Learning objective

After studying this chapter, you should be able to:

• Record journal entries for sales transactions involving merchandise.
• Describe briefly cost of goods sold and the distinction between perpetual and periodic inventory procedures.
• Record journal entries for purchase transactions involving merchandise.
• Describe the freight terms and record transportation costs.
• Determine cost of goods sold.
• Prepare a classified income statement.
• Analyze and use the financial results - gross margin percentage.
• Prepare a work sheet and closing entries for a merchandising company (Appendix).

Source: Textbook Equity, https://learn.saylor.org/pluginfile.php/41219/mod_resource/content/3/AccountingPrinciples.pdf
This work is licensed under a Creative Commons Attribution 3.0 License.

A career as a CEO

Are you a leader? Would you enjoy someday becoming the president or chief executive officer (CEO) of the company you work for? Then you should consider a degree in accounting. The accounting field greatly values individuals with leadership potential. Accounting students with the most job offers and the highest starting salaries are also likely to be the ones who best demonstrate an ability to lead others. Recruiters in public accounting (i.e. auditing, tax, consulting) and private accounting (i.e. financial reporting, cost accounting, financial analysis, internal auditing) alike demonstrate a strong preference for students with leadership potential.

Fortunately, you do not have to run a company to demonstrate leadership abilities to college recruiters. Some examples of leadership potential that would look good on a resume include organizing a successful fund-raiser, participating effectively as an officer in a student club, or taking the lead in a group project. If you do not have a resume yet, stop by the career placement center at your college and ask them to assist you in preparing one. Many students at your level already have a resume, and it takes time to refine and develop an effective one. A well-prepared resume will be important for securing internship opportunities and part-time work in the business field, as well as for landing that first job upon graduation.

Did you know that the chief executive officers (CEO) of many of the largest manufacturing, merchandising, and service organizations in the United States have degrees in accounting? James Dimon of JPMorgan Chase, Gary C. Kelly of Southwest Airlines, Phil Knight of Nike, James J. Mulva of ConocoPhillips, and Indra K. Nooyi of PepsiCo all have degrees in accounting. It is really not that surprising that accounting majors are so successful, as accounting provides an excellent foundation in business. With a strong accounting foundation and the continued development of leadership abilities over your career, you might become a CEO yourself someday.

Your study of accounting began with service companies as examples because they are the least complicated type of business. You are now ready to apply the accounting process to a more complex business - a merchandising company. Although the fundamental accounting concepts for service businesses apply to merchandising businesses, merchandise accounting requires some additional accounts and techniques to record sales and purchases.

The normal flow of goods from manufacturer to final customer is as follows:

Manufacturers produce goods from raw materials and normally sell them to wholesalers. After performing certain functions, such as packaging or labeling, wholesalers sell the goods to retailers. Retailers sell the goods to final customers. The two middle boxes in the diagram represent merchandising companies. These companies buy goods in finished form for resale.

This chapter begins by comparing the income statement of a service company with that of a merchandising company. Then, we describe (1) how to record merchandise-related transactions (2) a classified income statement, and (3) the gross margin percentage. Finally, in the appendix we explain the work sheet and the closing process for a merchandising company.

Exhibit 32: Condensed income statements of a service company and a merchandising company compared

Two income statements compared - Service company and merchandising company

In Exhibit 32 we compare the main divisions of an income statement for a service company with those for a merchandising company. To determine profitability or net income, a service company deducts total expenses incurred from revenues earned. A merchandising company is a more complex business and, therefore, has a more complex income statement.

As shown in Exhibit 32, merchandising companies must deduct from revenues the cost of the goods they sell to customers to arrive at gross margin. Then, they deduct other expenses. The income statement of a merchandising company has three main divisions: (1) sales revenues, which result from the sale of goods by the company; (2) cost of goods sold, which is an expense that indicates how much the company paid for the goods sold; and (3) expenses, which are the company's other expenses in running the business.

In the next two sections we discuss the first two main divisions of the income statement of a merchandising company. The third division (expenses) is similar to expenses for a service company, which we illustrated in preceding chapters. As you study these sections, keep in mind how the divisions of the merchandising income statement are related to each other and produce the final figure - net income or net loss - which indicates the profitability of the company.

Sales revenues

The sale of goods occurs between two parties. The seller of the goods transfers them to the buyer in exchange for cash or a promise to pay at a later date. This exchange is a relatively simple business transaction. Sellers make sales to create revenues; this inflow of assets in the form of cash or accounts receivable results from selling goods to customers.

In Exhibit 32, we show a condensed income statement to emphasize its major divisions. Next, we describe the more complete income statement actually prepared by accountants. The merchandising company that we use to illustrate the income statement is Hanlon Retail Food Store. This section explains how to record sales revenues, including the effect of trade discounts. Then, we explain how to record two deductions from sales revenues - sales discounts and sales returns and allowances (Exhibit 33). The amount that remains is net sales. The formula for determining net sales is: Net sales = Gross sales - (Sales discounts + Sales returns and allowances)

HANLON RETAIL FOOD STORE

Partial income Statement

For the Year Ended 2010 December 31

Exhibit 33: Partial income statement of merchandising company

Exhibit 34: Invoice

In a sales transaction, the seller transfers the legal ownership (title) of the goods to the buyer. Usually, the physical delivery of the goods occurs at the same time as the sale of the goods. A business document called an invoice (a sales invoice for the seller and a purchase invoice for the buyer) becomes the basis for recording the sale.

An invoice is a document prepared by the seller of merchandise and sent to the buyer. The invoice contains the details of a sale, such as the number of units sold, unit price, total price billed, terms of sale, and manner of shipment. A retail company prepares the invoice at the point of sale. A wholesale company, which supplies goods to retailers, prepares the invoice after the shipping department notifies the accounting department that it has shipped the goods to the retailer. Exhibit 34 is an example of an invoice prepared by a wholesale company for goods sold to a retail company.

Using the invoice as the source document, a wholesale company records the revenue from the sale at the time of the sale for the following reasons:

• The seller has passed legal title of the goods to the buyer, and the goods are now the responsibility and property of the buyer.
• The seller has established the selling price of the goods.
• The seller has completed its obligation.
• The seller has exchanged the goods for another asset, such as cash or accounts receivable.
• The seller can determine the costs incurred in selling the goods.

Each time a company makes a sale, the company earns revenue. This revenue increases a revenue account called Sales. Recall from Chapter 2 that credits increase revenues. Therefore, the firm credits the Sales account for the amount of the sale.

Usually sales are for cash or on account. When a sale is for cash, the company credits the Sales account and debits Cash. For example, it records a USD 20,000 sale for cash as follows:

When a sale is on account, it credits the Sales account and debits Accounts Receivable. The following entry records a USD 20,000 sale on account:                              

To record the sales of merchandise on account.

Usually, a seller quotes the gross selling price, also called the invoice price, of goods to the buyer. However, sometimes a seller quotes a list price of goods along with available trade discounts. In this latter situation, the buyer must calculate the gross selling price. The list price less all trade discounts is the gross selling price. Merchandising companies that sell goods use the gross selling price as the credit to sales.

An accounting perspective: Uses of technology

A trade discount is a percentage deduction, or discount, from the specified list price or catalog price of merchandise. Companies use trade discounts to:

ñ Reduce the cost of catalog publication. A seller can use a catalog for a longer time by printing list prices in the catalog and giving separate discount sheets to salespersons whenever prices change.

ñ Grant quantity discounts.

ñ Allow quotation of different prices to various customers, such as retailers and wholesalers.

The seller's invoice may show trade discounts. However, sellers do not record trade discounts in their accounting records because the discounts are used only to calculate the gross selling price. Nor do trade discounts appear on the books of the purchaser. To illustrate, assume an invoice contains the following data:

The seller records a sale of USD 3,360. The purchaser records a purchase of USD 3,360. Thus, neither the seller nor the purchaser enters list prices and trade discounts on their books.

Sometimes the list price of a product is subject to several trade discounts; this series of discounts is a chain discount. Chain discounts exist, for example, when a wholesaler receives two trade discounts for services performed, such as packaging and distributing. When more than one discount is given, the buyer applies each discount to the declining balance successively. If a product has a list price of USD 100 and is subject to trade discounts of 20 per cent and 10 per cent, the gross selling price (invoice price) would be USD 100 - 0.2 (USD 100) = USD 80; USD 80 - 0.1(USD 80) = USD 72, computed as follows:

You could obtain the same results by multiplying the list price by the complements of the trade discounts allowed. The complement of 20 per cent is 80 per cent because 20 per cent + 80 per cent = 100 per cent. The complement of 10 per cent is 90 per cent because 10 per cent + 90 per cent = 100 per cent. Thus, the gross selling price is USD 100 X 0.8 X 0.9 = USD 72.

Two common deductions from gross sales are (1) sales discounts and (2) sales returns and allowances. Sellers record these deductions in contra revenue accounts to the Sales account. Contra accounts have normal balances that are opposite to the balance of the account they reduce. For example, since the Sales account normally has a credit balance, the Sales Discounts account and Sales Returns and Allowances account have debit balances. We explain the methods of recording these contra revenue accounts next.

Sales discounts Whenever a company sells goods on account, it clearly specifies terms of payment on the invoice. For example, the invoice in Exhibit 34 states the terms of payment as "net 30".

Net 30 is sometimes written as "n/30". Either way, this term means that the buyer may not take a discount and must pay the entire amount of the invoice (USD 20,000) on or before 30 days after 2010 December 19 (invoice date) - or 2011 January 18. In Exhibit 34, if the terms had read "n/10/EOM"

(EOM means end of month), the buyer could not take a discount, and the invoice would be due on the 10th day of the month following the month of sale - or 2011 January 10. Credit terms vary from industry to industry.

In some industries, credit terms include a cash discount of 1 per cent to 3 per cent to induce early payment of an amount due. A cash discount is a deduction from the invoice price that can be taken only if the invoice is paid within a specified time. A cash discount differs from a trade discount in that a cash discount is a deduction from the gross selling price for the prompt payment of an invoice. In contrast, a trade discount is a deduction from the list price to determine the gross selling price (or invoice price). Sellers call a cash discount a sales discount and buyers call it a purchase discount.

Companies often state cash discount terms as follows:

• 2/10, n/30 - means a buyer who pays within 10 days following the invoice date may deduct a discount of 2 per cent of the invoice price. If payment is not made within the discount period, the entire invoice price is due 30 days from the invoice date.
• 2/EOM, n/60 - means a buyer who pays by the end of the month of purchase may deduct a 2 per cent discount from the invoice price. If payment is not made within the discount period, the entire invoice price is due 60 days from the invoice date.
• 2/10/EOM, n/60 - means a buyer who pays by the 10th of the month following the month of purchase may deduct a 2 per cent discount from the invoice price. If payment is not made within the discount period, the entire invoice price is due 60 days from the invoice date.

Sellers cannot record the sales discount before they receive the payment since they do not know when the buyer will pay the invoice. A cash discount taken by the buyer reduces the cash that the seller actually collects from the sale of the goods, so the seller must indicate this fact in its accounting records. The following entries show how to record a sale and a subsequent sales discount.

Assume that on July 12, a business sold merchandise for USD 2,000 on account; terms are 2/10, n/30. On July 21 (nine days after invoice date), the business received a USD 1,960 check in payment of the account. The required journal entries for the seller are:

The Sales Discounts account is a contra revenue account to the Sales account. In the income statement, the seller deducts this contra revenue account from gross sales. Sellers use the Sales Discounts account (rather than directly reducing the Sales account) so management can examine the sales discounts figure to evaluate the company's sales discount policy. Note that the Sales Discounts account is not an expense incurred in generating revenue. Rather, the purpose of the account is to reduce recorded revenue to the amount actually realized from the sale.

Sales returns and allowances Merchandising companies usually allow customers to return goods that are defective or unsatisfactory for a variety of reasons, such as wrong color, wrong size, wrong style, wrong amounts, or inferior quality. In fact, when their policy is satisfaction guaranteed, some companies allow customers to return goods simply because they do not like the merchandise. A sales return is merchandise returned by a buyer. Sellers and buyers regard a sales return as a cancellation of a sale. Alternatively, some customers keep unsatisfactory goods, and the seller gives them an allowance off the original price. A sales allowance is a deduction from the original invoiced sales price granted when the customer keeps the merchandise but is dissatisfied for any of a number of reasons, including inferior quality, damage, or deterioration in transit. When a seller agrees to the sales return or sales allowance, the seller sends the buyer a credit memorandum indicating a reduction (crediting) of the buyer's account receivable. A credit memorandum is a document that provides space for the name and address of the concerned parties, followed by a space for the reason for the credit and the amount to be credited. A credit memorandum becomes the basis for recording a sales return or a sales allowance.

In theory, sellers could record both sales returns and sales allowances as debits to the Sales account because they cancel part of the recorded selling price.

However, because the amount of sales returns and sales allowances is useful information to management, it should be shown separately. The amount of returns and allowances in relation to goods sold can indicate the quality of the goods (high-return percentage, equals low quality) or of pressure applied by salespersons (high-return percentage, equals high-pressure sales). Thus, sellers record sales returns and sales allowances in a separate Sales Returns and Allowances account. The Sales Returns and Allowances account is a contra revenue account (to Sales) that records the selling price of merchandise returned by buyers or reductions in selling prices granted. (Some companies use separate accounts for sales returns and for sales allowances, but this text does not.)

Following are two examples illustrating the recording of sales returns in the Sales Returns and Allowances account:

• Assume that a customer returns USD 300 of goods sold on account. If payment has not yet been received, the required entry is:

• Assume that the customer has already paid the account and the seller gives the customer a cash refund. Now, the credit is to Cash rather than to Accounts Receivable. If the customer has taken a 2 per cent discount when paying the account, the company would return to the customer the sales price less the sales discount amount. For example, if a customer returns goods that sold for USD 300, on which a 2 per cent discount was taken, the following entry would be made:

The debit to the Sales Returns and Allowances account is for the full selling price of the purchase.

The credit of USD 6 reduces the balance of the Sales Discounts account.

Next, we illustrate the recording of a sales allowance in the Sales Returns and Allowances account. Assume that a company grants a USD 400 allowance to a customer for damage resulting from improperly packed merchandise. If the customer has not yet paid the account, the required entry would be:

If the customer has already paid the account, the credit is to Cash instead of Accounts Receivable. If the customer took a 2 per cent discount when paying the account, the company would refund only the net amount (USD 392). Sales Discounts would be credited for USD 8. The entry would be:

HANLON RETAIL FOOD STORE
Partial income Statement
For the Year Ended 2010 December 31

*This illustration is the same as Exhibit 33, repeated here for your convenience.

Exhibit 35: Partial income statement*

Exhibit 35 shows how a company could report sales, sales discounts, and sales returns and allowances in the income statement. More often, the income statement in a company's annual report begins with "Net sales" because sales details are not important to external financial statement users.

An accounting perspective: Business insight

An accounting perspective: Business insight

Cost of goods sold

Classified income statement

In preceding chapters, we illustrated the unclassified (or single-step) income statement. An unclassified income statement has only two categories - revenues and expenses. In contrast, a classified income statement divides both revenues and expenses into operating and nonoperating items. The statement also separates operating expenses into selling and administrative expenses. A classified income statement is also called a multiple-step income statement.

In Exhibit 39, we present a classified income statement for Hanlon Retail Food Store. This statement uses the previously presented data on sales (Exhibit 35) and cost of goods sold (Exhibit 38), together with additional assumed data on operating expenses and other expenses and revenues. Note in Exhibit 39 that a classified income statement has the following four major sections:

• Operating revenues.
• Cost of goods sold.
• Operating expenses.
• Nonoperating revenues and expenses (other revenues and other expenses).

The classified income statement shows important relationships that help in analyzing how well the company is performing. For example, by deducting cost of goods sold from operating revenues, you can determine by what amount sales revenues exceed the cost of items being sold. If this margin, called gross margin, is lower than desired, a company may need to increase its selling prices and/or decrease its cost of goods sold. The classified income statement subdivides operating expenses into selling and administrative expenses. Thus, statement users can see how much expense is incurred in selling the product and how much in administering the business. Statement users can also make comparisons with other years' data for the same business and with other businesses. Nonoperating revenues and expenses appear at the bottom of the income statement because they are less significant in assessing the profitability of the business.

An accounting perspective: Business insight

Management chooses whether to use a classified or unclassified income statement to present a company's financial data. This choice may be based either on how their competitors present their data or on the costs associated with assembling the data.

HANLON RETAIL FOOD STORE
Income Statement
For the Year Ended 2010 December 31

 Exhibit 39: Classified income statement for a merchandising company

Next, we explain the major headings of the classified income statement in Exhibit 39. The terms in some of these headings are already familiar to you. Although future illustrations of classified income statements may vary somewhat in form, we retain the basic organization.

• Operating revenues are the revenues generated by the major activities of the business - usually the sale of products or services or both.
• Cost of goods sold is the major expense in merchandising companies. Note the cost of goods sold section of the classified income statement in Exhibit 39. This chapter has already discussed the items used in calculating cost of goods sold. Merchandisers usually highlight the amount by which sales revenues exceed the cost of goods sold in the top part of the income statement. The excess of net sales over cost of goods sold is the gross margin or gross profit. To express gross margin as a percentage rate, we divide gross margin by net sales. In Exhibit 39, the gross margin rate is approximately 39.3 per cent (USD 103,000/USD 262,000). The gross margin rate indicates that out of each sales dollar, approximately 39 cents is available to cover other expenses and produce income. Business owners watch the gross margin rate closely since a small percentage fluctuation can cause a large dollar change in net income. Also, a downward trend in the gross margin rate may indicate a problem, such as theft of merchandise. For instance, one Southeastern sporting goods company, SportsTown, Inc., suffered significant gross margin deterioration from increased shoplifting and employee theft.
• Operating expenses for a merchandising company are those expenses, other than cost of goods sold, incurred in the normal business functions of a company. Usually, operating expenses are either selling expenses or administrative expenses. Selling expenses are expenses a company incurs in selling and marketing efforts. Examples include salaries and commissions of salespersons, expenses for salespersons' travel, delivery, advertising, rent (or depreciation, if owned) and utilities on a sales building, sales supplies used, and depreciation on delivery trucks used in sales. Administrative expenses are expenses a company incurs in the overall management of a business. Examples include administrative salaries, rent (or depreciation, if owned) and utilities on an administrative building, insurance expense, administrative supplies used, and depreciation on office equipment.

Certain operating expenses may be shared by the selling and administrative functions. For example, a company might incur rent, taxes, and insurance on a building for both sales and administrative purposes. Expenses covering both the selling and administrative functions must be analyzed and prorated between the two functions on the income statement. For instance, if USD 1,000 of depreciation expense relates 60 per cent to selling and 40 per cent to administrative based on the square footage or number of employees, the income statement would show USD 600 as a selling expense and USD 400 as an administrative expense.

• Nonoperating revenues (other revenues) and nonoperating expenses (other expenses) are revenues and expenses not related to the sale of products or services regularly offered for sale by a business. An example of a nonoperating revenue is interest that a business earns on notes receivable. An example of a nonoperating expense is interest incurred on money borrowed by the company.

To summarize the more important relationships in the income statement of a merchandising firm in equation form:

• Net sales = Gross sales - (Sales discounts + Sales returns and allowances).
• Net purchases = Purchases - (Purchase discounts + Purchase returns and allowances).
• Net cost of purchases = Net purchases + Transportation-in.
• Cost of goods sold = Beginning inventory + Net cost of purchases - Ending inventory.
• Gross margin = Net sales - Cost of goods sold.
• Income from operations = Gross margin - Operating (selling and administrative) expenses.
• Net income = Income from operations + Nonoperating revenues - Nonoperating expenses.

Each of these relationships is important because of the way it relates to an overall measure of business profitability. For example, a company may produce a high gross margin on sales. However, because of large sales commissions and delivery expenses, the owner may realize only a very small percentage of the gross margin as profit. The classifications in the income statement allow a user to focus on the whole picture as well as on how net income was derived (statement relationships).

An ethical perspective: World auto parts corporation

John Bentley is the chief financial officer for World Auto Parts Corporation. The company buys approximately USD 500 million of auto parts each year from small suppliers all over the world and resells them to auto repair shops in the United States. Most of the suppliers have cash discount terms of 2/10, n/30. John has instructed his personnel to pay invoices on the 30th day after the invoice date but to take the 2 per cent discount even though they are not entitled to do so. Whenever a supplier complains, John instructs his purchasing agent to find another supplier who will go along with this practice. When some of his own employees questioned the practice, John responded as follows:

This practice really does no harm. These small suppliers are much better off to go along and have our business than to not go along and lose it. For most of them, we are their largest customer. Besides, if they are willing to sell to others at a 2 per cent discount, why should they not be willing to sell to us at that same discount even though we pay a little later? The benefit to our company is very significant. Last year our profits were USD 100 million. A total of USD 10 million of the profits was attributable to this practice. Do you really want me to change this practice and give up USD 10 million of our profits?

Analyzing and using the financial results - Gross margin percentage

Understanding the learning objectives

Appendix: The work sheet for a merchandising company

Exhibit 40 shows a work sheet for a merchandising company. Lyons Company is a small sporting goods firm. The illustration for Lyons Company focuses on merchandise-related accounts. Thus, we do not show the fixed assets (land, building, and equipment). Except for the merchandise-related accounts, the work sheet for a merchandising company is the same as for a service company. Recall that use of a work sheet assists in the preparation of the adjusting and closing entries. The work sheet also contains all the information needed for the preparation of the financial statements.

To further simplify this illustration, assume Lyons needs no adjusting entries at month-end. The trial balance is from the ledger accounts at 2010 December 31. The USD 7,000 merchandise inventory in the trial balance is the beginning inventory. The sales and sales-related accounts and the purchases and purchases-related accounts summarize the merchandising activity for December 2010.

Lyons carries any revenue accounts (Sales) and contra purchases accounts (Purchase Discounts, Purchase Returns, and Allowances) in the Adjusted Trial Balance credit columns of the work sheet to the Income Statement credit column. It carries beginning inventory, contra revenue accounts (Sales Discounts, Sales Returns, and Allowances), Purchases, Transportation-In, and expense accounts (Selling Expenses, Administrative Expenses) in the Adjusted Trial Balance debit column to the Income Statement debit column.

Assume that ending inventory is USD 8,000. Lyons enters this amount in the Income Statement credit column because it is deducted from cost of goods available for sale (beginning inventory plus net cost of purchases) in determining cost of goods sold. It also enters the ending inventory in the Balance Sheet debit column to establish the proper balance in the Merchandise Inventory account. The beginning and ending inventories are on the Income Statement because Lyons uses both to calculate cost of goods sold in the income statement. Net income of USD 5,843 for the period balances the Income Statement columns. The firm carries the net income to the Statement of Retained Earnings credit column. Retained earnings of USD 18,843 balances the Statement of Retained Earnings columns. Lyons Company carries the retained earnings to the Balance Sheet credit column.

Lyons carries all other asset account balances (Cash, Accounts Receivable, and ending Merchandise

Inventory) to the Balance Sheet debit column. It also carries the liability (Accounts Payable) and Capital Stock account balances to the Balance Sheet credit column. The balance sheet columns total to USD 29,543.

Once the work sheet has been completed, Lyons prepares the financial statements. After entering any adjusting and closing entries in the journal, the firm posts them to the ledger. This process clears the records for the next accounting period. Finally, it prepares a post-closing trial balance.

Income statement Exhibit 41 shows the income statement Lyons prepared from its work sheet in Exhibit 40. The focus in this income statement is on determining the cost of goods sold.

Statement of retained earnings The statement of retained earnings, as you recall, is a financial statement that summarizes the transactions affecting the Retained Earnings account balance. In Exhibit 42, the statement of retained earnings shows an increase in equity resulting from net income and a decrease in equity resulting from dividends.

LYONS COMPANY
Worksheet
For the Month Ended 2010 December 31

Exhibit 40: Work sheet for a merchandising company

LYONS COMPANY
Income Statement
For the Month Ended 2010 December 31

Exhibit 41: Income statement for a merchandising company

LYONS COMPANY
Statement of Retained Earnings
For the Month Ended 2010 December 31

Exhibit 42: Statement of retained earnings

LYONS COMPANY
Balance Sheet 2010 December 31

Exhibit 43: Balance sheet for a merchandising company

Balance sheet The balance sheet, Exhibit 43, contains the assets, liabilities, and stockholders' equity items taken from the work sheet. Note the USD 8,000 ending inventory is a current asset. The Retained Earnings account balance comes from the statement of retained earnings.

Recall from Chapter 4 that the closing process normally takes place after the accountant has prepared the financial statements for the period. The closing process closes revenue and expense accounts by transferring their balances to a clearing account called Income Summary and then to Retained Earnings. The closing process reduces the revenue and expense account balances to zero so that information for each accounting period may be accumulated separately.

Lyons's accountant would prepare closing entries directly from the work sheet in Exhibit 40 using the same procedure presented in Chapter 4. The closing entries for Lyons Company follow.

The first journal entry debits all items appearing in the Income Statement credit column of the work sheet and credits Income Summary for the total of the column, USD 22,782.

• 1^st Entry

The second entry credits all items appearing in the Income Statement debit column and debits Income Summary for the total of that column, USD 16,939.

• 2^nd entry

The third entry closes the credit balance in the Income Summary account of USD 5,843 to the Retained Earnings account.

The fourth entry closes the Dividends account balance of $2,000 to the Retained Earnings account by debiting Retained Earnings and crediting Dividends.

Note how the first three closing entries tie into the totals in the Income Statement columns of the work sheet in Exhibit 40. In the first closing journal entry, the credit to the Income Summary account is equal to the total of the Income Statement credit column. In the second entry, the debit to the Income Summary account is equal to the subtotal of the Income Statement debit column. The difference between the totals of the two Income Statement columns (USD 5,843) represents net income and is the amount of the third closing entry.

Key terms

Adjunct account Closely related to another account; its balance is added to the balance of the related account in the financial statements.

Administrative expenses Expenses a company incurs in the overall management of a business.

Cash discount A deduction from the invoice price that can be taken only if the invoice is paid within a specified time. To the seller, it is a sales discount; to the buyer, it is a purchase discount. Chain discount Occurs when the list price of a product is subject to a series of trade discounts.

Classified income statement Divides both revenues and expenses into operating and nonoperating items. The statement also separates operating expenses into selling and administrative expenses. Also called the multiple-step income statement.

Consigned goods Goods delivered to another party who attempts to sell the goods for the owner at a commission.

Cost of goods available for sale Equal to beginning inventory plus net cost of purchases.

Cost of goods sold Shows the cost to the seller of the goods sold to customers; under periodic inventory procedure, cost of goods sold is computed as Beginning inventory + Net cost of purchases - Ending inventory.

Delivery expense A selling expense recorded by the seller for freight costs incurred when terms are FOB destination.

FOB destination Means free on board at destination; goods are shipped to their destination without charge to the buyer; the seller is responsible for paying the freight charges.

FOB shipping point Means free on board at shipping point; buyer incurs all transportation costs after the merchandise is loaded on a railroad car or truck at the point of shipment.

Freight collect Terms that require the buyer to pay the freight bill on arrival of the goods.

Freight prepaid Terms that indicate the seller has paid the freight bill at the time of shipment.

Gross margin or gross profit Net sales - Cost of goods sold; identifies the number of dollars available to cover expenses other than cost of goods sold.

Gross margin percentage Gross margin divided by net sales.

Gross selling price (also called the invoice price) The list price less all trade discounts.

Income from operations Gross margin - Operating (selling and administrative) expenses.

Invoice A document prepared by the seller of merchandise and sent to the buyer. It contains the details of a sale, such as the number of units sold, unit price, total price billed, terms of sale, and manner of shipment. It is a purchase invoice from the buyer’s point of view and a sales invoice from the seller’s point of view.

Manufacturers Companies that produce goods from raw materials and normally sell them to wholesalers.

Merchandise in transit Merchandise in the hands of a freight company on the date of a physical inventory.

Merchandise inventory The quantity of goods available for sale at any given time.

Net cost of purchases Net purchases + Transportation-in.

Net income Income from operations + Nonoperating revenues - Nonoperating expenses.

Net purchases Purchases - (Purchase discounts +Purchase returns and allowances).

Net sales Gross sales - (Sales discounts + Sales returns and allowances).

Nonoperating expenses (other expenses) Expenses incurred by a business that are not related to the acquisition and sale of the products or services regularly offered for sale.

Nonoperating revenues (other revenues) Revenues not related to the sale of products or services regularly offered for sale by a business.

Operating expenses Those expenses other than cost of goods sold incurred in the normal business functions of a company.

Operating revenues Those revenues generated by the major activities of a business.

Passage of title A legal term used to indicate transfer of legal ownership of goods.

Periodic inventory procedure A method of accounting for merchandise acquired for sale to customers wherein the cost of merchandise sold and the cost of merchandise on hand are determined only at the end of the accounting period by taking a physical inventory.

Perpetual inventory procedure A method of accounting for merchandise acquired for sale to customers wherein the Merchandise Inventory account is continuously updated to reflect items on hand; this account is debited for each purchase and credited for each sale so that the current balance is shown in the account at all times.

Physical inventory Consists of counting physical units of each type of merchandise on hand.

Purchase discount See Cash discount.

Purchase Discounts account A contra account to Purchases that reduces the recorded gross invoice cost of the purchase to the price actually paid.

Purchase Returns and Allowances account An account used under periodic inventory procedure to record the cost of merchandise returned to a seller and to record reductions in selling prices granted by a seller because merchandise was not satisfactory to a buyer; viewed as a reduction in the recorded cost of purchases.

Purchases account An account used under periodic inventory procedure to record the cost of goods or merchandise bought for resale during the current accounting period.

Retailers Companies that sell goods to final consumers.

Sales allowance A deduction from original invoiced sales price granted to a customer when the customer keeps the merchandise but is dissatisfied for any of a number of reasons, including inferior quality, damage, or deterioration in transit.

Sales discount See Cash discount.

Sales Discounts account A contra revenue account to Sales; it is shown as a deduction from gross sales in the income statement.

Sales return From the seller’s point of view, merchandise returned by a buyer for any of a variety of reasons; to the buyer, a purchase return.

Sales Returns and Allowances account A contra revenue account to Sales used to record the selling price of merchandise returned by buyers or reductions in selling prices granted.

Selling expenses Expenses a company incurs in selling and marketing efforts.

Trade discount A percentage deduction, or discount, from the specified list price or catalog price of merchandise to arrive at the gross invoice price; granted to particular categories of customers (e.g. retailers and wholesalers). Also see Chain discount.

Transportation-In account An account used under periodic inventory procedure to record inward freight costs incurred in the acquisition of merchandise; a part of cost of goods sold.

Unclassified income statement Shows only major categories for revenues and expenses. Also called the single-step income statement.

Wholesalers Companies that normally sell goods to other companies (retailers) for resale.