1. Accounting for Merchandising Businesses
Chapter 4

2. Learning Objectives
After studying this chapter, you should be able to:
Distinguish the activities and financial statements of a service business from those of a merchandising business
Describe and illustrate the financial statements of a merchandising business
Describe the accounting for the sale of merchandise
Describe the accounting for the purchase of merchandise
(Continued…)

3. Learning Objectives
After studying this chapter, you should be able to:
Describe the accounting for freight and sales taxes
Illustrate the dual nature of merchandising transactions
Describe the accounting for merchandise shrinkage
Financial Analysis: Describe and illustrate the gross profit percent, average markup percent, and ratio of sales to assets in assessing a company’s financial performance

4. Learning Objective 1
Distinguish the activities and financial statements of a service business from those of a merchandising business

5. Service Businesses vs. Merchandise Operations
Revenue activities involve the buying
and selling of merchandise
Example: Home Depot Inc.
Service Businesses
Revenue activities involve providing services to customers
Example: Family Health Care, P.C.
The activities of a service business differ from those of a merchandising business. The revenue activities of a service organization involve providing services to customers and earning fees for those services whereas the revenue activities of a merchandising organization involve the buying and selling of products.

6. Gross Profit for a Merchandise Operation
The revenue activities of a service business involve providing services to customers. On the income statement for a service business, the revenues from services are reported as fees earned. The operating expenses incurred in providing the services are subtracted from the fees earned to arrive at net income.
A merchandising business purchases goods to be sold to customers. When the merchandise is sold, the revenue is reported as sales, and its cost is recognized as an expense. This expense is called the cost of merchandise sold. The cost of merchandise sold is subtracted from sales to arrive at gross profit. This amount is called gross profit because it is the profit before deducting operating expenses. 

7. Learning Objective 2
Describe and illustrate the financial statements of a merchandising business

8. Multiple-Step Income Statement
Considers customer returns and discounts
Assume a perpetual inventory system
A Multiple-Step Income Statement contains several sections, subsections, and subtotals. The revenue section is expanded to include Sales and Sales Returns And Allowances and Sales Discounts. Net sales represent the revenue generated by TechUSA after taking into account customer returns of merchandise and sales discounts that may have been granted to customers.
A multiple-step income statement makes it easier for a stakeholder to analyze the operations of an organization. The gross profit subtotal represents the difference between sales revenue generated from selling products minus the cost of those products. Operating income measures the organization’s results from their total operations and takes into account selling and administrative expenses. Net income is the final measurement of an organization’s performance. Not only does net income measure the profit or loss from business operations, it also measures the impact of any other peripheral income activities or expenses.
TechUSA is using a perpetual inventory system. This is indicated by the fact that cost of merchandise sold is a one-line item on the income statement. Under a perpetual system, each purchase and sale of merchandise is recorded in the inventory and cost of merchandise sold account. The next slide explores cost of merchandise sold in more detail under a periodic inventory system. 
Measures
income/loss from
the core operations
of the business

9. Cost of Merchandise Sold – Periodic Inventory
If a company utilizes a periodic inventory system, the calculation of cost of merchandise sold may be a bit more complex. Any merchandise not sold at the end of an accounting period is called merchandise inventory and reported as an asset on the company’s balance sheet. The inventory balance at the beginning of an accounting period is the starting point for the calculation of cost of merchandise sold. Purchases of inventory are added to the beginning inventory balance. These purchases are adjusted by any necessary purchase returns, allowances or discounts. Any freight paid to acquire the inventory is added to the net purchases to arrive at the cost of merchandise purchased. A count and valuation is made of inventory at the end of the accounting period and that amount is subtracted from cost of merchandise purchased in order to arrive at the cost of merchandise sold.

10. Income Statement
A single-step income statement deducts the total of all expenses in one step from the total of all revenues. This emphasizes total revenues and total expenses of a company in determining net income.

11. Retained Earnings Statement
The retained earnings statement for a merchandising company does not differ from a service company.

12. Balance Sheet Value of units on hand, not sold
The balance sheet of a merchandising organization will include the account Merchandise Inventory in the Current Asset section. This amount represents the value of any products that remain unsold at the end of an accounting period.

13. Statement of Cash Flows
On the statement of cash flows, the positive cash flow from operating activities is used to fund cash paid for purchase of equipment under investing activities and cash paid out to shareholders in the form of dividends and to creditors to pay off notes payable.
The net cash flows from operating activities is arrived at, using a method known as the indirect method. This method, which reconciles net income with net cash flows from operating activities. Note that the cash balance reported on the statement of cash flows agrees with the amount reported for cash on the balance sheet.
Equals cash on balance sheet

14. Integrated Financial Statements
The integration of TechUSA’s financial statements is as shown in this Exhibit.

15. Learning Objective 3
Describe the accounting for the sale of merchandise

16. Cost of Merchandise Sold
Sales Transactions
Assume that on January 3, TechUSA sells merchandise for $1,800 that cost $1,200
Normally, sales are recorded by increasing cash or accounts receivable and increasing sales revenue. In a perpetual inventory system, the cost of merchandise sold is also recorded at the time of sale. Under this method, the merchandise inventory account will always reflect the amount of merchandise on hand.
Sales Revenue
Cost of Merchandise Sold

17. Sample Sales Invoice Credit terms
Terms for payment to the customer are normally indicated on the invoice and are called credit terms. Normally, cash or net cash mean cash is expected on delivery. A credit period gives the buyer a period of time to pay in full. Discounts encourage the buyer to pay before the end of the credit period.
The credit period usually begins with the date of the sale as shown on the invoice. If payment is due within a stated number of days after the date of the invoice, such as 30 days, the terms are net 30 days. These terms may be written as n/30.
Credit terms

18. Sales Discounts
As a means of encouraging the buyer to pay before the end of the credit period, the seller may offer a discount. In this example, the customer placed an order on May 29 and TechUSA invoiced the sale on June 3 with terms 2/10, n/30 which means a cash discount of 2% will be offered to the buyer if he pays within 10 days. In other words, the buyer would pay $1,470 instead of $1,500 to TechUSA if he pays on or before June 13, 20Y7. Otherwise, the balance is due in full after 30 days of invoice.

19. Sales Discounts
Assume that cash is received within the discount period on June 13 from the credit sale of $1,500
Discounts taken by customers for early payment are recoded as sales discounts by the seller when the invoice is paid and recorded in a separate contra account which is an offsetting account to sales.
 In this case, it is assumed that cash is received within the discount period on June 13 from the credit sale of $1,500. Consequently, the effect on the accounts and financial statements of the receipt of the cash is as shown.
Sales Discounts

20. Sales Returns and Allowances
Sales return refers to the merchandise returned by the seller. The seller may also reduce the initial price of the goods due to defects or other reasons. This is called sales allowances. Credit memorandums are issued to the buyer to track the goods returned. This memorandum shows the amount of and the reason for the seller’s credit to accounts receivable.

21. Sales Returns and Allowances
Assume that the cost of the merchandise returned in the preceding credit memorandum was $140
Like sales discounts, sales returns and allowances offset sales revenue. The accounts receivable account is reduced by the amount listed on the credit memo, in this example $225. Since the merchandise is returned to the seller, the cost of the returned merchandise must be added back to the Merchandise Inventory account, in this case $140. The seller must also decrease the cost of merchandise returned from the cost of merchandise sold account, since this account was increased when the goods were sold. If sales are reduced by $225 and cost of merchandise sold is decreased by $140, the net impact will be an $85 decrease in net income which will also reflected in the retained earnings balance.

22. Learning Objective 4
Describe the accounting for the purchase of merchandise

23. Purchase Transaction - Using the Perpetual System
Computers make perpetual inventory systems the norm in most organizations. Under the perpetual inventory system, merchandise inventory is increased as purchases are made. If cash is paid for the purchase, cash is reduced for the cost of the merchandise. Merchandise purchases are also often made on account, which would require an increase to accounts payable for the cost of the purchase instead of a reduction to cash.

24. Purchases Discounts Purchases Discounts
Purchases discounts are taken by the buyer for early payment of an invoice. The effect of a purchase discount is to reduce the cost of merchandise purchased. When paying the invoice, the buyer decreases the merchandise inventory account for the amount of the discount. In this way, merchandise inventory shows the net cost to the buyer.
Purchases Discounts

25. Purchases Returns and Allowances
A Purchase Return occurs when merchandise is returned to the seller. A purchase allowance is a price adjustment requested by the buyer and granted by the seller. The buyer sends a debit memorandum to the seller to make these invoice/account adjustment requests. A debit memorandum, as shown in the exhibit, informs the seller of the amount the buyer proposes to decrease to the account payable due the seller. It also states the reasons for the return or the request for a price reduction.

26. Return of Merchandise
To show the effect of purchases return, the buyer will decrease Accounts Payable, the amount owed to the seller. An increase will be made to merchandise inventory to reflect the value of the merchandise returned.

27. Learning Objective 5
Describe the accounting for freight and sales taxes

28. Freight
Terms of sale should indicate when ownership of the merchandise passes from seller to buyer. This point determines who must pay the transportation costs. If the shipping terms are FOB (free on board) shipping point, the title passes from seller to buyer when the goods are shipped and the buyer pays the freight. If the shipping terms are FOB (free on board) destination, the title passes from seller to buyer at the destination point and the seller will pay the freight charges. The transportation cost paid by the buyer becomes a part of the merchandise cost.

29. Freight
Assume that on December 10, TechUSA buys merchandise from Magna Data on account, $900, terms FOB shipping point, and pays the freight cost of $50
TechUSA incurs $50 of transportation costs on $900 of merchandise purchased. The shipping terms are FOB shipping point, which means the title transferred to TechUSA when the merchandise was shipped and therefore TechUSA will pay for the shipping charges. The total $950 of cost recorded in Merchandise Inventory represents $900 inventory cost plus $50 freight charges.

30. Payment is made to state taxing authority to satisfy obligation
Sales Taxes
When sale is made, liability for sales tax is recorded as an obligation by the seller
Payment is made to state taxing authority to satisfy obligation
Most states and other taxing units levy a tax on sales of merchandise. A liability for sales tax is incurred by the seller when a sale is made. The liability is relieved when the tax collected is paid to the proper entity.

31. Learning Objective 6
Illustrate the dual nature of merchandising transactions

32. Dual Nature of Merchandise Transactions
Each transaction affects a buyer and a seller. When Company A sells merchandise to Company B, Company A will record sale and Company B will record purchase for the same amount.
Company A records a sale
Company B records a purchase

33. Learning Objective 7
Describe the accounting for merchandise shrinkage

34. Merchandise Shrinkage
Merchandising businesses could experience loss of inventory due to…
Shoplifting
Employee theft
Errors in recording or counting inventory
Even in a perpetual inventory system, a physical inventory should be taken at the end of each accounting period to determine if the inventory physically on hand equals what is shown in the accounting records as the balance in Merchandise Inventory. Any difference between the two balance is called inventory shrinkage or inventory shortage.

35. Merchandise Shrinkage
To illustrate, TechUSA’s inventory records indicate the following on December 31, 20Y7
The effect of the shrinkage is recorded with a decrease to the Merchandise Inventory account and an increase to Cost of Merchandise Sold. Some companies record inventory losses or shrinkage in a separate account on the Income Statement when the amount of the shrinkage is unusually large. After the shrinkage is recorded, the balance of Merchandise Inventory agrees with the physical inventory on hand.

36. Learning Objective 8
Financial Analysis: Describe and illustrate the gross profit percent, average markup percent, and ratio of sales to assets in assessing a company’s financial performance

37. Financial Analysis
Ratios useful in analyzing and assessing a company’s financial performance
Gross profit percent
Average markup percent
Ratio of sales to assets
The gross profit percent, average markup percent, and ratio of sales to assets are useful in analyzing and assessing a company’s financial performance. These measures are especially useful in assessing the operations and performance of merchandising businesses.

38. Gross Profit Percent Average Markup Percent
Gross profit: sales less cost of merchandise sold
Gross Profit
Gross Profit Percent =
Net Sales
Gross Profit
Average Markup Percent =
Cost of Merchandise Sold
Gross profit is calculated as sales less cost of merchandise sold.
The gross profit percent is computed by dividing gross profit by net sales. It is a measure of profitability before other operating expenses are deducted.
The gross profit can also be used to compute the average markup percent on the cost of merchandise sold. It is computed as gross profit divided by cost of merchandise sold.

39. Gross Profit Percent Average Markup Percent
Data (in millions) taken from two recent years financial statements of Walgreen Company
Let us now look at an illustration. Data from two recent years’ financial statements of Walgreen Company has been provided. All amounts are in millions.
The gross profit percent, rounded to one decimal place, is calculated for both the years by dividing gross profit by net sales. The average markup percent, rounded to one decimal place, is calculated for both the years by dividing gross profit by cost of merchandise sold. Note the gross profit percent and average markup percent did not change significantly from Year 1 to Year 2.

40. Ratio of Sales to Assets
Useful in assessing how efficiently a company generates sales from its assets
Ratio of Sales to Assets
Net Sales =
Average Total Assets
The ratio of sales to assets is useful in assessing how efficiently a company generates sales from its assets. It is computed by dividing net sales by average total assets.
Any significant non operating assets such as investments are normally excluded from total assets in computing the ratio of sales to assets.

41. Ratio of Sales to Assets
Data (in millions) taken from two recent years financial statements of Walgreen Company
Let us now look at an illustration. Data from two recent years’ financial statements of Walgreen Company has been provided. All amounts are in millions.
The ratio of sales to assets, rounded to two decimal places, for Years 1 and 2 is calculated by dividing net sales by average total assets.
In Year 1, Walgreen generated $2.69 of sales per asset dollar, while in Year 2 it generated only $2.35 of sales per asset dollar. This indicates that the company was slightly less efficient in using its assets to generate sales in Year 2.

42. End of Chapter 4