Introduction to Accounting for Merchandising Operations

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Objectives Review accrual accounting basics Introduce terminology for merchandising operations

Accrual basics revenue recognition income determination matching

Revenue Recognition Revenue is recognized when the earning process is substantially complete and the measurability and the collectibility of the dollar amount is reasonably assured.

Revenue Recognition Revenue is recognized when the earning process is substantially complete and the measurability and the collectibility of the dollar amount is reasonably assured. For most businesses revenue is recognized when goods are shipped to customers or services are provided.

Question: If in January: What was the Revenue for January? A photographer starts a new business on January 1st The photographer takes, develops and delivers pictures worth $7,500 to customers The photographer invoices $6,000 of these services in January but does not get around to invoicing a large corporate customer in February for the $1,500 owed for photos finished and delivered in January Customers paid $5,000 for photos The photographer expects all amounts owed will be collected eventually What was the Revenue for January?

Question: Answer: $7,500 If in January: A photographer starts a new business on January 1st The photographer takes, develops and delivers pictures worth $7,500 to customers The photographer invoices $6,000 of these services in January but does not get around to invoicing a large corporate customer in February for the $1,500 owed for photos finished and delivered in January Customers paid $5,000 for photos The photographer expects all amounts owed will be collected eventually What was the Revenue for January? Answer: $7,500

The earning process The earning process can stretch over a considerable period of time and is fraught with uncertainties Accountants recognize revenue at the earliest point when the work done to earn it is substantially complete

Revenue: an increase in net assets from operations

Income Determination Under accrual accounting expenses incurred are matched with related revenue to determine net income for a particular time period

Income Determination Revenue $xxx Less: Expenses ($xx) Net Income $ xx Under accrual accounting expenses incurred are matched with related revenue to determine net income for a particular time period

Question: If in January: A photographer has Sales of $7,500 Photographic Supplies worth $700 are purchased on account $500 is paid for the Photographic Supplies purchased $400 of Photographic Supplies are used up What was the Net Income for January if there were no other expenses?

Question: Answer: $7,100 If in January: A photographer has Sales of $7,500 Photographic Supplies worth $700 are purchased on account $500 is paid for the Photographic Supplies purchased $400 of Photographic Supplies are used up What was the Net Income for January if there were no other expenses? Answer: $7,100

Net Income = Revenue - Expenses = $7,500 – Supply Expense Recognize expense: Dr Supplies (balance sheet account) Cr Cash or Accounts Payable … not at time of purchase Dr Supplies Expense (income statement) Cr Supplies (balance sheet account) … recognize expense at time assets expire/are used up

Expenses: a decrease in net assets (“used up” assets)

Matching Mismatched shoes are silly .. Unmatched revenues and expenses are misleading

Matching Revenue $xxx Less: Expenses ($xx) Net Income $ xx Mismatched shoes are silly .. Unmatched revenues and expenses are misleading

Cash vs Accrual Basis In contrast to the accrual basis, cash basis accounting recognizes revenue when money is received and recognizes money when paid

Cash vs Accrual Basis In contrast to the accrual basis, cash basis accounting recognizes revenue when money is received and recognizes money when paid Cash basis may distort the portrayal of financial position and over or understate performance measurement

service operations Provide services rather than selling products Have relatively small supply costs Match expenses to revenue at end of period

Merchandising Operations Buy and sell finished goods Cost of Goods Sold – the cost of items shipped to customers - is usually a large expense Inventory – is reported on the Balance Sheet: it is goods held for sale

Merchandising Operations Cost of Goods Sold (COGS) is a significant expense for a merchandising operations COGS is often reported as a separate line item on the Income Statement

Merchandising Operations Cost of Goods Sold (COGS) is a significant expense for a merchandising operations COGS is often reported as a separate line item on the Income Statement Often the change in inventory is computed at the time of each sale (the perpetual method)

income statement Revenue $xxx Cost of Goods Sold xxx Gross Profit xxx Operating Expenses Selling Expenses xxx Administrative Expenses xxx xxx Net Income $xxx

Balance Sheet ASSETS Current Assets Cash $xxx Accounts receivable xxx Inventory, at cost xxx Prepaid expenses xxx Total Current Assets xxxx Capital Assets Land $ xxx Buildings and Equipment xxx less: Accumulated depreciation xxx xxxx Total Assets $xxxx

Recognizing Cost of Goods Sold …not expensed when goods are purchased Dr Inventory (balance sheet account) Cr Cash or Accounts Payable … COGS is recognized when goods are sold Dr Cost of Goods Sold (income statement) Cr Inventory (balance sheet account)

Recognizing Cost of Goods Sold …not expensed when goods are purchased Dr Inventory (balance sheet account) Cr Cash or Accounts Payable … COGS is recognized when goods are sold Dr Cost of Goods Sold (income statement) Cr Inventory (balance sheet account) Well controlled merchandise operations use a separate inventory account for each item

Perpetual inventory system separate account for each inventory item accounting entry for every inventory receipt and shipment Dr Inventory Cr Accounts Payable or Cash When received

Perpetual inventory system separate account for each inventory item accounting entry for every inventory receipt and shipment Dr Inventory Cr Accounts Payable or Cash Dr Cost of Goods Sold Cr Inventory When received When sold and shipped

Merchandising Operations Cost of Goods Sold (COGS) is a significant expense for a merchandising operations COGS is often reported as a separate line item on the Income Statement Often the change in inventory is computed at the time of each sale (the perpetual method) Sometimes the change in inventory is computed at the end of the accounting period (the periodic method)

Periodic inventory system used by small, non-computerized operations debit all receipts to ‘Purchases’ account count and value inventory at period-end adjusting entry at period-end: Dr or Cr Inventory (adjust to count: dr if inventory has increased during the period cr if inventory has decreased during the period) Dr Cost of Goods Sold (to balance entry) Cr Purchases (to make balance $0)

Merchandising Operations Cost of Goods Sold (COGS) is a significant expense for a merchandising operations COGS is often reported as a separate line item on the Income Statement Often the change in inventory is computed at the time of each sale (the perpetual method) Sometimes the change in inventory is computed at the end of the accounting period (the periodic method) Even if the perpetual method is used, inventory must be counted and valued and the accounting records adjusted to the computed value

Mug promotions Prepare financial statements for the world’s simplest merchandising business

Mug promotions Buys ceramic mugs for $2 each Customizes the mugs with a logo (in this example magically at no labour cost to focus attention on the inventory transactions) Sells the customized mugs on account for $3 each

Mug Promotions Begins June: Cash $ 5,000 Accounts Receivable $ 2,000 Inventory $ 4,000 Accounts Payable $ 1,000 During June: receives 1,000 mugs and ships 2,500 mugs invoices customers for 2,000 mugs collects $5,000 from customers Pays suppliers $2,000

Question: What was revenue in June? Begins June: Cash $ 5,000 Accounts Receivable $ 2,000 Inventory $ 4,000 Accounts Payable $ 1,000 During June: receives 1,000 mugs and ships 2,500 mugs invoices customers for 2,000 mugs collects $5,000 from customers Pays suppliers $2,000 Mugs sell for $3 each on account; mugs cost $2 each

Answer: Mug Promotions Income Statement for June Revenue $7,500 Mugs sell for $3 each and 2,500 were shipped in June. Revenue is recognized when goods are delivered.

Question: What was COGS in June? Begins June: Cash $ 5,000 Accounts Receivable $ 2,000 Inventory $ 4,000 Accounts Payable $ 1,000 During June: receives 1,000 mugs and ships 2,500 mugs invoices customers for 2,000 mugs collects $5,000 from customers Pays suppliers $2,000 Mugs sell for $3 each on account; mugs cost $2 each

Answer: Mug Promotions Income Statement for June Revenue $7,500 Cost of goods sold 5,000 Gross Profit $2,500 Mugs cost $2 each. Cost of goods sold is matched to revenue - - 2,500 mugs were sold in June so the cost of 2,500 mugs, 2,500 x $2, is recognized as Cost of Goods Sold There are no other expenses – Net Income is also $2,500

Question: What was Cash Balance at June 30th? Begins June: Cash $ 5,000 Accounts Receivable $ 2,000 Inventory $ 4,000 Accounts Payable $ 1,000 During June: receives 1,000 mugs and ships 2,500 mugs invoices customers for 2,000 mugs collects $5,000 from customers Pays suppliers $2,000 Mugs sell for $3 each on account; mugs cost $2 each

Answer: ASSETS June 30 June 1 Cash $8,000 $ 5,000 Accounts Receivable ?? $ 2,000 Inventory ?? $ 4,000 ?? $11,000 LIABILITIES and OWNER’s EQUITY Accounts Payable ?? $ 1,000 Owner’s Equity ?? ?? Cash Balance June 1 ($5,000) + Customer Receipts ($5,000) – payments to suppliers ($2,000)

Question: What was Accounts Receivable Balance at June 30th? Begins June: Cash $ 5,000 Accounts Receivable $ 2,000 Inventory $ 4,000 Accounts Payable $ 1,000 During June: receives 1,000 mugs and ships 2,500 mugs invoices customers for 2,000 mugs collects $5,000 from customers Pays suppliers $2,000 Mugs sell for $3 each on account; mugs cost $2 each

Answer ASSETS June 30 June 1 Cash $8,000 $ 5,000 Accounts Receivable 4,500 $ 2,000 Inventory ?? $ 4,000 ?? $11,000 LIABILITIES and OWNER’s EQUITY Accounts Payable ?? $ 1,000 Owner’s Equity ?? ?? A/R Balance June 1 ($2,000) + Credit Sales ($7,500) - Customer Receipts ($5,000)

Question: What was Inventory Balance at June 30th? Begins June: Cash $ 5,000 Accounts Receivable $ 2,000 Inventory $ 4,000 Accounts Payable $ 1,000 During June: receives 1,000 mugs and ships 2,500 mugs invoices customers for 2,000 mugs collects $5,000 from customers Pays suppliers $2,000 Mugs sell for $3 each on account; mugs cost $2 each

Answer ASSETS June 30 June 1 Cash $8,000 $ 5,000 Accounts Receivable 4,500 $ 2,000 Inventory 1,000 $ 4,000 $13,500 $11,000 LIABILITIES and OWNER’s EQUITY Accounts Payable ?? $ 1,000 Owner’s Equity ?? ?? Inventory Balance June 1 ($4,000) + mugs purchased (1,000 x $2 = $2,000) – cost of mugs shipped ($5,000)

Question: What was Accounts Payable Balance at June 30th? Begins June: Cash $ 5,000 Accounts Receivable $ 2,000 Inventory $ 4,000 Accounts Payable $ 1,000 During June: receives 1,000 mugs and ships 2,500 mugs invoices customers for 2,000 mugs collects $5,000 from customers Pays suppliers $2,000 Mugs sell for $3 each on account; mugs cost $2 each

Answer ASSETS June 30 June 1 Cash $8,000 $ 5,000 Accounts Receivable 4,500 $ 2,000 Inventory 1,000 $ 4,000 $13,500 $11,000 LIABILITIES and OWNER’s EQUITY Accounts Payable $1,000 $ 1,000 Owner’s Equity ?? ?? Accounts Payable Balance June 1 ($1,000) + mugs purchased (1,000 x $2 = $2,000) – payments ($2,000)

Question: What was Owner’s Equity Balance at June 30th? Begins June: Cash $ 5,000 Accounts Receivable $ 2,000 Inventory $ 4,000 Accounts Payable $ 1,000 During June: receives 1,000 mugs and ships 2,500 mugs invoices customers for 2,000 mugs collects $5,000 from customers Pays suppliers $2,000 Mugs sell for $3 each on account; mugs cost $2 each

Answer ASSETS June 30 June 1 Cash $8,000 $ 5,000 Accounts Receivable 4,500 $ 2,000 Inventory 1,000 $ 4,000 $13,500 $11,000 LIABILITIES and OWNER’s EQUITY Accounts Payable $1,000 $ 1,000 Owner’s Equity ?? $10,000 ?? $11,000 Balance Sheet Equation – Assets = Liabilities + OE

Question: Do June 30th Statements Balance? Does the computed Net Income change Owner’s Equity to balance the Balance Sheet? Begins June: Cash $ 5,000 Accounts Receivable $ 2,000 Inventory $ 4,000 Accounts Payable $ 1,000 During June: receives 1,000 mugs and ships 2,500 mugs invoices customers for 2,000 mugs collects $5,000 from customers Pays suppliers $2,000 Mugs sell for $3 each on account; mugs cost $2 each

Answer ASSETS June 30 June 1 Cash $8,000 $ 5,000 Accounts Receivable 4,500 $ 2,000 Inventory 1,000 $ 4,000 $13,500 $11,000 LIABILITIES and OWNER’s EQUITY Accounts Payable $1,000 $ 1,000 Owner’s Equity $12,500 $10,000 $13,500 $11,000 Yes! Owner’s Equity at June 1 + Net Income ($2,500) is $12,500 which balances

Retained Earnings (RE) Net Income = Revenue - Expenses Financial Statements Balance Sheet Assets = Liabilities + Shareholders' Equity Share Capital + Retained Earnings Cash Flow Statement Changes in cash result from: investing activities financing activities operating activities Statement of Retained Earnings (RE) Dividends decrease RE Net Income increases RE Income Statement Net Income = Revenue - Expenses Businesses differ on B/S: is there inventory existence of inventories raw as well as finished for a manufacturer merchandisers buy and sell finished products and include both wholesalers and retailers Review articulation: Articulate at the micro level - T-Accounts too Adjusting entries affect one B/S account one I/S account Cash flow is not equal to Net Income

Computing COGS Opening Inventory $xxxx Plus net cost of purchases Purchases $xxxx Less: Purchases returns and allowances (xxx) Less: Purchase discounts (xx) Add: Transporation in xx xxx Cost of Goods Available xxxx Less ending inventory (xxx) COGS $xxxx

manufacturing operations also use Inventory and Cost of Goods Sold accounts costs included in inventory not only product costs, but also certain manufacturing costs and period costs (e.g., rent and utilities) Separate inventories amounts are reported: raw materials inventories, work-in-process inventories and finished goods inventories.

inventory errors Errors which incorrectly includes or excludes items from ending inventory will result in both income statement and balance sheet errors Errors in inventory valuation will result in both income statement and balance sheet errors. Inventory errors can be HUGE

merchandising example www.homedepot.com world's largest home improvement retailer For year ended February 3, 2002: over 1,500 stores and 280,000 employees

merchandising example www.homedepot.com world's largest home improvement retailer over 1,500 stores and over 250,000 employees Net Sales over $50 billion US Cost of Goods Sold over $30 billion US

Accounting’s contribution Home Depot: has over 40,000 different inventory items has over 6 Billion US$ in inventory Good inventory accounting is a part of its success story