I've attached the question as a word file as well as the class text to help with the assignment. Thanks!

c05MerchandisingOperationsandtheMultiple-StepIncomeStatement.qxd 8/14/10 2:14 PM Page 226 chapter 5 MERCHANDISING OPERATIONS AND THE MULTIPLE-STEP INCOME STATEMENT the navigator Scan Study Objectives Read Feature Story Scan Preview Read Text and Answer Do it! p. 235 p. 239 p. 243 study objectives After studying this chapter, you should be able to: p. 245 Work Using the Decision Toolkit Review Summary of Study Objectives Work Comprehensive Do it! p. 254 Answer Self-Test Questions Complete Assignments Go to WileyPLUS for practice and tutorials Read A Look at IFRS p. 276 1 Identify the differences between a service company and a merchandising company. 2 Explain the recording of purchases under a perpetual inventory system. 3 Explain the recording of sales revenues under a perpetual inventory system. 4 Distinguish between a single-step and a multiple-step income statement. 5 Determine cost of goods sold under a periodic system. 6 Explain the factors affecting profitability. 7 Identify a quality of earnings indicator. 226 c05MerchandisingOperationsandtheMultiple-StepIncomeStatement.qxd 8/14/10 2:14 PM Page 227 feature story In his book The End of Work, Jeremy Rifkin notes that of U.S. retail space per person is until the 20th century the word consumption evoked vastly greater than that of any other negative images; to be labeled a \"consumer\" was an country. It appears that we live to shop. insult. (In fact, one of the deadliest diseases in history, The first great retail giant was Sears, Roebuck. It tuberculosis, was often referred to as \"consumption.\") started as a catalog company enabling people in ru- Twentieth-century merchants realized, however, that in ral areas to buy things by mail. For decades it was the order to prosper, they had to convince people of the uncontested merchandising leader. need for things not previously needed. For example, General Motors made annual changes in its cars so that people would be dis- W H O D O E S N'T S H O P AT WAL-MART? Today, Wal-Mart is the undisputed champion provider of basic (and perhaps not-so-basic) human needs. Wal-Mart opened its first contented with the cars they already owned. Thus store in 1962, and it now has almost 8,000 stores, began consumerism. serving more than 100 million customers every week. Today, consumption describes the U.S. lifestyle in A key cause of Wal-Mart's incredible growth is its a nutshell. We consume twice as much today per per- amazing system of inventory control and distribution. son as we did at the end of World War II. The amount Wal-Mart has a management information system that employs six satellite channels, from which company computers receive 8.4 million updates every minute on Wal-Mart net sales, years ending January 31st (billions) $ 0 50 100 150 200 250 300 350 400 2009 7.9 2008 7.3 2007 6.8 2006 6.1 2005 5.3 2004 4.9 2003 4.7 2002 4.4 2001 2000 450 what items customers buy and the relationship among items sold to each person. Measured by sales revenues, Wal-Mart is the largest company in the world. In six years, it went from selling almost no groceries to being America's largest grocery retailer. It would appear that things have never looked bet- Total number of stores,'000 4.2 4.0 Source: \"How Big Can It Grow?\" The Economist (April 17, 2004), pp. 67-69, and www.walmart.com (accessed March 17, 2008). ter at Wal-Mart. On the other hand, a Wall Street Journal article, entitled \"How to Sell More to Those Who Think It's Cool to Be Frugal,\" suggests that consumerism as a way of life might be dying. Don't bet your high-definition 3D TV on it though. INSIDE CHAPTER 5 . . . Morrow Snowboards Improves Its Stock Appeal (p. 231) Should Costco Change Its Return Policy? (p. 238) Disclosing More Details (p. 242) Strategic Errors Can Be Costly (p. 248) 227 c05MerchandisingOperationsandtheMultiple-StepIncomeStatement.qxd 8/14/10 2:14 PM Page 228 preview of chapter 5 Merchandising is one of the largest and most influential industries in the United States. It is likely that a number of you will work for a merchandiser. Therefore, understanding the financial 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 statementthe multiplestep income statement. The content and organization of the chapter are as follows. Merchandising Operations Merchandising Operations Recording Purchases of Merchandise Operating cycles Flow of costs perpetual and periodic inventory systems Freight costs Purchase returns and allowances Purchase discounts Summary of purchasing transactions Recording Sales of Merchandise Sales returns and allowances Sales discounts Income Statement Presentation Sales revenues Gross profit Operating expenses Evaluating Profitability Gross profit rate Profit margin ratio Nonoperating activities Determining cost of goods soldperiodic system Merchandising Operations study objective 1 Identify the differences between a service company and a merchandising company. Illustration 5-1 Income measurement process for a merchandising company Wal-Mart, Kmart, and Target 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 Office Depot might buy office supplies from wholesaler United Stationers. The primary source of revenues 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: the cost of goods sold and operating expenses. The 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 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. Sales Revenue Less Cost of Goods Sold Equals Gross Profit Less Operating Expenses 228 Equals Net Income (Loss) c05MerchandisingOperationsandtheMultiple-StepIncomeStatement.qxd 8/14/10 2:14 PM Page 229 Merchandising Operations 229 OPERATING CYCLES The operating cycle of a merchandising company ordinarily is longer than that of a service company. The purchase of merchandise inventory and its eventual sale lengthen the cycle. Illustration 5-2 contrasts the operating cycles of service and merchandising companies. Note that the added asset account for a merchandising company is the Inventory account. Illustration 5-2 Operating cycles for a service company and a merchandising company Service Company Receive Cash Perform Services Cash Accounts Receivable Merchandising Company Receive Cash Buy Inventory Cash Sell Inventory Brien's itunes playlist Sgt. Pepper's L. H.C.B. When My Ship Comes In What Gonna Do Wia Cowboy? All I Want is A Life Accounts Receivable MENU Inventory TV FLOW OF COSTS The flow 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 describes these relationships. Companies use one of two systems to account for inventory: a perpetual inventory system or a periodic inventory system. Beginning Inventory Cost of Goods Purchased Cost of Goods Available for Sale Cost of Goods Sold Ending Inventory Illustration 5-3 Flow of costs c05MerchandisingOperationsandtheMultiple-StepIncomeStatement.qxd 230 8/14/10 2:14 PM Page 230 chapter 5 Merchandising Operations and the Multiple-Step Income Statement Perpetual System Helpful Hint Even under perpetual inventory systems, companies perform physical inventories. This is done as a control procedure to verify inventory levels, in order to detect theft or \"shrinkage.\" In a perpetual inventory system, companies maintain detailed records of the cost of each inventory purchase and sale. These records continuouslyperpetually 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 floor. 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. 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 periodthat 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 at the end of the accounting period. Illustration 5-4 graphically compares the sequence of activities and the timing of the cost of goods sold computation under the two inventory systems. Illustration 5-4 Comparing perpetual and periodic inventory systems Inventory Purchased Item Sold D L SO Perpetual Record purchase of inventory Item Sold No entry Record revenue and compute and record cost of goods sold Inventory Purchased End of Period D OL Periodic S Record purchase of inventory End of Period Compute and record cost of goods sold Record revenue only Additional Considerations 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 continuouslyperpetually show the quantity and cost of the inventory that should be on hand at any time. c05MerchandisingOperationsandtheMultiple-StepIncomeStatement.qxd 8/14/10 2:14 PM Page 231 Recording Purchases of Merchandise 231 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. As noted in the Feature Story, much of Wal-Mart's success is attributed to its sophisticated inventory system. Some businesses find it either unnecessary or uneconomical to invest in a sophisticated, computerized perpetual inventory system such as Wal-Mart's. However, many small merchandising businesses, in particular, find that basic computerized accounting packages provide some of the essential benefits of a perpetual inventory system. Yet, managers of some small businesses still find that they can control their merchandise and manage day-to-day operations using a periodic inventory system. Because the perpetual inventory system is growing in popularity and use, we illustrate it in this chapter. An appendix to this chapter describes the journal entries for the periodic system. Investor Insight Morrow Snowboards Improves Its Stock Appeal 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 first 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 the 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? (See page 276.) Recording Purchases of Merchandise 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 in Inventory and a decrease 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 (page 232), for example, Sauk Stereo (the buyer) uses as a purchase invoice the sales invoice prepared by PW Audio Supply, Inc. (the seller). The associated entry for Sauk Stereo for the invoice from PW Audio Supply increases Inventory and increases Accounts Payable. May 4 Inventory Accounts Payable (To record goods purchased on account from PW Audio Supply) study objective Explain the recording of purchases under a perpetual inventory system. A = L 3,800 3,800 2 3,800 3,800 Cash Flows no effect + SE c05MerchandisingOperationsandtheMultiple-StepIncomeStatement.qxd 232 8/14/10 2:14 PM Page 232 chapter 5 Merchandising Operations and the Multiple-Step Income Statement Illustration 5-5 Sales invoice used as purchase invoice by Sauk Stereo INVOICE NO. 731 PW Audio Supply, Inc. 27 Circle Drive Harding, Michigan 48281 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 S O L D Firm Name Sauk Stereo Attention of James Hoover, Purchasing Agent T O Address 125 Main Street Chelsea Illinois 60915 State Zip City Date 5/4/12 Catalog No. X572Y9820 A2547Z45 Salesperson Malone Terms 2/10, n/30 Description FOB Shipping Point Quantity Price Amount Printed Circuit Board-prototype 1 2,300 $2,300 Production Model Circuits 5 300 1,500 TOTAL $3,800 IMPORTANT: ALL RETURNS MUST BE MADE WITHIN 10 DAYS Under the perpetual inventory system, companies record purchases of merchandise for sale in the Inventory account. Thus, Wal-Mart 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 specific 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, Wal-Mart would increase (debit) Supplies. FREIGHT COSTS The sales agreement should indicate whothe seller or the buyeris 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 board to the buyer's place of business, and the seller pays the freight. For example, the sales invoice in Illustration 5-5 indicates FOB shipping point. c05MerchandisingOperationsandtheMultiple-StepIncomeStatement.qxd 8/14/10 2:14 PM Page 233 Recording Purchases of Merchandise 233 Thus, the buyer (Sauk Stereo) pays the freight charges. Illustration 5-6 illustrates these shipping terms. Illustration 5-6 Shipping terms FOB Shipping Point Ownership passes to buyer here FOB Destination Buyer pays freight costs Seller pays freight costs Public Carrier Co. Seller Buyer Ownership passes to buyer here Public Carrier Co. Seller Buyer 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. For example, if Sauk Stereo (the buyer) pays Haul-It Freight Company $150 for freight charges on May 6, the entry on Sauk Stereo's books is: A May 6 Inventory Cash (To record payment of freight on goods purchased) 150 150 = L + SE = L + SE 150 150 Cash Flows 150 Thus, any freight costs incurred by the buyer are part of the cost of merchandise purchased. The reason: Inventory cost should include any freight charges necessary to deliver the goods to the buyer. 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 or Delivery Expense. For example, if the freight terms on the invoice in Illustration 5-5 had required that PW Audio Supply (the seller) pay the $150 freight charges, the entry by PW Audio Supply would be: A May 4 Freight-out Cash (To record payment of freight on goods sold) 150 Exp 150 150 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. PURCHASE RETURNS AND ALLOWANCES A purchaser may be dissatisfied with the merchandise received because the goods are damaged or defective, of inferior quality, or do not meet the purchaser's specifications. In such cases, the purchaser may return the goods to the seller for 150 Cash Flows 150 c05MerchandisingOperationsandtheMultiple-StepIncomeStatement.qxd 234 8/14/10 2:14 PM Page 234 chapter 5 Merchandising Operations and the Multiple-Step Income Statement 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 Accounts Payable and decreases Inventory. A = L + SE 300 300 Cash Flows no effect May 8 Accounts Payable Inventory (To record return of goods purchased from PW Audio Supply) 300 300 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. Helpful Hint The term net in \"net 30\" means the remaining amount due after subtracting any returns and allowances and partial payments. 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 (page 232), 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 specified 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 first 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 first 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 $3,800 less purchase returns and allowances of $300) on May 14, the last day of the discount period. 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. c05MerchandisingOperationsandtheMultiple-StepIncomeStatement.qxd 8/14/10 2:14 PM Page 235 Recording Purchases of Merchandise May 14 Accounts Payable Cash Inventory (To record payment within discount period) 3,500 3,430 70 A L + SE + SE 3,500 3,430 70 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. Cash Flows 3,430 A June 3 = 235 Accounts Payable Cash (To record payment with no discount taken) = L 3,500 3,500 3,500 3,500 Cash Flows 3,500 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. SUMMARY OF PURCHASING TRANSACTIONS The following T account (with transaction descriptions in blue) 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 finally, 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. Inventory Purchase May 4 3,800 May 8 300 Freight-in 6 150 14 70 Balance Purchase return Purchase discount 3,580 before you go on... Do it! On September 5, De La Hoya Company buys merchandise on account from Junot Diaz Company. The selling price of the goods 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. Solution Sept. 5 8 Inventory Accounts Payable (To record goods purchased on account) Accounts Payable Inventory (To record return of defective goods) Related exercise material: BE5-4, Do it! 5-1, and E5-1. 1,500 1,500 200 200 PURCHASE TRANSACTIONS Action Plan Purchaser records goods at cost. When goods are returned, purchaser reduces Inventory. c05MerchandisingOperationsandtheMultiple-StepIncomeStatement.qxd 236 8/14/10 2:14 PM Page 236 chapter 5 Merchandising Operations and the Multiple-Step Income Statement Recording Sales of Merchandise study objective 3 Explain the recording of sales revenues under a perpetual inventory system. A = L + Companies record sales revenues, like service revenues, when earned, in compliance with the revenue recognition principle. Typically, companies earn sales revenues 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 tapes provide evidence of cash sales. A sales invoice, like the one that was shown in Illustration 5-5 (page 232), 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) as follows (assume the merchandise cost PW Audio Supply $2,400). SE 3,800 May 4 3,800 Rev Cash Flows no effect A = L + Accounts Receivable Sales Revenue (To record credit sale to Sauk Stereo per invoice #731) 3,800 Cost of Goods Sold Inventory (To record cost of merchandise sold on invoice #731 to Sauk Stereo) 2,400 3,800 SE 2,400 Exp 2,400 Cash Flows no effect 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 financial reporting. For example, General Electric now provides more detail on its revenues and operating profits. 4 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 TV sets, DVD players, and microwave ovens. Wal-Mart might use separate accounts for sporting goods, children's clothing, and hardwareor it might have even more narrowly defined 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 more strategically to changes in sales patterns. For example, if TV sales are increasing while microwave oven sales are decreasing, the company might reevaluate both its advertising and pricing policies on each of these items to ensure they are optimal. On its income statement presented to outside investors a merchandising company would normally provide only a single sales figurethe 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 five types. The reason: The additional categories will better enable financial statement users to evaluate the growth of the company's consumer and Internet businesses. c05MerchandisingOperationsandtheMultiple-StepIncomeStatement.qxd 8/14/10 2:14 PM Page 237 Recording Sales of Merchandise A N ATO M Y O F A F R AU D 1 Holly Harmon was a cashier at a national superstore for only a short while when she began stealing merchandise using three methods. First, 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. Second, Holly rang an item up 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 rang up the plastic containers but not the goods within them. One day, Holly did not call in sick or show up for work. In such instances, the company reviews past surveillance tapes to look for suspicious activity by employees. This enabled the store to observe the thefts and to identify the participants. 237 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. 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 flag 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. SALES RETURNS AND ALLOWANCES We now look at the \"flipside\" 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 have assumed that the goods were not defective. If they were defective, PW Audio Supply would make an adjustment to the Inventory account to reflect their decline in value.) A May 8 8 Sales Returns and Allowances Accounts Receivable (To record credit granted to Sauk Stereo for returned goods) Inventory Cost of Goods Sold (To record cost of goods returned) 140 = L 300 300 + SE 300 Rev 300 Cash Flows no effect A 140 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. 1 The \"Anatomy of a Fraud\" stories in this textbook are adapted from Fraud Casebook: Lessons from the Bad Side of Business, edited by Joseph T. Wells (Hoboken, NJ: John Wiley & Sons, Inc., 2007). Used by permission. The names of some of the people and organizations in the stories are fictitious, but the facts in the stories are true. = L + SE 140 140 Exp Cash Flows no effect c05MerchandisingOperationsandtheMultiple-StepIncomeStatement.qxd 238 8/14/10 2:14 PM Page 238 chapter 5 Merchandising Operations and the Multiple-Step Income Statement As mentioned previously, Sales Returns and Allowances is a contra revenue account to Sales Revenue. 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 problemsinferior merchandise, inefficiencies in filling 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. Accounting Across the Organization Should Costco Change Its Return Policy? In most industries, sales returns are relatively minor. But returns of consumer electronics can really take a bite out of profits. Recently, the marketing executives at Costco Wholesale Corp. faced a difficult 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-definition 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 significant returns, what are the implications for revenue recognition? (See page 276.) SALES DISCOUNTS As mentioned in our discussion of purchase transactions, the seller may offer the customer a cash discountcalled by the seller a sales discountfor 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: A = L + SE 3,430 May 14 70 Rev 3,500 Cash Flows 3,430 Cash Sales Discounts Accounts Receivable (To record collection within 2/10, n/30 discount period from Sauk Stereo) 3,430 70 3,500 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, 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. The following T accounts summarize the three sales-related transactions and show their combined effect on net sales. c05MerchandisingOperationsandtheMultiple-StepIncomeStatement.qxd 8/14/10 2:14 PM Page 239 Income Statement Presentation Sales Revenue 3,800 Sales Returns and Allowances 239 Sales Discounts 300 70 Net Sales $3,430 before you go on... Do it! 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. Solution Sept. 5 5 Sept. 8 8 Accounts Receivable Sales Revenue (To record credit sale) 1,500 1,500 Cost of Goods Sold Inventory (To record cost of goods sold on account) 800 Sales Returns and Allowances Accounts Receivable (To record credit granted for receipt of returned goods) 200 Inventory Cost of Goods Sold (To record cost of goods returned) SALES TRANSACTIONS 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. Any goods returned increase Inventory and reduce Cost of Goods Sold. The merchandise inventory should be recorded at its fair value (scrap value). 105 800 200 105 Related exercise material: BE5-2, BE5-3, Do it! 5-2, E5-2, E5-3, and E5-4. Income Statement Presentation Companies widely use two forms of the income statement. One is the singlestep 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 classified 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 (page 240) shows a single-step statement for Wal-Mart. There are two primary reasons for using the single-step form: (1) A company does not realize any type of profit 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. study objective 4 Distinguish between a single-step and a multiplestep income statement. c05MerchandisingOperationsandtheMultiple-StepIncomeStatement.qxd 240 8/14/10 2:14 PM Page 240 chapter 5 Merchandising Operations and the Multiple-Step Income Statement Illustration 5-7 Singlestep income statements WAL-MART STORES, INC. Income Statements (in millions) For the years ended January 31 2009 $374,307 4,169 405,607 378,476 306,158 286,350 76,651 70,174 1,900 353 7,145 1,794 538 6,889 392,207 365,745 $ 13,400 Expenses Cost of goods sold Selling, general, and administrative expenses 2008 $401,244 4,363 Revenues Net sales Other revenues $ 12,731 Interest expense Other expense Income taxes Net income International Note The IASB and FASB are involved in a joint project to evaluate the format of financial statements. The first phase of that project involves a focus on how to best present revenues and expenses. One longer-term result of the project may well be an income statement format that better reflects how businesses are run. 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 Wal-Mart income statement in Illustration 5-8 is an example. The multiple-step income statement has three important line items: gross profit, income from operations, and net income. They are determined as follows. 1. Subtract cost of goods sold from net sales to determine gross profit. 2. Deduct operating expenses from gross profit to determine income from operations. 3. Add or subtract the results of activities not related to operations to determine net income. Illustration 5-8 Multiple-step income statements WAL-MART STORES, INC. Income Statements (in millions) For the years ended January 31 2009 2008 $401,244 306,158 $374,307 286,350 Gross profit Operating expenses Selling, general, and administrative expenses 95,086 87,957 76,651 70,174 Income from operations Other revenues and gains Other revenues Other expenses and losses Interest expense Other expense 18,435 17,783 4,363 4,169 1,900 353 1,794 538 Income before income taxes Income tax expense 20,545 7,145 19,620 6,889 $ 13,400 $ 12,731 Net sales Cost of goods sold Net income c05MerchandisingOperationsandtheMultiple-StepIncomeStatement.qxd 8/14/10 2:14 PM Page 241 Income Statement Presentation 241 Note that companies report income tax expense in a separate section of the income statement before net income. The net incomes in Illustrations 5-7 and 5-8 are the same. The difference in the two income statements is the amount of detail displayed and the order presented. The following discussion provides additional information about the components of a multiple-step income statement. SALES REVENUES The income statement for a merchandising company typically presents gross sales revenues for the period. The company deducts sales returns and allowances and sales discounts (both contra accounts) from sales revenue in the income statement to arrive at net sales. Illustration 5-9 shows the sales revenues section of the income statement for PW Audio Supply. Illustration 5-9 Statement presentation of sales revenues section PW AUDIO SUPPLY, INC. Income Statement (partial) Sales revenues Sales revenue Less: Sales returns and allowances Sales discounts Net sales $ 480,000 $12,000 8,000 20,000 $460,000 GROSS PROFIT Companies deduct cost of goods sold from sales revenue to determine gross profit. As shown in Illustration 5-8, for example, Wal-Mart had a gross profit of $95.1 billion in fiscal year 2009. Sales revenue used for this computation is net sales, which takes into account sales returns and allowances and sales discounts. On the basis of the PW Audio Supply sales data presented in Illustration 5-9 (net sales of $460,000) and the cost of goods sold (assume a balance of $316,000), PW Audio Supply's gross profit is $144,000, computed as follows. Net sales Cost of goods sold $ 460,000 316,000 Gross profit $144,000 It is important to understand what gross profit isand what it is not. Gross profit represents the merchandising profit of a company. Because operating expenses have not been deducted, it is not a measure of the overall profit of a company. Nevertheless, management and other interested parties closely watch the amount and trend of gross profit. Comparisons of current gross profit with past amounts and rates and with those in the industry indicate the effectiveness of a company's purchasing and pricing policies. OPERATING EXPENSES Operating expenses are the next component in measuring net income for a merchandising company. At Wal-Mart, for example, operating expenses were $76.7 billion in fiscal year 2009. At PW Audio Supply, operating expenses were $114,000. The firm determines its income from operations by subtracting operating expenses from gross profit. Thus, income from operations is $30,000, as shown below. Gross profit Operating expenses $144,000 114,000 Income from operations $ 30,000 Alternative Terminology Gross profit is sometimes referred to as gross margin. c05MerchandisingOperationsandtheMultiple-StepIncomeStatement.qxd 242 8/14/10 2:14 PM Page 242 chapter 5 Merchandising Operations and the Multiple-Step Income Statement NONOPERATING ACTIVITIES Nonoperating activities consist of various revenues and expenses and gains and losses that are unrelated to the company's main line of operations. When nonoperating items are included, the label \"Income from operations\" (or \"Operating income\") precedes them. This label clearly identifies the results of the company's normal operations, an amount determined by subtracting cost of goods sold and operating expenses from net sales. The results of nonoperating activities are shown in the categories \"Other revenues and gains\" and \"Other expenses and losses.\" Illustration 5-10 lists examples of each. Nonoperating income is sometimes very significant. For example, in a recent quarter Sears Holdings earned more than half of its net income from investments in derivative securities. Illustration 5-10 Examples of nonoperating activities Other Revenues and Gains Interest revenue from notes receivable and marketable securities. Dividend revenue from investments in capital stock. Rent revenue from subleasing a portion of the store. Gain from the sale of property, plant, and equipment. Other Expenses and Losses Ethics Note Companies manage earnings in various ways. ConAgra Foods recorded a nonrecurring gain for $186 million from the sale of Pilgrim's Pride stock to help meet an earnings projection for the quarter. Interest expense on notes and loans payable. Casualty losses from recurring causes, such as vandalism and accidents. Loss from the sale or abandonment of property, plant, and equipment. Loss from strikes by employees and suppliers. The distinction between operating and nonoperating activities is crucial to external users of financial data. These users view operating income as sustainable and many nonoperating activities as nonrecurring. When forecasting next year's income, analysts put the most weight on this year's operating income, and less weight on this year's nonoperating activities. Ethics Insight Disclosing More Details After Enron, increased investor criticism and regulator scrutiny forced many companies to improve the clarity of their financial disclosures. For example, IBM announced that it would begin providing more detail regarding its \"Other gains and losses.\" It had previously included these items in its selling, general, and administrative expenses, with little disclosure. Disclosing other gains and losses in a separate line item on the income statement will not have any effect on bottom-line income. However, analysts complained that burying these details in the selling, general, and administrative expense line reduced their ability to fully understand how well IBM was performing. For example, previously if IBM sold off one of its buildings at a gain, it would include this gain in the selling, general, and administrative expense line item, thus reducing that expense. This made it appear that the company had done a better job of controlling operating expenses than it actually had. Other companies that also recently announced changes to increase the informativeness of their income statements included PepsiCo and General Electric. ? Why have investors and analysts demanded more accuracy in isolating \"Other gains and losses\" from operating items? (See page 276.) The nonoperating activities are reported in the income statement immediately after the operating activities. Included among these activities in Illustration 5-8 c05MerchandisingOperationsandtheMultiple-StepIncomeStatement.qxd 8/14/10 2:14 PM Page 243 Income Statement Presentation 243 (page 240) for Wal-Mart is interest expense of $1.9 billion for fiscal year 2009. The amount remaining, after adding the operating and nonoperating sections together, is Wal-Mart's net income of $13.4 billion. In Illustration 5-11 we have provided the multiple-step income statement of a hypothetical company. This statement provides more detail than that of WalMart and thus is useful as a guide for homework. (For WileyPLUS homework, individual revenues and expenses are listed in order of magnitude.) For homework problems, use the multiple-step form of the income statement unless the requirements state otherwise. Illustration 5-11 Multiplestep income statement PW AUDIO SUPPLY, INC. Income Statement For the Year Ended December 31, 2012 Sales revenues Sales revenue Less: Sales returns and allowances Sales discounts $480,000 $12,000 8,000 20,000 Net sales Cost of goods sold 460,000 316,000 Gross profit Operating expenses Salaries and wages expense Utilities expense Advertising expense Depreciation expense Freight-out Insurance expense Calculation of gross profit 144,000 64,000 17,000 16,000 8,000 7,000 2,000 Total operating expenses Income from operations Other revenues and gains Interest revenue Gain on disposal of plant assets Calculation of income from operations 114,000 30,000 3,000 Results of activities not related to operations 600 3,600 Other expenses and losses Interest expense Casualty loss from vandalism 1,800 200 2,000 1,600 Income before income taxes Income tax expense 31,600 10,100 Net income $ 21,500 before you go on... Do it! The following information is available for Art Center Corp. for the year ended December 31, 2012. Other revenues and gains Other expenses and losses Cost of goods sold $ 8,000 3,000 147,000 Net sales Operating expenses $442,000 187,000 Prepare a multiple-step income statement for Art Center Corp. The company has a tax rate of 25%. MULTIPLE-STEP INCOME STATEMENT c05MerchandisingOperationsandtheMultiple-StepIncomeStatement.qxd 244 8/14/10 2:14 PM Page 244 chapter 5 Merchandising Operations and the Multiple-Step Income Statement Action Plan Subtract cost of goods sold from net sales to determine gross profit. Subtract operating expenses from gross profit to determine income from operations. Multiply the tax rate by income before tax to determine tax expense. Solution ART CENTER CORP. Income Statement For the Year Ended December 31, 2012 Net sales Cost of goods sold $442,000 147,000 Gross profit Operating expenses 295,000 187,000 Income from operations Other revenues and gains Other expenses and losses 108,000 8,000 3,000 Income before income taxes Income tax expense Net income 5,000 113,000 28,250 $ 84,750 Related exercise material: BE5-5, BE5-6, Do it! 5-3, and E5-5. study objective 5 Determine cost of goods sold under a periodic system. Illustration 5-12 Basic formula for cost of goods sold using the periodic system DETERMINING COST OF GOODS SOLD UNDER A PERIODIC SYSTEM Determining cost of goods sold is different when a periodic inventory system is used rather than a perpetual system. As you have seen, a company using a perpetual system makes an entry to record cost of goods sold and to reduce inventory each time a sale is made. A company using a periodic system does not determine cost of goods sold until the end of the period. At the end of the period the company performs a count to determine the ending balance of inventory. It then calculates cost of goods sold by subtracting ending inventory from the goods available for sale. Goods available for sale is the sum of beginning inventory plus purchases, as shown in Illustration 5-12. Beginning Inventory Cost of Goods Purchased Cost of Goods Available for Sale Ending Inventory Cost of Goods Sold Another difference between the two approaches is that the perpetual system directly adjusts the Inventory account for any transaction that affects inventory (such as freight costs, returns, and discounts). The periodic system does not do this. Instead, it creates different accounts for purchases, freight costs, returns, and discounts. These various accounts are shown in Illustration 5-13 (page 245), which presents the calculation of cost of goods sold for PW Audio Supply using the periodic approach. Note that the basic elements from Illustration 5-12 are highlighted in Illustration 5-13. You will learn more in Chapter 6 about how to determine cost of goods sold using the periodic system. The use of the periodic inventory system does not affect the form of presentation in the balance sheet. As under the perpetual system, a company reports inventory in the current assets section. Appendix 5A provides further detail on the use of the periodic system. c05MerchandisingOperationsandtheMultiple-StepIncomeStatement.qxd 8/14/10 2:14 PM Page 245 Evaluating Profitability Illustration 5-13 Cost of goods sold for a merchandiser using a periodic inventory system PW AUDIO SUPPLY, INC. Cost of Goods Sold For the Year Ended December 31, 2012 Cost of goods sold Inventory, January 1 Purchases Less: Purchase returns and allowances Purchase discounts 245 $ 36,000 $325,000 $10,400 6,800 Net purchases Add: Freight-in 17,200 307,800 12,200 Cost of goods purchased 320,000 Cost of goods available for sale Inventory, December 31 356,000 40,000 Cost of goods sold $316,000 Helpful Hint The far right column identifies the primary items that make up cost of goods sold of $316,000. The middle column explains cost of goods purchased of $320,000. The left column reports contra purchase items of $17,200. before you go on... Do it! Aerosmith Company's accounting records show the following at the yearend December 31, 2012. Purchase Discounts Freight-in Purchases Beginning Inventory Ending Inventory Purchase Returns $ 3,400 6,100 162,500 18,000 20,000 5,200 Assuming that Aerosmith Company uses the periodic system, compute (a) cost of goods purchased and (b) cost of goods sold. Solution (a) Cost of goods purchased $160,000: Purchases Purchase returns Purchase discounts Freight-in $162,500 $5,200 $3,400 $6,100 $160,000 (b) Cost of goods sold $158,000: Beginning inventory Cost of goods purchased Ending inventory $18,000 $160,000 $20,000 $158,000 COST OF GOODS SOLDPERIODIC SYSTEM Action Plan To determine cost of goods purchased, adjust purchases for returns, discounts, and freight-in. To determine cost of goods sold, add cost of goods purchased to beginning inventory, and subtract ending inventory. Related exercise material: BE5-7, BE5-8, BE5-9, Do it! 5-4, E5-10, and E5-11. Evaluating Profitability GROSS PROFIT RATE A company's gross profit may be expressed as a percentage by dividing the amount of gross profit by net sales. This is referred to as the gross profit rate. For PW Audio Supply, the gross profit rate is 31.3% ($144,000 $460,000). Analysts generally consider the gross profit rate to be more informative than the gross profit amount because it expresses a more meaningful (qualitative) relationship between gross profit and net sales. For example, a gross profit amount of $1,000,000 may sound impressive. But if it was the result of sales of $100,000,000, the company's gross profit rate was only 1%. A 1% gross profit rate is acceptable in very few industries. Illustration 5-14 (page 246) demonstrates that gross profit rates differ greatly across industries. study objective 6 Explain the factors affecting profitability. c05MerchandisingOperationsandtheMultiple-StepIncomeStatement.qxd 246 8/14/10 2:14 PM Page 246 chapter 5 Merchandising Operations and the Multiple-Step Income Statement Illustration 5-14 Gross profit rate by industry Industry Software and programming 74.8% Pharmaceutical 70.9% Semiconductors 51% Footwear 44.5% Food processing 30.4% Chemical manufacturing 21.4% 10% 20% 30% 40% 50% 60% 70% 80% A decline in a company's gross profit rate might have several causes. The company may have begun to sell products with a lower \"markup\"for example, budget blue jeans versus designer blue jeans. Increased competition may have resulted in a lower selling price. Or, the company may be forced to pay higher prices to its suppliers without being able to pass these costs on to its customers. The gross profit rates for Wal-Mart and Target, and the industry average, are presented in Illustration 5-15. Illustration 5-15 profit rate Gross Gross Profit Rate Gross Profit Net Sales Wal-Mart ($ in millions) 2009 $95,086 $401,244 = 23.7% Target Industry Average 2008 2009 2009 23.5% 30.0% 25.1% Wal-Mart's gross profit rate increased from 23.5% in 2008 to 23.7% in 2009. In its Management Discussion and Analysis (MD&A), Wal-Mart explained, \"The gross profit margin increase in fiscal 2009 compared to fiscal 2008 was primarily due to lower inventory shrinkage and less markdown activity as a result of more effective merchandising in the Wal-Mart U.S. segment. Additionally, the increase in gross profit margin in fiscal 2008 included a $97 million refund of excise taxes previously paid on past merchandise sales of prepaid phone cards.\" At first glance, it might be surprising that Wal-Mart has a lower gross profit rate than Target and the industry average. It is likely, however, that this can be explained by the fact that grocery products are becoming an increasingly large component of Wal-Mart's sales. (In 2010, Wal-Mart announced that groceries now represent more than 50% of its sales.) In fact, in its MD&A, Wal-Mart once stated, \"Because food items carry a lower gross margin than our other merchandise, increasing food sales tends to have an unfavorable impact on our total gross margin.\" Also, Wal-Mart has substantial warehouse-style sales in its Sam's Club stores, which are a low-margin, high-volume operation. In later chapters, we will provide further discussion of the trade-off between sales volume and gross profit. c05MerchandisingOperationsandtheMultiple-StepIncomeStatement.qxd 8/14/10 2:14 PM Page 247 Evaluating Profitability 247 DECISION TOOLKIT DECISION CHECKPOINTS Is the price of goods keeping pace with changes in the cost of inventory? INFO NEEDED FOR DECISION TOOL TO USE FOR DECISION Gross profit Gross profit Net sales rate Gross profit and net sales HOW TO EVALUATE RESULTS Higher ratio suggests the average margin between selling price and inventory cost is increasing. Too high a margin may result in lost sales. PROFIT MARGIN RATIO The profit margin ratio measures the percentage of each dollar of sales that results in net income. We compute this ratio by dividing net income by net sales (revenue) for the period. How do the gross profit rate and profit margin ratio differ? The gross profit rate measures the margin by which selling price exceeds cost of goods sold. The profit margin ratio measures the extent by which selling price covers all expenses (including cost of goods sold). A company can improve its profit margin ratio by either increasing its gross profit rate and/or by controlling its operating expenses and other costs. For example, at one time Radio Shack reported increased profit margins which it accomplished by closing stores and slashing costs. While its total sales have been declining, its profitability as measured by its profit margin has increased. Profit margins vary across industries. Businesses with high turnover, such as grocery stores (Safeway and Kroger) and discount stores (Target and Wal-Mart), generally experience low profit margins. Low-turnover businesses, such as high-end jewelry stores (Tiffany and Co.) or major drug manufacturers (Merck), have high profit margins. Illustration 5-16 shows profit margin ratios from a variety of industries. Illustration 5-16 Profit margin ratio by industry Industry 19.7% Software and programming Semiconductors 15.3% Pharmaceutical 15% Footwear 10% Chemical manufacturing 7.6% Food processing 6.4% 10% 20% 30% Profit margins for Wal-Mart and Target and the industry average are presented in Illustration 5-17. Illustration 5-17 margin ratio Profit Margin Ratio Net Income Net Sales Wal-Mart ($ in millions) 2009 $13,400 $401,244 = 3.3% Target Industry Average 2008 2009 2009 3.4% 3.4% 3.5% Profit c05MerchandisingOperationsandtheMultiple-StepIncomeStatement.qxd 248 8/14/10 2:14 PM Page 248 chapter 5 Merchandising Operations and the Multiple-Step Income Statement Wal-Mart's profit margin declined from 3.4% to 3.3% between 2008 and 2009. This means that the company generated 3.3 of profit on each dollar of sales. This occurred even though the gross profit rate increased. The cause of the decline in the profit margin ratio was increased operating expenses. Wal-Mart's MD&A discussion states: \"In fiscal 2009, operating expenses increased primarily due to higher utility costs, a pre-tax charge of approximately $352 million resulting from the settlement of 63 wage and hour class action lawsuits, higher health benefit costs and increased corporate expenses compared to fiscal 2008. Corporate expenses have increased primarily due to our long-term transformation projects to enhance our information systems for merchandising, finance and human resources.\" How does Wal-Mart compare to its competitors? Its profit margin ratio was lower than Target's in 2009 and was less than the industry average. Thus, its profit margin ratio does not suggest exceptional profitability. However, we must again keep in mind that an increasing percentage of Wal-Mart's sales is from low-margin groceries. Accounting Across the Organization Strategic Errors Can Be Costly In its death spiral toward bankruptcy, Kmart appeared to make two very costly strategic errors. First, in an effort to attract customers, it decided to reduce selling prices on over 30,000 items. The problem was that this reduced its gross profit rateand didn't even have the intended effect of increasing sales because Wal-Mart quickly matched these price cuts. Because Wal-Mart operated much more efficiently than Kmart, Wal-Mart could afford to absorb these price cuts and still operate at a profit. Kmart could not. Its second error was to try to reduce operating costs by cutting its advertising expenditures. This resulted in a reduction in customersand sales revenue. ? Explain how Wal-Mart's profitability gave it a strategic advantage over Kmart. (See page 276.) DECISION TOOLKIT DECISION CHECKPOINTS Is the company maintaining an adequate margin between sales and expenses? KEEPING AN EYE ON CASH study objective Identify a quality of earnings indicator. INFO NEEDED FOR DECISION Net income and net sales TOOL TO USE FOR DECISION Profit margin Net income Net sales ratio HOW TO EVALUATE RESULTS Higher value suggests favorable return on each dollar of sales. In Chapter 4, you learned that earnings have high quality if they provide a full and transparent depiction of how a company performed. In order to quickly assess earnings quality, analysts sometimes employ the quality of earnings ratio. It is calculated as net cash provided by operating activities divided by net income. 7 Quality of Earnings Ratio Net Cash Provided by Operating Activities Net Income c05MerchandisingOperationsandtheMultiple-StepIncomeStatement.qxd 8/14/10 2:14 PM Page 249 Using the Decision Toolkit In general, a measure significantly less than 1 suggests that a company may be using more aggressive accounting techniques in order to accelerate income recognition (record income in earlier periods). A measure significantly greater than 1 suggests that a company is using conservative accounting techniques, which cause it to delay the recognition of income. Measures that are significantly less than 1 do not provide definitive evidence of low-quality earnings. Low measures do, however, indicate that analysts should investigate the company's earnings quality by evaluating the causes of the difference between net income and net cash provided by operating activities. Examples of factors that would cause differences are presented in Chapter 4 (pp. 191-192). Here are recent quality of earnings ratios for a number of well-known companies, all of which have measures in excess of 1. Company Name ($ in millions) Net Cash Provided by Operating Activities DuPont Intel Nike Microsoft Wal-Mart $4,741 $11,170 $1,736 $19,037 $26,249 Net Income Quality of Earnings Ratio $1,769 $4,369 $1,487 $14,569 $14,335 2.7 2.6 1.2 1.3 1.8 USING THE DECISION TOOLKIT After having once been as dominant as Wal-Mart, in recent years Sears has struggled to survive. It has enacted many changes trying to turn itself around. In the 1990s, it shocked and disappointed many loyal customers by closing its catalog business. It also closed 113 stores and eliminated 50,000 jobs. None of these changes was enough to make Sears truly competitive, so in March 2005 Sears merged with Kmart to form the third largest U.S. retailer. Here is recent data for Sears Holdings, Inc. Year ended ($ in millions) 01/30/10 01/31/09 Net income Sales revenue Cost of goods sold $ 235 44,043 31,824 $ 53 46,770 34,118 Instructions Using the basic facts in the table, evaluate the following components of Sears's profitability for the years ended January 30, 2010, and January 31, 2009. Profit margin ratio Gross profit rate How do Sears's profit margin ratio and gross profit rate compare to those of Wal-Mart and Target for 2009? Solution Year ended ($ in millions) 01/30/10 01/31/09 Profit margin ratio $235 0.5% $44,043 $53 0.1% $46,770 Gross profit rate $12,219* 27.7% $44,043 $12,652** 27.1% $46,770 *$44,043 $31,824 **$46,770 $34,118 249 c05MerchandisingOperationsandtheMultiple-StepIncomeStatement.qxd 250 8/14/10 2:14 PM Page 250 chapter 5 Merchandising Operations and the Multiple-Step Income Statement Sears's profit margin ratio (income per dollar of sales) increased from 0.1% to 0.5%. This is well below both Wal-Mart's (3.3%) and Target's (3.4%). Thus, Sears is not as effective at turning its sales into net income as these two competitors. Sears's gross profit rate improved from 27.1% to 27.7%. This suggests that its ability to maintain its mark-up above its cost of goods sold improved during this period. Sears's gross profit rate of 27.7% is lower than Target's (30.0%) but higher than Wal-Mart's (23.7%). As discussed in the chapter, Wal-Mart's gross profit is depressed by the fact that it sells many grocery products, which are very low-margin. Target is superior to Sears both in its ability to maintain its mark-up above its costs of goods sold (its gross profit rate) and in its ability to control operating costs (its profit margin ratio). Summary of Study Objectives 1 Identify the differences between a service company and a merchandising company. Because of the presence of inventory, a merchandising company has sales revenue, cost of goods sold, and gross profit. To account for inventory, a merchandising company must choose between a perp