Chapter 5 Merchandising Operations

Chapter 5 Merchandising Operations

Learning Objective 1 Describe merchandising operations and the two types of merchandise inventory systems

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.

The Operating Cycle of a Merchandising Business
It begins when the company purchases inventory from an individual or a business, called a vendor. The company then sells the inventory to a customer. Finally, 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.

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.

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 are 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.

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.

Wal-Mart

(continued) 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.

Wal-Mart

The two inventory accounting systems:
Merchandise Inventory Systems: Perpetual and Periodic Inventory Systems Businesses need to determine the value of 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 keeps a running 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. In a perpetual inventory system, the “cash register” at the store is a computer terminal that records sales and updates inventory records. Bar codes are scanned by a laser. The bar coding is linked to merchandise inventory and cost data that are used to keep track of each unique inventory item. However, note that even in a perpetual inventory system, the business must count inventory at least once a year. The physical count captures inventory transactions that are not recorded by the electronic system (such as misplaced, stolen, or damaged inventory). The count establishes the correct amount of ending inventory for the financial statements and also serves as a check on the perpetual records.

An invoice is the seller’s request for payment from the purchaser.
HOW ARE PURCHASES OF MERCHANDISE INVENTORY RECORDED IN A PERPETUAL INVENTORY SYSTEM? The cycle of a merchandiser begins with the purchase of merchandise inventory. An invoice is the seller’s request for payment from the purchaser. Invoices are also called bills. Sellers have sales invoices. Purchasers have purchase invoices The cycle of a merchandiser begins with the purchase of merchandise inventory. An invoice is the seller’s request for payment from the purchaser. Invoices are also called bills. Sellers have sales invoices. Purchasers have purchase invoices

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 1, Ignoring the purchase terms, the Merchandise Inventory account is an asset and is increased with a debit.

Purchase of Merchandise Inventory
Smart Touch Learning receives the goods from Exhibit 5-3 on June 3 and makes a payment on that date. On June 3, Smart Touch Learning will record the purchase by debiting Merchandise Inventory. © 2018 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.

Purchase Discounts A purchase discount is a discount that businesses offer to purchasers as an incentive for early payment. Credit terms are the payment terms of purchase or sale as stated on the invoice. Most credit terms express the discount, the discount time period, and the final due date. Example: 3/15, n/30 means a 3% discount if paid within 15 day, otherwise the full amount is due in 30 days. 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. Credit terms of “3/15, NET 30 DAYS” mean that Smart Touch Learning can deduct 3% from the total bill (excluding freight charges, if any) if the company pays within 15 days of the invoice date. Otherwise, the full amount—NET—is due in 30 days. These credit terms can also be expressed as “3/15, n/30.” Terms of “n/30” mean that no discount is offered and payment is due 30 days after the invoice date. Most credit terms express the discount, the discount time period, and the final due date. Occasionally, the credit terms are expressed as EOM, which means payment is due at the end of the current month.

Purchase Discounts Under credit terms of “3/15, NET 30 DAYS”, 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 1, 2019).

Purchase Discounts The purchase discount is credited to the Merchandise Inventory account because the discount for early payment decreases the actual cost paid for Merchandise Inventory: Notice that the balance in the Merchandise Inventory account, $33,950, is exactly what was paid for the Merchandise Inventory on June 15, Also notice that the Accounts Payable account shows that the invoice was paid in full with no remaining balance.

Purchase Discounts Assume instead that Smart Touch Learning pays on June 24, after the discount period ends, 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. If Smart Touch Learning must pay the full $35,000 if payment is made on June 24, after the discount period ends.

Purchase Returns and Allowances
The invoice price for a purchaser may need to be adjusted for purchase returns or purchase allowances. Purchase returns exist when sellers allow purchasers to return merchandise that is defective, damaged, or otherwise unsuitable. Purchase allowances are amounts 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.”

On June 4, Smart Touch Learning returns 20 tablets valued at a total of $7,000 from the June 1 purchase. 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. The exact same entry is made for a purchase allowance granted to the buyer from the seller (vendor). The only difference between a purchase return and a purchase allowance is that, in the case of the allowance, Smart Touch Learning keeps the inventory.

On June 10, Smart Touch Learning purchased 15 tablets on account with credit terms of 3/15, n/30 at a cost of $5,250. Five tablets are returned on June 15 for $1,750, and payment is made on June 20. Occasionally, a business will return merchandise inventory or receive an allowance before payment has been made. In this scenario, if the payment of the invoice is made within the discount period, the discount should be calculated net of the return or allowance. Suppose that on June 10, Smart Touch Learning purchased 15 tablets from Southwest Electronics Direct on account with credit terms of 3/15, n/30 at a cost of $5,250. Five days later, Smart Touch Learning returned five tablets to the vendor because of damages and received a purchase return of $1,750. When Smart Touch Learning makes payment on June 20 (within the discount period), it will calculate the discount on the amount due less the return or $3,500 ($5,250 - $1,750). Smart Touch Learning’s discount will be $105 ($3,500 * 0.03). © 2018 Pearson Education, Inc.

Transportation Costs Purchase agreements specify shipping terms to determine when title of the goods transfers to the purchaser and who pays the freight. FOB shipping point means the buyer takes ownership (title) to the goods after the goods leave the seller’s place of business (shipping point). The buyer (owner of the goods while in transit) usually pays the freight. FOB destination means the buyer takes ownership (title) to the goods at the delivery destination point. The seller (owner of the goods while in transit) usually pays the freight. 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. © 2018 Pearson Education, Inc.

Transportation Costs When merchandisers are required to pay for shipping costs: Freight in is the transportation cost to ship goods into the purchaser’s warehouse; thus, it is freight on purchased goods. Freight out is the transportation cost to ship goods out of the seller’s warehouse and to the customer; thus, it is freight on goods sold to a customer. Freight in is the transportation cost to ship goods into the purchaser’s warehouse; thus, it is freight on purchased goods. Freight out is the transportation cost to ship goods out of the seller’s warehouse and to the customer; thus, it is freight on goods sold to a customer. © 2018 Pearson Education, Inc.

Transportation Costs 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.

Transportation Costs Freight In
Assume Smart Touch Learning pays a $60 freight charge on June 3 for a purchase with FOB shipping point: Assume Smart Touch Learning pays a $60 freight charge on June 3 for a purchase with FOB shipping point. Smart Touch Learning should record a debit to Merchandise Inventory and a credit to Cash.

Transportation Costs Freight In Within Discount Period
Under FOB shipping point, the seller sometimes prepays the transportation cost as a convenience and lists this cost on the invoice. Assume, Smart Touch Learning purchases $5,000 of goods, with freight charge of $400, on June 20 on account with terms of 3/5, n/30. The terms of shipment are FOB shipping point. 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. Assume, for example, Smart Touch Learning makes a $5,000 purchase of goods, coupled with a related freight charge of $400, on June 20 on account with terms of 3/5, n/30. The terms of shipment are FOB shipping point. The seller prepays the freight charge.

Transportation Costs Freight In Within Discount Period
If Smart Touch Learning pays within the discount period, the discount will be computed only on the $5,000 merchandise cost, resulting in a $150 discount: If Smart Touch Learning pays within the discount period, the discount will be computed only on the $5,000 merchandise cost, not on the total invoice of $5,400. The $400 freight is not eligible for the discount. So, the 3% discount would be $150 ($5,000 * 0.03).

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 © 2018 Pearson Education, Inc.

Cost of Inventory Purchased
During the year, Smart Touch Learning buys $281,750 of inventory, returns $61,250 of the goods, and takes a $4,410 early payment discount. The company also pays $14,700 of freight in. Net costs are calculated as: During the year, Smart Touch Learning buys $281,750 of inventory, returns $61,250 of the goods, and takes a $4,410 early payment discount. The company also pays $14,700 of freight in. Net costs equal $230,790. © 2018 Pearson Education, Inc.

Learning Objective 3 Account for the sale of merchandise inventory using a perpetual inventory system

Two entries are required to record sale transactions:
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.

Cash and Credit Card Sales
Smart Touch Learning sold the two tablets for $1,000 cash. The cost of the tablets was $700. To record the sale by Smart Touch Learning, two journal entries must be recorded. The first journal entry records the cash sale of $1,000 by debiting Cash and crediting Sales Revenue. A second journal entry must also be made to record the expense and decrease the Merchandise Inventory balance. Suppose these goods sold by Smart Touch Learning cost $700. The second journal entry would transfer the $700 from the Merchandise Inventory account to the Cost of Goods Sold account. The Cost of Goods Sold account keeps a current balance throughout the period in a perpetual inventory system of the cost of merchandise inventory sold. In this example, Cost of Goods Sold is $700 (the cost to Smart Touch Learning) rather than $1,000, the sales price (retail price) of the goods. Cost of Goods Sold is always based on the company’s cost, not the retail price.

Sales on Account Smart Touch Learning sold 5 tablets for $500 each, making a $2,500 sale on account on June 15. The goods cost $1,750. Many sales are made on account (on credit) instead of with cash or a credit card.

Sales Discounts Many sellers offer customers a discount for early payment. Sales discounts are a reduction in the amount of revenue earned on sales for early payment. The new revenue recognition standards require sales to be recorded at the net amount or the amount of the sale less any sales discounts. Many sellers offer customers a discount for early payment. Sales discounts are a reduction in the amount of revenue earned on sales for early payment. The new revenue recognition standards require sales to be recorded at the net amount or the amount of the sale less any sales discounts. © 2018 Pearson Education, Inc.

Sales Discounts On June 21, Smart Touch Learning sold 10 tablets for $500 each on account with terms of 2/10, n/30. The goods cost $3,500. Assume on June 21, Smart Touch Learning sold 10 tablets for $500 each on account with terms of 2/10, n/30. The goods cost $3,500. In this case, Smart Touch Learning will record the sale at the net amount of $4,900—the $5,000 less the 2% discount, $100 ($5,000 * 0.02). © 2018 Pearson Education, Inc.

Sales Discounts When the customer makes payment within the discount period, Smart Touch Learning will record the receipt of cash and decrease the Accounts Receivable for $4,900 as follows: Smart Touch Learning credited the Accounts Receivable for the net amount of the invoice. By doing this, Smart Touch Learning has shown that the invoice was paid in full with no remaining balance. © 2018 Pearson Education, Inc.

Sales Discounts If the customer does not pay within the discount period, the customer must pay the full $5,000 amount. Smart Touch Learning would record the discount lost as follows: If for some reason the customer does not pay within the discount period, the customer will no longer receive the $100 discount and the customer must pay the full $5,000 amount. Smart Touch Learning would record the discount lost using the account Sales Discounts Forfeited. The account, Sales Discounts Forfeited, increases Other Income and Expenses on the income statement. Notice that in either scenario, if the customer paid within the discount period or outside of the discount period, Smart Touch Learning credited the Accounts Receivable for the net amount of the invoice. By doing this, Smart Touch Learning has shown that the invoice was paid in full with no remaining balance.

Sales Returns and Allowances
The return of goods by a customer or the granting of an allowance is called Sales Returns and Allowances. Estimating Sales Returns Under the new revenue recognition standard, companies should only record sales revenue in the amount they expect to eventually realize. Companies must decrease sales revenue by an estimated amount of sales returns. Historical data can be used for this estimate. The return of goods by a customer or the granting of an allowance is called Sales Returns and Allowances. Under the new revenue recognition standard, companies should only record sales revenue in the amount they expect to eventually realize. Companies must decrease sales revenue by an estimated amount of sales returns. Historical data can be used for this estimate.

Estimating Sales Returns Smart Touch Learning had sales of $1,000,000 and cost of goods sold of $600,000 for the period. Smart Touch Learning estimates that approximately 4% of the merchandise sold will be returned. Smart Touch Learning had sales of $1,000,000 for the period ending December 31, The cost of goods sold related to those sales was $600,000. Smart Touch Learning estimates that approximately 4% of the merchandise sold will be returned, or $40,000 ($1,000,000 * 4%) of sales revenue and $24,000 ($600,000 * 4%) of merchandise inventory. Smart Touch Learning will need to record two adjusting entries on December 31 to account for the estimated returns. The first adjusting entry involves a debit to Sales Revenue that reduces sales for the year by the expected amount of the returns, thereby recording sales revenue at the net amount the company expects to eventually collect. The Refunds Payable account is a liability account and is reported on the balance sheet. In the second adjusting entry, Smart Touch Learning debits an asset account, Estimated Returns Inventory, that represents the cost of the inventory the company believes it will receive in returns. The corresponding credit to Cost of Goods Sold decreases the expense. © 2018 Pearson Education, Inc.

Actual Return of Inventory On January 20, 2020, a customer returned merchandise purchased with cash with a sales price of $2,000. The cost of the goods was $800. When a customer actually returns the inventory, the company will need to record the refund of cash to the customer (or credit of Accounts Receivable), and also the return of merchandise inventory. For example, assume that on January 20, 2020, a customer returned merchandise purchased with cash with a sales price of $2,000. The cost of the goods was $800. In recording the entries, Smart Touch Learning decreases the payable associated with the amount of estimated refunds. In addition, the Merchandise Inventory account has increased because the company received the returned inventory. To offset this, the Estimated Returns Inventory account decreases. © 2018 Pearson Education, Inc.

Sales Allowance On January 28, 2020, Smart Touch Learning grants a $100 sales allowance for goods damaged in transit. The goods were sold on account and remain unpaid. In situations of a sales allowance, a customer requests a refund of some portion owed but the customer does not return the inventory. When a seller grants a sales allowance, the company issues a credit memo indicating that the company will reduce the customer’s Accounts Receivable or issue a cash refund. The company also reduces the estimated refunds payable. Because there is no return of goods, the company does not need to record a second entry to adjust the Merchandise Inventory account. Suppose that on January 28, 2020, Smart Touch Learning grants a $100 sales allowance for goods damaged in transit. The goods were sold on account and remain unpaid. © 2018 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 delivery expense to the seller. Remember that a 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. Delivery expense is an operating expense and is debited to the Delivery Expense account. For example, assume Smart Touch Learning paid $30 to ship goods to a customer on June 21, 2019. © 2018 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. Businesses take a physical count of inventory at least once a year. Merchandise Inventory is adjusted based on the physical count. A merchandiser adjusts and closes accounts the same way a service entity does. If a worksheet is used, the unadjusted trial balance is entered, and the worksheet is completed to determine net income or net loss. In addition to adjusting for estimated sales returns as illustrated earlier in the chapter, merchandisers must also adjust for inventory shrinkage. The Merchandise Inventory account should stay current at all times in a perpetual inventory system. However, the actual amount of inventory on hand may differ from what the books show. This difference can occur because of theft, damage, and errors and is referred to as inventory shrinkage. For this reason, businesses take a physical count of inventory at least once a year. The most common time to count inventory is at the end of the fiscal year. The business then adjusts the Merchandise Inventory account based on the physical count. Smart Touch Learning must record an adjusting entry to account for this lost inventory. © 2018 Pearson Education, Inc.

Adjusting Merchandise Inventory Based on a Physical Count
Smart Touch Learning’s Merchandise Inventory account shows an unadjusted balance of $31,530, but a physical count comes to only $30,000. Smart Touch Learning’s Merchandise Inventory account shows an unadjusted balance of $31,530. With no shrinkage—due to theft or error—the business should have inventory costing $31,530. But on December 31, Smart Touch Learning counts the inventory on hand, and the total cost comes to only $30,000. Cost of Goods Sold should be debited and Merchandise Inventory should be credited for the amount of shrinkage ($1,530). This entry brings Merchandise Inventory to its correct balance and increases Cost of Goods Sold for the cost of the lost inventory. © 2018 Pearson Education, Inc.

Closing the Accounts of a Merchandiser
The four-step closing process for a merchandising company follows: Step 1: Make the revenue accounts equal zero via the Income Summary account. Step 2: Make expense accounts equal zero via the Income Summary account. Step 3: Make the Income Summary account equal zero via the Retained Earnings account. This closing entry transfers net income (or net loss) to Retained Earnings. Step 4: Make the Dividends account equal zero via the Retained Earnings account. The four-step closing process for a merchandising company follows: Step 1: Make the revenue accounts equal zero via the Income Summary account. Step 2: Make expense accounts equal zero via the Income Summary account. Step 3: Make the Income Summary account equal zero via the Retained Earnings account. This closing entry transfers net income (or net loss) to Retained Earnings. Step 4: Make the Dividends account equal zero via the Retained Earnings account.

Exhibit 5-6 presents Smart Touch Learning’s adjusted trial balance and closing entries for the year (new accounts are highlighted in blue). Closing means to zero out all temporary accounts. Exhibit 5-6 presents Smart Touch Learning’s adjusted trial balance and closing entries for the year (new accounts are highlighted in blue). © 2018 Pearson Education, Inc.

HOW ARE A MERCHANDISER’S FINANCIAL STATEMENTS PREPARED?
The formats for income statements are: The single-step income statement groups all revenues together and then lists and deducts all expenses together without calculating any subtotals. The multi-step income statement contains subtotals to highlight significant relationships. In addition to net income, it reports gross profit and operating income. 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. © 2018 Pearson Education, Inc.

A single-step income statement does not provide subtotals. Many companies use this format. The single-step format clearly distinguishes revenues from expenses and works well for service entities because they have no gross profit to report. © 2018 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. Both merchandisers and service companies report operating expenses in two categories: • Selling expenses are expenses related to marketing and selling the company’s goods and services. These include sales salaries, sales commissions, advertising, depreciation on store buildings and equipment, store rent, utilities on store buildings, property taxes on store buildings, and delivery expense. • Administrative expenses include expenses not related to marketing the company’s goods and services. These include office expenses, such as the salaries of the executives and office employees; depreciation on office buildings and equipment; rent other than on stores (for example, rent on the administrative office); utilities other than on stores (for example, utilities on the administrative office); and property taxes on the administrative office building. Gross profit minus operating expenses equals operating income (also called income from operations). Operating income measures the results of the entity’s major ongoing activities (normal operations). © 2018 Pearson Education, Inc.

Multi-Step Income Statement
Other income and expenses reports 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 reports the federal and state income taxes that are incurred by the corporation. After operating income (sometimes called income from operations), the next section of the income statement is other income and expenses. This category reports revenues and expenses that fall outside the business’s main, day-to-day, regular operations. Examples include interest revenue, sales discounts forfeited, interest expense, and gains and losses on the sale of plant assets. These examples have nothing to do with the business’s “normal” operations. As a result, they are classified as “other” items. Lastly, corporations are required to pay income tax. Therefore, the last section of the income statement is the income tax expense section. This section reports the federal and state income taxes that are incurred by the corporation. The calculation of income tax expense is complicated and will be covered in later accounting courses and is only presented here for informational purposes. © 2018 Pearson Education, Inc.

A multi-step income statement is different than a single-step income statement because it lists several important subtotals. In addition to net income (the bottom line), it also reports subtotals for gross profit, operating income (also called income from operations), and income before income tax expense. The income statement begins by calculating gross profit. Gross profit is the markup on the merchandise inventory and is calculated as net sales revenue minus cost of goods sold. Net sales revenue is sales revenue less discounts, and estimated returns and allowances. Gross profit, along with net income, is a measure of a business’s success. A sufficiently high gross profit is vital to a merchandiser. Next, the operating expenses, those expenses other than cost of goods sold, are listed. © 2018 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 is very similar, except for two new assets accounts: Merchandise Inventory Estimated Returns 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. © 2018 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. © 2018 Pearson Education, Inc.

HOW DO WE USE THE GROSS PROFIT PERCENTAGE TO EVALUATE BUSINESS PERFORMANCE?
Kohl’s Corporation reported the following: Gross profit percentage for year ending Jan. 2015: Gross profit percentage for year ending Jan. 2016: Visit to view a link to Kohl’s Corporation’s annual report. The gross profit percentage decreased slightly from fiscal year 2014 to 2015, signifying that the percentage of gross profit on sales is decreasing. However, when compared with the industry average for gross profit percentage, 35%, Kohl’s is slightly higher than average. Kohl’s should monitor the amount of profit it is earning on its merchandise inventory and take action if the percentage continues to drop.

Gross Profit Percentage—Example
CISCO

Perpetual inventory systems are too expensive for smaller businesses.
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.

Purchases of Merchandise Inventory
Referring back to Exhibit 5-3, 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.

Recording Purchase Returns and Allowances Prior to payment, on June 4, Smart Touch Learning returned 20 tablets to the vendor costing $7,000. Suppose that, prior to payment, on June 4, Smart Touch Learning returned 20 tablets to the vendor costing $7,000. 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. They are contra accounts to the Purchases account. © 2018 Pearson Education, Inc.

Recording Purchase Returns and Allowances During the period, the business records the cost of all inventory bought in the Purchases account. The balance of Purchases is a gross amount because it does not include subtractions for discounts, returns, or allowances. Net purchases is the remainder after subtracting the contra accounts from Purchases: © 2018 Pearson Education, Inc.

Recording Transportation Costs Smart Touch Learning pays a $60 freight charge on June 3. Under the periodic inventory system, freight in is debited to a separate Freight In account (an adjunct expense account) as opposed to debiting the Merchandise Inventory account. © 2018 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.

Sale of Merchandise Inventory
On June 21, Smart Touch Learning sold 10 tablets for a total sale of $5,000 on account with terms of 2/10, n/30. Accounting for sales discounts and sales returns and allowances is the same as in a perpetual inventory system, except that there are no entries for merchandise inventory.

Preparing Financial Statements
The periodic inventory system requires an additional calculation—the cost of goods sold. At the end of each period, the company combines a number of accounts to compute cost of goods sold for the period, and this calculation is shown on the income statement. The periodic inventory system requires an additional calculation—the cost of goods sold. At the end of each period, the company combines a number of accounts to compute cost of goods sold for the period, and this calculation is shown on the income statement. © 2018 Pearson Education, Inc.

Preparing Financial Statements
Cost of goods sold is calculated as follows for Smart Touch Learning: Cost of Goods Sold equals $540,000 for Smart Touch Learning.

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.

The adjusted trial balance shows the accounts associated with the periodic inventory system.

The four-step closing process under the periodic inventory system: Step 1: Using the periodic inventory system, Sales Revenue and Sales Discounts Forfeited are closed with a debit via the Income Summary account. All other temporary accounts with credit balances are also closed. The ending Merchandise Inventory and Estimated Returns Inventory are recorded as debits. There is a four-step closing process under the periodic inventory system. Step 1: Using the periodic inventory system, Sales Revenue and Sales Discounts Forfeited are closed with a debit via the Income Summary account. All other temporary accounts with credit balances are also closed. The ending Merchandise Inventory and Estimated Returns Inventory are recorded as debits. © 2018 Pearson Education, Inc.

The four-step closing process under the periodic inventory system: Step 2: Expense accounts and other temporary accounts with debit balances are closed via the Income Summary account. The beginning Merchandise Inventory, Purchases, and Freight In are also closed via the Income Summary account. There is a four-step closing process under the periodic inventory system. Step 2: Expense accounts and other temporary accounts with debit balances are closed via the Income Summary account. The beginning Merchandise Inventory, Purchases, and Freight In are also closed via the Income Summary account. The key difference in the closing process under the periodic inventory system is how merchandise inventory is handled. In the periodic inventory system, the ending merchandise inventory balance must be recorded as a debit during closing and the beginning merchandise inventory balance must be recorded as a credit during closing. The additional Purchases and related contra and adjunct accounts must also be closed.

The four-step closing process under the periodic inventory system: Step 3 and Step 4: These steps, closing the Income Summary and Dividends accounts, are the same under both the perpetual and periodic methods. There is a four-step closing process under the periodic inventory system. Step 3 and Step 4: These steps, closing the Income Summary and Dividends accounts, are the same under both the perpetual and periodic methods.

Chapter 5 Merchandising Operations

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Chapter 5 Merchandising Operations

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