ch05 fundamental of financial accounting by edmonds (4th edition)

Fundamental Financial Accounting Conceptsby Edmonds, McNair, Milam, Olds PowerPoint® presentation by J. Lawrence Bergin Fourth Edition 5- 2 Chapter 5 Accounting for Merchandising Businesses McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 3 Chapter 5: Accounting for Merchandising Businesses In Chapter 5 we will consider the following questions. q What is the difference between a service firm and a merchandising firm? q How does a firm account for inventory? q How are financial statements affected by the purchase and sale of merchandise inventory? McGraw-Hill/Irwin Sale © The McGraw-Hill Companies, Inc., 2003 5- 4 Four Major Types of Businesses q Service s accountants, attorneys, physicians q Merchandising s Wal-Mart, Safeway, The Gap q Manufacturing s General Motors, 3M, Reynolds Metals q Financial s Citicorp, Merrill Lynch, American Express © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin [Obviously, some businesses provide more than one of the functions listed above] 5- 5 Four Major Types of Businesses Which type of business is a musician? Service, Merchandising, Manufacturing, Financial? •Performs at concerts Service business •Sells CDs during breaks Merchandiser •Records and duplicates own CDs Manufacturer © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin 5- 6 Net Sales Sales (sometimes called “Gross Sales”) Minus: Sales Returns and Allowances Minus: Sales Discounts (often given to credit customers who pay the seller quickly) = Net Sales McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 7 Cost of Goods Sold q Cost of goods sold is calculated as the number of units sold during the period multiplied by their unit costs. item for most non-service businesses. q Cost of goods sold is a major expense q The measurement of cost of goods sold is an excellent example of the application of the matching principle Why? The Cost of Goods Sold EXPENSE is recorded in the period the units are SOLD (REVENUE is recognized), regardless of when the units are paid for. So, the EXPENSE is MATCHED against the related REVENUE. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 8 Cost of Goods Sold What is included in the “net” cost of purchases? Beginning inventory Add: Purchases (net) Cost of Goods Available for Sale Deduct: Ending inventory Cost of goods sold Cost of Goods Available for Sale expresses the total cost of what has been available for sale throughout a given time period. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 9 Cost of Goods Sold Beginning inventory Plus: Purchases Minus: Purchase Returns & Allowances Minus: Purchase Discounts Plus: Transportation-in Purchases, net = Cost of Goods available for sale Minus: Ending inventory = Cost of goods sold “Cost of Goods Available for Sale” is the total cost of what has been available for sale throughout a given time period. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 10 Income Statement Formats Single Step with details Single Step condensed Multi-step with details Multi-step condensed Let’s look at examples….. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 11 Income Statement Formats Multi-step with details Multi-step: condensed 100 60 40 Net Sales 100 Less: Cost of goods Sold 60 Gross Profit Margin 40 Operating Expenses: Selling Expenses 10 Administrative Exp. 11 Total Operating Exp. 21 Operating Income 19 Non-Operating Rev. (Exp.) Interest Expense (1) 21 18 19 Income before tax Income Tax expense 3 (1) Net Income 15 18 3 15 © The McGraw-Hill Companies, Inc., 2003 Net Sales Less: Cost of goods sold Gross Profit Margin Operating Expenses: Selling: Sales Salaries 8 Advertising 2 Total Selling 10 Administrative: Admin. Salaries 3 Building Rent 8 Total Adm. Exp. 11 Total Operating Exp. Operating Income Non-Operating Rev. (Exp.) Interest Expense Income before tax Income Tax expense Net Income McGraw-Hill/Irwin 5- 12 The multi-step INCOME Statement format classifies interest as a NON-operating item. But, interest is still an OPERATING ACTIVITY on the CASHFLOW Statement. Multi-step with details Multi-step: condensed Net Sales Less: Cost of goods sold Gross Profit Margin Operating Expenses: Selling: Sales Salaries 8 Advertising 2 Total Selling 10 Administrative: Admin. Salaries 3 Building Rent 8 Total Adm. Exp. 11 Total Operating Exp. Operating Income Non-Operating Rev. (Exp.) Interest Expense Income before tax Income Tax expense Net Income McGraw-Hill/Irwin Income Statement Formats 100 60 40 Net Sales 100 Less: Cost of goods Sold 60 Gross Profit Margin 40 Operating Expenses: Selling Expenses 10 Administrative Exp. 11 Total Operating Exp. 21 Operating Income 19 Non-Operating Rev. (Exp.) Interest Expense (1) 21 18 19 Income before tax Income Tax expense 3 (1) Net Income 15 18 3 15 © The McGraw-Hill Companies, Inc., 2003 5- 13 Income Statement Formats Single-step with details Single-step: condensed Net Sales 100 Less Expenses: Cost of goods sold 60 Selling 10 Administrative 11 Interest Expense 1 Income Tax Expense 3 Total Expenses 85 Net Income 15 Net Sales 100 Less Expenses: Cost of goods sold 60 Sales Salaries 8 Advertising 2 Admin. Salaries 3 Building Rent 8 Interest Expense 1 Income Tax Expense 3 Total Expenses 85 Net Income 15 When using the Condensed form for either multi- or single-step, if there isn’t enough information to separate the expenses into Selling & Administrative categories, list their sum as “Operating © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Expenses”. 5- 14 Income Statement Formats Single-step with details Single-step: condensed A common modification of the single-step method is to have the income tax expense separated out. Net Sales Less Operating Exp. Cost of goods sold Sales Salaries Advertising Admin. Salaries Building Rent Interest Expense Total Oper. Exp. Income before taxes Income Tax Expense Net Income McGraw-Hill/Irwin 60 8 2 3 8 1 100 Net Sales 100 Less Expenses: Cost of goods sold 60 Selling 10 Administrative 11 Total Oper. Exp. 81 Income before taxes 19 Income Tax Expense 4 82 Net Income 15 18 3 15 © The McGraw-Hill Companies, Inc., 2003 5- 15 Income Statement Formats The meaning of these three special items are covered in more Treatment of Special items advanced courses. Results of Discontinued Operations, Extraordinary Gains and Losses, and Cumulative Effect of a Change in Accounting Principle No matter which income statement format is used, these 3 special items are ALWAYS at the bottom of the income statement. McGraw-Hill/Irwin Sales Less Expenses: Cost of goods sold Selling Administrative Total Oper. Exp. Income before taxes Income Tax Expense Inc. from Continuing Operations 100 60 10 11 Net Income Discontinued Operation-Disposal Gain Extraordinary Item-Tornado Loss Cumulative Effect of a Change in Accounting Principle 81 19 4 15 2 (3) 4 18 © The McGraw-Hill Companies, Inc., 2003 5- 16 Inventory q Inventory is tangible property that is held for resale or will be used in producing goods or services. q Inventory is reported on the balance sheet as an asset. q Types of inventory: Merchandise inventory Raw materials inventory Work in process inventory Finished goods inventory McGraw-Hill/Irwin manufacturer © The McGraw-Hill Companies, Inc., 2003 5- 17 Inventory Cost The cost principle requires that inventory be recorded for the price paid or the consideration given up. What type of transaction is the purchase of inventory? Asset Exchange if cash paid. Asset Source if “on account”. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 18 Inventory Cost q The amount recorded for inventory should include: s Invoice price (minus purchase discounts), transportation-in costs (also called “freight-in”), inspection costs, and preparation costs. costs of purchases until raw materials are ready for use or until merchandise is ready for shipment to customers. The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin © q The company should accumulate 5- 19 Terms of Sales & Purchases Discount Terms: 2/10, n/30 (for example) s s s 2% discount if balance paid in ten days, remainder to be paid within 30 days of sale tells when and how much must be paid There is a high interest cost of not taking purchase discounts when offered. Let’s look at an example. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 20 What is the annual interest rate equivalent of NOT taking a 2/10, n30 discount? Q. How many “extra” days can ABC Co. keep its money if it gives up the 2% discount? A. 20 extra days. ABC could pay on day 10 and still take the discount. By not taking the discount ABC can keep the money from day 11 through day 30, which is 20 more days. Q. How many 20 day periods are there in a 360 day year? A. 360/20 = 18 twenty day periods in a year. Q. What is the approximate ANNUAL interest rate cost of not taking 2% discounts? A. 2% lost discount for each of 18 twenty day periods = (2%x18) = 36% annual interest rate CONCLUSION If you can borrow at less than 36% APR, borrow to take the discount. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 21 Terms of Sales & Purchases q F. O. B. (Free On Board) shipping point or F.O.B. destination s tells who pays for the shipping and when ownership “title” passes from the seller to the buyer. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 22 FOB Shipping and FOB Destination q FOB Shipping Point: Buyer pays the shipping costs because ownership “title” transfers to buyer at the point the shipment starts on its journey. Seller pays shipping costs because title does not transfer to the buyer until the goods reach their destination (the buyer’s place of business). © The McGraw-Hill Companies, Inc., 2003 q FOB Destination: McGraw-Hill/Irwin 5- 23 Timing is EVERYTHING... q Recognize revenue when “earned” earned when an exchange (seller to buyer) occurs q Three levels of the matching principle s Product costs (e.g., inventory costs): assets until produce revenue v direct cause & effect relationship between revenue and expense s Period costs: systematic & rational allocation v e.g., depreciation costs s Period costs: recognize as expense as incurred v e.g., advertising costs s McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 24 Perpetual Inventory Systems q The inventory account is continuously updated for the following events: s Purchases s Purchase Discounts Taken s Purchase Returns & Allowances s Sales (remove from inventory the COST of the units sold) s Sales Returns (add to inventory the COST of units returned) The necessary detailed record-keeping required by the perpetual system has become much easier with current computer technology. q A physical count of the inventory is still required at the end of the accounting period to assure accurate inventory records in case of errors or theft. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 25 Perpetual Inventory Systems q Cost of Goods Sold . . . Contains the cost of units that have been sold to customers. s Is a temporary account. s (It will be closed out at the end of the period.) s Is an expense account. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 26 Transaction Analysis q The following selected events occurred during 2004 at Clock Company which uses the PERPETUAL INVENTORY SYSTEM. q For each event: Determine the effect on the financial statements. s Record the event in the journal and ledger. s McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 27 Transactions 1. Purchased 1000 units for $4 each on account. Terms: 2/10, n/30 2. Paid a trucking company $500 to deliver the purchased units to our warehouse. 3. Sold 620 units on account for $6 each. (Terms 1/10, n/30) 3A: Record the revenue. 4A: Remove the revenue. 5A: Record the 1% sales discount. 3B: Record cost of goods. 4B: Return the units to inventory. 5B: Record the cash collection. 4. The customer in Transaction #3 returned 20 units for credit. 5. Customer in Trans. #3 paid within the 10 day discount period. 6. Returned 50 units to our supplier who granted us credit for the cost of the units but not for any transportation costs. 7. A physical inventory count shows 340 units on-hand, indicating 10 units have been lost. 8. Paid for the Trans. #1 purchase within the 10 day discount period. 8A: Record 2% purchase discount. 8B: Record the cash payment. 9. Record payment of the $340 shipping cost to customer in Tran. #3. (Original sale was based on F.O.B. destination.) McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 28 1. Purchased 1000 units for $4 each on account. (Terms: 2/10, n/30) BALANCE SHEET (and Accounting Equation) ASSETS = LIABILITY + STK. EQUITY Accts. Accounts Com. Retain. INCOME STATEMENT Rev./ Gain Exp./ = Net CASHFLOW STATEMENT OA,IA,FA $ amt Cash + Receiv. + Inventory = Payable + Stk. + Earn. - Loss = Inc. 1 4,000 = 4,000 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 29 1. Journalize & Post the purchase. BALANCE SHEET (and Accounting Equation) ASSETS = LIABILITY + STK. EQUITY Accts. Accounts Com. Retain. Cash + Receiv. + Inventory = Payable + Stk. + Earn. INCOME STATEMENT Rev./ Gain Exp./ = Debit Credit CASHFLOW STATEMENT OA,IA,FA $ amt Net - Loss = Inc. 1 Date 4,000 = 4,000 GENERAL JOURNAL Account Titles 1 Inventory Accounts Payable to record 1000 units purchased for $4 ea. on credit 4000 4000 GENERAL LEDGER ("T" - Accounts) Cash 5000 Assets Accounts Receiv. bb 4000 = Liabilities Accounts Payable + bb 1000 bb 4000 (1) Equity Common Stock Retained Earnings 6000 bb 2000 bb Sales Returns Sales Revenue Inventory (1) 4000 Cost of Gds Sold Transportation Out McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 30 1. Paid a trucking company $500 to deliver the purchased units to our warehouse. Freight charges paid to get inventory to our place of business (called TRANSPORTATION IN) is part of the cost of the purchase. It is added to the Inventory account, thus increasing the asset value. It is NOT “expensed”. BALANCE SHEET (and Accounting Equation) ASSETS = LIABILITY + STK. EQUITY Accts. Accounts Com. Retain. Cash + Receiv. + Inventory = Payable + Stk. + Earn. INCOME STATEMENT Rev./ Gain Exp./ = Net CASHFLOW STATEMENT OA,IA,FA $ amt - Loss = Inc. 2 (500) 500 = (500) OA McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 31 2. Journalize & Post the transportation cost BALANCE SHEET (and Accounting Equation) ASSETS = LIABILITY + STK. EQUITY Accts. Accounts Com. Retain. Cash + Receiv. + Inventory = Payable + Stk. + Earn. INCOME STATEMENT Rev./ Gain Exp./ = Debit Credit CASHFLOW STATEMENT OA,IA,FA $ amt Net - Loss = Inc. 2 (500) Date 500 = GENERAL JOURNAL (500) OA Account Titles 2 Inventory Cash to record $500 Transportation In cost 500 500 GENERAL LEDGER ("T" - Accounts) bb Assets Cash Accounts Receiv. 5000 500 (2) bb 4000 = Liabilities Accounts Payable + 1000 bb 4000 (1) Equity Common Stock Retained Earnings 6000 bb 2000 bb Sales Returns Sales Revenue Inventory (1) 4000 (2) 500 Cost of Gds Sold Transportation Out McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 32 3. Sold 620 units on account for $6 each. (Terms 1/10, n/30) 3a. Record the Sales Revenue and related Receivable. $6 sales price x 620 units = $3720 BALANCE SHEET (and Accounting Equation) ASSETS = LIABILITY + STK. EQUITY Accts. Accounts Com. Retain. Cash + Receiv. + Inventory = Payable + Stk. + Earn. INCOME STATEMENT Rev./ Gain Exp./ Net CASHFLOW STATEMENT OA,IA,FA $ amt 3a 3,720 = 3,720 - Loss = Inc. 3,720 = 3,720 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 33 3a. Journalize and Post the sale. BALANCE SHEET (and Accounting Equation) ASSETS = LIABILITY + STK. EQUITY Accts. Accounts Com. Retain. Cash + Receiv. + Inventory = Payable + Stk. + Earn. 3a Date INCOME STATEMENT Rev./ Gain 3,720 Debit CASHFLOW STATEMENT OA,IA,FA $ amt Exp./ Net = 3,720 - Loss = Inc. 3,720 = GENERAL JOURNAL Account Titles 3,720 Credit 3a Accounts Receivable Sales Revenue to record 620 units sold @ $6 ea. 3720 3720 GENERAL LEDGER ("T" - Accounts) Assets = Liabilities + Accounts Payable Cash Accounts Receiv. 5000 500 (2) bb 4000 1000 bb (3a)3720 4000 (1) Equity Common Stock Retained Earnings 6000 bb 2000 bb Sales Returns Sales Revenue 3720 (3a) Cost of Gds Sold Transportation Out bb Inventory (1) 4000 (2) 500 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 34 3b. Record the Cost of the Goods Sold and their removal from inventory. What is the cost of each item in inventory? $4.00 invoice price + $0.50 transportation = $4.50 per unit $500 transport / 1000 units 620 units sold x $4.50 cost each = $2790 BALANCE SHEET (and Accounting Equation) ASSETS = LIABILITY + STK. EQUITY Accts. Accounts Com. Retain. Cash + Receiv. + Inventory = Payable + Stk. + Earn. INCOME STATEMENT Cost of goods sold CASHFLOW STATEMENT OA,IA,FA $ amt Rev./ Gain Exp./ Net 3b McGraw-Hill/Irwin (2,790) = (2,790) - Loss = Inc. 2,790 = (2,790) © The McGraw-Hill Companies, Inc., 2003 5- 35 3b. Journalize and Post the cost of the sale. BALANCE SHEET (and Accounting Equation) ASSETS = LIABILITY + STK. EQUITY Accts. Accounts Com. Retain. Cash + Receiv. + Inventory = Payable + Stk. + Earn. INCOME STATEMENT Rev./ Gain Exp./ Net CASHFLOW STATEMENT OA,IA,FA $ amt 3b Date (2,790) 3b = - Loss = Inc. 2,790 = (2,790) Credit GENERAL JOURNAL Account Titles Debit Cost of Goods Sold Inventory to record the $4.50 cost of 620 units sold 2790 2790 GENERAL LEDGER ("T" - Accounts) Assets Cash Accounts Receiv. 5000 500 (2) bb 4000 (3a)3720 = Liabilities + Accounts Payable 1000 bb 4000 (1) Equity Common Stock Retained Earnings 6000 bb 2000 bb Sales Returns Sales Revenue 3720 (3a) Cost of Gds Sold (3b) 2790 Transportation Out bb Inventory (1) 4000 (3b) 2790 (2) 500 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 36 4. The customer in Transaction #3A returned 20 units for credit. 4a. Remove the previously recorded Sales Revenue and related Account Receivable. $6 sales price x 20 units = $120 A separate “Sales Return” contra-revenue account may be used. CASHFLOW STATEMENT OA,IA,FA $ amt BALANCE SHEET (and Accounting Equation) INCOME STATEMENT ASSETS = LIABILITY + STK. EQUITY Accts. Accounts Com. Retain. Rev./ Exp./ Net Cash + Receiv. + Inventory = Payable + Stk. + Earn. 4a (120) = - Loss = Inc. (120) (120) = (120) Gain McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 37 4a. Journalize and Post the sales return. BALANCE SHEET (and Accounting Equation) INCOME STATEMENT ASSETS = LIABILITY + STK. EQUITY Accts. Accounts Com. Retain. Rev./ Exp./ Net Cash + Receiv. + Inventory = Payable + Stk. + Earn. 4a Date CASHFLOW STATEMENT OA,IA,FA $ amt Gain (120) - Loss = Inc. = Credit (120) = GENERAL JOURNAL Account Titles (120) Debit 4a Sales Returns (a contra-revenue) Accounts Receivable record 20 units returned by customer @ $6 ea. 120 120 GENERAL LEDGER ("T" - Accounts) Assets = Liabilities + Accounts Payable Cash Accounts Receiv. 5000 500 (2) bb 4000 120 (4a) 1000 bb (3a)3720 4000 (1) Equity Common Stock Retained Earnings 6000 bb 2000 bb Sales Returns Sales Revenue (4a) 120 3720 (3a) Cost of Gds Sold (3b)2790 Transportation Out bb Inventory (1) 4000 2790 (3b) (2) 500 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 38 4b. Put the cost of the 20 returned units back into inventory and out of Cost of Goods Sold. (Recall, the units were “costed out” of inventory and charged to Cost of Goods Sold at $4.50 each in Tr. #3b.) $4.50 x 20 units = $90 Reduction in “Cost of Goods Sold”. CASHFLOW STATEMENT OA,IA,FA $ amt BALANCE SHEET (and Accounting Equation) INCOME STATEMENT ASSETS = LIABILITY + STK. EQUITY Accts. Accounts Com. Retain. Rev./ Exp./ Net Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain 4b McGraw-Hill/Irwin 90 = 90 - Loss = Inc. (90) = 90 © The McGraw-Hill Companies, Inc., 2003 5- 39 4b. Journalize and Post the return to inventory. BALANCE SHEET (and Accounting Equation) INCOME STATEMENT ASSETS = LIABILITY + STK. EQUITY Accts. Accounts Com. Retain. Rev./ Exp./ Net Cash + Receiv. + Inventory = Payable + Stk. + Earn. 4b Date CASHFLOW STATEMENT OA,IA,FA $ amt Gain - Loss = Inc. (90) = 90 90 = GENERAL JOURNAL Account Titles 90 Debit Credit 4b Inventory Cost of Goods Sold record 20 units returned to inventory @ $4.50 ea. 90 90 GENERAL LEDGER ("T" - Accounts) Assets = Liabilities + Accounts Payable Cash Accounts Receiv. 5000 500 (2) bb 4000 120 (4a) 1000 bb (3a)3720 4000 (1) Equity Common Stock Retained Earnings 6000 bb 2000 bb Sales Returns Sales Revenue (4a) 120 3720 (3a) Cost of Gds Sold Transportation Out (3b)2790 90 (4b) bb Inventory (1) 4000 2790 (3b) (2) 500 (4b) 90 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 40 5a. The Transaction #3a customer paid within the ten day discount period. Record the Sales Discount. (1/10, n/30) $3,720 120 3,600 1% $ 36 CASHFLOW STATEMENT OA,IA,FA $ amt Original Account Receivable (Transaction 3a) Less: Sales Return (Transaction 4a) Amount owed by customer before discount x 1% sales discount Sales Discount BALANCE SHEET (and Accounting Equation) INCOME STATEMENT ASSETS = LIABILITY + STK. EQUITY Accts. Accounts Com. Retain. Rev./ Exp./ Net Cash + Receiv. + Inventory = Payable + Stk. + Earn. 3a 4a 3,720 (120) = = Gain 3,720 (120) - Loss = Inc. = 3,720 = = (120) 3,720 (120) 5a (36) = (36) (36) (36) McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 41 5a. Journalize and Post the 1% Sales Discount. ASSETS Accts. 5a Date = LIABILITY + STK. EQUITY STATEMENT Exp./ = Credit Accounts = Com. Retain. Rev./ Gain (36) Debit Net (36) OA,IA,FA $ amt Cash + Receiv. + Inventory = Payable + Stk. + Earn. (36) (36) - Loss = Inc. GENERAL JOURNAL Account Titles 5a Sales Revenue (or Sales Discount) Accounts Receivable to record 1% discount on Trans. #3a credit sale 36 36 GENERAL LEDGER ("T" - Accounts) bb Assets = Liabilities + Accounts Payable Cash Accounts Receiv. 5000 500 (2) bb 4000 120 (4a) 1000 bb 36 (5a) (3a)3720 4000 (1) Equity Common Stock Retained Earnings 6000 bb 2000 bb Sales Returns Sales Revenue (4a) 120 (5a) 36 3720 (3a) Cost of Gds Sold Transportation Out (3b)2790 90 (4b) Inventory (1) 4000 2790 (3b) (2) 500 (4b) 90 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 42 5b. The Transaction #3a customer paid within the ten day discount period. Record the cash collection. $3,720 (120) (36) $3,564 CASHFLOW STATEMENT OA,IA,FA $ amt Original Account Receivable (Transaction 3a) Less: Sales Return (Transaction 4a) Less: Sales Discount (Transaction 5a) Cash receipt that will satisfy the account BALANCE SHEET (and Accounting Equation) INCOME STATEMENT ASSETS = LIABILITY + STK. EQUITY Accts. Accounts Com. Retain. Rev./ Exp./ Net Cash + Receiv. + Inventory = Payable + Stk. + Earn. 3a 4a 5a 5b 3,720 (120) (36) = = Gain 3,720 (120) (36) - Loss = Inc. = 3,720 = = = (120) (36) 3,720 (120) (36) = = 3,564 (3,564) 3,564 OA McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 43 5b. Journalize and Post the cash collection. BALANCE SHEET (and Accounting Equation) INCOME STATEMENT ASSETS = LIABILITY + STK. EQUITY Accts. Accounts Com. Retain. Rev./ Exp./ Net Cash + Receiv. + Inventory = Payable + Stk. + Earn. 5b 3,564 Date CASHFLOW STATEMENT OA,IA,FA $ amt Gain - Loss = Inc. = (3,564) = GENERAL JOURNAL Account Titles Debit 3,465 OA Credit 5b Cash Accounts Receivable Collect from Tr. 3 customer (less return and disc.) 3564 3564 GENERAL LEDGER ("T" - Accounts) Assets = Liabilities + Equity Accounts Payable Cash Accounts Receiv. Common Stock Retained Earnings bb 5000 500 (2) bb 4000 120 (4a) 1000 bb 6000 bb 2000 bb 36 (5a) (5b) 3564 (3a)3720 4000 (1) Sales Returns Sales Revenue 3564 (5b) (4a) 120 (5a) 36 3720 (3a) Inventory (1) 4000 2790 (3b) (2) 500 (4b) 90 Cost of Gds Sold Transportation Out (3b)2790 90 (4b) McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 44 1. Returned 50 units to our supplier who granted us credit for the cost of the items but not for any transportation costs. Supplier cost was $4.00 per unit x 50 = $200. Transportation cost recorded when units were purchased was $0.50 per unit x 50 = $25. BALANCE SHEET (and Accounting Equation) INCOME STATEMENT ASSETS = LIABILITY + STK. EQUITY Accts. Accounts Com. Retain. Rev./ Exp./ Net Cash + Receiv. + Inventory = Payable + Stk. + Earn. 6 (225) = (200) (25) Gain CASHFLOW STATEMENT OA,IA,FA $ amt - Loss = Inc. 25 = (25) 200 OA Technically, this LOSS should be reported in the operating expense section of the income statement. However, this loss is usually NOT MATERIAL, so most companies record it as an increase in the COST OF GOODS SOLD expense account. That’s what we’ll do here. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 45 6. Returned 50 units to our supplier who granted us credit for the cost of the items but not for any transportation costs. BALANCE SHEET (and Accounting Equation) INCOME STATEMENT ASSETS = LIABILITY + STK. EQUITY Accts. Accounts Com. Retain. Rev./ Exp./ Net Cash + Receiv. + Inventory = Payable + Stk. + Earn. 6 Date CASHFLOW STATEMENT OA,IA,FA $ amt Gain - Loss = Inc. 25 = (25) 200 (225) = GENERAL JOURNAL Account Titles (25) Debit 200 OA Credit 6 Accounts Payable Cost of Goods Sold (or "Inventory Loss") Inventory Adjustment for inventory returned to our supplier. 200 25 225 GENERAL LEDGER ("T" - Accounts) Assets = Liabilities + Equity Accounts Payable Cash Accounts Receiv. Common Stock Retained Earnings bb 5000 500 (2) bb 4000 120 (4a) (6) 200 1000 bb 6000 bb 2000 bb 36 (5a) (5b) 3564 (3a)3720 4000 (1) Sales Returns Sales Revenue 3564 (5b) (4a) 120 (5a) 36 3720 (3a) Inventory (1) 4000 2790 (3b) (2) 500 225 (6) (4b) 90 Cost of Gds Sold Transportation Out (3b)2790 90 (4b) (6) 25 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 46 7. A physical inventory count shows 340 units on-hand, indicating 10 units have been lost. Units in Beginning Inventory + Units Purchased this period (1000- 50 purchase returns) = Units Available for Sale - Units Sold (620 – 20 sales returns) = Units that should be in ending inventory 350 - Actual ending inventory from count = Units missing x $4.50 cost per unit BALANCE SHEET (and Accounting Equation) INCOME STATEMENT ASSETS = LIABILITY + STK. EQUITY Accts. Accounts Com. Retain. Rev./ Exp./ Net Cash + Receiv. + Inventory = Payable + Stk. + Earn. 7 McGraw-Hill/Irwin 0 950 950 (600) (340) 10 $45.00 CASHFLOW STATEMENT OA,IA,FA $ amt Gain - Loss = Inc. 45 = (45) (45) = (45) © The McGraw-Hill Companies, Inc., 2003 5- 47 7. A physical inventory count shows 340 units on-hand, indicating 10 units have been lost. BALANCE SHEET (and Accounting Equation) INCOME STATEMENT ASSETS = LIABILITY + STK. EQUITY Accts. Accounts Com. Retain. Rev./ Exp./ Net Cash + Receiv. + Inventory = Payable + Stk. + Earn. 7 (45) = (45) Gain CASHFLOW STATEMENT OA,IA,FA $ amt - Loss = Inc. 45 = (45) Technically, this LOSS should be reported in the operating expense section of the income statement. However, this loss is usually NOT MATERIAL, so most companies record it as an increase in the COST OF GOODS SOLD expense account. That’s what we’ll do here. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 48 7. A physical inventory count shows 340 units on-hand, indicating 10 units have been lost. BALANCE SHEET (and Accounting Equation) INCOME STATEMENT ASSETS = LIABILITY + STK. EQUITY Accts. Accounts Com. Retain. Rev./ Exp./ Net Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain CASHFLOW STATEMENT OA,IA,FA $ amt - Loss = Inc. 45 = (45) 7 Date (45) = GENERAL JOURNAL Account Titles (45) Debit Credit 7 Cost of Goods Sold (or "Inventory Loss") Inventory Adjustment for missing inventory 45 45 GENERAL LEDGER ("T" - Accounts) Assets = Liabilities + Equity Accounts Payable Cash Accounts Receiv. Common Stock Retained Earnings bb 5000 500 (2) bb 4000 120 (4a) (6) 200 1000 bb 6000 bb 2000 bb 36 (5a) (5b) 3564 (3a)3720 4000 (1) Sales Returns Sales Revenue 3564 (5b) (4a) 120 (5a) 36 3720 (3a) Inventory (1) 4000 2790 (3b) (2) 500 225 (6) (4b) 90 45 (7) Cost of Gds Sold Transportation Out (3b)2790 90 (4b) (6) 25 (7) 45 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 49 8a. Paid within discount period, so record the 2% discount on the $4000 Tran. #1 purchase less $200 Tran. #6 return. Purchase (Transaction #1) Less Purchase Return (Trans. #6) Amount owed X discount % Amount of Purchase Discount $ $4000 200 3800 2% 76 This reduces the cost of the inventory and the amount we owe the supplier. CASHFLOW STATEMENT OA,IA,FA $ amt BALANCE SHEET (and Accounting Equation) INCOME STATEMENT ASSETS = LIABILITY + STK. EQUITY Accts. Accounts Com. Retain. Rev./ Exp./ Net Cash + Receiv. + Inventory = Payable + Stk. + Earn. 8a McGraw-Hill/Irwin Gain - Loss = Inc. = (76) = (76) © The McGraw-Hill Companies, Inc., 2003 5- 50 8a. Paid within discount period, so record the discount on the $4000 Tr. #1 purchase less $200 Tr. #6 return. BALANCE SHEET (and Accounting Equation) INCOME STATEMENT ASSETS = LIABILITY + STK. EQUITY Accts. Accounts Com. Retain. Rev./ Exp./ Net Cash + Receiv. + Inventory = Payable + Stk. + Earn. 8a Date CASHFLOW STATEMENT OA,IA,FA $ amt Gain - Loss = Inc. = (76) = Account Titles (76) Debit GENERAL JOURNAL Credit 8a Accounts Payable Inventory 2% discount taken on $3,800 purchase less return 76 76 GENERAL LEDGER ("T" - Accounts) Assets = Liabilities + Equity Accounts Payable Cash Accounts Receiv. Common Stock Retained Earnings bb 5000 500 (2) bb 4000 120 (4a) (6) 200 1000 bb 6000 bb 2000 bb 36 (5a) (8a) 76 4000 (1) (5b) 3564 (3a)3720 Sales Returns Sales Revenue 3564 (5b) (4a) 120 (5a) 36 3720 (3a) Inventory (1) 4000 2790 (3b) Cost of Gds Sold Transportation Out (2) 500 225 (6) (3b)2790 90 (4b) (4b) 90 45 (7) (6) 25 76 (8a) (7) 45 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 51 8b. Paid the remaining balance on the Transaction #1 inventory purchase. $4000 purchase (Trans. #1) - 200 purchase return (Trans. #6) - 76 purchase discount (Trans. #8a) $3724 remainder to pay supplier BALANCE SHEET (and Accounting Equation) INCOME STATEMENT ASSETS = LIABILITY + STK. EQUITY Accts. Accounts Com. Retain. Rev./ Exp./ Net Cash + Receiv. + Inventory = Payable + Stk. + Earn. 8b (3,724) = CASHFLOW STATEMENT OA,IA,FA $ amt Gain - Loss = Inc. = (3,724) (3,724) OA McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 52 8b. Paid the remaining balance on the Transaction #1 inventory purchase. ($4000-200-76=$3724 to pay) BALANCE SHEET (and Accounting Equation) INCOME STATEMENT ASSETS = LIABILITY + STK. EQUITY Accts. Accounts Com. Retain. Rev./ Exp./ Net Cash + Receiv. + Inventory = Payable + Stk. + Earn. 8b (3,724) Date CASHFLOW STATEMENT OA,IA,FA $ amt Gain - Loss = Inc. = = (3,724) Debit (3,724) OA GENERAL JOURNAL Account Titles Credit 8b Accounts Payable Cash Paid balance due to supplier after return and discount. 3724 3724 GENERAL LEDGER ("T" - Accounts) Assets = Liabilities + Equity Accounts Payable Cash Accounts Receiv. Common Stock Retained Earnings bb 5000 500 (2) bb 4000 120 (4a) (6) 200 1000 bb 6000 bb 2000 bb 36 (5a) (8a) 76 4000 (1) (5b) 3564 3724 (8b) (3a)3720 Sales Returns Sales Revenue 3564 (5b) (8b) 3724 (4a) 120 (5a) 36 3720 (3a) Inventory (1) 4000 2790 (3b) Cost of Gds Sold Transportation Out (2) 500 225 (6) (3b)2790 90 (4b) (4b) 90 45 (7) (6) 25 76 (8a) (7) 45 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 53 9. The Sale recorded in Transaction #3a was made with terms of F.O.B. destination. Record payment of the $340 shipping cost. Transportation charges on PURCHASES are added to the cost of the asset, INVENTORY. (Transportation IN) Transportation charges to ship products TO CUSTOMERS are reported as operating expenses on the income statement. The appropriate account title is TRANSPORTATION OUT (or FREIGHT OUT or SHIPPING EXPENSE). BALANCE SHEET (and Accounting Equation) INCOME STATEMENT ASSETS = LIABILITY + STK. EQUITY Accts. Accounts Com. Retain. Rev./ Exp./ Net Cash + Receiv. + Inventory = Payable + Stk. + Earn. 9 (340) = CASHFLOW STATEMENT OA,IA,FA $ amt Gain - Loss = Inc. 340 = (340) (340) (340) OA McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 54 9. The Sale recorded in Transaction #3a was made with terms of F.O.B. destination. Record payment of the $340 shipping cost. BALANCE SHEET (and Accounting Equation) INCOME STATEMENT ASSETS = LIABILITY + STK. EQUITY Accts. Accounts Com. Retain. Rev./ Exp./ Net Cash + Receiv. + Inventory = Payable + Stk. + Earn. 9 Date CASHFLOW STATEMENT OA,IA,FA $ amt Gain - Loss = Inc. 340 = (340) (340) = GENERAL JOURNAL Account Titles (340) Debit (340) OA Credit 9 Transportation Out (or Shipping Exp.) Cash Paid $340 cost to ship to customer. 340 340 GENERAL LEDGER ("T" - Accounts) Assets = Liabilities + Equity Accounts Payable Cash Accounts Receiv. Common Stock Retained Earnings bb 5000 500 (2) bb 4000 120 (4a) (6) 200 1000 bb 6000 bb 2000 bb 36 (5a) (8a) 76 4000 (1) (5b) 3564 3724 (8b) (3a)3720 Sales Returns Sales Revenue 340 (9) 3564 (5b) (8b) 3724 (4a) 120 (5a) 36 3720 (3a) Inventory (1) 4000 2790 (3b) Cost of Gds Sold Transportation Out (2) 500 225 (6) (3b)2790 90 (4b) (9) 340 (4b) 90 45 (7) (6) 25 76 (8a) (7) 45 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 55 Clock Company Ending Balances of LEDGER Accounts GENERAL LEDGER ("T" - Accounts) Assets = Liabilities + Equity Accounts Payable Cash Accounts Receiv. Common Stock Retained Earnings bb 5000 500 (2) bb 4000 120 (4a) (6) 200 1000 bb 6000 bb 2000 bb (5b) 3564 3724 (8b) (3a)3720 36 (5a) (8a) 76 4000 (1) Sales Returns Sales Revenue 340 (9) 3564 (5b) (8b) 3724 (4a) 120 (5a) 36 3720 (3a) eb 4000 eb 4000 1000 eb 3684 eb Inventory (1) 4000 2790 (3b) (2) 500 225 (6) (4b) 90 45 (7) 76 (8a) eb 1454 Cost of Gds Sold Transportation Out (3b)2790 90 (4b) (9) 340 (6) 25 (7) 45 eb 2770 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 56 using the Perpetual Inventory System BALANCE SHEET (and Accounting Equation) ASSETS = LIABILITY + STK. EQUITY Accts. Accounts Com. Retain. Cash + Receiv. + Inventory = Payable + Stk. BB 1 2 3a 3b 4a 4b 5a 5b 6 7 8a 8b 9 EB (3,724) (340) 4,000 + 4,000 + 3,564 (36) (3,564) (120) (500) 3,720 5,000 4,000 = Summary Transactions Rev./ Gain Exp./ = = = 3,720 (2,790) (120) 90 (36) (200) (76) (3,724) (340) 1,000 + 6,000 + 2,454 3,564 (25) (45) (36) (120) 3,720 INCOME STATEMENT Net CASHFLOW STATEMENT OA,IA,FA $ amt + Earn. 2,000 - Loss = Inc. 1,000 4,000 6,000 5,000 bal. (500) OA 4,000 = 500 = = = 3,720 2,790 = (2,790) = (90) = = = 25 = 45 = = = 340 = (340) 454 (3,724) OA (340) OA 4,000 bal. (25) (45) (120) 90 (36) 3,564 OA (2,790) = = 90 = = = (225) = (45) = (76) = = = 1,454 = - 3,110 = McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 57 Let’s look at another Inventory system. Periodic Inventory System Separate Accounts Used When using the Periodic system, inventory transactions are not recorded directly in the INVENTORY account. Instead, separate accounts are used for PURCHASES PURCHASE RETURNS & ALLOWANCES PURCHASE DISCOUNTS TRANSPORTATION IN McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 58 q Periodic Inventory Systems Because entries are not made to the inventory account during the accounting period, the amount of inventory is not known until the end of the period when the inventory count is done. The PERIODIC system is being used Bar codes/scanners less and less due to advancements in technology that make the extra record keeping of the perpetual system easy and inexpensive. Periodic inventory systems require more closing entries at the end of the period. (Purchases, Purchase Returns and Allowances, Purchase Discounts, and Transportation In are all separate TEMPORARY accounts that must be closed out at the end of the period.) © The McGraw-Hill Companies, Inc., 2003 q q McGraw-Hill/Irwin 5- 59 Periodic Inventory System Purchases and Purchase Returns and Allowances q Purchases is an account that holds the current period’s inventory purchases (a debit balance) and is used in the calculation of Cost of Goods Sold on the Income Statement. q The Purchase Returns and Allowances account also is used to calculate Cost of Goods Sold on the income statement. It is a deduction from the cost of purchases in a periodic inventory system. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 60 Periodic Inventory System Purchase Discounts When using the Periodic system Purchase Discounts are recorded in a separate account. This helps managers keep track of the company’s performance in taking advantage of discounts. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 61 q The ending inventory is determined at the Periodic Inventory Systems end of the period by taking a physical count of the goods remaining on hand. of the accounting period by subtracting the ending inventory (determined from the physical count) from the Cost of Goods Available for Sale. Beginning Inventory $ 400 + Purchases, net 2000 = Goods Available for Sale 2400 - Ending Inv. (from count) 500 = Cost of Goods Sold $1900 © The McGraw-Hill Companies, Inc., 2003 q Cost of goods sold is calculated at the end McGraw-Hill/Irwin 5- 62 Using a few selected transactions, let’s look at the differences between the journal entries for the Perpetual and Periodic Inventory Systems. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 63 Selected transactions comparing the PERPETUAL vs. PERIODIC Inventory Systems PERPETUAL INVENTORY SYSTEM Accounts Debit Date/Event 1 Inventory 4000 Accounts Payable Purchased 1000 units on account Credit 4000 PERIODIC INVENTORY SYSTEM Accounts Debit Date/Event 1 Purchases 4000 Accounts Payable Purchased 1000 units on account Credit 4000 2 Inventory Cash Paid trucking fee on purchases 551 551 2 Transportation In Cash Paid trucking fee on purchases 551 551 3 Accounts Payable Inventory Returned 50 units to supplier for credit 200 200 3 Accounts Payable Purchase Returns & Allow. Returned 50 units to supplier for credit 200 200 4A Accounts Payable Inventory Purch. Disc. ($4000-200)x2% = $76 76 76 4A Accounts Payable Purchase Discounts Purch. Disc. ($4000-200)x2% = $76 76 76 4B Accounts Payable Cash Paid remaining balance to supplier Ave. $ = [4000+551-200-76] /950= $4.50 3724 3724 4B Accounts Payable Cash Paid remaining balance to supplier Ave. $ = [4000+551-200-76] /950= $4.50 3724 3724 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 64 Selected transactions comparing PERPETUAL vs. PERIODIC Inventory Systems – Cont’d PERPETUAL INVENTORY SYSTEM Accounts Debit Date/Event 5A Accounts Receivable 3720 Sales Revenue Sold 620 units @ $6 on account Credit 3720 PERIODIC INVENTORY SYSTEM Accounts Debit Date/Event 5A Accounts Receivable 3720 Sales Revenue Sold 620 units @ $6 on account Credit 3720 5B Cost of Goods Sold Inventory Remove 620 units from inv.@ $4.50 2790 2790 5B NO ENTRY. The Cost of Goods Sold and inventory adjustment are made for ALL sales at the end of the period. Sales (or Sales Returns) Accounts Receivable Customer returned 20 units sold @ $6 6A Sales (or Sales Returns) Accounts Receivable Customer returned 20 units sold @ $6 120 120 6A 120 120 6B Inventory Cost of Goods Sold Returned units put into inv. @ $4.50 90 90 6B NO ENTRY. The Cost of Goods Sold & Inventory accounts were NOT affected when the original sale was recorded, so NO reversal needed now. Cost of Goods Sold Inventory Purchase Returns & Allow. Purchase Discounts Purchases Transportation In Year-end inventory adjustment 7 NO YR-END ADJUSTING ENTRY REQUIRED The inventory and Cost of Goods Sold account are already "up-to-date". 7 Use a Yr.-end inventory count to determine the inventory adjustment. McGraw-Hill/Irwin 200 76 4000 551 © The McGraw-Hill Companies, Inc., 2003 5- 65 Selected transactions comparing PERPETUAL vs. Use the Cost of Goods Sold schedule to calculate the cost of the units that are “gone”PERIODIC Inventory Systems – Cont’d and ASSUMED to have been PERPETUAL INVENTORY SYSTEM PERIODIC INVENTORY SYSTEM sold. Could some of the units actually Accounts Debit Credit Accounts Debit Date/Event Date/Event have been lost, stolen, or thrown away? 6A Accounts Receivable 6A Accounts Receivable 3720 3720 Sales Revenue 3720 Sales Revenue Sold 620 units @ $6 on account Sold 620 units @ $6 on account Begin. Inventory $ 0 + Cost of Goods $2790 4000 6B Purchase Sold 6B Inventory - Purchase Returns ( 200)2790 Remove 620 units from inv.@ $4.50 - Purchase Discounts ( 76) 7A Sales (or Sales Returns) 120 7A + Transportation In 551 120 Accounts Receivable Purchases, net sold @ $6 4275 Customer returned 20 units Cost of Goods Avail. for Sale 4275 7B 7B Inventory 90 Less:Cost of GoodsInventory Ending Sold (90 1575) Returned Cost of units put into inv. @ $4.50 Goods Sold $2700 Credit 3720 NO ENTRY. The Cost of Goods Sold and inventory adjustment are made for ALL sales at the end of the period. 120 Ending Inventory $1575 Less: Begin. Inv. 0 Customer returned 20 units sold @ $6 Add to Inv. account $1575 Sales (or Sales Returns) Accounts Receivable 120 NO ENTRY. The Cost of Goods Sold & Inventory accounts were NOT affected when the original sale was recorded, so NO reversal needed now. Cost of Goods Sold Inventory Purchase Returns & Allow. Purchase Discounts Purchases Transportation In Year-end inventory adjustment 2700 1575 200 76 4000 551 8 NO YR-END ADJUSTING ENTRY REQUIRED The inventory and Cost of Goods Sold account are already "up-to-date". 8 A Yr-end count shows 350 units (at a cost of $4.50 each) still in stock =$1575 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 66 Accounting and Inventory Management The accounting system plays three roles in inventory management: q Provides accurate information for financial statements and tax reports. q Provides up-to-date information on inventory quantities and cost. q Provides information necessary to protect inventory from theft and misuse. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 67 Ratios: Gross Margin Percentage q Gross margin %: s gross margin as a percent of sales Net sales – CGS = Gross Margin Net sales Net Sales s McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 68 Ratios: Return on sales q Return on sales = Net income Net sales Revenues - expenses Net sales McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 69 Common-size Income Statement income statement is expressed as a % of that year’s Net Sales. q Each item on the % Net Sales 100.0 - Cost 60.0 40.0 Comparisons are made to: Budget Previous year(s) Competitors McGraw-Hill/Irwin =G.P © The McGraw-Hill Companies, Inc., 2003 5- 70 Comparative Common-size Income Statements 2005 % of N.Sales 2004 % of N.Sales $2,000 1,200 800 100.0 Net Sales Cost of Goods Sold Gross Profit Operating Expenses: Selling Expenses Administrative Exp. Total Oper. Exp. Net Income McGraw-Hill/Irwin $3,000 2,000 1,000 100.0 600 700 1,300 ($300) 400 300 700 $100 © The McGraw-Hill Companies, Inc., 2003 5- 71 Comparative Common-size Income Statements 2005 % of N.Sales 2004 % of N.Sales $2,000 1,200 800 100.0 60.0 40.0 Net Sales Cost of Goods Sold Gross Profit Operating Expenses: Selling Expenses Administrative Exp. Total Oper. Exp. Net Income McGraw-Hill/Irwin $3,000 2,000 1,000 100.0 66.7 33.3 600 700 1,300 ($300) 20.0 23.3 43.3 (10.0) 400 300 700 $100 20.0 15.0 35.0 5.0 © The McGraw-Hill Companies, Inc., 2003 5- 72 Question: Why did the company have a net loss when sales increased by $1,000? 2005 Net Sales Cost of Goods Sold Gross Profit Operating Expenses: Selling Expenses Administrative Exp. Total Oper. Exp. Net Income McGraw-Hill/Irwin % of N.Sales 2004 % of N.Sales $2,000 1,200 800 100.0 60.0 40.0 $3,000 2,000 1,000 100.0 66.7 33.3 600 700 1,300 ($300) 20.0 23.3 43.3 (10.0) 400 300 700 $100 20.0 15.0 35.0 5.0 © The McGraw-Hill Companies, Inc., 2003 5- 73 Income Statement Trend Analysis Trend Analysis shows both Dollar and % changes from one year to the next year for each item on the income statement. Example: From 2004 to 2005 Net Sales increased from $2,000 to $3,000. So…… Net Sales increased $1,000 which is a 50% increase over 2004 Net Sales. ($1,000 incr./$2,000 Net Sales of 2004= 50%) McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 74 Income Statement Trend Analysis 2005 2004 $ inc.(dec.) % inc.(dec) Net Sales Cost of Goods Sold Gross Profit Operating Expenses: Selling Expenses Administrative Exp. Total Oper. Exp. Net Income McGraw-Hill/Irwin $3,000 $2,000 2,000 1,000 1,200 800 $1,000 800 200 50.0 66.7 25.0 600 700 1,300 ($300) 400 300 700 $100 200 400 600 ($400) 50.0 133.3 85.7 (400.0) © The McGraw-Hill Companies, Inc., 2003 5- 75 Income Statement Trend Analysis 2005 2004 $ inc.(dec) % inc.(dec) Net Sales Cost of Goods Sold Gross Profit Operating Expenses: Selling Expenses Administrative Exp. Total Oper. Exp. Net Income McGraw-Hill/Irwin $3,000 $2,000 2,000 1,000 1,200 800 $1,000 50.0 600 700 1,300 ($300) 400 300 700 $100 © The McGraw-Hill Companies, Inc., 2003 5- 76 How about analyzing the Balance Sheet? The same techniques are used to analyze the Balance Sheet. Common-size Analysis: Use the TOTAL ASSETS amount as the 100% figure. So, …….. Express each Balance Sheet item as a % of Total Assets. Trend Analysis: Same approach as used on the income statement. 1. Calculate the $ change for each bal. sheet item. 2. Express the $ change as a % of the previous year’s (or base year’s) amount. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 77 Chapter 5 Remember, Your objectives are to understand what you are doing and to be able to analyze the financial information. Memorization without understanding is meaningless! McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 5- 78 Chapter 5 The End McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003