Accounting and Finance Foundations

Unit 7

Accounting and Finance Foundations Unit 7: Financial Statements 547

Financial Statements

Chapter 18

Student Guide

An important component to consider for the Cost of Goods Sold section of the income statement is the

net cost of purchases. The net cost of purchases includes freight-in charges on the purchases, purchase

returns and allowances, raw materials, labor, overhead costs, and/or discounts received by suppliers. The

Purchase Returns and Allowances account includes products that your company returned because the

products were wrong, defective, etc. The net cost of purchases is calculated as follows:

Add: Purchases 130,000

Freight-in 20,000

150,000

Less: Purchase discounts $0.00

Purchase Returns & Allowances (2,000)

Net Purchases $148,000

Freight charges and/or shipping costs may differ depending on your company’s shipping agreement. For

example, FOB (free on board) shipping point means that the seller of the goods delivers the goods to the

shipping point at your company’s expense. Goods shipped FOB (free on board) shipping point are included

in your company’s inventory upon shipment. FOB (free on board) destination means that the seller of the

goods is required to deliver the goods to the destination point at its expense. Goods shipped FOB destina-

tion are included in your company’s inventory when the products are received.

In Unit 6, we discussed the periodic inventory system and the perpetual inventory system. Under the per-

petual inventory system, inventory is recorded throughout the accounting period. The inventory account-

ing records include the quantity of inventory as well as all the costs of the products your company bought

or sold. Under the perpetual inventory system, the costs of the products are recorded in the Product Inven-

tory account when the items are purchased. When the items are sold, the merchandise is transferred from

the Product Inventory account to the Cost of Goods Sold account. The Purchase account is not used under

the perpetual inventory system. Companies that specialize in retail or that sell high-value items tend to use

the perpetual inventory system.

Under the periodic inventory system, the cost of goods sold is recorded at the end of the accounting

period as an adjusting entry. To calculate the cost of goods sold under this system, the cost of the physi-

cal inventory, based on actual count, is deducted from the cost of goods available for sale. Journal entries

are made at the end of the accounting period to zero the beginning inventory totals and to enter the ending

inventory of the current period. Therefore, you will see the figure for inventory on hand only on the balance

sheet.

The Income Statement Lesson 18.1 (cont’d)