Chapter 5: Extending The Recording Process Flashcards
What are trading firms?
Trading firms are those businesses that sell goods to customers to earn revenue. They differ from service firms, as service firms derive their revenue from providing clients with a service.
Some trading firms are manufacturers, which produce goods that are later sold. Others simply buy goods from wholesalers, and sell them without alteration.
Measuring profit for a retailer is conceptually the same as for a service entity. That is, profit (or loss) results from deducting expenses for the period from revenue for the period. For a retailer, the primary source of revenue is the sale of inventory. This revenue source is often referred to as sales revenue or sales.
Unlike expenses for a service business, expenses for a retailer or trading entity are divided into two categories: (1) the cost of sales and (2) other expenses.
What is the cost of sales?
The cost of sales is the total cost of inventory sold during the period. This expense is directly related to the revenue recognised from the sale of the goods.
What is gross profit?
Sales revenue less cost of sales is called gross profit on sales.
Eg. when a calculator costing $15 is sold for $25, the gross profit is $10. Retail or trading entities report gross profit on sales in the statement of profit or loss.
After gross profit is calculated, other expenses are deducted to determine profit or loss.
What are other expenses?
Most of these expenses are incurred in the process of earning sales revenue. Examples of expenses are sales salaries, advertising expense and insurance expense.
The expenses of a retail or trading entity include many of the expenses found in a service business.
The operating cycle.
The operating cycle of a retailer differs from that of a service business.
The operating cycle of a retailer ordinarily is longer than that of a service business.
The purchase of inventory or stock and its eventual sale lengthen the cycle.
Note that the added asset account for a retail business is an inventory account. It is usually entitled Inventory or Stock.
Recall that assets are the economic resources of a business that are expected to be of benefit in the future.
Inventory is classified as an asset, and is usually reported as a current asset on the statement of financial position.
What are the two systems that can be used to account for inventory?
The perpetual inventory system and the periodic inventory system.
Explain the perpetual inventory system.
This involves maintains detailed records of the cost of each inventory purchase and sale. This system continuously — perpetually — shows the quantity and cost of inventory that should be on hand at any time.
Eg. A Ford dealership has separate inventory records for each car, ute and van on its lot. With the use of bar codes and optical scanners, a supermarket can keep a daily running record of every box of cereal and every jar of jam that it buys and sells.
Under a perpetual inventory system, the cost of sales is determined each time a sale occurs.
The widespread use of computers and electronic scanners now enables many more businesses to install perpetual inventory systems.
Recording purchases of inventory.
Purchases of inventory may be made for cash or on account (credit). Purchases are normally recorded when the goods are received from the seller.
Every purchase should be supported by business documents that provide written evidence of the transaction (cash purchase - cheque butt or cash register receipt, credit purchase - purchase invoice).
Cash purchases are recorded by an increase in Inventory and a decrease in Cash.
Under the perpetual inventory system, purchases of inventory or stock for sale are recorded in the Inventory account. However, not all business purchases are debited to Inventory.
Eg. Purchases of assets acquired for use and not for resale - such as supplies and equipment - are recorded as increases to specific asset accounts rather than to Inventory.
The inventory account only records movements of stock to be sold.
Recording purchase returns and allowances.
A purchaser may be dissatisfied with the goods received. The goods may be damaged or defective, of inferior quality, or perhaps they do not meet the purchaser’s specifications. In such cases, the purchaser may return the goods to the seller.
The purchaser is granted credit if the sale was made on credit, or a cash refund if the purchase was for cash. This transaction is known as a purchase return.
Alternatively, the purchaser may choose to keep the goods if the seller is willing to grant an allowance (deduction) from the purchase price. This transaction is known as a purchase allowance.
Eg. Assume that Beyer Video returned goods costing $300 to Sellers Electrics. Beyer Video increased Inventory when the goods were received. So, Beyer Video decreases Inventory when it returns the goods or when it is granted an allowance. Beyer Video debits Accounts Payble as the business now owes $300 less to the supplier.
Recording sales.
Sales revenues, like service revenues, are recorded when earned. This is done in accordance with the revenue recognition principle.
Typically, sales revenues are earned when the goods are transferred from the seller to the buyer. At this point the sales transaction is completed, and the sales price has been established.
Sales may be made on credit or for cash. Every sales transaction should be supported by a business document that provides written evidence of the sale. Cash register tapes provide evidence of cash sales. A sales invoice, provides support for a credit sale.
When a sale takes place, two separate entries must be recorded.
What are the two separate entries recorded when a sale takes place?
The first records the sale itself and the resulting revenue, while the second records the cost of the sale to the entity.
The entity must record a debit (or increase) to either Cash or Accounts Receivable (depending on the terms of the sale), and a credit (or increase) to Sales. This entry records the selling price, or the price paid by the customer to the entity. It recognises that revenue has been earned, and that the entity either has cash on hand as a result, or has a customer owing the entity money.
The second entry records a debit (or increase) to the Cost of Sales account, and a credit (or decrease) to the Inventory account at the cost price of the goods. The cost price will be unknown to the customer, but represents the cost of the goods to the entity. It is important to understand this journal entry. The Inventory account, an asset, must be decreased as the seller no longer has the stock (remember, to decrease an asset account, credit it).
Under the perpetual inventory system, what happens to stock?
Recall that under the perpetual inventory system, a constant record of stock movements is maintained. Therefore, every time stock moves in or out of the business, the Inventory account will be involved.
The debit entry increases the expense account, Cost of Sales which thereby reduces OE. In a retail entity, inventory on hand is an asset. However, once it is sold, it becomes an expense as it is transferred to the Cost of Sales account. This account is compared against Sales to determine the ‘mark up’ or gross profit earned on the sale.
Recording sales returns and allowances.
When a customer returns goods, the seller may give a cash refund or a credit note. A credit note reduces the amount owed by the customer. Cash refunds and credit notes are recorded as sales returns and allowances on the books of the seller.
Sellers Electrics’ entries to record credit for returned goods that are not faulty or damaged involve two entries. (1) The first is an increase in Sales Returns and Allowances and a decrease (indented) in Accounts Receivable at the $300 selling price. (2) The second is an increase in Inventory (assume a $140 cost) and a decrease (indented) in Cost of Sales.
If a cash refund had been given, the cash account would be credited for $300 instead of Accounts Receivable.
What happens when goods returned are faulty or damaged?
They cannot be returned to inventory for resale.
Sellers Electrics’ entries to record a credit for faulty goods returned would involve two entries:
(1) an increase in Sales Returns and Allowances and a decrease in Accounts Receivable (or Cash if a refund is given) at the $300 selling price, and
(2) an increase in an expense account called Inventory Write-down and a decrease in Cost of Sales ($140).
What can the inventory write-down account be used for?
Recording inventory shrinkage, inventory waste, inventory obsolescence or inventory that has been lost or stolen. This information can then be reported separately to management.
The inventory write-down or stock loss amount will then be added to the Cost of Sales total in determining gross profit in the statement of profit or loss.
