depend on the �inancial statements to be honestly prepared. Information would have no credibility. There is no doubt that a sound, well-functioning economy depends on accurate and dependable �inancial reporting.

United States regulators and lawmakers were very concerned that the economy would suffer if investors lost con�idence in corporate accounting because of unethical �inancial reporting. Congress passed the Sarbanes-Oxley Act (SOX) to reduce unethical corporate behavior and decrease the likelihood of future corporate scandals. As a result of SOX, top management must now certify the accuracy of �inancial information. In addition, penalties for fraudulent �inancial activity are much more severe. Also, SOX increased both the independence of the outside auditors who review the accuracy of corporate �inancial statements and the oversight role of boards of directors.

ETHICS NOTE

Circus-founder P.T. Barnum is alleged to have said, “Trust everyone, but cut the deck.” What Sarbanes-Oxley does is to provide measures that (like cutting the deck of playing cards) help ensure that fraud will not occur.

Ethics Notes help sensitize you to some of the ethical issues in accounting.

Effective �inancial reporting depends on sound ethical behavior. To sensitize you to ethical situations and to give you practice at solving ethical dilemmas, we address ethics in a number of ways in this textbook. (1) A number of the Feature Stories and other parts of the text discuss the central importance of ethical behavior to �inancial reporting. (2) Ethics Insight boxes and marginal Ethics Notes highlight ethics situations and issues in actual business settings. (3) Many of the People, Planet, and Pro�it Insight boxes focus on ethical issues that companies face in measuring and reporting social and environmental issues. (4) At the end of each chapter, an Ethics Case simulates a business situation and asks you to put yourself in the position of a decision-maker in that case.

When analyzing these various ethics cases and your own ethical experiences, you should apply the three steps outlined in Illustration 1-3 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch01lo1#c01-�ig-0003) .

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ILLUSTRATION 1-3 Steps in analyzing ethics cases

 ETHICS INSIGHT 

Dewey & LeBoeuf LLP

I Felt the Pressure—Would You?

“I felt the pressure.” That's what some of the employees of the now- defunct law �irm of Dewey & LeBoeuf LLP indicated when they helped to overstate revenue and use accounting tricks to hide losses and cover up cash shortages. These employees worked for the former �inance director and former chief �inancial of�icer (CFO) of the �irm. Here are some of their comments:

“I was instructed by the CFO to create invoices, knowing they would not be sent to clients. When I created these invoices, I knew that it was inappropriate.”

“I intentionally gave the auditors incorrect information in the course of the audit.”

What happened here is that a small group of lower-level employees over a period of years carried out the instructions of their bosses. Their bosses, however, seemed to have no concern as evidenced by various e-mails with one another in which they referred to their �inancial manipulations as accounting tricks, cooking the books, and fake income.

Source: Ashby Jones, “Guilty Pleas of Dewey Staff Detail the Alleged Fraud,” Wall Street Journal (March 28, 2014).

Why did these employees lie, and what do you believe should be their penalty for these lies? (Go to WileyPLUS for this answer and additional questions.)

Insight boxes provide examples of business situations from various perspectives—ethics, investor, international, and corporate social responsibility. Guideline answers to the critical thinking questions

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are available in WileyPLUS and at www.wiley.com/college/weygandt (http://www.wiley.com/college/weygandt) . Additional questions are offered in WileyPLUS.

DO IT! 1

Business Organization Forms

DO IT! exercises prompt you to stop and review the key points you have just studied. The Action Plan offers you tips about how to approach the problem.

In choosing the organizational form for your outdoor guide service, you should consider the pros and cons of each. Identify each of the following organizational characteristics with the organizational form or forms with which it is associated.

1. Easier to raise funds.

2. Simple to establish.

3. No personal legal liability.

4. Tax advantages.

5. Easier to transfer ownership.

Action Plan ✓ Know which organizational form best matches the business

type, size, and preferences of the owner(s).

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SOLUTION

1. Easier to raise funds: Corporation.

2. Simple to establish: Sole proprietorship and partnership.

3. No personal legal liability: Corporation.

4. Tax advantages: Sole proprietorship and partnership.

5. Easier to transfer ownership: Corporation.

Related exercise material: BE1-1 and DO IT! 1-1.

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5

Merchandising Operations and the Multiple-Step Income Statement

 CHAPTER PREVIEW 

Merchandising is one of the largest and most in�luential industries in the United States. It is likely that a number of you will work for a merchandiser. Therefore, understanding the �inancial statements of merchandising companies is important. In this chapter, you will learn the basics about reporting merchandising transactions. In addition, you will learn how to prepare and analyze a commonly used form of the income statement—the multiple-step income statement.

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Buy Now, Vote Later

Have you ever shopped for outdoor gear at an REI (Recreational Equipment Incorporated) store? If so, you might have been surprised if a salesclerk asked if you were a member. A member? What do you mean a member? REI is a consumer cooperative, or “co-op” for short. To �igure out what that means, consider this quote from the company's annual report:

As a cooperative, the Company is owned by its members. Each member is entitled to one vote in the election of the Company's Board of Directors. Since January 1, 2008, the nonrefundable, nontransferable, one-time membership fee has been $20 dollars. As of December 31, 2010, there were approximately 10.8 million members.

Voting rights? Now that's something you don't get from shopping at Wal-Mart. REI members get other bene�its as well, including sharing in the company's pro�its through a dividend at the end of the year. The more you spend, the bigger your dividend.

Since REI is a co-op, you might wonder whether management's incentives might be a little different. Management is still concerned about making a pro�it, as it ensures the long-term viability of the company. REI's members also want the company to be run ef�iciently, so that prices remain low. In order for its members to evaluate just how well management is doing, REI publishes an audited annual report, just like publicly traded companies do.

How well is this business model working for REI? Well, it has consistently been rated as one of the best places to work in the United States by Fortune magazine. Also, REI had sustainable business practices long before social responsibility became popular at other companies. The CEO's Stewardship Report states “we reduced the absolute amount of energy we use despite opening four new stores and growing our business; we grew the amount of FSC-certi�ied paper we use to 58.4 percent of our total paper footprint—including our cash register receipt paper; we facilitated 2.2 million volunteer hours and we provided $3.7 million to more than 330 conservation and recreation nonpro�its.”

So, while REI, like other retailers, closely monitors its �inancial results, it also strives to succeed in other areas. And, with over 10 million votes at stake, REI's management knows that it has to deliver.

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LEARNING OBJECTIVE 1

Describe merchandising operations and inventory systems. 

REI, Wal-Mart, and Amazon.com are called merchandising companies because they buy and sell merchandise rather than perform services as their primary source of revenue. Merchandising companies that purchase and sell directly to consumers are called retailers. Merchandising companies that sell to retailers are known as wholesalers. For example, retailer Walgreens might buy goods from wholesaler McKesson; retailer Of�ice Depot might buy of�ice supplies from wholesaler United Stationers. The primary source of revenue for merchandising companies is the sale of merchandise, often referred to simply as sales revenue or sales. A merchandising company has two categories of expenses: cost of goods sold and operating expenses.

Cost of goods sold is the total cost of merchandise sold during the period. This expense is directly related to the revenue recognized from the sale of goods. Illustration 5-1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo1#c05-�ig-0001) shows the income measurement process for a merchandising company. The items in the two blue boxes are unique to a merchandising company; they are not used by a service company.

ILLUSTRATION 5-1 Income measurement process for a merchandising company

OPERATING CYCLES The operating cycle of a merchandising company ordinarily is longer than that of a service company. The purchase of inventory and its eventual sale lengthen the cycle. Illustration 5-2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo1#c05-�ig-0002) contrasts the operating cycles of service and merchandising companies. Note that the added asset account for a merchandising company is the Inventory account.

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ILLUSTRATION 5-2 Operating cycles for a service company and a merchandising company

FLOW OF COSTS The �low of costs for a merchandising company is as follows. Beginning inventory plus the cost of goods purchased is the cost of goods available for sale. As goods are sold, they are assigned to cost of goods sold. Those goods that are not sold by the end of the accounting period represent ending inventory. Illustration 5-3 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo1#c05-�ig-0003) describes these relationships. Companies use one of two systems to account for inventory: a perpetual inventory system or a periodic inventory system.

ILLUSTRATION 5-3 Flow of costs

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Perpetual System

In a perpetual inventory system, companies maintain detailed records of the cost of each inventory purchase and sale. These records continuously—perpetually—show the inventory that should be on hand for every item. For example, a Ford dealership has separate inventory records for each automobile, truck, and van on its lot and showroom �loor. Similarly, a grocery store uses bar codes and optical scanners to keep a daily running record of every box of cereal and every jar of jelly that it buys and sells. Under a perpetual inventory system, a company determines the cost of goods sold each time a sale occurs.

▼ HELPFUL HINT

Even under perpetual inventory systems, companies perform physical inventory counts. This is done as a control procedure to verify inventory levels, in order to detect theft or “shrinkage.”

Periodic System

In a periodic inventory system, companies do not keep detailed inventory records of the goods on hand throughout the period. They determine the cost of goods sold only at the end of the accounting period— that is, periodically. At that point, the company takes a physical inventory count to determine the cost of goods on hand.

To determine the cost of goods sold under a periodic inventory system, the following steps are necessary:

1. Determine the cost of goods on hand at the beginning of the accounting period.

2. Add to it the cost of goods purchased.

3. Subtract the cost of goods on hand as determined by the physical inventory count at the end of the accounting period.

Illustration 5-4 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo1#c05-�ig-0004) graphically compares the sequence of activities and the timing of the cost of goods sold computation under the two inventory systems.

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ILLUSTRATION 5-4 Comparing perpetual and periodic inventory systems

Advantages of the Perpetual System

Companies that sell merchandise with high unit values, such as automobiles, furniture, and major home appliances, have traditionally used perpetual systems. The growing use of computers and electronic scanners has enabled many more companies to install perpetual inventory systems. The perpetual inventory system is so named because the accounting records continuously—perpetually—show the quantity and cost of the inventory that should be on hand at any time.

A perpetual inventory system provides better control over inventories than a periodic system. Since the inventory records show the quantities that should be on hand, the company can count the goods at any time to see whether the amount of goods actually on hand agrees with the inventory records. If shortages are uncovered, the company can investigate immediately. Although a perpetual inventory system requires additional clerical work and additional cost to maintain inventory records, a computerized system can minimize this cost. Much of Amazon.com's success is attributed to its sophisticated inventory system.

Some businesses �ind it either unnecessary or uneconomical to invest in a sophisticated, computerized perpetual inventory system such as Amazon's. However, many small merchandising businesses now use basic accounting software, which provides some of the essential bene�its of a perpetual inventory system. Yet, managers of some small businesses still �ind that they can control their merchandise and manage day- to-day operations using a periodic inventory system.

Because of the widespread use of the perpetual inventory system, we illustrate it in this chapter. An appendix to this chapter describes the journal entries for the periodic system.

INVESTOR INSIGHT

Morrow Snowboards, Inc.

Improving Stock Appeal

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Investors are often eager to invest in a company that has a hot new product. However, when snowboard maker Morrow Snowboards, Inc. issued shares of stock to the public for the �irst time, some investors expressed reluctance to invest in Morrow because of a number of accounting control problems. To reduce investor concerns, Morrow implemented a perpetual inventory system to improve its control over inventory. In addition, it stated that it would perform a physical inventory count every quarter until it felt that its perpetual inventory system was reliable.

If a perpetual system keeps track of inventory on a daily basis, why do companies ever need to do a physical count? (Go to WileyPLUS for this answer and additional questions.)

DO IT! 1

Merchandising Operations and Inventory Systems

Indicate whether the following statements are true or false. If false, indicate how to correct the statement.

1. The primary source of revenue for a merchandising company results from performing services for customers.

2. The operating cycle of a service company is usually shorter than that of a merchandising company.

3. Sales revenue less cost of goods sold equals gross pro�it.

4. Ending inventory plus the cost of goods purchased equals cost of goods available for sale.

Action Plan ✓ Review merchandising concepts.

✓ Understand the �low of costs in a merchandising company.

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SOLUTION

1. False. The primary source of revenue for a service company results from performing services for customers.

2. True.

3. True.

4. False. Beginning inventory plus the cost of goods purchased equals cost of goods available for sale.

Related exercise material: BE1-1 and DO IT! 5-1.

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LEARNING OBJECTIVE 2

Record purchases under a perpetual inventory system. 

Companies may purchase inventory for cash or on account (credit). They normally record purchases when they receive the goods from the seller. Every purchase should be supported by business documents that provide written evidence of the transaction. Each cash purchase should be supported by a canceled check or a cash register receipt indicating the items purchased and amounts paid. Companies record cash purchases by an increase (debit) in Inventory and a decrease (credit) in Cash.

Each purchase should be supported by a purchase invoice, which indicates the total purchase price and other relevant information. However, the purchaser does not prepare a separate purchase invoice. Instead, the purchaser uses as a purchase invoice the copy of the sales invoice sent by the seller. In Illustration 5-5 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo2#c05-�ig-0005) , for example, Sauk Stereo (the buyer) uses as a purchase invoice the sales invoice prepared by PW Audio Supply, Inc. (the seller).

ILLUSTRATION 5-5 Sales invoice used as purchase invoice by Sauk Stereo

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The associated entry for Sauk Stereo for the invoice from PW Audio Supply increases (debits) Inventory and increases (credits) Accounts Payable.

Under the perpetual inventory system, companies record purchases of merchandise for sale in the Inventory account. Thus, REI would increase (debit) Inventory for clothing, sporting goods, and anything else purchased for resale to customers.

Not all purchases are debited to Inventory, however. Companies record purchases of assets acquired for use and not for resale, such as supplies, equipment, and similar items, as increases to speci�ic asset accounts rather than to Inventory. For example, to record the purchase of materials used to make shelf signs or for cash register receipt paper, REI would increase (debit) Supplies.

▼ HELPFUL HINT

To better understand the contents of this invoice, identify these items:

1. Seller

2. Invoice date

3. Purchaser

4. Salesperson

5. Credit terms

6. Freight terms

7. Goods sold: catalog number, description, quantity, price per unit

8. Total invoice amount

FREIGHT COSTS The sales agreement should indicate who—the seller or the buyer—is to pay for transporting the goods to the buyer's place of business. When a common carrier such as a railroad, trucking company, or airline transports the goods, the carrier prepares a freight bill in accord with the sales agreement.

Freight terms are expressed as either FOB shipping point or FOB destination. The letters FOB mean free on board. Thus, FOB shipping point means that the seller places the goods free on board the carrier, and the buyer pays the freight costs. Conversely, FOB destination means that the seller places the goods free on

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board to the buyer's place of business, and the seller pays the freight. For example, the sales invoice in Illustration 5-5 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo2#c05-�ig-0005) indicates FOB shipping point. Thus, the buyer (Sauk Stereo) pays the freight charges. Illustration 5-6 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo2#c05-�ig-0006) illustrates these shipping terms.

ILLUSTRATION 5-6 Shipping terms

Freight Costs Incurred by Buyer

When the buyer pays the transportation costs, these costs are considered part of the cost of purchasing inventory. As a result, the account Inventory is increased (debited). For example, if Sauk Stereo (the buyer) pays Public Freight Company $150 for freight charges on May 6, the entry on Sauk Stereo's books is:

Thus, any freight costs incurred by the buyer are part of the cost of merchandise purchased. The reason: Inventory cost should include all costs to acquire the inventory, including freight necessary to deliver the goods to the buyer. Companies recognize these costs as cost of goods sold when inventory is sold.

Freight Costs Incurred by Seller

In contrast, freight costs incurred by the seller on outgoing merchandise are an operating expense to the seller. These costs increase an expense account titled Freight-Out (sometimes called Delivery Expense). For example, if the freight terms on the invoice in Illustration 5-5 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo2#c05-�ig-0005) had required that PW Audio Supply (the seller) pay the $150 freight charges, the entry by PW Audio Supply would be:

When the seller pays the freight charges, the seller will usually establish a higher invoice price for the goods, to cover the expense of shipping.

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PURCHASE RETURNS AND ALLOWANCES A purchaser may be dissatis�ied with the merchandise received because the goods are damaged or defective, of inferior quality, or do not meet the purchaser's speci�ications. In such cases, the purchaser may return the goods to the seller for credit if the sale was made on credit, or for a cash refund if the purchase was for cash. This transaction is known as a purchase return. Alternatively, the purchaser may choose to keep the merchandise if the seller is willing to grant a reduction of the purchase price. This transaction is known as a purchase allowance.

Assume that Sauk Stereo returned goods costing $300 to PW Audio Supply on May 8. The following entry by Sauk Stereo for the returned merchandise decreases (debits) Accounts Payable and decreases (credits) Inventory.

Because Sauk Stereo increased Inventory when the goods were received, Inventory is decreased (credited) when Sauk Stereo returns the goods.

Suppose instead that Sauk Stereo chose to keep the goods after being granted a $50 allowance (reduction in price). It would reduce (debit) Accounts Payable and reduce (credit) Inventory for $50.

PURCHASE DISCOUNTS The credit terms of a purchase on account may permit the buyer to claim a cash discount for prompt payment. The buyer calls this cash discount a purchase discount. This incentive offers advantages to both parties. The purchaser saves money, and the seller is able to shorten the operating cycle by converting the accounts receivable into cash earlier.

The credit terms specify the amount of the cash discount and time period during which it is offered. They also indicate the length of time in which the purchaser is expected to pay the full invoice price. In the sales invoice in Illustration 5-5 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo2#c05- �ig-0005) (page 220), credit terms are 2/10, n/30, which is read “two-ten, net thirty.” This means that a 2% cash discount may be taken on the invoice price, less (“net of”) any returns or allowances, if payment is made within 10 days of the invoice date (the discount period). Otherwise, the invoice price, less any returns or allowances, is due 30 days from the invoice date. Alternatively, the discount period may extend to a speci�ied number of days following the month in which the sale occurs. For example, 1/10 EOM (end of month) means that a 1% discount is available if the invoice is paid within the �irst 10 days of the next month.

When the seller elects not to offer a cash discount for prompt payment, credit terms will specify only the maximum time period for paying the balance due. For example, the credit terms may state the time period as n/30, n/60, or n/10 EOM. This means, respectively, that the buyer must pay the net amount in 30 days, 60 days, or within the �irst 10 days of the next month.

When an invoice is paid within the discount period, the amount of the discount decreases Inventory. Why? Because the merchandiser records inventory at its cost and, by paying within the discount period, it has reduced that cost. To illustrate, assume Sauk Stereo pays the balance due of $3,500 (gross invoice price of

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$3,800 less purchase returns and allowances of $300) on May 14, the last day of the discount period. Since the terms are 2/10, n/30, the cash discount is $70 ($3,500×2%) and the amount of cash Sauk Stereo paid is $3,430 ($3,500−$70). The entry Sauk Stereo makes to record its May 14 payment decreases (debits) Accounts Payable by the amount of the gross invoice price, reduces (credits) Inventory by the $70 discount, and reduces (credits) Cash by the net amount owed.

If Sauk Stereo failed to take the discount and instead made full payment of $3,500 on June 3, Sauk Stereo would reduce (debit) Accounts Payable and reduce (credit) Cash for $3,500 each.

A merchandising company usually should take all available discounts. Passing up the discount may be viewed as paying interest for use of the money. For example, passing up the discount offered by PW Audio Supply would be like Sauk Stereo paying an interest rate of 2% for the use of $3,500 for 20 days. This is the equivalent of an annual interest rate of approximately 36.5%(2%×365/20). Obviously, it would be better for Sauk Stereo to borrow at prevailing bank interest rates of 6% to 10% than to lose the discount.

▼ HELPFUL HINT

The term net in “net 30” means the remaining amount due after subtracting any returns and allowances and partial payments.

SUMMARY OF PURCHASING TRANSACTIONS The following T-account (with transaction descriptions in red) provides a summary of the effect of the previous transactions on Inventory. Sauk Stereo originally purchased $3,800 worth of inventory for resale. It then returned $300 of goods. It paid $150 in freight charges, and �inally, it received a $70 discount off the balance owed because it paid within the discount period. This results in a balance in Inventory of $3,580.

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DO IT! 2

Purchase Transactions

On September 5, De La Hoya Company buys merchandise on account from Junot Diaz Company. The purchase price of the goods paid by De La Hoya is $1,500. On September 8, De La Hoya returns defective goods with a selling price of $200. Record the transactions on the books of De La Hoya Company.

Action Plan ✓ Purchaser records goods at cost.

✓ When goods are returned, purchaser reduces Inventory.

Related exercise material: BE5-2, BE5-4, DO IT! 5-2, E5-1, E5-2, and E5-4.

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LEARNING OBJECTIVE 3

Record sales under a perpetual inventory system. 

In accordance with the revenue recognition principle, companies record sales revenue, like service revenue, when the performance obligation is satis�ied. Typically, that performance obligation is satis�ied when the goods are transferred from the seller to the buyer. At this point, the sales transaction is completed and the sales price is established.

Sales may be made on credit or for cash. Every sales transaction should be supported by a business document that provides written evidence of the sale. Cash register documents provide evidence of cash sales. A sales invoice, like the one that was shown in Illustration 5-5 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo2#c05-�ig-0005) (page 220), provides support for each sale. The original copy of the invoice goes to the customer, and the seller keeps a copy for use in recording the sale. The invoice shows the date of sale, customer name, total sales price, and other relevant information.

The seller makes two entries for each sale. (1) It increases (debits) Accounts Receivable or Cash, as well as increases (credits) Sales Revenue. (2) It increases (debits) Cost of Goods Sold and decreases (credits) Inventory. As a result, the Inventory account will show at all times the amount of inventory that should be on hand.

To illustrate a credit sales transaction, PW Audio Supply records the sale of $3,800 on May 4 to Sauk Stereo (see Illustration 5-5 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo2#c05-�ig- 0005) ) as follows (assume the merchandise cost PW Audio Supply $2,400).

For internal decision-making purposes, merchandising companies may use more than one sales account. For example, PW Audio Supply may decide to keep separate sales accounts for its sales of TVs, Blu-ray players, and headsets. REI might use separate accounts for camping gear, children's clothing, and ski equipment—or it might have even more narrowly de�ined accounts. By using separate sales accounts for major product lines, rather than a single combined sales account, company management can monitor sales trends more closely and respond to changes in sales patterns more strategically. For example, if TV sales are increasing while Blu-ray player sales are decreasing, the company might reevaluate both its advertising and pricing policies on each of these items to ensure they are optimal.

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On its income statement presented to outside investors, a merchandising company would normally provide only a single sales �igure—the sum of all of its individual sales accounts. This is done for two reasons. First, providing detail on all of its individual sales accounts would add considerable length to its income statement. Second, companies do not want their competitors to know the details of their operating results. However, at one time Microsoft expanded its disclosure of revenue from three to �ive types. The reason: The additional categories enabled �inancial statement users to better evaluate the growth of the company's consumer and Internet businesses.

ANATOMY OF A FRAUD1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05ifrs#c05-

note-0006)

Holly Harmon was a cashier at a national superstore for only a short time when she began stealing merchandise using three methods. Under the �irst method, her husband or friends took UPC labels from cheaper items and put them on more expensive items. Holly then scanned the goods at the register. Using the second method, Holly scanned an item at the register but then voided the sale and left the merchandise in the shopping cart. A third approach was to put goods into large plastic containers. She scanned the plastic containers but not the goods within them. After Holly quit, a review of past surveillance tapes enabled the store to observe the thefts and to identify the participants.

Total take: $12,000

THE MISSING CONTROLS

Human resource controls. A background check would have revealed Holly's previous criminal record. She would not have been hired as a cashier.

Physical controls. Software can �lag high numbers of voided transactions or a high number of sales of low-priced goods. Random comparisons of video records with cash register records can ensure that the goods reported as sold on the register are the same goods that are shown being purchased on the video recording. Finally, employees should be aware that they are being monitored.

Source: Adapted from Wells, Fraud Casebook (2007), pp. 251–259.

At the end of “Anatomy of a Fraud” stories, which describe real-world frauds, we discuss the missing control activity that would likely have presented or uncovered the fraud.

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▼ HELPFUL HINT

The merchandiser credits the Sales Revenue account only for sales of goods held for resale. Sales of assets not held for resale, such as equipment or land, are credited directly to the asset account.

ETHICS NOTE

Many companies are trying to improve the quality of their �inancial reporting. For example, General Electric now provides more detail on its revenues and operating pro�its.

SALES RETURNS AND ALLOWANCES We now look at the “�lip side” of purchase returns and allowances, which the seller records as sales returns and allowances. These are transactions where the seller either accepts goods back from a purchaser (a return) or grants a reduction in the purchase price (an allowance) so that the buyer will keep the goods. PW Audio Supply's entries to record credit for returned goods involve (1) an increase (debit) in Sales Returns and Allowances (a contra account to Sales Revenue) and a decrease (credit) in Accounts Receivable at the $300 selling price, and (2) an increase (debit) in Inventory (assume a $140 cost) and a decrease (credit) in Cost of Goods Sold, as shown below. (We assumed that the goods were not defective. If they were defective, PW Audio Supply would make an entry to the Inventory account to re�lect their decline in value.)

Suppose instead that the goods were not returned but the seller granted the buyer an allowance by reducing the purchase price. In this case, the seller would debit Sales Returns and Allowances and credit Accounts Receivable for the amount of the allowance. An allowance has no impact on Inventory or Cost of Goods Sold.

Sales Returns and Allowances is a contra revenue account to Sales Revenue, which means it is offset against a revenue account on the income statement. The normal balance of Sales Returns and Allowances is a debit. Companies use a contra account, instead of debiting Sales Revenue, to disclose in the accounts and in the income statement the amount of sales returns and allowances. Disclosure of this information is important to management. Excessive returns and allowances suggest problems—inferior merchandise,

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inef�iciencies in �illing orders, errors in billing customers, or mistakes in delivery or shipment of goods. Moreover, a decrease (debit) recorded directly to Sales Revenue would obscure the relative importance of sales returns and allowances as a percentage of sales. It also could distort comparisons between total sales in different accounting periods.

At the end of the accounting period, if the company anticipates that sales returns and allowances will be material, the company should make an adjusting entry to estimate the amount of returns. In some industries, such as those relating to the sale of books and periodicals, returns are often material. The accounting for situations where returns must be estimated is addressed in advanced accounting courses.

 ACCOUNTING ACROSS THE ORGANIZATION 

Costco Wholesale Corp.

The Point of No Returns?

In most industries, sales returns are relatively minor. But returns of consumer electronics can really take a bite out of pro�its. Recently, the marketing executives at Costco Wholesale Corp. faced a dif�icult decision. Costco has always prided itself on its generous return policy. Most goods have had an unlimited grace period for returns. A new policy will require that certain electronics must be returned within 90 days of their purchase. The reason? The cost of returned products such as high-de�inition TVs, computers, and iPods cut an estimated 8¢ per share off Costco's earnings per share, which was $2.30.

Source: Kris Hudson, “Costco Tightens Policy on Returning Electronics,” Wall Street Journal (February 27, 2007), p. B4.

If a company expects signi�icant returns, what are the implications for revenue recognition? (Go to WileyPLUS for this answer and additional questions.)

SALES DISCOUNTS As mentioned in our discussion of purchase transactions, the seller may offer the customer a cash discount —called by the seller a sales discount—for the prompt payment of the balance due. Like a purchase discount, a sales discount is based on the invoice price less returns and allowances, if any. The seller increases (debits) the Sales Discounts account for discounts that are taken. The entry by PW Audio Supply to record the cash receipt on May 14 from Sauk Stereo within the discount period is:

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Like Sales Returns and Allowances, Sales Discounts is a contra revenue account to Sales Revenue. Its normal balance is a debit. Sellers use this account, instead of debiting Sales Revenue, to disclose the amount of cash discounts taken by customers. If the customer does not take the discount, PW Audio Supply increases (debits) Cash for $3,500 and decreases (credits) Accounts Receivable for the same amount at the date of collection.

At the end of the accounting period, if the amount of potential discounts is material, the company should make an adjusting entry to estimate the discounts. This would not usually be the case for sales discounts but might be necessary for other types of discounts such as volume discounts, which are addressed in more advanced accounting courses. The following T-accounts summarize the three sales-related transactions and show their combined effect on net sales.

DO IT! 3

Sales Transactions

On September 5, De La Hoya Company buys merchandise on account from Junot Diaz Company. The selling price of the goods is $1,500, and the cost to Diaz Company was $800. On September 8, De La Hoya returns goods with a selling price of $200 and a cost of $105. Record the transactions on the books of Junot Diaz Company.

Action Plan ✓ Seller records both the sale and the cost of goods sold at the

time of the sale.

✓ When goods are returned, the seller records the return in a contra account, Sales Returns and Allowances, and reduces Accounts Receivable.

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✓ Any goods returned increase Inventory and reduce Cost of Goods Sold. The inventory should be recorded at the lower of its cost or its fair value (scrap value).

Related exercise material: BE5-2, BE5-3, DO IT! 5-3, E5-2, E5-3, and E5-4.

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LEARNING OBJECTIVE 4

Prepare a multiple-step income statement and a comprehensive income statement. 

SINGLE-STEP INCOME STATEMENT Companies widely use two forms of the income statement. One is the single-step income statement. The statement is so named because only one step, subtracting total expenses from total revenues, is required in determining net income (or net loss).

In a single-step statement, all data are classi�ied into two categories: (1) revenues, which include both operating revenues and nonoperating revenues and gains (for example, interest revenue and gain on sale of equipment); and (2) expenses, which include cost of goods sold, operating expenses, and nonoperating expenses and losses (for example, interest expense, loss on sale of equipment, or income tax expense). The single-step income statement is the form we have used thus far in the text. Illustration 5-7 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo4#c05-�ig-0007) (page 228) shows a single-step statement for REI.

ILLUSTRATION 5-7 Single-step income statements

There are two primary reasons for using the single-step form. (1) A company does not realize any type of pro�it or income until total revenues exceed total expenses, so it makes sense to divide the statement into these two categories. (2) The form is simple and easy to read.

MULTIPLE-STEP INCOME STATEMENT

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A second form of the income statement is the multiple-step income statement. The multiple-step income statement is often considered more useful because it highlights the components of net income. The REI income statement in Illustration 5-8 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo4#c05-�ig-0008) is an example.

ILLUSTRATION 5-8 Multiple-step income statements

The multiple-step income statement has three important line items: gross pro�it, income from operations, and net income. They are determined as follows.

1. Subtract cost of goods sold from net sales to determine gross pro�it.

2. Deduct operating expenses from gross pro�it to determine income from operations.

3. Add or subtract the results of activities not related to operations to determine net income.

Note that companies report income tax expense in a separate section of the income statement before net income. The net incomes in Illustrations 05-07 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo4#c05-�ig-0007) and 05-0008 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo4#c05-�ig-0008) are the same. The two income statements differ in the amount of detail displayed and the order presented. The following discussion provides additional information about the components of a multiple-step income statement.

INTERNATIONAL NOTE

The IASB and FASB are involved in a joint project to evaluate the format of �inancial statements. The �irst phase of that project involves a focus on how to

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best present revenues and expenses. One longer-term result of the project may be an income statement format that better re�lects how businesses are run.

Sales

The income statement for a merchandising company typically presents gross sales for the period. The company deducts sales returns and allowances and sales discounts (both contra accounts) from sales revenue in the income statement to arrive at net sales. Illustration 5-9 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo4#c05-�ig-0009) shows the sales section of the income statement for PW Audio Supply.

ILLUSTRATION 5-9 Statement presentation of sales section

Gross Pro�it

The excess of net sales over cost of goods sold is gross pro�it. It is determined by deducting cost of goods sold from net sales. As shown in Illustration 5-8 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo4#c05-�ig-0008) , REI had a gross pro�it of $960 million for the year ended January 3, 2015. This computation uses net sales, which takes into account sales returns and allowances and sales discounts.

On the basis of the PW Audio Supply sales data presented in Illustration 5-9 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo4#c05-�ig-0009) (net sales of $460,000) and the cost of goods sold (assume a balance of $316,000), PW Audio Supply's gross pro�it is $144,000, computed as follows.

Net sales $ 460,000 Cost of goods sold 316,000

Gross pro�it $144,000

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It is important to understand what gross pro�it is—and what it is not. Gross pro�it represents the merchandising pro�it of a company. Because operating expenses have not been deducted, it is not a measure of the overall pro�it of a company. Nevertheless, management and other interested parties closely watch the amount and trend of gross pro�it. Comparisons of current gross pro�it with past amounts and rates and with those in the industry indicate the effectiveness of a company's purchasing and pricing policies.

ALTERNATIVE TERMINOLOGY

Gross pro�it is sometimes referred to as gross margin.

Operating Expenses

Operating expenses are the next component in measuring net income for a merchandising company. At REI, for example, operating expenses were $778 million for the year ended January 3, 2015.

At PW Audio Supply, operating expenses were $114,000. The �irm determines its income from operations by subtracting operating expenses from gross pro�it. Thus, income from operations is $30,000, as shown below.

Gross pro�it $144,000 Operating expenses 114,000

Income from operations $  30,000

Nonoperating Activities

Nonoperating activities consist of various revenues and expenses and gains and losses that are unrelated to the company's main line of operations. When nonoperating items are included, the label “Income from operations” (or “Operating income”) precedes them. This label clearly identi�ies the results of the company's normal operations, an amount determined by subtracting cost of goods sold and operating expenses from net sales. The results of nonoperating activities are shown in the categories “Other revenues and gains” and “Other expenses and losses.” Illustration 5-10 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo4#c05-�ig-0010) lists examples of each.

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ILLUSTRATION 5-10 Examples of nonoperating activities

Nonoperating income is sometimes very signi�icant. For example, in one quarter, Sears Holdings earned more than half of its net income from investments in derivative securities.

The distinction between operating and nonoperating activities is crucial to external users of �inancial data. These users view operating income as sustainable and many nonoperating activities as non-recurring. When forecasting next year's income, analysts put the most weight on this year's operating income and less weight on this year's nonoperating activities.

 ETHICS INSIGHT 

IBM

Disclosing More Details

After Enron, increased investor criticism and regulator scrutiny forced many companies to improve the clarity of their �inancial disclosures. For example, IBM began providing more detail regarding its “Other gains and losses.” It had previously included these items in its selling, general, and administrative expenses, with little disclosure. For example, previously if IBM sold off one of its buildings at a gain, it included this gain in the selling, general, and administrative expense line item, thus reducing that expense. This made it appear that the company had done a better job of controlling operating expenses than it actually had.

As another example, when eBay recently sold the remainder of its investment in Skype to Microsoft, it reported a gain in “Other revenues and gains” of $1.7 billion. Since eBay's total income from operations was $2.4 billion, it was very important that the gain from the Skype sale not be buried in operating income.

Why have investors and analysts demanded more accuracy in isolating “Other gains and losses” from operating items? (Go to WileyPLUS for this answer and additional questions.)

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Nonoperating activities are reported in the income statement immediately after operating activities. Included among “Other revenues and gains” in Illustration 5-11 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo4#c05-�ig-0011) (page 231) are Interest Revenue and Gain on Disposal of Plant Assets. Included in “Other expenses and losses” are Interest Expense and Casualty Loss from Vandalism.

In Illustration 5-11 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo4#c05-�ig- 0011) , we have provided the multiple-step income statement of PW Audio Supply. This statement provides more detail than that of REI and thus is useful as a guide for homework. For homework problems, use the multiple-step form of the income statement unless the requirements state otherwise.

ILLUSTRATION 5-11 Multiple-step income statement

ETHICS NOTE

Companies manage earnings in various ways. ConAgra Foods recorded a non- recurring gain for $186 million from the sale of Pilgrim's Pride stock to help meet an earnings projection for the quarter.

COMPREHENSIVE INCOME STATEMENT Chapter 2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02#ch02) discussed the fair value principle. Accounting standards require companies to mark the recorded values of certain types of assets and liabilities to their fair values at the end of each reporting period. In some instances, the unrealized gains or losses that result from adjusting recorded amounts to fair value are included in net income. However, in other cases, these unrealized gains and losses are not included in net income. Instead,

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these excluded items are reported as part of a more inclusive earnings measure, called comprehensive income. Examples of such items include certain adjustments to pension plan assets, gains and losses on foreign currency translation, and unrealized gains and losses on certain types of investments. Items that are excluded from net income but included in comprehensive income are either reported in a combined statement of net income and comprehensive income, or in a separate comprehensive income statement. The comprehensive income statement presents items that are not included in the determination of net income, referred to as other comprehensive income. Illustration 5-12 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo4#c05-�ig-0012) (page 232) shows how comprehensive income is presented in a separate comprehensive income statement. It assumes that PW Audio Supply had an unrealized gain of $2,700 with $400 of related tax expense. Use this format when preparing your homework.

ILLUSTRATION 5-12 Combined statement of net income and comprehensive income

DO IT! 4

Multiple-Step Income Statement

The following information is available for Art Center Corp. for the year ended December 31, 2017.

Other revenues and gains $   8,000 Sales revenue $462,000 Other expenses and losses 3,000 Operating expenses 187,000 Cost of goods sold 147,000 Sales discounts 20,000 Other comprehensive income 10,000

Prepare a multiple-step income statement and comprehensive income statement for Art Center Corp. The company has a tax rate of 25%. This rate also applies to other comprehensive income.

Action Plan ✓ Subtract cost of goods sold from net sales to determine gross

pro�it.

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✓ Subtract operating expenses from gross pro�it to determine income from operations.

✓ Add/subtract nonoperating items to determine income before tax.

✓ Multiply the tax rate by income before tax to determine tax expense.

Related exercise material: BE5-5, BE5-6, BE5-7, DO IT! 5-4, E5-5, E5-6, E5-7, E5-8, E5-9, E5-10, and E5-11.

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LEARNING OBJECTIVE 5

Determine cost of goods sold under a periodic inventory system. 

Determining cost of goods sold is different when a periodic inventory system is used rather than a perpetual system. As you have seen, a company using a perpetual system makes an entry to record cost of goods sold and to reduce inventory each time a sale is made. A company using a periodic system does not determine cost of goods sold until the end of the period. At the end of the period, the company performs a count to determine the ending balance of inventory. It then calculates cost of goods sold by subtracting ending inventory from the goods available for sale. Cost of goods available for sale is the sum of beginning inventory plus purchases, as shown in Illustration 5-13 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo5#c05-�ig-0013) .

ILLUSTRATION 5-13 Basic formula for cost of goods sold using the periodic system

Another difference between the two approaches is that the perpetual system directly adjusts the Inventory account for any transaction that affects inventory (such as freight costs, purchase returns, and purchase discounts). The periodic system does not do this. Instead, it creates different accounts for purchases, freight costs, purchase returns, and purchase discounts. These various accounts are shown in Illustration 5-14 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo5#c05-�ig-0014) , which presents the calculation of cost of goods sold for PW Audio Supply using the periodic approach. Note that the basic elements from Illustration 5-13 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo5#c05-�ig-0013) are highlighted in Illustration 5-14 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo5#c05-�ig-0014) . You will learn more in Chapter 6 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch06#ch06) about how to determine cost of goods sold using the periodic system.

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ILLUSTRATION 5-14 Cost of goods sold for a merchandiser using a periodic inventory system

The use of the periodic inventory system does not affect the form of presentation in the balance sheet. As under the perpetual system, a company reports inventory in the current assets section.

Appendix 5A (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo7#app5) provides further detail on the use of the periodic system.

DO IT! 5

Cost of Goods Sold—Periodic System

Aerosmith Company's accounting records show the following at the year-end December 31, 2017.

Purchase Discounts $   3,400 Freight-In 6,100 Purchases 162,500 Beginning Inventory 18,000 Ending Inventory 20,000 Purchase 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.

Action Plan ✓ To determine cost of goods purchased, adjust purchases for

returns, discounts, and freight-in.

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✓ To determine cost of goods sold, add cost of goods purchased to beginning inventory, and subtract ending inventory.

Related exercise material: BE5-8, BE5-9, BE5-10, DO IT! 5-5, E5-12, and E5-13.

▼ HELPFUL HINT

The far right column identi�ies the primary items that make up cost of goods sold of $316,000. The middle column explains cost of goods purchased of $320,000. The left column reports contra purchase items of $17,200.

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LEARNING OBJECTIVE 6

Compute and analyze gross pro�it rate and pro�it margin. 

GROSS PROFIT RATE A company's gross pro�it may be expressed as a percentage by dividing the amount of gross pro�it by net sales. This is referred to as the gross pro�it rate. For PW Audio Supply, the gross pro�it rate is 31.3% ($144,000÷$460,000).

Analysts generally consider the gross pro�it rate to be more informative than the gross pro�it amount because it expresses a more meaningful (qualitative) relationship between gross pro�it and net sales. For example, a gross pro�it amount of $1,000,000 may sound impressive. But if it was the result of sales of $100,000,000, the company's gross pro�it rate was only 1%. Illustration 5-15 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo6#c05-�ig-0015) demonstrates that gross pro�it rates differ greatly across industries.

ILLUSTRATION 5-15 Gross pro�it rate by industry

A decline in a company's gross pro�it rate might have several causes. The company may have begun to sell products with a lower “markup”—for example, budget blue jeans versus designer blue jeans. Increased competition may have resulted in a lower selling price. Or, maybe the company was forced to pay higher prices to its suppliers and was not able to pass these costs on to its customers. The gross pro�it rates for REI and Dick's Sporting Goods, and the industry average, are presented in Illustration 5-16 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo6#c05-�ig-0016) .

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ILLUSTRATION 5-16 Gross pro�it rate

REI's gross pro�it rate increased from 43.1% in 2013 to 43.3% in 2014. What might cause changes in REI's gross pro�it rate? When the economy changes, retailers also often adjust their selling prices. Changes in national weather patterns can also affect the amount of time people spend outdoors—and therefore impact their purchases of REI merchandise.

Why does REI's gross pro�it rate differ so much from that of Dick's Sporting Goods and the industry average? The gross pro�it rate often differs across retailers because of differences in the nature of their goods. First, REI focuses on outdoor equipment, while Dick's also sells sporting goods and hunting gear. The markup may differ signi�icantly in these different product sectors. Also, although REI and Dick's both sell outdoor equipment, the quality of the equipment they sell differs. REI tends to sell more “high-end” goods, while Dick's tends to sell goods in a more “affordable” range. Higher-quality goods often receive a higher markup, but the retailer also sells fewer of them. In general, retailers adopt either a high-volume–low- margin approach (e.g., Wal-Mart) or a low-volume–high-margin approach (e.g., Saks Fifth Avenue). The strategic choice is often revealed in differences in the companies' gross pro�it rates.

DECISION TOOLS

The gross pro�it rate helps companies decide if the prices of their goods are in line with changes in the cost of inventory.

PROFIT MARGIN The pro�it margin measures the percentage of each dollar of sales that results in net income. We compute this ratio by dividing net income by net sales (revenue) for the period.

How do the gross pro�it rate and pro�it margin differ? The gross pro�it rate measures the margin by which selling price exceeds cost of goods sold. The pro�it margin measures the extent by which selling price covers all expenses (including cost of goods sold). A company can improve its pro�it margin by either increasing its gross pro�it rate and/or by controlling its operating expenses and other costs. For example, at one time Radio Shack reported increased pro�it margins which it accomplished by closing stores and slashing costs. Eventually, however, it was forced to �ile for bankruptcy as sales continued to decline.

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Pro�it margins vary across industries. Businesses with high turnovers, such as grocery stores (Safeway and Kroger) and discount stores (Target and Wal-Mart), generally experience low pro�it margins. Low-turnover businesses, such as high-end jewelry stores (Tiffany and Co.) or major drug manufacturers (Merck), have high pro�it margins. Illustration 5-17 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo6#c05-�ig-0017) shows pro�it margins from a variety of industries.

ILLUSTRATION 5-17 Pro�it margins by industry

Pro�it margins for REI and Dick's Sporting Goods and the industry average are presented in Illustration 5- 18 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo6#c05-�ig-0018) .

ILLUSTRATION 5-18 Pro�it margin

REI's pro�it margin increased from 0.9% to 2.0% between 2013 and 2014. This means that the company generated 2.0¢ of pro�it on each dollar of sales. This increase occurred partly because the gross pro�it rate increased.

A change in the pro�it margin can be caused by a change in the gross pro�it rate, a change in the amount of operating expenses relative to sales, or a change in the amount of other items (other revenues and gains, or other expenses and losses) relative to sales. From Illustration 5-16 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo6#c05-�ig-0016) , we know that REI's gross pro�it rate increased slightly. From analyzing the information in Illustration 5-8 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo4#c05-�ig-0008) , we see that operating expenses as a percentage of sales decreased from 36.6%($739,148÷$2,017,476) in 2013 to 35.1%($778,251÷$2,217,131) in 2014. Therefore, in 2014, most of the increase in REI's pro�it margin occurred because of the decline in operating expenses as a percentage of sales.

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How does REI compare to its competitors? Its pro�it margin was lower than Dick's in 2014 and was less than the industry average. Thus, its pro�it margin does not suggest exceptional pro�itability.

PEOPLE, PLANET, AND PROFIT INSIGHT

PepsiCo Inc.

Selling Green

Here is a question an executive of PepsiCo Inc. was asked: Should PepsiCo market green? The executive indicated that the company should, as he believes it's the No. 1 thing consumers all over the world care about. Here are some of his thoughts on this issue:

“Sun Chips are part of the food business I run. It's a ‘healthy snack.’ We decided that Sun Chips, if it's a healthy snack, should be made in facilities that have a net-zero footprint. In other words, I want off the electric grid everywhere we make Sun Chips. We did that. Sun Chips should be made in a facility that puts back more water than it uses. It does that. And we partnered with our suppliers and came out with the world's �irst compostable chip package.

Now, there was an issue with this package: It was louder than the New York subway, louder than jet engines taking off. What would a company that's committed to green do: walk away or stay committed? If your people are passionate, they're going to �ix it for you as long as you stay committed. Six months later, the compostable bag has half the noise of our current package.

So the view today is: we should market green, we should be proud to do it … it has to be a 360 process, both internal and external. And if you do that, you can monetize environmental sustainability for the shareholders.”

Source: “Four Problems—and Solutions,” Wall Street Journal (March 7, 2011), p. R2.

What is meant by “monetize environmental sustainability” for shareholders? (Go to WileyPLUS for this answer and additional questions.)

KEEPING AN EYE ON CASH In Chapter 4 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch04#ch04) , you learned that earnings have high quality if they provide a full and transparent depiction of how a company performed. In order to quickly assess earnings quality,

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analysts sometimes employ the quality of earnings ratio. It is calculated as net cash provided by operating activities divided by net income.

In general, a measure signi�icantly less than 1 suggests that a company may be using more aggressive accounting techniques in order to accelerate income recognition (record income in earlier periods). A measure signi�icantly greater than 1 suggests that a company is using conservative accounting techniques, which cause it to delay the recognition of income.

Measures that are signi�icantly less than 1 do not provide de�initive evidence of low-quality earnings. Low measures do, however, indicate that analysts should investigate the causes of the difference between net income and net cash provided by operating activities. Examples of factors that would cause differences are presented in Chapter 4 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch04#ch04) (page 179).

Here are recent quality of earnings ratios for a number of well-known companies, all of which have measures in excess of 1.

DO IT! 6

Gross Pro�it Rate and Pro�it Margin

Rachel Rose, Inc. reported the following in its 2017 and 2016 income statements.

2017 2016 Net sales $80,000 $120,000 Cost of goods sold 40,000 60,000 Operating expenses    14,000 28,000 Income tax expense 8,000 12,000 Net income $18,000 $ 20,000

Determine the company's gross pro�it rate and pro�it margin. Discuss the cause for changes in the ratios.

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Action Plan ✓ To determine gross pro�it rate, divide gross pro�it by net sales.

✓ To �ind pro�it margin, divide net income by net sales.

SOLUTION

The company's gross pro�it rate remained constant. However, its pro�it margin increased signi�icantly due to a sharp decline in its operating costs as a percentage of sales, which declined from 23%($28,000÷$120,000) in 2016 to 17.5% ($14,000÷$80,000) in 2017.

Related exercise material: BE5-11, BE5-12, BE5-13, DO IT! 5-6, E5-7, E5-8, E5-9, and E5- 14.

DECISION TOOLS

The pro�it margin helps companies decide if they are maintaining an adequate margin between sales and expenses.

USING DECISION TOOLS—MOUNTAIN EQUIPMENT COOPERATIVE Like REI, Mountain Equipment Cooperative (MEC) is a retailer of outdoor equipment organized as a cooperative (though MEC only sells to its members, who pay a one-time fee of $5). Also like REI, MEC has a signi�icant commitment to sustainability. Many of its stores employ state-of-the-art building techniques to minimize energy use, and it pledges 1% of annual sales revenue to environmental causes. Since MEC is a Canadian company, it follows International Financial Reporting Standards (IFRS) rather than U.S. GAAP. The A Look at

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IFRS section at the end of each chapter of this textbook discusses some of the main accounting differences that you would need to be aware of to make a thorough comparison of REI and MEC. Here is recent data for MEC.

Year ended ($ in thousands) 12/28/14 12/29/13 Net income $     60 $    361 Sales revenue 336,071 320,871 Cost of goods sold 226,099 215,614

INSTRUCTIONS

Using the basic facts in the table, evaluate the following components of MEC's pro�itability for the years ended December 28, 2014, and December 29, 2013.

Pro�it margin

Gross pro�it rate

How do MEC's pro�it margin and gross pro�it rate compare to those of REI and Dick's Sporting Goods for 2014?

SOLUTION

MEC's pro�it margin (income per dollar of sales) remained constant at 0.0%. This is well below both REI's (2.0%) and Dick's (5.4%). Thus, MEC is not as effective at turning its sales into net income as these two competitors.

MEC's gross pro�it rate declined slightly from 32.8% to 32.7%. This suggests that its ability to maintain its markup above its cost of goods sold declined slightly during this period. MEC's gross pro�it rate of 32.7% is lower than REI's (43.3%) but higher than Dick's (31.3%). Dick's gross pro�it is depressed by the fact that it sells many low-margin products. REI is superior to MEC both in its ability to maintain its markup above its costs of goods sold (its gross pro�it rate) and in its ability to control operating costs (its pro�it margin).

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LEARNING OBJECTIVE *7

 APPENDIX 5A: Record purchases and sales of inventory under a periodic inventory system. 

As described in this chapter, companies may use one of two basic systems of accounting for inventories: (1) the perpetual inventory system or (2) the periodic inventory system. In the chapter, we focused on the characteristics of the perpetual inventory system. In this appendix, we discuss and illustrate the periodic inventory system. One key difference between the two systems is the point at which the company computes cost of goods sold. For a visual reminder of this difference, you may want to refer back to Illustration 5-4 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo1#c05-�ig-0004) on page 218.

RECORDING MERCHANDISE TRANSACTIONS In a periodic inventory system, companies record revenues from the sale of merchandise when sales are made, just as in a perpetual system. Unlike the perpetual system, however, companies do not attempt on the date of sale to record the cost of the merchandise sold. Instead, they take a physical inventory count at the end of the period to determine (1) the cost of the merchandise then on hand and (2) the cost of the goods sold during the period. And, under a periodic system, companies record purchases of merchandise in the Purchases account rather than the Inventory account. Purchase returns and allowances, purchase discounts, and freight costs on purchases are recorded in separate accounts.

To illustrate the recording of merchandise transactions under a periodic inventory system, we will use purchase/sale transactions between PW Audio Supply, Inc. and Sauk Stereo, as illustrated for the perpetual inventory system in this chapter.

RECORDING PURCHASES OF MERCHANDISE On the basis of the sales invoice (Illustration 5-5 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo2#c05-�ig-0005) , shown on page 220) and receipt of the merchandise ordered from PW Audio Supply, Sauk Stereo records the $3,800 purchase as follows.

Purchases is a temporary account whose normal balance is a debit.

FREIGHT COSTS

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When the purchaser directly incurs the freight costs, it debits the account Freight-In (or Transportation-In). For example, if Sauk Stereo pays Public Freight Company $150 for freight charges on its purchase from PW Audio Supply on May 6, the entry on Sauk Stereo's books is as follows.

Like Purchases, Freight-In is a temporary account whose normal balance is a debit. Freight-In is part of cost of goods purchased. The reason is that cost of goods purchased should include any freight charges necessary to bring the goods to the purchaser. Freight costs are not subject to a purchase discount. Purchase discounts apply on the invoice cost of the merchandise.

Purchase Returns and Allowances

Sauk Stereo returns goods costing $300 to PW Audio Supply and prepares the following entry to recognize the return.

Purchase Returns and Allowances is a temporary account whose normal balance is a credit.

Purchase Discounts

On May 14, Sauk Stereo pays the balance due on account to PW Audio Supply, taking the 2% cash discount allowed by PW Audio Supply for payment within 10 days. Sauk Stereo records the payment and discount as follows.

Purchase Discounts is a temporary account whose normal balance is a credit.

RECORDING SALES OF MERCHANDISE The seller, PW Audio Supply, records the sale of $3,800 of merchandise to Sauk Stereo on May 4 (sales invoice No. 731, Illustration 5-5 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo2#c05-�ig-0005) , page 220) as follows.

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Sales Returns and Allowances

To record the returned goods received from Sauk Stereo on May 8, PW Audio Supply records the $300 sales return as follows.

Sales Discounts

On May 14, PW Audio Supply receives payment of $3,430 on account from Sauk Stereo. PW Audio Supply honors the 2% cash discount and records the payment of Sauk Stereo's account receivable in full as follows.

COMPARISON OF ENTRIES—PERPETUAL VS. PERIODIC

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REVIEW AND PRACTICE

LEARNING OBJECTIVES REVIEW 1. Describe merchandising operations and inventory systems. Because of the

presence of inventory, a merchandising company has sales revenue, cost of goods sold, and gross pro�it. To account for inventory, a merchandising company must choose between a perpetual inventory system and a periodic inventory system.

2. Record purchases under a perpetual inventory system. The Inventory account is debited for all purchases of merchandise and for freight costs, and it is credited for purchase discounts and purchase returns and allowances.

3. Record sales under a perpetual inventory system. When inventory is sold, Accounts Receivable (or Cash) is debited and Sales Revenue is credited for the selling price of the merchandise. At the same time, Cost of Goods Sold is debited and Inventory is credited for the cost of inventory items sold. Separate contra revenue accounts are maintained for Sales Returns and Allowances and Sales Discounts. These accounts are debited as needed to record returns, allowances, or discounts related to the sale.

4. Prepare a multiple-step income statement and a comprehensive income statement. In a single-step income statement, companies classify all data under two categories, revenues or expenses, and net income is determined in one step. A multiple-step income statement shows numerous steps in determining net income, including results of nonoperating activities. A comprehensive income statement adds or subtracts any items of other comprehensive income to net income to arrive at comprehensive income.

5. Determine cost of goods sold under a periodic inventory system. The periodic system uses multiple accounts to keep track of transactions that affect inventory. To determine cost of goods sold, �irst calculate cost of goods purchased by adjusting purchases for returns, allowances, discounts, and freight-in. Then calculate cost of goods sold by adding cost of goods purchased to beginning inventory and subtracting ending inventory.

6. Compute and analyze gross pro�it rate and pro�it margin. Pro�itability is affected by gross pro�it, as measured by the gross pro�it rate, and by management's ability to control costs, as measured by the pro�it margin.

7. Record purchases and sales of inventory under a periodic inventory system. To record purchases, entries are required for (a) cash and credit purchases, (b) purchase returns and allowances, (c) purchase discounts, and (d) freight costs. To record sales, entries are required for (a) cash and credit sales, (b) sales returns and allowances, and (c) sales discounts.

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GLOSSARY REVIEW Comprehensive income An income measure that includes gains and losses that are

excluded from the determination of net income.

Comprehensive income statement A statement that presents items that are not included in the determination of net income, referred to as other comprehensive income.

Contra revenue account An account that is offset against a revenue account on the income statement.

Cost of goods sold The total cost of merchandise sold during the period.

Gross pro�it rate Gross pro�it expressed as a percentage by dividing the amount of gross pro�it by net sales.

Gross pro�it The excess of net sales over the cost of goods sold.

Net sales Sales less sales returns and allowances and sales discounts.

Periodic inventory system An inventory system in which a company does not maintain detailed records of goods on hand throughout the period and determines the cost of goods sold only at the end of an accounting period.

Perpetual inventory system A detailed inventory system in which a company maintains the cost of each inventory item, and the records continuously show the inventory that should be on hand.

Pro�it margin Measures the percentage of each dollar of sales that results in net income, computed by dividing net income by net sales.

Purchase allowance A deduction made to the selling price of merchandise, granted by the seller, so that the buyer will keep the merchandise.

Purchase discount A cash discount claimed by a buyer for prompt payment of a balance due.

Purchase invoice A document that provides support for each purchase.

Purchase return A return of goods from the buyer to the seller for cash or credit.

Quality of earnings ratio A measure used to indicate the extent to which a company's earnings provide a full and transparent depiction of its performance; computed as net

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cash provided by operating activities divided by net income.

Sales discount A reduction given by a seller for prompt payment of a credit sale.

Sales invoice A document that provides support for each sale.

Sales returns and allowances Transactions in which the seller either accepts goods back from the purchaser (a return) or grants a reduction in the purchase price (an allowance) so that the buyer will keep the goods.

Sales revenue Primary source of revenue for a merchandising company.

PRACTICE MULTIPLE-CHOICE QUESTIONS (LO 1)

1. Which of the following statements about a periodic inventory system is true?

(a) Companies determine cost of goods sold only at the end of the accounting period.

(b) Companies continuously maintain detailed records of the cost of each inventory purchase and sale.

(c) The periodic system provides better control over inventories than a perpetual system.

(d) The increased use of computerized systems has increased the use of the periodic system.

(LO 2)

2. Under a perpetual inventory system, when goods are purchased for resale by a company:

(a) purchases on account are debited to Inventory.

(b) purchases on account are debited to Purchases.

(c) purchase returns are debited to Purchase Returns and Allowances.

(d) freight costs are debited to Freight-Out.

(LO 3)

3. Which sales accounts normally have a debit balance?

(a) Sales Discounts.

(b) Sales Returns and Allowances.

(c) Both (a) and (b).

(d) Neither (a) nor (b).

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(LO 3)

4. A company makes a credit sale of $750 on June 13, terms 2/10, n/30, on which it grants a return of $50 on June 16. What amount is received as payment in full on June 23?

(a) $700.

(b) $686.

(c) $685.

(d) $650.

(LO 3)

5. To record the sale of goods for cash in a perpetual inventory system:

(a) only one journal entry is necessary to record cost of goods sold and reduction of inventory.

(b) only one journal entry is necessary to record the receipt of cash and the sales revenue.

(c) two journal entries are necessary: one to record the receipt of cash and sales revenue, and one to record the cost of goods sold and reduction of inventory.

(d) two journal entries are necessary: one to record the receipt of cash and reduction of inventory, and one to record the cost of goods sold and sales revenue.

(LO 4)

6. Gross pro�it will result if:

(a) operating expenses are less than net income.

(b) net sales are greater than operating expenses.

(c) net sales are greater than cost of goods sold.

(d) operating expenses are greater than cost of goods sold.

(LO 4)

7. If net sales are $400,000, cost of goods sold is $310,000, and operating expenses are $60,000, what is the gross pro�it?

(a) $30,000.

(b) $90,000.

(c) $340,000.

(d) $400,000.

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(LO 4)

8. The multiple-step income statement for a merchandising company shows each of these features except:

(a) gross pro�it.

(b) cost of goods sold.

(c) a sales section.

(d) an investing activities section.

(LO 5)

9. If beginning inventory is $60,000, cost of goods purchased is $380,000, and ending inventory is $50,000, what is cost of goods sold under a periodic system?

(a) $390,000.

(b) $370,000.

(c) $330,000.

(d) $420,000.

(LO 5)

10. Bufford Corporation had reported the following amounts at December 31, 2017: sales revenue $184,000, ending inventory $11,600, beginning inventory $17,200, purchases $60,400, purchase discounts $3,000, purchase returns and allowances $1,100, freight-in $600, and freight-out $900. Calculate the cost of goods available for sale.

(a) $69,400.

(b) $74,100.

(c) $56,900.

(d) $197,700.

(LO 6)

11. Which of the following would affect the gross pro�it rate? (Assume sales remains constant.)

(a) An increase in advertising expense.

(b) A decrease in depreciation expense.

(c) An increase in cost of goods sold.

(d) A decrease in insurance expense.

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(LO 6)

12. The gross pro�it rate is equal to:

(a) net income divided by sales.

(b) cost of goods sold divided by sales.

(c) net sales minus cost of goods sold, divided by net sales.

(d) sales minus cost of goods sold, divided by cost of goods sold.

(LO 6)

13. During the year ended December 31, 2017, Bjornstad Corporation had the following results: net sales $267,000, cost of goods sold $107,000, net income $92,400, operating expenses $55,400, and net cash provided by operating activities $108,950. What was the company's pro�it margin?

(a) 40%.

(b) 60%.

(c) 20.5%.

(d) 34.6%.

(LO 6)

14. A quality of earnings ratio:

(a) is computed as net income divided by net cash provided by operating activities.

(b) that is less than 1 indicates that a company might be using aggressive accounting tactics.

(c) that is greater than 1 indicates that a company might be using aggressive accounting tactics.

(d) is computed as net cash provided by operating activities divided by total assets.

(LO 7)

*15. When goods are purchased for resale by a company using a periodic inventory system:

(a) purchases on account are debited to Inventory.

(b) purchases on account are debited to Purchases.

(c) purchase returns are debited to Purchase Returns and Allowances.

(d) freight costs are debited to Purchases.

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SOLUTIONS

1. (a) Under the periodic inventory system, cost of goods sold is determined only at the end of the accounting period. The other choices are incorrect because (b) detailed records of the cost of each inventory purchase and sale are maintained continuously when a perpetual, not periodic, system is used; (c) the perpetual system provides better control over inventories than a periodic system; and (d) the increased use of computerized systems has increased the use of the perpetual, not periodic, system.

2. (a) Under a perpetual inventory system, when a company purchases goods for resale, purchases on account are debited to the Inventory account, not (b) Purchases or (c) Purchase Returns and Allowances. Choice (d) is incorrect because freight costs are also debited to the Inventory account, not the Freight-Out account.

3. (c) Both Sales Discounts and Sales Returns and Allowances normally have a debit balance. Choices (a) and (b) are both correct, but (c) is the better answer. Choice (d) is incorrect as both (a) and (b) are correct.

4. (b) The full amount of $686 is paid within 10 days of the purchase ($750−$50)−[($750−$50)×2%]. The other choices are incorrect because (a) does not consider the discount of $14; (c) the amount of the discount is based upon the amount after the return is granted ($700×2%), not the amount before the return of merchandise ($750×2%); and (d) does not constitute payment in full on June 23.

5. (c) Two journal entries are necessary: one to record the receipt of cash and sales revenue, and one to record the cost of goods sold and reduction of inventory. The other choices are incorrect because (a) only considers the recognition of the expense and ignores the revenue, (b) only considers the recognition of revenue and leaves out the expense or cost of merchandise sold, and (d) the receipt of cash and sales revenue, not reduction of inventory, are paired together, and the cost of goods sold and reduction of inventory, not sales revenue, are paired together.

6. (c) Gross pro�it will result if net sales are greater than cost of goods sold. The other choices are incorrect because (a) operating expenses and net income are not used in the computation of gross pro�it; (b) gross pro�it results when net sales are greater than cost of goods sold, not operating expenses; and (d) gross pro�it results when net sales, not operating expenses, are greater than cost of goods sold.

7. (b) Gross pro�it=Net sales ($400,000)−Cost of goods sold ($310,000)=$90,000, not (a) $30,000, (c) $340,000, or (d) $400,000.

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8. (d) An investing activities section appears on the statement of cash �lows, not on a multiple-step income statement. Choices (a) gross pro�it, (b) cost of goods sold, and (c) a sales section are all features of a multiple-step income statement.

9. (a) Beginning inventory ($60,000)+Cost of goods purchased ($380,000)−Ending inventory ($50,000)=Cost of goods sold ($390,000), not (b) $370,000, (c) $330,000, or (d) $420,000.

10. (b) Beginning inventory ($17,200)+Purchases ($60,400)−Purchases discounts ($3,000)−Purchase returns and allowances ($1,100)+Freight-in ($600)=Cost of goods available for sale ($74,100). The other choices are therefore incorrect.

11. (c) Gross pro�it rate=Gross pro�it÷Net sales. Therefore, any changes in sale revenue, sales returns and allowances, sales discounts, or cost of goods sold will affect the ratio. Changes in (a) advertising expense, (b) depreciation expense, or (d) insurance expense will not affect the computation of the gross pro�it rate.

12. (c) Gross pro�it rate=Gross pro�it (Net sales−Cost of goods sold)÷Net sales. The other choices are therefore incorrect.

13. (d) Net income ($92,400)÷Net sales ($267,000)=Pro�it margin of 34.6%, not (a) 40%, (b) 60%, or (c) 20.5%.

14. (b) A quality of earnings ratio that is less than 1 indicates that a company might be using aggressive accounting tactics. The other choices are incorrect because (a) Quality of earnings=Net cash provided by operating activities÷Net income,not vice versa; (c) a ratio that is signi�icantly greater than 1 suggests that a company is using conservative accounting techniques, and (d) Quality of earnings=Net cash provided by operating activities÷Net income (not Total assets).

15. (b) Purchases for resale are debited to the Purchases account. The other choices are incorrect because (a) purchases on account are debited to Purchases, not Inventory; (c) Purchase Returns and Allowances are always credited; and (d) freight costs are debited to Freight-In, not Purchases.

PRACTICE EXERCISES

Prepare purchase and sales entries.

(LO 2, 3)

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1. On June 10, Vareen Company purchased $8,000 of merchandise from Harrah Company, FOB shipping point, terms 3/10, n/30. Vareen pays the freight costs of $400 on June 11. Damaged goods totaling $300 are returned to Harrah for credit on June 12. The fair value of these goods in $70. On June 19, Vareen pays Harrah Company in full, less the purchase discount. Both companies use a perpetual inventory system.

INSTRUCTIONS (a) Prepare separate entries for each transaction on the books of Vareen Company.

(b) Prepare separate entries for each transaction for Harrah Company. The merchandise purchased by Vareen on June 10 had cost Harrah $4,800.

Prepare multiple-step and single-step income statements.

(LO 4)

2. In its income statement for the year ended December 31, 2017, Marten Company reported the following condensed data.

Interest expense $    70,000 Net sales $2,200,000 Operating expenses 725,000 Interest revenue 25,000 Cost of goods sold 1,300,000 Loss on disposal of plant assets 17,000 Income tax expense 10,000

INSTRUCTIONS

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(a) Prepare a multiple-step income statement.

(b) Prepare a single-step income statement.

PRACTICE PROBLEM

Prepare a multiple-step income statement.

(LO 4)

The adjusted trial balance for the year ended December 31, 2017, for Dykstra Company is shown below.

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INSTRUCTIONS

Prepare a multiple-step income statement for Dykstra Company. Assume a tax rate of 30%.

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WileyPLUS Brief Exercises, DO IT! Exercises, Exercises, Problems, and many additional resources are available for practice in WileyPLUS.

NOTE: All asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter.

QUESTIONS 1. (a) “The steps in the accounting cycle for a merchandising company differ from the steps in the

accounting cycle for a service company.” Do you agree or disagree?

(b) Is the measurement of net income in a merchandising company conceptually the same as in a service company? Explain.

2. How do the components of revenues and expenses differ between a merchandising company and a service company?

3. Maria Lopez, CEO of Sales Bin Stores, is considering a recommendation made by both the company's purchasing manager and director of �inance that the company should invest in a sophisticated new perpetual inventory system to replace its periodic system. Explain the primary difference between the two systems, and discuss the potential bene�its of a perpetual inventory system.

4. (a) Explain the income measurement process in a merchandising company.

(b) How does income measurement differ between a merchandising company and a service company?

5. Waymon Co. has net sales of $100,000, cost of goods sold of $70,000, and operating expenses of $18,000. What is its gross pro�it?

6. Masie Ascot believes revenues from credit sales may be recorded before they are collected in cash. Do you agree? Explain.

7. (a) What is the primary source document for recording (1) cash sales and (2) credit sales?

(b) Using XXs for amounts, give the journal entry for each of the transactions in part (a), assuming perpetual inventory.

8. A credit sale is made on July 10 for $900, terms 1/15, n/30. On July 12, the purchaser returns $100 of goods for credit. Give the journal entry on July 19 to record the receipt of the balance due within the discount period.

9. As the end of Smyle Company's �iscal year approached, it became clear that the company had considerable excess inventory. Marvin Ross, the head of marketing and sales, ordered salespeople to “add 20% more units to each order that you ship. The customers can always ship the extra back next period if they decide they don't want it. We've got to do it to meet this year's sales goal.” Discuss the accounting implications of Marvin's action.

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10. To encourage bookstores to buy a broader range of book titles and to discourage price discounting, the publishing industry allows bookstores to return unsold books to the publisher. This results in very signi�icant returns each year. To ensure proper recognition of revenues, how should publishing companies account for these returns?

11. Goods costing $1,900 are purchased on account on July 15 with credit terms of 2/10, n/30. On July 18, the purchaser receives a $300 credit from the supplier for damaged goods. Give the journal entry on July 24 to record payment of the balance due within the discount period.

12. Scribe Company reports net sales of $800,000, gross pro�it of $560,000, and net income of $230,000. What are its operating expenses?

13. Mai Company has always provided its customers with payment terms of 1/10, n/30. Members of its sale force have commented that competitors are offering customers 2/10, n/45. Explain what these terms mean, and discuss the implications to Mai of switching its payment terms to those of its competitors.

14. In its year-end earnings announcement press release, Ransome Corp. announced that its earnings increased by $15 million relative to the previous year. This represented a 20% increase. Inspection of its income statement reveals that the company reported a $20 million gain under “Other revenues and gains” from the sale of one of its factories. Discuss the implications of this gain from the perspective of a potential investor.

15. Identify the distinguishing features of an income statement for a merchandising company.

16. Why is the normal operating cycle for a merchandising company likely to be longer than for a service company?

17. What title does Apple use for gross pro�it? By how much did its total gross pro�it change, and in what direction, in 2014?

18. What merchandising account(s) will appear in the post-closing trial balance?

19. What types of businesses are most likely to use a perpetual inventory system?

20. Identify the accounts that are added to or deducted from purchases to determine the cost of goods purchased under a periodic system. For each account, indicate (a) whether it is added or deducted, and (b) its normal balance.

21. In the following cases, use a periodic inventory system to identify the item(s) designated by the letters X and Y.

Purchases−X−Y=Net purchases.

Cost of goods purchased−Net purchases=X.

Beginning inventory+X=Cost of goods available for sale.

Cost of goods available for sale−Cost of goods sold=X.

22. What two ratios measure factors that affect pro�itability?

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23. What factors affect a company's gross pro�it rate—that is, what can cause the gross pro�it rate to increase and what can cause it to decrease?

24. Earl Massey, director of marketing, wants to reduce the selling price of his company's products by 15% to increase market share. He says, “I know this will reduce our gross pro�it rate, but the increased number of units sold will make up for the lost margin.” Before this action is taken, what other factors does the company need to consider?

25. Mark Coney is considering investing in Wiggles Pet Food Company. Wiggles' net income increased considerably during the most recent year even though many other companies in the same industry reported disappointing earnings. Mark wants to know whether the company's earnings provide a reasonable depiction of its results. What initial step can Mark take to help determine whether he needs to investigate further?

26. On July 15, a company purchases on account goods costing $1,900, with credit terms of 2/10, n/30. On July 18, the company receives a $400 credit memo from the supplier for damaged goods. Give the journal entry on July 24 to record payment of the balance due within the discount period assuming a periodic inventory system.

BRIEF EXERCISES

Compute missing amounts in determining net income.

(LO 1, 4), AP

BE5-1 Presented here are the components in Salas Company's income statement. Determine the missing amounts.

Sales Revenue Cost of Goods Sold Gross Pro�it Operating Expenses Net Income $ 71,200 (b) $?30,000 (d) $12,100 $108,000 $70,000 (c) (e) $29,500 (a) $71,900 $109,600 $46,200 (f)

Journalize perpetual inventory entries.

(LO 2, 3), AP

BE5-2 Rita Company buys merchandise on account from Linus Company. The selling price of the goods is $900 and the cost of the goods sold is $590. Both companies use perpetual inventory systems. Journalize

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the transactions on the books of both companies.

Journalize sales transactions.

(LO 3), AP

BE5-3 Prepare the journal entries to record the following transactions on Borst Company's books using a perpetual inventory system.

(a) On March 2, Borst Company sold $800,000 of merchandise to McLeena Company, terms 2/10, n/30. The cost of the merchandise sold was $540,000.

(b) On March 6, McLeena Company returned $140,000 of the merchandise purchased on March 2. The cost of the merchandise returned was $94,000.

(c) On March 12, Borst Company received the balance due from McLeena Company.

Journalize purchase transactions.

(LO 2), AP

BE5-4 From the information in BE5-3, prepare the journal entries to record these transactions on McLeena Company's books under a perpetual inventory system.

Prepare sales section of income statement.

(LO 4), AP

BE5-5 Barto Company provides this information for the month ended October 31, 2017: sales on credit $300,000, cash sales $150,000, sales discounts $5,000, and sales returns and allowances $19,000. Prepare the sales section of the income statement based on this information.

Identify placement of items on a multiple-step income statement.

(LO 4), AP

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BE5-6 Explain where each of these items would appear on a multiple-step income statement: gain on disposal of plant assets, cost of goods sold, depreciation expense, and sales returns and allowances.

Prepare a comprehensive income statement.

(LO 4), AP

BE5-7 The following information relates to Karen Weigel Inc. for the year 2017.

Retained earnings, January 1, 2017 $48,000 Advertising expense $  1,800 Dividends during 2017 5,000 Rent expense 10,400 Service revenue 62,500 Utilities expense 3,100 Salaries and wages expense 28,000 Other comprehensive income (net of tax) 400

After analyzing the data, (a) compute net income and (b) prepare a comprehensive income statement for the year ending December 31, 2017.

Determine cost of goods sold using basic periodic formula.

(LO 5), AP

BE5-8 Silas Company sold goods with a total selling price of $800,000 during the year. It purchased goods for $380,000 and had beginning inventory of $67,000. A count of its ending inventory determined that goods on hand was $50,000. What was its cost of goods sold?

Compute net purchases and cost of goods purchased.

(LO 5), AP

BE5-9 Assume that Spacey Company uses a periodic inventory system and has these account balances: Purchases $404,000, Purchase Returns and Allowances $13,000, Purchase Discounts $9,000, and Freight-In $16,000. Determine net purchases and cost of goods purchased.

Compute cost of goods sold and gross pro�it.

(LO 5), AP

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BE5-10 Assume the same information as in BE5-9 and also that Spacey Company has beginning inventory of $60,000, ending inventory of $90,000, and net sales of $612,000. Determine the amounts to be reported for cost of goods sold and gross pro�it.

Calculate pro�itability ratios.

(LO 6), AP

BE5-11 Dublin Corporation reported net sales of $250,000, cost of goods sold of $150,000, operating expenses of $50,000, net income of $32,500, beginning total assets of $520,000, and ending total assets of $600,000. Calculate each of the following values and explain what they mean: (a) pro�it margin and (b) gross pro�it rate.

Calculate pro�itability ratios.

(LO 6), AP

BE5-12 Garten Corporation reported net sales $800,000, cost of goods sold $520,000, operating expenses $210,000, and net income $68,000. Calculate the following values and explain what they mean: (a) pro�it margin and (b) gross pro�it rate.

Evaluate quality of earnings.

(LO 6), C

BE5-13 Cabo Corporation reported net income of $346,000, cash of $67,800, and net cash provided by operating activities of $221,200. What does this suggest about the quality of the company's earnings? What further steps should be taken?

Journalize purchase transactions.

(LO 7), AP

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*BE5-14 Prepare the journal entries to record these transactions on Kimble Company's books using a periodic inventory system.

(a) On March 2, Kimble Company purchased $800,000 of merchandise from Poe Company, terms 2/10, n/30.

(b) On March 6, Kimble Company returned $95,000 of the merchandise purchased on March 2.

(c) On March 12, Kimble Company paid the balance due to Poe Company.

DO IT! EXERCISES

Answer general questions about merchandisers.

(LO 1), C

Do IT! 5-1 Indicate whether the following statements are true or false.

1. A merchandising company reports gross pro�it but a service company does not.

2. Under a periodic inventory system, a company determines the cost of goods sold each time a sale occurs.

3. A service company is likely to use accounts receivable but a merchandising company is not likely to do so.

4. Under a periodic inventory system, the cost of goods on hand at the beginning of the accounting period plus the cost of goods purchased less the cost of goods on hand at the end of the accounting period equals cost of goods sold.

Record transactions of purchasing company.

(LO 2), AP

Do IT! 5-2 On October 5, Iverson Company buys merchandise on account from Lasse Company. The selling price of the goods is $5,000, and the cost to Lasse Company is $3,000. On October 8, Iverson returns defective goods with a selling price of $640 and a scrap value of $240. Record the transactions of Iverson Company, assuming a perpetual approach.

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Record transactions of selling company.

(LO 3), AP

Do IT! 5-3 Assume information similar to that in DO IT! 5-2. That is: On October 5, Iverson Company buys merchandise on account from Lasse Company. The selling price of the goods is $5,000, and the cost to Lasse Company is $3,000. On October 8, Iverson returns defective goods with a selling price of $640 and a scrap value of $240. Record the transactions on the books of Lasse Company, assuming a perpetual approach.

Prepare multiple-step income statement and comprehensive income statement.

(LO 4), AP

Do IT! 5-4 The following information is available for Berlin Corp. for the year ended December 31, 2017:

Other revenues and gains $  12,700 Sales revenue $592,000 Other expenses and losses 13,300 Operating expenses 186,000 Cost of goods sold 156,000 Sales returns and allowances 40,000 Other comprehensive income 5,400

Prepare a multiple-step income statement for Berlin Corp. and comprehensive income statement. The company has a tax rate of 30%. This rate also applies to the other comprehensive income.

Determine cost of goods sold using periodic system.

(LO 5), AP

Do IT! 5-5 Clean Lake Corporation's accounting records show the following at year-end December 31, 2017:

Purchase Discounts $  5,900 Beginning Inventory $31,720 Freight-In 8,400 Ending Inventory 27,950 Freight-Out 11,100 Purchase Returns and Allowances 3,600 Purchases 162,500

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Assuming that Clean Lake Corporation uses the periodic system, compute (a) cost of goods purchased and (b) cost of goods sold.

Compute and analyze pro�itability ratios.

(LO 6), AN

Do IT! 5-6 Owen Wise, Inc. reported the following in its 2017 and 2016 income statements.

2017 2016 Net sales $150,000 $120,000 Cost of goods sold 90,000 72,000 Operating expenses 32,000 16,000 Income tax expense 18,000 10,000 Net income $ 10,000 $ 22,000

Determine the company's gross pro�it rate and pro�it margin for both years. Discuss the cause for changes in the ratios.

EXERCISES

Journalize purchase transactions.

(LO 2), AP

E5-1 This information relates to Rice Co.

1. On April 5, purchased merchandise from Jax Company for $28,000, terms 2/10, n/30.

2. On April 6, paid freight costs of $700 on merchandise purchased from Jax.

3. On April 7, purchased equipment on account for $30,000.

4. On April 8, returned $3,600 of April 5 merchandise to Jax Company.

5. On April 15, paid the amount due to Jax Company in full.

Instructions

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(a) Prepare the journal entries to record the transactions listed above on Rice Co.'s books. Rice Co. uses a perpetual inventory system.

(b) Assume that Rice Co. paid the balance due to Jax Company on May 4 instead of April 15. Prepare the journal entry to record this payment.

Journalize perpetual inventory entries.

(LO 2, 3), AP

E5-2 Assume that on September 1, Of�ice Depot had an inventory that included a variety of calculators. The company uses a perpetual inventory system. During September, these transactions occurred.

Sept. 6 Purchased calculators from Dragoo Co. at a total cost of $1,650, terms n/30. 9 Paid freight of $50 on calculators purchased from Dragoo Co. 10 Returned calculators to Dragoo Co. for $66 credit because they did not meet speci�ications. 12 Sold calculators costing $520 for $690 to Fryer Book Store, terms n/30. 14 Granted credit of $45 to Fryer Book Store for the return of one calculator that was not ordered.

The calculator cost $34. 20 Sold calculators costing $570 for $760 to Heasley Card Shop, terms n/30.

Instructions

Journalize the September transactions.

Journalize sales transactions.

(LO 3), AP

E5-3 The following transactions are for Alonzo Company.

1. On December 3, Alonzo Company sold $500,000 of merchandise to Arte Co., terms 1/10, n/30. The cost of the merchandise sold was $330,000.

2. On December 8, Arte Co. was granted an allowance of $25,000 for merchandise purchased on December 3.

3. On December 13, Alonzo Company received the balance due from Arte Co.

Instructions

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(a) Prepare the journal entries to record these transactions on the books of Alonzo Company. Alonzo uses a perpetual inventory system.

(b) Assume that Alonzo Company received the balance due from Arte Co. on January 2 of the following year instead of December 13. Prepare the journal entry to record the receipt of payment on January 2.

Journalize perpetual inventory entries.

(LO 2, 3), AP

E5-4 On June 10, Pais Company purchased $9,000 of merchandise from McGiver Company, terms 3/10, n/30. Pais pays the freight costs of $400 on June 11. Goods totaling $600 are returned to McGiver for credit on June 12. On June 19, Pais Company pays McGiver Company in full, less the purchase discount. Both companies use a perpetual inventory system.

Instructions (a) Prepare separate entries for each transaction on the books of Pais Company.

(b) Prepare separate entries for each transaction for McGiver Company. The merchandise purchased by Pais on June 10 cost McGiver $5,000, and the goods returned cost McGiver $310.

Prepare sales section of income statement.

(LO 4), AP

E5-5 The adjusted trial balance of Doqe Company shows these data pertaining to sales at the end of its �iscal year, October 31, 2017: Sales Revenue $900,000, Freight-Out $14,000, Sales Returns and Allowances $22,000, and Sales Discounts $13,500.

Instructions Prepare the sales section of the income statement.

Prepare an income statement, a comprehensive income statement, and calculate pro�itability ratios.

(LO 4, 6), AP

E5-6 Presented below is information for Lieu Co. for the month of January 2017.

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Cost of goods sold $212,000 Rent expense $ 32,000 Freight-out 7,000 Sales discounts 8,000 Insurance expense 12,000 Sales returns and allowances 20,000 Salaries and wages expense 60,000 Sales revenue 370,000 Income tax expense 5,000 Other comprehensive income (net of $400 tax) 2,000

Instructions (a) Prepare an income statement using the format presented in Illustration 5-11

(http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo4#c05-�ig-0011) .

(b) Prepare a comprehensive income statement.

(c) Calculate the pro�it margin and the gross pro�it rate.

Compute missing amounts and calculate pro�itability ratios.

(LO 4, 6), AP

E5-7 Financial information is presented here for two companies.

Yoste Company Noone Company Sales revenue $90,000 ? Sales returns and allowances ? $  5,000 Net sales  84,000  100,000 Cost of goods sold  58,000 ? Gross pro�it ?   40,000 Operating expenses  14,380 ? Net income ?   17,000

Instructions (a) Fill in the missing amounts. Show all computations.

(b) Calculate the pro�it margin and the gross pro�it rate for each company.

(c) Discuss your �indings in part (b).

Prepare multiple-step income statement and calculate pro�itability ratios.

(LO 4, 6), AP

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E5-8 In its income statement for the year ended December 31, 2017, Darren Company reported the following condensed data.

Salaries and wages expense $465,000 Loss on disposal of plant assets $   83,500 Cost of goods sold 987,000 Sales revenue 2,210,000 Interest expense 71,000 Income tax expense 25,000 Interest revenue 65,000 Sales discounts 160,000 Depreciation expense 310,000 Utilities expense 110,000

Instructions (a) Prepare a multiple-step income statement.

(b) Calculate the pro�it margin and gross pro�it rate.

(c) In 2016, Darren had a pro�it margin of 5%. Is the decline in 2017 a cause for concern? (Ignore income tax effects.)

Prepare multiple-step income statement and calculate pro�itability ratios.

(LO 4, 6), AP

E5-9 Suppose in its income statement for the year ended June 30, 2017, The Clorox Company reported the following condensed data (dollars in millions).

Salaries and wages expense $  460 Research and development expense $  114 Depreciation expense 90 Sales revenue 5,730 Income tax expense 276 Interest expense 161 Loss on disposal of plant assets 46 Advertising expense 499 Cost of goods sold 3,104 Sales returns and allowances 280 Rent expense 105 Utilities expense 60

Instructions (a) Prepare a multiple-step income statement.

(b) Calculate the gross pro�it rate and the pro�it margin and explain what each means.

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(c) Assume the marketing department has presented a plan to increase advertising expenses by $340 million. It expects this plan to result in an increase in both net sales and cost of goods sold of 25%. (Hint: Increase both sales revenue and sales returns and allowances by 25%.) Redo parts (a) and (b) and discuss whether this plan has merit. (Assume a tax rate of 34%, and round all amounts to whole dollars.)

Prepare an income statement and comprehensive income statement.

(LO 4), AP

E5-10 In its income statement for the year ended December 31, 2017, Laine Inc. reported the following condensed data.

Operating expenses $  725,000 Interest revenue $   33,000 Cost of goods sold 1,256,000 Loss on disposal of plant assets 17,000 Interest expense 70,000 Net sales 2,200,000 Income tax expense 47,000 Other comprehensive income (net of $1,200 tax) 8,300

Instructions (a) Prepare an income statement.

(b) Prepare a comprehensive income statement.

Prepare a multiple-step income statement.

(LO 4), AP

E5-11 The following selected accounts from the Blue Door Corporation's general ledger are presented below for the year ended December 31, 2017:

Advertising expense $  55,000 Interest revenue $  30,000 Common stock 250,000 Inventory 67,000 Cost of goods sold 1,085,000 Rent revenue 24,000 Depreciation expense 125,000 Retained earnings 535,000 Dividends 150,000 Salaries and wages expense 675,000 Freight-out 25,000 Sales discounts 8,500 Income tax expense 70,000 Sales returns and allowances 41,000 Insurance expense 15,000 Interest expense 70,000 Sales revenue 2,400,000

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Instructions Prepare a multiple-step income statement.

Prepare cost of goods sold section using periodic system.

(LO 5), AP

E5-12 The trial balance of Mendez Company at the end of its �iscal year, August 31, 2017, includes these accounts: Beginning Inventory $18,700, Purchases $154,000, Sales Revenue $190,000, Freight-In $8,000, Sales Returns and Allowances $3,000, Freight-Out $1,000, and Purchase Returns and Allowances $5,000. The ending inventory is $21,000.

Instructions Prepare a cost of goods sold section (periodic system) for the year ending August 31, 2017.

Prepare cost of goods sold section using periodic system.

(LO 5), AP

E5-13 Below is a series of cost of goods sold sections for companies B, M, O, and S.

B M O S Beginning inventory $   250 $   120 $   700 $     (j) Purchases 1,500 1,080 (g) 43,590 Purchase returns and allowances 80 (d) 290 (k) Net purchases (a) 1,040 7,410 42,290 Freight-in 130 (e) (h) 2,240 Cost of goods purchased (b) 1,230 8,050 (l) Cost of goods available for sale 1,800 1,350 (i) 49,530 Ending inventory 310 (f) 1,150 6,230 Cost of goods sold (c) 1,230 7,600 43,300

Instructions Fill in the lettered blanks to complete the cost of goods sold sections.

Evaluate quality of earnings.

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(LO 6), C

E5-14 Dorsett Corporation reported sales revenue of $257,000, net income of $45,300, cash of $9,300, and net cash provided by operating activities of $23,200. Accounts receivable have increased at three times the rate of sales during the last 3 years.

Instructions (a) Explain what is meant by high quality of earnings.

(b) Evaluate the quality of the company's earnings. Discuss your �indings.

(c) What factors might have contributed to the company's quality of earnings?

Journalize purchase transactions.

(LO 7), AP

*E5-15 This information relates to Al�ie Co.

1. On April 5, purchased merchandise from Bach Company for $27,000, terms 2/10, n/30.

2. On April 6, paid freight costs of $1,200 on merchandise purchased from Bach Company.

3. On April 7, purchased equipment on account for $30,000.

4. On April 8, returned some of the April 5 merchandise to Bach Company, which cost $3,600.

5. On April 15, paid the amount due to Bach Company in full.

Instructions (a) Prepare the journal entries to record these transactions on the books of Al�ie Co. using a periodic

inventory system.

(b) Assume that Al�ie Co. paid the balance due to Bach Company on May 4 instead of April 15. Prepare the journal entry to record this payment.

EXERCISES: SET B AND CHALLENGE EXERCISES Visit the book's companion website, at www.wiley.com/college/kimmel (http://www.wiley.com/college/kimmel) , and choose the Student Companion site to access Exercises: Set B and Challenge Exercises.

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PROBLEMS: SET A

Journalize, post, and prepare partial income statement, and calculate ratios.

(LO 2, 3, 4, 6), AP

P5-1A Winters Hardware Store completed the following merchandising transactions in the month of May. At the beginning of May, Winters' ledger showed Cash of $8,000 and Common Stock of $8,000.

May 1 Purchased merchandise on account from Black Wholesale Supply for $8,000, terms 1/10, n/30. 2 Sold merchandise on account for $4,400, terms 2/10, n/30. The cost of the merchandise sold was

$3,300. 5 Received credit from Black Wholesale Supply for merchandise returned $200. 9 Received collections in full, less discounts, from customers billed on May 2. 10 Paid Black Wholesale Supply in full, less discount. 11 Purchased supplies for cash $900. 12 Purchased merchandise for cash $3,100. 15 Received $230 refund for return of poor-quality merchandise from supplier on cash purchase. 17 Purchased merchandise from Wilhelm Distributors for $2,500, terms 2/10, n/30. 19 Paid freight on May 17 purchase $250. 24 Sold merchandise for cash $5,500. The cost of the merchandise sold was $4,100. 25 Purchased merchandise from Clasps Inc. for $800, terms 3/10, n/30. 27 Paid Wilhelm Distributors in full, less discount. 29 Made refunds to cash customers for returned merchandise $124. The returned merchandise had

cost $90. 31 Sold merchandise on account for $1,280, terms n/30. The cost of the merchandise sold was $830.

Winters Hardware's chart of accounts includes Cash, Accounts Receivable, Inventory, Supplies, Accounts Payable, Common Stock, Sales Revenue, Sales Returns and Allowances, Sales Discounts, and Cost of Goods Sold.

Instructions (a) Journalize the transactions using a perpetual inventory system.

(b) Post the transactions to T-accounts. Be sure to enter the beginning cash and common stock balances.

(c) Gross pro�it $2,828

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(c) Prepare an income statement through gross pro�it for the month of May 2017.

(d) Calculate the pro�it margin and the gross pro�it rate. (Assume operating expenses were $1,400.)

Journalize purchase and sale transactions under a perpetual system.

(LO 2, 3), AP

P5-2A Powell Warehouse distributes hardback books to retail stores and extends credit terms of 2/10, n/30 to all of its customers. During the month of June, the following merchandising transactions occurred.

June 1 Purchased books on account for $1,040 (including freight) from Catlin Publishers, terms 2/10, n/30.

3 Sold books on account to Garfunkel Bookstore for $1,200. The cost of the merchandise sold was $720.

6 Received $40 credit for books returned to Catlin Publishers. 9 Paid Catlin Publishers in full. 15 Received payment in full from Garfunkel Bookstore. 17 Sold books on account to Bell Tower for $1,200. The cost of the merchandise sold was $730. 20 Purchased books on account for $720 from Priceless Book Publishers, terms 1/15, n/30. 24 Received payment in full from Bell Tower. 26 Paid Priceless Book Publishers in full. 28 Sold books on account to General Bookstore for $1,300. The cost of the merchandise sold was

$780. 30 Granted General Bookstore $130 credit for books returned costing $80.

Instructions

Journalize the transactions for the month of June for Powell Warehouse, using a perpetual inventory system.

Journalize, post, and prepare trial balance and partial income statement.

(LO 2, 3, 4), AP

P5-3A At the beginning of the current season on April 1, the ledger of Granite Hills Pro Shop showed Cash $2,500, Inventory $3,500, and Common Stock $6,000. The following transactions were completed during April 2017.

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Apr. 5 Purchased golf bags, clubs, and balls on account from Arnie Co. $1,500, terms 3/10, n/60. 7 Paid freight on Arnie purchase $80. 9 Received credit from Arnie Co. for merchandise returned $200. 10 Sold merchandise on account to members $1,340, terms n/30. The merchandise sold had a cost of

$820. 12 Purchased golf shoes, sweaters, and other accessories on account from Woods Sportswear $830,

terms 1/10, n/30. 14 Paid Arnie Co. in full. 17 Received credit from Woods Sportswear for merchandise returned $30. 20 Made sales on account to members $810, terms n/30. The cost of the merchandise sold was $550. 21 Paid Woods Sportswear in full. 27 Granted an allowance to members for clothing that did not �it properly $80. 30 Received payments on account from members $1,220.

The chart of accounts for the pro shop includes Cash, Accounts Receivable, Inventory, Accounts Payable, Common Stock, Sales Revenue, Sales Returns and Allowances, and Cost of Goods Sold.

Instructions (a) Journalize the April transactions using a perpetual inventory system.

(b) Using T-accounts, enter the beginning balances in the ledger accounts and post the April transactions.

(c) Tot. trial balance $8,150

(c) Prepare a trial balance on April 30, 2017.

(d) Gross pro�it $ 700

(d) Prepare an income statement through gross pro�it for the month of April 2017.

Prepare �inancial statements and calculate pro�itability ratios.

(LO 4, 6), AP

P5-4A Wolford Department Store is located in midtown Metropolis. During the past several years, net income has been declining because suburban shopping centers have been attracting business away from city areas. At the end of the company's �iscal year on November 30, 2017, these accounts appeared in its adjusted trial balance.

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Accounts Payable $ 26,800 Accounts Receivable 17,200 Accumulated Depreciation—Equipment 68,000 Cash 8,000 Common Stock 35,000 Cost of Goods Sold 614,300 Freight-Out 6,200 Equipment 157,000 Depreciation Expense 13,500 Dividends 12,000 Gain on Disposal of Plant Assets 2,000 Income Tax Expense 10,000 Insurance Expense 9,000 Interest Expense 5,000 Inventory 26,200 Notes Payable 43,500 Prepaid Insurance 6,000 Advertising Expense $ 33,500 Rent Expense 34,000 Retained Earnings 14,200 Salaries and Wages Expense 117,000 Salaries and Wages Payable 6,000 Sales Returns and Allowances 20,000 Sales Revenue 904,000 Utilities Expense 10,600

Additional data: Notes payable are due in 2021.

Instructions (a) Prepare a multiple-step income statement, a retained earnings statement, and a classi�ied balance sheet.

(a) Net income $ 32,900

Tot. assets $146,400

(b) Calculate the pro�it margin and the gross pro�it rate.

(c) The vice president of marketing and the director of human resources have developed a proposal whereby the company would compensate the sales force on a strictly commission basis. Given the increased incentive, they expect net sales to increase by 15%. As a result, they estimate that gross pro�it will increase by $40,443 and expenses by $58,600. Compute the expected new net income. (Hint: You do not need to prepare an income statement.) Then, compute the revised pro�it margin and gross pro�it

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rate. Comment on the effect that this plan would have on net income and on the ratios, and evaluate the merit of this proposal. (Ignore income tax effects.)

Prepare a correct multiple-step income statement.

(LO 4), AP

P5-5A An inexperienced accountant prepared this condensed income statement for Simon Company, a retail �irm that has been in business for a number of years.

SIMON COMPANY Income Statement For the Year Ended December 31, 2017

Revenues Net sales $850,000 Other revenues 22,000 872,000 Cost of goods sold 555,000 Gross pro�it 317,000 Operating expenses Selling expenses 109,000 Administrative expenses 103,000 212,000 Net earnings $105,000

As an experienced, knowledgeable accountant, you review the statement and determine the following facts.

1. Net sales consist of sales $911,000, less freight-out on merchandise sold $33,000, and sales returns and allowances $28,000.

2. Other revenues consist of sales discounts $18,000 and rent revenue $4,000.

3. Selling expenses consist of salespersons' salaries $80,000, depreciation on equipment $10,000, advertising $13,000, and sales commissions $6,000. The commissions represent commissions paid. At December 31, $3,000 of commissions have been earned by salespersons but have not been paid. All compensation should be recorded as Salaries and Wages Expense.

4. Administrative expenses consist of of�ice salaries $47,000, dividends $18,000, utilities $12,000, interest expense $2,000, and rent expense $24,000, which includes prepayments totaling $6,000 for the �irst quarter of 2018.

Instructions

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Prepare a correct detailed multiple-step income statement. Assume a 25% tax rate.

Net income $67,500

Journalize, post, and prepare adjusted trial balance and �inancial statements.

(LO 4), AP

P5-6A The trial balance of People's Choice Wholesale Company contained the following accounts shown at December 31, the end of the company's �iscal year.

PEOPLE'S CHOICE WHOLESALE COMPANY Trial Balance December 31, 2017 Debit Credit Cash $    31,400 Accounts Receivable 37,600 Inventory 70,000 Land 92,000 Buildings 200,000 Accumulated Depreciation—Buildings $    60,000 Equipment 83,500 Accumulated Depreciation—Equipment 40,500 Notes Payable 54,700 Accounts Payable 17,500 Common Stock 160,000 Retained Earnings 67,200 Dividends 10,000 Sales Revenue 922,100 Sales Discounts 6,000 Cost of Goods Sold 709,900 Salaries and Wages Expense 51,300 Utilities Expense 11,400 Maintenance and Repairs Expense 8,900 Advertising Expense 5,200 Insurance Expense 4,800

$1,322,000 $1,322,000

Adjustment data:

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1. Depreciation is $8,000 on buildings and $7,000 on equipment. (Both are operating expenses.)

2. Interest of $4,500 is due and unpaid on notes payable at December 31.

3. Income tax due and unpaid at December 31 is $24,000.

Other data: $15,000 of the notes payable are payable next year.

Instructions (a) Journalize the adjusting entries.

(b) Create T-accounts for all accounts used in part (a). Enter the trial balance amounts into the T-accounts and post the adjusting entries.

(c) Tot. trial balance $1,365,500

(c) Prepare an adjusted trial balance.

(d) Net income $  81,100

Tot. assets $ 399,000

(d) Prepare a multiple-step income statement and a retained earnings statement for the year, and a classi�ied balance sheet at December 31, 2017.

Determine cost of goods sold and gross pro�it under a periodic system.

(LO 4, 5), AP

P5-7A At the end of Oates Department Store's �iscal year on November 30, 2017, these accounts appeared in its adjusted trial balance.

Freight-In $   5,060 Inventory (beginning) 41,300 Purchases 613,000 Purchase Discounts 7,000 Purchase Returns and Allowances 6,760 Sales Revenue 902,000 Sales Returns and Allowances 20,000

Additional facts:

1. Inventory on November 30, 2017, is $36,200.

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2. Note that Oates Department Store uses a periodic system.

Instructions

Prepare an income statement through gross pro�it for the year ended November 30, 2017.

Gross pro�it $272,600

Calculate missing amounts and assess pro�itability.

(LO 4, 5, 6), AN

P5-8A Zhou Inc. operates a retail operation that purchases and sells snowmobiles, among other outdoor products. The company purchases all inventory on credit and uses a periodic inventory system. The Accounts Payable account is used for recording inventory purchases only; all other current liabilities are accrued in separate accounts. You are provided with the following selected information for the �iscal years 2015 through 2018, inclusive.

Instructions (a) Calculate the missing amounts.

(b) The vice presidents of sales, marketing, production, and �inance are discussing the company's results with the CEO. They note that sales declined over the 3-year �iscal period, 2016−2018. Does that mean that pro�itability necessarily also declined? Explain, computing the gross pro�it rate and the pro�it margin for each �iscal year to help support your answer.

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Journalize, post, and prepare trial balance and partial income statement under a periodic system.

(LO 5, 7), AP

P5-9A At the beginning of the current season on April 1, the ledger of Granite Hills Pro Shop showed Cash $2,500, Inventory $3,500, and Common Stock $6,000. The following transactions occurred during April 2017.

Apr. 5 Purchased golf bags, clubs, and balls on account from Arnie Co. $1,500, terms 3/10, n/60. 7 Paid freight on Arnie Co. purchases $80. 9 Received credit from Arnie Co. for merchandise returned $200. 10 Sold merchandise on account to members $1,340, terms n/30. 12 Purchased golf shoes, sweaters, and other accessories on account from Woods Sportswear $830,

terms 1/10, n/30. 14 Paid Arnie Co. in full. 17 Received credit from Woods Sportswear for merchandise returned $30. 20 Made sales on account to members $810, terms n/30. 21 Paid Woods Sportswear in full. 27 Granted credit to members for clothing that did not �it properly $80. 30 Received payments on account from members $1,220.

The chart of accounts for the pro shop includes Cash, Accounts Receivable, Inventory, Accounts Payable, Common Stock, Sales Revenue, Sales Returns and Allowances, Purchases, Purchase Returns and Allowances, Purchase Discounts, and Freight-In.

Instructions (a) Journalize the April transactions using a periodic inventory system.

(b) Using T-accounts, enter the beginning balances in the ledger accounts and post the April transactions.

(c) Tot. trial balance $8,427

(c) Prepare a trial balance on April 30, 2017.

(d) Gross pro�it $ 700

(d) Prepare an income statement through gross pro�it, assuming inventory on hand at April 30 is $4,263.

PROBLEMS: SET B AND SET C

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Visit the book's companion website, at www.wiley.com/college/kimmel (http://www.wiley.com/college/kimmel) , and choose the Student Companion site to access Problems: Set B and Set C.

CONTINUING PROBLEM Cookie Creations

(Note: This is a continuation of the Cookie Creations problem from Chapters 1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch01#ch01) through 4 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch04#ch04) .)

CC5 Because Natalie has had such a successful �irst few months, she is considering other opportunities to develop her business. One opportunity is to become the exclusive distributor of a line of �ine European mixers. Natalie comes to you for advice on how to account for these mixers.

Go to the book's companion website, at www.wiley.com/college/kimmel (http://www.wiley.com/college/kimmel) , to see the completion of this problem.

COMPREHENSIVE ACCOUNTING CYCLE | REVIEW ACR5-1 On December 1, 2017, Devine Distributing Company had the following account balances.

Debit Credit Cash $  7,200 Accumulated Depreciation—Equipment $  2,200 Accounts Receivable 4,600 Inventory 12,000 Accounts Payable 4,500 Supplies 1,200 Salaries and Wages Payable 1,000 Equipment 22,000 Common Stock 15,000 $47,000 Retained Earnings 24,300 $47,000

During December, the company completed the following summary transactions.

Dec. 6 Paid $1,600 for salaries due employees, of which $600 is for December and $1,000 is for November salaries payable.

8 Received $1,900 cash from customers in payment of account (no discount allowed). 10 Sold merchandise for cash $6,300. The cost of the merchandise sold was $4,100. 13 Purchased merchandise on account from Hecht Co. $9,000, terms 2/10, n/30. 15 Purchased supplies for cash $2,000.

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18 Sold merchandise on account $12,000, terms 3/10, n/30. The cost of the merchandise sold was $8,000.

20 Paid salaries $1,800. 23 Paid Hecht Co. in full, less discount. 27 Received collections in full, less discounts, from customers billed on December 18.

Adjustment data:

1. Accrued salaries payable $800.

2. Depreciation $200 per month.

3. Supplies on hand $1,500.

4. Income tax due and unpaid at December 31 is $200.

Instructions (a) Journalize the December transactions using a perpetual inventory system.

(b) Enter the December 1 balances in the ledger T-accounts and post the December transactions. Use Cost of Goods Sold, Depreciation Expense, Salaries and Wages Expense, Sales Revenue, Sales Discounts, Supplies Expense, Income Tax Expense, and Income Taxes Payable.

(c) Journalize and post adjusting entries.

(d) Totals $65,500

(d) Prepare an adjusted trial balance.

(e) Net income $540

Prepare an income statement and a retained earnings statement for December and a classi�ied balance sheet at December 31.

ACR5-2 On November 1, 2017, IKonk, Inc. had the following account balances. The company uses the perpetual inventory method.

Debit Credit Cash $   9,000 Accumulated Depreciation—Equipment $  1,000 Accounts Receivable 2,240 Supplies 860 Accounts Payable 3,400 Equipment 25,000 Unearned Service Revenue 4,000 $37,100 Salaries and Wages Payable 1,700 Common Stock 20,000 Retained Earnings 7,000 $37,100

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During November, the following summary transactions were completed.

Nov. 8 Paid $3,550 for salaries due employees, of which $1,850 is for November and $1,700 is for October.

10 Received $1,900 cash from customers in payment of account. 11 Purchased merchandise on account from Dimas Discount Supply for $8,000, terms

2/10, n/30. 12 Sold merchandise on account for $5,500, terms 2/10, n/30. The cost of the

merchandise sold was $4,000. 15 Received credit from Dimas Discount Supply for merchandise returned $300. 19 Received collections in full, less discounts, from customers billed on sales of $5,500 on

November 12. 20 Paid Dimas Discount Supply in full, less discount. 22 Received $2,300 cash for services performed in November. 25 Purchased equipment on account $5,000. 27 Purchased supplies on account $1,700. 28 Paid creditors $3,000 of accounts payable due. 29 Paid November rent $375. 29 Paid salaries $1,300. 29 Performed services on account and billed customers $700 for those services. 29 Received $675 from customers for services to be performed in the future.

Adjustment data:

1. Supplies on hand are valued at $1,600.

2. Accrued salaries payable are $500.

3. Depreciation for the month is $250.

4. $650 of services related to the unearned service revenue has not been performed by month-end.

Instructions (a) Enter the November 1 balances in ledger T-accounts.

(b) Journalize the November transactions.

(c) Post to the ledger accounts. You will need to add some accounts.

(d) Journalize and post adjusting entries.

(e) Prepare an unadjusted trial balance at November 30.

(f) Prepare a multiple-step income statement and a retained earnings statement for November and a classi�ied balance sheet at November 30.

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(g) Journalize and post closing entries.

EXPAND YOUR | CRITICAL THINKING

FINANCIAL REPORTING PROBLEM: Apple Inc.

E

CT5-1 The �inancial statements for Apple Inc. appear in Appendix A (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/a01#a01) at the end of this textbook.

Instructions

Answer these questions using the Consolidated Income Statement.

(a) What was the percentage change in total revenue and in net income from 2013 to 2014?

(b) What was the pro�it margin in each of the 3 years? (Use “Total Revenue.”) Comment on the trend.

(c) What was Apple's gross pro�it rate in each of the 3 years? (Use “Net Sales” amounts.) Comment on the trend.

COMPARATIVE ANALYSIS PROBLEM: Columbia Sportswear Company vs. VF Corporation

E

CT5-2 The �inancial statements of Columbia Sportswear Company are presented in Appendix B (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/a02#a02) . Financial statements of VF Corporation are presented in Appendix C (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/a03#a03) .

Instructions (a) Based on the information contained in these �inancial statements, determine the following

values for each company.

1. Pro�it margin for 2014. (For VF, use “Total Revenues.”)

2. Gross pro�it for 2014.

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3. Gross pro�it rate for 2014.

4. Operating income for 2014.

5. Percentage change in operating Income from 2014 to 2013. (For Columbia, use Income from operations.)

(b) What conclusions concerning the relative pro�itability of the two companies can be drawn from these data?

COMPARATIVE ANALYSIS PROBLEM: Amazon.com, Inc. vs. Wal-Mart Stores, Inc.

E

CT5-3 The �inancial statements of Amazon.com, Inc. are presented in Appendix D (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/a04#a04) . Financial statements of Wal-Mart Stores, Inc. are presented in Appendix E (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/a05#a05) .

Instructions (a) Based on the information contained in these �inancial statements, determine the following

values for each company.

1. Pro�it margin for 2014. (For Amazon, use “Total net sales.”)

2. Gross pro�it for 2014.

3. Gross pro�it rate for 2014.

4. Operating income for 2014.

5. Percentage change in operating income from 2014 to 2013.

(b) What conclusions concerning the relative pro�itability of the two companies can be drawn from these data?

INTERPRETING FINANCIAL STATEMENTS

E

CT5-4 Recently, it was announced that two giant French retailers, Carrefour SA and Promodes SA, would merge. A headline in the Wall Street Journal blared, “French Retailers Create New Wal- Mart Rival.” While Wal-Mart's total sales would still exceed those of the combined company, Wal- Mart's international sales are far less than those of the combined company. This is a serious concern for Wal-Mart, since its primary opportunity for future growth lies outside of the United States.

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Below are basic �inancial data for the combined corporation (in euros) and Wal-Mart (in U.S. dollars). Even though their results are presented in different currencies, by employing ratios we can make some basic comparisons.

Carrefour (in millions) Wal-Mart (in millions) Sales revenue €70,486    $256,329    Cost of goods sold 54,630    198,747    Net income 1,738    9,054    Total assets 39,063    104,912    Current assets 14,521    34,421    Current liabilities 13,660    37,418    Total liabilities 29,434    61,289   

Instructions

Compare the two companies by answering the following.

(a) Calculate the gross pro�it rate for each of the companies, and discuss their relative abilities to control cost of goods sold.

(b) Calculate the pro�it margin, and discuss the companies' relative pro�itability.

(c) Calculate the current ratio and debt to assets ratio for each of the two companies, and discuss their relative liquidity and solvency.

(d) What concerns might you have in relying on this comparison?

REAL-WORLD FOCUS

E

CT5-5 Purpose: No �inancial decision-maker should ever rely solely on the �inancial information reported in the annual report to make decisions. It is important to keep abreast of �inancial news. This activity demonstrates how to search for �inancial news on the Internet.

Address: http://biz.yahoo.com/i (http://biz.yahoo.com/i) , or go to www.wiley.com/college/kimmel (http://www.wiley.com/college/kimmel)

Steps

1. Type in either Wal-Mart, Target Corp., or Kmart.

2. Choose News.

3. Select an article that sounds interesting to you and that would be relevant to an investor in these companies.

Instructions

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(a) What was the source of the article (e.g., Reuters, Businesswire, Prnewswire)?

(b) Assume that you are a personal �inancial planner and that one of your clients owns stock in the company. Write a brief memo to your client summarizing the article and explaining the implications of the article for their investment.

DECISION-MAKING ACROSS THE ORGANIZATION

CT5-6 Three years ago, Karen Suez and her brother-in-law Reece Jones opened Gigasales Department Store. For the �irst 2 years, business was good, but the following condensed income statement results for 2017 were disappointing.

E

GIGASALES DEPARTMENT STORE

Income Statement

For the Year Ended December 31, 2017

Net sales $700,000 Cost of goods sold 560,000 Gross pro�it 140,000 Operating expenses Selling expenses $100,000 Administrative expenses 20,000 120,000 Net income $ 20,000

Karen believes the problem lies in the relatively low gross pro�it rate of 20%. Reece believes the problem is that operating expenses are too high. Karen thinks the gross pro�it rate can be improved by making two changes. (1) Increase average selling prices by 15%; this increase is expected to lower sales volume so that total sales dollars will increase only 4%. (2) Buy merchandise in larger quantities and take all purchase discounts. These changes selling price and to purchasing practices are expected to increase the gross pro�it rate from its current rate of 20% to a new rate of 25%. Karen does not anticipate that these changes will have any effect on operating expenses.

Reece thinks expenses can be cut by making these two changes. (1) Cut 2018 sales salaries of $60,000 in half and give sales personnel a commission of 2% of net sales. (2) Reduce store deliveries to one day per week rather than twice a week; this change will reduce 2018 delivery expenses of $40,000 by 40%. Reece feels that these changes will not have any effect on net sales.

Karen and Reece come to you for help in deciding the best way to improve net income.

Instructions

With the class divided into groups, answer the following.

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(a) Prepare a condensed income statement for 2018 assuming (1) Karen's changes are implemented and (2) Reece's ideas are adopted.

(b) What is your recommendation to Karen and Reece?

(c) Prepare a condensed income statement for 2018 assuming both sets of proposed changes are made.

(d) Discuss the impact that other factors might have. For example, would increasing the quantity of inventory increase costs? Would a salary cut affect employee morale? Would decreased morale affect sales? Would decreased store deliveries decrease customer satisfaction? What other suggestions might be considered?

COMMUNICATION ACTIVITY

E

CT5-7 The following situation is presented in chronological order.

1. Aikan decides to buy a sur�board.

2. He calls Sur�ing Hawaii Co. to inquire about their sur�boards.

3. Two days later, he requests Sur�ing Hawaii Co. to make him a sur�board.

4. Three days later, Sur�ing Hawaii Co. sends him a purchase order to �ill out.

5. He sends back the purchase order.

6. Sur�ing Hawaii Co. receives the completed purchase order.

7. Sur�ing Hawaii Co. completes the sur�board.

8. Aikan picks up the sur�board.

9. Sur�ing Hawaii Co. bills Aikan.

10. Sur�ing Hawaii Co. receives payment from Aikan.

Instructions

In a memo to the president of Sur�ing Hawaii Co., answer the following questions.

(a) When should Sur�ing Hawaii Co. record the sale?

(b) Suppose that with his purchase order, Aikan is required to make a down payment. Would that change your answer to part (a)?

ETHICS CASE

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CT5-8 Tabitha Andes was just hired as the assistant treasurer of Southside Stores, a specialty chain store company that has nine retail stores concentrated in one metropolitan area. Among other things, the payment of all invoices is centralized in one of the departments Tabitha will manage. Her primary responsibility is to maintain the company's high credit rating by paying all bills when due and to take advantage of all cash discounts.

Pete Wilson, the former assistant treasurer who has been promoted to treasurer, is training Tabitha in her new duties. He instructs Tabitha that she is to continue the practice of preparing all checks “net of discount” and dating the checks the last day of the discount period. “But,” Pete continues, “we always hold the checks at least 4 days beyond the discount period before mailing them. That way we get another 4 days of interest on our money. Most of our creditors need our business and don't complain. And, if they scream about our missing the discount period, we blame it on the mailroom or the post of�ice. We've only lost one discount out of every hundred we take that way. I think everybody does it. By the way, welcome to our team!”

Instructions (a) What are the ethical considerations in this case?

(b) What stakeholders are harmed or bene�ited?

(c) Should Tabitha continue the practice started by Pete? Does she have any choice?

ALL ABOUT YOU

E

CT5-9 There are many situations in business where it is dif�icult to determine the proper period in which to record revenue. Suppose that after graduation with a degree in �inance, you take a job as a manager at a consumer electronics store called FarWest Electronics. The company has expanded rapidly in order to compete with Best Buy.

FarWest has also begun selling gift cards. The cards are available in any dollar amount and allow the holder of the card to purchase an item for up to 2 years from the time the card is purchased. If the card is not used during those 2 years, it expires.

Instructions

Answer the following questions.

At what point should the revenue from the gift cards be recognized? Should the revenue be recognized at the time the card is sold, or should it be recorded when the card is redeemed? Explain the reasoning to support your answers.

FASB CODIFICATION ACTIVITY

E

CT5-10 If your school has a subscription to the FASB Codi�ication, go to http://aaahg.org/ascLogin.cfm (http://aaahg.org/ascLogin.cfm) to log in and prepare responses to the following.

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(a)Access the glossary (“Master Glossary”) to answer the following.

1. What is the de�inition provided for inventory?

2. What is a customer?

(b) What guidance does the Codi�ication provide concerning reporting inventories above cost?

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LEARNING OBJECTIVE 8

Compare the accounting for merchandising under GAAP and IFRS. 

The basic accounting entries for merchandising are the same under both GAAP and IFRS. The income statement is a required statement under both sets of standards. The basic format is similar although some differences do exist.

KEY POINTS

Following are the key similarities and differences between GAAP and IFRS related to inventories.

Similarities

Under both GAAP and IFRS, a company can choose to use either a perpetual or a periodic inventory system.

The de�inition of inventories is basically the same under GAAP and IFRS.

As indicated above, the basic accounting entries for merchandising are the same under both GAAP and IFRS.

Both GAAP and IFRS require that income statement information be presented for multiple years. For example, IFRS requires that 2 years of income statement information be presented, whereas GAAP requires 3 years.

Differences

Under GAAP, companies generally classify income statement items by function. Classi�ication by function leads to descriptions like administration, distribution, and manufacturing. Under IFRS, companies must classify expenses either by nature or by function. Classi�ication 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 �inancial statements.

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

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other comprehensive income. The effect of this difference is that the use of IFRS result in more transactions affecting equity (other comprehensive income) but not net income.

LOOKING TO THE FUTURE

The IASB and FASB are working on a project that would rework the structure of �inancial statements. Speci�ically, this project will address the issue of how to classify various items in the income statement. A main goal of this new approach is to provide information that better represents how businesses are run. In addition, this approach draws attention away from just one number—net income. It will adopt major groupings similar to those currently used by the statement of cash �lows (operating, investing, and �inancing), so that numbers can be more readily traced across statements. For example, the amount of income that is generated by operations would be traceable to the assets and liabilities used to generate the income. Finally, this approach would also provide detail, beyond that currently seen in most statements (either GAAP or IFRS), by requiring that line items be presented both by function and by nature. The new �inancial statement format was heavily in�luenced by suggestions from �inancial statement analysts.

IFRS Practice

IFRS SELF-TEST QUESTIONS

1. Which of the following would not be included in the de�inition of inventory under IFRS? (a) Photocopy paper held for sale by an of�ice-supply store.

(b) Stereo equipment held for sale by an electronics store.

(c) Used of�ice equipment held for sale by the human relations department of a plastics company.

(d) All of the above would meet the de�inition.

2. 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.

3. 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.

4. Which of the following statements is false? (a) IFRS speci�ically requires use of a multiple-step income statement.

(b) Under IFRS, companies can use either a perpetual or periodic system.

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(c) The proposed new format for �inancial statements was heavily in�luenced by the suggestions of �inancial statement analysts.

(d) The new income statement format will try to de-emphasize the focus on the “net income” line item.

IFRS EXERCISES

IFRS5-1 Explain the difference between the “nature-of-expense” and “function-of-expense” classi�ications.

IFRS5-2 For each of the following income statement line items, state whether the item is a “by nature” expense item or a “by function” expense item.

________ Cost of goods sold.

________ Depreciation expense.

________ Salaries and wages expense.

________ Selling expenses.

________ Utilities expense.

________ Delivery expense.

________ General and administrative expenses.

IFRS5-3 Matilda Company reported the following amounts (in euros) in 2017: Net income, €150,000; Unrealized gain related to revaluation of buildings, €10,000; and Unrealized loss on non-trading securities, €(35,000). Determine Matilda's total comprehensive income for 2017.

INTERNATIONAL FINANCIAL REPORTING PROBLEM: Louis Vuitton

IFRS5-4 The �inancial statements of Louis Vuitton are presented in Appendix F (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/a06#a06) . Instructions for accessing and using the company's complete annual report, including the notes to its �inancial statements, are also provided in Appendix F (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/a06#a06) .

Instructions

Use Louis Vuitton's annual report to answer the following questions.

(a) Does Louis Vuitton use a multiple-step or a single-step income statement format? Explain how you made your determination.

(b) Instead of “interest expense,” what label does Louis Vuitton use for interest costs that it incurs?

(c) Using the notes to the company's �inancial statements, determine the following:

1. Composition of the inventory.

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2. Amount of inventory (gross) before impairment.

Answers to IFRS Self-Test Questions

1. c 2. d 3. c 4. a

1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo3#c05-note-0006a) The “Anatomy of a Fraud” stories in this textbook are adapted from Fraud Casebook: Lessons from the Bad Side of Business, edited by Joseph T. Wells (Hoboken, NJ: John Wiley & Sons, Inc., 2007). Used by permission. The names of some of the people and organizations in the stories are �ictitious, but the facts in the stories are true.