Financial Accounting Chapter 5

Merchandising Companies

• Merchandising companies are businesses that buy and sell goods instead of services.
• Two main types: retailers and wholesalers.
• Retailers sell directly to final consumers (e.g., Walmart), whereas wholesalers sell to retailers.

Revenue Recognition

• Both retailers and wholesalers record revenue in the same manner.
• Primary source of revenue is called sales revenue or simply revenue.

Income Statement Insights

• The largest expense typically found on an income statement is the cost of goods sold (COGS), listed first.
• Gross Profit is calculated by subtracting Cost of Goods Sold from Revenues.

Service Company vs. Merchandising Company

• Service companies do not report COGS or Gross Profit on their income statements.
• The operating cycle for a service company involves cash flows from performing services to collecting accounts receivable.
• Merchandising companies have a longer operating cycle including purchasing inventory, selling it, and collecting cash from customers.

Inventory Calculations

• Cost of Goods Available for Sale is computed as Beginning Inventory plus Cost of Goods Purchased.
• To determine COGS or Ending Inventory, subtract COGS from Goods Available for Sale.

Inventory Systems

• Periodic Inventory System:
  • Does not maintain detailed records; COGS is determined at the end of the accounting period via a physical count.
• Perpetual Inventory System:
  • Keeps detailed records of every inventory purchase and sale. Each sale updates inventory instantly.

Perpetual System Advantages

• Offers ongoing insights into inventory quantities and costs.
• Provides superior control and measurement compared to a periodic system.
• Commonly used for high unit value merchandise.

Inventory Transactions

• Inventory cost is recorded when goods are received from the seller.
• A purchase invoice provides details about the goods and the associated costs.

Inventory Ownership and Freight Terms

• FOB Shipping Point: Buyer assumes ownership and pays freight costs once goods are accepted by the carrier.
• FOB Destination: Seller retains ownership until the goods reach the buyer; the seller covers transportation costs.

Purchase Allowances and Discounts

• A Purchase Allowance allows buyers to keep goods with a price reduction from the seller.
• Returns or allowances reduce the inventory account, credited in the perpetual inventory system.
• Purchase discounts benefit both buyers (cost saving) and sellers (faster cash conversion).

Payment Terms

• 2/10, n/30: 2% discount if paid within 10 days; otherwise, the full amount is due in 30 days.
• 1/10 EOM: 1% discount if paid within the first 10 days of the following month.
• n/10 EOM: Full amount due within the first 10 days of the next month.

Accounting for Sales

• In a perpetual inventory system, when goods are sold for cash, two journal entries are made: one for sales revenue and another for recording COGS and reducing inventory.

Quality of Earnings

• A quality of earnings ratio significantly less than 1 may indicate aggressive accounting practices to accelerate income recognition.

Practical Example

• If Cosmos Corporation, using a perpetual system, bought $2,000 worth of merchandise, returned $400, and pays its bill later under credit terms of 2/10, n/30, the cash credited when paying would be $1,600.