Merchandising Activities Chapter 6 Chapter 6: Merchandising Activities

Operating Cycle of a Merchandising Company The operating cycle of a business is the time it takes a business to start with cash, purchase inventory, sell the inventory, and finally collect cash from customers. The operating cycle of a business that sells inventory on credit is typically longer than that of a business that sells only on a cash basis. This is due to additional time between when a customer buys inventory and when the customer pays off the accounts receivable.

Income Statement of a Merchandising Company Cost of goods sold represents the expense of goods that are sold to customers. Gross profit is a useful means of measuring the profitability of sales transactions. The income statements of merchandising companies have an additional expense item called Cost of Goods Sold. The Cost of Goods Sold account represents the cost of merchandise sold during the period to help earn revenue. Cost of Goods Sold is presented as a separate expense item on the income statement. Net Sales minus Cost of Goods Sold equals Gross Profit. Gross Profit is the amount left, after subtracting the cost of the inventory sold, to cover all other expenses and a profit.

Perpetual Inventory Systems On September 5, Worley Co. purchased 100 laser lights for resale for $30 per unit from Electronic City on account. In the perpetual inventory system, the inventory account is continuously updated to reflect purchases, sales, and returns of inventory. On September 5th, Worley Company purchased on account from Electronic City one hundred laser lights for $30 each. Worley Company would debit Inventory and credit Accounts Payable for $3,000.

Perpetual Inventory Systems On September 10, Worley Co. sold 10 laser lights for $50 per unit on account to ABC Radios. Retail 10 ´ $50 = $500 On September 10th, Worley Company sold 10 laser lights for $50 each to ABC Radios on account. Under the perpetual inventory system, a sale of inventory requires two entries. One entry is a debit to Accounts Receivable and a credit to Sales for the retail amount of the sale, which in this case is $500. Another entry is a debit to Cost of Goods Sold and a credit to Inventory for the cost of the inventory sold, which in this case is $300. The retail amount is the selling price to the customer and the cost amount is the cost paid for the inventory sold. 10 ´ $30 = $300 Cost

Perpetual Inventory Systems On September 15, Worley Co. paid Electronic City $3,000 for the September 5 purchase. On September 15th, Worley Company paid Electronic City $3,000 for the September 5th purchase. Worley Company would debit Accounts Payable and credit Cash for $3,000.

Taking a Physical Inventory In order to ensure the accuracy of their perpetual records, most businesses take a complete physical count of the merchandise on hand at least once a year. Reasonable amounts of inventory shrinkage are viewed as a normal cost of doing business. Examples include breakage, spoilage and theft. On December 31, Worley Co. counts its inventory. An inventory shortage of $2,000 is discovered. Most companies take a physical count of inventory at least once a year. Theoretically, the physical count should match the number of items in the inventory records. In reality, this is not the case. The physical count does not match the records due to spoilage, breakage, damage, obsolescence, and theft. The physical count helps get the records up to date to reflect what is actually on hand. When a physical count identifies inventory shrinkage, an entry is made to debit Cost of Goods Sold and credit Inventory. This entry increases Cost of Goods Sold, an expense account, and decreases the Inventory account.

Periodic Inventory System On September 5, Worley Co. purchased 100 laser lights for resale for $30 per unit from Electronic City on account. Notice that no entry is made to Inventory. Under the periodic inventory system, no effort is made to keep the inventory account or the cost of goods sold account up to date. Only on a periodic basis are these two accounts updated. On September 5th, Worley Company purchased on account from Electronic City 100 laser lights for $30 each. Worley Company would debit Purchases and credit Accounts Payable for $3,000. Notice that an entry is not made to the Inventory account. Instead, the purchase is debited to a new account called Purchases.

Periodic Inventory System On September 10, Worley Co. sold 10 laser lights for $50 per unit on account to ABC Radios. Retail On September 10th, Worley Company sold 10 laser lights for $50 each to ABC Radios on account. Under the periodic inventory system, a sale of inventory requires only one entry: a debit to Accounts Receivable and a credit to Sales for the retail amount of the sale, which in this case is $500. The cost entry that was made under the perpetual inventory system is not required because the periodic system does not attempt to keep the inventory and cost of good sold accounts up to date.

Computing Cost of Goods Sold The accounting records of Party Supply show the following: Inventory, Jan. 1 $ 14,000 Purchases (during year) 130,000 Inventory, Dec. 31 12,000 Because the periodic system does not maintain a cost of goods sold account, cost of goods sold must be calculated at the end of the period. Here is some information for Party Supply. On January 1st, they have beginning inventory of $14,000. They have purchases during the year totaling $130,000. On December 31st, the physical inventory count was $12,000. To calculate the cost of goods sold for Party Supply, start with the beginning inventory and add the purchases during the year. This provides the cost of goods available for sale during the period. From this, subtract the ending inventory and arrive at the cost of goods sold during the period.

Creating a Cost of Goods Sold Account Party Supply must create the Cost of Goods Sold account. Party Supply must record the ending inventory amount. A Cost of Goods Sold account is created with two special closing entries. The first entry zeroes out the balances in the beginning Inventory account and the Purchases account. For Party Supply, this entry consists of a credit to Inventory for $14,000 and to Purchases for $130,000 and a debit to Cost of Goods Sold for $144,000. The second closing entry records the physical count in the Inventory account and adjusts the balance in the Cost of Goods Sold account. For Party Supply, this entry requires a debit to Inventory and a credit to Cost of Goods Sold for $12,000. After these special closing entries, the Purchases account is closed, the Inventory account reflects the ending inventory amount, and the Cost of Goods Sold account reflects the calculated cost of goods sold amount. The remaining steps for completing closing entries in a periodic inventory system are the same as discussed earlier for the perpetual inventory system.

Selecting an Inventory System Which inventory system should a company use? This table suggests some characteristics to consider when selecting an inventory system. If a company has a professional management team, needs timely information about items in inventory, and has a computerized accounting system, then a perpetual inventory system is likely the better option. However, if a company is run by its owners, does not need timely information about items in inventory, uses a manual accounting system, and maintains merchandise on site, then a periodic inventory may be the solution. Many companies can find an accounting software package that is able to handle a perpetual inventory system very effectively.

Recording Purchases at Net Cost On July 6, Jack & Jill, Inc. purchased $4,000 of merchandise on credit with terms of 2/10, n/30 from Kid’s Clothes. Prepare the journal entry for Jack & Jill, Inc. Many companies plan to take advantage of cash discounts offered, so they record their purchases net of the discount. Since they typically take the discount, this process simplifies future entries. If a cash discount is not taken in the future, then a purchase discounts lost account is used. On July 6th, Jack & Jill, Inc. purchased $4,000 of merchandise on account from Kid’s Clothes with terms two ten net thirty. Jack & Jill, Inc. debits Inventory and credits Accounts Payable for $3,920, which is net of the two percent cash discount. $4,000 ´ 98% = $3,920

Returns of Unsatisfactory Merchandise On August 5, Jack & Jill, Inc. returned $500 of unsatisfactory merchandise purchased from Kid’s Clothes on credit terms of 2/10, n/30. The purchase was originally recorded at net cost. Prepare the entry for Jack & Jill, Inc. On August 5th, Jack & Jill, Inc. returned $500 of unsatisfactory merchandise to Kid’s Clothes. The inventory was originally purchased on credit with terms of two ten net thirty, and the purchase was originally recorded at net cost. To record the return, Jack & Jill, Inc. would debit Accounts Payable and credit Inventory for the net cost of the goods returned, which in this case would be $490. $500 ´ 98% = $490

Transportation Costs on Purchases Transportation costs related to the acquisition of assets are part of the cost of the asset being acquired. In general, the cost of any asset includes any transportation costs related to getting the asset to the buyer’s place of business. This is also the case for inventory. Transportation costs incurred by the buyer are included in the cost of Inventory.

Transactions Related to Sales Just as inventory returns and cash discounts impact a buyer’s entries, they also impact a seller’s entries. Sellers use the Sales Returns and Allowances account to record inventory returned to the seller, or adjustments in prices sellers allow due to customer dissatisfaction. Sellers use the Sales Discounts account to record cash discounts taken by customers who pay within the discount period. Net sales equals Sales minus Sales Returns and Allowances and Sales Discounts. Let’s see how these accounts are treated in journal entries. Credit terms and merchandise returns affect the amount of revenue earned by the seller.

Delivery Expenses Delivery costs incurred by sellers are debited to Delivery Expense, an operating expense. When sellers incur transportation costs, they are debited to an operating expense account called Delivery Expense. This is considered a cost of doing business and is treated as a regular operating expense of the business.

Modifying an Accounting System Most businesses use special journals rather than a general journal to record routine transactions that occur frequently. Most businesses use special journals to help streamline the recording of routine entries. When companies use special journals, similar entries are recorded together. Companies may have several special journals such as a Cash Receipts Journal, Cash Payments Journal, Sales Journal, and several others. When using special journals, the General Journal is used only for a few entries that do not fit in a special journal. Relative to the general journal, special journals offer the following advantages: • Transactions are recorded faster and more efficiently. • Many special journals may be in operation at one time, further increasing the company’s ability to handle a large volume of transactions. • Automation may reduce the risk of errors. • Employees maintaining special journals generally do not need expertise in accounting. • The recording of transactions may be an automatic side effect of other basic business activities, such as collecting cash from customers.

Financial Analysis Gross Profit Margins Net Sales Trends over time Comparable store sales Sales per square foot of selling space Gross profit ¸ Net sales Overall gross profit margin Gross profit margins by department and products Analysts and investors use many different measures to gain insights about a company. Looking at the trends in net sales and gross profit margins over time can provide information on how well a company is doing. Reviewing net sales for stores may help identify individual stores that are struggling or that are doing extremely well. Sales per square foot of selling space helps measure how efficiently stores are generating sales with the space they have to use. Reviewing gross profit margins for departments or products may help identify individual departments or products that are not performing as expected or that are exceeding expectations.

End of Chapter 6 End of Chapter 6.