I'm Larry Walther, and this is principlesofaccounting.com, Chapter 5.
In this particular module, we will look at purchase recognition issues for
the merchandising business.
Now there are a number of considerations related to this learning goal.
So I have several videos that relate.
This first relates to the gross versus net recording under a periodic inventory
system.
Recognize that inventory are the goods held for resale.
And that a business needs to be very mindful of their inventory levels.
Financial difficulties can quickly arise
if a large portion of inventory held by a business remains unsold.
Goods go out of style, becomes obsolete, and so forth.
That is a very treacherous area that has taken down many businesses.
So business managers must pay very close attention to inventory content and level.
The first phase of acquiring inventory is the acquisition.
And inventory acquisitions, or really, inventory in total,
can be accounted for under a perpetual system.
Which is a real-time inventory system that updates inventory records with each
purchase and sale transaction.
Or with a periodic inventory system.
This is a system that utilizes a purchases account.
It does not update the inventory records with each transaction.
We determine our ending inventory by a physical count.
The periodic system is easier to implement, but
far less robust in terms of providing accounting information.
Again, this particular module is going to look at the periodic system.
In a subsequent module, we'll look closer at the perpetual system.
So now focusing on the periodic inventory system.
When inventory is purchased, we debit purchases and credit accounts payable.
I'm assuming we're buying on account there.
The Purchases account is unique to the periodic system.
It's not an expense or an asset, it is a unique account.
Its balance represents total inventory purchases during a period.
And the amount of total inventory that purchased during a period eventually
needs to be apportioned between cost of goods sold and inventory.
So here I have on the left the total purchases in the pie chart.
And we need to asses of the total purchases.
How much of those purchases were actually sold and
should be subsequently recognized as cost of goods sold?
And how much of the purchases remain in the inventory at the end of a period?
So we have an apportionment process for the account.
Now let's turn our attention to purchase returns and allowances.
These will be goods that we've purchased and returned to our supplier.
How do we account for this transaction?
First we might prepare a debit memorandum to indicate to the purchaser
that we are debiting their accounts payable account.
On our books, our accounts payable, reflecting what we owe them,
is being debited.
Meaning we're reducing the payable,
we're not intending to pay because we've returned the item.
The off-setting credit to that debit is to purchase returns and allowances.
Here's a journal entry.
I'm returning $1,000 of goods, I'm debiting accounts payable.
That's reflective of the debit memorandum.
I'm not intending to pay the payable that we're carrying on our books,
the reduction.
And the credit is purchase returns and allowances.
Rather than crediting the purchase account,
we'll credit this purchase returns and allowances account.
The reason for keeping purchase returns and allowances in a separate account is so
we have a sence of what level of returns we're making.
Even, perhaps, who those goods are being returned to and the reasons for that.
Purchase returns and allowances are subtracted from purchases
to calculate the amount of net purchases for a period.
Another item that's subtracted in calculating net purchases
are purchase discounts.
This would describe the cash discounts from the purchaser's perspective.
We're buying goods, they may be slight discounts, but
it's good business practice to take those discounts.
It represents substantial savings over time.
Our accounting system needs to be sufficiently robust to allow us to
identify discounts and be sure to pay on time to take those discounts.
Occasionally, a vendor may take a payment late and still grant the discount.
But the sure process is to pay on time to get the discount.
Now if we look at how we're going to account for the recording of these,
we're gonna look at two methods, a gross method and a net method.
They yield eventually the same bottom line affects, but
just is simply a different emphasis in our accounting system.
Under the gross method, if we buy $5,000 of goods subject to a 2% discount,
I will record purchases and accounts payable at a full $5,000 purchase amount.
We're not yet reflecting the possibility of a discount.
This is the gross amount of the purchase.
If we pay in time to get the discount,
then we'll record the discount in a separate account.
So here I'm paying $4,900.
I'm taking the $100, or 2% of $5,000, discount.
So I'm actually going to go ahead and
debit accounts payable the amount on my books.
But credit cash only $4,900, the amount I'm paying.
The difference is credited to purchase discount.
Again, a contract account for
the purchases account, an amount that's subtracted from purchases.
If payment is made outside of the discount period, then all we'll
need to do is credit cash and debit accounts payable for the full amount.
We're not entitled to the discount.
If we look at exactly the same transaction under the net method,
the initial purchase is recorded for the net amount.
So here I'm recording the purchases for $4,900,
anticipating the taking of the discount already.
If payment is made within the discount period, it's very simply a matter
of crediting cash and debiting accounts payable for the amount that's due, 4,900.
If the payment is made late,
however, then I need to record the full $5,000 credit to cash.
But only $4,900 to show the reduction of the account payable,
the amount that was initially established when I bought the goods.
Now I'm going to have a debit a Purchase Discounts Lost account.
That's an additional cost that would be added to the purchases.
Or, perhaps, even showing as a financing cost in the income statement.
There's a couple of ways that could be handled, but
it clearly increases the cost of the goods.
Let's close by comparing the gross and net methods.
The Purchase Discounts Lost account is only used with the net method.
And it draws attention to the fact that discounts are not being taken.
That's a good bit of information for managers to be aware of,
what discounts are being lost.
However, the Purchase Discounts Account that reflects the discounts taken,
is only used under the gross method.
So we have a difference there.
So here's an example comparing the two with the discount taken.
On the left, I show purchases 5,000 less purchase discounts taken of $100.
My purchases net to $4,900.
Under the net method, I've got purchase plus purchase discounts lost of 0.
So I've got $4,900 in either case.
That's what I paid for the goods.
That's what I'm reflecting when I took the discount.
A different presentation, a different set of debits and
credits to come to the same end result.
If the discount had not been taken, under the gross method,
I would simply show gross purchases of $5,000.
There's no discounts.
And under the net method, I show purchases of 4,900 plus the purchase discounts lost.
But again, I've spent $5,000 and measured that under either system.
So it really goes to the issue of what information are you trying to
glean from your accounting records.
Am I trying to first and foremost identify the discounts that I'm not taking?
Or do I wanna know the dollar value of discounts that are taken?
For businesses that have a policy of taking all discounts,
the net method is very good.
Because it helps management identify any discounts that are not lost,
breakdowns in the information system.