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The basic issue to be negotiated is the point at which ownership is transferred from the buyer to the seller. The place of the transfer is called the FOB point, which is the abbreviation for the phrase, free on board. The meaning of different FOB points is explained by the diagram in Illustration 3.
Under an FOB shipping point agreement (also called FOB factory), the buyer accepts ownership at the seller’s place of business. As a result, the buyer is responsible for paying the shipping costs and bears the risk of damage or loss while the goods are in shipment. In addition, the goods are part of the buyer’s inventory while they are in transit because the buyer already owns them.
Alternatively, an FOB destination agreement causes ownership of the goods to pass at the buyer’s place of business. If so, the seller is responsible for paying the shipping charges and bears the risk of damage or loss in transit. Furthermore, the seller does not record the sales revenue until the goods arrive at the destination because the transaction is not complete before that point in time.
Debit and Credit Memoranda
Buyers and sellers often find that they need to adjust the amount that is owed between them. For example, purchased merchandise may not meet specifications, unordered goods may be received, different quantities may be received than were ordered and billed, and billing errors may occur.
In some cases, the original balance can be adjusted by the buyer without a negotiation. For example, a seller may make an error on an invoice. If the buying company discovers the error, it can make its own adjustment and notify the seller by sending a debit memorandum or a credit memorandum. A debit memorandum is a business document that informs the recipient that the sender has debited the account receivable or payable. It provides the notification with words like these: “We debit your account,” followed by the amount and an explanation. On the other hand, a credit memorandum informs the recipient that the sender has credited the receivable or payable. See Illustration 4 for two situations that involve these documents.
ILLUSTRATION 4 The Use of Debit and Credit Memoranda
Situation — the buyer finds a $100 overstatement in an invoice from the seller
Debit Memorandum
We have debited your account for $100 because of an error
Seller
Buyer
Debits the account payable Credits the account
to the seller for $100 and sends receivable from
the debit memorandum the buyer for $100
Situation — the seller agrees to give a $250 allowance to the buyer for defective goods
Credit Memorandum
We have credited your account for $250 as an allowance
Buyer
Seller
Debits the account payable Credits the account receivable
to the seller for $250 from the buyer for $250
and sends the credit memorandum
The debit memorandum in Illustration 4 is based on a case in which buyer initially records an invoice as an account payable and later discovers an error by the seller that overstated the total bill by $100. The buyer corrects the balance of its liability and formally notifies the seller of the mistake with debit memorandum reading: “We have debited your account for $100 because of an error.” Additional information is also provided about the invoice, its date, and the nature of the error. The buyer sends a debit memorandum because the correction debits the account payable to reduce its balance. The buyer’s debit to the payable is offset by a credit to the Purchases асcount.
When the seller receives its copy of the debit memorandum, it records a credit to the buyer’s account receivable to reduce its balance. An equal debit recorded in the Sales account. Neither company uses a contra account because the adjustment was created by an error.
In other situations, an adjustment can be made only after negotiations between the buyer and the seller. For example, suppose that a buyer claims that some merchandise does not meet specifications. The amount of the allowance to be given by the seller can be determined only after discussion. Assume that a buyer accepts delivery of merchandise and records the transaction with a $750 debit to the Purchases account and an equal credit to Accounts Payable. Later, the buyer discovers that some of the merchandise is flawed, and can be sold only if it is marked down substantially. After a phone call and brief negotiations, the seller agrees to grant a $250 allowance against the original purchase price.
The seller records the allowance with a debit to the Sales Returns and Allowances contra account and a credit to Accounts Receivable. Then, the seller formally notifies the buyer of the allowance with a credit memorandum. A credit memorandum is used because the adjustment credited the receivable reduce its balance. When the buyer receives the credit memorandum, it debits Accounts Payable and credits Purchases Returns and Allowances. Contra accounts provide both companies’ managers with useful information about the allowance.
Inventory Shrinkage
Merchandising companies lose merchandise in a variety of ways, including shoplifting and deterioration while an item is on the shelf or in the warehouse. These losses are called shrinkage.
Even though perpetual inventory systems track all goods as they move into and out of the company, they are not able to directly measure shrinkage caused by shoplifting or thefts by employees. However, these systems allow the accountant to measure shrinkage by comparing a physical count with recorded quantities.
Because periodic inventory systems do not identify quantities on hand, they cannot provide direct measures of shrinkage. In fact, all that they can determine is the cost of the goods on hand and the goods that passed out of the inventory. The amount that passed out includes the cost of goods sold, stolen, or destroyed. For example, suppose that shoplifters took merchandise that cost $500. Because the goods were not on hand for a physical count, the ending inventory’s cost is $500 smaller than it would have been. Ultimately, the $500 is included in the cost of the goods sold.
Alternative Income Statement Formats
Within the framework of generally accepted accounting principles, companies have flexibility in selecting a format for their financial statements. In fact, practice shows that many different formats are used. This section of the chapter describes several possible formats that Meg’s Mart could use for its income statement.
illustration 5 Classified Income Statement for Internal Use
MEG’S MART
Income Statement
For Year Ended December 31,19X2
Sales. $321,000
Less: Sales returns and allowances $ 2,000
Sales discounts ….... . . ….... 4,300 6,300
Net sales $314,700
Cost of goods sold:
Merchandise inventory, December 31,19X1 . . $ 19,000
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
Goods available for sale …... $251,400
Merchandise inventory, December 31,19X2 . . 21,000
Cost of goods sold 230,400
Gross profit from sales . $ 84,300
Operating expenses:
Selling expenses:
Depreciation expense, store equipment …. $ 3,000
Sales salaries expense 18,500
Rent expense, selling space . 8,100
Store supplies expense 1,200
Advertising expense 2,700
Total selling expenses $ 33,500
General and administrative expenses:
Depreciation expense, office equipment … $700
Office salaries expense 25,300
Insurance expense 600
Rent expense, office space 900
Office supplies expense 1,800
Total general and administrative expenses . . 29,300
Total operating expenses 62,800
Net income $ 21,500
In Illustration 5, we present a classified income statement that would probably be distributed only to the company’s managers because of the details that it includes. The sales and cost of goods sold sections are the same as the calculations presented earlier in the chapter. The difference between the net sales and cost of goods sold is the gross profit for the year.
Also notice that the operating expenses section classifies the expenses into two categories. Selling expenses include the expenses of promoting sales through displaying and advertising the merchandise, making sales, and delivulfil goods to customers. General and administrative expenses support the overall operations of a business and include the expenses of such activities as accounting, human resource management, and financial management.
Some expenses may be divided between categories because they contribute to both activities. For example, Illustration 5 reflects the fact that Meg’s Mart divided the total rent expense of $9,000 for its store building between the two categories. Ninety percent ($8,100) was selling expense and the remaining 10% ($900) was general and administrative expense. The cost allocation should reflect an economic relationship between the prorated amounts and the activities. For example, the allocation in this case could be based on relative rental values.
ILLUSTRATION 6 Multiple-Step Income Statement
MEG’S MART
Income Statement For Year Ended December 31,19X2
Net sales…………………………………………………………..$314,700
Cost of goods sold…………………………………… 230,400
Gross profit from sales……………………………… $ 84,300
Operating expenses:
Selling expenses:
Depreciation expense, store equipment………………… . $ 3,000
Sales salaries expense…………………………………….. 18,500
Rent expense, selling space………………………………. 8,100
Store supplies expense…………………………………… 1,200
Advertising expense………………………………………. 2,700
Total selling expenses………………………………………. $33,500
General and administrative expenses:
Depreciation expense, office equipment………………… $ 700
Office salaries expense …………………………………… 25,300
Insurance expense………………………………………… 600
Rent expense, office space………………………………. 900
Office supplies expense………………………………….. 1,800
Total general and administrative expenses……………… 29,300
Total operating expenses………………………… 62,800
Net income…………………………………………… $ 21,500
In Illustration 6, we use the multiple-step income statement format that would probably be used in external reports. The only difference between this format and the one in Illustration 5 is that it leaves out the detailed calculations of net sales and cost of goods sold. The format is called multiple-step because it shows several intermediate totals between sales and net income.
In contrast, we present a single-step income statement for Meg’s Mart in Illustration 7. This simpler format presents only one intermediate total for total operating expenses.
ILLUSTRATION 7 Single-Step Income Statements
MEG’S MART
Income Statement For Year Ended December 31,19X2
Net sales………………………………………………………….$314,700
Cost of goods sold………………………………………………$ 230,400
Selling expenses……………………………………… 33,500
General and administrative expenses…………………………… 29,300
Total operating expenses……………………………… 293,200
Net income…………………………………………… $ 21,500
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