In a perpetual inventory system multiple performance obligations

Perpetual Inventory System And Inventory Valuation Methods

Part 1: Perpetual Inventory System

Present a detailed explanation of the recording of purchases under a perpetual inventory system. Use hypothetical figures to illustrate the perpetual inventory system. After presenting your hypothetical figures, discuss how a perpetual inventory system is different from a periodic inventory system. Your answer should illustrate understanding of the perpetual inventory system.

Part 2: Inventory Valuation Methods

Identify the differences between F.I.F.O., L.I.F.O., and the average-cost method of inventory valuation. Be sure to include the effects of each method on cost of goods sold and net income in your answer. Also discuss the differences between the physical movement of goods and cost flow assumptions. Your answer should illustrate understanding of the three major inventory valuation methods, and the relationship between physical inventory flow and cost flow assumptions.

Required Resource

Text

Kimmel, P. D., Weygandt, J. J., & Kieso, D. E. (2016). Financial accounting: Tools for business decision making (8th ed.). Retrieved from https://content.ashford.edu/

Chapter 5: Merchandising Operations and the Multiple-Step Income Statement

Chapter 6: Reporting and Analyzing Inventory

(Chapters 5 & 6 are in the attachments)

Recommended Resources

Article

Bloom, R., & Cenker, W. J. (2008, December 31). The death of LIFO?. Journal of Accounting. Retrieved from http://www.journalofaccountancy.com/issues/2009/jan/deathoflifo.htm

Website

Textbook Student Companion Site . http://bcs.wiley.com/he-bcs/Books?action=index&itemId=1118953908&bcsId=9831

Review the PowerPoint presentations for Chapter 5 and Chapter 6 found on the textbook publisher’s website.

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05if… 1/101

4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05if… 2/101

LEARNING OBJECTIVE 1

Identify the forms of business organization and the uses of accounting information. 

Suppose you graduate with a business degree and decide you want to start your own business. But what kind of business? You enjoy working with people, especially teaching them new skills. You also spend most of your free time outdoors, kayaking, backpacking, skiing, rock climbing, and mountain biking. You think you might be successful in opening an outdoor guide service where you grew up, in the Sierra Nevada mountains.

FORMS OF BUSINESS ORGANIZATION Your next decision is to determine the organizational form of your business. You have three choices—sole proprietorship, partnership, or corporation.

SOLE PROPRIETORSHIP

You might choose the sole proprietorship form for your outdoor guide service. A business owned by one person is a sole proprietorship. It is simple to set up and gives you control over the business. Small owner-operated businesses such as barber shops, law of�ices, and auto repair shops are often sole proprietorships, as are farms and small retail stores.

PARTNERSHIP

Another possibility is for you to join forces with other individuals to form a partnership. A business owned by two or more persons associated as partners is a partnership. Partnerships often are formed because one individual does not have enough economic resources to initiate or expand the business. Sometimes partners bring unique skills or resources to the partnership. You and your partners should formalize your duties and contributions in a written partnership agreement. Retail and service-type businesses, including professional practices (lawyers, doctors, architects, and certi�ied public accountants), often organize as partnerships.

4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05if… 3/101

Alternative Terminology notes present synonymous terms that you may come across in practice.

CORPORATION

As a third alternative, you might organize as a corporation. A business organized as a separate legal entity owned by stockholders is a corporation. Investors in a corporation receive shares of stock to indicate their ownership claim. Buying stock in a corporation is often more attractive than investing in a partnership because shares of stock are easy to sell (transfer ownership). Selling a proprietorship or partnership interest is much more involved. Also, individuals can become stockholders by investing relatively small amounts of money. Therefore, it is easier for corporations to raise funds. Successful corporations often have thousands of stockholders, and their stock is traded on organized stock exchanges like the New York Stock Exchange. Many businesses start as sole proprietorships or partnerships and eventually incorporate.

Other factors to consider in deciding which organizational form to choose are taxes and legal liability. If you choose a sole proprietorship or partnership, you generally receive more favorable tax treatment than a corporation. However, proprietors and partners are personally liable for all debts and legal obligations of the business; corporate stockholders are not. In other words, corporate stockholders generally pay higher taxes but have no personal legal liability. We will discuss these issues in more depth in a later chapter.

Finally, while sole proprietorships, partnerships, and corporations represent the main types of business organizations, hybrid forms are now allowed in all states. These hybrid business forms combine the tax advantages of partnerships with the limited liability of corporations. Probably the most common among these hybrids types are limited liability companies (LLCs) and subchapter S corporations. These forms are discussed extensively in business law classes.

4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05if… 4/101

The combined number of proprietorships and partnerships in the United States is more than �ive times the number of corporations. However, the revenue produced by corporations is eight times greater. Most of the largest businesses in the United States—for example, Coca-Cola, ExxonMobil, General Motors, Citigroup, and Microsoft—are corporations. Because the majority of U.S. business is done by corporations, the emphasis in this textbook is on the corporate form of organization.

ALTERNATIVE TERMINOLOGY

Stockholders are sometimes called shareholders.

USERS AND USES OF FINANCIAL INFORMATION The purpose of �inancial information is to provide inputs for decision-making. Accounting is the information system that identi�ies, records, and communicates the economic events of an organization to interested users. Users of accounting information can be divided broadly into two groups: internal users and external users.

Internal Users

Internal users of accounting information are managers who plan, organize, and run a business. These include marketing managers, production supervisors, �inance directors, and company of�icers. In running a business, managers must answer many important questions, as shown in Illustration 1-1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch01lo1#c01-�ig-0001) .

ILLUSTRATION 1-1 Questions that internal users ask

Accounting Across the Organization boxes show applications of accounting information in various business functions.

To answer these and other questions, you need detailed information on a timely basis. For internal users, accounting provides internal reports, such as �inancial comparisons of operating alternatives, projections of income from new sales campaigns, and forecasts of cash needs for the next year. In addition, companies present summarized �inancial information in the form of �inancial statements.

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch01lo1#c01-fig-0001
4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05if… 5/101

 ACCOUNTING ACROSS THE ORGANIZATION 

Clif Bar & Company

Owning a Piece of the Bar

The original Clif Bar® energy bar was created in 1990 after six months of experimentation by Gary Erickson and his mother in her kitchen. Today, the company has almost 300 employees and is considered one of the leading Landor's Breakaway Brands®. One of Clif Bar & Company's proudest moments was the creation of an employee stock ownership plan (ESOP) in 2010. This plan gives its employees 20% ownership of the company. The ESOP also resulted in Clif Bar enacting an open-book management program, including the commitment to educate all employee-owners about its �inances. Armed with basic accounting knowledge, employees are more aware of the �inancial impact of their actions, which leads to better decisions.

What are the bene�its to the company and to the employees of making the �inancial statements available to all employees? (Go to WileyPLUS for this answer and additional questions.)

External Users

There are several types of external users of accounting information. Investors (owners) use accounting information to make decisions to buy, hold, or sell stock. Creditors such as suppliers and bankers use accounting information to evaluate the risks of selling on credit or lending money. Some questions that investors and creditors may ask about a company are shown in Illustration 1-2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch01lo1#c01-�ig-0002) .

ILLUSTRATION 1-2 Questions that external users ask

The information needs and questions of other external users vary considerably. Taxing authorities, such as the Internal Revenue Service, want to know whether the company complies with the tax laws. Customers are interested in whether a company like General Motors will continue to honor product warranties and

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch01lo1#c01-fig-0002
4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05if… 6/101

otherwise support its product lines. Labor unions, such as the Major League Baseball Players Association, want to know whether the owners have the ability to pay increased wages and bene�its. Regulatory agencies, such as the Securities and Exchange Commission or the Federal Trade Commission, want to know whether the company is operating within prescribed rules. For example, Enron, Dynegy, Duke Energy, and other big energy-trading companies reported record pro�its at the same time as California was paying extremely high prices for energy and suffering from blackouts. This disparity caused regulators to investigate the energy traders to make sure that the pro�its were earned by legitimate and fair practices.

ACCOUNTING ACROSS THE ORGANIZATION

Spinning the Career Wheel

How will the study of accounting help you? A working knowledge of accounting is desirable for virtually every �ield of business. Some examples of how accounting is used in business careers include the following.

General management: Managers of Ford Motors, Massachusetts General Hospital, California State University– Fullerton, a McDonald's franchise, and a Trek bike shop all need to understand accounting data in order to make wise business decisions.

Marketing: Marketing specialists at Procter & Gamble must be sensitive to costs and bene�its, which accounting helps them quantify and understand. Making a sale is meaningless unless it is a pro�itable sale.

Finance: Do you want to be a banker for Citicorp, an investment analyst for Goldman Sachs, or a stock broker for Merrill Lynch? These �ields rely heavily on accounting knowledge to analyze �inancial statements. In fact, it is dif�icult to get a good job in a �inance function without two or three courses in accounting.

Real estate: Are you interested in being a real estate broker for Prudential Real Estate? Because a third party—the bank— is almost always involved in �inancing a real estate transaction, brokers must understand the numbers involved: Can the buyer afford to make the payments to the bank? Does the cash �low from an industrial property justify the purchase price? What are the tax bene�its of the purchase?

How might accounting help you? (Go to WileyPLUS for this answer and additional questions.)

4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05if… 7/101

ETHICS IN FINANCIAL REPORTING People won't gamble in a casino if they think it is “rigged.” Similarly, people won't “play” the stock market if they think stock prices are rigged. At one time, the �inancial press was full of articles about �inancial scandals at Enron, WorldCom, HealthSouth, and AIG. As more scandals came to light, a mistrust of �inancial reporting in general seemed to be developing. One article in the Wall Street Journal noted that “repeated disclosures about questionable accounting practices have bruised investors' faith in the reliability of earnings reports, which in turn has sent stock prices tumbling.” Imagine trying to carry on a business or invest money if you could not depend on the �inancial statements to be honestly prepared. Information would have no credibility. There is no doubt that a sound, well-functioning economy depends on accurate and dependable �inancial reporting.

United States regulators and lawmakers were very concerned that the economy would suffer if investors lost con�idence in corporate accounting because of unethical �inancial reporting. Congress passed the Sarbanes-Oxley Act (SOX) to reduce unethical corporate behavior and decrease the likelihood of future corporate scandals. As a result of SOX, top management must now certify the accuracy of �inancial information. In addition, penalties for fraudulent �inancial activity are much more severe. Also, SOX increased both the independence of the outside auditors who review the accuracy of corporate �inancial statements and the oversight role of boards of directors.

ETHICS NOTE

Circus-founder P.T. Barnum is alleged to have said, “Trust everyone, but cut the deck.” What Sarbanes-Oxley does is to provide measures that (like cutting the deck of playing cards) help ensure that fraud will not occur.

Ethics Notes help sensitize you to some of the ethical issues in accounting.

Effective �inancial reporting depends on sound ethical behavior. To sensitize you to ethical situations and to give you practice at solving ethical dilemmas, we address ethics in a number of ways in this textbook. (1) A number of the Feature Stories and other parts of the text discuss the central importance of ethical behavior to �inancial reporting. (2) Ethics Insight boxes and marginal Ethics Notes highlight ethics situations and issues in actual business settings. (3) Many of the People, Planet, and Pro�it Insight boxes focus on ethical issues that companies face in measuring and reporting social and environmental issues. (4) At the end of each chapter, an Ethics Case simulates a business situation and asks you to put yourself in the position of a decision-maker in that case.

When analyzing these various ethics cases and your own ethical experiences, you should apply the three steps outlined in Illustration 1-3 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch01lo1#c01-�ig-0003) .

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch01lo1#c01-fig-0003
4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05if… 8/101

ILLUSTRATION 1-3 Steps in analyzing ethics cases

 ETHICS INSIGHT 

Dewey & LeBoeuf LLP

I Felt the Pressure—Would You?

“I felt the pressure.” That's what some of the employees of the now- defunct law �irm of Dewey & LeBoeuf LLP indicated when they helped to overstate revenue and use accounting tricks to hide losses and cover up cash shortages. These employees worked for the former �inance director and former chief �inancial of�icer (CFO) of the �irm. Here are some of their comments:

“I was instructed by the CFO to create invoices, knowing they would not be sent to clients. When I created these invoices, I knew that it was inappropriate.”

“I intentionally gave the auditors incorrect information in the course of the audit.”

What happened here is that a small group of lower-level employees over a period of years carried out the instructions of their bosses. Their bosses, however, seemed to have no concern as evidenced by various e-mails with one another in which they referred to their �inancial manipulations as accounting tricks, cooking the books, and fake income.

Source: Ashby Jones, “Guilty Pleas of Dewey Staff Detail the Alleged Fraud,” Wall Street Journal (March 28, 2014).

Why did these employees lie, and what do you believe should be their penalty for these lies? (Go to WileyPLUS for this answer and additional questions.)

Insight boxes provide examples of business situations from various perspectives—ethics, investor, international, and corporate social responsibility. Guideline answers to the critical thinking questions

4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05if… 9/101

are available in WileyPLUS and at www.wiley.com/college/weygandt (http://www.wiley.com/college/weygandt) . Additional questions are offered in WileyPLUS.

DO IT! 1

Business Organization Forms

DO IT! exercises prompt you to stop and review the key points you have just studied. The Action Plan offers you tips about how to approach the problem.

In choosing the organizational form for your outdoor guide service, you should consider the pros and cons of each. Identify each of the following organizational characteristics with the organizational form or forms with which it is associated.

1. Easier to raise funds.

2. Simple to establish.

3. No personal legal liability.

4. Tax advantages.

5. Easier to transfer ownership.

Action Plan ✓ Know which organizational form best matches the business

type, size, and preferences of the owner(s).

http://www.wiley.com/college/weygandt
4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05… 10/101

SOLUTION

1. Easier to raise funds: Corporation.

2. Simple to establish: Sole proprietorship and partnership.

3. No personal legal liability: Corporation.

4. Tax advantages: Sole proprietorship and partnership.

5. Easier to transfer ownership: Corporation.

Related exercise material: BE1-1 and DO IT! 1-1.

4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05… 11/101

5

Merchandising Operations and the Multiple-Step Income Statement

 CHAPTER PREVIEW 

Merchandising is one of the largest and most in�luential industries in the United States. It is likely that a number of you will work for a merchandiser. Therefore, understanding the �inancial statements of merchandising companies is important. In this chapter, you will learn the basics about reporting merchandising transactions. In addition, you will learn how to prepare and analyze a commonly used form of the income statement—the multiple-step income statement.

4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05… 12/101

Buy Now, Vote Later

Have you ever shopped for outdoor gear at an REI (Recreational Equipment Incorporated) store? If so, you might have been surprised if a salesclerk asked if you were a member. A member? What do you mean a member? REI is a consumer cooperative, or “co-op” for short. To �igure out what that means, consider this quote from the company's annual report:

As a cooperative, the Company is owned by its members. Each member is entitled to one vote in the election of the Company's Board of Directors. Since January 1, 2008, the nonrefundable, nontransferable, one-time membership fee has been $20 dollars. As of December 31, 2010, there were approximately 10.8 million members.

Voting rights? Now that's something you don't get from shopping at Wal-Mart. REI members get other bene�its as well, including sharing in the company's pro�its through a dividend at the end of the year. The more you spend, the bigger your dividend.

Since REI is a co-op, you might wonder whether management's incentives might be a little different. Management is still concerned about making a pro�it, as it ensures the long-term viability of the company. REI's members also want the company to be run ef�iciently, so that prices remain low. In order for its members to evaluate just how well management is doing, REI publishes an audited annual report, just like publicly traded companies do.

How well is this business model working for REI? Well, it has consistently been rated as one of the best places to work in the United States by Fortune magazine. Also, REI had sustainable business practices long before social responsibility became popular at other companies. The CEO's Stewardship Report states “we reduced the absolute amount of energy we use despite opening four new stores and growing our business; we grew the amount of FSC-certi�ied paper we use to 58.4 percent of our total paper footprint—including our cash register receipt paper; we facilitated 2.2 million volunteer hours and we provided $3.7 million to more than 330 conservation and recreation nonpro�its.”

So, while REI, like other retailers, closely monitors its �inancial results, it also strives to succeed in other areas. And, with over 10 million votes at stake, REI's management knows that it has to deliver.

4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05… 13/101

LEARNING OBJECTIVE 1

Describe merchandising operations and inventory systems. 

REI, Wal-Mart, and Amazon.com are called merchandising companies because they buy and sell merchandise rather than perform services as their primary source of revenue. Merchandising companies that purchase and sell directly to consumers are called retailers. Merchandising companies that sell to retailers are known as wholesalers. For example, retailer Walgreens might buy goods from wholesaler McKesson; retailer Of�ice Depot might buy of�ice supplies from wholesaler United Stationers. The primary source of revenue for merchandising companies is the sale of merchandise, often referred to simply as sales revenue or sales. A merchandising company has two categories of expenses: cost of goods sold and operating expenses.

Cost of goods sold is the total cost of merchandise sold during the period. This expense is directly related to the revenue recognized from the sale of goods. Illustration 5-1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo1#c05-�ig-0001) shows the income measurement process for a merchandising company. The items in the two blue boxes are unique to a merchandising company; they are not used by a service company.

ILLUSTRATION 5-1 Income measurement process for a merchandising company

OPERATING CYCLES The operating cycle of a merchandising company ordinarily is longer than that of a service company. The purchase of inventory and its eventual sale lengthen the cycle. Illustration 5-2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo1#c05-�ig-0002) contrasts the operating cycles of service and merchandising companies. Note that the added asset account for a merchandising company is the Inventory account.

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch05lo1#c05-fig-0001
https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch05lo1#c05-fig-0002
4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05… 14/101

ILLUSTRATION 5-2 Operating cycles for a service company and a merchandising company

FLOW OF COSTS The �low of costs for a merchandising company is as follows. Beginning inventory plus the cost of goods purchased is the cost of goods available for sale. As goods are sold, they are assigned to cost of goods sold. Those goods that are not sold by the end of the accounting period represent ending inventory. Illustration 5-3 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo1#c05-�ig-0003) describes these relationships. Companies use one of two systems to account for inventory: a perpetual inventory system or a periodic inventory system.

ILLUSTRATION 5-3 Flow of costs

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch05lo1#c05-fig-0003
4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05… 15/101

Perpetual System

In a perpetual inventory system, companies maintain detailed records of the cost of each inventory purchase and sale. These records continuously—perpetually—show the inventory that should be on hand for every item. For example, a Ford dealership has separate inventory records for each automobile, truck, and van on its lot and showroom �loor. Similarly, a grocery store uses bar codes and optical scanners to keep a daily running record of every box of cereal and every jar of jelly that it buys and sells. Under a perpetual inventory system, a company determines the cost of goods sold each time a sale occurs.

▼ HELPFUL HINT

Even under perpetual inventory systems, companies perform physical inventory counts. This is done as a control procedure to verify inventory levels, in order to detect theft or “shrinkage.”

Periodic System

In a periodic inventory system, companies do not keep detailed inventory records of the goods on hand throughout the period. They determine the cost of goods sold only at the end of the accounting period— that is, periodically. At that point, the company takes a physical inventory count to determine the cost of goods on hand.

To determine the cost of goods sold under a periodic inventory system, the following steps are necessary:

1. Determine the cost of goods on hand at the beginning of the accounting period.

2. Add to it the cost of goods purchased.

3. Subtract the cost of goods on hand as determined by the physical inventory count at the end of the accounting period.

Illustration 5-4 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo1#c05-�ig-0004) graphically compares the sequence of activities and the timing of the cost of goods sold computation under the two inventory systems.

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch05lo1#c05-fig-0004
4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05… 16/101

ILLUSTRATION 5-4 Comparing perpetual and periodic inventory systems

Advantages of the Perpetual System

Companies that sell merchandise with high unit values, such as automobiles, furniture, and major home appliances, have traditionally used perpetual systems. The growing use of computers and electronic scanners has enabled many more companies to install perpetual inventory systems. The perpetual inventory system is so named because the accounting records continuously—perpetually—show the quantity and cost of the inventory that should be on hand at any time.

A perpetual inventory system provides better control over inventories than a periodic system. Since the inventory records show the quantities that should be on hand, the company can count the goods at any time to see whether the amount of goods actually on hand agrees with the inventory records. If shortages are uncovered, the company can investigate immediately. Although a perpetual inventory system requires additional clerical work and additional cost to maintain inventory records, a computerized system can minimize this cost. Much of Amazon.com's success is attributed to its sophisticated inventory system.

Some businesses �ind it either unnecessary or uneconomical to invest in a sophisticated, computerized perpetual inventory system such as Amazon's. However, many small merchandising businesses now use basic accounting software, which provides some of the essential bene�its of a perpetual inventory system. Yet, managers of some small businesses still �ind that they can control their merchandise and manage day- to-day operations using a periodic inventory system.

Because of the widespread use of the perpetual inventory system, we illustrate it in this chapter. An appendix to this chapter describes the journal entries for the periodic system.

INVESTOR INSIGHT

Morrow Snowboards, Inc.

Improving Stock Appeal

4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05… 17/101

Investors are often eager to invest in a company that has a hot new product. However, when snowboard maker Morrow Snowboards, Inc. issued shares of stock to the public for the �irst time, some investors expressed reluctance to invest in Morrow because of a number of accounting control problems. To reduce investor concerns, Morrow implemented a perpetual inventory system to improve its control over inventory. In addition, it stated that it would perform a physical inventory count every quarter until it felt that its perpetual inventory system was reliable.

If a perpetual system keeps track of inventory on a daily basis, why do companies ever need to do a physical count? (Go to WileyPLUS for this answer and additional questions.)

DO IT! 1

Merchandising Operations and Inventory Systems

Indicate whether the following statements are true or false. If false, indicate how to correct the statement.

1. The primary source of revenue for a merchandising company results from performing services for customers.

2. The operating cycle of a service company is usually shorter than that of a merchandising company.

3. Sales revenue less cost of goods sold equals gross pro�it.

4. Ending inventory plus the cost of goods purchased equals cost of goods available for sale.

Action Plan ✓ Review merchandising concepts.

✓ Understand the �low of costs in a merchandising company.

4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05… 18/101

SOLUTION

1. False. The primary source of revenue for a service company results from performing services for customers.

2. True.

3. True.

4. False. Beginning inventory plus the cost of goods purchased equals cost of goods available for sale.

Related exercise material: BE1-1 and DO IT! 5-1.

4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05… 19/101

LEARNING OBJECTIVE 2

Record purchases under a perpetual inventory system. 

Companies may purchase inventory for cash or on account (credit). They normally record purchases when they receive the goods from the seller. Every purchase should be supported by business documents that provide written evidence of the transaction. Each cash purchase should be supported by a canceled check or a cash register receipt indicating the items purchased and amounts paid. Companies record cash purchases by an increase (debit) in Inventory and a decrease (credit) in Cash.

Each purchase should be supported by a purchase invoice, which indicates the total purchase price and other relevant information. However, the purchaser does not prepare a separate purchase invoice. Instead, the purchaser uses as a purchase invoice the copy of the sales invoice sent by the seller. In Illustration 5-5 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo2#c05-�ig-0005) , for example, Sauk Stereo (the buyer) uses as a purchase invoice the sales invoice prepared by PW Audio Supply, Inc. (the seller).

ILLUSTRATION 5-5 Sales invoice used as purchase invoice by Sauk Stereo

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch05lo2#c05-fig-0005
4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05… 20/101

The associated entry for Sauk Stereo for the invoice from PW Audio Supply increases (debits) Inventory and increases (credits) Accounts Payable.

Under the perpetual inventory system, companies record purchases of merchandise for sale in the Inventory account. Thus, REI would increase (debit) Inventory for clothing, sporting goods, and anything else purchased for resale to customers.

Not all purchases are debited to Inventory, however. Companies record purchases of assets acquired for use and not for resale, such as supplies, equipment, and similar items, as increases to speci�ic asset accounts rather than to Inventory. For example, to record the purchase of materials used to make shelf signs or for cash register receipt paper, REI would increase (debit) Supplies.

▼ HELPFUL HINT

To better understand the contents of this invoice, identify these items:

1. Seller

2. Invoice date

3. Purchaser

4. Salesperson

5. Credit terms

6. Freight terms

7. Goods sold: catalog number, description, quantity, price per unit

8. Total invoice amount

FREIGHT COSTS The sales agreement should indicate who—the seller or the buyer—is to pay for transporting the goods to the buyer's place of business. When a common carrier such as a railroad, trucking company, or airline transports the goods, the carrier prepares a freight bill in accord with the sales agreement.

Freight terms are expressed as either FOB shipping point or FOB destination. The letters FOB mean free on board. Thus, FOB shipping point means that the seller places the goods free on board the carrier, and the buyer pays the freight costs. Conversely, FOB destination means that the seller places the goods free on

4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05… 21/101

board to the buyer's place of business, and the seller pays the freight. For example, the sales invoice in Illustration 5-5 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo2#c05-�ig-0005) indicates FOB shipping point. Thus, the buyer (Sauk Stereo) pays the freight charges. Illustration 5-6 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo2#c05-�ig-0006) illustrates these shipping terms.

ILLUSTRATION 5-6 Shipping terms

Freight Costs Incurred by Buyer

When the buyer pays the transportation costs, these costs are considered part of the cost of purchasing inventory. As a result, the account Inventory is increased (debited). For example, if Sauk Stereo (the buyer) pays Public Freight Company $150 for freight charges on May 6, the entry on Sauk Stereo's books is:

Thus, any freight costs incurred by the buyer are part of the cost of merchandise purchased. The reason: Inventory cost should include all costs to acquire the inventory, including freight necessary to deliver the goods to the buyer. Companies recognize these costs as cost of goods sold when inventory is sold.

Freight Costs Incurred by Seller

In contrast, freight costs incurred by the seller on outgoing merchandise are an operating expense to the seller. These costs increase an expense account titled Freight-Out (sometimes called Delivery Expense). For example, if the freight terms on the invoice in Illustration 5-5 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo2#c05-�ig-0005) had required that PW Audio Supply (the seller) pay the $150 freight charges, the entry by PW Audio Supply would be:

When the seller pays the freight charges, the seller will usually establish a higher invoice price for the goods, to cover the expense of shipping.

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch05lo2#c05-fig-0005
https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch05lo2#c05-fig-0006
https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch05lo2#c05-fig-0005
4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05… 22/101

PURCHASE RETURNS AND ALLOWANCES A purchaser may be dissatis�ied with the merchandise received because the goods are damaged or defective, of inferior quality, or do not meet the purchaser's speci�ications. In such cases, the purchaser may return the goods to the seller for credit if the sale was made on credit, or for 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 merchandise if the seller is willing to grant a reduction of the purchase price. This transaction is known as a purchase allowance.

Assume that Sauk Stereo returned goods costing $300 to PW Audio Supply on May 8. The following entry by Sauk Stereo for the returned merchandise decreases (debits) Accounts Payable and decreases (credits) Inventory.

Because Sauk Stereo increased Inventory when the goods were received, Inventory is decreased (credited) when Sauk Stereo returns the goods.

Suppose instead that Sauk Stereo chose to keep the goods after being granted a $50 allowance (reduction in price). It would reduce (debit) Accounts Payable and reduce (credit) Inventory for $50.

PURCHASE DISCOUNTS The credit terms of a purchase on account may permit the buyer to claim a cash discount for prompt payment. The buyer calls this cash discount a purchase discount. This incentive offers advantages to both parties. The purchaser saves money, and the seller is able to shorten the operating cycle by converting the accounts receivable into cash earlier.

The credit terms specify the amount of the cash discount and time period during which it is offered. They also indicate the length of time in which the purchaser is expected to pay the full invoice price. In the sales invoice in Illustration 5-5 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo2#c05- �ig-0005) (page 220), credit terms are 2/10, n/30, which is read “two-ten, net thirty.” This means that a 2% cash discount may be taken on the invoice price, less (“net of”) any returns or allowances, if payment is made within 10 days of the invoice date (the discount period). Otherwise, the invoice price, less any returns or allowances, is due 30 days from the invoice date. Alternatively, the discount period may extend to a speci�ied number of days following the month in which the sale occurs. For example, 1/10 EOM (end of month) means that a 1% discount is available if the invoice is paid within the �irst 10 days of the next month.

When the seller elects not to offer a cash discount for prompt payment, credit terms will specify only the maximum time period for paying the balance due. For example, the credit terms may state the time period as n/30, n/60, or n/10 EOM. This means, respectively, that the buyer must pay the net amount in 30 days, 60 days, or within the �irst 10 days of the next month.

When an invoice is paid within the discount period, the amount of the discount decreases Inventory. Why? Because the merchandiser records inventory at its cost and, by paying within the discount period, it has reduced that cost. To illustrate, assume Sauk Stereo pays the balance due of $3,500 (gross invoice price of

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch05lo2#c05-fig-0005
4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05… 23/101

$3,800 less purchase returns and allowances of $300) on May 14, the last day of the discount period. Since the terms are 2/10, n/30, the cash discount is $70 ($3,500×2%) and the amount of cash Sauk Stereo paid is $3,430 ($3,500−$70). The entry Sauk Stereo makes to record its May 14 payment decreases (debits) Accounts Payable by the amount of the gross invoice price, reduces (credits) Inventory by the $70 discount, and reduces (credits) Cash by the net amount owed.

If Sauk Stereo failed to take the discount and instead made full payment of $3,500 on June 3, Sauk Stereo would reduce (debit) Accounts Payable and reduce (credit) Cash for $3,500 each.

A merchandising company usually should take all available discounts. Passing up the discount may be viewed as paying interest for use of the money. For example, passing up the discount offered by PW Audio Supply would be like Sauk Stereo paying an interest rate of 2% for the use of $3,500 for 20 days. This is the equivalent of an annual interest rate of approximately 36.5%(2%×365/20). Obviously, it would be better for Sauk Stereo to borrow at prevailing bank interest rates of 6% to 10% than to lose the discount.

▼ HELPFUL HINT

The term net in “net 30” means the remaining amount due after subtracting any returns and allowances and partial payments.

SUMMARY OF PURCHASING TRANSACTIONS The following T-account (with transaction descriptions in red) provides a summary of the effect of the previous transactions on Inventory. Sauk Stereo originally purchased $3,800 worth of inventory for resale. It then returned $300 of goods. It paid $150 in freight charges, and �inally, it received a $70 discount off the balance owed because it paid within the discount period. This results in a balance in Inventory of $3,580.

4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05… 24/101

DO IT! 2

Purchase Transactions

On September 5, De La Hoya Company buys merchandise on account from Junot Diaz Company. The purchase price of the goods paid by De La Hoya is $1,500. On September 8, De La Hoya returns defective goods with a selling price of $200. Record the transactions on the books of De La Hoya Company.

Action Plan ✓ Purchaser records goods at cost.

✓ When goods are returned, purchaser reduces Inventory.

Related exercise material: BE5-2, BE5-4, DO IT! 5-2, E5-1, E5-2, and E5-4.

4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05… 25/101

LEARNING OBJECTIVE 3

Record sales under a perpetual inventory system. 

In accordance with the revenue recognition principle, companies record sales revenue, like service revenue, when the performance obligation is satis�ied. Typically, that performance obligation is satis�ied when the goods are transferred from the seller to the buyer. At this point, the sales transaction is completed and the sales price is 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 documents provide evidence of cash sales. A sales invoice, like the one that was shown in Illustration 5-5 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo2#c05-�ig-0005) (page 220), provides support for each sale. The original copy of the invoice goes to the customer, and the seller keeps a copy for use in recording the sale. The invoice shows the date of sale, customer name, total sales price, and other relevant information.

The seller makes two entries for each sale. (1) It increases (debits) Accounts Receivable or Cash, as well as increases (credits) Sales Revenue. (2) It increases (debits) Cost of Goods Sold and decreases (credits) Inventory. As a result, the Inventory account will show at all times the amount of inventory that should be on hand.

To illustrate a credit sales transaction, PW Audio Supply records the sale of $3,800 on May 4 to Sauk Stereo (see Illustration 5-5 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo2#c05-�ig- 0005) ) as follows (assume the merchandise cost PW Audio Supply $2,400).

For internal decision-making purposes, merchandising companies may use more than one sales account. For example, PW Audio Supply may decide to keep separate sales accounts for its sales of TVs, Blu-ray players, and headsets. REI might use separate accounts for camping gear, children's clothing, and ski equipment—or it might have even more narrowly de�ined accounts. By using separate sales accounts for major product lines, rather than a single combined sales account, company management can monitor sales trends more closely and respond to changes in sales patterns more strategically. For example, if TV sales are increasing while Blu-ray player sales are decreasing, the company might reevaluate both its advertising and pricing policies on each of these items to ensure they are optimal.

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch05lo2#c05-fig-0005
https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch05lo2#c05-fig-0005
4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05… 26/101

On its income statement presented to outside investors, a merchandising company would normally provide only a single sales �igure—the sum of all of its individual sales accounts. This is done for two reasons. First, providing detail on all of its individual sales accounts would add considerable length to its income statement. Second, companies do not want their competitors to know the details of their operating results. However, at one time Microsoft expanded its disclosure of revenue from three to �ive types. The reason: The additional categories enabled �inancial statement users to better evaluate the growth of the company's consumer and Internet businesses.

ANATOMY OF A FRAUD1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05ifrs#c05-

note-0006)

Holly Harmon was a cashier at a national superstore for only a short time when she began stealing merchandise using three methods. Under the �irst method, her husband or friends took UPC labels from cheaper items and put them on more expensive items. Holly then scanned the goods at the register. Using the second method, Holly scanned an item at the register but then voided the sale and left the merchandise in the shopping cart. A third approach was to put goods into large plastic containers. She scanned the plastic containers but not the goods within them. After Holly quit, a review of past surveillance tapes enabled the store to observe the thefts and to identify the participants.

Total take: $12,000

THE MISSING CONTROLS

Human resource controls. A background check would have revealed Holly's previous criminal record. She would not have been hired as a cashier.

Physical controls. Software can �lag high numbers of voided transactions or a high number of sales of low-priced goods. Random comparisons of video records with cash register records can ensure that the goods reported as sold on the register are the same goods that are shown being purchased on the video recording. Finally, employees should be aware that they are being monitored.

Source: Adapted from Wells, Fraud Casebook (2007), pp. 251–259.

At the end of “Anatomy of a Fraud” stories, which describe real-world frauds, we discuss the missing control activity that would likely have presented or uncovered the fraud.

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch05ifrs#c05-note-0006
4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05… 27/101

▼ HELPFUL HINT

The merchandiser credits the Sales Revenue account only for sales of goods held for resale. Sales of assets not held for resale, such as equipment or land, are credited directly to the asset account.

ETHICS NOTE

Many companies are trying to improve the quality of their �inancial reporting. For example, General Electric now provides more detail on its revenues and operating pro�its.

SALES RETURNS AND ALLOWANCES We now look at the “�lip side” of purchase returns and allowances, which the seller records as sales returns and allowances. These are transactions where the seller either accepts goods back from a purchaser (a return) or grants a reduction in the purchase price (an allowance) so that the buyer will keep the goods. PW Audio Supply's entries to record credit for returned goods involve (1) an increase (debit) in Sales Returns and Allowances (a contra account to Sales Revenue) and a decrease (credit) in Accounts Receivable at the $300 selling price, and (2) an increase (debit) in Inventory (assume a $140 cost) and a decrease (credit) in Cost of Goods Sold, as shown below. (We assumed that the goods were not defective. If they were defective, PW Audio Supply would make an entry to the Inventory account to re�lect their decline in value.)

Suppose instead that the goods were not returned but the seller granted the buyer an allowance by reducing the purchase price. In this case, the seller would debit Sales Returns and Allowances and credit Accounts Receivable for the amount of the allowance. An allowance has no impact on Inventory or Cost of Goods Sold.

Sales Returns and Allowances is a contra revenue account to Sales Revenue, which means it is offset against a revenue account on the income statement. The normal balance of Sales Returns and Allowances is a debit. Companies use a contra account, instead of debiting Sales Revenue, to disclose in the accounts and in the income statement the amount of sales returns and allowances. Disclosure of this information is important to management. Excessive returns and allowances suggest problems—inferior merchandise,

4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05… 28/101

inef�iciencies in �illing orders, errors in billing customers, or mistakes in delivery or shipment of goods. Moreover, a decrease (debit) recorded directly to Sales Revenue would obscure the relative importance of sales returns and allowances as a percentage of sales. It also could distort comparisons between total sales in different accounting periods.

At the end of the accounting period, if the company anticipates that sales returns and allowances will be material, the company should make an adjusting entry to estimate the amount of returns. In some industries, such as those relating to the sale of books and periodicals, returns are often material. The accounting for situations where returns must be estimated is addressed in advanced accounting courses.

 ACCOUNTING ACROSS THE ORGANIZATION 

Costco Wholesale Corp.

The Point of No Returns?

In most industries, sales returns are relatively minor. But returns of consumer electronics can really take a bite out of pro�its. Recently, the marketing executives at Costco Wholesale Corp. faced a dif�icult decision. Costco has always prided itself on its generous return policy. Most goods have had an unlimited grace period for returns. A new policy will require that certain electronics must be returned within 90 days of their purchase. The reason? The cost of returned products such as high-de�inition TVs, computers, and iPods cut an estimated 8¢ per share off Costco's earnings per share, which was $2.30.

Source: Kris Hudson, “Costco Tightens Policy on Returning Electronics,” Wall Street Journal (February 27, 2007), p. B4.

If a company expects signi�icant returns, what are the implications for revenue recognition? (Go to WileyPLUS for this answer and additional questions.)

SALES DISCOUNTS As mentioned in our discussion of purchase transactions, the seller may offer the customer a cash discount —called by the seller a sales discount—for the prompt payment of the balance due. Like a purchase discount, a sales discount is based on the invoice price less returns and allowances, if any. The seller increases (debits) the Sales Discounts account for discounts that are taken. The entry by PW Audio Supply to record the cash receipt on May 14 from Sauk Stereo within the discount period is:

4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05… 29/101

Like Sales Returns and Allowances, Sales Discounts is a contra revenue account to Sales Revenue. Its normal balance is a debit. Sellers use this account, instead of debiting Sales Revenue, to disclose the amount of cash discounts taken by customers. If the customer does not take the discount, PW Audio Supply increases (debits) Cash for $3,500 and decreases (credits) Accounts Receivable for the same amount at the date of collection.

At the end of the accounting period, if the amount of potential discounts is material, the company should make an adjusting entry to estimate the discounts. This would not usually be the case for sales discounts but might be necessary for other types of discounts such as volume discounts, which are addressed in more advanced accounting courses. The following T-accounts summarize the three sales-related transactions and show their combined effect on net sales.

DO IT! 3

Sales Transactions

On September 5, De La Hoya Company buys merchandise on account from Junot Diaz Company. The selling price of the goods is $1,500, and the cost to Diaz Company was $800. On September 8, De La Hoya returns goods with a selling price of $200 and a cost of $105. Record the transactions on the books of Junot Diaz Company.

Action Plan ✓ Seller records both the sale and the cost of goods sold at the

time of the sale.

✓ When goods are returned, the seller records the return in a contra account, Sales Returns and Allowances, and reduces Accounts Receivable.

4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05… 30/101

✓ Any goods returned increase Inventory and reduce Cost of Goods Sold. The inventory should be recorded at the lower of its cost or its fair value (scrap value).

Related exercise material: BE5-2, BE5-3, DO IT! 5-3, E5-2, E5-3, and E5-4.

4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05… 31/101

LEARNING OBJECTIVE 4

Prepare a multiple-step income statement and a comprehensive income statement. 

SINGLE-STEP INCOME STATEMENT Companies widely use two forms of the income statement. One is the single-step income statement. The statement is so named because only one step, subtracting total expenses from total revenues, is required in determining net income (or net loss).

In a single-step statement, all data are classi�ied into two categories: (1) revenues, which include both operating revenues and nonoperating revenues and gains (for example, interest revenue and gain on sale of equipment); and (2) expenses, which include cost of goods sold, operating expenses, and nonoperating expenses and losses (for example, interest expense, loss on sale of equipment, or income tax expense). The single-step income statement is the form we have used thus far in the text. Illustration 5-7 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo4#c05-�ig-0007) (page 228) shows a single-step statement for REI.

ILLUSTRATION 5-7 Single-step income statements

There are two primary reasons for using the single-step form. (1) A company does not realize any type of pro�it or income until total revenues exceed total expenses, so it makes sense to divide the statement into these two categories. (2) The form is simple and easy to read.

MULTIPLE-STEP INCOME STATEMENT

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch05lo4#c05-fig-0007
4/8/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch01lo1,ch05,ch05lo1,ch05lo2,ch05lo3,ch05lo4,ch05lo5,ch05lo6,ch05lo7,ch05… 32/101

A second form of the income statement is the multiple-step income statement. The multiple-step income statement is often considered more useful because it highlights the components of net income. The REI income statement in Illustration 5-8 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo4#c05-�ig-0008) is an example.

ILLUSTRATION 5-8 Multiple-step income statements

The multiple-step income statement has three important line items: gross pro�it, income from operations, and net income. They are determined as follows.

1. Subtract cost of goods sold from net sales to determine gross pro�it.

2. Deduct operating expenses from gross pro�it to determine income from operations.

3. Add or subtract the results of activities not related to operations to determine net income.

Note that companies report income tax expense in a separate section of the income statement before net income. The net incomes in Illustrations 05-07 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo4#c05-�ig-0007) and 05-0008 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05lo4#c05-�ig-0008) are the same. The two income statements differ in the amount of detail displayed and the order presented. The following discussion provides additional information about the components of a multiple-step income statement.

INTERNATIONAL NOTE

The IASB and FASB are involved in a joint project to evaluate the format of �inancial statements. The �irst phase of that project involves a focus on how to

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch05lo4#c05-fig-0008
https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch05lo4#c05-fig-0007
https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch05lo4#c05-fig-0008