Accounting for Merchandising Businesses

Accounting for Merchandising Businesses
Chapter Four Accounting for Merchandising Businesses Previous chapters have discussed accounting for service businesses. These businesses obtain revenue by providing some kind of service. This chapter introduces accounting practices for merchandising businesses.

Inventory Inventory is tangible property that is held for resale or will be used in producing goods or services. Inventory is reported on the balance sheet as an asset. Types of inventory: Merchandise inventory Raw materials inventory Work in process inventory Finished goods inventory manufacturer

Inventory Cost The cost principle requires that inventory be recorded for the price paid or the consideration given up. What type of transaction is the purchase of inventory? Asset Exchange if cash paid. Asset Source if “on account”.

Inventory Cost The amount recorded for inventory should include:
Invoice price (minus purchase discounts), transportation-in costs (also called “freight-in”), inspection costs, and preparation costs. The company should accumulate costs of purchases until raw materials are ready for use or until merchandise is ready for shipment to customers.

Income Statement Change
Because of Cost of Goods Sold, the format for the Income Statement is modified: Net Sales ,500 Less: Cost of goods sold ,000 Gross Profit Margin ,500 The difference between sales revenue and cost of goods sold is called gross margin or gross profit. Selling and administrative expenses are subtracted from gross margin to arrive at net income.

Product Costs Versus Selling and Administrative Costs
Costs that are included in inventory. Selling & Admin. Costs Costs that are not included in inventory. They are sometimes called period costs. Part I Inventory costs are shown on the balance sheet in an asset account named Merchandise Inventory. Inventory costs are frequently called product costs. Examples of inventory costs include the price of the goods purchased, shipping and handling costs, transit insurance, and storage costs. Part II Costs that are not included in inventory are usually called selling and administrative costs or period costs. Examples of period costs include advertising, administrative salaries, sales commissions, insurance and interest.

Cost of Goods Sold Cost of goods sold is calculated as the number of units sold during the period multiplied by their unit costs. Cost of goods sold is a major expense item for most non-service businesses. The measurement of cost of goods sold is an excellent example of the application of the matching principle Why? The Cost of Goods Sold EXPENSE is recorded in the period the units are SOLD (REVENUE is recognized), regardless of when the units are paid for. So, the EXPENSE is MATCHED against the related REVENUE.

Cost of Goods Sold Beginning inventory Add: Purchases (net)
Cost of Goods Available for Sale Deduct: Ending inventory Cost of goods sold Cost of Goods Available for Sale expresses the total cost of what has been available for sale throughout a given time period.

Allocation of Inventory Cost Between Asset and Expense Accounts
Cost of Goods Available for Sale Merchandise Inventory (Balance Sheet) Cost of Goods Sold (Income Statement) Part I The amount of inventory that is available for sale during a specific accounting period is calculated as beginning inventory plus purchases. Part II The cost of goods available for sale is allocated between the asset account Merchandise Inventory and an expense account called Cost of Goods Sold. The Merchandise Inventory account reports the cost of inventory items that have not been sold during the period. The cost of items sold is reported in the expense account, Cost of Goods Sold. 5-9 9

Purchase $4,000 of Office Supplies
Date Account Title Debit Credit Jan. 6 Supplies 4,000 Cash ,000 Post from General Journal to the General Ledger Supplies Cash 4,000 4,000

Record use of $3,000 of Supplies
$1,000 of Supplies left over at the end of the month Date Account Title Debit Credit Jan. 30 Supplies Expense 3,000 Supplies ,000 Record use of $3,000 of Supplies Post from General Journal to the General Ledger Supplies Expense Supplies 3,000 3,000

Purchase 1,000 units of Inventory for $4,000
Date Account Title Debit Credit Jan. 6 Inventory 4,000 Cash ,000 Purchase 1,000 $4.00 each Post from General Journal to the General Ledger Inventory Cash 4,000 4,000

Record sale of 750 units of Inventory
$1,000 of Inventory left over at the end of the month Date Account Title Debit Credit Jan. 30 Cost of Goods Sold 3,000 Inventory ,000 Record sale of 750 units of Inventory Post from General Journal to the General Ledger Cost of Goods Sold Inventory 3,000 3,000

Record sale of Inventory @ $10 each
$3,000 of Inventory was sold for $7,500 Cash Date Account Title Debit Credit Jan. 30 Cash ,500 Revenue ,500 Record sale of $10 each Post from General Journal to the General Ledger Cash Sales Revenue 7,500 7,500

Cash Discounts A deduction from the invoice price granted to induce early payment of the amount due. Terms Time Due Discount Period Full amount less discount Credit Period Full amount due Purchase or Sale Cash discounts are a deduction from the invoice price granted to induce early payment of the amount due. If payment is made within the discount period, a reduction is given. If payment is not made within the discount period, the full amount of the invoice is due.

Terms of Sales & Purchases
Discount Terms: 2/10, n/30 (for example) 2% discount if balance paid in ten days, remainder to be paid within 30 days of sale tells when and how much must be paid There is a high interest cost of not taking purchase discounts when offered.

2/10, n/30 Cash Discounts Percentage of Discount
Cash discount terms are typically written as this slide shows. This particular discount term would be read as “two ten net thirty.” The first number represents the discount percentage. The second number represents the discount period. The letter “n” stands for the word net. The last number represents the entire credit period. In this case, if the customer pays within 10 days, then a 2% discount may be taken. If not, then all of the amount is due within 30 days. Percentage of Discount # of Days Discount Is Available Otherwise, the Full Amount Is Due # of Days when Full Amount Is Due

Terms of Sales & Purchases
F. O. B. (Free On Board) shipping point or F.O.B. destination tells who pays for the shipping and when ownership “title” passes from the seller to the buyer. Transportation costs are sometimes included in the cost of merchandise inventory. For example, when buyers pay transportation costs to get merchandise inventory to them, the transportation costs are included in the merchandise inventory cost. F O B terms designate when title passes and who pays the transportation cost. F O B stands for Free On Board. So, if the shipping terms are Free On Board shipping point, that means that ownership transfers from the seller to the buyer when the seller provides the goods to the carrier. It also means that the buyer will pay the transportation cost. On the other hand, if the shipping terms are Free On Board destination, that means that ownership transfers from the seller to the buyer when the buyer receives the goods. It also means that seller will pay the transportation cost. So, if goods are shipped F O B shipping point, then the buyer owns the goods in transit and will pay the transportation costs. This transportation cost will be added to the Merchandise Inventory account.

FOB Shipping and FOB Destination
FOB Shipping Point: Buyer pays the shipping costs because ownership “title” transfers to buyer at the point the shipment starts on its journey. FOB Destination: Seller pays shipping costs because title does not transfer to the buyer until the goods reach their destination (the buyer’s place of business).

Who Pays for FOB? Supplier Destination Business Customer
Shipping Point Supplier Destination – Supplier pays Destination Business Shipping Pt – Business pays Shipping Point Destination – Business pays Destination Shipping Pt – Customer pays Customer

Purchased 1000 units for $4 each on account. (Terms: 2/10, n/30)
Asset Source Transaction Let’s see how a perpetual inventory system works by looking at the following transactions.

1. Journalize & Post the purchase.

Paid a trucking company $500 to deliver the purchased units to our warehouse.
Freight charges paid to get inventory to our place of business (called TRANSPORTATION IN) is part of the cost of the purchase. It is added to the Inventory account, thus increasing the asset value. It is NOT “expensed”. Recall that shipping costs incurred for inventory are product costs and are recorded as part of the inventory asset account. Asset Exchange Transaction

2. Journalize & Post the transportation cost

3. Sold 620 units on account for $6 each. (Terms 1/10, n/30)
3a. Record the Sales Revenue and related Receivable. $6 sales price x 620 units = $3720 Asset Source Transaction

3a. Journalize and Post the sale.

What is the cost of each item in inventory?
3b. Record the Cost of the Goods Sold and their removal from inventory. What is the cost of each item in inventory? $4.00 invoice price + $0.50 transportation = $4.50 per unit $500 transport / 1000 units 620 units sold x $4.50 cost each = $2790 Group Work ex 5-4

620 units sold x $4.50 cost each = $2790
3b. Record the Cost of the Goods Sold and their removal from inventory. 620 units sold x $4.50 cost each = $2790 Cost of goods sold Group Work ex 5-4 Asset Use Transaction

3b. Journalize and Post the cost of the sale.
Group Work exercise 5-4

4. The customer in Transaction #3A returned 20 units for credit.
4a. Remove the previously recorded Sales Revenue and related Account Receivable. A separate “Sales Return” contra-revenue account may be used. $6 sales price x 20 units = $120 Asset Use Transaction

4a. Journalize and Post the sales return.

4b. Put the cost of the 20 returned units back into inventory and out of Cost of Goods Sold. (Recall, the units were “costed out” of inventory and charged to Cost of Goods Sold at $4.50 each in Tr. #3b.) Reduction in “Cost of Goods Sold”. $4.50 x 20 units = $90 Asset Source Transaction

4b. Journalize and Post the return to inventory.

5a. The Transaction #3a customer paid within the ten day discount period. Record the Sales Discount. (1/10, n/30) Original Account Receivable (Transaction 3a) $3,720 Less: Sales Return (Transaction 4a) Amount owed by customer before discount 3,600 x 1% sales discount % Sales Discount $ Asset Source Transaction

5a. Journalize and Post the 1% Sales Discount.

5b. The Transaction #3a customer paid within the ten day discount period Record the cash collection. Original Account Receivable (Transaction 3a) $3,720 Less: Sales Return (Transaction 4a) (120) Less: Sales Discount (Transaction 5a) (36) Cash receipt that will satisfy the account $3,564 Asset Exchange Transaction

5b. Journalize and Post the cash collection.

Returned 50 units to our supplier who granted us credit for the cost of the items but not for any transportation costs. Supplier cost was $4.00 per unit x 50 = $200. Transportation cost recorded when units were purchased was $0.50 per unit x 50 = $25. Technically, this LOSS should be reported in the operating expense section of the income statement. However, this loss is usually NOT MATERIAL, so most companies record it as an increase in the COST OF GOODS SOLD expense account. That’s what we’ll do here.

6. Returned 50 units to our supplier who granted us credit for the cost of the items but not for any transportation costs.

7. A physical inventory count shows 340 units on-hand, indicating 10 units have been lost.
Units in Beginning Inventory + Units Purchased this period ( purchase returns) = Units Available for Sale Units Sold (620 – 20 sales returns) (600) = Units that should be in ending inventory Actual ending inventory from count (340) = Units missing x $4.50 cost per unit $45.00

Technically, this LOSS should be reported in the operating expense section of the income statement. However, this loss is usually NOT MATERIAL, so most companies record it as an increase in the COST OF GOODS SOLD expense account. That’s what we’ll do here.

8a. Paid within discount period, so record the % discount on the $4000 Tran. #1 purchase less $200 Tran. #6 return. Purchase (Transaction #1) $4000 Less Purchase Return (Trans. #6) Amount owed X discount % % Amount of Purchase Discount $ 76 This reduces the cost of the inventory and the amount we owe the supplier.

8a. Paid within discount period, so record the discount on the $4000 Tr. #1 purchase less $200 Tr. #6 return.

8b. Paid the remaining balance on the Transaction #1 inventory purchase. $4000 purchase (Trans. #1) purchase return (Trans. #6) purchase discount (Trans. #8a) $3724 remainder to pay supplier

8b. Paid the remaining balance on the Transaction #1 inventory purchase. ($4000-200-76=$3724 to pay)

9. The Sale recorded in Transaction #3a was made with terms of F. O. B
9. The Sale recorded in Transaction #3a was made with terms of F.O.B. destination Record payment of the $340 shipping cost. Transportation charges on PURCHASES are added to the cost of the asset, INVENTORY. (Transportation IN) Transportation charges to ship products TO CUSTOMERS are reported as operating expenses on the income statement. The appropriate account title is TRANSPORTATION OUT (or FREIGHT OUT or SHIPPING EXPENSE).

9. The Sale recorded in Transaction #3a was made with terms of F. O. B
9. The Sale recorded in Transaction #3a was made with terms of F.O.B. destination. Record payment of the $340 shipping cost.

Clock Company Ending Balances of LEDGER Accounts

Transaction Analysis The following selected events occurred during 2004 at Clock Company which uses the PERPETUAL INVENTORY SYSTEM. For each event: Determine the effect on the financial statements. Record the event in the journal and ledger.

Lost, Damaged, or Stolen Inventory
Most merchandise companies experience some level of inventory shrinkage, a term that reflects decreases in inventory for reasons other than sales to customers. Most merchandise companies experience some level of inventory shrinkage, a term that reflects decreases in inventory for reasons other than sales to customers.

Lost, Damaged, or Stolen Inventory
Assume a company determined that $500 of inventory was lost through shrinkage. Here is how it would effect the statements: Part I Assume a company determined $500 of inventory was lost through shrinkage. Here is how it would effect the statements: Assets would decrease $500 and equity would decrease $500. Part II In general journal form, the entry would be debit Inventory Loss (or Cost of Goods Sold) and credit Inventory for $500. Part III Theoretically, inventory losses are operating expenses. However, because such losses are normally immaterial in amount, they are usually added to cost of goods sold for external reporting purposes. In general journal form, the entry is as follows:

Timing is EVERYTHING... Recognize revenue when “earned”
earned when an exchange (seller to buyer) occurs Three levels of the matching principle Product costs (e.g., inventory costs): assets until produce revenue direct cause & effect relationship between revenue and expense Period costs: systematic & rational allocation e.g., depreciation costs Period costs: recognize as expense as incurred e.g., advertising costs

Perpetual Inventory Systems
The inventory account is continuously updated for the following events: Purchases Purchase Discounts Taken Purchase Returns & Allowances Sales (remove from inventory the COST of the units sold) Sales Returns (add to inventory the COST of units returned) The necessary detailed record-keeping required by the perpetual system has become much easier with current computer technology. A physical count of the inventory is still required at the end of the accounting period to assure accurate inventory records in case of errors or theft. Most modern companies maintain their inventory records using the perpetual inventory system. This inventory system adjusts the inventory account perpetually (continually) throughout the accounting period for each purchase or sale of inventory.

Perpetual Inventory Systems
Cost of Goods Sold . . . Contains the cost of units that have been sold to customers. Is a temporary account. (It will be closed out at the end of the period.) Is an expense account.

Periodic Inventory System Separate Accounts Used
Let’s look at another Inventory system. Periodic Inventory System Separate Accounts Used When using the Periodic system, inventory transactions are not recorded directly in the INVENTORY account. Instead, separate accounts are used for PURCHASES PURCHASE RETURNS & ALLOWANCES PURCHASE DISCOUNTS TRANSPORTATION IN In certain businesses, it is impractical to maintain perpetual inventory records. A periodic inventory system provides an alternative procedure for recording inventory purchases and sales. In a periodic system, purchases of inventory are recorded in a Purchases account. Other inventory-related transactions, such as transportation-in and purchase discounts, returns, and allowances are recorded in separate temporary accounts. Ending inventory is determined by a year-end physical account, and cost of goods sold is calculated using a Schedule of Cost of Goods Sold.

Periodic Inventory Systems
Because entries are not made to the inventory account during the accounting period, the amount of inventory is not known until the end of the period when the inventory count is done. The PERIODIC system is being used less and less due to advancements in technology that make the extra record keeping of the perpetual system easy and inexpensive. Periodic inventory systems require more closing entries at the end of the period. (Purchases, Purchase Returns and Allowances, Purchase Discounts, and Transportation In are all separate TEMPORARY accounts that must be closed out at the end of the period.) The Cost of Goods Sold schedule is used for internal purposes only! It is not shown on the financial statements. Cost of goods sold is reported as one line on the income statement, just as it would be in a perpetual system.

Periodic Inventory System Purchases and Purchase Returns and Allowances
Purchases is an account that holds the current period’s inventory purchases (a debit balance) and is used in the calculation of Cost of Goods Sold on the Income Statement. The Purchase Returns and Allowances account also is used to calculate Cost of Goods Sold on the income statement. It is a deduction from the cost of purchases in a periodic inventory system. Bar codes/scanners

Periodic Inventory System Purchase Discounts
When using the Periodic system Purchase Discounts are recorded in a separate account. This helps managers keep track of the company’s performance in taking advantage of discounts.

Periodic Inventory Systems
The ending inventory is determined at the end of the period by taking a physical count of the goods remaining on hand. Cost of goods sold is calculated at the end of the accounting period by subtracting the ending inventory (determined from the physical count) from the Cost of Goods Available for Sale. Beginning Inventory $ Purchases, net = Goods Available for Sale Ending Inv. (from count) = Cost of Goods Sold $1900

Gross Margin Percentage
This measure indicates how much of each sales dollar is left after deducting the cost of goods sold to cover expenses and provide a profit. Gross Margin Net Sales The gross margin percentage indicates how much of each sales dollar is left after deducting the cost of goods sold to cover expenses and provide a profit. It is calculated as gross margin divided by net sales. Other things being equal, the company with the higher gross margin percentage is pricing its products higher. Other things being equal, the company with the higher gross margin percentage is pricing its products higher.

Ratios: Gross Margin Percentage
Gross margin as a percent of sales Net sales – CGS gross margin Net sales net sales = Net sales = $1, Each Dollar of Sales contributes $.60 (600 / 1,000) to the CGS = (400) Gross Margin (profit before GS & A expenses). GM = $ 600

Ratios: Gross Margin Percentage
Net sales – CGS = $1,000 – 400 Net sales $1,000 = $600___ = % or $.60 $1,000 This tells us that each dollar of sales contributes 60 cents to the Gross Margin. Net sales = $1, Each Dollar of Sales contributes $.60 (600 / 1,000) to the CGS = (400) Gross Margin (profit before GS & A expenses). GM = $ 600

Return on Sales Net Income Net Sales
Net income expressed as a percentage of sales provides insight as to how much of each sales dollar is left as net income after all expenses are paid. Net Income Net Sales In practice, the net income percentage is frequently called the return on sales ratio. Return on sales expresses net income as a percentage of sales and provides insight as to how much of each sales dollar is left as net income after all expenses are paid. It is calculated as net income divided by net sales. Other things being equal, the company with the higher return on sales percentage is doing a better job of controlling costs. Other things being equal, the company with the higher return on sales percentage is doing a better job of controlling costs.

Ratios: Return on sales
Net income Net sales Revenues - expenses Net Income = $500 Net Sales = $1,000 Each dollar of Sales generates $.50 (500 / 1,000) of net income

Ratios: Return on sales
Net income = Net sales $500___ = 50% or $.50 $1,000 Each dollar of sales is generating 50 cents of Net Income Net Income = $500 Net Sales = $1,000 Each dollar of Sales generates $.50 (500 / 1,000) of net income

Income Statement Formats
Single Step - with details condensed Multi-step - with details condensed Let’s look at examples…..

Multi-step with details Multi-step: condensed Net Sales Less: Cost of goods sold Gross Profit Margin Operating Expenses: Selling: Sales Salaries Advertising Total Selling Administrative: Admin. Salaries Building Rent Total Adm. Exp Total Operating Exp Operating Income 19 Non-Operating Rev. (Exp.) Interest Expense (1) Income before tax 18 Income Tax expense 3 Net Income Net Sales Less: Cost of goods Sold Gross Profit Margin Operating Expenses: Selling Expenses Administrative Exp Total Operating Exp Operating Income Non-Operating Rev. (Exp.) Interest Expense (1) Income before tax 18 Income Tax expense Net Income Notice that a multistep income statement is more informative than one which simply subtracts expenses from revenues. Income statements that display a single comparison of total revenues and total expenses are called single-step income statements. A multistep income statement separates cost of goods sold from other expenses in order to show the company’s gross margin. Also note that operating income is reported separately from net income. Nonoperating items, which include interest revenue or expenses and gains or losses on the sale of assets, are reported after operating income to arrive at net income.

The multi-step INCOME Statement format classifies interest as a NON-operating item. But, interest is still an OPERATING ACTIVITY on the CASHFLOW Statement. Multi-step with details Multi-step: condensed Net Sales Less: Cost of goods sold Gross Profit Margin Operating Expenses: Selling: Sales Salaries Advertising Total Selling Administrative: Admin. Salaries Building Rent Total Adm. Exp Total Operating Exp Operating Income 19 Non-Operating Rev. (Exp.) Interest Expense (1) Income before tax 18 Income Tax expense 3 Net Income Net Sales Less: Cost of goods Sold Gross Profit Margin Operating Expenses: Selling Expenses Administrative Exp Total Operating Exp Operating Income Non-Operating Rev. (Exp.) Interest Expense (1) Income before tax 18 Income Tax expense Net Income

Single-step with details Single-step: condensed Net Sales Less Expenses: Cost of goods sold 60 Selling Administrative Interest Expense Income Tax Expense 3 Total Expenses Net Income 15 Net Sales Less Expenses: Cost of goods sold Sales Salaries Advertising Admin. Salaries Building Rent Interest Expense Income Tax Expense 3 Total Expenses Net Income

Single-step with details Single-step: condensed A common modification of the single-step method is to have the income tax expense separated out. Net Sales Less Operating Exp. Cost of goods sold Sales Salaries Advertising Admin. Salaries Building Rent Interest Expense Total Oper. Exp Income before taxes Income Tax Expense Net Income Net Sales Less Expenses: Cost of goods sold 60 Selling Administrative Total Oper. Exp Income before taxes Income Tax Expense Net Income

Common-size Income Statement
Each item on the income statement is expressed as a % of that year’s Net Sales. Comparisons are made to: Budget Previous year(s) Competitors % Net Sales - Cost =G.P

Comparative Common-size Income Statements
Net Sales $3, $2,000 Cost of Goods Sold , ,200 Gross Profit , Operating Expenses: Selling Expenses Administrative Exp Total Oper. Exp , Net Income ($300) $100 % of N.Sales 100.0 % of N.Sales 100.0

Comparative Common-size Income Statements
Net Sales $3, $2,000 Cost of Goods Sold , ,200 Gross Profit , Operating Expenses: Selling Expenses Administrative Exp Total Oper. Exp , Net Income ($300) $100 % of N.Sales 100.0 66.7 33.3 20.0 23.3 43.3 (10.0) % of N.Sales 100.0 60.0 40.0 20.0 15.0 35.0 5.0 This exhibit contains 2012 and 2013 income statements. These are called common size financial statements. In common size income statements, all items on the income statement are stated as a percentage of net sales. Express the percent column as dollar and cents. (It makes more sense that way). So, for 2013, for every $1.00 of sales, we spent $0.60 on inventory and $0.15 on Administrative expenses. In 2013, for every $1.00 in sales, we spent $0.667 on inventory as well as 23.3 cents for Administrative expenses. Even though more were spent on Selling expenses, it was still $.20 for every dollar of sales earned. This tells me that higher inventory cost decreased our profitability in 2013 (probably explains some of the increase in sales). Also, Administrative expenses increased at a faster pace compared to These two factors contributed to a loss in Since Sales stayed at $0.20 for every dollar earned, it did not contribute to the loss in 2013.

Income Statement Trend Analysis
Trend Analysis shows both Dollar and % changes from one year to the next year for each item on the income statement. Example: From 2012 to 2013 Net Sales increased from $2,000 to $3,000. So…… Net Sales increased $1,000 which is a 50% increase over 2012 Net Sales. ($1,000 incr./$2,000 Net Sales of 2012 = 50%)

Income Statement Trend Analysis
Net Sales $3,000 $2,000 Cost of Goods Sold , ,200 Gross Profit , Operating Expenses: Selling Expenses Administrative Exp Total Oper. Exp , Net Income ($300) $100 $ inc.(dec.) $1,000 800 200 400 600 ($400) % inc.(dec) 50.0 66.7 25.0 133.3 85.7 (400.0)

How about analyzing the Balance Sheet?
The same techniques are used to analyze the Balance Sheet. Common-size Analysis: Use the TOTAL ASSETS amount as the 100% figure. So, …….. Express each Balance Sheet item as a % of Total Assets. Trend Analysis: Same approach as used on the income statement. 1. Calculate the $ change for each bal. sheet item Express the $ change as a % of the previous year’s (or base year’s) amount.

End of Chapter 4 Remember,
Your objectives are to understand what you are doing and to be able to analyze the financial information. Memorization without understanding is meaningless!

Accounting for Merchandising Businesses

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