## Introduction to Inventories and the Classified Income Statement

Read this chapter and pay attention to the comparison of the two income statements. This chapter reviews the difference in reporting and financial presentation of information for service and merchandising operations and compares recording inventories for two separate types of businesses.

### Cost of goods sold

The second main division of an income statement for a merchandising business is cost of goods sold. Cost of goods sold is the cost to the seller of the goods sold to customers. For a merchandising company, the cost of goods sold can be relatively large. All merchandising companies have a quantity of goods on hand called merchandise inventory to sell to customers. Merchandise inventory (or inventory) is the quantity of goods available for sale at any given time. Cost of goods sold is determined by computing the cost of (1) the beginning inventory, (2) the net cost of goods purchased, and (3) the ending inventory.

Look at the cost of goods sold section of Hanlon Retail Food Store's income statement in Exhibit 36. The merchandise inventory on 2010 January 1, was USD 24,000. The net cost of purchases for the year was USD 166,000. Thus, Hanlon had USD 190,000 of merchandise available for sale during 2010. On 2010 December 31, the merchandise inventory was USD 31,000, meaning that this amount was left unsold. Subtracting the unsold inventory (the ending inventory), USD 31,000, from the amount Hanlon had available for sale during the year, USD 190,000, gives the cost of goods sold for the year of USD 159,000. Understanding this relationship shown on Hanlon Retail Food Store's partial income statement gives you the necessary background to determine the cost of goods sold as presented in this section.

 Cost of goods sold: Merchandise inventory, 2010 January 1 $24,000 Purchases$167,000 Less: Purchase discounts $3,000 Purchase returns and allowances 8,000 11,000 Net Purchases$156,000 Add: Transportation-in 10,000 Net cost of purchases 166,000 Cost of goods available for sale $190,000 Less: Merchandise inventory, 2010 December 31 31,000 Cost of goods sold$159,000

Exhibit 36: Determination of cost of goods sold for Hanlon Retail Food Store

To determine the cost of goods sold, accountants must have accurate merchandise inventory figures. Accountants use two basic methods for determining the amount of merchandise inventory -  perpetual inventory procedure and periodic inventory procedure. We mention perpetual inventory procedure only briefly here. In the next chapter, we emphasize perpetual inventory procedure and further compare it with periodic inventory procedure.

When discussing inventory, we need to clarify whether we are referring to the physical goods on hand or the Merchandise Inventory account, which is the financial representation of the physical goods on hand. The difference between perpetual and periodic inventory procedures is the frequency with which the Merchandise Inventory account is updated to reflect what is physically on hand. Under perpetual inventory procedure, the Merchandise Inventory account is continuously updated to reflect items on hand. For example, your supermarket uses a scanner to ring up your purchases. When your box of Rice Krispies crosses the scanner, the Merchandise Inventory account shows that one less box of Rice Krispies is on hand.

Under periodic inventory procedure, the Merchandise Inventory account is updated periodically after a physical count has been made. Usually, the physical count takes place immediately before the preparation of financial statements.

Perpetual inventory procedure Companies use perpetual inventory procedure in a variety of business settings. Historically, companies that sold merchandise with a high individual unit value, such as automobiles, furniture, and appliances, used perpetual inventory procedure. Today, computerized cash registers, scanners, and accounting software programs automatically keep track of inflows and outflows of each inventory item. Computerization makes it economical for many retail stores to use perpetual inventory procedure even for goods of low unit value, such as groceries.

Under perpetual inventory procedure, the Merchandise Inventory account provides close control by showing the cost of the goods that are supposed to be on hand at any particular time. Companies debit the Merchandise Inventory account for each purchase and credit it for each sale so that the current balance is shown in the account at all times. Usually, firms also maintain detailed unit records showing the quantities of each type of goods that should be on hand. Company personnel also take a physical inventory by actually counting the units of inventory on hand. Then they compare this physical count with the records showing the units that should be on hand. Chapter 7 describes perpetual inventory procedure in more detail.

Periodic inventory procedure Merchandising companies selling low unit value merchandise (such as nuts and bolts, nails, Christmas cards, or pencils) that have not computerized their inventory systems often find that the extra costs of record-keeping under perpetual inventory procedure more than outweigh the benefits. These merchandising companies often use periodic inventory procedure.

Under periodic inventory procedure, companies do not use the Merchandise Inventory account to record each purchase and sale of merchandise. Instead, a company corrects the balance in the Merchandise Inventory account as the result of a physical inventory count at the end of the accounting period. Also, the company usually does not maintain other records showing the exact number of units that should be on hand. Although periodic inventory procedure reduces record-keeping, it also reduces control over inventory items.

Companies using periodic inventory procedure make no entries to the Merchandise Inventory account nor do they maintain unit records during the accounting period. Thus, these companies have no up-to-date balance against which to compare the physical inventory count at the end of the period. Also, these companies make no attempt to determine the cost of goods sold at the time of each sale. Instead, they calculate the cost of all the goods sold during the accounting period at the end of the period. To determine the cost of goods sold, a company must know:

• Beginning inventory (cost of goods on hand at the beginning of the period).
• Net cost of purchases during the period.
• Ending inventory (cost of unsold goods at the end of the period).

The company would show this information as follows:

 Beginning inventory $34,000 Add: Net cost of purchases during the period 140,000 Cost of goods available for sale during the period$174,000 Deduct: Ending inventory 20,000 Cost of goods sold during the period $154,000 In this schedule, notice that the company began the accounting period with USD 34,000 of merchandise and purchased an additional USD 140,000, making a total of USD 174,000 of goods that could have been sold during the period. Then, a physical inventory showed that USD 20,000 remained unsold, which implies that USD 154,000 was the cost of goods sold during the period. Of course, the USD 154,000 is not necessarily the precise amount of goods sold because no actual record was made of the dollar cost of the goods sold. Periodic inventory procedure basically assumes that everything not on hand at the end of the period has been sold. This method disregards problems such as theft or breakage because the Merchandise Inventory account contains no up-to-date balance at the end of the accounting period against which to compare the physical count. Under periodic inventory procedure, a merchandising company uses the Purchases account to record the cost of merchandise bought for resale during the current accounting period. The Purchases account, which is increased by debits, appears with the income statement accounts in the chart of accounts. To illustrate entries affecting the Purchases account, assume that Hanlon Retail Food Store made two purchases of merchandise from Smith Wholesale Company. Hanlon purchased USD 30,000 of merchandise on credit (on account) on May 4, and on May 21 purchased USD 20,000 of merchandise for cash. The required journal entries for Hanlon are:  May 4 Purchases (+A) 30,000 Accounts Payable (+L) 30,000 To record purchases of merchandise on account. 21 Purchases (+A) 20,000 Cash (-A) 20,000 To record purchase of merchandise for cash. The buyer deducts purchase discounts and purchase returns and allowances from purchases to arrive at net purchases. The accountant records these items in contra accounts to the Purchases account. Purchase discounts Often companies purchase merchandise under credit terms that permit them to deduct a stated cash discount if they pay invoices within a specified time. Assume that credit terms for Hanlon's May 4 purchase are 2/10, n/30. If Hanlon pays for the merchandise by May 14, the store may take a 2 per cent discount. Thus, Hanlon must pay only USD 29,400 to settle the USD 30,000 account payable. The entry to record the payment of the invoice on May 14 is:  May 14 Accounts Payable (-L) 30,000 Cash (-A) 29,400 Purchase Discount (+SE) 600 To record payment on account within the discount period. The buyer records the purchase discount only when the invoice is paid within the discount period and the discount is taken. The Purchase Discounts account is a contra account to Purchases that reduces the recorded invoice price of the goods purchased to the price actually paid. Hanlon reports purchase discounts in the income statement as a deduction from purchases. Companies base purchase discounts on the invoice price of goods. If an invoice shows purchase returns or allowances, they must be deducted from the invoice price before calculating purchase discounts. For example, in the previous transaction, the invoice price of goods purchased was USD 30,000. If Hanlon returned USD 2,000 of the goods, the seller calculates the 2 per cent purchase discount on USD 28,000. Interest rate implied in cash discounts To decide whether you should take advantage of discounts by using your cash or borrowing, make this simple analysis. Assume that you must pay USD 10,000 within 30 days or USD 9,800 within 10 days to settle a USD 10,000 invoice with terms of 2/10, n/30. By advancing payment 20 days from the final due date, you can secure a discount of USD 200. The interest expense incurred to borrow USD 9,800 at 12 per cent per year for 20 days is USD 65.33, calculated as (USD 9,800 x .12 x 20/360). You would save USD 134.67 (USD 200 - USD 65.33) by borrowing the money and paying the invoice within the discount period. In terms of an annual rate of interest, the 2 per cent rate of discount for 20 days is equivalent to a 36 per cent annual rate: (360/20) X 2 per cent. The formula is: $\text{Equivalent annual rate of interest} = \dfrac{\text{The number of days in a year(assumed to be 360)}}{\text{The number of days from the and of the discount period until the final due date}} \times \text{The percentage rate of discount}$ You can convert all cash discount terms to their approximate annual interest rate equivalents by use of this formula. Thus, a company could afford to pay up to 36 per cent [(360/20) X 2 per cent] on borrowed funds to take advantage of discount terms of 2/10, n/ 30. The company could pay 18 per cent on terms of 1/10, n/30. Purchase returns and allowances A purchase return occurs when a buyer returns merchandise to a seller. When a buyer receives a reduction in the price of goods shipped, a purchase allowance results. Then, the buyer commonly uses a debit memorandum to notify the seller that the account payable with the seller is being reduced (Accounts Payable is debited). The buyer may use a copy of a debit memorandum to record the returns or allowances or may wait for confirmation, usually a credit memorandum, from the seller. Both returns and allowances reduce the buyer's debt to the seller and decrease the cost of the goods purchased. The buyer may want to know the amount of returns and allowances as the first step in controlling the costs incurred in returning unsatisfactory merchandise or negotiating purchase allowances. For this reason, buyers record purchase returns and allowances in a separate Purchase Returns and Allowances account. If Hanlon returned USD 350 of merchandise to Smith Wholesale before paying for the goods, it would make this journal entry:  Accounts Payable (-L) 350 Purchase Returns and Allowances (+SE) 350 To record return of damaged merchandise to supplier The entry would have been the same to record a USD 350 allowance. Only the explanation would change. If Hanlon had already paid the account, the debit would be to Cash instead of Accounts Payable, since Hanlon would receive a refund of cash. If the company took a discount at the time it paid the account, only the net amount would be refunded. For instance, if a 2 per cent discount had been taken, Hanlon's journal entry for the return would be:  Cash (+A) 343 Purchase Discounts (-SE) 7 Purchase Returns and Allowances (+SE) 350 To record return of damaged merchandise to supplier and record receipt of cash. Purchase returns and allowances is a contra account to the Purchases account, and the income statement shows it as a deduction from purchases. When both purchase discounts and purchase returns and allowances are deducted from purchases, the result is net purchases. Transportation costs are an important part of cost of goods sold. To understand how to account for transportation costs, you must know the meaning of the following terms: ñ FOB shipping point means "free on board at shipping point". The buyer incurs all transportation costs after the merchandise has been loaded on a railroad car or truck at the point of shipment. Thus, the buyer is responsible for ultimately paying the freight charges. • FOB destination means "free on board at destination". The seller ships the goods to their destination without charge to the buyer. Thus, the seller is ultimately responsible for paying the freight charges. • Passage of title is a term that indicates the transfer of the legal ownership of goods. Title to the goods normally passes from seller to buyer at the FOB point. Thus, when goods are shipped FOB shipping point, title usually passes to the buyer at the shipping point. When goods are shipped FOB destination, title usually passes at the destination. • Freight prepaid means the seller must initially pay the freight at the time of shipment. • Freight collect indicates the buyer must initially pay the freight bill on the arrival of the goods. To illustrate the use of these terms, assume that a company ships goods FOB shipping point, freight collect. Title passes at the shipping point. The buyer is responsible for paying the USD 100 freight costs and does so. The seller makes no entry for freight charges; the entry on the buyer's books is:  Transportation-In (or Freight-In) (+SE) 100 Cash (-A) 100 To record payment of freight bill on goods purchased. The Transportation-In account records the inward freight costs of acquiring merchandise. Transportation-In is an adjunct account in that it is added to net purchases to arrive at net cost of purchases. An adjunct account is closely related to another account (Purchases, in this instance), and its balance is added to the balance of the related account in the financial statements. Recall that a contra account is just the opposite of an adjunct account. Buyers deduct a contra account, such as accumulated depreciation, from the related fixed asset account in the financial statements. When shipping goods FOB destination, freight prepaid, the seller is responsible for and pays the freight bill. Because the seller cannot bill a separate freight cost to the buyer, the buyer shows no entry for freight on its books. The seller, however, has undoubtedly considered the freight cost in setting selling prices. The following entry is required on the seller's books:  Delivery Expense (or Transportation-Out Expense) (-SE) 100 Cash (-A) 100 To record freight cost on goods sold. When the terms are FOB destination, the seller records the freight costs as delivery expense; this selling expense appears on the income statement with other selling expenses. FOB terms are especially important at the end of an accounting period. Goods in transit then belong to either the seller or the buyer, and one of these parties must include these goods in its ending inventory. Goods shipped FOB destination belong to the seller while in transit, and the seller includes these goods in its ending inventory. Goods shipped FOB shipping point belong to the buyer while in transit, and the buyer records these goods as a purchase and includes them in its ending inventory. For example, assume that a seller ships goods on 2009 December 30, and they arrive at their destination on 2010 January 5. If terms are FOB destination, the seller includes the goods in its 2009 December 31, inventory, and neither seller nor buyer records the exchange transaction until 2010 January 5. If terms are FOB shipping point, the buyer includes the goods in its 2009 December 31, inventory, and both parties record the exchange transaction as of 2009 December 30. Sometimes the seller prepays the freight as a convenience to the buyer, even though the buyer is ultimately responsible for it. The buyer merely reimburses the seller for the freight paid. For example, assume that Wood Company sold merchandise to Loud Company with terms of FOB shipping point, freight prepaid. The freight charges were USD 100. The following entries are necessary on the books of the buyer and the seller:  Buyer - Loud Company Seller - Wood Company Transportation-In (-SE) 100 Accounts Receivable (+A) 100 Accounts Payable (+L) 100 Cash (-A) 100 Such entries are necessary because Wood initially paid the freight charges when not required to do so. Therefore, Loud Company must reimburse Wood for the charges. If the buyer pays freight for the seller (e.g. FOB destination, freight collect), the buyer merely deducts the freight paid from the amount owed to the seller. The following entries are necessary on the books of the buyer and the seller:  Buyer - Loud Company Seller - Wood Company Accounts Payable (-L) 100 Delivery Expense (-SE) 100 Cash (-A) 100 Accounts Receivable (-A) 100 Purchase discounts may be taken only on the purchase price of goods. Therefore, a buyer who owes the seller for freight charges cannot take a discount on the freight charges owed, even if the buyer makes payment within the discount period. We summarize our discussion of freight terms and the resulting journal entries to record the freight charges in Exhibit 37. Merchandise inventory is the cost of goods on hand and available for sale at any given time. To determine the cost of goods sold in any accounting period, management needs inventory information. Management must know its cost of goods on hand at the start of the period (beginning inventory), the net cost of purchases during the period, and the cost of goods on hand at the close of the period (ending inventory). Since the ending inventory of the preceding period is the beginning inventory for the current period, management already knows the cost of the beginning inventory. Companies record purchases, purchase discounts, purchase returns and allowances, and transportation-in throughout the period. Therefore, management needs to determine only the cost of the ending inventory at the end of the period in order to calculate cost of goods sold. Taking a physical inventory Under periodic inventory procedure, company personnel determine ending inventory cost by taking a physical inventory. Taking a physical inventory consists of counting physical units of each type of merchandise on hand. To calculate inventory cost, they multiply the number of each kind of merchandise by its unit cost. Then, they combine the total costs of the various kinds of merchandise to provide the total ending inventory cost. In taking a physical inventory, company personnel must be careful to count all goods owned, regardless of where they are located, and include them in the inventory.  Shipping point: Detroit- Destination: San Diego Goods travel from shipping point to destination If shipping terms are: FOB shipping point - Buyer incurs the freight charges FOB destination - Seller incurs the freight charges If the freight terms are combined as follows: Terms Party that Initially Pays Party that Ultimately Bears (1) FOB shipping point, freight collect Buyer Buyer (2) FOB destination, freight prepaid Seller Seller (3) FOB shipping point, freight prepaid Seller Buyer (4) FOB destination, freight collect Buyer Seller Exhibit 37: Summary of shipping terms Explanations: FOB shipping point, freight collect – Buyer both incurs and initially pays the freight chargers. The proper party (buyer) paid the freight. The buyer debits Transportation-In and credits Cash. FOB destination, freight prepaid – Seller both incurs and initially pays the freight charges. The proper party (seller) paid the freight. The seller debits Delivery Expense and credits Cash. FOB shipping point, freight prepaid – Buyer incurs the freight chargers, and seller initially pays the freight charges. Buyer must reimburse seller for freight charges. The seller debits Accounts Receivable and credits Cash upon paying the freight. The buyer debits Transportation-In and credits Accounts Payable when informed of the freight charges. FOB destination, freight collect – Seller incurs freight charges, and buyer initially pays freight charges. Buyer deducts freight charges from amount owed to seller. The buyer debits Accounts Payable and credits Cash when paying the freight. The seller debits Delivery Expense and credits Accounts Receivable when informed of the freight charges. Thus, companies should include goods shipped to potential customers on approval in their inventories. Similarly, companies should not record consigned goods (goods delivered to another party who attempts to sell them for a commission) as sold goods. These goods remain the property of the owner (consignor) until sold by the consignee and must be included in the owner's inventory. Merchandise in transit is merchandise in the hands of a freight company on the date of a physical inventory. As stated above, buyers must record merchandise in transit at the end of the accounting period as a purchase if the goods were shipped FOB shipping point and they have received title to the merchandise. In general, the goods belong to the party who ultimately bears the transportation charges. When accounting personnel know the beginning and ending inventories and the various items making up the net cost of purchases, they can determine the cost of goods sold. To illustrate, assume the following account balances for Hanlon Retail Food Store as of 2010 December 31:  Merchandise Inventory, 2010 January 1$24,000 Dr. Purchases 167,000 Dr. Purchase Discounts 3,000 Cr. Purchase Returns and Allowances 8,000 Cr. Transportation-In 10,000 Dr.

By taking a physical inventory, Hanlon determined the 2010 December 31, merchandise inventory to be USD 31,000. Hanlon then calculated its cost of goods sold as shown in Exhibit 38. This computation appears in a section of the income statement directly below the calculation of net sales.

 Cost of goods sold: Merchandise inventory, 2010 January 1 $24,000 Purchases$167,000 Less: Purchase discounts $3,000 Purchase returns and allowances 8,000 11,000 Net Purchases$156,000 Add: Transportation-in 10,000 Net cost of purchases 166,000 Cost of goods available for sale $190,000 Less: Merchandise inventory, 2010 December 31 31,000 Cost of goods sold$159,000

This illustration is the same as Exhibit 36, repeated here for your convenience.

Exhibit 38: Determination of cost of goods sold for Hanlon Retain Food Store*

In Exhibit 38, Hanlon's beginning inventory (USD 24,000) plus net cost of purchases (USD 166,000) is equal to cost of goods available for sale (USD 190,000). The firm deducts the ending inventory cost (USD 31,000) from cost of goods available for sale to arrive at cost of goods sold (USD 159,000).

Another way of looking at this relationship is the following diagram:

Beginning inventory and net cost of purchases combine to form cost of goods available for sale. Hanlon divides the cost of goods available for sale into ending inventory (which is the cost of goods not sold) and cost of goods sold.

To continue the calculation appearing in Exhibit 38, net cost of purchases (USD 166,000) is equal to purchases (USD 167,000), less purchase discounts (USD 3,000) and purchase returns and allowances (USD 8,000), plus transportation-in (USD 10,000).

As shown in Exhibit 38, ending inventory cost (merchandise inventory) appears in the income statement as a deduction from cost of goods available for sale to compute cost of goods sold. Ending inventory cost (merchandise inventory) is also a current asset in the end-of-period balance sheet.

Companies use periodic inventory procedure because of its simplicity and relatively low cost. However, periodic inventory procedure provides little control over inventory. Firms assume any items not included in the physical count of inventory at the end of the period have been sold. Thus, they mistakenly assume items that have been stolen have been sold and include their cost in cost of goods sold.

To illustrate, suppose that the cost of goods available for sale was USD 200,000 and ending inventory was USD 60,000. These figures suggest that the cost of goods sold was USD 140,000. Now suppose that USD 2,000 of goods were actually shoplifted during the year. If such goods had not been stolen, the ending inventory would have been USD 62,000 and the cost of goods sold only USD 138,000. Thus, the USD 140,000 cost of goods sold calculated under periodic inventory procedure includes both the cost of the merchandise delivered to customers and the cost of merchandise stolen.

#### An accounting perspective: Uses of technology

Many companies are building private networks to link their employees, customers, and suppliers together. These networks within the Internet are referred to as companies' intranets. The Internet can be likened to the entire universe, while an intranet can be likened to a solar system within the universe. A company's intranet is built to be secure from outside users. For instance, these networks are designed to be secure against "hackers" and other unauthorized persons. The intranet software typically encrypts data sent over the Internet to safeguard financial transactions.