Accounting for Service and Merchandising Companies

Reporting Income for a Service Company

• Service companies sell a service to earn revenue
• Service companies do not have inventory
• Service companies have only one cost of goods sold: expenses

Reporting Income for a Merchandiser

• Merchandising companies sell products to earn revenue
• Examples of a merchandiser: clothing, shoes, sporting goods
• Net sales - cost of goods sold = gross profit - expenses = net income
• Example: Nordstrom sells $1000 worth of shoes, the cost to buy the shoes from Nike is $200, so gross profit is $800, then subtract $100 in wage expenses for a net income of $700

Operating Cycle for a Merchandiser

• Begins with the purchase of merchandise and ends with the collection of cash for the sale of merchandise

Inventory Systems

• Perpetual system keeps a running count of inventory
• Periodic system counts up inventory at the end of the period

Perpetual Inventory Systems

• Tracks the cost of each purchase and sale of inventory
• Information is readily available for determining the amount of inventory on hand at any time
• Purchases
  • Debits inventory when purchasing goods
  • Credits cash or accounts payable based on method of payment
• Sales
  • Debits cash or accounts receivable
  • Credits sales revenue
  • Debits cost of goods sold and credits inventory for the amount the goods are sold

Transactions for Merchandise Purchases

• Purchases without Cash Discounts:: When inventory is bought
• Purchases with Cash Discounts:: Discount is offered for paying within a specified period

Purchases with Cash Discounts: Gross Method

• Cash discount is recorded when payment is made
• Example: Inventory cost $1000, cash discount is 2/10, n/30
  • Paid within 10 days:
    • Debit Inventory - $20
    • Credit Cash - $980
  • Paid after 10 days:
    • Debit Inventory - $0
    • Credit Cash - $1000

Payment within Discount Period: Journal Entry

• Debit inventory for the amount of the discount
• Credit cash for the net purchase price

Payment after Discount Period

• No discount is recorded
• Debit Inventory for the full cost of the goods
• Credit cash for the full purchase price

Allowances

• Seller allows a customer to return goods or may reduce the price for damaged goods
• Purchase Allowances:
  • Debit Accounts Payable or Cash
  • Credit Inventory
• Sales Allowances:
  • Debit Sales Returns and Allowances
  • Credit Accounts Receivable or Cash

Shipping Terms

• FOB Shipping Point: Buyer pays for the transportation costs
  • Example: If you buy a car from a dealership in California and are picking it up in New York, the shipping costs from California to New York are your responsibility
• FOB Destination: Seller pays for the transportation costs
  • Example: If you order a rug online, the seller is most likely going to pay for the cost of having the rug shipped to your home

Itemized Costs of Purchases

• Inventory is debited for everything that increases the cost of inventory
• Inventory is credited for everything that decreases the cost of inventory
• Example of costs that are added to inventory:
  • Freight (freight paid by the buyer)
• Example of costs that are subtracted from inventory:
  • Purchase returns
  • Purchase allowances

Acid-Test Ratio

• A measure of a company's ability to pay its current liabilities with its most liquid assets
• Formula: Quick Assets (Cash + Short-Term Investments + Receivables) / Current Liabilities
• A value of at least 1.0 indicates that a company should be able to pay its current liabilities

Gross Margin Ratio

• Measures the percentage of sales available to cover expenses and provide a profit
• Formula: Net Sales - Cost of Goods Sold / Net Sales
• Example: A gross margin ratio of 40% means that 40% of sales are available to cover expenses and provide a profit

Determining Inventory Items

• Merchandise Inventory: Goods held for sale
• Raw Materials Inventory: Goods used in the manufacturing process
• Goods in Process Inventory: Goods that are partially completed in the manufacturing process
• Finished Goods Inventory: Goods that are completed and waiting to be sold

Goods in Transit

• Goods that are being shipped from the seller to the buyer
• FOB shipping point:
  • Goods are owned by the buyer once shipped
• FOB destination:
  • Goods are owned by the seller until they reach the buyer

Goods on Consignment

• Goods that are held by a consignee for sale
• The consignor owns the goods and the consignee sells the goods for them
• The consignee does not take ownership of the goods but they receive a commission for their sale

Goods Damaged or Obsolete

• These items are not included in inventory because they are considered to have no value or minimal value
• Any value they do have will be classified as a loss

Determining Inventory Costs

• Specific Identification Method:
  • This method is used when it is easy to identify the goods that were sold
• **FIFO (First-In, First-Out): **
  • This method assumes that the oldest inventory is the first to be sold
• **LIFO (Last-In, First-Out): **
  • This method assumes that the newest inventory is the first to be sold
• Weighted-Average Method:
  • This method uses a weighted average to calculate the cost of goods sold

Taking a Physical Count

• Inventory is physically counted to verify the quantity and quality of goods on hand
• This is done periodically based on the company's needs

Inventory Costing Methods: Perpetual System

• Specific Identification Method:
  • This method is used when it is easy to identify the goods that were sold
• **FIFO (First-In, First-Out): **
  • This method assumes that the oldest inventory is the first to be sold
• **LIFO (Last-In, First-Out): **
  • This method assumes that the newest inventory is the first to be sold
• Weighted-Average Method:
  • This method uses a weighted average to calculate the cost of goods sold
  • This method is a compromise between FIFO and LIFO

Lower of Cost or Market (LCM)

• The market value of inventory is compared to its cost
• The lower of the two values is used for inventory valuation and cost of goods sold
• This ensures that inventory is not overvalued and protects the company from potential losses

Effects of Inventory Methods for Financial and Tax Reporting

• FIFO:
  • This method results in the highest net income and the highest ending inventory balance during periods of rising prices
• LIFO:
  • This method results in the lowest net income and the lowest ending inventory balance during periods of rising prices
• Weighted-Average:
  • This method results in a net income and ending inventory balance that is between FIFO and LIFO

Effects of Inventory Error on Financial Statements

• An error in inventory can have a significant impact on the financial statements
• Examples of errors:
  • Incorrect counts of inventory
  • Incorrect costing methods
  • Overstating or understating inventory

Inventory Turnover and Days' Sales in Inventory Ratios

• These ratios measure how efficiently a company is managing its inventory
• Inventory Turnover Ratio:
  • measures how quickly a company is selling its inventory
  • Formula: Cost of Goods Sold / Average Inventory
• Days' Sales in Inventory:
  • measures the average number of days that inventory is held before it is sold
  • Formula: (Average Inventory / Cost of Goods Sold) * 365

Accounts Receivables

• Cash balances owed by customers
• Direct Write-Off Method:
  • Records the amount of bad debts when it is determined that a customer will not pay
  • This method is not allowed under GAAP because it does not match the expense to revenue
• Allowance Method:
  • Estimates the amount of bad debts that is expected to be uncollectible
  • This is a more common method than the direct write-off method because it matches the expense to revenue

Allowance Methods

• Percentage of Sales Method:
  • Estimates bad debts as a percentage of sales
  • This method is easier to use but less accurate than the other methods
• Percentage of Receivables Method:
  • Estimates bad debts as a percentage of accounts receivable
  • This method is more accurate than the percentage of sales method but more complex
• Aging of Receivables Method:
  • Estimates bad debts by aging the accounts receivable to determine how long they have been outstanding
  • This method is the most accurate method but also the most complex method

Aging of Accounts Receivable

• This method groups accounts receivable by the date of the transaction
• The older the account, the less likely it is to be collected

Notes Receivables

• A written promise to pay a specific sum of money on a specified date
• They usually bear interest
• Honoring a note: When the maker pays the Note at maturity
• Dishonoring a note: When the maker fails to pay the Note at maturity

Recording Notes Receivable

• When a company accepts a Note, a journal entry is made to record the Note Receivable
• Debit Notes Receivable for the face value of the Note
• Credit Accounts Receivable for the amount of the accounts receivable that is being converted into a Note

Notes Receivable in Acceptance of Past-Due Accounts Receivable

• This is used when a customer is unable to pay an account receivable and a Note is given to the company in exchange
• Debit Notes Receivable and Credit Accounts Receivable in a journal entry

Honoring and Dishonoring of a Note and Adjustments for Interest

• A journal entry is made to remove the Note when it is paid at maturity
• To record an honored note:
  • Debit Cash for the amount of the note and the interest for the note
  • Credit Notes Receivable for the face value of the note
  • Credit Interest Revenue for the amount of interest earned
• To record a dishonored note:
  • Debit Accounts Receivable for the amount of the note and the interest earned
  • Credit Notes Receivable for the face value of the note
  • Credit Interest Revenue for the amount of interest earned

Recording End-of-Period Interest Adjustments

• Under the accrual basis of accounting, interest earned on Notes Receivable is recognized in the accounting period in which it is earned
• To record accrued interest:
  • Debit Interest Receivable and Credit Interest Revenue
  • Interest Receivable represents the interest that has been earned but not yet received

Disposal of Receivables

• Factoring: Selling accounts receivable to a finance company
• Assigning: Transferring accounts receivable to a bank, but the original company remains responsible for the account

Accounts Receivable Turnover

• Measures how quickly a company is collecting its accounts receivable
• Formula: Net Sales / Average Accounts Receivable
• A higher turnover rate of accounts receivable is generally better than a low turnover rate
• Higher accounts receivable turnover generally represents:
  • A faster collection process
  • Better management of credit and collections
• Lower accounts receivable turnover generally represents:
  • Slower cash collection process
  • Poor management of credit and collections