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3. Alternative Inventory System

Earlier in the chapter this was stated:

"Now, there are two different techniques for recording the purchase - depending on whether a periodic system or a perpetual system is in use. Generalizing, the periodic inventory system is easier to implement but is less robust than the "real-time" tracking available under a perpetual system. Conversely, the perpetual inventory system involves more "systemization" but is a far superior business management tool."

The periodic system only required the recording of inventory purchases to a Purchases account; inventory records were updated only during the closing process based on the results of a physical count. No attempt is made to adjust inventory records concurrent with actual purchase and sale transactions. The weakness of the periodic system is that it provides no real-time data about the levels of inventory or gross profit data. If inventory is significant, the lack of up-to-date inventory data can be very costly. Managers need to know what is selling, and what is not selling, in order to optimize business success. That is why many successful merchants use sophisticated computer systems to implement perpetual inventory management. You have no doubt noted bar code scanners at a checkout for quickly pricing goods, but did you know that the business's inventory records may also be updated as the item is being scanned? With a high-performance perpetual system, each purchase or sale results in an immediate update of the inventory and cost of sales data in the accounting system. The following entries are appropriate to record the purchase and subsequent resale of an inventory item:

Entry to record purchase of inventory:

12-12-X1

Inventory

3,000

Accounts Payable

3,000

Purchased $3,000 of inventory on account

Entries to record sale of inventory:

12-21-X1

Accounts Receivable

5,000

Sales

5,000

Sold merchandise on account

12-21-X1

Cost of Goods Sold

3,000

Inventory

3,000

To record the cost of merchandise sold

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

If you think the perpetual system looks easier, don't be deceived. Consider that it is no easy task to determine the cost of each item of inventory as it is sold, and that is required for a proper application of the perpetual system. In a large retail environment, that is almost impossible without a sophisticated computer system. Nevertheless, such systems have become commonplace. This has come about with the decline in the cost of computers, along with a growth in "chain stores" that can apply the same technology to many individual stores.

One final point should be noted. A physical count of goods, where employees take to the store and count every item on hand, is still needed with a perpetual system. No matter how good the computer system, differences between the computer record and physical quantity on hand will arise. Differences are created by theft, spoilage, waste, errors, and so forth. Therefore, merchants must occasionally undertake a physical count, and adjust the Inventory accounts to reflect what is actually on hand.

4. Income Statement Enhancements

The expanded income statement for Bill's Sporting Goods was presented above. Yet, there are even more issues that can influence the form and shape of the income statement.

In the illustration for Bill's Sporting Goods, the operating expenses were all reported together. Often, companies will wish to further divide the expense items according to their nature: selling expenses (those associated with the sale of merchandise) or general and administrative (costs incurred in the management of the business). Some costs must be allocated between the two categories; like depreciation of the corporate headquarters wherein both sales and administrative activities are conducted.

A business may, from time to time, have incidental or peripheral transactions that contribute to income. For example, a business might sell land at a gain. Or, a fire might produce a loss. These gains and losses are often reported separate and apart from the measures of revenues and expenses associated with central ongoing operations.

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

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

The income statement below illustrates the added concepts via a multiple-step income statement. A multiple-step approach divides the businesses operating results into separate categories or steps, and simplifies the financial statement user's ability to understand the intricacy of an entity's operations. This illustration is fairly elaborate, but you also need to know that income reporting can become even more involved. In a subsequent chapter, you will learn about additional special reporting for other unique situations, like discontinued operations, extraordinary events, and so forth.

HUNTER COMPANY Income Statement For the Year Ending December 31, 20X9

REVENUES

Sales

$660,000

Less: Sales discounts

$ 5,000

Sales returns & allowances

2,000

7,000

Net sales

$653,000

COST OF GOODS SOLD

Beginning inventory, Jan. 1

$120,000

Add: Purchases

$230,000

Freight-in

10,000

$240,000

Less: Purchase discounts

$ 2,400

Purchase returns & allowances

3,600

6,000

Net purchases

234,000

Goods available for sale

$354,000

Less: Ending inventory, Dec. 31

71,000

Cost of goods sold

283,000

GROSS PROFIT

$370,000

SELLING EXPENSES

Advertising

$ 70,000

Freight-out

4,000

Depreciation

28,000

Utilities

11,000

Salaries

29,000

$142,000

GENERAL & ADMINISTRATIVE

Salaries

$ 63,000

Depreciation

17,000

Utilities

22,000

Insurance

44,000

Rent

24,000

170,000

OTHER

Loss on sale of land

$ 2,000

Interest expense

7,000

9,000

321,000

INCOME BEFORE TAX

$ 49,000

Income tax expense

10,000

NET INCOME

39 000

Accountants must always be cognizant of the capacity of the financial statement user to review and absorb the reports. Sometimes, the accountant may decide that a simplified presentation is more useful. In those cases, the income statement may be presented in a "single-step" format. This very simple approach reports all revenues (and gains) together, and the aggregated expenses (and losses) are tallied and subtracted to arrive at income. The single-step income statement for Hunter is shown below:

HUNTER COMPANY Income Statement For the Year Ending December 31, 20X9

REVENUES

Net sales

$653,000

EXPENSES AND LOSSES

Cost of goods sold

$283,000

Selling expenses

142,000

General & administrative

170,000

Loss on sale of land

2,000

Interest expense

7,000

604,000

INCOME BEFORE TAX

$ 49,000

Income tax expense

10,000

NET INCOME

$ 39,000

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

4.1. Analysis of a Detailed Income Statement

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

Gross Profit Margin = Gross Profit/Net Sales $370,000/$653,000 = 56.66% for Hunter

Net Profit on Sales = Net Income/Net Sales $39,000/$653,000 = 5.97% for Hunter

There are countless variations of these calculations, but they all go to the same issue - evaluating trends in performance unrelated to absolute dollar amounts.

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

 
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