# The Calculation of Net Purchases

A number of new accounts have been introduced in this chapter. Purchases, Purchase Returns and Allowances, Purchase Discounts, and Freight-in have all been illustrated. Each of these accounts is necessary to calculate the "net purchases" during a period. Notice that the table at right reveals total purchases of \$400,000 during the period. This would be based on the total invoice amount for all goods purchased during the period, as identified from the Purchases account in the ledger. The cost of the purchases is increased for the freight-in costs. Purchase discounts and purchase returns and allowances are subtracted. The result is that the "net purchases" are \$420,000. Net purchases reflect the actual costs that were deemed to be ordinary and necessary to bring the goods to their location for resale to an end customer. Importantly, storage costs, insurance, interest and other similar costs are considered to be period costs that are not attached to the product. Instead, those ongoing costs are simply expensed in the period incurred as an operating expense of the business.

 Add: Purchases \$400,000 Freight-in 40,000 \$440,000 Less: Purchase discounts \$ 6,000 Purchase returns & allowances 14,000 20,000 Net purchases \$420,000

# Cost of Goods Sold

Early in this chapter, it was indicated that the cost of purchases must ultimately be allocated between cost of goods sold and inventory, depending

on the portion of the purchased goods that have been resold to end customers. This allocation must also take into consideration any beginning inventory that was carried over from prior periods.

Very simply, goods that remain unsold at the end of an accounting period should not be "expensed" as cost of goods sold. Therefore, the calculation of cost of goods sold requires an assessment of total goods available for sale, from which ending inventory is subtracted.

With a periodic system, the ending inventory is determined by a physical count. In that process, the goods held are actually counted and assigned cost based on a consistent method. The actual methods for assigning cost to ending inventory is the subject of considerable discussion in the inventory chapter. For now, let's just take it as a given that the \$91,000 shown represents the cost of ending inventory.

Understanding the allocation of costs to ending inventory and cost of goods sold is very important and is worthy of additional emphasis. Consider the following diagram:

The beginning inventory is equal to the prior year's ending inventory, as determined by reference to the prior year's ending balance sheet. The net purchases is extracted from this year's ledger (i.e., the balances of Purchases, Freight-in, Purchase Discounts, and Purchase Returns & Allowances). Goods available for sale is just the sum of beginning inventory and net purchases. Goods available for sale is not an account, per se; it is merely an abstract result from adding two amounts together. Now, the total cost incurred (cost of goods available for sale) must be "allocated" according to its nature at the end of the year - if the goods are still held, those costs become an asset amount (inventory), and to the extent the goods are not still held, those costs are attributed to the cost of goods sold expense category.

# Detailed Income Statement for Merchandise Operation

Wow, what a lot of activity to consider - net sales, net purchases, cost of sales, gross profit, etc.! How do you keep all this straight? A detailed income statement provides the necessary organization of data in an understandable format. Study the following detailed income statement for Bill's Sporting Goods.

As you do so, focus on the following points:

o Note the calculation of net sales

o Note the inclusion of the details about net purchases

o Note the cost of sales

o Note the gross profit amount

o Note that freight-out is reported in the expense section

Be aware that the income statement you see for a merchandising company may not present all of this detail. Depending on the materiality of the individual line items, it may be sufficient to only present line items for the key elements, like net sales, cost of sales, gross profit, various expense accounts, and net income.

# Closing Entries

Because of all the new income statement related accounts that were introduced for the merchandising concern, it is helpful to revisit the closing process. Recall the importance of closing; to transfer the net income to retained earnings, and reset the income statement accounts to zero in preparation for the next accounting period. As a result, all income statement accounts with a credit balance must be debited and vice versa. The closing entries for Bill's Sporting Goods appear on the following page. Several items are highlighted in these journal entries, and are discussed further in the next paragraph.

These closing entries are a bit more complex than that from the earlier chapter. In particular, note that the closing includes all of the new accounts like purchases, discounts, etc. In addition, it is very important to update the inventory records. You may be confused to see inventory being debited and credited in the closing process. After all isn't inventory a balance sheet (real) account? And, don't we only close the temporary accounts? Why then is inventory included in the closing? The answer is that inventory must be updated to reflect the ending balance on hand. Remember that the periodic system resulted in a debit to purchases, not inventory. Further, as goods are sold, no entry is made to reduce inventory. Therefore, the Inventory account would continue to carry the beginning of year balance throughout the year. As a result, Inventory must be updated at the time of closing. The following entries accomplish just that objective by crediting/removing the beginning balance and debiting/establishing the ending balance. If you study these entries carefully, you will note that they include causing the Income Summary account to be reduced by the cost of sales amount (beginning inventory + net purchases - ending inventory).

 12-31-X5 Sales 750,000 Purchase Discounts 6,000 Purchase Returns & Allowances 14,000 Inventory 91,000 Income Summary 861,000 To close income statement accounts with a credit balance, and establish ending inventory balance 12-31-X5 Income Summary 850,000 Sales Discounts 7,000 Sales Returns & Allowances 3,000 Purchases 400,000 Freight-in 40,000 Advertising Expense 60,000 Freight-out 32,000 Depreciation Expense 18,000 Utilities Expense 29,000 Salaries Expense 134,000 Rent Expense 12,000 Inventory 115,000 To close income statement accounts with a debit balance, and remove the beginning inventory balance 12-31-X5 Income Summary 11,000 Retained Earnings 11,000 To close Income Summary to retained earnings (note that the balance is equal to the net income)