CHAPTER 9

Completing the Cycle for a Merchandising Business

Ma. Rona Corda-Prado, CPA University of St. La Salle

DETERMINING INVENTORY QUANTITIES

Physical Inventory taken for two reasons:
Perpetual System
1. Check accuracy of inventory records. 2. Determine amount of inventory lost (wasted raw

materials, shoplifting, or employee theft).

Periodic System
1. Determine the inventory on hand

2. Determine the cost of goods sold for the period.

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DETERMINING INVENTORY QUANTITIES

Taking a Physical Inventory
Involves counting, weighing, or measuring each kind of inventory on hand.
Taken, when the business is closed or when business is slow. at end of the accounting period.
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DETERMINING INVENTORY QUANTITIES

Determining Ownership of Goods

Goods in Transit
Purchased goods not yet received. Sold goods not yet received by the customer.
Goods in transit should be included in the inventory of the company that has legal title to the goods. Legal title is determined by the terms of sale.
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DETERMINING INVENTORY QUANTITIES

Terms of Sale
Ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller.

Ownership of the goods remains with the seller until the goods reach the buyer.
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DETERMINING INVENTORY QUANTITIES

Review Question
Goods in transit should be included in the inventory of the buyer when the: a. public carrier accepts the goods from the seller.

b. goods reach the buyer.

c. terms of sale are FOB destination.

d. terms of sale are FOB shipping point.

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DETERMINING INVENTORY QUANTITIES

Determining Ownership of Goods
Consigned Goods

In some lines of business, it is common to hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of goods. These are called consigned goods.

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DETERMINING INVENTORY QUANTITIES

Goods in transit purchased FOB shipping point are included in the count. Goods in transit purchased FOB destination are excluded in the count. Goods in transit sold FOB shipping point are excluded in the count. Goods in transit sold FOB destination are included in the count.

Goods out on consignment are included in the count.

Goods accepted on consignment are excluded in the count.
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COMPLETING THE ACCOUNTING CYCLE - PERIODIC

Set up of inventory is done for a periodic system after a physical count is done. Physical count involves the following steps:

1.All merchandise owned by the business is counted 2.Total Cost per Item = Quantity counted/item x cost/unit 3.Total Cost of Inventory = Total Cost per Item

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COMPLETING THE ACCOUNTING CYCLE - PERIODIC

At the end of the period, entries are made to reflect in the inventory account the ending balance to:

1. Remove the beginning balance from the merchandise inventory account and to transfer to income summary 2. Record the ending balance in the merchandise inventory and to establish it to the income summary
Methods: Adjusting Entry Method or Closing Entry Method
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COMPLETING THE ACCOUNTING CYCLE - PERIODIC

ADJUSTING ENTRY METHOD

CLOSING ENTRY METHOD

Income Summary xxx Income Summary xxx Merchandise Inventory, Merchandise Inventory, Beginning xxx Beginning xxx Temporary Accounts with Debit Balances xxx

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COMPLETING THE ACCOUNTING CYCLE - PERIODIC

ADJUSTING ENTRY METHOD
Merchandise Inventory, Ending xxx Income Summary xxx

CLOSING ENTRY METHOD

Merchandise Inventory, Ending xxx Temporary Accounts With Credit Balances xxx Income Summary

xxx

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COMPLETING THE ACCOUNTING CYCLE - PERPETUAL

Adjusting Entries
Generally the same as a service company. One additional adjustment to make the records agree with the actual inventory on hand. Involves adjusting Merchandise Inventory and Cost of Goods Sold.

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COMPLETING THE ACCOUNTING CYCLE - PERPETUAL

In order to ensure the accuracy of their perpetual inventory records, most businesses take a complete physical count of the merchandise on hand at least once a year. When a physical inventory is taken ,management uses the inventory ledger to determine whether the inventory on hand corresponds to the amount indicated in the inventory subsidiary ledger. Inventory shrinkage or shortage - unrecorded decrease in inventory resulting from breakage, spoilage, employee theft and shoplifting (count < records)
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PERIODIC

PERPETUAL

To adjust perpetual inventory records to reflect the results of the year end physical count: Actual < Records No entry Cost of Goods Sold xxx Merchandise Inventory xxx To adjust perpetual inventory records to reflect the results of the year end physical count: Actual > Records No entry Merchandise Inventory xxx Cost of Goods Sold xxx
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INVENTORY ERRORS
Common Cause:
Failure to count or price inventory correctly. Not properly recognizing the transfer of legal title to goods in transit. Errors affect both the income statement and balance sheet.

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FINANCIAL STATEMENT EFFECTS OF INVENTORY ERRORS

Income Statement Effects
Inventory Error Understate ending inventory Understate beginning inventory Overstate ending inventory Overstate beginning inventory Cost of Goods Sold Net Income Overstated Understated Understated Overstated Understated Overstated Overstated Understated

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INVENTORY ERRORS
Income Statement Effects
Inventory errors affect the computation of cost of goods sold and net income in two periods. An error in ending inventory of the current period will have a reverse effect on net income of the next accounting period. Over the two years, the total net income is correct because the errors offset each other. The ending inventory depends entirely on the accuracy of taking and costing the inventory.
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INVENTORY ERRORS
2008 Incorrect Sales Beginning inventory Cost of goods purchased Cost of goods available Ending inventory Cost of good sold Gross profit Operating expenses Net income $ 80,000 20,000 40,000 60,000 12,000 48,000 32,000 10,000 $ 22,000 Correct $ 80,000 20,000 40,000 60,000 15,000 45,000 35,000 10,000 $ 25,000 2009 Incorrect $ 90,000 12,000 68,000 80,000 23,000 57,000 33,000 20,000 $ 13,000 Correct $ 90,000 15,000 68,000 83,000 23,000 60,000 30,000 20,000 $ 10,000

Combined income for 2-year period is correct.

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($3,000) Net Income understated

$3,000 Net Income overstated

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FINANCIAL STATEMENT EFFECTS OF INVENTORY ERRORS

Balance Sheet Effects

Effect of inventory errors on the balance sheet is determined by using the basic accounting equation:.

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EFFECT OF INVENTORY ERROR

CURRENT YEAR
Gross Profit, Profit & Owners Equity

NEXT YEAR
Gross Profit, Profit & Owners Equity

Inv, End

COGS

Current Assets

Inv, Beg

COGS

+ -

+ -

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INVENTORY ERRORS
Review Question
Understating ending inventory will overstate: a. assets. b. cost of goods sold.

c. net income.
d. owner's equity.

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COMPLETING THE ACCOUNTING CYCLE

CLOSING ENTRIES Close all accounts that affect net income.
1. 2. Close Revenue Accounts to Income Summary Sales, Sales Discounts, Sales Returns and Allowances Close Costs and Expenses to Income Summary

a)
b) 3. 4.

Perpetual: COGS
Periodic: Purchases, Purchase Discounts, Purchase Returns and Allowances, Freight-In

Close Income Summary to Capital Close Withdrawals to Capital

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WORKSHEET - PERPETUAL INVENTORY

Refer to pp 425 for worksheet used in a periodic system

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FORMS OF FINANCIAL STATEMENTS

Single-Step Income Statement
Subtract total expenses from total revenues Format that we used for the income statement of service businesses

Two reasons for using the single-step format:

1) Company does not realize any type of profit

until total revenues exceed total expenses.

2) Format is simpler and easier to read.

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FORMS OF FINANCIAL STATEMENTS

Multiple-Step Income Statement
Shows several steps in determining net income. Two steps relate to principal operating activities.

Distinguishes between operating and nonoperating activities.

Nature of Expense Method - expenses are combined according to their nature and not reallocated between various functions of the company; used in smaller companies
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FORMS OF FINANCIAL STATEMENTS

Multiple-Step Income Statement
Function of Expense Method - also referred to as COGS method and classifies expenses according to their function as part of cost of sales, distribution or selling, administrative and other operating expenses More relevant to users but can be arbitrary and subjective More commonly used
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SOURCES OF INCOME
Sale of merchandise to customers - all sales to customers during the period. Sales returns, allowances and discounts should be deducted from gross sales to arrive at net sales Rendering of services - includes professional fees, media advertising commissions, insurance agency commissions, admission fees for artistic performance and tuition fee, among others
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SOURCES OF INCOME
Use of entity resources - includes interest, rent, royalty and dividend income Disposal of resources other than products - gain on sale of investments, gain on sale of property, plant and equipment and gain on sale of intangible assets

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COMPONENTS OF EXPENSE
Cost of sales Distribution of costs or selling expenses Administrative expenses Other expenses Income tax expense

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SELLING EXPENSES
Costs which are directly related to selling, advertising and delivery of goods to customers Include salesmens salaries, sales commissions, traveling and marketing expenses, advertising and publicity expenses, store supplies used, freight out, depreciation of delivery equipment and other expenses related directly with the selling function
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ADMINISTRATIVE EXPENSES
Includes all operating expenses not related to selling expenses and cost of goods sold, such as doubtful accounts, office salaries and expenses of general executives and of the general accounting and credit department, office supplies used, certain taxes, contributions, professional fees, depreciation of office building and office equipment and amortization of intangibles
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Costs of administering the business.

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OTHER EXPENSES
Expenses not directly related to the selling and administrative function Expenses include charges to income such as loss on sale of trading securities, loss on sale of property, plant and equipment, loss on sale of long-term investments and other losses

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FORMS OF FINANCIAL STATEMENTS

Key Items:
Net sales Gross profit

Gross profit rate

Operating expenses

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FORMS OF FINANCIAL STATEMENTS

Key Items:
Nonoperating activities Net income
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FUNCTIONAL FORMAT

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NOTES TO FINANCIAL STATEMENTS

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FORMS OF FINANCIAL STATEMENTS

Classified Balance Sheet

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