Transcript for:
Understanding Merchandising Operations in Accounting

okay so today we're gonna look at chapter four so here in chapter four we're picking up right after your first exam so first exam we're really trying to get the groundwork set um for the rest of the course so hopefully you're familiar with all the terminology that we used on exam one you're familiar with how we prepare our basic journal entries those normal balances how we do our closing accounts and our adjusting entries and how we prepare our financial statements and all of that is hopefully fairly well understood by you at this point and if that is the case then you're in a good spot coming into chapter four um if you're not it might be worth taking a couple of minutes and reviewing some of those topics or coming by my office and talking to me sending me an email trying to make sure you um you understand all that foundational stuff because now we're gonna start getting into some more specific areas of accounting so pretty much everything we've covered up until now applies just broadly across all of the county what we're looking at here in chapter four though is going to primarily deal with what we call merchandising operations so when we look here in chapter four we want to realize how income gets reported for different types of organizations for what's called a service company so think like an accounting firm right you come in you pay them to prepare to prepare your tax return they do so they book revenue but the wages they paid to the employees or the cpas to actually prepare those um tax returns for you is going to be their expenses along with things like overhead running electrical and property taxes and all that kind of stuff all that stuff that they're having to do to actually be able to provide you the service will be an expense the difference in those two items will come out to be net income for merchandise it's a little bit different because with a merchandiser they're not selling a service so much as they're selling a product so here's the deal right you walk in to academy and you look at something and you buy it right say you play golf and they've got a new set of golf clubs you want you go grab the golf set you take it up to the front you check out you're good to go right you bought a product you can take it straight off the shelf take it right up to the counter and purchase it but with a service provider right let's now think about maybe a salon right so they do haircuts and things you can't walk in and pick a haircut off the shelf and leave with it that doesn't work it's not how it goes so it's a little bit different in how we account for these two types of companies so in this chapter we're primarily concerned with the merchandiser so the person or the business is actually selling in this case completed goods so maybe they're selling golf clubs or clothing maybe they're selling parts for your car or for something else but that's what we're dealing with here in chapter four is this idea of sales um related to merchandisers so you'll notice we still start with net sales just like we did before if you know here they call it revenue but it's the same issue right we're dealing with the same thing essentially and we're still ending with net income so the bookends of this are very similar it's the stuff in the middle that changes a little bit notice the big change is immediately after net sales for a merchandiser we have this special cost and it's called cost of goods sold cost of goods sold is where our inventory will go to once we have sold it so before the sale occurs our inventory sits on the balance sheet in an account called inventory but once it has been sold it has to come off the balance sheet so we'll credit the asset inventory but we need a debit and that debit will be moving us over to the income statement with the account cost of goods sold this is a type of expense account but it's such an important expense account we'll actually list it in its own line up on the income statement at the very top so we'll have net sales immediately after that we'll find cost of goods sold and right below that we will have our first subtotal which is gross profit so once we've gotten our gross profit we'll then back out any other expenses things like salaries expense wages expense utilities expense anything like that then once we've backed out all of our expenses we'll of course be able to calculate net income now you'll notice the difference here and how these income statements look so when i'm looking at nordstrom which is of course a merchandising company they sell clothing and other items they'd follow this pattern of net sales minus cost of goods sold as gross profit which is a very important formula you definitely want to know we'll be leaning on that formula for several of our other formulas as well so definitely an important one to know for the exam minus expenses gives you net income but for the service it's a little bit more straightforward it's simply revenues minus expenses equals net income so do be aware of that now here's the deal when we have an operating cycle it's essentially how long it takes us to go from point a through the entire process all the way back around to collecting cash so for a merchandiser what this means is we start by purchasing the good that we plan to sell we then move that into our inventory account eventually we'll make a sale typically on credit so i'll have that credit sale which will create an accounts receivable at some point that accounts receivable will turn hopefully into cash so we'll collect cash then use that cash to purchase more inventory which will then generate more sales which will generate more accounts receivable which will then result in more cash and the cycle goes on and on and on and this is what we see for a merchandiser now this right here is perhaps my favorite graphic in the entire course i do think you need to memorize this one i do think you need to be able to recreate it from memory thankfully it's a pretty logical graph for us and it may be my favorite if only because it's so simple so what we see here is something that we'll be talking about not only in this chapter but in many chapters to come pretty much any time we are dealing with inventory we're also dealing with cost of goods sold so this really helps us place these items in relation to one another and really helps us stay organized so here's the deal when we're dealing with inventory you start with some amount always it could be zero right if you're a new company your beginning inventory is zero but there's always a number that can be assigned to beginning inventory next we're going to add in what is called our net purchases this is anything that we bought minus anything we had to send back right so we bought something and it was defective or whatever the case was and we didn't keep that and we sent it back to the manufacturer well that's going to come out and what we're left with is our net purchases those two items together beginning inventory plus net purchases gives us what is called merchandise available for sale or inventory available for sale right so this is what we have in total so if i had nothing i bought ten thousand dollars worth of stuff i've now got ten thousand dollars that is available at this point in time that full ten thousand dollars rests on which financial statement hopefully what you just said is the balance sheet because inventory is of course an asset so right now we've got ten thousand dollars on the balance sheet in inventory but what if instead of the amount being just on the balance sheet we actually sold say 20 of that well 20 of that was sold that means that there should only be 80 of that left on the balance sheet so we have ten thousand right here eighty percent running through to ending inventory is eight thousand and twenty percent got sold running through to my income statement and cost of goods sold for two thousand dollars this can then be solved backwards so eight thousand plus two thousand is of course ten thousand which is equal to ten thousand plus zero so it works in either direction however you want to go about it another really useful way to use this is to realize that you can go and deal with this in terms of units as well so if i had zero units and i bought a hundred more units so i've got 100 units available for sale which means if i sold 20 then i've got 80 units left in the inventory i strongly recommend you track both units and dollars to help you make sure that you don't drop something along the way it's a very powerful graphic it's very useful as we move through this chapter and the remainder of the semester so basically two broad categories of inventory systems that we need to talk about the first that we're going to talk about is what is called a perpetual system a perpetual system is what happens when every time there's a purchase or sale those inventory records are immediately updated so i want you to think you go to walmart you have 10 items in your basket you go to the self checkout and you scan those what happens when you swipe that barcode across the scanner right that machine goes right and it beeps at you indicating that it has recorded the transaction but what's actually happening here is with every beep right every item you swipe across that barcode scanner you are generating two journal entries in walmart's records so quick question how much do you want to go look at all of walmart's records right you can imagine the billions of journal entries that are being made every year in walmart's system so hopefully they've got some good internal controls in place to make sure those transactions are being recorded properly but that's what's happening one journal entry is being made to record the revenue so hopefully a debit to cash a credit to sales revenue bam that's their first journal entry the second one they're going to have to make though is to reduce their inventories they're going to debit cost of goods sold and credit that inventory for that specific item so they know okay well you just bought a loaf of bread and if you bought it then we don't have that loaf of bread in here this enables them to reorder bread or whatever else at a specified time as soon as that inventory level hits say a hundred loaves of bread we place an order for more red this is a perpetual system it's very useful they tend to provide better information in periodic systems but they're of course more difficult to implement and more expensive because it requires that you have a barcode scanner that you've got inventory software set up that can handle this amount of information that you've got everything in the store barcoded so it takes quite a bit of an investment to actually set up a perpetual system but if you can do it it does give you really solid information most of the time now on the other hand you've got periodic systems and these simply update records at the end of the accounting period so maybe every month quarter or year they come into a physical inventory and say okay well we started with a million dollars and stuff we've now got 615 000 and stuff that difference is 3.85 that 385 must have been sold now you see a hole in this periodic system because i think there's a pretty glaring issue here and this is that when you come in with this periodic system you are making an assumption that anything that is not currently in inventory was sold but what could have happened to some of that stuff let's think back to our walmart example does walmart sell anything that could go bad okay so let's think things like milk things like bread things like the fruits and vegetables that they have up front typically all those things could expire is it possible that some of walmart's stuff that is possible to actually expire that is perishable and some of it will expire before it is sold well of course it is but under a periodic system they would be treating all those expired items as sold they would also be treating any items that grew legs and walked out the door or were stolen right all those items would also be ran through cost of goods sold so there are some problems with the periodic system but typically much cheaper to implement much easier to deal with now that said what does gap say about a physical inventory so if any of you have ever worked in retail okay so for example when i was in high school i did i worked at academy so i worked at academy and every year once a year toward the end of the year we would i don't remember when their their year-end is it may or may not be 12 31 um i can't remember for sure but right as that company's year-end was coming up we would have to go do a physical inventory of the store which meant we had to come in and unbox every box to go through all the top stock go through all the stuff all the pegs all the stuff in the warehouse and see exactly what we had so at this point we would typically find all kinds of stuff right we'd find stuff that customers had hidden to come back for and they'd get replaced you know wherever they're supposed to go because we didn't know why they were there but they weren't in the right spot we'd find stuff that you know was broken we find stuff that had been returned and booked in the wrong and all kinds of stuff you find all kinds of things when you go back and do these physical inventories so that said do you think i'm required under usgap to do a physical inventory every year even if i'm using a perpetual system and the answer is of course yes regardless of your inventory system you must do at least one physical inventory each year and that is to make sure that everything is properly stated i cannot tell you the number of times i had people call me and say hey do you all have this specific basketball goal or do you all have this specific item that we keep back in the storage way back across the parking lot typically in a separate area did we have that in stock well i would go to the computer i'd pull it up and i'd say yes on the computer and it says we have three of them and i did that for a while and then once or twice people would show up and i would go back there to get it for them and that was not actually there for whatever reason maybe somebody scanned the wrong barcode and thought a different item got sold maybe someone had broken in there and stolen one or two items who knows what happened but for whatever reason when it actually came time to go put my hands on the product the product had disappeared so these perpetual systems are great they do a much better job of you know identifying what you have and what you need than a periodic system but they still have their own problems for that reason you are still required to do a physical inventory at least once a year regardless of if you choose a perpetual or periodic method now what we want to look at here is this item of actually seeing how these purchases happen so in this class we're going to be primarily concerned with a perpetual system is the journal entry method that we'll be using in the appendix i believe it does cover the entries for periodic i do not require you to go over those if i do change my mind on that i will make an announcement in class we will go over it in class but typically we simply cover the perpetual system for the lack of time as we don't typically have enough time to cover both methods if for whatever reason we do have enough time we may briefly cover um periodic it is certainly not you know impossible for us to do so i believe i've covered it once or twice but typically we just don't have the time so we stick with simply perpetual so if you need to cover the appendix i will make that known in class if you are uncertain feel free to ask that and i will inform you of that but typically we will simply focus here on the perpetual system since this is an introductory class unless we just have an abundance of time for some reason um we will we will stick with that so in this case we are looking on november the second our company's zmart and remember we are the company purchased 500 worth of merchandise inventory for cash now in this textbook they refer to inventory as merchandise inventory basically every time if not exactly every time i will typically just refer to this as inventory but please note right if you're doing something in mcgraw hill you will need to find the account called merchandise inventory as that's the account title they are looking for for the sake of brevity and so i don't have to say merchandise inventory ten thousand times we'll simply refer to this as inventory from here on um in the verbiage so do be aware of that small distinction as you're working through stuff if you look on your homework and you say well there's not an inventory account where is it just keep looking around you'll find merchandise inventory eventually and that'll be the account you're looking for now notice in this case you bought inventory inventory of course is an asset assets increase with a debit because their normal balance is of course a debit so debit to merchandise inventory increases that account balance and a credit to cash which of course is also an asset is decreasing that account balance we have one asset increasing when i said decreasing our accounting equation remains in balance as it should once again notice your total debits are 500 our total credits are 500 indicating total debits equal total credits and we have achieved balance there as well now what happens if we actually do have a discount so in this case on november the 2nd zmart purchased 500 of merchandise inventory on account credit terms 210 and 30. so here's the first thing you've got to understand is what the heck those terms mean because i'll be honest with you if i just look at that i have no idea what that means unless i've read the chapter so what the chapter tells us is this is the common notation that we will see when we are dealing with discounts so i want you to take this term right this whole thing is the credit terms so two two tells us that we get a two percent discount so the first number is the amount of the discount specifically a percentage sorry two percent discount is available to us if we do what right so that's what the 10 is so we get 2 off the purchase price but only if we pay within 10 days right so i get 2 off if i pay within 10 days but if i don't pay within 10 days the balance is due in 30 days so 210 2 off if i pay within 10 days otherwise the net balance right the n is net balance is due in 30 days so if i'm in charge of paying this bill for my company when should i pay the bill and so you say well within 10 days say sure that's a good that's a good answer but specifically when if i've got ten days to pay this bill to get the two percent discount do i want to rush out and pay this bill on day one no right i don't get a discount for paying on day one if i have the option i'm paying on day ten i will not pay on day one i will not pay on day two i will not pay on day nine i will pay on day ten because the longer i can hold on to my cash the better off that i am so i will take full advantage of these terms if i want the discount i will pay on the very last day the discount is available conversely if i don't take the discount maybe i don't have the cash maybe i don't feel like dealing with it i'd rather just pay at the end of the month whatever the case is if i choose not to pay within day 10 maybe the bill got slipped under something i didn't find it till day 12. right i find the bill on day 12 do i rush and write a check on day 12 what do you think no right because once that discount period that 10 days has expired i'm no better off paying this bill on day 12 than i am on day 30. so for that reason to better manage my cash i will delay the payment on that bill until day 30. if they want me to pay before day 30 they need to adjust their credit terms if they want me to pay before day 10 they need to adjust the credit terms but if these are the terms i'm given the only two dates that are acceptable for me to pay are day 10 or day 30. now please hear me well i am not telling you to ever pay late right don't pay on day 32 don't pay on day 38 pay on day 30 do not pay late but never pay early unless there's an incentive to do so now once again they're going over the items that we just talked about a moment ago so this is a good graphic if you are a little bit confused as to exactly what that is but that two of course represents the discount percentage the 10 is the number of days that you can earn that discount by paying early the end of course is the net amount and the 30 is of course the overall credit period so you get the discount within 10 days if you pay if you don't pay within 10 days you pay 100 in 30 days so that's what we see here now this is just a timeline it does a pretty good job of showing you how this all relates over time so here what i'm going to call time zero you got your invoice date for a certain amount of time you have a discount available during this point of time the amount you would actually pay is the full invoice amount less that discount so if the full invoice amount was a hundred percent which it will be of course and the discount amount was two percent then you would pay 98 right here but this second this discount period ends notice you're now in the general credit period which does not offer a discount which means now you owe the full invoice amount so that is what we see here now here's an example of an invoice i'm not super concerned that you'd be able to label all of this if you want to see an example of how this might actually look in practice this is a great item to look at as far as your exam this isn't super relevant but as we say the whole point for taking this class is to prepare you to actually be able to do this kind of work in practice and for that reason it is important that you understand how this works so in this case you've got of course the company's name the invoice date the number of the invoice specifically all of that information available to you you see the terms 210 net 30 you'll notice the freight is labeled as fob destination what on earth does that mean who knows but i think we'll talk about it here in just a moment but this will be incredibly important here in this chapter as well as the rest of the course after chapter four i will not define fob destination again probably i will just use the information as we need it for fob destination um an fob shipping point so you will need to be very familiar with those not only here in chapter four but of course through the rest of the course and remember once again that final exam is comprehensive so we want to make sure we're maintaining this information maybe reviewing old notes every so often just to make sure you are sharp when it comes time for that comprehensive final exam you'll notice now down below this you of course have the items that they are purchasing the quantity and the price this gives you a total amount in this case they ignore shipping and tax and so we have our total here in the event that they take the discount this will generate a total of 490 instead of 500 and we'll see how all of that works now i want to point out something notice here you've got the payment occurring within that discount period so here's what happens on november the 12th remember the purchase was november the 2nd on november the 12th that is 10 days later so they are within the discount period they are paying on the correct date they should be paying on november the 12th and they are paying on november the 12th you'll notice what has happened is a debit to accounts payable initially we had a credit to accounts payable because we bought this on credit so we set up a liability with a credit to accounts payable but at that point in time we debited merchandise inventory for the full 500 what this has done to us then is at this point in time we've got our asset overstated remember back in chapter one right we're throwing it back once again we're talking about this idea in chapter one the historical cost principle the historical cost principle tells us that we record items specifically our assets at the amount that we pay for them well if i got my inventory for 490 instead of 500 i did not pay 500 for my inventory which means as long as my inventory is stated at 500 it is overstated i must bring that balance down to reflect the actual amount paid so if i need to bring my inventory balance down from 500 to 490 then what needs to happen is a credit to inventory for ten dollars we'll then credit the cash account for the actual amount paid to 490 and this will wipe out the entire balance and accounts payable allowing our 500 debit to accounts payable to be offset with two credits totaling out to five hundred dollars now you'll notice the amount paid was calculated is 500 dollars times 98 percent and if you wanted to calculate the credit to inventory here simply the 500 times two percent which is ten dollars now this is what this looks like of course on our ledger originally we had a debit to merchandise inventory for 500 and a credit to accounts payable now at the end of the period when we actually paid this or i'm sorry on the actual date that we paid which was the 12th we came back we had to eliminate that payable so we had a liability with a credit balance which is normal we eliminated the full balance by paying it off for five hundred dollars that gives us a zero balance left that we owe you'll notice our inventory had to be written down by ten dollars and giving it an ending balance of 490 and our cash came out as 4.90 so this all looks good remember historical cost principle says our inventory in this case must be valued at the amount paid well our ending balance and inventory is 490 and the amount of cash paid was 4.90 so it looks like we did this all properly now what happens if we pay after the discount period well this gets a lot easier simply a debit to accounts payable which is reducing that liability once again down to zero and they credit to cash now with that said we've now got a couple of other items we need to look at we've got what are called purchase returns and purchase allowances so purchase returns occur when the merchandise is returned by the purchaser to the supplier i ordered number two plywood and you sent me number six plywood i don't need that you sent me the wrong stuff i'm sending it right back to you right that's the way that a purchase return works we'll talk about what that looks like and then we'll look at what is called a purchase allowance so a purchase allowance is simply a price reduction to the buyer when we receive defective or unacceptable merchandise so i asked you for a certain item and what you sent me wasn't exactly right but i can probably make it work but because what you sent me wasn't what i really wanted or what i really asked for then what i'm going to do is send that back to you if you don't give me an allowance so i'm looking at returning this but you say wait a minute all right we made this custom for you we understand we didn't quite hit the specs it wasn't quite what you wanted so how about instead of you paying ten thousand dollars for this you pay seven thousand dollars for it you keep it you make it work and we'll refund you the three thousand dollars right whatever the case is so we'll look at how an allowance works so an allowance the purchaser right the buyer actually keeps the inventory but under a return they're actually sending it back so two totally different situations we want to make sure we understand how they work so here we're going to first look at an allowing so here on november the 5th zmart the buyer of course issues a 30 debit memorandum for an allowance from trex for defective merchandise so we bought something from trex it was not correct and whatever reason for whatever the case is whatever they sent us was not what we wanted was not what we needed was defective in some way so what i'm going to do is set up and debit to accounts payable so originally when i purchased this from them i would have debited merchandise inventory and credited accounts payable but now i have not paid them yet so because i've not yet paid them what i'm going to do is simply reduce the amount i owe them so i'll debit accounts payable and credit my merchandise inventory account doing so resets everything properly because what we've done is reduced the balance that we owe in accounts payable and we've reduced the value of that inventory once again keeping in line with that historical cost principle if i'm getting a discount on this which is essentially what this allowance represents then i should not have that inventory listed at the full price on my balance sheet so we will have to lower that account now a return is a little bit more involved because we actually have the item leaving us so we buy it it comes in we send it back right so there's a lot more movement here than just with an allowance so in this case zmark purchases 250 dollars of merchandise on june the first terms are 210 and 60. now what on earth do those terms tell me we get a discount of how much two percent but only if we pay within 10 days if i don't pay within 10 days then the balance the net amount is due when in 60 days so that's what we need okay now it's very likely on your exam i will have questions where you have to understand that terminology to be able to do the math to solve a question but it is also very likely i may just have a question that says what do the terms 3 15 and 45 mean and you'll have to tell me well that means you get a 3 discount if you pay within 15 days otherwise the balance is due in 45 days right so i could just have a question in the multiple choice specifically where i just say hey interpret these terms for me and as long as you can do that you may pick up a couple of points doing so so very important that you understand how these terms work because i can almost guarantee you're going to have a question about either a return an allowance something along those lines maybe a purchase that deals with these terms and without understanding them you will be lost among the accounting on how to actually solve for all the numbers so here we go on june the third we returned fifty dollars of goods before paying the invoice okay now when zmart pays on june 11th they take the two percent discount on the remaining balance so i'm going to be honest with you this is a lot nicer than i tend to be if this was a question i had written i would have simply told you on on uh june the 1st is zmart purchased inventory for 250 with these terms then on june the third they returned fifty dollars worth of goods and they paid the bill on june the 11th right they've given you a lot more information here that i would give you where you would really have to understand what was going on because here's the deal if you return the goods on gene the third but you don't pay till june the 11th do you see that that happened before you paid the cash so i shouldn't really have to tell you that june the third we paid or we returned to the goods before the cash was paid because you can pull that out of the information so make sure you're reading these things very carefully so you understand the order on june the first we purchased something well what happens when i purchase inventory is pretty straightforward at this point it's simply a debit to merchandise inventory which is an asset which is increasing and a credit to accounts payable which of course is a liability which is also increasing with a credit and your inventory of course is increasing with a debit so we've got our two accounts going up keeping our accounting equation once again in balance now on june the third when this return happens what needs to occur the first thing that liability needs to go down because i returned some of the goods because i returned some of the goods i no longer have them so if i no longer have them i no longer owe you for those goods so my liability must come down the way we lower that liability amount of course is with a debit to accounts payable we then need to lower the actual inventory balance because we sent that back so i no longer have it if i no longer have the inventory which is an asset then that asset needs to be decreased and we of course decrease an asset with a credit so we'll take care of that next now on june the 11th it is time to pay but how much do i actually owe you do i owe the 250 if not why not so be careful right you owe 250 on june the first but because you sent 50 back you no longer owe the full 250. you now owe only 200. because you only owe 200 the 2 discount that was available to you is only available on that 200 so first things first wipe out the accounts payable for the full balance of 200 reducing it to zero you'll then credit merchandise inventory for four dollars crediting merchandise inventory for four dollars will of course bring that balance down to be properly stated let's track this through started at 250 return 50. now you're sitting at a balance of 200 minus the four would leave your inventory stated at a price of 196 dollars coincidentally the amount of cash we are actually paying is 196 dollars so have we applied that historical cost principle correctly absolutely because remember we value our assets at the amount that is paid for them even though this came in initially at 250 then we sent some back then we took a discount that rule is still true so remember we paid off a 200 bill in the end for 196 because we took advantage of that four dollar discount now next item that we want to talk about is incredibly important in this chapter and future chapters so make sure you understand it okay i know i feel like i say that all the time but it's true this course really builds on itself so we want to make sure we're understanding what we're doing in each chapter so that we don't get behind later so first two things on this chapter are the two different types of shipping terms sorry on this slide are these two types of shipping terms we've got fob shipping point and fob destination okay the fob simply means free on board i don't care that you understand that that's what it means okay i guess there might be a multiple choice question that asks what it means but truthfully it's useless to us so what i would do if i were you i would ignore that fob label and i would simply deal with shipping point and destination that part that comes after fob simply tells you where ownership changes hands so what you're noticing is under fob shipping point the ownership changes as soon as the goods are loaded onto the truck and sent off at that point in time the seller no longer owns this it is now the buyers conversely with fob destination it's the remains of the seller's item until it finally gets delivered at the final destination so this is the difference and you say well who cares the only difference is the the time it's in the truck essentially why does that matter well i want you to think specifically toward the end of the year we just had christmas we just had the end of the last year so what you're looking for here is what happens for inventory that's put on a truck say under fob shipping point okay if it's fob shipping point and it was put on the truck on 12 31 at that point in time the company no longer owns the item that is because as soon as they put it on the truck it is now the property of the purchaser so what just happened is these companies selling the inventory can actually go ahead and book revenue and reduce inventory right now in the current period but that also means that the buyer must reflect the purchase of this and include this inventory in their actual inventory on their balance sheet even though it's still on a truck 3 000 miles away it is their inventory so when you actually go to a physical account you're going to have to remember to think about all these things that you paid for fob shipping point now the other side of this is fob destination so with fob destination at 12 31 if amazon puts something on a truck in california to deliver say somewhere down in florida right incredibly unlikely they've got a much better distribution network than this but we're going to take an extreme here just to make this very obvious there's no way to get from that distribution point in california on 12 31 by truck all the way down to the southeastern tip of florida on 12 31 it just can't happen so what's going to happen is on 12 31 they will not yet have a sale because they have not yet finished the service they do not get to actually book revenue until the actual goods are delivered all the way down on that southeastern coast of florida at that point then they get to book the sale so here's the deal who pays the shipping okay so this is the real question here and this is why it matters so under fob shipping point yeah i want you to think goods go on the truck truck driver starts driving down the road something jumps out in the middle of the road truck driver swerves off jumps out of the truck truck goes flying off the cliff bursts into flames down at the bottom of the cliff everything in the truck is destroyed truck drivers safe no harm no foul but what just happened with that inventory and who is responsible so if this was an fob shipping point then the ownership transfers at the time the items are loaded in the truck and the truck takes off what this tells you is that that inventory belonged to the buyer the whole way well if it belongs to the buyer the buyer pays shipping and if the buyer pays shipping they're the one that needs the shipping insurance to cover something like the truck flying off a cliff exploding at the bottom and everything burning up in a fire but if you're dealing with fob destination then that means that ownership does not change hands until the actual goods get delivered which means the entire time the items are in the truck they're the property of the seller what that then means is the seller is the one responsible for paying the shipping cost and for actually paying for that shipping insurance so when you go on amazon and you see free two-day shipping what you are really seeing there is that amazon is employing this method of shipping called fob destination where they're saying it is actually amazon's item all the way up until they deliver it to your door once they deliver it to your door you sign for it you pick it up on your porch whatever happens then that is your item but until that second it is actually still the property of amazon and so this is how shipping works and we'll deal with this as we go through they go ahead and show you how the journal entries look so under fob shipping point the buyer pays the transportation cost which means that will be treated as part of inventory because we stated earlier in the semester i believe that inventory is not just the purchase price of inventory but also any cost necessary to receive it to get it set up installed anything like that will be the price of that asset and of course they'll simply pay that with cash so it simply goes into inventory which will then of course be moved over to cost of goods sold on the income statement when the inventory is actually sold in the future when we're dealing with fop destination the seller is paying for the shipping which means it is simply treated as another expense and a debit to delivery expense of course on the income statement immediately and a credit to cash so here we go zmart purchased merchandise fob shipping point transportation charge is 75 they purchased its fob shipping point because of that they are paying the shipping they'll simply add this to inventory and credit cash so a debit to inventory a credit to cash now here we're going to look at the actual cost of our purchase so we have an invoice cost of our merchandise to thirty five eight hundred but we received a discount of forty two hundred dollars for whatever reason we had a purchase return and allowance of fifteen hundred dollars as well we added the transportation cost that we had to pay which gives us the total net cost of merchandise purchases of just over two hundred and thirty two thousand dollars now we're gonna look at the other side so we've looked at the purchase side now we need to look at these sales so here we have our net sales notice this is our gross sales which is our total number of sales our top number minus a couple of things so here we're going to look at things like discounts returns and allowances all being contra revenue accounts that will bring us down to our net sales number which of course is the top line of our income statement is net sales typically minus cost of results will give us that gross profit number notice here each sales transaction for seller merchandise involves two entries so in this chapter and every chapter from here on when i have you make a sale of something you have sold inventory whatever the case there are two journal entries you must make they're both vitally important the first is revenue received in the form of an asset so what that means is somehow you've generated revenue and you got something maybe it was cash maybe it was a promise to pay called an accounts receivable maybe they gave you land or a truck or a building or equipment they gave you something in return so you got some kind of asset and of course the recognition of the cost of that merchandise that you sold to the customer so this is where you're going to have to reduce the inventory balance on your balance sheet and increase your cost of goods sold well look at how this works here zmart sold a thousand dollars of merchandise on credit the merchandise has a cost basis of 300 so right away if i asked you bam what is the gross profit on this sale you should be able to tell me seven hundred dollars it is my sales price of a thousand minus my cost of goods sold to 300 which gives me gross profit of 700. but if i actually look at my journal entries right and i'll be very honest with you you need to be extremely careful on your exam if it asks you for the revenue side this is the journal entry you must record if it asks you for the cost side this is the journal entry you must record if you get them flipped they will both be completely wrong and so be very careful as you're answering don't put the cost information in the revenue journal entry or vice versa you've got to make sure you put them in the right spot so with the revenue side journal entry what you are dealing with of course is the revenue so the credit here is to your revenue account sales the textbook calls this sales i will refer to this as sales revenue to drive home the point that this is a revenue account that goes on the income statement and increases equity right that is the reason that i will be referring to sales as sales revenue almost every time if you're taking this in mcgraw-hill sales is fine if you're taking this on paper you must write sales revenue so that i understand that you understand that this is a revenue account which goes on the income statement if this is a written exam and you only give me sales you will very likely lose partial credit for that account title so in connect can't do anything about it connect goes with sales so that's what we'll have to use but if you're taking a written exam if you want full credit that account title for that credit should be sales revenue now for accounts receivable that of course our asset so we sold something notice this tells us on credit if you see the phrase on credit on account anything like that or you just see credit terms then you will know immediately we did not receive cash this must run through accounts receivable as we see here of course accounts receivable is an asset which increases with a debit and goes on the balance sheet so there's our first journal entry anytime you have a sale the revenue side will look something like this a debit to accounts receivable a credit to sales but that is only one half granted that is the more pleasant half of the journal entry because that is the side that makes us look good now we need to deal with the side that might make us look not so good right which is the cost side in this case it's fine right we still generated a ton of gross profit on the sale so it still looks okay but the way this journal retreat looks in the way that will look every time is a debit to cost of goods sold and they credit to whatever it is that you sold in this case merchandise inventory which of course i'll simply refer to as inventory so debit cost will be sold which is an expense which goes on the income statement and they credit to merchandise inventory which of course is an asset that goes on the balance sheet we do see that here now just like the purchase discounts and all of those items that we saw earlier when we were buying we can of course offer those same items to our customers in an attempt to increase the speed at which we collect cash so all of this credit period stuff is the same as we saw earlier but let's see how the journal entries differ so in this case zmark completes a one thousand dollar credit sale terms two ten and forty five so two percent discount if we receive the cash then ten days if not they owe us the full amount in 45 days so straight away we're going to book a debit to accounts receivable a credit to sales for the full amount that is what happens on november the 12th but notice what also happens on november the 12th since we made the sale is we also have to book the cost side the cost of course being a debit to cost to be sold for 300 and then credit to merchandise inventory for 300. now in the event they pay within the discount period a couple of things happen one we wipe out the full balance of accounts receivable with a credit to accounts receivable of one thousand dollars that way we don't call them up in a couple of weeks and say hey you still owe us 20 and they say no we don't we paid you within the discount period the discount was 20 but now we've annoyed our customer so we don't want to do that so what we do is we credit the full balance for account research for accounts receivable remember accounts receivable is an asset which increases with a debit since it should be decreasing here we are crediting that account now we're coming in with a debit to cash but how much cash only 98 they get that two percent discount they pay within 10 days they purchased on november the 12th they paid on the 22nd that is within 10 days so they do get that discount what that means is the cash is only 98 percent of a thousand which is of course 980. at this point in time we've got 980 for debits a thousand for credits i don't think we've found the one time in all of accounting history where our debits are okay with not equaling credits in fact i think that rule is going to hold still even in this case so we've got to figure out what to do with 20 dollars so we'll go ahead and jot down the 20 and then think about where it should go well in this case we want to actually know why we lost this 20 dollars where it went so we're going to use a specific account called sales discounts this sales discounts account will contain the 20 discount that we have given our customer for paying early now in the case that they pay after the discount period this is much simpler simply a debit to cash for a thousand credit to accounts receivable for one thousand dollars now the next item that we want to consider is a sales return allowance of course sales returns and allowances involve dissatisfied customers and could result in lost future sales so what we don't want is these items to occur but if they do happen we want to try to make it right as best as we can so sales returns refer to merchandise of course that are that are completely returned to us and sales allowances of course is where we give them a discount to keep the defective product so in this case the customer returns merchandise which sold for fifteen dollars and cost nine so here's how this works if we have a sales return and allowance right or either one the textbook uses the account sales returns and allowances which makes your accounting a little bit easier because you don't have to distinguish between the two the textbook uses the same title if you're taking a paper exam for me i want to point out i will take the full name sales returns and allowances that is perfectly fine if you want to write that every time just to make sure you're safe i will accept that on the other hand if you want to just use sales returns or sales allowances that is fine but be careful because if you give me sales returns and it's actually an allowance it is wrong if you give me sales allowance and it is actually a return it is wrong but if you go with the full title you are safe so keep that in mind as you decide as you decide how you're going to write things down on the test but that is the way that we are going to be dealing with this so safest option of course use the full title um i do accept abbreviations on the written exams as long as you've provided somewhere on that same page what that abbreviation means so if you want to use like sales rna for sales returns and allowances and there's three different journal entries that require you to use that for example then at the top of that page or the bottom of that page somewhere very clearly i need you to write sales returns and allowances equals sales rna and then i'm good with it but if you just give me sales rna that will be wrong i've got to make sure you understand what the abbreviations mean that you decide to use so do make sure you follow that procedure okay now we have dealt with the revenue side of this so we sold it for 15. because they returned it we had to give them the cash back so cash goes down by 15 which of course is an asset sales returns and allowances is increasing by 15. it's a contra revenue account so we put another contra account here and this contra revenue account of course goes on the income statement it deals with that net sales computation at the very top it gets dealt with way up there and it is of course reducing the overall revenue amount so we do see that going up with a debit remember contra means opposite revenue increases with a credit so a contra revenue increases with a debit now two situations here one they return merchandise that was not defective for example you go to the store you buy something you get home you decide or you realize oh we already had that you take it back right is there anything wrong with the item you bought no but did did you need it no so if you don't need it there's nothing wrong with it you take it back they say okay is there anything wrong with the product you probably think well why do they care right well here's why it depends on how they're going to rebook this entry because if there's nothing wrong with a product they can simply rewrap it put it back on the shelf sell it again good to go but if there is something wrong with that product they can't put it back on there at full price so you go you buy something you get home it's completely broken doesn't work doesn't turn on doesn't function doesn't do anything it's supposed to do you take that back they say all right well why are you returning it did you not need it was it the wrong color did it not work what happened and you say oh no it was totally broken everything with it i guess when they shipped it here or something everything inside was just shattered right well that's a different story than something that is just the wrong color the wrong size so what we want to make sure we are doing here is showing that difference so in the first case when things are not defective it's a pretty straightforward journal entry we simply reverse the sale so when we sold this we debited cost of goods sold credited merchandise inventory when you bring it back we simply reverse that a debit to merchandise inventory to put it back in the inventory account a credit to cost of goods sold to reduce that account now the next thing you want to do is come down and look if the returned goods are defective so if the returned goods are defective then what you're going to have to do is first start with that credit to cost of goods sold that's where i would begin okay of course jump down a couple of lines indented always make sure that credit goes after all the debits and is indented some to the right while your debits are of course up into the margin but i would start with the easiest part of this the easiest part of this is if they brought it back it is not sold if it's not sold it can't be in cost of goods sold so what you're going to have to do is credit cost of goods sold that's the very first thing that i would do then you got to figure out what to do with this nine dollars so in this case it looks like that item was really only worth two dollars by the time we figured out what all was wrong with it so we restore that two dollars back to inventory but let me ask you do you think this is the time in the entire accounting world that it's okay for debits not to equal credits because by guess here is certainly not right our debits must always in total equal our credits and that's what we see here so we've got this two dollars going back on the balance sheet and inventory we've got the nine dollars coming off of my income statement from cost of goods sold that leaves a seven dollar difference so what i would do is go ahead and jot down that seven and then think what account would make sense so this is the first of these accounts that we've seen this is what is called a loss from defective merchandise so a loss is very similar to an expense it is not an expense but it is similar because it is so similar in fact it will be reported on our income statement as well so when you look at your income statement now on the second exam we will notice four main groups of things showing up on your income statement revenues and expenses that we saw previously what about dividends do they go on the income statement no remember dividends are a direct reduction of equity assuming we've got a cash dividend that goes on two financial statements the statement of retained earnings and the statement of cash flows it will not touch the income statement it will not directly touch the balance sheet it will indirectly in the sense that it will reduce retained earnings which will then flow into the equity section of the balance sheet but on our income statement which is our focus here we've got revenues and expenses and then we've got two other things gains and losses so those are the four main categories of items that we will see throughout the semester showing up on our income statements here's our very first loss so we have a loss from defective merchandise of seven dollars allowing that journal entry to balance out now here we go let's look at an allowance so assume that 40 to the merchandise zmart sold on november 12th is defective but the vi but the buyer decides to keep it because we offered a 25 price reduction so instead of them paying us forty dollars now they only have to pay us thirty so how does this work well in this case what we're going to have to do is debit sales returns and allowances for ten dollars and then we will credit cash notice the date here right this is the journal entry for november the 24th okay if we come back you'll notice that they paid within the discount period on november the 22nd since they've already paid we're having to actually return cash so we'll debit sales returns and allowances for ten dollars we'll credit cash once again cash is an asset goes on the balance sheet sales returns and allowances is a contra revenue account and of course goes on the income statement with a debit normal balance so that journal entry looks fine next we want to look at some adjustments and some closing entries for our merchandising company that's a really good um graph i will say i don't like it quite as much as our inventory graph but that's just because this one has a lot more going on but it is very useful for figuring out how stuff moves through time so you'll notice from the supplier we've got net purchases in beginning inventory which gives us our merchandise available for sale because this cost of goods sold in the inventory so this is essentially that same inventory chart we saw previously just rotated on the side okay and then we've got some more stuff moving on to the next period but here's what's really cool about this chart is it shows us that our cost of goods sold number hits our current period income statement right away boom this period that is where your cost of goods sold is being reported but your ending inventory hits two places it hits your current period balance sheet as ending inventory that is true but remember the balance sheet persists across time the income statement is only for that one period so the income statement is january 1 of this year to 12 31 of this year at the end of 12 31 everything on it gets reset it goes to zero as of january one of the next year and zero all the way up until we've had sales and all that stuff happen throughout the year and at the end of the year we've got some numbers for the income statement which then get reset back to zero at the end of that year to begin the next year income statement is always starting fresh at zero but the balance sheet is permanent what that means is if you have cash at 12 31 it doesn't magically poof away january 1 of the next year how horrible would that be but on the other side that also means your liabilities they don't go away either so if you owe somebody money at 12 31 of this year january 1 you don't get to call them up and say oh i'm not paying you anymore because you waited until the next year that doesn't work so what that means is all that stuff on the balance sheet is going to carry over to the next period in this case our specific account we're looking at is ending inventory so notice ending inventory will be reported on the current period balance sheet of course the current asset but it will also be reported on the balance sheet at the beginning of the next year as beginning inventory because whenever we ended 12 31 went right 12 31 at 11 59 pm without 59 seconds that ticking over to 12 a.m and one second in a couple of seconds right my inventory doesn't magically poof away whatever i ended year one with is what i start year two with whatever i end your two with is what i start year three with and this is the kind of logic we're gonna need in the rest of this chapter and even in the rest of this course as well as the next course is understanding how these items move through time so our ending inventory of year one becomes beginning inventory year two we'll add to that our purchases which gives us our new merchandise available for sale then whatever was sold we'll move through the cost of goods sold on our income statement whatever was not sold will remain an ending inventory becoming our ending inventory balance on the balance sheet in year two and becoming our beginning inventory balance in year three now here we go what happens if at the end of the period i go and i look right i'm at academy i'm doing my physical account and i realize after i get done we are missing 250 worth of stuff what happens do i fudge the numbers do i hide it do i cover it up do i what do i do all right what does a good honest accountant do okay so here's what happens we come back there we do our account we say oh my goodness we have misplaced 250 worth of stuff throughout the year either someone stole it broke it ate it destroyed it you know lost it whatever happened 250 worth of stuff is missing when we notice that what we have to do is update our records so the first thing is we're going to treat any missing items as if they were sold so i'm going to debit cost of goods sold which will reduce my net income because it's an extra expense on the income statement so i debit cost of goods sold and i credit my merchandise inventory and that of course is because my credit to merchandise inventory is showing that we don't have that item anymore so that is what we see now we've got some new revenue req rules that require reporting of sales at the net amount expected um we're not going to deal with this too heavily in here but we might talk about it from time to time so here we've got closing entries for our merchandisers remember back in chapter three we dealt with closing entries um for our service providers primarily so here we're looking for merchandisers it's essentially the exact same thing only a few little changes remember we said we closed revenues expenses and dividends revenues and expenses run through income summary we then close income summary through retained earnings and we debit um retained earnings and credit our dividends to get rid of it at the end so essentially the same process is happening we've got a couple of extra accounts that only apply to merchandisers here so the first one is sales so we see a debit to sales or credit to income summary that's how we're going to get rid of those revenue accounts next we're going to close all those debit balances into income summary pretty much everything here is the same with a couple of key exceptions we will see things like sales discounts returns and allowances and cost of goods sold for a merchandiser you just don't have that with a service provider um because i'm not selling you a product so you can't return anything i can't let you keep it for less there's not a good being sold in the same sense so those accounts just don't exist um for service providers so those will be new items having to be closed out for your merchandiser we've then got um the closing of income summary so in this case we had 321 000 as a credit to income summary 308 000 as a debit which of course means there was a credit balance selected income summary that credit balance will then have to be debited to bring income summary down to zero with a credit to retained earnings notice here a credit to retained earnings of course is increasing equity because retained earnings is part of equity and equity increases with a credit this makes sense to us because we had more revenue than we had expenses which tells us that retained earnings should be increasing and in fact it is so that all looks good to us next we see that retained earnings will be debited for four thousand because we paid a cash dividend in this case of four thousand dollars or rather declared a cash dividend of four thousand dollars so we'll see that as well now next thing we want to look at is what is called a multiple step income statement so here we're going to see very similar to what we saw whenever we looked at the classified balance sheet versus an unclassified balance sheet it's just got a few more a few more sections it's no more difficult it's just a little bit more organized a little bit more useful for us as we're actually using this to make decisions for our business so first thing we want to look at of course is the title of our financial statement this will be the same type of title that you will see on every financial statement we ever prepared if i have you prepare one you will be required to give me a formal title it will have the company's name as the first line today tomorrow and every day until the end of time the first line on any financial statement is your title of the company next you will tell me what financial statement you are preparing in this case you are preparing the income statement you will need to tell me that i need you to tell me is this an income statement statement of retained earnings balance sheet statement of cash flows that will be the second line and finally you will properly date your financial statement notice for the multiple step income statement this date says for the year ended 12 31 2019 it does not say as of 12 31 2019 very important distinction this financial statement says for the year ended 12 31 2019 because this is a period financial statement okay but a key distinction between the income statement and the balance sheet which are our two primary focuses in this course is that the balance sheet will say as of 12 31 2019 and that is because the balance sheet is as of that one specific date how much cash do we have on hand on that day how much do i owe people how much equipment do i have how much do we have in land in buildings all those types of things is as of that one specific date but the income statement is a period financial indicating it covers a range of time so this is for the year ended that period of time is the year that ends 12 31 2019 and that is why it is so important that we have that distinction there now all of that was our title we now need to look at the actual format of the financial statement itself notice we have sales and this is your gross sales okay so this is total sales but notice our net sales is actually the difference between the 321 and these two items your sales discount sales returns and allowances which gives you net sales of 314 700. in this textbook i believe they do have you do this computation fairly frequently on the face of your income statement in practice this is rarely done in practice what will happen is you will have net sales be your top line it will say 314 700 and it will say see note a in the back or whatever and they will show you this computation in the notes to the financial statements we typically don't see these types of formal calculations on financial statements but you could right it's not incorrect to do so it's just less common so we do see that now we see next our cost of goods sold coming out of 230 400 they show you how they got that to get that they ran through that big chart that we talked about earlier they plugged some things in they said well we've got beginning inventory of 19 000 we purchased 232 they gave us a total of 250 1 400. we realized then we had 21 000 left in ending inventory which means we must have sold what was not still in inventory which was 230 400. there's your cost to get sold number which gives you gross profit of 84 300. this is the first section of your multi-step income statement next you've got your operating expenses followed by your general and admin okay so we've got things like depreciation expense on store equipment sales salaries expenses rent expense on the selling space store supply expense all these items are selling expenses for forty two thousand one hundred you then got your general and admin or your g a right so normally you'll hear this um commonly referred to as sg a to selling general and admin is what we're talking about when you hear that that expression um here your general admin total out to 29.3 which gives you a total between these two of seventy one thousand four hundred seventy one thousand four hundred from eighty four thousand three hundred is twelve thousand nine hundred this is your income from operations now this is the number you want to base a decision on okay so if you look at a company and they have a astronomically high net income so this was 10 million dollars down here but their income from operations was negative then i would say that company is in severe distress there's a very good chance that company will not persist if things don't change now this year granted with the pandemic and everything very likely you could get a bad read on this okay maybe their industry was down especially if you had something like a tourist industry you had anything that requires travel maybe an airplane company anything like that probably not a great year um just because of all the restrictions and the lockdowns and everything so it may be a little bit misleading but that's what we see so if i was asking you to actually make a decision whether to invest in a company or another company you would typically be better off making that decision if you were only using their income statement okay which is a whole other conversation and not something i would recommend but if you for some reason had to make a choice and you could only use their income statement you're better off in the long run making that decision based off their income from operations because this is the repeatable stuff that they can do this is mcdonald's selling hamburgers this is ford selling cars this is any company selling their main product is what income from operations is derived from but all this other stuff is typically one-time stuff so stuff like earning interest maybe they bought a cd and they earned a little bit of interest maybe they sold a building and got a big gain so let's imagine this for example mcdonald's comes in they've got income from operations this year of negative a billion dollars right they just lost a ton of money for whatever reason people really didn't go to mcdonald's or they really messed up their expenses and they just had a tremendous loss this year so if that is the case what happens so you come down you look and you see their net income is 10 billion dollars okay so you say well how'd that happen right they lost a billion dollars doing what they do right buying food and selling it to consumers right they cook it they serve it they do all that stuff that is their main job that is what they exist to do well when they come through with a negative from income operations and a huge amount for other revenues and gains what is likely happening is they are selling their assets to generate gains so somehow they've got a building that's worth a million dollars someone paid them 2.5 for it and they do this with 10 000 locations and all sorts of equipment and everything else and by the time they get done liquidating all this stuff they've got gains of 11 billion dollars well that 11 billion offsets the 1 billion that was their negative income from operations you come down you look you see that income 10 billion dollars you say wow mcdonald's had an excellent year i need to hurry and invest in mcdonald's but what you just did is you invested in a company that sold every asset they own they're not able to do anything next year next year is certainly going to be a huge loss because here's the deal can you inflate your income statement one time by selling a bunch of stuff and booking a bunch of gains sure but that can't be repeated because how many times can i sell a building one once i've sold it it's not mine is selling it how many times can i sell land exactly one once it's sold it's not mine to sell again so you want to be very careful of this other section okay it is important and does go on the income statement there's a reason it is treated separately under a multiple step income statement that is because it is from non-operating activities which means this is much less likely to be repeated than the items up here that actually are your bread and butter operations okay once you take your total income from operations add in your total other revenues and gains expenses and losses in this case that adds two thousand dollars you come down to net income for just under fifteen thousand 000 now under a single step income statement you'll notice your net income number is the same but you'll notice we simply group things by revenue and then expense and you'll notice here the gains are included with revenues the expenses include any losses if they were there but in this case we just got that interest expense coming through so much less useful to us is it still good to see that the income is 14.9 sure but i would not feel nearly as comfortable making decisions with this financial statement as i would with this financial statement okay now once again we've got our balance sheet here we see our classified balance sheet indicating how we talked last time about our order of liquidity so we talked about this and we said our acronym here or our mnemonic was can she really invent something practical so csrisp so we said cash was of course first because it is cash already liquidity is simply how long does it take to turn this into cash and cash is cash so not very long next we said with short-term investments in this case i don't have any so they didn't list them next we said was receivables so are so there's our accounts receivable next then we said inventory which is of course listed next then they've got their supplies broken out into two groups that's fine and finally they're prepaids so things like prepaid insurance prepaid rent prepaid subscriptions prepaid anything now here's the deal you go up to your apartment you prepay your rent for the year okay 12 months you pay in advance six months in you decide oh my goodness my money's a little bit tighter than i wanted i'm really paid way ahead on my rent i think i'd like to go get that cash back um from them and i'll just start paying them month-to-month can you do that maybe it probably depends on the contract on the terms of the payment all that kind of stuff um but assuming you can it's still going to be very difficult to get cash back out of a prepaid because they already have your cash they really don't want to give it back to you and most of them will have something in the contract that says like if you prepay then you forfeit the right to receive the money you know back and revert to a monthly payment schedule or something if you really read them they've got a lot of weird terms in there a lot of times so it may not even be possible but assuming it is it is at least more difficult to get cash out of that than it is to sell your staple right so definitely the least liquid of those items now last couple of things in this chapter we got our acid test ratio acid test ratio we hinted at back at the end of chapter three and we talked about the current ratio remember current ratio is just current assets divided by current liabilities but our acid test ratio is what is called our quick assets divided by our current liabilities it does a little bit better job of indicating if a company will be able to actually pay back their debts so notice here with the asset test ratio this is cash plus our short-term investments plus receivables divided by our current liabilities so you said well that's very similar to the current ratio which was just current assets over current liabilities and i would say yes you are correct it is very similar but there are a few key exclusions so notice what is not included in that numerator inventory not included supplies not included prepaids not included so a lot of stuff left out of that numerator that is included with your current ratio so it's a much more conservative ratio it gives you a little bit better look at well are we just really bloated with inventory because what's the problem with inventory i can't pay bills with inventory i have to have cash most likely or some kind of investment i can quickly turn over or receivables which i can factor i have to have some way to get that cash very quickly to be able to pay off my bills and if i don't have it i have it still wrapped up in inventory i still got to sell it then it's got to go through credit sales then it's got to sit in receivables then i finally collect it but it takes a while prepaids we've already discussed extremely difficult to get stuff out of and supplies they're not really meant to be paying back creditors with and if we're having to sell our own stapler our own ink out of our own printer then it's probably a sign of severe economic distress for your organization so you want to be very careful there so acid test ratio very similar to the current ratio but slightly different a few major exceptions good rule of thumb here is you want your acid test ratio to have a value of at least one okay same thing use the same rule um for the current ratio at least one indicates that you at least have enough current assets to pay off your current liabilities um but once again the current ratio is kind of bloated it includes a lot of stuff that's not really good for paying off current liabilities so the more conservative test is the acid test ratio sometimes this will dip below one but hopefully not too much so that is what we see there now here we come in we look at this for nike we see cash short-term investments and receivables over current liabilities so they've got their total quick assets versus their current assets so if i asked you for example what amount of their current assets are not quick all you would do is of course take the difference here and you could tell me whatever that number is um about 6 800 or so it looks like um sorry 7 800 um here but not really here or there what we're trying to see here though is really a trend so notice two years ago nike's current ratio is 2.5 up to 2.8 up to 2.9 i don't know what years this data is from so this may or may not still be true so do keep that in mind of course with any of the things that are current one year two years ago as this video ages these will become certainly different um but for the purpose of this video this will work and notice once again as their current ratio has been ticking up so too as their acid test ratio on the other hand if you look at under armour you'll notice their current ratio two years ago was over three which was better than nike but their acid test ratio was primarily or was significantly lower what this probably indicates right the most likely culprit of a very low acid test ratio is an extremely high level of inventory so what i would say here is it looks like under armor is carrying much more inventory than nike so we come in we look at our current ratio still declining so 3.1 to 2.9 down to 2.2 but you will notice their acid test ratio actually ticked up just a little bit and that is probably because they managed their inventory a little bit better got it down a little bit tighter which resulted in this acid test ratio bumping just a little bit and then finally in the next year as their current ratio fell dramatically it was enough to actually pull their acid test ratio under one which of course is caused for alarm it's not much below one so i mean it's not horrible yet um and since their current ratio is still well over one they're probably fine but it is definitely more concerning um than an acid test ratio of 1.8 and 2.9 from their chief uh competitor so definitely something to look at there next we've got our gross margin ratio so we talked earlier about gross margin we said that was sales minus cost of goods sold so you see that built into the top so gross margin ratio is gross margin overnight sales or just net sales minus cost will be sold overnight sales once again you see here for whatever company this is they've got their gross margin they've got their net sales they're able to compute gross margin ratio for each of the three years looks like it's pretty stable around 46 percent um 46 two years ago up to 46.2 down a little bit um certainly probably want to look into it and see what caused this change because you can see their sales did go up um by quite a bit actually but their gross margin just barely ticked up so something is going on here you definitely want to figure out what is causing that because this trend could be negative if it continues but so far not enough of a change for me to really move into you know full-blown panic mode at this point with that that of course wraps up the end of the chapter if you do want to go through and look at the periodic information i do think it is worth looking at if it will be tested i will be sure to of course tell you that in class um but if you're an accounting major or minor i strongly recommend you review that appendix as it is heavily tested in future accounting courses and certainly something you want to be familiar with so with that said that wraps us up here in chapter four so we'll see you back here for chapter five next time thank y'all so much