164 Chapter 4 Accountingfor MerchandisingTransactions

Learning Objective
Identify the
Income Measurement for a Merchandising Organization
• • components of the
statement of profit Merchandising (or trading) organizations earn revenue by selling goods, or merchandise.
and loss of a Figure 4.1 illustrates how goods flow, beginning with the manufacturer, moving
merchandising through the wholesaler and the retailer, and ending with the consumer. The accounting
organization. principles and methods described in Chapters 1-3 apply equally to these organizations.
Figure 4.1 In addition, we need some additional accounts and procedures to record purchases and
FLOW OF MERCHANDISE sales. Exhibit 4.1 shows the statement of profit and loss of Vijay Electronics Limited,
THROUGH MARKETING a wholesaler.
CHANNEL

Merchandising
organizations play an
important role in the
supply chain by linking Consumer
the manufacturer with
the consumer.

EXHIBIT 4.1
The statement of profit and loss presents the revenue, cost of goods sold, and operating expenses.
Statement of
Profit and Lossfor VIJAY ELECTRONICS LIMITED
a Merchandising Statement of Profit and Loss
Organization For the year ended December 31, 20X2
Revenue from sale'S ' . ~439,120
Cost of goods sold . 298,700
Gross profit . 140,420
Operating expenses . 76,800
Selling expenses . 52,300
Administrative expenses . 24,500
Profit before interest and tax . 63,620
Interest expense ...........................................•.................................................................................................................... 4,700
Profit before tax . 58,920
Income tax . 26,000
Net profit . 32,920

The principle of income measurement for a merchandising organization is the

same as that for a service organization: net profit results from matching expenses
with revenues. The statement of profit and loss of a merchandising organization has
three components:
• Revenue from sales;
• Cost of goods sold; and
• Operating expenses.'
In common parlance, revenue is top line, costs and expenses are middle line, and
net profit is bottom line. For the sake of simplicity, at this stage we do not consider
one-time and non- recurring items, such as gains and losses on disposal of investments
and fixed assets.
The primary source of revenue for a merchandising organization is the sale of goods,
often referred to as revenue from sales or, simply, sales. The cost of goods sold is
the total cost of merchandise sold during the period. This expense is directly related
to the sales. The cost of goods sold is deducted from sales to arrive at an intermediate
income amount called gross profit. Gross profit, expressed as a percentage of sales,
Jr
1 Published financial statements of Indian companies do not usually disclose the cost of goods
sold and operating expenses. As a result, it is not possible to calculate some of the measures
described in this chapter.
 Revenue from Sales 165

is the gross profit ratio (or gross margin). Thus, a gross profit of 20 per cent on
sales of ~200,000 would mean that a business earned ~40,000 after meeting the cost
of goods sold. From Exhibit 4.1, we learn that Vijay Electronics earned a net sales
revenue of ~439,120 and incurred ~298,700 for the goods that were sold, thus earning
a gross profit of n40,420. The gross profit ratio is nearly 32 per cent.
Operating expenses are expenses incurred in running the business. They are
normally separated by function. Selling expenses arise from activities connected with
selling and distributing the goods and include storage charges, salaries for the sales staff
and commissions, and the cost of delivering goods to customers. Administrative expenses
are those associated with general services, such as accounting, personnel, corporate
office, and general administration. After calculating gross profit, we deduct operating
expenses to arrive at profit before interest and tax (PBIT), or operating profit.
Interest expense for borrowing and interest income from lending money are non-
operating items. For a business to be profitable, its sales should cover not only the cost
of goods sold but also its operating and interest expenses. Net profit, or profit after
tax (PAT), equals operating profit adjusted for non-operating items less income tax.

(~R_e_v_e_n_u_e_f_r_o_m
__ s_a_l_e_s )
Management, investors, and analysts monitor sales trends. An increasing trend learning Objective
indicates not only sales growth but also a probability of an increase in earnings .• Record transactions
On the other hand, a falling trend might portend a downturn in a company's related to. sales of
fortunes. Sales are compared with the previous year's sales (year on year, or '<YoY"). merchandise.
Quarterly sales are compared with sales in the previous quarter (quarter on quarter,
or "QoQ") and the year-ago quarter. Besides, sales are compared with competitors'
sales. These comparisons help to spot major trends in sales. Sales are a better indicator
of the future than profits. For example, Microsoft continues to report good profits
from its established personal computer products but future growth will be in mobile
devices.

FINANCIAL VIEW
It is obvious that sales growth is importantto any business. Managers build or lose their reputation on how
Sales Growth at Infosys
muchthe business grows on their watch. Take the case of Infosys,the IT services firm.The company had three
chiefexecutives during the period 2003 to 2013: Nandan Nilekani,2003-2007; S. Gopalakrishnan,2007-2011;
S. D. Shibulal,2011-2013. The followingtable presents the trend of the company's sales, profit,and stock price.

trowth %* Nandan Nilekani S. Gopalakrishnan S. D. Shibulal

Sales 42.3 18.3 10.7
Profit .•. 44.5 15.2 7.3
Stock price 54.0 10.3 - 7.1
• Compoundedannualgrowthrate
"'\"he slowingsales led to questions about the company's abilityto maintain its leadership position. Infosys'
peer,TataConsultancyServices was growingmuch faster. By 2012, Cognizanthad begun to replace Infosysas
thesecondlargest ITservices company.In June 2013, the company's founder-chairman,N. R. Narayana Murthy
whohad leftas its chief executivein 2002 returned as its executive chairmanand the stock price of Infosysrose
nearly8 per cent.
Sources: Companyannual reports, stock exchange websites, news reports.

Sales
Sales consist of cash sales and credit sales. Under accrual accounting, revenue is
considered to be earned in the rep.~rting period in which the ownership of the goods
passes from the seller to the buyer. As a result, a business recognizes revenue at the
time of the sale even though it may collect the payment later.
166 Chapter 4 Accounting for Merchandising Transactions

Revenue from the sale of goods is recognized when all the following conditions are
satisfied:
1. The entity has transferred to the buyer the significant risks and rewards of
ownership of the goods.
2. The entity retains neither continuing managerial involvement to the degree
usually associated with ownership nor effective control over the goods sold.
3. The amount of revenue can be measured reliably.
4. It is probable that the economic benefits associated with the transaction will
flow to the entity.
5. The costs incurred or to be incurred in respect of the transaction can be
measured reliably.f
Chapter 3 discusses conditions 3 and 4. We will see condition 5 in Chapter 5. Let
us now see how to apply conditions 1 and 2.
Transfer of the risks and rewards of ownership The buyer should be the economic
owner of the goods, even if there is no transfer of legal ownership. The litmus test of
ownership is who will get to keep the profit if the price of the goods goes up or bear the
loss if the price goes down. If the answer is 'buyer', it is a sale. Usually, the transfer
of the risks and rewards of ownership occurs with physical delivery of the goodsor
transfer of legal title. Thus, in a vast majority of transactions (e.g. retail sales) delivery
indicates sale. The Indian Sale of Goods Act lays down the principles for determining
when legal title is transferred. If the seller retains an insignificant risk of ownership,
the transaction is a sale. For example, many supermarkets offer terms such as "money
back if not completely satisfied." Here the seller recognizes the revenue and a liability
for returns based on past experience and other relevant factors.
No continuing involvement or control of the goods The spirit of a sale is that
the buyer can decide what to do with the goods once the sale is over. For example,
the seller of a piece of equipment cannot tell the buyer how much to produce, at what
price to sell the output, whom to sell it to, or what to do with the used equipment.
Exceptions include compliance with safety regulations or prevention of resale for illegal
use or to specified parties for legitimate reasons such as export ban by the government.
Invoice is a document that contains the details of a sale, such as the name of the
product, number of units sold, unit price, total price, taxes and duties, total amount
billed, and the payment and shipping terms. The seller prepares the invoice at the time
of sale and sends it to the buyer. A retailer prepares the invoice at the point of sale.
A wholesaler who supplies goods to retailers prepares the invoice after the shipping
department notifies the accounting department that it has shipped the goods to the
customer. Figure 4.2 shows a wholesaler's invoice.

Figure 4.2
A WHOLESALER'S INVOICE
Invoice
VIJAY ELECTRONICS LIMITED
M-14, Connaught Circus, New Delhi 110001
,
Invoice No. 1983 May 19, 20X8
Sold to: Aruna Store 19A R K Mutt Road Mylapore Chennai 600 004

For each sale transaction, Terms: Net 45, FOB destination

the seller prepares an
invoice showing Description Item Code Quantity Price per Unit Total
the amount payable by
the buyer and other Sony Mp3 Player P8 30 ~2,000 ~60,000
details. VAT, 8% 4,800
Total 64,800

2IAS 18:14/Ind AS 18:14/AS 9:10 and 9:11.

 Revenue from Sales 167

Vijay Electronics records the sale transaction in Figure 4.2 as follows:

May 19 Trade Receivables 64,800
Sales . 64,800
Sold merchandise on credit
If it is a cash sale, the entry would be as follows:
May 19 Cash 64,800
Sales . 64,800
Sold merchandise for cash
The balance in the Sales account shows the total amount of cash and credit sales
made during the reporting period. Since the seller may collect amounts due on credit
sales in a subsequent period, there may be a significant difference between cash
collections from sales and the amount of sales.

Sales Returns and Allowances

Most wholesalers and retailers allow their customers to return goods which are found to
be unsatisfactory or defective. Companies following a policy of "satisfaction guaranteed"
allow goods to be returned if the customer does not like them. A sales return is a
merchandise returned by a buyer. Sometimes, the customer may find after the sale
that the goods have minor defects and may agree to keep the goods if the seller
allows a reduction of the sales price, called sales allowance. A seller may grant sales
allowances for a number of reasons, including inferior quality, damage, deterioration
in transit, or variation in specifications. In all cases of sales returns and allowances,
the seller sends the buyer a document called credit note, which indicates that the
balance in the customer's account is being reduced.
We could record sales returns and allowances as debits, because they cancel a
portion of the sales revenue. However, information about the amount of sales returns
and allowances is useful to management and is, therefore, shown separately. High
returns could be an indication of the low quality of the goods or of high pressure
selling. Besides, handling returned goods is a costly and time-consuming affair. For
these reasons, we debit Sales Returns and Allowances, a contra-revenue account.
Suppose that on May 23 Vijay Electronics issues a credit note for n45 for the May
19 transaction. The following entry records this transaction:
May 23 Sales Returns and Allowances 145
Trade Receivables 145
.k Allowance for unsatisfactory merchandise sold on May 19
IN PRACTICE
Accounting for returns can be problematic in industries in which sales returns are as much a fact as sales. Sales Returns
Pharmaceutical companies are obliged to accept goods returned for reasons such as expiry, near-expiry
or damage. Luxury goods companies have to take back goods that go out of fashion. Publishers take
back copies of the previous edition of a book when they release a new edition. Accounting for expected
returns presents special difficulties.
Since the likely amount of sales returns is not certain, it has to be estimated. The estimate takes into
consideration relevant factors such as past experience, current and expected trends, contractual terms,
and industry practices. Any additional costs to sell the returned goods are also considered. A provision
for sales returns is made on the basis of the management's best estimate. The provision is reviewed at
each reporting date and revised if necessary. Sales returns around the reporting date may provide a
better indication of expected returns than experience in a past year.
The amount of provision made for a reporting period is deducted from the sales revenue recognized
for the period with appropriate disclosure. This would be in addition to (a) the actual sales returns
where the goods have been physically received and their receipt already recorded and (b) the goods
that have not been physically received but have been accepted for return. The amount of provision on
the reporting date is presented as an estimated liability in the balance sheet.

Trade Discounts
A trade discount is a percentage reduction granted to a customer from the specified
168 Chapter 4 Accountingfor MerchandisingTransactions

list price or catalogue price. Trade discounts serve several purposes. Trade discounts
enable firms to quote different prices to different types of customers and grant quantity
discounts. Also, the cost of printing catalogues is reduced, since a seller can use a
catalogue for a longer period of time and announce discounts whenever prices change.
Normally, the seller does not record trade discounts in the accounts. For example,
suppose that the list price of a CD is no, but the seller gives a discount of 10 per cent
for buying a box of 10 CDs. If you buy a box, the seller would record a revenue of ~90.

Sales Discounts
When a company sells goods on credit, it specifies the terms of payment on the invoice.
These terms vary from industry to industry. For example, the invoice in Figure 4.2
shows the terms of payment as "net 45". This is sometimes shortened as "n/45". The
term "n/45" means that the entire amount of invoice is due 45 days after May 19, 20X8
(invoice date), which is not later than July 3, 20X8. If the invoice is due 10 days after
the end of the month, the terms will be "n/10/eom".
Sometimes, credit terms include discounts for early payment, called cash discounts.
By offering an incentive for payment before the due date, the seller is able to speed
up its cash inflows. Cash discount is different from trade discount. While the former
is a deduction from the invoice price for prompt payment, the latter is a deduction
from the catalogue price to determine the invoice price. A cash discount is called a
sales discount by the seller and a purchase discount by the buyer. Credit terms of
"2/10, n/45" mean that the buyer will get a 2 per cent discount of the invoice amount
for paying within 10 days of the invoice date; alternatively, he may take 45 days and
pay the full invoice amount without discount.
HANDHOLD 4.1
PaymentDate OnJanuary1,20XX,Ankitaboughtgoodsfor ~4,000withterms"2/10,n/30".Ankitashouldpaythe seller
n,920 not laterthan January11, 20XX,or the fullamount of ~4,000not later than January31, 20XX.

The seller records the sales discounts at the time the customer pays since he does
not know at the time of sale when the customer will pay. The Sales Discounts account
shows the amount of sales discounts. Managers can examine the amount of sales
discounts to evaluate the company's credit and collection policy. The Sales Discounts
account appears in the statement of profit and loss as an expense. Suppose that a sale
for n,ooo on June 12 is on terms of "2/10, n/30". On June 22, the buyer pays ~980.
The seller records the following entries:
June 12 Trade Receivables...................................................................... 1,000
Sales 1,000
Sold merchandise on credit
22 Cash 980
Sales Discounts 20
Trade Receivables , 1,000
Collected from customers less discount
The sales discount is calculated on the invoice amount less any sales returns and
allowances.
TEST YOUR
Determine the last date for payment with and without cash discount for the invoices below. It is a
UNDERSTANDING 4.1 non-leap year.
PaymentDate
Invoice Date Payment Terms
1 May 13 2/10, n/30
2 January 15 1/10/eom, n/60
3 October 30 2/eom, n/60
4 July 31 3/10/eom, n/45
5 February 12 1/10, n/60
 Revenue from Sales 169

For presentation in the statement of profit and loss, the seller deducts sales returns
and allowances, trade discounts, and taxes and duties (e.g. value added tax, sales tax,
and goods and services tax), and reports only the net sales. Sales discounts are not
deducted.

HANDHOLD 4.2
Triveni Company has the following data for a quarter: Calculating Net Sales
• Credit sales at catalogue prices including taxes and duties, ~53,000
• Trade discounts, nO,600
• Cash sales, ~9,400
• Sales returns and allowances, n,700
• Sales discounts, ~800
• Value added tax, ~9,600.
The amount of sales that would appear on the statement of profit and loss for the period is ~40,500,
as the following calculation shows:
Credit sales at catalogue 'prices ~53,000
Cash sales 9,400
62,400
Less
Trade discounts nO,600
Sales returns and allowances 1,700
Value added tax 9,600 21,900
Net sales 40,500
Note that we do not deduct sales discounts for calculating net sales.

Exhibit 4.2 shows Vijay Electronics' presentation of revenue, assummg sales of

~461,020 and sales returns and allowances of ~21,900.

EXHIBIT 4.2
VIJAY ELECTRONICS LIMITED
Statement of Profit and Loss for the year ended December 31, 20X2 Statement of Profit
and Loss: Revenue
Revenue from Sales
Net Sales ~439,120 from Sales

TEST YOUR
The following occounts contain five transactions keyed together with letters:
UNDERSTANDING 4.2
Basic Merchandising
,, Sales
Transactions
I (a) 12,000
(d) 9,000

I ." Sales Returns and Allowances

(b) 600
I Sales Discounts
(e) 90

Trade Receivables
\
(a) 12,000 (b) 600
(d) 9,000 (c) 11,400
(e) 9,000

Cash
(c) 11,400
(e) 8,910
Write a short description of each transaction with the related amount(s}.
170 Chapter 4 Accounting for Merchandising Transactions

Learning Objective Substance over Form in Revenue Recognition

Explain how to
Accountants recognize revenue from sale of goods on the basis of the intention of the
• • determine substance
over form in sales contracting parties and the legal provisions for transfer of title to the goods. They
transactions. have to go beyond the legal form of a transaction and find out whether it meets the
conditions for revenue recognition. Sales transactions are structured in complex ways
for business, tax, and regulatory reasons. Revenue recognition should be based on the
economic substance of a transaction. That means determining whether the significant
risks and rewards of ownership have been transferred to the buyer, the price is certain
and the buyer will pay. We will now consider some special terms of sales to decide
when to recognize revenue.
Bill and hold sales In 'bill and hold' sales delivery is delayed at the buyer's request,
but the buyer takes title and accepts billing. Revenue is generally recognized when
the buyer takes title, if it is probable that (a) delivery will be made, (b) the item is on
hand; identified, and ready fordelivery to the buyer, (c) the buyer acknowledges the
deferred delivery instructions, and (d) the usual payment terms apply.
Conditional sales Goods may be shipped subject to conditions to be fulfilled by the
seller or the buyer, such as those described below:
Installation and inspection If the contract requires installation by the seller and
inspection by the buyer, the seller normally recognizes revenue when the buyer accepts
delivery and installation and inspection are complete.
On approval In a sale on approval, the buyer has to communicate his acceptance
or rejection of the goods within a specified time period. If there is uncertainty about
the possibility of return, revenue is recognized when the buyer accepts the goods or
the specified time period for rejection has elapsed without any communication from
the buyer.
Consignment In a consignment "sale", the recipient undertakes to sell the goodson
behalf of the shipper. The shipper is the owner of the goods and the recipient is the
shipper's agent. The shipper recognizes revenue when the recipient sells the goodsto
a third party.
Cash on delivery Revenue is recognized when the goods are delivered and cash is
received by the seller or its agent.
Layaway sales In a layaway sale, goods will be delivered when the buyer makes
the final payment in a series of instalments. Revenue from such sales is recognized
.. when the goods are delivered. However, when past experience indicates that most
such sales are consummated, revenue may be recognized when a significant deposit is
received provided the goods are on hand, identified, and ready for delivery to the buyer.
Sale and repurchase agreements In a sale and repurchase agreement, the seller
concurrently agrees to repurchase the same goods at a later date, or the seller has an
option to repurchase the goods, or the buyer has an option to require the repurchase
of the goods by the seller. Even though legal title may have been transferred, the
seller retains the risks and rewards of ownership. Sale and repurchase agreements
are usually product financing arrangements in which the seller raises a loan with the
goods being given as collateral. The cash inflow to the buyer is a loan receipt and not
a revenue. The difference between repurchase and sale prices represents the finance
charge for the loan. The transaction does not give rise to revenue.
Sales to distributors, dealers, or others for resale Revenue from such sales is
generally recognized when the risks and rewards of ownership have passed. However,
when the buyer is acting, in substance, as an agent, the sale is treated as a consignment
"sale".
 Cost of Goods Solds 171

Instalment sales Revenue from instalment sale of goods has two parts: (1) the cash
price or the price for immediate payment, and (2) interest on future instalments. The
revenue representing the cash price should be recognized at the date of sale. This is
just like recognizing revenue from a normal cash or credit sale. The interest element
should be recognized as revenue as it is earned, using the effective interest method."
Subscription to publications When the items are of similar value in each time
period, revenue is recognized on a straight-line basis over the period in which the
items are despatched. When the items vary in value from period to period, revenue
is recognized on the basis of the sales value of the item despatched in relation to the
total estimated sales value of all items covered by the subscription.
EARNlf':.,IGSQUALITY
Accounting sometimes makes a difference to the world in completely unexpected ways. Here is a bizarre case.
ANALYSIS
Have you ever imagined that accounting policies can affect paediatric vaccine stockpile held by the government?
A change in accounting rules did indeed cause a serious shortfall in the US government's stockpile. Under the new Managing Earnings
rule, companies can recognize revenue when a vaccine is given to a patient and not when it is sold to the stockpile. for Children's Health
Accountants and analysts do not think of shots that sit in manufacturers' warehouses as revenue. Companies use
phony sales, or "channel stuffing", to boost their revenue. Under this method, manufacturers transfer vaccines
to customers' or distributors' inventories and take them as sold, so they recognize any profit on the sales. The
accounting change came after the SEC issued a bulletin to clear up the confusion. A legislator remarked: "It's
absurd that we're not going to have pediatric childhood vaccine reserves in place because of some accounting."
Perhaps, it is not possible to have good accounting and vaccine stockpile, at the same time.
Adapted from: Accounting rule change affects pediatric vaccine stockpile, AccountingWEB.com, April 21, 2005.

On August 1, Manohar Company sold goods costing ~14,OOO to Vijay Company for ~15,OOO. TEST YOUR
Manohar Company will repurchase th~se goods on December 1 for ~16,800. How should Manohar UNDERSTANDING 4.3
Company treat this transaction? Revenue Recognition

(_C_os_t_o_f__G_O_O_d_S_S_O_ld_S )
The second most important part of a statement of profit and 10SB of a merchandising
organization is the cost of goods sold. Merchandise inventory, or inventory, is the
quantity of goods on hand and available for sale at a given time. The inventory on
hand at the beginning of the reporting period is called the beginning inventory,
.
Learning Objective
Calculate the cost
• ' of goods sold
using the periodic
inventory system.
or opening inventory. The inventory at the end of the period is called the ending
inventory, or closing inventory. The ending inventory appears on the balance
sheet as an asset. It will become a part of cost of goods sold in a later period when
it is sold. This year's beginning inventory was last year's ending inventory. Cost of
goods available for sale is the sum of the beginning inventory and the net cost of
purchases. Cost. of goods sold is the cost to the seller of goods sold to customers
and it is the largest item of expense for merchandising companies. It is determined
by computing the cost of (a) the beginning inventory, (b) the net purchases, and
(c)the ending inventory. For presentation in the statement of profit and loss, the buyer
deductsthe amount of purchase returns and allowances as well as purchase discounts,
and reports only the net purchases.
Exhibit 4.3 shows the cost of goods sold section of Vijay Electronics' statement of
profitand loss. The merchandise inventory on January 1, 20X2 was ~47,300. Assume
purchases of ~326,900, purchase returns and allowances of ~13,200 and purchase
discountsof ~1,400. So the amount of net purchases is ~312,300. Freight paid on
purchasesis ~28,100. The net cost of purchases consisting of net purchases and freight
is ~340,400.Vijay Electronics could have sold merchandise of ~387,700 during 20X2.
Thisis the cost of goods available for sale. On December 31, 20X2, the merchandise
inventorywas ~89,000. This is;;'he unsold inventory. Subtracting the ending inventory
fromthe cost of goods available for sale, we get the cost of goods sold of ~298,700.

3Chapters8 and 9 explain the effective interest method.

172 Chapter 4 Accounting for Merchandising Transactions

EXHIBIT 4.3 Cost of goods sold includes not only the cost of purchases but also the freight in and other incidental costs.
Statement of Profit
and Loss: Cost of VIJAY ELECTRONICS LIMITED
Goods Sold Statement of Profit and Loss
For the Year Ended December 31, 20X2

Cost of goods sold

Merchandise inventory, Dec. 31, 20X1 . ~ 47,300
Net purchases . ~312,300
Freight in . 28,100
Net cost of purchases . 340,400
Cost of goods available for sale . 387,700
Less Merchandise inventory, Dec. 31, 20X2 . 89,000
Cost of goods sold . 298,700

Figure 4.3 illustrates the flow of goods during a reporting period. Beginning
inventory and net cost of purchases, when combined, make up cost of goods available
for sale. The latter is explained by cost of goods sold and ending inventory.
Figure 4.3
RELATIONSHIP
BETWEEN INVENTORIES
AND COST OF GOODS
SOLD

Cost of goods available

for sale is the sum of
beginning inventory and
net cost of pu rchases
and is accounted for by
cost of goods sold and
ending inventory.

HANDHOLD 4.3
If the cost of goods available for sale is ~409,210 and the cost of ending inventory is ~73,460, what is
Calculating Cost of
the cost of goods sold?
Goods Sold
Cost of goods sold = Cost of goods available for sale - Ending inventory
= ~409,21O - n3,460
= ~335,750

The Periodic Inventory System

The amount of merchandise inventory is determined by using either the periodic
inventory system or the perpetual inventory system. Under the periodic inventory
system, the Merchandise Inventory account is updated only periodically after a
physical count has been made. Hence the name. Usually, the physical count takes
place at the end of the reporting period. Some stores, particularly smaller ones,
use periodic inventory.

Net Cost of Purchases

The term net cost of purchases means purchases less discounts and purchase returns
and allowances plus transport and handling costs on the purchases. Government levies,
such as import duties, purchase taxes, value added tax (VAT), goods and services tax
(GST), and octroi, also form a part of the cost of purchases if they are not recoverable
by the buyer when he sells the goods. The term net purchases refers to purchases less
discounts, ieturns, and allowances.
 Cost of Goods Solds 173

Purchases learning Objective

Record
Under the periodic inventory system, a merchandising company debits the Purchases
• • transactions
account to record the cost of merchandise bought for resale during the reporting related to
period. Suppose that Vijay Electronics purchased merchandise costing ~50,000 on purchases of
September 9. The required journal entry is: merchandise.
Sep. 9 Purchases 50,000
Trade Payables (or Cash) 50,000
Purchased merchandise on credit (or for cash)
Think of the Purchases account as a combination of an expense account and a
temporary asset account. The balance of the account does not indicate how much of
the goods has been sold. The Purchases account is used only for goods acquired for
resale (after processing in the case of manufacturing organizations). Other assets such
as office equipment, office supplies, and vehicles acquired for use in the business are
recorded in the appropriate asset accounts.

Purchase Returns and Allowances

When a buyer finds merchandise purchased to be unsatisfactory, he may return the
goods or accept an allowance on the price. The buyer sends a debit note to notify the
seller that the latter's balance is being reduced. Depending on the terms of purchase
and trade practice, the buyer may either debit the seller's account immediately or
wait for the seller's acceptance of the debit note before recording the debit. Purchase
returns and allowances are recorded by crediting the Purchase Returns and Allowances
account, as illustrated below:
Nov. 18 Trade Payables 3,100
Purchase Returns and Allowances...................................... 3,100
Returned unsatisfactory merchandise to supplier
As illustrated in Exhibit 4.3, the statement of profit and loss presents the purchases
net of purchase returns. The use of a separate account for returns provides information
for monitoring the efficiency of the purchase function and the quality and reliability
of the suppliers. High rates of purchase returns could indicate the need for reviewing
purchasing practices and eliminating certain vendors.

Purchase Discounts
Often, the credit terms for purchase permit the buyer to deduct a stated cash discount
if the buyer pays the invoice within a specified time period. Under the gross price
method, discou~ts taken are recorded in the Purchase Discounts account. Suppose
that the terms for a purchase of n,ooo of goods on January 3 are 2/10, ni30. If the
buyer pays the invoice latest by January 13, he can take a 2 per cent discount. Thus,
the buyer must pay only ~980 to settle the invoice. The following entry records the
transactions:
Jan. 3 Purchases . 1,000
Trade Payables . 1,000
Purchased merchandise on terms 2/10, n130
13 Trade Payables . 1,000
Cash . 980
Purchase Discounts . 20
Paid for merchandise within discount period
Well-managed companies take advantage of the discounts allowed by their suppliers.
If a buyer avails purchase dise5unts as a matter of policy, purchases can be recorded
at the invoice price less discounts. This procedure is known as the net price method.
174 Chapter 4 Accounting for Merchandising Transactions

If the invoice is paid after the discount period, the amount of discount is debited
to Discounts Lost account. Under the net price method, the January 3 purchase is
recorded as follows:
Jan. 3 Purchases . 980
Trade Payables . 980
Purchased merchandise on terms 2110, n/30
13 Trade Payables . 980
Cash . 980
Paid for merchandise within the discount period

The purchase discount is calculated on the invoice amount less any purchase return
and allowances.
Deciding on discounts How does a buyer decide whether to take advantage of
discounts by using cash or borrowing? Suppose that a company buys goods for ~1,OOO
with terms 2/10, n/30. It must pay ~980 in 10 days or n,ooo in 30 days. By advancing
payment by 20 days, the buyer earns a discount of ~20. This is equivalent to investing
~980 and earning an interest income of ~20 for a period of 20 days. On an annual
basis, the equivalent interest rate works out to 36.73 per cent, as computed below:

Equivalent annual rate of interest

Number of days in a year (say, 360) Discount (per cent)
x-----~-------.:-
Number of days payments is advanced (100 - Discount per cent)
, 360 2
'=-- x-'
20 98
= 36.73 per cent

If the interest rate on borrowing is less than 36.73 per cent per year, the buyer
should borrow and pay within the discount period, since it is beneficial to take the
discount.
TEST YOUR
Your supplier offers payment terms of 1110, n/30. Will you pay within the discount period if your bonk
UNDERSTANDING 4.4
Deciding on Discounts interest rate is 26 per cent per annum?

Freight on Purchases
h
Learning Objective Transportation costs are often an important part of the cost of merchandise purchased.
• Describe the The cost of merchandise includes any transportation charges necessary to bring the
• common freight goods to the buyer's place of business. A separate Freight In account is used to
terms and reco;d record inward freight charges incurred on merchandise purchased. The following entry
transportation records a freight of n50 paid on a purchase:
costs.
May 17 Freight In 150
Cash 150
Paid freight on merchandise purchased

The normal balance of the Freight In account is debit. As illustrated in Exhibit 4.3,
freight paid on purchases is added to net purchases to get the net cost of purchases.
Freight In is an adjunct account, an account whose balance is added to the balance
of another account. An adjunct account is the opposite of a contra account (e.g.
accumulated depreciation), the balance of which is deducted from another account.
Transit insurance on purchases is treated similar to freight in.
The invoice normally indicates whether the seller or the buyer is to pay the freight.
FOB shtf,ping point means "free on board at shipping point", i.e. the buyer incurs
all transportation costs after the merchandise has been loaded on a train or. truck.
FOB destination means "free on board to destination", i.e. the seller ships the goods
 Operating Expenses 175

to their destination without charge to the buyer. Thus, if the terms are FOB shipping
point, the buyer pays the freight; if the terms are FOB destination, the seller pays
the freight. The freight terms in the invoice in Figure 4.2 are FOB destination and,
therefore, Vijay Electronics must pay the freight.
Freight terms are also significant for another reason. Ownership of goods generally
passes to the buyer at the FOB point. Therefore, if the terms are FOB shipping point,
the buyer should include goods in transit at the year end in its ending inventory. If
the terms are FOB destination, the seller should include goods in transit at the year
end in its ending inventory.
HANDHOLD 4.4
Harish in Mumbai sells glass jars FOB Pune to Raghav in Pune. He places the merchandise duly packed
FOB Terms
on a truck leaving for Pune. The truck capsizes on its way and the goods are destroyed. Who must
bear the loss?
The terms are FOB destination. So ownership would pass to Raghav when the goods reach Pune.
During transit, Harish was the owner and he must bear the loss.

TEST YOUR
Compute the cost of goods sold from the following information: beginning inventory, ~ll ,000;
UNDERSTANDING 4.5
purchases, ~21 0,000; purchose returns and allowonces, V,OOO; purchase discounts, ~3,000; freight
Calculating Cost of
in, ~18,000; ending inventory, ~17,000.
Goods Sold

Inventory Losses
Merchandiseinventory is lost in a variety of ways, such as spoilage, employee theft, and
shoplifting. Under the periodic inventory system, inventory losses are automatically
includedin the cost of goods sold. To illustrate this point, let us assume the following:
costof goods available for sale, noo,ooo; spoilage, ~2,000; ending inventory, n 7,000.
Thus, the cost of goods sold is ~83,000 (cost of goods available for sale, noo,ooo -
endinginventory, n7,000). Had there been no spoilage, the ending inventory would
have been ~19,000, and the cost of goods sold would have been ~81,000 ~100,000 -
H9,OOO), or ~2,000 lower than that calculated earlier.
Despite their best efforts, businesses suffer inventory losses. Under the periodic
inventory system, the loss is tucked away in the cost of goods sold and a measure
of the loss is not available. A rough-and-ready method of computing inventory loss
under the periodic inventory system is explained later in this chapter. In Chapter 6,
youwill, see another system - the perpetual inventory system - that provides better
informationabout inventory loss.

~~o_pe_r_a_t_in_g__ E_x_p_e_n_s_e_s )

Thethird most important part of a statement of profit and loss of a merchandising

Learning Objective
organizationis operating expenses (also known as selling, general and administrative
under~tand
expensesor SGA). These are expenses other than cost of goods sold, interest, and income • operating
tax and are incurred in running the normal business of a company. These expenses expenses.
areoften grouped into useful categories such as selling and administrative expenses.
Selling expenses include expenses of storing and preparing goods for sale, promoting
sales, actually making sales, and delivering goods to customers. Examples include
salaries, sales commissions, sales staff travel, advertising, store rent, depreciation
on store equipment, and delivery expense. (Freight charges paid on purchases are
a part of cost of goods sold.) Administrative expenses are incurred in the overall
managementof a business and include expenses relating to office salaries, office rent,
officetelephone, board meeting; depreciation on office equipment, and research and
development.
 Revenue from Construction Contracts, Franchises, and Leases 233

End of period adjustment for interest income Interest income accrues on a day-
to-day basis, but usually is only recorded at the bill's maturity date. If, however, the
bill is outstanding at the end of a reporting period, accrued interest should be computed
and recorded to recognize the interest earned. For example, assume Vibha Company's
reporting period ends on September 30. The following entry records accrued interest
for 27 days (the number of days held in September as calculated in determining the
maturity date) on the bill:17
Sep. 30 Interest Receivable...... 90
Interest Income 90
To accrue interest on S. Krishna's bill:
no,ooo x 12% x 27/360 = ~90
The following entry records the collection of the bill on December 2:
Dec. 2 Cash 10,300
Bills Receivable . 10,000
Interest Receivable . 90
Interest Income . 210
Collected bill on maturity

This entry eliminates the bill and interest receivable and recognizes ~210 of interest
for the 63 days the bill was held in the current reporting period. IS

Revenue from Construction Contracts, Franchises, and Leases

Accounting for receivables and revenue recognition are closely related. In Learning Objective
Chapters 3 and 4, we have seen the basic principles of revenue recognition and some Explain revenue
special cases such as bill and hold sales, conditional sales, and layaway sales. We • • recognition for
construction
will now see revenue recognition for construction contracts, franchises, and leases that
contracts,
involve special considerations. franchises, and
leases.
Construction Contracts
A construction contract is "a contract specifically negotiated for the construction
of an asset or a combination of assets that are closely interrelated or interdependent
in terms of their design, technology, and function or their ultimate purpose or use.,,19
Long-term construction contracts differ from sales of goods in that the revenue-earning
process -m these contracts is usually spread over several financial years. Examples
include contracts for construction of bridges, tunnels, dams, ships, aircraft, buildings,
and complex pieces of equipment.
We follow the percentage of completion method for construction contracts.
Under this method, contract revenue and contract costs are recognized by reference
to the stage of completion of the contract activity at the end of the reporting period.f"
The advantage of this method is that it reflects revenues and costs in periods in which
the related economic activity occurs. When the outcome of a contract can be estimated
reliably, the percentage of completion method should be used. Otherwise, the contract
revenue should be recognized only to the extent of costs incurred which are expected
to be recovered. When it is probable that the total contract costs will exceed the total
contract revenue, the expected loss is recognized as an expense immediately.

17 We are being consistent with the procedure for determining the maturity date. Alternatively,
we can include the date of the bill. In this case, we will calculate accrued interest for 28 days,
but interest income allocated to 'spe next period will be for 62 days (instead of 63 days).
18 As an exercise, you may like to try the reversing entry described in Chapter 3.
19 lAS 11:3/Ind AS 11:3/AS 7:2.1.
20 lAS 11:22/Ind AS 11:22/AS 7:21.
234 Chapter 5 Internal Control Systems, Cash, and Receivables

Suppose that Ace Construction Company enters into a contract for construction
of a bridge in 20X7 at a fixed price of ~2,500,OOO. The details of the progress of the
contract are as follows:

2~7 2~8 2~9

Costs incurred to date ~ 620,000 n,664,000 ~2,080,000
Progress billings to date 180,000 740,000 1,120,000
Cash received to date 130,000 900,000 1,570,000
Estimated further costs 1,380,000 416,000 -0-

We compute the percentage completed and revenue recognized as follows:

20X7 20X8 2~9

Contract price ~2,500,000 ~2,500,000 ~2,500,000
Less Estimated total costs:
Costs incurred to date 620,000 1,664,000 2,080,000
Estimated further costs 1,380,000 416,000 -0-
2,000,000 2,080,000 2,080,000
Estimated gross profit 500,000 420,000 420,000

Percentage of completion:
Costs incurred to date 620,000 1,664,000 2,080,000
= 31% =80% = 100%
Estimated total costs 2,000,000 2,080,000 2,080,000

Revenue recognized:
20X7: ~2,500,000 x 31%
= ~775,000
20X8: ~2,500,000 x 80%
= ~2,000,000
Less recognized in 20X7 775,000
1,225,000
20X9: ~2,500,000 x 100%
= ~2,500,000
Less recognized in 20X6 and 20X7 2,000,000
775,000 1,225,000 500,000

In 20X7, Ace Construction should report a gross profit of n55,OOO, calculated

as follows: revenue, ~775,OOO - costs, ~620,OOO. The gross profit would be n81,OOO
in 20X8 and ~84,OOO in 20X9. You should verify these numbers to make sure that
you understand the method. If, as a result of uncertainties, Ace Construction cannot
estimate the percentage of completion reliably, it will not recognize any revenue or
profit in either 20X7 or 20X8. In 20X9, it will recognize the entire revenue and profit
on completion of the contract.

IN PRACTICE BHEL, India's largest manufacturer of power plant equipment, follows the percentage of completion
Recognizing Revenue method. It builds complex power plants that take several years to complete. BHEL's accounting policy
from Construction for revenue recognition is as follows:
Contracts

••
Sales are recorded based on significant risks and rewards of ownership being transferred in favour of the
customer. Sales include goods dispatched to customers by partial shipment.
For construction contracts entered into on or after 1 April, 2003:

.'@): Revenue is recognized on percentage completion method based on the percentage of actual cost incurred
up to the reporting date to the total estimated cost of the contract.

Franchises
A franchise is a contractual arrangement under which the franchiser grants the
franchisee the right to manufacture or sell certain products or services, to use