Financial Accounting Chapter 5

Questions and Answers

What are merchandising companies?

Companies that buy and sell goods (rather than sell services)

What are the two types of merchandising companies?

Service Providers

Retailers (correct)

Manufacturers

Wholesalers (correct)

Define: Retailer

A company that sells its merchandise to customers who are the final consumers of the product.

What are wholesalers?

Companies who sell products to retailers who later sell them to the final customers. Signup and view all the answers

There is a difference in how revenue is recorded for wholesalers versus retailers.

False Signup and view all the answers

The primary source of revenues is referred to as?

Sales revenue Signup and view all the answers

What tends to be the largest expense on the income statement?

Cost of goods sold Signup and view all the answers

How do we find gross profit?

Revenues - Cost of Goods Sold Signup and view all the answers

What two things are ignored in the income statement of a service company?

Gross Profit Signup and view all the answers

What is the operating cycle of a service company?

Cash --> Perform Services --> Accounts Receivable --> Mail --> Receive Cash Signup and view all the answers

What is the operating cycle of a merchandising company?

Cash --> Buy Inventory --> Deliver --> Inventory --> Sell Inventory --> Accounts Receivable --> Mail --> Receive Cash Signup and view all the answers

The operating cycle of a company is ordinarily longer than that of a company.

merchandising, service Signup and view all the answers

How do you find the cost of goods available for sale?

Beginning Inventory + Cost of Goods Purchased Signup and view all the answers

How do you find cost of goods sold or ending inventory?

You subtract Cost of Goods Sold from Cost of Goods Available for Sale to find ending inventory. Signup and view all the answers

What are the characteristics of the periodic inventory system?

Doesn't keep detailed records of the goods on hand = True Cost of goods sold is determined by count at the end of the accounting period = True Signup and view all the answers

How is the calculation of goods sold done in the periodic system?

Beginning Inventory + Purchases, net - Ending Inventory Signup and view all the answers

What are the characteristics of the perpetual system?

Maintain detailed records of the cost of each inventory purchase and sale = True Records continuously show inventory that should be on hand for every item = True Company determines cost of goods sold each time a sale occurs = True Signup and view all the answers

What are the advantages of the perpetual system?

Shows the quantity and cost of inventory on hand at any time Signup and view all the answers

When do we record the cost of inventory?

When the goods are received from the seller Signup and view all the answers

What is a purchase invoice?

It tells us what we're buying and how much it costs. Signup and view all the answers

If a company is given an invoice with inventory, how would they record this in a journal to show perpetual inventory?

Debit to inventory for amount, credit to accounts payable for same amount Signup and view all the answers

What does FOB shipping point mean?

The buyer pays for freight costs and gains ownership once the public carrier accepts the goods. Signup and view all the answers

What does FOB destination mean?

Ownership of the goods remains with the seller until the goods reach the buyer. Signup and view all the answers

Freight costs incurred by the seller are classified as?

Operating expense Signup and view all the answers

What is a purchase allowance?

The buyer may keep merchandise if the seller grants a price reduction. Signup and view all the answers

How do we record returns or allowances in the perpetual inventory system for buyers?

Decreases in the inventory account with a credit to the inventory T account. Signup and view all the answers

In a perpetual inventory system, a return of defective merchandise by a purchaser is recorded by crediting?

Inventory Signup and view all the answers

What are the advantages of purchase discounts?

Purchaser saves money Signup and view all the answers

What does this mean: 2/10, n/30?

2% discount if paid within 10 days, otherwise net amount due within 30 days Signup and view all the answers

What does this mean: 1/10 EOM?

1% discount if paid within the first 10 days of next month Signup and view all the answers

What does this mean: n/10 EOM?

Net amount due within the first 10 days of the next month Signup and view all the answers

The cost of goods sold is determined and recorded each time a sale occurs in a perpetual inventory system.

True Signup and view all the answers

Why are sales discounts offered?

To promote prompt payment of the balance due Signup and view all the answers

What quality of earnings ratio might a company have if it is using more aggressive accounting techniques to accelerate income recognition?

Significantly less than 1 Signup and view all the answers

Cosmos Corporation, which uses a perpetual inventory system, purchased $2,000 of merchandise on July 5 on account. Credit terms were 2/10, n/30. It returned $400 of the merchandise on July 9. What is one effect when Cosmos pays its bill on July 21?

Credit to Cash for $1,600 Signup and view all the answers

When recording the sale of goods for cash in a perpetual inventory system, what entries are made in the journal?

Two journal entries: one for cash receipt and sales revenue; the other for cost of goods sold and inventory reduction. Signup and view all the answers

Sales revenue less gross profit results in?

Cost of Goods Sold Signup and view all the answers

Study Notes

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.

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