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MEG’S MART
Calculation of Cost of Goods Sold For Year Ended December 31,19X2
Beginning inventory $ 19,000
Cost of goods purchased 232,400
Cost of goods available for sale $251,400
Less ending inventory (21,000)
Cost of goods sold $230,400
The following paragraphs explain how the accounting system accumulates the information that the accountant needs to make this calculation.
Measuring and Recording Merchandise Inventory
The merchandise on hand at the beginning of an accounting period is called the beginning inventory and the merchandise on hand at the end is called the ending inventory. (Because a new reporting period starts as soon as the old period ends, the ending inventory of one period is always the beginning inventory of the next.) When a periodic inventory system is used, the dollar amount of the ending inventory is determined by (1) counting the unsold items in the store and the stockroom, (2) multiplying the counted quantity of each type of good by its cost, and (3) adding all the costs of the different types of goods. The cost of goods sold is found by subtracting the cost of the ending inventory from the cost of the goods available for sale.
Through the closing process described later in the chapter, the periodic system records the cost of the ending inventory in the Merchandise Inventory account. The balance in this account is not changed during the next accounting period. In fact, entries are made to the Merchandise Inventory account only at the end of the period. Thus, neither the purchases of new merchandise nor the cost of goods sold is entered in the Merchandise Inventory account. As a result, the account no longer shows the cost of the merchandise on hand as soon as any goods are purchased or sold in the current period. Because the account’s balance describes the beginning inventory of the period, it cannot be used on a new balance sheet without being updated by the closing entries described later in this chapter.
Recording the Cost of Purchased Merchandise
A complete measure of the cost of purchased merchandise must include the effects of (1) any cash discounts provided by the suppliers, (2) the effects of any returns and allowances for unsatisfactory items received from the suppliers, and (3) any freight costs paid by the buyer to get the goods into the buyer’s inventory. The net cost of the goods’ purchased by Meg’s Mart for 19X2 is calculated as follows:
MEG’S MART
Calculation of Cost of Goods Purchased For Year Ended December 31,19X2
Purchases $235,800
Less:
Purchases returns and allowances . . $1,500
Purchases discounts 4,200 5,700
Net purchases $230,100
Add transportation-in 2,300
Cost of goods purchased $232,400
The following paragraphs explain how these amounts are found and then accumulated in the accounts.
The Purchases Account. Under a periodic inventory system, the cost of merchandise bought for resale is debited to a temporary account called Purchases. For example, Meg’s Mart would record a $1,000 credit purchase of merchandise on November 2 with this entry:
Nov. 2 Purchases ……………………………………… 1,000.00
Accounts Payable………………………… 1,000.00
Purchased merchandise on credit, invoice
dated November 2, terms 2/10, n/30.
The accountant uses the Purchases account to accumulate the cost of all merchandise bought during a period. This temporary account is a holding place for information used at the end of the year to calculate the cost of goods sold.
Purchases Discounts. When stores buy merchandise on credit, they may be offered cash discounts for paying within the discount period. These cash discounts are called purchases discounts by the buyer. When the buyer pays within the discount period, the accounting system records a credit to a contra-purchases account called Purchases Discounts. The following entry uses this account to record the payment for the merchandise purchased on November 2:
Nov. 2 Accounts Payable………………………1,000.00
Purchases Discounts………………… 20.00
Cash…………………………………… 980.00
Paid for the purchase of November 2 less
the discount.
By recording the amount of discounts taken, the accountant can help the manager determine whether any discounts are missed. For example, if all purchases are made on credit and all suppliers offer a 2% discount, the balance of the Purchases Discounts contra account should equal 2% of the balance of the Purchases account. If the accountant did not use the contra account, the $20 credit entry would be recorded as a reduction of the Purchases account balance. As a result, it would be more difficult to determine whether all discounts were taken.
The accountant uses the balance of the Purchases Discounts account to compute the net cost of the purchases for the period. However, published financial statements usually do not include this calculation because it is useful only for managers.
A Cash Management Technique. To ensure that discounts are not missed, most companies set up a system to pay all invoices within the discount period. Furthermore, careful cash management ensures that no invoice is paid until the last day of the discount period. A helpful technique for reaching both of these goals files every invoice in such a way that it automatically comes up for payment on the last day of its discount period. For example, a simple manual system uses 31 folders, one for each day in the month. After an invoice is recorded in the journal, it is placed in the file folder for the last day of its – discount period. Thus, if the last day of an invoice’s discount period is November 12, it is filed in folder number 12. Then, the invoice and any other invoices in the same folder are removed and paid on November 12. Computerized systems can accomplish the same result by using a code that identifies the last date in the discount period. When that date is reached, the computer automatically provides a reminder that the account should be paid.
Trade Discounts. Cash discounts represent real reductions below the original negotiated prices for merchandise. Thus, they differ from trade discounts offered by sellers in the process of negotiating the selling price. Trade discounts are offered as a percentage reduction in the list price of the goods. Because the list price is only the starting point in setting the final price for the goods, it is not recorded in the buyer’s accounting records as their cost. (Similarly, the seller records the net price as the amount of the sale.) For example, if Meg’s Mart purchased items with a $1,200 list price, net of a 25% trade discount, the purchase would be recorded as its negotiated price of $900 [$1,200 – (25% x $1,200)]. Any cash discounts on this purchase would be based on the $900 price and would be recorded in the Purchases Discounts account.
Purchases Returns and Allowances. Some merchandise received from suppliers is not acceptable and must be returned. In other cases, the purchaser may keep imperfect but marketable merchandise because the supplier grants an allowance against the purchase price.
Even though the seller does not charge the buyer for the returned goods or gives an allowance for imperfect goods, the buyer incurs costs in receiving, inspecting, identifying, and possibly returning defective merchandise. The occurrence of these costs can be signaled to the manager by recording the cost of the returned merchandise or the seller’s allowance in a separate contra-purchases account called Purchases Returns and Allowances. For example, this journal entry is recorded on November 14 when Meg’s Mart returns defective merchandise for a $265 refund of the original purchase price:
Nov. 14 Accounts Payable ……………………………265.00
Purchases Returns and Allowances………….265.00
Returned defective merchandise
As we described for Purchases Discounts, the accountant uses the balance of the Purchases Returns and Allowances account to compute the net cost of goods purchased during the period. However, published financial statements generally do not include this information because it is useful only for managers.
Discounts and Returned Merchandise. If part of a shipment of goods is returned within the discount period, the buyer can take the discount only on the remaining balance of the invoice. For example, suppose that Meg’s Mart is offered a 2% cash discount on $5,000 of merchandise. Two days later, the company returns $800 of the goods before the invoice is paid. When the $4,200 balance is paid within the discount period, Meg’s Mart can take the 2% discount only on that amount. Specifically, the company can deduct only an $84 discount (2% x $4,200).
Transportation Costs. Depending on the terms negotiated with its suppliers, a company may be responsible for paying the shipping costs for transporting the acquired goods to its own place of business. Because these costs are part of the sacrifice of making the goods ready for sale, generally accepted accounting principles require them to be added to the cost of the purchased goods.
The freight charges could be recorded with a debit to the Purchases account. However, more complete information about these costs is provided to management if they are debited to a special supplemental account called Transportation-In. The accountant adds this account’s balance to the net purchase price of the acquired goods to find the total cost of goods purchased.
The use of this account is demonstrated by the following entry, which records a $75 freight charge for incoming merchandise:
Nov. 24 Transportation-In …………………………….75.00
Cash ……………………………………….. 75.00
Paid freight charges on purchased merchandise
Because detailed information about freight charges is relevant only for managers, it is seldom found in external financial statements.
Freight paid to bring purchased goods into the inventory is accounted for separately from freight paid on goods sent to customers. The shipping cost of incoming goods is included in the cost of goods sold, while the shipping cost for outgoing goods is a selling expense.
ILLUSTRATION 3 Identifying Ownership Responsibilities and Risks
FOB Shipping Point
B
uyer accepts ownership when the goods leave the seller’s place of business; buyer has responsibility for the shipping costs and faces the risk of loss in transit.
Seller
(shipping point)
Buyer
(destination)
FOB Destination
Buyer accepts ownership when the goods arrive at the buyer’s place of business; seller has responsibility for the shipping costs and faces the risk of loss in transit
Identifying Ownership Responsibilities and Risks. When a merchandise transaction is planned, the buyer and seller need to establish which party will be responsible for paying any freight costs and which will bear the risk of loss during transit.
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