Chapter 5 Merchandising Operations

© 2016 Pearson Education, Inc. Learning Objectives Describe merchandising operations and the two types of merchandise inventory systems Account for the purchase of merchandise inventory using a perpetual inventory system Account for the sale of merchandise inventory using a perpetual inventory system © 2016 Pearson Education, Inc.

© 2016 Pearson Education, Inc. Learning Objectives Adjust and close the accounts of a merchandising business Prepare a merchandiser’s financial statements Use the gross profit percentage to evaluate business performance Account for the purchase and sale of merchandise inventory using a periodic inventory system (Appendix 5A) © 2016 Pearson Education, Inc.

© 2016 Pearson Education, Inc. Learning Objective 1 Describe merchandising operations and the two types of merchandise inventory systems © 2016 Pearson Education, Inc.

What Are Merchandising Operations? A merchandiser is a business that sells merchandise, or goods, to customers. The merchandise that this type of business sells is called merchandise inventory. A wholesaler buys goods from a manufacturer and sells them to retailers. A retailer buys merchandise from manufacturers or a wholesaler and then sells the goods to consumers. A merchandiser is a business that sells merchandise, or goods, to customers. The merchandise that a business sells to customers is called merchandise inventory. A wholesaler is a type of merchandiser that buys goods from manufacturers and then sells them to retailers. A retailer is a type of merchandiser that buys merchandise either from a manufacturer or a wholesaler and then sells those goods to consumers. © 2016 Pearson Education, Inc.

The Operating Cycle of a Merchandising Business The operating cycle begins when the company purchases inventory from a vendor. The company then sells the inventory to customers. The company collects cash from customers. The operating cycle has three main steps: A company purchases inventory from a vendor, the company sells the inventory to a customer, and the company collects cash from customers. A vendor is an individual or a business from whom a company purchases goods. © 2016 Pearson Education, Inc.

The Operating Cycle of a Merchandising Business The operating cycle of a merchandiser is presented in Exhibit 5-1. A merchandiser purchases inventory and then sells the inventory to customers in exchange for cash. © 2016 Pearson Education, Inc.

The Operating Cycle of a Merchandising Business The income statement of a merchandiser reports: Sales Revenue rather than Service Revenue The cost of merchandise sold to customers, called Cost of Goods Sold (COGS) Gross profit, which is net Sales Revenue minus Cost of Goods Sold Operating expenses, which re expenses other than Cost of Goods Sold Because the operating cycle of a merchandiser is different from that of a service company, the financial statements differ. On the income statement, a merchandising company reports revenues using an account called Sales Revenue rather than the account Service Revenue. A merchandiser also reports the cost of merchandise inventory that has been sold to customers, or Cost of Goods Sold (COGS). The Cost of Goods Sold is the cost of merchandise inventory that the business has sold to customers. Because COGS is usually a merchandiser’s main expense, an intermediary calculation, gross profit, is determined before net income is calculated. Gross profit is the excess of net Sales Revenue over Cost of Goods Sold. Operating expenses are expenses, other than Cost of Goods Sold, that are incurred in the entity’s major ongoing operations. © 2016 Pearson Education, Inc.

The Operating Cycle of a Merchandising Business The financial statements of merchandising companies also look somewhat different from what we have seen so far. The most notable difference is that the income statement for a merchandising company includes line items for Cost of Goods Sold and Gross Profit. © 2016 Pearson Education, Inc.

The Operating Cycle of a Merchandising Business The balance sheet shows a new asset account called Merchandise Inventory. Merchandise Inventory is a current asset since it is expected to be sold within the operating cycle. © 2016 Pearson Education, Inc.

© 2016 Pearson Education, Inc. Merchandise Inventory Systems: Perpetual and Periodic Inventory Systems Businesses need to determine the value on merchandise inventory on hand and the value sold. The two inventory accounting systems: A periodic inventory system requires a physical count of inventory to determine inventory on hand. A perpetual inventory system offers continuous computerized record of merchandise inventory. A periodic inventory system is an inventory system that requires businesses to obtain a physical count of inventory to determine quantities on hand. The periodic inventory system is most appropriate for inexpensive inventory that is sold by small shops that do not have optical-scan or point-of-sale capability. A perpetual inventory system is an inventory system that keeps a running computerized record of merchandise inventory. © 2016 Pearson Education, Inc.

© 2016 Pearson Education, Inc. Learning Objective 2 Account for the purchase of merchandise inventory using a perpetual inventory system © 2016 Pearson Education, Inc.

© 2016 Pearson Education, Inc. Look at the invoice from Southwest Electronics Direct in Exhibit 5-3. It shows that Smart Touch Learning acquired $35,000 of inventory on June 3, 2017. Ignoring the purchase terms, the Merchandise Inventory account is an asset and is increased with a debit. © 2016 Pearson Education, Inc.

Purchase of Merchandise Inventory Assume that Smart Touch Learning receives the goods on June 3 and makes a payment on that date. On June 3, Smart Touch Learning will record the purchase by debiting Merchandise Inventory. © 2016 Pearson Education, Inc.

Purchase of Merchandise Inventory Now assume that on June 3, instead of paying cash, Smart Touch Learning receives the merchandise inventory on account. If the transaction is on account, then Smart Touch Learning will record a credit to Accounts Payable for $35,000. At this point, we have not accounted for the purchase discount terms. If Smart Touch Learning takes advantage of the discount, we will adjust the Accounts Payable account appropriately at that time. © 2016 Pearson Education, Inc.

© 2016 Pearson Education, Inc. Purchase Discounts If Smart Touch Learning pays on June 15, which is within the discount period, the cash payment entry would be: Recall that we earlier recognized the vendor offered Smart Touch Learning sales terms of 3/15, NET 30 DAYS. According to the sales terms (3/15, NET 30 DAYS), Smart Touch Learning will receive a 3% discount if it pays within 15 days of the invoice date (June 3, 2017). The purchase discount is from the purchaser’s perspective. A purchase discount is a discount that businesses offer to purchasers as an incentive for early payment. The payment terms of the purchase or sale are stated on the invoice. © 2016 Pearson Education, Inc.

Purchase Returns and Allowances Sellers allow purchasers to return merchandise that is defective, damaged, or unsuitable. Purchase returns exist when sellers allow purchasers to return merchandise. Purchase allowances are granted to purchasers as an incentive to keep goods that are not as ordered. Purchase returns are a situation in which sellers allow purchasers to return merchandise that is defective, damaged, or otherwise unsuitable. A purchase allowance is an amount granted to the purchaser as an incentive to keep goods that are not “as ordered.” © 2016 Pearson Education, Inc.

Purchase Returns and Allowances Assume Smart Touch Learning returns $7,000 of the June 3 purchase on June 4. On June 4, Smart Touch Learning returns $7,000 of the inventory to the vendor. This has the effect of reducing the outstanding Account Payable from $35,000 to $28,000. © 2016 Pearson Education, Inc.

© 2016 Pearson Education, Inc. Transportation Costs While goods are in transit, rules are necessary to determine who bears the risk of loss. Either the buyer or the seller must pay the transportation costs of shipping merchandise inventory. The purchase agreement specifies FOB (free on board) terms to determine when title to the goods transfers to the purchaser and who pays the freight. FOB shipping point is a situation in which the buyer takes ownership (title) of the goods after the goods leave the seller’s place of business (shipping point), and the buyer typically pays the freight. FOB destination is a situation in which the buyer takes ownership (title) of the goods at the delivery destination point, and the seller typically pays the freight. © 2016 Pearson Education, Inc.

© 2016 Pearson Education, Inc. Freight In With FOB shipping point, the freight cost is paid by the buyer and is part of the inventory cost. Assume Smart Touch Learning pays a $60 freight charge on the June 3 purchase. Assume Smart Touch Learning pays a $60 freight charge related to the June 3 purchase. Smart Touch Learning should record a debit to Merchandise Inventory and a credit to Cash. When merchandisers are required to pay for shipping cost, those costs are classified as either freight in or freight out. Freight in is transportation cost to ship goods into the purchaser’s warehouse; therefore, it is freight on purchased goods. Freight out is the transportation cost to ship goods out of the seller’s warehouse; therefore, it is freight on goods sold to a customer. © 2016 Pearson Education, Inc.

Freight In Within Discount Period If Smart Touch Learning pays within the 15-day period, it gets a 3% discount. Discounts are computed only on the merchandise purchased from the seller. Discounts are not computed on the transportation costs because there is no discount on freight. Under FOB shipping point, the seller sometimes prepays the transportation cost as a convenience and lists this cost on the invoice. If Smart Touch Learning pays within the discount period, the discount will be computed only on the merchandise cost, not the total invoice amount. © 2016 Pearson Education, Inc.

Cost of Inventory Purchased Knowing the net cost of inventory allows a business to determine the actual cost of the merchandise purchased. Net cost of inventory is calculated as follows: The net cost of merchandise inventory purchased includes the purchase cost of inventory, less purchase returns and allowances, less purchase discounts, plus freight in. Knowing the net cost of inventory allows a business to determine the actual cost of the merchandise purchased. The calculation of net cost of inventory purchased is determined as follows: Purchase cost of inventory ‒ Purchase returns and allowances ‒ Purchase discounts + Freight in = Net cost of inventory purchased © 2016 Pearson Education, Inc.

© 2016 Pearson Education, Inc. Learning Objective 3 Account for the sale of merchandise inventory using a perpetual inventory system © 2016 Pearson Education, Inc.

© 2016 Pearson Education, Inc. How Are Sales of Merchandise Inventory Recorded in a Perpetual Inventory System? The amount a business earns from selling merchandise inventory is called Sales Revenue. Two entries are required to record sale transactions: The first entry records Sales Revenue and Cash or Accounts Receivable. The second entry records Cost of Goods Sold and Merchandise Inventory. After a company buys merchandise inventory, the next step is to sell the goods. At the time of sale, two entries must be recorded in the perpetual inventory system. One entry records the Sales Revenue and the Cash (or Accounts Receivable) at the time of sale. The second entry records Cost of Goods Sold (debit the expense) and reduces the Merchandise Inventory (credit the asset). Sales Revenue is the amount that a merchandiser earns from selling its inventory. © 2016 Pearson Education, Inc.

Sale of Merchandise Inventory A sales invoice is an agreement between buyer and seller. To the seller, a sales invoice is a bill that shows what amount the customer must pay. © 2016 Pearson Education, Inc.

Sale of Merchandise Inventory Smart Touch Learning sold 2 tablets for $1,000 cash. The cost of those tablets was $700. When we sell items to customers, we must record two journal entries. In this case, we see that Smart Touch Learning sold $1,000 worth of goods to a customer for cash of $1,000. The goods sold by Smart Touch Learning cost $700. © 2016 Pearson Education, Inc.

Sale of Merchandise Inventory Smart Touch Learning sold 10 tablets for $500 each on account with terms of 2/10, n/30 on June 21. The goods cost $3,500. Smart Touch Learning sold 10 tablets for $500 each, making a $5,000 (10 tablets × $500 per tablet) sale on account with terms 2/10, n/30 on June 21. The goods cost $3,500. Again, two entries are recorded for the transaction. First, we record a debit to Accounts Receivable for $1,000 and a corresponding credit to Sales Revenue for $1,000. Second, we record a reduction to the Merchandise Inventory account of $3,500 ($350 x 10), along with a corresponding debit to Cost of Goods Sold. © 2016 Pearson Education, Inc.

© 2016 Pearson Education, Inc. Sales Discounts A sales discount reduces the amount of cash received from a customer for early payment. Sales Discounts is a contra account to Sales Revenue. Assume the customer that purchased the tablets on June 21 made payment on June 30, within the discount period. Many sellers offer customers a discount for early payment. Sales discounts decrease the net amount of revenue earned on sales. The Sales Discounts account is a contra account to Sales Revenue. Sales Discounts is a contra revenue account and has a normal debit balance. © 2016 Pearson Education, Inc.

Sales Returns and Allowances The return of goods by a customer or the granting of an allowance is called sales returns and allowances. Sales Returns and Allowances is a contra account to Sales Revenue and has a normal debit balance. After making a sale, Smart Touch Learning may have a customer that returns goods, asking for a refund or credit to the customer’s account. Or the company may instead grant a sales allowance to encourage the customer to accept the nonstandard goods. Such an allowance reduces future cash collected from the customer. Sales returns and allowances decrease the seller’s receivable from a customer’s return of merchandise or from granting the customer an allowance from the amount owed to the seller. If we need to accept a return, in a perpetual system, we also need to make two entries. The first entry will show the reduction in Accounts Receivable with a corresponding entry in Sales Returns and Allowances. The second entry will show the Merchandise Inventory being re-stocked with the returned merchandise with a corresponding entry to Cost of Goods Sold. © 2016 Pearson Education, Inc.

© 2016 Pearson Education, Inc. Sales Return On June 25, a customer returns 3 tablets that were sold for $1,500, with a cost of goods sold of $1,050. When recording a return of merchandise, the seller must record two journal entries: one to record the sales return and decrease the receivable and the other to update the Merchandise Inventory account for the cost of the returned merchandise. © 2016 Pearson Education, Inc.

© 2016 Pearson Education, Inc. Sales Allowance On June 28, Smart Touch Learning grants a $100 sales allowance for goods damaged in transit. If we are granting a sales allowance, then there is no merchandise inventory to receive, so we make only one journal entry. © 2016 Pearson Education, Inc.

Sales Returns and Allowances Within Discount Period The discount is calculated net of the allowances and returns. On June 30, Smart Touch Learning receives payment on the receivable. If sales returns and allowances occur before the discount period has expired, any discount allowed would be calculated net of the returns and allowances. © 2016 Pearson Education, Inc.

Transportation Costs—Freight Out Smart Touch Learning paid $30 to ship goods to a customer on June 21. Remember: Freight out is a selling expense. Freight out expense is one in which the seller pays freight charges to ship goods to customers. Freight out is a delivery expense to the seller. © 2016 Pearson Education, Inc.

Net Sales Revenue and Gross Profit Net Sales Revenue is the amount a company has earned on sales of merchandise after returns, allowances, and discounts have been taken out. Net Sales Revenue is determined using the following formula: Net Sales Revenue is calculated as Sales Revenue less Sales Returns and Allowances and Sales Discounts. Net Sales Revenue is the amount a company has earned on sales of merchandise inventory after returns, allowances, and discounts have been taken out. © 2016 Pearson Education, Inc.

Net Sales Revenue and Gross Profit For the year, Smart Touch Learning sells $297,500 of merchandise inventory, receives $11,200 of sales returns and allowances, and accepts $5,600 of early payment discounts. Smart Touch Learning’s Net Sales Revenue is $280,700, which is found by subtracting Sales Returns and Allowances of $11,200 and Sales Discounts of $5,600 from Sales Revenue of $297,500. © 2016 Pearson Education, Inc.

Net Sales Revenue and Gross Profit Gross profit is a measure of a business’s success. It indicates the amount available to cover operating expenses. After determining Net Sales Revenue, Smart Touch Learning can then calculate its gross profit. Gross profit is Net Sales Revenue less Cost of Goods Sold. Gross profit, along with net income, is a measure of a business’s success. The gross profit must cover the company’s operating expenses for the company to survive. © 2016 Pearson Education, Inc.

© 2016 Pearson Education, Inc. Learning Objective 4 Adjust and close the accounts of a merchandising business © 2016 Pearson Education, Inc.

What Are the Adjusting and Closing Entries for a Merchandiser Actual inventory on hand may differ from what the books show. Inventory shrinkage is loss of inventory occurring from theft, damage, and errors. An adjustment is made to Merchandise Inventory based on the physical count of goods on hand. The Merchandise Inventory account should stay current at all times in a perpetual inventory system. However, actual inventory on hand often does not match the amount that the accounting systems reports. Inventory shrinkage is the loss of inventory that occurs because of theft, damage, or errors. When there is a difference between what the system says should be there and what is actually there, we need to make an adjustment to the accounting records so that the Merchandise Inventory account reflects the actual inventory on hand. © 2016 Pearson Education, Inc.

Closing the Accounts of a Merchandiser The new accounts used by a merchandising business are highlighted in blue. The new accounts introduced in this chapter are Merchandise Inventory, Sales Revenue, Sales Returns and Allowances, Sales Discounts, Cost of Goods Sold, and Delivery Expense. Merchandise Inventory is a permanent account. The income statement accounts are temporary accounts and closed at the end of the period. © 2016 Pearson Education, Inc.

Closing the Accounts of a Merchandiser Close revenues via the Income Summary. Close expenses and contra revenues via the Income Summary. Close Income Summary via Retained Earnings. Close Dividends via Retained Earnings. After the accounts have been adjusted, the temporary accounts of the merchandiser are closed into Income Summary. Using the four steps in the closing process, the Income Summary account and the Dividends account are closed. Revenues are closed to Income Summary. In the same way, expenses and contra revenue accounts are closed to Income Summary. © 2016 Pearson Education, Inc.

© 2016 Pearson Education, Inc. Learning Objective 5 Prepare a merchandiser’s financial statements © 2016 Pearson Education, Inc.

How Are a Merchandiser’s Financial Statements Prepared? The formats for income statements are: The single-step income statement presents revenues and expenses with no subtotals. The multi-step income statement presents revenues and expenses with subtotals to highlight significant relationships. The income statement can appear in two formats: the single-step format and the multi-step format. The single-step income statement is the income statement format that groups all revenues together and all expenses together, without calculating subtotals. A single-step income statement works well for service entities because they have no gross profit to report. A multi-step income statement is an income statement format that contains subtotals to highlight significant relationships. In addition to net income, it reports gross profit and operating income. © 2016 Pearson Education, Inc.

Single-Step Income Statement A single-step income statement does not provide subtotals. © 2016 Pearson Education, Inc.

Multi-Step Income Statement A multi-step income statement details the calculation of net sales revenue, gross profit, operating income, and net income. © 2016 Pearson Education, Inc.

Multi-Step Income Statement Operating expenses are reported in two categories: Selling expenses are related to marketing and selling the company’s goods and services. Administrative expenses include expenses not related to marketing the company’s goods and services. Gross profit minus operating expenses equals operating income. Companies report operating expenses in two categories: selling expenses and administrative expenses. Selling expenses are expenses related to marketing and selling the company’s goods and services. Administrative expenses are expenses incurred that are not related to marketing the company’s goods and services. Gross profit minus operating expenses equals operating income. Operating income measures the results of the entity’s major ongoing activities: gross profit minus operating expenses. © 2016 Pearson Education, Inc.

Multi-Step Income Statement After determining operating income, the next section of the income statement reports other revenues and expenses. The last section of the income statement reports income tax expense. After operating income (sometimes called income from operations), we subtract or add interest income or interest expenses and, if necessary, taxes, before computing net income. Other revenues and expenses are revenues or expenses that are outside the normal, day-to-day operations of a business, such as a gain or loss on the sale of plant assets or interest expense. Income tax expense is an expense incurred by a corporation related to federal and state income taxes. © 2016 Pearson Education, Inc.

Statement of Retained Earnings and the Balance Sheet The statements of retained earnings for merchandisers and service businesses are similar. The balance sheet for a merchandiser reports Merchandise Inventory. A merchandiser’s statement of retained earnings looks exactly like that of a service business. The balance sheet will also look the same as for a service business, except merchandisers have an additional current asset, Merchandise Inventory. Service businesses do not have merchandise inventory. © 2016 Pearson Education, Inc.

© 2016 Pearson Education, Inc. Learning Objective 6 Use the gross profit percentage to evaluate business performance © 2016 Pearson Education, Inc.

© 2016 Pearson Education, Inc. How Do We Use the Gross Profit Percentage to Evaluate Business Performance? The gross profit percentage measures the profitability of each sales dollar above the cost of goods sold. A high gross profit percentage is desired. The gross profit percentage is one of the most carefully watched measures of profitability. It reflects a business’s ability to earn a profit on its merchandise inventory. A small increase in the gross profit percentage from last year to this year may signal an important rise in income. Conversely, a small decrease from last year to this year may signal trouble. In general, a high gross profit percentage is desired. © 2016 Pearson Education, Inc.

© 2016 Pearson Education, Inc. Learning Objective 7 Account for the purchase and sale of merchandise inventory using a periodic inventory system (Appendix 5A) © 2016 Pearson Education, Inc.

© 2016 Pearson Education, Inc. How Are Merchandise Inventory Transactions Recorded in a Periodic Inventory System? Perpetual inventory systems are too expensive for smaller businesses. Periodic inventory systems require physical counts of inventory to determine quantities on hand. Merchandise Inventory is updated at the end of the period, during the closing process. In a periodic inventory system, purchases, purchase discounts, purchase returns and allowances, and freight in costs are recorded in separate accounts during the year, and then the Merchandise Inventory account is updated during the closing process. In a periodic system of accounting for inventory, each purchase of inventory is not tracked directly in the accounting system. Rather, purchases are recorded in a Purchases account. Information related to sales of inventory during the period is accumulated and accounted for at the end of the period in one large sum. © 2016 Pearson Education, Inc.

Purchases of Merchandise Inventory The entry to record the receipt of goods on account on June 3 and payment on June 15 using the periodic inventory system is as follows: In this invoice example, Smart Touch Learning is being billed for the purchase of 100 touch screen tablet computers, at an amount of $350 each. The invoice has sales terms stated as 3/15, NET 30 DAYS. In a periodic system, Smart Touch Learning will still credit Accounts Payable. However, the debit will go to an account called Purchases. This account will be used to accumulate all the purchase information for the period. At the end of the period, the Purchases account will be closed via the Income Summary. © 2016 Pearson Education, Inc.

Recording Purchase Returns and Allowances Prior to payment, on June 4, Smart Touch Learning returned 20 tablets, costing $7,000, to the vendor. When we return goods to the seller, we reduce Accounts Payable. In addition, we record the amount of the return or allowance in a contra expense account called Purchase Returns and Allowances. This account will be closed via the Income Summary at the end of the period. © 2016 Pearson Education, Inc.

Recording Purchase Returns and Allowances A business records the cost of all inventory bought in the Purchases account. Net Purchases is the sum of Purchases less Purchase Returns and Allowances and Purchase Discounts. In the periodic inventory system, instead of recording the return to Merchandise Inventory, a separate account, Purchase Returns and Allowances, is used. Both Purchase Discounts and Purchase Returns and Allowances are contra expense accounts. The balance of Purchases is a gross amount because it does not include subtractions for discounts, returns, or allowances. Net purchases are Purchases less Purchase Returns and Allowances less Purchase Discounts. © 2016 Pearson Education, Inc.

Recording Transportation Costs On June 3, Smart Touch Learning paid a freight charge. The payment of the freight bill related to shipping the inventory from the seller to Smart Touch Learning will be recorded in a Freight In account rather than directly to Merchandise Inventory. At the end of the period, this account will be closed via the Income Summary. © 2016 Pearson Education, Inc.

Sale of Merchandise Inventory No running record of merchandise inventory is maintained. There is no need to record an entry to Merchandise Inventory and Cost of Goods Sold. Accounting for sales discount and sales return and allowances is the same as under the perpetual inventory system. Recording sales of merchandise inventory is streamlined in the periodic inventory system. With no running record of merchandise inventory to maintain, there is no need to record an entry to Merchandise Inventory and Cost of Goods Sold. Instead, a sale of inventory involves recording only the Sales Revenue portion. © 2016 Pearson Education, Inc.

Adjusting and Closing Entries No adjustment is required for inventory shrinkage. Temporary accounts are closed via the Income Summary: Purchase Returns and Allowances Purchase Discounts Purchases Freight In There is no need to record an adjustment for inventory shrinkage since there is no difference between the accounting records and the physical count of inventory on hand. The process of recording the ending Merchandise Inventory is completed through the closing entry process. © 2016 Pearson Education, Inc.

Adjusting and Closing Entries The adjusted trial balance shows the accounts associated with the periodic inventory system. © 2016 Pearson Education, Inc.

Adjusting and Closing Entries The temporary accounts associated with the periodic inventory system are closed via the Income Summary. © 2016 Pearson Education, Inc.

Preparing Financial Statements The financial statements under the perpetual and periodic inventory systems are similar. However, the periodic inventory system requires an additional calculation: the cost of goods sold. © 2016 Pearson Education, Inc.

Preparing Financial Statements Exhibit 5A-3 provides a side-by-side comparison of journal entries for perpetual vs. periodic inventory systems for the same company’s transactions. © 2016 Pearson Education, Inc.

Preparing Financial Statements Exhibit 5A-3 provides a side-by-side comparison of journal entries perpetual vs. periodic inventory systems for the same company’s transactions. © 2016 Pearson Education, Inc.

Preparing Financial Statements Exhibit 5A-3 provides a side-by-side comparison of journal entries for perpetual vs. periodic inventory systems for the same company’s transactions. © 2016 Pearson Education, Inc.