Please answer all of the following questions.

Chapter 4 questions Question 1 The Accounting Cycle - How do the different steps affect the financial statements? What is the effect on the financial statements of missing a step when completing the accounting cycle?

Question 2 Preparing Financial Statements - Step 7 of the Accounting Cycle is preparing the Financial Statements. There is a specific order that the Financial Statements need to be prepared. Discuss the specific order and explain why it is important.

Question 3 Closing Entries - Step 8 of the Accounting Cycle is to journalize and post the closing entries. What are the four closing journal entries? In your opinion, why are these necessary?

Question 4 Worksheets - In your opinion, what is the main purpose and benefits of a financial statement worksheet in assisting with the completion of the accounting cycle? Note that a using a worksheet is optional

Chapter 5 questions

• • Question 1 Merchandising Companies - Up until now, we have been studying the accounting cycle of a service company. In Chapter 5 we will look at the additional accounting procedures for a merchandising company. How would you describe the difference between the operating cycles of a Service Company and that of a Merchandising Company? What accounts would a merchandising company have in its chart of accounts that would be different from a service-based company?

• • Question 2 Perpetual vs Periodic System - What is the difference between a perpetual inventory system and a periodic inventory system? Pick one and discuss the advantages and disadvantages.

• • Question 3 Cost of Goods Sold - One unique aspect of merchandising financial statements is the Cost of Goods Sold account. How would you calculate cost of goods sold at the end of an accounting period under a periodic inventory system? What items make up cost of goods sold?
  • Question 4 Single step vs multiple step - What is the difference between a single step income statement and a multiple step income statement? What are the advantages and disadvantages of each? If you were a business owner, which type would you prefer to use?

The Adjusted Trial Balance and Financial Statements LEARNING OBJECTIVE 6 Describe the nature and purpose of the adjusted trial balance. After a company has journalized and posted all adjusting entries, it prepares another trial balance from the ledger accounts. This trial balance is called an adjusted trial balance. It shows the balances of all accounts, including those adjusted, at the end of the accounting period. The purpose of an adjusted trial balance is to prove the equality of the total debit balances and the total credit balances in the ledger after all adjustments. Because the accounts contain all data needed for financial statements, the adjusted trial balance is the primary basis for the preparation of financial statements. PREPARING THE ADJUSTED TRIAL BALANCE Illustration 426 presents the adjusted trial balance for Sierra Corporation prepared from the ledger accounts in Illustration 425. The amounts affected by the adjusting entries are highlighted in color. Illustration 4-26 Adjusted trial balance PREPARING FINANCIAL STATEMENTS Companies can prepare financial statements directly from an adjusted trial balance. Illustrations 4 27 and 428 present the relationships between the data in the adjusted trial balance of Sierra Corporation and the corresponding financial statements. As Illustration 427 shows, companies prepare the income statement from the revenue and expense accounts. Similarly, they derive the retained earnings statement from the Retained Earnings account, Dividends account, and the net income (or net loss) shown in the income statement. As Illustration 428 shows, companies then prepare the balance sheet from the asset, liability, and stockholders' equity accounts. They obtain the amount reported for retained earnings on the balance sheet from the ending balance in the retained earnings statement. Illustration 4-27 Preparation of the income statement and retained earnings statement from the adjusted trial balance Illustration 4-28 Preparation of the balance sheet from the adjusted trial balance QUALITY OF EARNINGS \"Did you make your numbers today?\" is a question asked often in both large and small businesses. Companies and employees are continually under pressure to \"make the numbers\"that is, to have earnings that are in line with expectations. Therefore, it is not surprising that many companies practice earnings management. Earnings management is the planned timing of revenues, expenses, gains, and losses to smooth out bumps in net income. The quality of earnings is greatly affected when a company manages earnings up or down to meet some targeted earnings number. A company that has a high quality of earnings provides full and transparent information that will not confuse or mislead users of the financial statements. A company with questionable quality of earnings may mislead investors and creditors, who believe they are relying on relevant and reliable information. As a result, investors and creditors lose confidence in financial reporting, and it becomes difficult for our capital markets to work efficiently. Companies manage earnings in a variety of ways. One way is through the use of onetime items to prop up earnings numbers. For example, ConAgra Foods recorded a nonrecurring gain from the sale of Pilgrim's Pride stock for $186 million to help meet an earnings projection for the quarter. Another way is to inflate revenue numbers in the shortrun to the detriment of the longrun. For example, BristolMyers Squibb provided sales incentives to its wholesalers to encourage them to buy products at the end of the quarter (often referred to as channelstuffing). As a result BristolMyers was able to meet its sales projections. The problem was that the wholesalers could not sell that amount of merchandise and ended up returning it to BristolMyers. The result was that BristolMyers had to restate its income numbers. Ethics Insight Cooking the Books? Allegations of abuse of the revenue recognition principle have become all too common in recent years. For example, it was alleged that Krispy Kreme sometimes doubled the number of doughnuts shipped to wholesale customers at the end of a quarter to boost quarterly results. The customers shipped the unsold doughnuts back after the beginning of the next quarter for a refund. Conversely,Computer Associates International was accused of backdating salesthat is, reporting a sale in one quarter that did not actually occur until the beginning of the following quarter in order to achieve the previous quarter's sales targets. What motivates sales executives and finance and accounting executives to participate in activities that result in inaccurate reporting of revenues? Companies also manage earnings through improper adjusting entries. Regulators investigated Xerox for accusations that it was booking too much revenue upfront on multiyear contract sales. Financial executives at Office Max resigned amid accusations that the company was recognizing rebates from its vendors too early and therefore overstating revenue. Finally, WorldCom's abuse of adjusting entries to meet its net income targets is unsurpassed. It used adjusting entries to increase net income by reclassifying liabilities as revenue and reclassifying expenses as assets. Investigations of the company's books after it went bankrupt revealed adjusting entries of more than a billion dollars that had no supporting documentation. The good news is that, as a result of investor pressure as well as the SarbanesOxley Act, many companies are trying to improve the quality of their financial reporting. For example, hotel operatorMarriott is now providing detailed information on the writeoffs it has on loan guarantees it gives hotels. General Electric has decided to provide more detail on its revenues and operating profits for individual businesses it owns. IBM is attempting to provide a better breakdown of its earnings. At the same time, regulators are taking a tough stand on the issue of quality of earnings. For example, one regulator noted that companies may be required to restate their financials every single time that they account for any transaction that had no legitimate purpose but was done solely for an accounting purpose, such as to smooth net income. TRIAL BALANCE Skolnick Co. was organized on April 1, 2014. The company prepares quarterly financial statements. The adjusted trial balance amounts at June 30 are shown below. Debit Credit Cash $ 6,700 Accumulated DepreciationEquipment $850 Accounts Receivable 600 Notes Payable 5,000 Prepaid Rent 900 Accounts Payable 1,510 Supplies 1,000 Salaries and Wages Payable 400 Equipment 15,000 Interest Payable 50 Dividends 600 Unearned Rent Revenue 500 Salaries and Wages Expense 9,400 Common Stock 14,000 Rent Expense 1,500 Retained Earning 0 Depreciation Expense 850 Service Revenue 14,200 Supplies Expense 200 Rent Revenue 800 Utilities Expense 510 Interest Expense 50 $37,31 $37,310 0 (a) Determine the net income for the quarter April 1 to June 30. (b) Determine the total assets and total liabilities at June 30, 2014, for Skolnick Co. (c) Determine the balance in Retained Earnings at June 30, 2014. Action Plan In an adjusted trial balance, all asset, liability, revenue, and expense accounts are properly stated. To determine the ending balance in Retained Earnings, add net income and subtract dividends. Solution (a) The net income is determined by adding revenues and subtracting expenses. The net income is computed as follows. Revenues Service revenue $14,20 0 Rent revenue 800 Total revenues $15,000 Expenses Salaries and wages expense 9,400 Rent expense 1,500 Depreciation expense 850 Utilities expense 510 Supplies expense 200 Interest expense Total expenses Net income 50 12,510 $ 2,490 (b) Total assets and liabilities are computed as follows. Assets Cash Accounts receivable Supplies Prepaid rent Equipment $ 6,700 600 1,000 900 $15,00 0 850 Less: Accumulated depreciation equipment Total assets Liabilities Notes payable Accounts payable Unearned rent revenue Salaries and wages payable Interest payable $5,000 1,510 500 400 50 14,150 $23,350 Total liabilities $7,460 (c) Retained earnings, April 1 $0 Add: Net income 2,490 Less: Dividends 600 Retained earnings, June $1,890 30 Related exercise material: BE49, BE410, BE411, BE412, 43, E412, E413, E415, and E416. Closing the Books LEARNING OBJECTIVE 7 Explain the purpose of closing entries. In previous chapters, you learned that revenue and expense accounts and the Dividends account are subdivisions of retained earnings, which is reported in the stockholders' equity section of the balance sheet. Because revenues, expenses, and dividends relate only to a given accounting period, they are considered temporary accounts. In contrast, all balance sheet accounts are consideredpermanent accounts because their balances are carried forward into future accounting periods. Illustration 429 identifies the accounts in each category. Illustration 4-29 Temporary versus permanent accounts PREPARING CLOSING ENTRIES At the end of the accounting period, companies transfer the temporary account balances to the permanent stockholders' equity accountRetained Earningsthrough the preparation of closing entries. Closing entries transfer net income (or net loss) and dividends to Retained Earnings, so the balance in Retained Earnings agrees with the retained earnings statement. For example, in the adjusted trial balance in Illustration 424 , Retained Earnings has a balance of zero. Prior to the closing entries, the balance in Retained Earnings is its beginningoftheperiod balance. (For Sierra, this is zero because it is Sierra's first month of operations.) In addition to updating Retained Earnings to its correct ending balance, closing entries produce a zero balance in each temporary account. As a result, these accounts are ready to accumulate data about revenues, expenses, and dividends that occur in the next accounting period. Permanent accounts are not closed. When companies prepare closing entries, they could close each income statement account directly to Retained Earnings. However, to do so would result in excessive detail in the Retained Earnings account. Instead, companies close the revenue and expense accounts to another temporary account, Income Summary. The balance in Income Summary is the net income or loss for the year. Income Summary is then closed, which transfers the net income or net loss from this account to Retained Earnings. Illustration 430 depicts the closing process. While it still takes the average large company seven days to close, some companies such as Cisco employ technology that allows them to do a socalled \"virtual close\" almost instantaneously any time during the year. Besides dramatically reducing the cost of closing, the virtual close provides companies with accurate data for decisionmaking whenever they desire it. Illustration 4-30 The closing process Illustration 431 shows the closing entries for Sierra Corporation. Illustration 432 diagrams the posting process for Sierra Corporation's closing entries. Illustration 4-31 Closing entries journalized Illustration 4-32 Posting of closing entries Alternative Terminology Temporary accounts are sometimes called nominal accounts, and permanent accounts are sometimes called real accounts. Helpful Hint Income Summary is a very descriptive title: Companies close total revenues to Income Summary and total expenses to Income Summary. The balance in Income Summary in this case is net income of $2,860. PREPARING A POST-CLOSING TRIAL BALANCE After a company journalizes and posts all closing entries, it prepares another trial balance, called a post closing trial balance, from the ledger. A postclosing trial balance is a list of all permanent accounts and their balances after closing entries are journalized and posted. The purpose of this trial balance is to prove the equality of the total debit balances and total credit balances of the permanent account balances that the company carries forward into the next accounting period. Since all temporary accounts will have zero balances, the postclosing trial balance will contain only permanentbalance sheetaccounts. CLOSING ENTRIES After making entries to close its revenue and expense accounts to Income Summary, Hancock Company has the following balances. Dividends $15,000 Retained Earnings 42,000 Income Summary 18,000 (credit balance) Prepare the remaining closing entries at December 31. Action Plan Close Income Summary to Retained Earnings. Close Dividends to Retained Earnings. Solution Dec. 31 Income Summary 18,000 Retained Earnings 18,000 (To close net income to retained earnings) 31 Retained Earnings 15,000 Dividends 15,000 (To close dividends to retained earnings) Related exercise material: BE413, BE414, 44, E414, and E418. SUMMARY OF THE ACCOUNTING CYCLE LEARNING OBJECTIVE Describe the required steps in the accounting cycle. 8 Illustration 433 shows the required steps in the accounting cycle. You can see that the cycle begins with the analysis of business transactions and ends with the preparation of a postclosing trial balance. Companies perform the steps in the cycle in sequence and repeat them in each accounting period. Illustration 4-33 Required steps in the accounting cycle Steps 13 may occur daily during the accounting period, as explained in Chapter 3. Companies perform Steps 47 on a periodic basis, such as monthly, quarterly, or annually. Steps 8 and 9, closing entries and a post closing trial balance, usually take place only at the end of a company's annual accounting period. Helpful Hint Some companies reverse certain adjusting entries at the beginning of a new accounting period. The company makes a reversing entry at the beginning of the next accounting period. This entry is the exact opposite of the adjusting entry made in the previous period. Appendix 4A Adjusting Entries in an Automated World Using a Worksheet LEARNING OBJECTIVE 1 0 Describe the purpose and the basic form of a worksheet. In the previous discussion, we used Taccounts and trial balances to arrive at the amounts used to prepare financial statements. Accountants frequently use a device known as a worksheet to determine these amounts. A worksheet is a multiplecolumn form that may be used in the adjustment process and in preparing financial statements. Accountants can prepare worksheets manually, but today most use computer spreadsheets. As its name suggests, the worksheet is a working tool for the accountant. A worksheet is not a permanent accounting record; it is neither a journal nor a part of the general ledger. The worksheet is merely a supplemental device used to make it easier to prepare adjusting entries and the financial statements. Small companies with relatively few accounts and adjustments may not need a worksheet. In large companies with numerous accounts and many adjustments, a worksheet is almost indispensable. Illustration 4A1 shows the basic form and procedures for preparing a worksheet. Note the headings: The worksheet starts with two columns for the Trial Balance. The next two columns record all Adjustments. Next is the Adjusted Trial Balance. The last two sets of columns correspond to the Income Statement and the Balance Sheet. All items listed in the Adjusted Trial Balance columns are included in either the Income Statement or the Balance Sheet columns. Illustration 4A-1 Form and procedure for a worksheet Summary of Learning Objective for Appendix 4A 10. Describe the purpose and the basic form of a worksheet. The worksheet is a device to make it easier to prepare adjusting entries and the financial statements. Companies often prepare a worksheet using a computer spreadsheet. The sets of columns of the worksheet are, from left to right, the unadjusted trial balance, adjustments, adjusted trial balance, income statement, and balance sheet. Merchandising Operations LEARNING OBJECTIVE 1 Identify the differences between a service company and a merchandising company. REI, WalMart, and Amazon.com are called merchandising companies because they buy and sell merchandise rather than perform services as their primary source of revenue. Merchandising companies that purchase and sell directly to consumers are called retailers. Merchandising companies that sell to retailers are known as wholesalers. For example, retailer Walgreens might buy goods from wholesaler McKesson; retailer 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 51 shows the income measurement process for a merchandising company. The items in the two blue boxes are unique to a merchandising company; they are not used by a service company. Illustration 5-1 Income measurement process for a merchandising company OPERATING CYCLES The operating cycle of a merchandising company ordinarily is longer than that of a service company. The purchase of inventory and its eventual sale lengthen the cycle. Illustration 52 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 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 53 describes these relationships. Companies use one of two systems to account for inventory: a perpetual inventory system or a periodic inventory system. Illustration 5-3 Flow of costs Perpetual System In a perpetual inventory system, companies maintain detailed records of the cost of each inventory purchase and sale. These records continuouslyperpetuallyshow 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. 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.\" 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 54 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 Advantages of the Perpetual System Companies that sell merchandise with high unit values, such as automobiles, furniture, and major home appliances, have traditionally used perpetual systems. The growing use of computers and electronic scanners has enabled many more companies to install perpetual inventory systems. The perpetual inventory system is so named because the accounting records continuouslyperpetuallyshow the quantity and cost of the inventory that should be on hand at any time. A perpetual inventory system provides better control over inventories than a periodic system. Since the inventory records show the quantities that should be on hand, the company can count the goods at any time to see whether the amount of goods actually on hand agrees with the inventory records. If shortages are uncovered, the company can investigate immediately. Although a perpetual inventory system requires additional clerical work and additional cost to maintain inventory records, a computerized system can minimize this cost. Much of Amazon.com's success is attributed to its sophisticated inventory system. Some businesses find it either unnecessary or uneconomical to invest in a sophisticated, computerized perpetual inventory system such as Amazon's. However, many small merchandising businesses 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 daytoday operations using a periodic inventory system. Because of the widespread use of the perpetual inventory system, we illustrate it in this chapter. An appendix to this chapter describes the journal entries for the periodic system. Investor Insight Morrow Snowboards 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. Recording Purchases of Merchandise LEARNING OBJECTIVE 2 Explain the recording of purchases under a perpetual inventory system. Companies may purchase inventory for cash or on account (credit). They normally record purchases when they receive the goods from the seller. Every purchase should be supported by business documents that provide written evidence of the transaction. Each cash purchase should be supported by a canceled check or a cash register receipt indicating the items purchased and amounts paid. Companies record cash purchases by an increase (debit) in Inventory and a decrease (credit) in Cash. Each purchase should be supported by a purchase invoice, which indicates the total purchase price and other relevant information. However, the purchaser does not prepare a separate purchase invoice. Instead, the purchaser uses as a purchase invoice the copy of the sales invoice sent by the seller. In Illustration 55, for example, Sauk Stereo (the buyer) uses as a purchase invoice the sales invoice prepared by PW Audio Supply, Inc. (the seller). Illustration 5-5 Sales invoice used as purchase invoice by Sauk Stereo The associated entry for Sauk Stereo for the invoice from PW Audio Supply increases (debits) Inventory and increases (credits) Accounts Payable. May 4 Inventory 3,800 Accounts Payable 3,800 (To record goods purchased on account from PW Audio Supply) Under the perpetual inventory system, companies record purchases of merchandise for sale in the Inventory account. Thus, REI would increase (debit) Inventory for clothing, sporting goods, and anything else purchased for resale to customers. Not all purchases are debited to Inventory, however. Companies record purchases of assets acquired for use and not for resale, such as supplies, equipment, and similar items, as increases to 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, REI would increase (debit) Supplies. Helpful Hint To better understand the contents of this invoice, identify these items: 1. Seller 2. Invoice date 3. Purchaser 4. Salesperson 5. Credit terms 6. Freight terms 7. Goods sold: catalog number, description, quantity, price per unit 8. Total invoice amount FREIGHT COSTS The sales agreement should indicate 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. Thus, the buyer (Sauk Stereo) pays the freight charges. Illustration 56 illustrates these shipping terms. Illustration 5-6 Shipping terms Freight Costs Incurred by Buyer When the buyer pays the transportation costs, these costs are considered part of the cost of purchasing inventory. As a result, the account Inventory is increased (debited). For example, if Sauk Stereo (the buyer) pays Public Freight Company $150 for freight charges on May 6, the entry on Sauk Stereo's books is: May 6 Inventory 150 Cash 150 (To record payment of freight on goods purchased) Thus, any freight costs incurred by the buyer are part of the cost of merchandise purchased. The reason: Inventory cost should include all costs to acquire the inventory, including freight necessary to deliver the goods to the buyer. Companies recognize these costs as cost of goods sold when inventory is sold. Freight Costs Incurred by Seller In contrast, freight costs incurred by the seller on outgoing merchandise are an operating expense to the seller. These costs increase an expense account titled FreightOut (sometimes called Delivery Expense). For example, if the freight terms on the invoice in Illustration 55 had required that PW Audio Supply (the seller) pay the $150 freight charges, the entry by PW Audio Supply would be: May 4 FreightOut 150 Cash 150 (To record payment of freight on goods sold) 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 credit if the sale was made on credit, or for a cash refund if the purchase was for cash. This transaction is known as a purchase return. Alternatively, the purchaser may choose to keep the merchandise if the seller is willing to grant a reduction of the purchase price. This transaction is known as a purchase allowance. Assume that Sauk Stereo returned goods costing $300 to PW Audio Supply on May 8. The following entry by Sauk Stereo for the returned merchandise decreases (debits) Accounts Payable and decreases (credits) Inventory. May 8 Accounts Payable 300 Inventory 300 (To record return of goods purchased from PW Audio Supply) Because Sauk Stereo increased Inventory when the goods were received, Inventory is decreased (credited) when Sauk Stereo returns the goods. Suppose instead that Sauk Stereo chose to keep the goods after being granted a $50 allowance (reduction in price). It would reduce (debit) Accounts Payable and reduce (credit) Inventory for $50. PURCHASE DISCOUNTS The credit terms of a purchase on account may permit the buyer to claim a cash discount for prompt payment. The buyer calls this cash discount a purchase discount. This incentive offers advantages to both parties. The purchaser saves money, and the seller is able to shorten the operating cycle by converting the accounts receivable into cash earlier. The credit terms specify the amount of the cash discount and time period during which it is offered. They also indicate the length of time in which the purchaser is expected to pay the full invoice price. In the sales invoice in Illustration 55, credit terms are 2/10, n/30, which is read \"twoten, 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 , and the amount of cash Sauk Stereo paid is . 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. May 14 Accounts Payable 3,500 Cash Inventory (To record payment within discount period) 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. June 3 Accounts Payable 3,500 Cash 3,500 (To record payment with no discount taken) 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 . Obviously, it would be better for Sauk Stereo to borrow at prevailing bank interest rates of 6% to 10% than to lose the discount. Helpful Hint The term net in \"net 30\" means the remaining amount due after subtracting any returns and allowances and partial payments. SUMMARY OF PURCHASING TRANSACTIONS The following Taccount (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. PURCHASE TRANSACTIONS On September 5, De La Hoya Company buys merchandise on account from Junot Diaz Company. The selling price of the goods is $1,500. On September 8, De La Hoya returns defective goods with a selling price of $200. Record the transactions on the books of De La Hoya Company. Action Plan Purchaser records goods at cost. When goods are returned, purchaser reduces Inventory. Solution Sept 5 Inventory 1,500 . Accounts Payable 1,500 (To record goods purchased on account) 8 Accounts Payable 200 Inventory 200 (To record return of defective goods) Recording Sales of Merchandise LEARNING OBJECTIVE 3 Explain the recording of sales revenues under a perpetual inventory system. In accordance with the revenue recognition principle, companies record sales revenue, like service revenue, when the performance obligation is satisfied. Typically, that performance obligation is satisfied when the goods are transferred from the seller to the buyer. At this point, the sales transaction is completed and the sales price is established. Sales may be made on credit or for cash. Every sales transaction should be supported by a business document that provides written evidence of the sale. Cash register documents provide evidence of cash sales. A sales invoice, like the one that was shown in Illustration 55, 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 55) as follows (assume the merchandise cost PW Audio Supply $2,400). May 4 Accounts Receivable 3,800 Sales Revenue 3,800 (To record credit sale to Sauk Stereo per invoice #731) 4 Cost of Goods Sold 2,400 Inventory 2,400 (To record cost of merchandise sold on invoice #731 to Sauk Stereo) For internal decisionmaking purposes, merchandising companies may use more than one sales account. For example, PW Audio Supply may decide to keep separate sales accounts for its sales of TVs, DVD players, and microwave ovens. REI might use separate accounts for camping gear, children's clothing, and ski equipment or 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 enabled financial statement users to better evaluate the growth of the company's consumer and Internet businesses. 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. ANATOMY OF A FRAUD1 Holly Harmon was a cashier at a national superstore for only a short while when she began stealing merchandise using three methods. Under the first method, her husband or friends took UPC labels from cheaper items and put them on more expensive items. Holly then scanned the goods at the register. Using the second method, Holly scanned an item at the register but then voided the sale and left the merchandise in the shopping cart. A third approach was to put goods into large plastic containers. She scanned the plastic containers but not the goods within them. 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. 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 lowpriced goods. Random comparisons of video records with cash register records can ensure that the goods reported as sold on the register are the same goods that are shown being purchased on the video recording. Finally, employees should be aware that they are being monitored. Source: Adapted from Wells, Fraud Casebook (2007), pp. 251-259. At the end of \"Anatomy of a Fraud\" stories, which describe realworld frauds, we discuss the missing control activity that would likely have presented or uncovered the fraud. SALES RETURNS AND ALLOWANCES We now look at the \"flip side\" of purchase returns and allowances, which the seller records as sales returns and allowances. These are transactions where the seller either accepts goods back from a purchaser (a return) or grants a reduction in the purchase price (an allowance) so that the buyer will keep the goods. PW Audio Supply's entries to record credit for returned goods involve (1) an increase (debit) in Sales Returns and Allowances (a contra account to Sales Revenue) and a decrease (credit) in Accounts Receivable at the $300 selling price, and (2) an increase (debit) in Inventory (assume a $140 cost) and a decrease (credit) in Cost of Goods Sold, as shown below. (We assumed that the goods were not defective. If they were defective, PW Audio Supply would make an entry to the Inventory account to reflect their decline in value.) Ma 8 Sales Returns and Allowances y 300 Accounts Receivable 300 (To record credit granted to Sauk Stereo for returned goods) 8 Inventory 140 Cost of Goods Sold 140 (To record cost of goods returned) Suppose instead that the goods were not returned but the seller granted the buyer an allowance by reducing the purchase price. In this case, the seller would debit Sales Returns and Allowances and credit Accounts Receivable for the amount of the allowance. An allowance has no impact on Inventory or Cost of Goods sold. Sales Returns and Allowances is a contra revenue account to Sales Revenue, which means it is offset against a revenue account on the income statement. The normal balance of Sales Returns and Allowances is a debit. Companies use a contra account, instead of debiting Sales Revenue, to disclose in the accounts and in the income statement the amount of sales returns and allowances. Disclosure of this information is important to management. Excessive returns and allowances suggest 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 highdefinition 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? SALES DISCOUNTS As mentioned in our discussion of purchase transactions, the seller may offer the customer a cash discount called by the seller a sales 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: May 14 Cash 3,430 Sales Discounts 70 Accounts Receivable 3,500 (To record collection within 2/10, n/30 discount period from Sauk Stereo) Like Sales Returns and Allowances, Sales Discounts is a contra revenue account to Sales Revenue. Its normal balance is a debit. Sellers use this account, instead of debiting Sales Revenue, to disclose the amount of cash discounts taken by customers. If the customer does not take the discount, PW Audio Supply increases (debits) Cash for $3,500 and decreases (credits) Accounts Receivable for the same amount at the date of collection. The following Taccounts summarize the three salesrelated transactions and show their combined effect on net sales. SALES TRANSACTIONS On September 5, De La Hoya Company buys merchandise on account from Junot Diaz Company. The selling price of the goods is $1,500, and the cost to Diaz Company was $800. On September 8, De La Hoya returns goods with a selling price of $200 and a cost of $105. Record the transactions on the books of Junot Diaz Company. Action Plan Seller records both the sale and the cost of goods sold at the time of the sale. When goods are returned, the seller records the return in a contra account, Sales Returns and Allowances, and reduces Accounts Receivable. Any goods returned increase Inventory and reduce Cost of Goods Sold. The inventory should be recorded at the lower of its cost or its fair value (scrap value). Solution Sept . Sept . 5 Accounts Receivable 5 8 Sales Revenue (To record credit sale) Cost of Goods Sold Inventory (To record cost of goods sold) Sales Returns and Allowances Accounts Receivable (To record credit granted for receipt of returned goods) 8 Inventory 1,500 1,500 800 800 200 105 200 Cost of Goods Sold (To record cost of goods returned) 105 Income Statement Presentation LEARNING OBJECTIVE 4 Distinguish between a singlestep and a multiplestep income statement. 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 singlestep 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 singlestep income statement is the form we have used thus far in the text. Illustration 57 shows a singlestep statement for REI. Illustration 5-7 Single-step income statements There are two primary reasons for using the singlestep 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. A second form of the income statement is the multiplestep income statement. The multiplestep income statement is often considered more useful because it highlights the components of net income. The REI income statement in Illustration 58 is an example. Illustration 5-8 Multiple-step income statements The multiplestep 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. Note that companies report income tax expense in a separate section of the income statement before net income. The net incomes in Illustrations 57 and 58 are the same. The two income statements differ in the amount of detail displayed and the order presented. The following discussion provides additional information about the components of a multiplestep income statement. 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 longerterm result of the project may well be an income statement format that better reflects how businesses are run. 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 59 shows the sales section of the income statement for PW Audio Supply. Illustration 5-9 Statement presentation of sales section GROSS PROFIT The excess of net sales over cost of goods sold is gross profit. It is determined by deducting cost of goods sold from sales revenue. As shown in Illustration 58, REI had a gross profit of $729 million in 2010. This computation uses 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 59 (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. 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. Alternative Terminology Gross profit is sometimes referred to as gross margin. OPERATING EXPENSES Operating expenses are the next component in measuring net income for a merchandising company. At REI, for example, operating expenses were $613.5 million in 2010. 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. 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 510 lists examples of each. Illustration 5-10 Examples of nonoperating activities 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. 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 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. 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 began 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 bottomline 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. As another example, when eBay recently sold the remainder of its investment in Skype to Microsoft, it reported a gain in \"Other revenues and gains\" of $1.7 billion. Since eBay's total income from operations was $2.4 billion, it was very important that the gain from the Skype sale not be buried in operating income. Why have investors and analysts demanded more accuracy in isolating \"Other gains and losses\" from operating items? Nonoperating activities are reported in the income statement immediately after operating activities. Included among \"Other revenues and gains\" in Illustration 58 are Interest Revenue and Gain on Disposal of Plant Assets. Included in \"Other expenses and losses\" are Interest Expense and Casualty Loss from Vandalism. In Illustration 511, we have provided the multiplestep income statement of PW Audio Supply. This statement provides more detail than that of REI and thus is useful as a guide for homework. For homework problems, use the multiplestep form of the income statement unless the requirements state otherwise. Illustration 5-11 Multiplestep income statement MULTIPLE-STEP INCOME STATEMENT The following information is available for Art Center Corp. for the year ended December 31, 2014. Other revenues and gains $ 8,000 Other expenses and 3,000 losses Cost of goods sold 147,000 Sales revenue $462,000 Operating expenses 187,000 Sales discounts 20,000 Prepare a multiplestep income statement for Art Center Corp. The company has a tax rate of 25%. 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. Add/subtract nonoperating items to determine income before tax. Multiply the tax rate by income before tax to determine tax expense. Solution Related exercise material: BE55, BE56, 53, and E55. DETERMINING COST OF GOODS SOLD UNDER A PERIODIC SYSTEM LEARNING OBJECTIVE 5 Determine 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 512. Illustration 5-12 Basic formula for cost of goods sold using the periodic system 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, purchase returns, and purchase discounts). The periodic system does not do this. Instead, it creates different accounts for purchases, freight costs, purchase returns, and purchase discounts. These various accounts are shown in Illustration 513, which presents the calculation of cost of goods sold for PW Audio Supply using the periodic approach. Note that the basic elements from Illustration 512 are highlighted in Illustration 513. You will learn more in Chapter 6 about how to determine cost of goods sold using the periodic system. Illustration 5-13 Cost of goods sold for a merchandiser using a periodic inventory 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. COST OF GOODS SOLDPERIODIC SYSTEM Aerosmith Company's accounting records show the following at the yearend December 31, 2014. Purchase Discounts $ 3,400 FreightIn 6,100 Purchases 162,500 Beginning Inventory 18,000 Ending Inventory 20,000 Purchase Returns and Allowances 5,200 Assuming that Aerosmith Company uses the periodic system, compute (a) cost of goods purchased and (b) cost of goods sold. Action Plan To determine cost of goods purchased, adjust purchases for returns, discounts, and freightin. To determine cost of goods sold, add cost of goods purchased to beginning inventory, and subtract ending inventory. Solution (a) (b) Related exercise material: BE57, BE58, BE59, 54, E510, and E511. 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. Income Statement Presentation LEARNING OBJECTIVE 4 Distinguish between a singlestep and a multiplestep income statement. 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 singlestep 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 singlestep income statement is the form we have used thus far in the text. Illustration 57 shows a singlestep statement for REI. Illustration 5-7 Single-step income statements There are two primary reasons for using the singlestep 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. A second form of the income statement is the multiplestep income statement. The multiplestep income statement is often considered more useful because it highlights the components of net income. The REI income statement in Illustration 58 is an example. Illustration 5-8 Multiple-step income statements The multiplestep 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. Note that companies report income tax expense in a separate section of the income statement before net income. The net incomes in Illustrations 57 and 58 are the same. The two income statements differ in the amount of detail displayed and the order presented. The following discussion provides additional information about the components of a multiplestep income statement. 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 longerterm result of the project may well be an income statement format that better reflects how businesses are run. 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 59 shows the sales section of the income statement for PW Audio Supply. Illustration 5-9 Statement presentation of sales section GROSS PROFIT The excess of net sales over cost of goods sold is gross profit. It is determined by deducting cost of goods sold from sales revenue. As shown in Illustration 58, REI had a gross profit of $729 million in 2010. This computation uses 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 59 (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. 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. Alternative Terminology Gross profit is sometimes referred to as gross margin. OPERATING EXPENSES Operating expenses are the next component in measuring net income for a merchandising company. At REI, for example, operating expenses were $613.5 million in 2010. 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. 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 510 lists examples of each. Illustration 5-10 Examples of nonoperating activities 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. 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 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. 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 began 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 bottomline 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. As another example, when eBay recently sold the remainder of its investment in Skype to Microsoft, it reported a gain in \"Other revenues and gains\" of $1.7 billion. Since eBay's total income from operations was $2.4 billion, it was very important that the gain from the Skype sale not be buried in operating income. Why have investors and analysts demanded more accuracy in isolating \"Other gains and losses\" from operating items? Nonoperating activities are reported in the income statement immediately after operating activities. Included among \"Other revenues and gains\" in Illustration 58 are Interest Revenue and Gain on Disposal of Plant Assets. Included in \"Other expenses and losses\" are Interest Expense and Casualty Loss from Vandalism. In Illustration 511, we have provided the multiplestep income statement of PW Audio Supply. This statement provides more detail than that of REI and thus is useful as a guide for homework. For homework problems, use the multiplestep form of the income statement unl