Chapter Five: Special Issues for logo

Your goals for this “merchandising” chapter are to learn about:


Purchase the 2016-2017 Edition of the Financial Accounting Textbook (Chapters 1 through 16 including problem sets) for $89.95 here.

Purchase the PDF download of the textbook for $39.95 here:

Add to CartView Cart


New!! Financial Accounting Bundle

Purchase the 2016-2017 Edition Bundle of the Financial Accounting Textbook, Workbook, and Solutions Manual PDF download (Chapters 1 through 16) for $99.95 here:

Add to CartView Cart


Purchase the Financial Accounting Workbook 2016-2017 Edition (Chapters 1 through 16) for $39.95 here.

Purchase the PDF download of the Workbook for $39.95 here:

Add to Cart View Cart



Purchase the Financial Accounting Solutions Manual 2016-2017 Edition (Chapters 1 through 16) for $49.95 here.

Purchase the PDF download of the Solutions Manual for $39.95 here:

Add to Cart View Cart

Store PictureThe discussions in earlier chapters were all based on service businesses like law firms and architects. Service businesses are a large component of an advanced economy. However, a lot of money is also spent in stores or on the internet. Such businesses are generally referred to as "merchants," and their goal is to purchase inventory and resell it at a higher price to customers. This chapter focuses on the merchandising business, where measuring income involves unique considerations, like the computation and presentation of an amount called "gross profit."

Chair Depot Gross profit is the difference between sales and cost of goods sold and is reported on the income statement as an intermediate amount. Observe the income statement for Chair Depot below. The gross profit number indicates that the company is selling merchandise for more than cost. The company also incurred other operating expenses in the course of business. The presentation of gross profit is important for users of the financial statements. If the gross profit rate is small, the business might have trouble making a profit, even if sales improved. The reverse is true if the gross profit rate is strong; improved sales can markedly improve the bottom-line net income (especially if operating expenses do not change)! Separating gross profit from other components is an important part of reporting.






The Sales account is a revenue account used to record sales of merchandise. Sales are initially recorded via one of the following entries, depending on whether the sale is for cash or is a sale on account:

Cash Sale General Journal



Occasionally, a customer returns merchandise. When that occurs, the following entry should be made:

Sales Returns and Allowance General Journal

Notice that the above entry included a debit to Sales Returns and Allowances (rather than canceling the sale). The Sales Returns and Allowances account is a contra-revenue account that is deducted from sales. The calculation of sales less sales returns and allowances is sometimes called "net sales." This approach allows interested parties to easily track the level of sales returns in relation to overall sales. Important information is revealed about the relative level of returns, thereby providing a measure of customer satisfaction or dissatisfaction. Sales returns (on account) are typically documented by the creation of an instrument known as a credit memorandum. The credit memorandum indicates that a customer's Account Receivable balance has been credited (reduced) and that payment for the returned goods is not expected. If the transaction involved a cash refund, the only difference in the entry would involve a credit to Cash instead of Accounts Receivable. The calculation of net sales would be unaffected.

The following income statement provides an example showing the presentation of net sales:

Chair Depot Income Statement

Note the use of the word "allowances" in the account title "Sales Returns and Allowances." What is the difference between a return and an allowance? Perhaps a customer's reason for wishing to return an item is because of a minor defect; the customer may be willing to keep the item if the price is reduced. The merchant may give an allowance to induce the customer not to return the item. The entry to record the allowance would ordinarily involve the same accounts as those previously illustrated for the return. However, one could use a separate account for returns and another for allowances.


Product catalogs often provide a list price for an item. Those list prices may bear little relation to the ultimate selling price. A merchant may offer customers a trade discount that involves a reduction from list price. Ultimately, the purchaser is responsible for the invoice price, that is, the list price less the negotiated trade discount. Trade discounts are not entered in the accounting records. They are not considered to be a part of the sale because the exchange agreement was based on the reduced price.

Remember the general rule that sales are recorded when an exchange takes place. Because the measurement of the sale is based on the exchange price, the amount recorded as a sale is the invoice price. The entries previously shown for a $4,000 sale would also be appropriate if the list price was $5,000, subject to a 20% trade discount.


Credit Card PictureIn the retail trade, merchants often issue credit cards. Why? Because they induce people to spend, and interest charges that may be assessed can themselves provide a generous source of additional revenue. However, these company-issued cards introduce added costs: customers that don't pay (known as bad debts), maintenance of a credit department, periodic billings, and so forth.

To avoid these issues, many merchants accept other forms of credit cards like Visa and MasterCard. When a merchant accepts these cards, they are usually paid instantly by the credit card company (net of a service charge that is negotiated in the general range of 1% to 3% of the sale). The subsequent billing and collection is handled by the credit card company. Many merchants will record the full amount of the sale as revenue, and then recognize an offsetting expense for the amount charged by the credit card companies.


CASH DISCOUNTS/sales discounts

Merchants often sell to other businesses. Assume that Barber Shop Supply Company sells equipment and supplies to various barber shops on open account. An open account is a standing agreement to extend credit for purchases. In these settings, the seller would like to be paid promptly after billing and may encourage prompt payment by offering a cash discount (also known as a sales discount).

To be entitled to the cash discount, the buyer must pay the invoice promptly. The amount of time one has available to pay is expressed in a unique manner, such as 2/10, n/30. These terms mean that a 2% discount is available if the purchaser pays the invoice within 10 days; otherwise, the net amount is expected to be paid within 30 days. Assume that Barber Shop Supply Company sold goods for $1,000, subject to terms of 2/10, n/30. The following entry would be recorded at the time of sale:

Cash Discount General Journal

The invoice that would be issued by Barber Shop Supply follows. Take special note of the invoice date, terms, and invoice amount.

Barber Shop Supply Invoice Example

If Hair Port Landing pays the invoice in time to receive the discount, a check for $980 would be received by Barber Shop Supply:

Hair Port Landing Check Illustration

Link to Excel ExerciseThe following entry reflects that the customer took advantage of the discount by paying within the 10-day window. Notice that the entry reduces Accounts Receivable for the full invoice amount because the payment satisfied the total obligation. The discount is recognized in a special Sales Discounts account, which is subtracted in calculating net sales (similar to Sales Returns and Allowance).

Cash Discount General Journal continued

If the customer pays too late to get the discount, then the payment received should be for the full invoice amount, and it would be recorded as follows:

Cash Discount General Journal continued

Having looked at several of the important and unique issues for recognizing sales transactions of merchandising businesses, it is now time to turn to the accounting for purchasing activities.


Purchase Considerations For Merchandising Businesses

A quick stroll through most any retail store will reveal a substantial investment in inventory. Even if a merchant is selling goods at a healthy profit, financial difficulties can creep up if a large part of the inventory remains unsold for a long period of time. Goods go out of style, become obsolete, and so forth. Therefore, a prudent business manager will pay very close attention to inventory content and level. There are many detailed accounting issues that pertain to inventory, and a separate chapter is devoted exclusively to inventory issues. This chapter's introduction is brief, focusing on elements of measurement that are unique to the merchant's accounting for the basic cost of goods.


The first phase of the merchandising cycle occurs when the merchant acquires goods to be stocked for resale to customers. The appropriate accounting for this action requires the recording of the purchase. There are two different techniques for recording the purchase; a periodic system or a perpetual system. Generally, the periodic inventory system is easier to implement but is less robust than the "real-time" tracking available under a perpetual system. Conversely, the perpetual inventory system involves more constant data update and is a far superior business management tool. The following presentation begins with a close examination of the periodic system. Later in the chapter the perpetual system will be described.


When a purchase occurs and a periodic inventory system is in use, the merchant should record the transaction via the following entry:

Periodic Inventory System General Journal

The Purchases account is unique to the periodic system. The Purchases account is not an expense or asset, per se. Instead, the account's balance represents total inventory purchased during a period, and this amount must ultimately be apportioned between cost of goods sold on the income statement and inventory on the balance sheet. The apportionment is based upon how much of the purchased goods are resold versus how much remains in ending inventory. Soon, the accounting mechanics of how this occurs will be shown. But, for the moment, simply focus on the concepts portrayed by the following graphic:

Periodic Inventory System illustration


Recall the earlier discussion of sales returns and allowances. Now examine how a purchaser of inventory would handle a return to its vendor/supplier. First, it is a common business practice to contact the supplier before returning goods. Unlike the retail trade, transactions between businesses are not so easily undone. A supplier may require that a customer first obtain an "RMA" or "Return Merchandise Authorization." This indicates a willingness on the part of the supplier to accept the return. When the merchandise is returned to a supplier, a debit memorandum may be prepared to indicate that the purchaser is to debit their Accounts Payable account; the corresponding credit is to Purchases Returns and Allowances:

Purchase Returns and Allowances General Journal

Purchase returns and allowances are subtracted from purchases to calculate the amount of net purchases for a period. The specific calculation of net purchases will be demonstrated after a few more concepts are introduced.

CASH DISCOUNTS/purchase discounts

Recall the previous discussion of cash discounts (sometimes called purchase discounts from the purchaser's perspective). Discounts are typically very favorable to the purchaser, as they are designed to encourage early payment.Discount terms vary considerably. Here are some examples:

  • 1/15, n/30 -- 1% if paid within 15 days, net due in 30 days
  • 1/10, n/eom -- 1% if paid within 10 days, net due end of month
  • .5/10, n/60 -- ½% if paid within 10 days, net due in 60 days

While discounts may seem slight, they can represent substantial savings and should usually be taken. Consider the following calendar, assuming a purchase was made on May 31, terms 2/10, n/30. The discount can be taken if payment is made within the "blue shaded" days. The discount cannot be taken during the "yellow shaded" days (of which there are twenty). The bill becomes past due during the "purple shaded" days. What is important to note here is that skipping past the discount period will only achieve a twenty-day deferral of the payment. Consider that a 2% return is "earned" by paying 20 days early. This is indeed a large savings. There are approximately 18 twenty-day periods in a year (365/20), and, at 2% per twenty-day period, this equates to over a 36% annual interest rate equivalent.

Cash Discount Calendar illustration

A business should set up its accounting system to timely process, and take advantage of, all reasonable discounts. In a small business setting, this might entail using a system where invoices are filed for payment to match the discount dates. A larger company will usually have an automated payment system where checks are scheduled to process concurrent with invoice discount dates. Very large payments, and global payments, are frequently processed as "wire transfers." This method enables the purchaser to retain use of funds (and the ability to generate investment income on those funds) until the very last minute. This is considered to be a good business practice.

Many vendors will accept a "discounted payment" outside of the discount period. In other words, a purchaser might wait 30, 60, or 90 days and still take the discount! Some vendors are glad to receive the payment and will still grant credit for the discount. Others will return the payment and insist on the full amount due. Is it a good business practice to "bend the terms" of the agreement to take a discount when the supplier will stand for this practice? Is it ethical to "bend the terms" of the agreement? Are these two questions really one and the same?

GROSS method

A fundamental accounting issue is how to account for purchase transactions when discounts are offered. One technique is the gross method of recording purchases. This technique records purchases at their total gross or full invoice amount:

Gross Recording of Purchases/Discounts General Journal

If payment is made within the discount period, the purchase discount is recognized in a separate account. The Purchase Discounts account is similar to Purchases Returns & Allowances, as it is deducted from total purchases to calculate the net purchases for the period:

Gross Recording of Purchases/Discounts General Journal continued

If payment is made outside the discount period, the purchaser loses the right to take a discount. Therefore, the full amount of the invoice becomes due and payable. The following entry would be needed to reflect this payment:

Gross Recording of Purchases/Discounts General Journal continued

NET method

Rather than recording purchases under the gross method, a company may elect to record the purchase and payment under a net method. With this technique, the initial purchase is again recorded by debiting Purchases and crediting Accounts Payable. However, the amount of the entry is for the invoice amount of the purchase, less the anticipated discount. Assuming the company intends to take the discount, this entry results in recording the net anticipated payment into the accounts.

Net Recording of Purchases/Discounts Lost General Journal

If payment is made within the discount period, the entry is quite straightforward because the payable was initially established at the net of discount amount:

Net Recording of Purchases/Discounts Lost General Journal continued

If payment is made outside the discount period, the lost discounts are recorded in a separate account. The Purchase Discounts Lost account is debited to reflect the added cost associated with missing out on the available discount amount:

Net Recording of Purchases/Discounts Lost General Journal continued


Link to Excel ExerciseIn evaluating the gross and net methods, notice that the Purchase Discounts Lost account (used only with the net method) indicates the total amount of discounts missed during a particular period. The presence of this account draws attention to the fact that discounts are not being taken, frequently an unfavorable situation. The Purchase Discounts account (used only with the gross method) identifies the amount of discounts taken, but does not indicate discounts missed, if any. For reporting purposes, purchases discounts are subtracted from purchases to arrive at net purchases, while purchases discounts lost are recorded as an expense following the gross profit number for a particular period.

The following illustration contrasts the gross and net methods for a case where the discount is taken. Notice that $4,900 is accounted for under each method. The gross method reports the $5,000 gross purchase, less the applicable discount. In contrast, the net method only shows the $4,900 purchase amount.

Gross vs. Net Method

The next illustration contrasts the gross and net methods for the case where the discount is lost. Notice that $5,000 is accounted for under each method. The gross method simply reports the $5,000 gross purchase, without any discount. In contrast, the net method shows purchases of $4,900 and an additional $100 expense pertaining to lost discounts.

Gross vs. Net Method


A potentially significant inventory-related cost pertains to freight. The importance of considering this cost in any business transaction is critical. The globalization of commerce, rising energy costs, and the increasing use of overnight delivery via more expensive air transportation all contribute to high freight costs. Freight costs can easily exceed 10% of the value of a transaction. As a result, business negotiations relate not only to matters of product cost, but must also include consideration of freight terms.

Link to Excel ExerciseFreight agreements are often described by abbreviations that describe the place of delivery, when the risk of loss shifts from the seller to the buyer, and who is to be responsible for the cost of shipping. One very popular abbreviation is F.O.B., which stands for "free on board." Its historical origin related to a seller's duty to place goods on a shipping vessel without charge to the buyer.

International commercial terms ("incoterms") and abbreviations (e.g., FCA, DDU, etc.) have been developed by the International Chamber of Commerce. As a result, great care should be taken to understand the specific nature of various freight agreements that occur in global commerce.

Freight on Board illustrationIn the U.S., the F.O.B. point is normally understood to represent the place where ownership of goods transfers. Along with shifting ownership comes the responsibility for the purchaser to assume the risk of loss, pay for the goods, and pay freight costs beyond the F.O.B. point.

In the illustration at left, notice that money is paid by the seller to the transport company. This is the case where the terms called for F.O.B. Destination -- the seller had to get the goods to the destination. This situation reverses in the next illustration: F.O.B. Shipping Point -- the buyer had to pay to get the goods delivered. The third illustration calls for the buyer to bear the freight cost (F.O.B. Shipping Point). However, the cost is prepaid by the seller as an accommodation. Notice that the buyer then sends payment to the seller to reimburse for the prepaid freight; ultimately the buyer is still bearing the freight cost. Of course, other scenarios are possible. For example, terms could be F.O.B. St. Louis, in which case the seller would pay to get the goods from New York to St. Louis, and the buyer would pay to bring the goods from St. Louis to Los Angeles.

Take a moment and look at the invoice presented earlier in this chapter for Barber Shop Supply. Notice that the seller was in Chicago and the purchaser was in Dallas. Just to the right of the invoice date, note that the terms were F.O.B. Dallas. This means that Barber Shop Supply is responsible for getting the goods to the customer in Dallas. That is why the invoice included $0 for freight; the purchaser was not responsible for the freight cost. Had the terms been F.O.B. Chicago, then Hair Port Landing would have to bear the freight cost.

Next are presented appropriate journal entries to deal with alternative scenarios.

  • If goods are sold F.O.B. destination, the seller is responsible for costs incurred in moving the goods to their destination. Freight cost incurred by the seller is called freight-out and is reported as a selling expense that is subtracted from gross profit in calculating net income.

Seller's entry:

F.O.B. Destination Buyers General Journal Entry

Purchaser's entry:

F.O.B. Destination Seller's General Journal Entry

  • If goods are sold F.O.B. shipping point, the purchaser is responsible for paying freight costs incurred in transporting the merchandise from the point of shipment to its destination. Freight cost incurred by a purchaser is called freight-in, and is added to purchases in calculating net purchases:

Seller's entry:

F.O.B. Shipping Point Buyers General Journal Entry

Purchaser's entry:

F.O.B. Shipping Point Seller's General Journal Entry

  • If goods are sold F.O.B. shipping point, freight prepaid, the seller prepays the trucking company as an accommodation to the purchaser. This prepaid freight increases the accounts receivable of the seller. That is, the seller expects payment for the merchandise and a reimbursement for the freight. The purchaser would record this transaction by debiting Purchases for the amount of the purchase, debiting Freight-In for the amount of the freight, and crediting Accounts Payable for the combined amount due to the seller.

Seller's entry:

F.O.B. Shipping Point, Freight Prepaid Buyers General Journal Entry

Purchaser's entry:

F.O.B. Shipping Point, Freight Prepaid Seller's General Journal Entry

Cash discounts for prompt payment are not usually available on freight charges. For example, if there was a 2% discount on the above purchase, it would amount to $200 ($10,000 X 2%), NOT $208 ($10,400 X 2%).


A number of new accounts have been introduced in this chapter. Purchases, Purchase Returns and Allowances, Purchase Discounts, and Freight-in have all been illustrated. Each of these accounts is necessary to calculate the "net purchases" during a period. Assume total purchases of $400,000 during the period. This would be based on the total invoice amount for all goods purchased during the period, as identified from the Purchases account in the ledger. The cost of the purchases is increased for the freight-in costs. Purchase discounts and purchase returns and allowances are subtracted. The result is "net purchases" of $420,000. Net purchases reflect the actual costs that were deemed to be ordinary and necessary to bring the goods to their location for resale to an end customer.

Calculation of Net Purchases illustration

Importantly, storage costs, insurance, interest and other similar costs are considered to be period costs that are not attached to the product. Instead, those ongoing costs are simply expensed in the period incurred as operating expenses of the business.


Link to Excel ExerciseThe cost of all purchases must ultimately be allocated between cost of goods sold and inventory, depending on the portion of the purchased goods that have been resold to end customers. This allocation must also give consideration to any beginning inventory that was carried over from prior periods.

Cost of Goods Sold illustration

Very simply, goods that remain unsold at the end of an accounting period should not be "expensed" as cost of goods sold. Therefore, the calculation of cost of goods sold requires an assessment of total goods available for sale, from which ending inventory is subtracted. With a periodic system, the ending inventory is determined by a physical count. In that process, the goods held are actually counted and assigned cost based on a consistent method. The actual methods for assigning cost to ending inventory is the subject of considerable discussion in the inventory chapter. Understanding the allocation of costs to ending inventory and cost of goods sold is very important and is worthy of additional emphasis. Consider the following diagram:

Cost of Goods Sold diagram

The beginning inventory is equal to the prior year's ending inventory, as determined by reference to the prior year's ending balance sheet. The net purchases is extracted from this year's ledger (i.e., the balances of Purchases, Freight-in, Purchase Discounts, and Purchase Returns & Allowances). Goods available for sale is the sum of beginning inventory and net purchases. Goods available for sale is not an account, per se; it is merely a defined result from adding two amounts together. The total cost incurred (i.e., cost of goods available for sale) must be "allocated" according to its nature at the end of the year. The cost of goods still held are assigned to inventory (an asset), and the remainder is attributed to cost of goods sold (an expense).


Link to Excel ExerciseThere is a lot of activity to consider: net sales, net purchases, cost of sales, gross profit, etc.! A detailed income statement can provide the necessary organization to present all of the data in an understandable format. Study the following detailed income statement.

Bill's Sporting Goods Detailed Income Statement

In reviewing the above income statement, be sure to notice (1) the calculation of net sales, (2) the inclusion of details about the calculation of net purchases (including the treatment of freight-in), (3) the calculation of cost of goods sold and presentation of gross profit, and (4) that freight-out is a selling expense included among the various expenses subtracted from gross profit. Be aware that the income statement for a merchandising company may not present all of this detail. Depending on the materiality of the individual line items, it may be sufficient to only present line items for the key elements, like net sales, cost of sales, gross profit, various expense accounts, and net income.


Because of all the new income statement-related accounts that were introduced for the merchandising concern, it is helpful to revisit the closing process. Recall the objective of closing; to transfer the net income to retained earnings and to reset the income statement accounts to zero in preparation for the next accounting period. As a result, all income statement accounts with a credit balance must be debited and vice versa. The closing entries for Bill's Sporting Goods follow. Several items are highlighted in these journal entries and are discussed further in the next paragraph.

Link to Excel ExerciseThese closing entries are a bit more complex than that from the earlier chapter. In particular, note that the closing includes all of the new accounts like purchases, discounts, etc. In addition, it is important to update the inventory records. It may be confusing to see Inventory being debited and credited in the closing process. After all, isn't Inventory a balance sheet (real) account? And, aren't the temporary accounts the only ones closed? Why then is Inventory included in the closing? The answer is that Inventory must be updated to reflect the ending balance on hand.

Remember that the periodic system resulted in a debit to Purchases, not Inventory. Further, as goods are sold, no entry is made to reduce Inventory. Therefore, the Inventory account would continue to carry the beginning of year balance throughout the year. As a result, Inventory must be updated at the time of closing. These entries accomplish that objective by crediting/removing the beginning balance and debiting/establishing the ending balance. Note that these entries also cause the Income Summary account to be reduced by the cost of sales amount (beginning inventory + net purchases - ending inventory).

Closing Entry General Journal


Alternative Inventory System

The periodic system only required the recording of inventory purchases to a Purchases account; inventory records were updated only during the closing process based on the results of a physical count. No attempt is made to adjust inventory records at the time of actual purchase and sale transactions. The weakness of the periodic system is that it provides no real-time data about the levels of inventory or gross profit data. If inventory is significant, the lack of up-to-date inventory data can be very costly.

Link to Excel ExerciseManagers need to know what is selling, and what is not selling, in order to optimize business success. That is why many successful merchants use sophisticated computer systems to implement perpetual inventory management. Bar code scanners at a retail checkout not only facilitate speedy transactions but may also be linked to an accounting information system. With a high-performance perpetual system, each purchase or sale results in an immediate update of the inventory and cost of sales data in the accounting system. The following entries are appropriate to record the purchase and subsequent resale of an inventory item:

Entry to record purchase of inventory:

Purchase of Inventory General Journal

Entries to record sale of inventory:

Record Sale of Inventory General Journal

Inventory PictureWith the perpetual system, the Purchases account is not needed. The Inventory account and Cost of Goods Sold account are constantly being adjusted as transactions occur. Freight-in is added to the Inventory account. Discounts and returns reduce the Inventory account. Therefore, the determination of cost of goods sold is by reference to the account's general ledger balance, rather than needing to resort to the calculations illustrated for the periodic system.

If the perpetual system looks simpler, don't be deceived. Consider that it is no easy task to determine the cost of each item of inventory as it is sold, and that is required with a perpetual system. In a large retail environment, that is almost impossible without a sophisticated computer system. Nevertheless, such systems have become commonplace with the decline in the cost of computers.

One final point should be noted. No matter how good the computer system, differences between the computer record and physical quantity of inventory on hand will arise. Differences are created by theft, spoilage, waste, errors, and so forth. Therefore, merchants must occasionally undertake a physical count and adjust the Inventory accounts to reflect what is actually on hand.


Income Statement Enhancements

Video LectureAccountants must always be cognizant of the capacity of financial statement users to review and absorb reports. Sometimes, the accountant may decide that a simplified presentation is sufficient. In those cases, the income statement may be presented in a "single-step" format.

This very simple approach reports all revenues (and gains) together, and the aggregated expenses (and losses) are tallied and subtracted to arrive at income. A single-step income statement is shown below:

Hunter Company Single-StepIncome Statement

Caution should be used when examining a single-step presentation. One should look at more than the bottom-line net income, and be certain to discern the components that make up income. For example, a company's core operations could be very weak, but the income could be good because of a non-recurring gain from the sale of assets. Tearing away such "masking" effects are a strong argument in favor of a more complex multiple-step approach.

A multiple-step income statement divides business operating results into separate categories or steps, and enhances the financial statement user's ability to understand the intricacy of an entity's operations. Often, companies will wish to further divide the expense items according to their nature: selling expenses (costs associated with the sale of merchandise) or general and administrative (costs incurred in the management of the business). Some costs must be allocated between the two categories; like depreciation of the corporate headquarters wherein both sales and administrative activities are conducted.

A business may, from time to time, have incidental or peripheral transactions that contribute to income. For example, a business might sell land at a gain. Or, a fire might produce a loss. These gains and losses are often reported separately from the ongoing measures of revenues and expenses. A subsequent chapter includes coverage of additional special reporting for other unique situations, like discontinued operations.

Likewise, many businesses break out the financing costs (i.e., interest expense) from the other expense components. This tends to separate the operating impacts from the cost of capital needed to produce those operating results. This is not to suggest that interest is not a real cost. Instead, the company has made decisions about borrowing money ("leverage"), and breaking out the interest cost separately allows users to have a better perspective of how well borrowing decisions are working. Investors want to know if enough extra income is being produced to cover the added financing costs associated with growth through debt financing.

Hunter Company Multiple-Step Income Statement

Not to be overlooked in the determination of income is the amount of any tax that must be paid. Businesses are subject to many taxes, not the least of which is income tax, which must be paid, and is usually based on complex formulas related to the amount of business income or value added in production. As a result, it is customary to present income before tax, then the amount of tax, and finally the net income.


Link to Excel ExerciseNo matter which income statement format is used, detailed data is of no value if it is not carefully evaluated. One should monitor not only absolute dollar amounts, but should also pay close attention to ratios and percentages. It is typical to monitor the gross profit margin and the net profit on sales:

Gross Profit Margin = Gross Profit/Net Sales

$370,000/$653,000 = 56.66% for Hunter


Net Profit on Sales  = Net Income/Net Sales

$39,000/$653,000 = 5.97% for Hunter

There are countless variations of these calculations, but they all highlight the issue of evaluating trends in performance separate and apart from absolute dollar amounts. Be aware that margins can be tricky. For example, suppose Liu's Janitorial Supply sold plastic trash cans. During Year 1, sales of cans were $3,000,000, and these units cost $2,700,000. During Year 2, oil prices dropped significantly. Oil is a critical component in plastics, and Liu passed along cost savings to his customers. Liu's Year 2 sales were $1,000,000, and the cost of goods sold was $700,000. Liu was very disappointed in the sales drop. However, he should not despair, as his gross profit was $300,000 in each year, and the gross profit margin soared during Year 2. The gross profit margin in Year 1 was 10% ($300,000/$3,000,000), and the gross profit margin in Year 2 was 30% ($300,000/$1,000,000). Despite the plunge in sales, Liu may actually be better off. Although this is a dramatic example to make the point, even the slightest shift in business circumstances can change the relative relationships between revenues and costs. A smart manager or investor will always keep a keen eye on business trends revealed by the shifting of gross profit and net profit percentages over time.

Global issues in income reporting

Globe PictureInternational financial reporting standards and practices do not prescribe a detailed format for the income statement. Thus, the concepts of "multiple-step" and "single-step" presentations are not as relevant. Instead, the global perspective focuses on reporting of revenues, financing costs, profit shares from ventures/investments, tax expense, and profit or loss. Further, expenses may be classified according to either nature or function.

Classification by "nature" means that a company would elect to categorize and present information relating to utilities expense, salaries expense, advertising expense, insurance expense, and the like. Alternatively, classification by "function" means that a company would instead classify expenses according to their purpose: manufacturing, administrative, sales, and so on. If a functional classification scheme is used in the income statement, then supplemental disclosures ordinarily provide additional detail about the underlying nature of costs incurred by the organization.

In addition, global accounting rules are sometimes more permissive than U.S. rules when it comes to recording gains or losses that are based upon changing values of long-term assets like land and buildings. Thus, a company that is reporting globally might prepare an additional statement that reconciles net income to this broader concept of income measurement. The statement is sometimes called a statement of recognized income and expense.


The Control Structure

Video LectureAn organization should carefully define various measures to safeguard its assets, check the reliability and accuracy of accounting information, ensure compliance with management policies, and evaluate operating performance and efficiency. The internal control structure depends on the accounting system, the control environment, and the control procedures. The control environment is the combined effect of a firm's policies and attitudes toward control implementation.

Link to Excel ExerciseControl procedures are specifically integrated into the accounting system and relate to the following:

  • One important control is limited access to assets. This control feature assures that only authorized and responsible employees can obtain access to key assets. For example, a supplies stock area may be accessible only to department supervisors.
  • Separation of duties is another important control. Activities like transaction authorization, transaction recording, and asset custody should be performed by different employees. Separating functions reduces the possibility of errors (because of cross-checking of accounting records to assets on hand, etc.) and fraud (because of the need for collusion among employees).
  • A number of accountability procedures can be implemented to improve the degree of internal control:
    • Duty authorization is a control feature which requires that certain functions be performed by a specific person (e.g., customer returns of merchandise for credit can be approved only by a sales manager).
    • Prenumbered documents allow ready identification of missing items. For example, checks are usually prenumbered so that missing checks can be identified rapidly.
    • Independent verification of records is another control procedure. Examples include comparing cash in a point of sale terminal with the sales recorded on that register and periodic reconciliation of bank accounts.
  • A company may engage an accounting firm or CPA to provide an independent review of the company's accounting records and internal controls. The accountant may offer suggestions for improvement and test the established system to determine if it is functioning as planned.

In designing and implementing an internal control system, careful attention should be paid to the costs and benefits of the system. It is folly to develop a system which costs more to establish and maintain than it is worth to the company.

retail CONTROLs

Security Camera pictureThe basic elements of control are common to most businesses. However, the merchandiser must pay special attention to several unique considerations. Foremost is asset control. Obviously, the retailer has a huge investment in inventory, and that inventory is not easily "isolated." As a result, theft and spoilage are all too common. Retailers should go to great lengths to protect against these costly events.

Think, for a moment, about walking through an electronics retail store. Upon entering the front door, one may first notice "architecturally pleasing" barricades (like planter boxes or posts) to prevent crash entry. Next is a doorman (guard), who perhaps oversees separate entrances and exits, and is responsible for matching receipts to goods leaving the store. An alarm may sound if a hidden inventory sensor has not been deactivated at check out.

A quick glance up may reveal cameras. The most expensive items are display only; to buy these items a claim ticket is presented at a caged area. Only authorized employees can enter that area. At check out, point-of-sale terminals must be accessed with a key that is assigned to an employee. The terminal tracks who processed the sale. In addition, an employee may look inside a box or bag that contains a customer's purchased items, picture IDs are examined, and so forth. In general, the goal is simple -- make sure that only purchased merchandise gets out of the store. Several times daily, the cash drawers in the terminals will be pulled (replaced with another) and their contents audited. Daily bank runs (maybe via armored courier) will occur to make sure that funds are quickly and safely deposited in the bank. These controls are visible at the "front end" of the business.


Purchasing cycle controls are invisible to the customer, but equally as important. And, these purchasing controls are pervasive in other non-merchandising businesses as well. There is no single correct process but the following concepts should be considered:

  • Purchases should be initiated only by appropriate supervisory personnel, in accord with budgets or other authorizing plans.
  • The purchasing action should be undertaken by trained purchasing personnel who know how to negotiate the best terms (with full understanding of freight issues, discount issues, and so forth).
  • Purchasing departments should have strong procedural rules, including prohibitions against employees receiving "gifts" and limitations on dealings with related parties.
  • Large purchases should be preceded by solicitation of bids from multiple vendors.
  • A purchase order should be prepared to initiate the actual order.
  • When goods are received, the receiving department should not accept them without inspection, including matching the goods to an open purchase order to make sure that what is being delivered was in fact ordered.
  • The receiving department should prepare a receiving report, indicating that goods have been received in good order.
  • When an invoice ("bill") is received, it should be carefully matched to the original purchase order and receiving report. The bill should be scheduled for payment in time to take advantage of available discounts. It is important to only pay for goods that were ordered and received. In a large organization, the person preparing the payment has likely never seen the goods; hence the importance of complete documentation.
  • Before payment is released, an independent supervisor should make one last review of all the documents.

In an automated environment many of these processes and documents will be generated and preserved electronically. However, the underlying controls are of equal importance.

CONTROL systems

Accountants spend much of their time dealing with issues that are complex, like designing and testing the control environment. For example, an auditor does not just look at a bunch of transactions to see if the debits and credits are correct. Instead, the control environment will be studied and tested to see if it is working as planned. If it is, then the "system" should be producing correct financial data, and much less time can be devoted to actually focusing on specific transactions.