Accounting Chapter 5

How can a company improve its profit margin?

by either increasing its gross profit rate and/or by controlling its operating expenses and other costs

Excessive returns and allowances suggest problems

inferior merchandise, inefficiencies in filling orders, errors in billing customers, or mistakes in delivery or shipment of goods

Profit 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. Net income/Net Sales(revenue) for the period

Merchandising Companies

they buy and sell merchandise rather than perform services as their primary source of revenue

Sales invoice

A document that provides support for each sale.

Operating Expenses

Costs involved in operating a business, such as rent, utilities, and salaries.

There are two primary reasons for using the single-step form.

(1) A company does not realize any type of profit 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.

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.

In a single-step statement, all data are classified 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); (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).

Purchase discount

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

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. - a company determines the cost of goods sold each time a sale occurs

Purchase invoice

- A document that provides support for each purchase. - which indicates the total purchase price and other relevant info - The purchaser does not prepare a separate purchase invoice, the purchaser uses as a purchase invoice the copy of the sales invoice sent by the seller

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 cash provided by operating activities divided by net income. - It is calculated as net cash provided by operating activities divided by net income.

Sales discount

- A reduction given by a seller for prompt payment of a credit sale. - The seller increases (debits) the Sales Discounts account for discounts that are taken. - Sales Discounts is a contra revenue account to Sales Revenue. Its normal balance is a debit.

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. - 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

Comprehensive income

- An income measure that includes gains and losses that are excluded from the determination of net 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.

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.

The flow of costs

- Beginning inventory + The cost of goods purchased = 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

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 - 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

FREIGHT COSTS

- FOB: mean free on board - FOB shipping point: means that the seller places the goods free on board the carrier, and the buyer pays - FOB destination: means that the seller places the goods free on board to the buyer's place of business, and the seller pays the freight the freight costs

Freight Costs Incurred by Seller

- 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)(Assets (-), SE (-)) (Cash Flow (-)) - For example, if the freight terms on the invoice had required that PW Audio Supply (the seller) pay the $150 freight charges

Gross profit rate

- Gross profit expressed as a percentage by dividing the amount of gross profit by net sales. - A company's gross profit may be expressed as a percentage by dividing the amount of gross profit by net sales. - Analysts generally consider the gross profit rate to be more informative than the gross profit amount because it expresses a more meaningful (qualitative) relationship between gross profit and net sales

Other Expenses and Losses (Non-operating activities)

- Interest expense: on notes and loans payable. - Casualty losses: from such causes as vandalism and accidents. - Loss: from the sale or abandonment of property, plant, and equipment. - Loss: from strikes by employees and suppliers.

Other Revenues and Gains (Non-operating activities)

- Interest revenue: from notes receivable and marketable securities. - Dividend revenue: from investments in capital stock. - Rent revenue: from subleasing a portion of the store. - Gain: from the sale of property, plant, and equipment.

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. - Assets (-), L (-)

wholesalers

- Merchandising companies that sell to retailers - For example, retailer Walgreens might buy goods from wholesaler McKesson

Net sales

- Sales less sales returns and allowances and sales discounts. - The company deducts sales returns and allowances and sales discounts (both contra accounts) from sales revenue in the income statement

A decline in a company's gross profit rate might have several causes.

- The company may have begun to sell products with a lower "markup" - Increased competition may have resulted in a lower selling price. - maybe the company was forced to pay higher prices to its suppliers and was not able to pass these costs on to its customers

Gross profit

- The excess of net sales over the cost of goods sold. - It is determined by deducting cost of goods sold from net sale - Gross profit represents the merchandising profit of a company. - Because operating expenses have not been deducted, it is not a measure of the overall profit of a company.

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

How do the gross profit rate and profit margin differ?

- The gross profit rate measures the margin by which selling price exceeds cost of goods sold. - The profit margin measures the extent by which selling price covers all expenses (including cost of goods sold)

MULTIPLE-STEP INCOME STATEMENT

- The multiple-step income statement is often considered more useful because it highlights the components of net - a form of income statement that contains several sections, subsections, and subtotals

Cost of goods sold

- The total cost of merchandise sold during the period - This expense is directly related to the revenue recognized from the sale of goods

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. - is a Contra revenue account to Sales Revenue - The normal balance of Sales Returns and Allowances is a debit.

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) (Assets + -) (Cash Flow (-)) - For example, if Sauk Stereo (the buyer) pays Public Freight Company $150 for freight charges on May 6,

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 identifies the results of the company's normal operations, an amount determined by subtracting cost of goods sold and operating expenses from net sales

When an invoice is paid within the discount period

- the amount of the discount decreases Inventory - Because the merchandiser records inventory at its cost and, by paying within the discount period, it has reduced that cost.

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.

The multiple-step income statement has three important line items: gross profit, income from operations, and net income.

1). Subtract cost of goods sold from net sales to determine gross profit. 2). Deduct operating expenses from gross profit to determine income from operations. 3). Add or subtract the results of activities not related to operations to determine net income.

A merchandising company has two categories of expense:

1). cost of goods sold 2).operating expenses

Companies use one of two systems to account for inventory:

1).a perpetual inventory system 2). a periodic inventory system

Purchase allowance

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

Purchase return

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

retailers

Merchandising companies that purchase and sell directly to consumers

Sales revenue

Primary source of revenue for a merchandising company

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).

Companies record cash purchases by what?

by an increase (debit) in Inventory and a decrease (credit) in Cash

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