ACCOUNTING FOR MERCHANDISING OPERATIONS CHAPTER 5 ACCOUNTING FOR MERCHANDISING OPERATIONS

MERCHANDISING COMPANY A merchandising company is an enterprise that buys and sells goods to earn a profit. 1. Wholesalers sell to retailers. 2. Retailers sell to consumers. A merchandiser’s primary source of revenue is sales, whereas a service company’s primary source of revenue is service revenue.

OPERATING CYCLES FOR A SERVICE COMPANY AND A MERCHANDISING COMPANY Cash Receive Cash Perform Services Accounts Receivable Cash Merchandising Company Accounts Receivable Receive Cash Buy Inventory Merchandise Inventory Sell Inventory

ILLUSTRATION 5-1 INCOME MEASUREMENT PROCESS FOR A MERCHANDISING COMPANY Cost of Goods Sold Less Sales Revenue Gross Profit Equals Operating Expenses Less Net Income (Loss) Equals

INVENTORY SYSTEMS Merchandising entities may use either (or both) of the following inventory systems: 1. Perpetual – where detailed records of each inventory purchase and sale are maintained. Cost of goods sold is calculated at the time of each sale. 2. Periodic – detailed records are not maintained. Cost of goods sold is calculated only at the end of the accounting period. This chapter covers the perpetual method.

RECORDING COST OF GOODS PURCHASED When merchandise is purchased for resale to customers, the account, Merchandise Inventory, is debited for the cost of the goods. Purchases may be made for cash or on account (credit). The purchase is normally recorded by the purchaser when the goods are received from the seller.

PURCHASES OF MERCHANDISE For purchases on account, Merchandise Inventory is debited and Accounts Payable is credited. For cash purchases, Merchandise Inventory is debited and Cash is credited.

FREIGHT COSTS The sales agreement should indicate whether the seller or the buyer is to pay the cost of transporting the goods to the buyer’s place of business. FOB Shipping Point 1. Goods delivered to shipping point by seller 2. Buyer pays freight costs from shipping point to destination FOB Destination 1. Goods delivered to destination by seller 2. Seller pays freight costs

ACCOUNTING FOR FREIGHT COSTS Merchandise Inventory is debited by the buyer, if the buyer pays the freight bill (FOB shipping point). Freight Out (or Delivery Expense) is debited by the seller, if the seller pays the freight bill (FOB destination).

ACCOUNTING FOR FREIGHT COSTS When the purchaser directly incurs the freight costs, the account Merchandise Inventory is debited and Cash is credited.

PURCHASE RETURNS AND ALLOWANCES A purchaser may be dissatisfied with merchandise received because the goods 1. are damaged or defective, 2. are of inferior quality, or 3. are not in accord with the purchaser’s specifications.

PURCHASE RETURNS AND ALLOWANCES For purchases returns and allowances that were originally made on account, Accounts Payable is debited and Merchandise Inventory is credited. For cash returns and allowances, Cash is debited and Merchandise Inventory is credited.

QUANTITY DISCOUNTS Volume purchase terms may permit the buyer to claim a quantity discount. The merchandise inventory is simply recorded at the discounted cost.

PURCHASE DISCOUNTS Credit terms may permit the buyer to claim a cash discount for the prompt payment of a balance due. The buyer calls this discount a purchase discount. A purchase discount is based on the invoice cost less any returns and allowances granted.

SALES TRANSACTIONS Revenues are reported when earned in accordance with the revenue recognition principle. In a merchandising company. revenues are earned when the goods are transferred from seller to buyer.

SALES TRANSACTIONS 1. The first entry records the sale of goods to a customer at the retail (selling) price. 2. The second entry releases the goods from inventory at cost and charges the goods to cost of goods sold.

SALES TAXES Sales tax is expressed as a percentage of the sales price on selected goods sold to customers by a retailer. They are collected on most revenues, and paid on many costs. Sales taxes may include the federal goods and services tax (GST) and the provincial sales tax (PST), if any. These two taxes have been combined into one harmonized sales tax (HST) in some Atlantic Provinces.

SALES TAXES ON REVENUES The retailer collects the tax from the customer when the sale occurs, and periodically (usually monthly) remits the collections to the Receiver General. Sales taxes are not revenue but are a current liability until remitted.

SALES RETURNS AND ALLOWANCES Sales Returns occur when customers are dissatisfied with merchandise and are allowed to return the goods to the seller for credit or a refund. Sales Allowances occur when customers are dissatisfied, and the seller allows a deduction from the selling price.

SALES RETURNS AND ALLOWANCES The normal balance of Sales Returns and Allowances is a debit. Sales Returns and Allowances is a contra revenue account to the Sales account.

RECORDING SALES RETURNS AND ALLOWANCES 1. The first entry reduces the balance owed by the customer and records the goods returned at retail price. 2. The second entry records the physical return of goods to inventory at cost and removes the goods from the cost of goods sold account.

QUANTITY DISCOUNTS A quantity discount is the offer of a cash discount to a customer in return for a volume sale. Quantity discounts result in a sales price reduction. They are not separately journalized. Instead the sale is recorded at the reduced price.

SALES DISCOUNTS A sales discount is the offer of a cash discount to a customer in exchange for the prompt payment of a balance due. Similar to Sales Returns and Allowances, Sales Discounts is also a contra revenue account with a normal debit balance.

COMPLETING THE ACCOUNTING CYCLE A merchandising company requires the same types of adjusting entries as a service company, with one additional adjustment for inventory to ensure the recorded inventory amount agrees with the actual quantity on hand. A physical count is an important control feature since a perpetual system indicates what should be there but a count will determine what is actually there.

COMPLETING THE ACCOUNTING CYCLE A merchandising company also requires the same types of closing entries as a service company. The additional accounts that need to be closed out in a merchandising account include Sales, Sales Returns and Allowances, Cost of Goods Sold, and Freight Out. Merchandise Inventory is an asset account and is not closed at the end of the period.

ILLUSTRATION 5-9 STATEMENT PRESENTATION OF SALES REVENUE SECTION As contra revenue accounts, sales returns and allowances (and sales discounts, if any) are deducted from sales in the income statement to arrive at Net Sales.

ILLUSTRATION 5-10 CALCULATION OF GROSS PROFIT Gross profit is calculated by deducting cost of goods sold from net sales as follows: Gross profit is often expressed as a percentage of sales.

ILLUSTRATION 5-12 CALCULATION OF NET INCOME Net income is calculated by deducting operating expenses from gross profit as follows: Net income is the “bottom line” of a company’s income statement.

ILLUSTRATION 5-14 This is the format of a multi-step income statement that has both operating and non-operating activities. As shown, the non-operating activities are reported immediately after the company’s primary operating activities.

CLASSIFIED BALANCE SHEET On the balance sheet, merchandise inventory is reported as a current asset and appears immediately below accounts receivable. This is because current assets are listed in the order of their liquidity.

USING THE INFORMATION IN THE FINANCIAL STATEMENTS Inventory is particularly important because: It is a large current asset on the balance sheet It becomes a large expense on the income statement It is vulnerable to theft or misuse

USING THE INFORMATION IN THE FINANCIAL STATEMENTS A balancing act is needed to ensure that a sufficient, but not excessive, quantity of inventory is on hand. Two ratios help evaluate the management of inventory: Inventory turnover Days sales in inventory

INVENTORY TURNOVER Inventory turnover = Cost of goods sold Average inventory

DAYS SALES IN INVENTORY Inventory turnover