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Chapter 5

Accounting for merchandising operations

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Learning objectives 1. Differentiate between a service business and a merchandising business 2. Identify the differences between the perpetual and the periodic inventory system 3. Record purchase transactions under the perpetual inventory system 4. Record sales transactions under the perpetual inventory system

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Learning objectives 5. Prepare adjusting and closing entries under the perpetual inventory system 6. Describe and prepare the multiple-step and single-step income statements

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Learning objective 1

Differentiate between a service business and a merchandising business

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Merchandising operations ▪ Merchandiser - a business that derives their earnings from buying and then selling products to customers – Service business derives earnings from providing services to customers

▪ Merchandise inventory - the goods purchased by a merchandiser for resale to customers – Also known as merchandise or inventory

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Merchandising operations Two types of merchandising businesses: 1. Wholesalers - businesses that purchase products and sell them to other wholesalers or retailers 2. Retailers - businesses that purchase their products from manufacturers or wholesalers and sell them to the end customer

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Merchandising and service businesses ▪ The main differences between a merchandising business and a service business can be seen by comparing the income statements of the two Merchandiser's Income Statement For the month ended May 31, 2011

Service Business Income Statement For the month ended May 31, 2011

$

$

Sales

1,000

Revenues

1,000

Cost of Goods Sold

(400)

Expenses

(500)

Gross Profit Expenses Net income/(Net loss)

600

Net income/(Net loss)

500

(100) 500

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Merchandising and service businesses ▪ The merchandiser uses a Sales or Sales Revenues account to record sales of merchandise – Service business uses a Revenues account to record earnings from providing services to customers

▪ Two new line items unique to merchandisers 1. Cost of goods sold 2. Gross profit

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Accounts unique to merchandisers Cost of goods sold ▪ The cost of the inventory sold by the business during the accounting period – Also known as cost of sales or cost of merchandise sold

Gross profit ▪ Net sales revenues minus the cost of goods sold ▪ Represents the amount of earnings the business has made from selling its goods – Also known as gross margin 10

Accounts unique to merchandisers ▪ Merchandisers also report the value of merchandise inventory purchased for resale in the Merchandise Inventory account – Also known as just Inventory

▪ Reported as a current asset in the balance sheet

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Operating cycle ▪ The duration of time between when the business acquires materials or services, uses them in their operations, and finally receives cash from selling their goods or services ▪ Length of time varies between business types – E.g. Fruit seller may be a few weeks – E.g. Car seller may be months

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Cost flow of inventory ▪ Operating cycle of a merchandiser can be translated into the cost flow of inventory over an accounting period – Net purchases: purchases less any purchases that are returned

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Learning objective 2

Identify the differences between the perpetual and the periodic inventory system

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Perpetual and periodic inventory systems ▪ Perpetual inventory system continuously keeps track of the value of inventory available for sale and cost of goods sold as each transaction occurs ▪ Periodic inventory system updates the value of inventory available for sale and the cost of goods sold only at the end of the accounting period

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Perpetual and periodic inventory systems ▪ Inventory transactions are demonstrated using the perpetual inventory system ▪ Periodic inventory system is illustrated in the appendix

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Learning objective 3

Record purchase transactions under the perpetual inventory system

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Invoice ▪ A bill created by the seller and sent to the buyer that contains the details of the sale ▪ It is a source document used by the seller to record the sale and by the buyer to record the purchase

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Invoice ▪ Seller ▪ Invoice date ▪ Invoice number ▪ Buyer ▪ Purchase order number ▪ Credit terms ▪ Shipping terms ▪ Merchandise details ▪ Invoice total 19

Purchase of merchandise for cash Example: ▪ Purchased 10 snowboards for $300 each (10 x $300 = $3,000) and paid for them in cash Purchase of merchandise for cash: Aug.

4 Merchandise Inventory Cash

(Purchased merchandise for cash.)

3,000 3,000

Purchase of merchandise on credit ▪ A credit sale credits the Accounts Payable account instead of the Cash account

Purchase of merchandise for cash: Aug.

4 Merchandise Inventory Accounts Payable

(Purchased merchandise on credit.)

3,000 3,000

Purchase returns and allowances ▪ Sometimes when an order of merchandise is received by the buyer it may need to be returned to the supplier ▪ A purchase return or allowance is an adjustment of the purchase price of merchandise recorded in the accounts of the buyer ▪ The difference between a purchase return and a purchase allowance is that the merchandise is not returned to the seller in a purchase allowance

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Purchase returns and allowances Example: ▪ Returned 3 snowboards for a full refund of (3 x $300 = $900) Purchase return: Aug.

6 Accounts Payable Merchandise Inventory

(Returned merchandise purchased on credit.)

900 900

Trade discounts on purchases ▪ Sellers may grant customers a reduction to the price of the goods if a minimum quantity is purchased ▪ A trade discount is a reduction of the list price of merchandise that is granted to the buyer ▪ The list price is the full price of an item listed in the catalog of the seller before deducting any trade discounts ▪ The value of the trade discount is not separately recorded in the accounts

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Trade discounts on purchases Example: ▪ Supplier offers 10% trade discount on snowboarding pants if total purchase is greater than $3,000 ▪ Purchased 30 pairs at a list price of $120 (30 x $120 = $3,600) ▪ Eligible for 10% discount (10% x $3,600 = $360) ▪ Amount recorded in Merchandise Inventory account ($3,600 - $360 = $3240) 25

Trade discounts on purchases Remember: ▪ Amount of trade discount is not recorded in the accounts! Trade discount on purchase: Aug.

7 Merchandise Inventory Cash

(Cash purchase of inventory with trade discount.)

3,240 3,240

Purchase discounts Purchase discounts: ▪ Discounts received for payment of an account within the discount period ▪ Recorded in the accounts of the buyer

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Credit terms Credit terms: ▪ Specify when the full amount of an invoice is due to be paid, including: – Percentage discount – Discount period – Credit period of an invoice

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Credit terms ▪ Credit terms may be stated as: 2/14, n/30 ▪ 2 = percentage discount ▪ 14 = discount period, the time that a customer has to take advantage of the purchase discount ▪ n/30 = net 30 = credit period, the time that a customer has to pay an invoice by the due date ▪ Where no discount is given terms are stated as n/30

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Credit terms Example:

2/14, n/30 ▪ The customer gets a 2% discount on the purchase price if the invoice is paid in full within 14 days of the invoice, otherwise they are liable to pay the full balance within 30 days of the invoice

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Credit period

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Credit terms ▪ Alternatively credit terms could be stated n/EOM (net end of month) ▪ n/15 EOM means that the invoice is to be paid in full 15 days after the end of the month in which the invoice was issued

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Example – calculating purchase discounts Steps to calculate purchase discounts: 1. Calculate the outstanding amount of the invoice to be paid 2. Calculate the amount of the discount 3. Calculate the amount of cash to be paid 4. Record the journal entry

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Example – calculating purchase discounts Example: ▪ Purchases = $3,000 ▪ Purchase returns = $900 ▪ Credit terms = 2/10 n/30 ▪ Paid invoice within discount period

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Example – calculating purchase discounts Step 1: Calculate the outstanding amount of the invoice to be paid Accounts Payable = Invoice total - purchase returns & allowances = $3,000 - $900 = $2,100

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Example – calculating purchase discounts Step 2: Calculate the amount of the discount

Discount = Accounts payable x discount (%) = $2,100 x 2% = $2,100 x 0.02 = $42

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Example – calculating purchase discounts Step 3: Calculate the amount of cash to be paid

Cash payment = Accounts payable - discount ($) = $2,100 - $42 = $2,058

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Example – calculating purchase discounts Step 4: Record the journal entry Purchase discount: Aug.

1 Accounts Payable Merchandise Inventory Cash

2,100 42 2,058

(Payment of accounts payable within discount period.)

▪ If the invoice was paid after the discount period then the journal entry for the repayment debits Accounts Payable and credits Cash for the full amount of the invoice less the purchase return

Transportation costs ▪ There are usually additional costs associated with transporting purchased goods ▪ Buyer and seller must agree who pays for these costs ▪ The party that owns the title of the goods is responsible for paying the costs incurred to transport the goods ▪ Shipping terms determine when the title passes from the seller to the buyer

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Shipping terms ▪ The FOB point (free on board) determines when the ownership passes from the seller to the buyer ▪ There are two FOB points: 1. FOB shipping point 2. FOB destination

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FOB shipping point FOB shipping point: ▪ Title of the goods passes to the buyer when the merchandise leaves the shipping point ▪ The buyer is responsible for paying transport costs and bears the risk of damage to the goods while they are in transit

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FOB destination FOB destination: ▪ Title of the goods passes to the buyer when the merchandise arrives at the buyers ▪ The seller is responsible for paying transport costs and bears the risk of damage to the goods while they are in transit

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Shipping Terms

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Example – transportation costs ▪ $90 charge to transport snowboards from the seller to the buyer ▪ Different journal entries depending on whether it is the seller or the buyer that pays for these costs

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Example – transportation costs FOB shipping point: ▪ Buyer records the payment as part of inventory because it is a cost incurred to transport the inventory and prepare it so it is ready to be sold FOB shipping point transportation charges (in the books of the buyer): Aug.

4 Merchandise Inventory Cash

(Paid transportation charges with cash.)

90 90

Example – transportation costs FOB destination: ▪ Seller records the payment in the Delivery Expense account ▪ This is because transport charges are considered costs incurred in order to sell the merchandise, not a cost of the merchandise itself FOB destination transportation charges (in the books of the seller): Aug.

4 Delivery Expense Cash

(Paid transportation charges with cash.)

90 90

Learning objective 4

Record sales transactions under the perpetual inventory system

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Sale of merchandise on credit ▪ Perpetual inventory system requires two journal entries ▪ One records the revenue earned ▪ The other transfers the cost of the merchandise sold to an expense account and records the reduction of the value of the inventory held

Sale of merchandise on credit Example: ▪ Sold 5 Slopestyle jackets on credit for $450 each (5 x $450 = $2,250) ▪ Cost $200 each (5 x $200 = $1,000)

Sale of merchandise on credit Sale of merchandise on credit (record revenue earned): Aug.

17 Accounts Receivable

2,250

Sales Revenues

2,250

(Sold merchandise on credit.)

Sale of merchandise on credit (transfer asset to expense account): Aug.

17 Cost of Goods Sold Merchandise Inventory

(Cost of merchandise sold.)

1,000 1,000

Sales returns and allowances ▪ A sales return or allowance is an adjustment to the selling price of merchandise recorded in the accounts of the seller ▪ The difference between a sales return and a sales allowance is that the merchandise is not returned to the seller in a sales allowance ▪ Different journal entries for the sales return and the sales allowance

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Sales returns and allowances A sales return must record two journal entries: 1. The reduction in the revenue earned and associated asset, either Cash or Accounts Receivable 2. The increase in the merchandise inventory held by the business and the reduction in the expense of the cost of merchandise sold A sales allowance only records the first entry because the merchandise is not returned

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Sales returns and allowances ▪ Reduction in revenue is recorded in an account called Sales Returns and Allowances ▪ Sales Returns and Allowances is a contra revenue account that has a normal debit balance ▪ It is reported as a reduction in sales revenue in the income statement

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Example – sales return Example: ▪ Customer returned 2 Slopestyle jackets ▪ Originally sold for $450 each (2 x $450 = $900) ▪ Cost $200 each (2 x $200 = $400) ▪ Jackets were in good condition so can be returned to inventory at full cost

Example – sales return Sales return (reduction in revenue and asset): Aug.

21 Sales Returns and Allowances

900

Accounts Receivable

900

(Customer returned merchandise purchased on credit.)

Sales return (merchandise returned to inventory): Aug.

21 Merchandise Inventory Cost of Goods Sold

(Cost of merchandise returned to inventory.)

400 400

Sales returns – damaged goods ▪ If the goods are returned damaged then an estimate is made as to how much they can be sold for ▪ If they are estimated to be sold for lower than their original cost, then they must be recorded in inventory at this lower value ▪ The difference in the new selling price and the cost of the merchandise is recorded as a debit to an expense account called Loss from Defective Merchandise

Sales returns – damaged goods Example: ▪ Customer returned 2 Slopestyle jackets ▪ Cost $200 each (2 x $200 = $400) ▪ Estimated can only be sold for $150 each (2 x $150 = $300) ▪ Difference is loss from defective merchandise ($400 - $300 = $100)

Sales returns – damaged goods ▪ First journal entry to record the reduction in revenue and asset is the same ▪ Second journal entry to record the merchandise returned to inventory recognizes the loss from the damaged goods Sales return (damaged merchandise returned to inventory): Aug.

21 Merchandise Inventory Loss from Defective Merchandise Cost of Goods Sold

(Cost of damaged merchandise returned to inventory.)

300 100 400

Sales allowance ▪ A sales allowance may refund part or all of the purchase price ▪ The buyer keeps the merchandise, so the seller only needs to record the first journal entry

Example - sales allowance Example: ▪ The goods arrived damaged at the buyers ▪ Seller agreed to a $340 reduction in the price of the goods Sales allowance (only records the reduction in revenue and asset): Aug.

21 Sales Returns and Allowances Accounts Receivable

340 340

(Sales allowance for damaged merchandise.)

▪ The buyer kept the goods so the seller does not record the return of the merchandise to inventory

Trade discounts on sales ▪ Sellers may grant customers a reduction to the price of the goods if a minimum quantity is purchased ▪ The value of the trade discount is not separately recorded in the accounts

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Example - trade discounts on sales Example: ▪ The list price of snow mittens is $100 ▪ A 20% trade discount is given for purchases of 10 or more, so discount price is $80 each ▪ A customer purchases 10 for $80 each ▪ Seller records revenue of $800 based on the discounted price (not the list price)

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Sales discounts Sales discounts: ▪ Discounts offered to customers to encourage payment of their account within the discount period ▪ Recorded in the accounts of the seller ▪ Sales returns and allowances and any transport costs on the invoice do not receive the discount

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Example – calculating sales discounts Steps to calculate sales discounts: 1. Calculate the outstanding amount of the invoice to be received from customer 2. Calculate the amount of the discount 3. Calculate the amount of cash to be received 4. Record the journal entry

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Example – calculating sales discounts Example: ▪ Invoice total = $ 4,500 ▪ Sales returns = $850 ▪ Transport costs = $250 (included in invoice total) ▪ Credit terms = 3/14 n/60 ▪ Customer paid invoice within discount period

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Example – calculating sales discounts Step 1: Calculate the outstanding amount of the invoice to be received from customer Accounts Invoice = Receivable total

Sales returns Transport & allowances costs

= $4,500 - $850 - $250 = $3,400

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Example – calculating sales discounts Step 2: Calculate the amount of the discount

Discount = Accounts receivable x discount (%) = $3,400 x 3% = $3,400 x 0.03 = $102

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Example – calculating sales discounts Step 3: Calculate the amount of cash to be received

Cash receipt = Accounts receivable - discount ($) = $3,400 - $102 = $3,298

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Example – calculating sales discounts Step 4: Record the journal entry Sales discount: Aug.

27 Cash Sales Discounts Accounts Receivable

3,298 102 3,400

(Receipt of accounts receivable within discount period.)

▪ If the invoice was paid after the discount period then the journal entry for the cash receipt debits Cash and credits Accounts Receivable for the full amount of the invoice less the sales return

Sales Taxes ▪ Most states and many other taxation authorities impose a tax on the sale of merchandise to the final consumer ▪ Seller collects tax at time of sale, incurring a liability to forward the tax to the taxation authority ▪ Recorded in the Sales Tax Payable account ▪ Sales taxes usually stated as a % of the sales price

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Example – sales taxes Example: ▪ Sales price = $100 ▪ Sales tax = 5% = $5 ▪ Price charged to customer = $105 Credit sale with sales tax: Aug.

30 Cash Revenues Sales Tax Payable

(Credit sale with sales tax.)

105 100 5

Example – sales taxes ▪ Periodically, the seller remits the tax collected over a period to the taxation authority in one lump sum

Payment of sales tax to taxation authority: Jan.

15 Sales Tax Payable Cash

(Paid sales tax collected to taxation authority.)

7,000 7,000

Sales taxes ▪ Taxation authorities normally exempt businesses from paying sales taxes on merchandise purchased if that merchandise is to be resold to customers and they hold a resellers certificate ▪ Generally only the final consumer that pays the sales taxes on their purchases

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Learning objective 5

Prepare adjusting and closing entries under the perpetual inventory system

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Adjusting entries for a merchandiser ▪ At the end of the accounting period a physical inventory count is taken ▪ This is used to calculate the dollar value of the inventory on hand ▪ The value of inventory on hand is compared to the balance of the Merchandise Inventory account ▪ These values are rarely equal due to inventory shrinkage

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Inventory shrinkage ▪ Inventory shrinkage (or shortage) is the reduction in the value of inventory due to: – Theft – Deterioration – Breakage – Errors in the Merchandise Inventory account

▪ Calculated as the difference between the value of Inventory reported in the Merchandise Inventory account and the value of inventory revealed through the inventory count 76

Inventory shrinkage ▪ An adjusting entry is recorded to make the balance of the Merchandise Inventory account equal to the value of inventory physically on hand ▪ Inventory shrinkage is recorded in the Cost of Goods Sold account when not material

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Example - inventory shrinkage Example: ▪ Balance of Merchandise Inventory account before adjustment = $70,000 ▪ Inventory count = $68,000 worth of inventory on hand ▪ Shrinkage = $70,000 - $68,000 = $2,000

Example - inventory shrinkage Journal entry:

Inventory shrinkage: Aug.

31 Cost of Goods Sold Merchandise Inventory

(Adjusting entry for inventory shrinkage.)

2,000 2,000

Inventory shrinkage ▪ If the shrinkage is material, then may need to be disclosed as a separate line item on the income statement ▪ Debit Loss on Inventory Shrinkage rather than Cost of Goods Sold

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Closing entries of a merchandiser ▪ At the end of the accounting period closing entries are recorded ▪ Same steps for both service businesses and merchandisers: – Step 1: Close all temporary accounts with a credit balance to the Income Summary account – Step 2: Close all temporary accounts with a debit balance to the Income Summary account. – Step 3: Close the Income Summary account to equity – Step 4: Close the Withdrawals account to equity 81

Closing entries of a merchandiser ▪ First two steps include closing the additional temporary accounts unique to merchandising operations ▪ Last two steps are the same as for service businesses so will not be shown ▪ Accounts unique to merchandisers are highlighted

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Step 1: Close accounts with credit balance ▪ Merchandiser uses the Sales Revenues account rather than the Revenues account used by the service entity Journal entry to close all temporary accounts with a credit balance: Dec.

31 Sales Revenues Income Summary

(To close temporary accounts with a credit balance.)

200,000 200,000

Step 2: Close accounts with debit balance ▪ Merchandiser has additional expense accounts that need to be closed at the end of the accounting period Journal entry to close all temporary accounts with a debit balance: Dec.

31 Income Summary

110,000

Sales Returns and Allowances

2,000

Sales Discounts

4,000

Cost of Goods Sold Delivery Expense Other Expenses

(To close temporary accounts with a debit balance

70,000 6,000 28,000

Learning objective 6

Describe and prepare the multiple-step and single-step income statements

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Multiple step income statement ▪ Multiple-step income statement is an income statement format that presents revenues and expenses of the business under several categories ▪ Highlights the relation between categories through the use of subtotals

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Multiple step income statement There are three main sections of the multiple-step income statement: 1. Calculation of gross profit 2. Income from operations 3. Nonoperating items Together these sections result in the net income or net loss for the period

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Calculation of gross profit ▪ Gross profit shows the amount of gross profit earned through the principle revenue generating activities of the business Extremely Board Income Statement (extract) For the month ended December 31, 2011 $ Sales Revenues

$ 200,000

Sales returns and allowances

(2,000)

Sales discounts

(4,000)

(6,000)

Net sales

194,000

Cost of goods sold

(70,000)

Gross profit

124,000

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Income from operations ▪ Income from operations represents the income earned from the central operations of the business ▪ For a merchandiser or manufacturer it is calculated as gross profit less the operating expenses of the business ▪ For a service business it is calculated as operating revenues less operating expenses

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Income from operations ▪ Operating expenses of the business are further subdivided into two expense categories ▪ Selling expenses are the expenses incurred in selling the merchandise of the business ▪ Include: – Advertising costs – Display costs – Storage costs – Selling and delivery costs

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Income from operations ▪ General and administrative expenses are the expenses incurred to support the running of the business ▪ Include expenses incurred for business support services such as human resource management and the accounting and finance departments

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Income from operations $

$

Gross profit

$ 124,000

Operating expenses: Selling expenses: Wages expense - sales staff

(11,000)

Delivery expense

(6,000)

Advertising expense

(5,000)

Total selling expenses

(22,000)

General and administrative expenses: Salaries expense - office staff Depreciation expense - office equipment Total general and administrative expenses Total operating expenses Income from operations

(10,000) (2,000) (12,000) (34,000) 90,000

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Nonoperating items and net income ▪ Nonoperating items are items that are not involved in the central operations of the business ▪ Generally either: – Small in value so as not to be considered part of the main operations of the business – Items that do not recur each period

▪ Nonoperating items may be divided into two classifications

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Nonoperating items and net income 1. Other revenues and gains may include: ▪ Interest revenue ▪ Dividend revenue ▪ Rent revenue ▪ Gains made by selling an item of property, plant or equipment

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Nonoperating items and net income 2. Other expenses and losses may include: ▪ Interest expense ▪ Losses from the sale of property, plant and equipment ▪ You will learn about some of these items later

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Nonoperating items and net income ▪ Finally, the net income earned or the net loss incurred during the period is calculated as the final bottom line of the income statement

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Income from operations $

$

$

Income from operations

90,000

Other revenues and gains: Dividend revenues

2,000

Gain on sale of equipment

5,000

Total other revenues and gains

7,000

Other expenses and losses: Interest expense Total other expenses and losses Net income / (Net loss)

(1,000) (1,000) 96,000

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Single-step income statement ▪ Single-step income statement is an income statement format that presents all of the revenues of the business together and then subtracts all of the expenses in one step to arrive at the net income or loss of the business ▪ More difficult for users to compare and analyze the gross profit or income from operations of the business ▪ No breakdown of expense categories ▪ But is simpler to prepare 98

Single-step income statement $

$

Revenues Net sales

194,000

Dividend revenues

2,000

Gain on sale of equipment

5,000

Total revenues

201,000

Expenses Cost of goods sold

(70,000)

Selling expenses

(22,000)

General and administrative expenses

(12,000)

Interest expense Total Expenses Net income / (Net loss)

(1,000) (105,000) 96,000

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