1. Merchandising Operations
Chapter 5
Copyright ©2014 Pearson Education, Inc. publishing as Prentice Hall

2. What Are Merchandising Operations?
Seller of goods
Can be wholesaler or retailer
Inventory is a very important asset
Managing A/R is critical to success
Almost every business sells goods or services. When a business sells goods, we refer to that business as a “merchandiser.”
Although most of the operations in any business can be similar, regardless of the type of business, in a merchandising business, there are some special kinds of processes that are unique. The first of those unique processes is the Merchandiser Operating Cycle.
The business acquires inventory for resale. Either it plans on selling the inventory “as is,” but with a premium added, or the business will further process the inventory it acquires, adding value, and then re-selling it for a higher price.
Inventory can be purchased either with cash or on account. When inventory is purchased on account, the buyer will take possession of the inventory, selling it later, and then paying for those goods at a later date. Acquiring inventory on account requires the use of the Accounts Payable account.

3. Merchandiser Financial Statements
Income Statement differs from a service company
Cost of Goods Sold
Gross Profit
The financial statements of merchandising companies also looks somewhat different from what we have seen so far. The most notable difference is that the income statement for a merchandising company includes a line item for “Cost of Goods Sold.”

4. Merchandiser Financial Statements
Largest expense for merchandisers
When Cost of Goods Sold is subtracted from Net Sales Revenue the interim sub-total is referred to as Gross Profit. We then subtract the Operating Expenses to arrive at Net Income.
Calculated as:
Net Sales—COGS

5. Merchandiser Financial Statements
Merchandise Inventory is usually the only type of inventory.
(There is no raw materials or work-in-progress.)
Merchandise Inventory is usually purchased on credit, so Accounts Payable may also be higher than a Service Company.
The major difference with respect to the balance sheet is that a merchandiser will include a Merchandise Inventory account that is usually several times larger than any Inventory account that might appear on the balance sheet of a service company. The Merchandise Inventory is treated as a current asset.
Copyright ©2014 Pearson Education, Inc. publishing as Prentice Hall

6. Income Statement Differences

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9. Balance Sheet Differences

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11. Periodic
As computer technology takes over more and more accounting, the Periodic Method is used less and less.
Inventory on hand is physically counted
Inexpensive inventory
There are two approaches to accounting for inventory; Perpetual Inventory Accounting and Periodic Inventory Accounting.
In the Periodic Inventory Accounting approach, Purchases for the period are added to Beginning Inventory to arrive at an interim total referred to as Cost of Goods Available for Sale. At the end of the period, the inventory is physically counted. Subtracting the End-of-Period Inventory amount from the Cost of Goods Available for Sale leads to Cost of Goods Sold.
The periodic approach is most appropriate for inexpensive inventory that is sold by small shops that do not have opscan or point-of-sale capability.
Small shops without opscan capability

12. Every inflow and outflow is tracked in real time
Perpetual
When items are scanned in the receiving dock or at the cash register, the inventory is automatically updated on a continuous basis.
Every inflow and outflow is tracked in real time
Merchandising and purchase systems are integrated with the accounting system
In a Perpetual Inventory Accounting approach, each purchase of new inventory and each sale is entered into the system in real time. In this way, inventory is constantly updated.
Although this can be very time consuming if done by hand, computers enable perpetual inventory accounting to be used in a very efficient way. Each time a unit of product is sold, the inventory is adjusted. Each time new inventory arrives, the inventory account is likewise adjusted.

13. Purchase of Inventory(perpetual)
Assume that Smart Touch Learning pays for the inventory at the point of sale.
On June 3, Smart Touch Learning will record the purchase by debiting Merchandise Inventory. If the transaction is paid for immediately with cash, the credit for the entry will go to Cash.

14. Purchase on Account(perpetual)
If we had received the inventory, but chosen to pay later . . .
If the transaction is “on account”, the Smart Touch Learning will record a credit to Accounts Payable for $35,000. At this point, we have not accounted for the sales terms. If Smart Touch Learning takes advantage of the discount, we will adjust the Accounts Payable account appropriately at that time.

15. Purchase Returns and Allowances
When all or a portion of a purchase is returned to the seller, it is recorded as a reduction of the merchandise inventory account.
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 Southwest Electronics Direct. This has the effect of reducing the outstanding Account Payable from $35,000 to $28,000.

16. Transportation Costs
While goods are in transit, rules are necessary to determine who bears the risk of loss.
When goods are in transit from the seller to the buyer, an issue arises as to who bears the risk of loss in the event that the inventory becomes lost or damaged while in the custody of the third-party shipper.
To equitably arrive at a solution, “shipping terms” were developed that assign the risk of loss by contract to either the buyer or the seller.
Dating from the days of commercial sailing ships, the term “Free-on-Board” or FOB identifies the shipping terms. FOB Shipping Point indicates that the risk of loss passes to the buyer at the point that the goods are placed in the custody of the third party shipper. In FOB Shipping Point situations, the buyer pays for the shipping costs.
The phrase FOB Destination Point indicates that the risk of loss stays with the seller until the goods arrive at the buyer’s designated transfer point. This may be a warehouse, or even the buyer’s place of business. In FOB Destination Point situations, the seller pays for the shipping costs.

17. 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.
Only the cost of transporting inventory into the buyer’s place of business is considered part of the cost of the inventory. Any shipping fees associated with shipping inventory to customers is treated as a selling expense and is not part of the cost of the inventory.

18. Purchase Discounts
Invoices that accompany credit purchases often indicate “credit terms,” which offer the buyer discount if they pay early.
Recall that we earlier recognized that Southwest Electronics Direct offered Smart Touch Learning sales terms of 3/15, Net 30 Days. The terms indicate that Smart Touch Learning can receive a discount on the original sales price, if they choose to pay early, within a defined period of time.

19. 3/15, NET 30 DAYS Purchase Discounts
The amount of the discount is determined by the “credit terms” indicated on the invoice.
Discount Period
Total Credit Period
Discount
Percent
3/15, NET 30 DAYS
The first number indicates the amount of the discount being offered. In this case, a 3% discount is available to the purchaser. This number can vary, depending on how motivated the seller is to encourage the buyer to pay early. If the seller is in need of immediate cash inflow, then they might offer a higher discount. If the seller does not have a critical need for immediate positive cash flow, then the seller might offer a lower discount.
The second number indicates the length of the discount period, measured from the date of the invoice. In this case, the discount period is 15 days from the invoice date of June 1, Even if Smart Touch Learning does not receive the invoice until 10 days into the discount period, the discount period begins on the date of the invoice.
The final part of the “credit terms” indicates when the full amount of the bill is due. If the purchaser does not take advantage of the early payment discount, then the full amount of the bill is due this many days after the original date of the invoice. In this case, the bill must be paid 30 days after the invoice date if the discount is not taken.

20. Purchase Discounts
If Smart Touch Learning pays within the 15 day period, they get a 3% discount.
$35,000 – $7,000
$28,000 x 3%
If Smart Touch Learning pays the bill early, then they are entitled to the discount. The entry to record their payment would show that the amount of the accounts payable is satisfied, by debiting Accounts Payable for the amount remaining on the books. In addition, the entry will show the actual amount of cash paid to the seller by crediting Cash. By multiplying the accounts payable balance by (1—Discount %), the actual cash payment can be determined. Finally, a credit is recorded in the Merchandise Inventory account to show the amount of the discount taken. This effectively reduces the cost of the inventory on the books. It is calculated by multiplying the accounts payable amount by the discount percent.
Accounts Payable = $35,000 - $7,000 Return = $28,000
Discount = $28,000 x 3% = $840
Cash Paid = $28,000 x 97% = $27,160

21. A Look at the Merchandise Inventory Account . . .
The merchandise inventory account will reflect the net results of all the transactions for the period.
$7,000 Purchase Return and $ 840 Purchase Discount
Freight Charge
At this point, the Merchandise Inventory account will contain several entries:
The June 3 amount associated with the original cost of the inventory acquired.
A June 3 amount showing the amount of the freight charges paid related to the acquired inventory.
A June 4 amount showing the amount of inventory returned to the seller.
A June 15 amount showing the amount of the discount taken due to early payment of the invoice.
Note: Purchase discount based on $28,000. Discount cannot be applied towards any freight charges if they are included on the invoice

22. Recording a Sale
In a perpetual system, two entries must be made for every sale
Record the sale
Record the reduction of inventory
Because we are using a perpetual approach to accounting for the inventory, we will actually be making two entries.
The first entry will record the sale and the related receipt of cash or account receivable.
The second entry will record the reduction of inventory and the related Cost of Goods Sold for this particular transaction.

23. Recording a Cash Sale
Smart Touch Learning sold 2 tablets for $1,000 cash. The cost of those tablets was $700.
Let’s assume that, on June 19, Smart Touch Learning sold 2 tablets in a cash sale for a total of $1,000. Also, assume that these tablets each had a cost of $350.
First, we record a debit to Cash for $1,000 and a corresponding credit to Sales Revenue for $1,000.
Second, we record a reduction to the Merchandise Inventory account of $700 ($350 x 2), along with a corresponding debit to Cost of Goods Sold.
Cash Sale
Cost of Goods Sold

24. Recording a Credit Sale
Smart Touch Learning sold 10 tablets for $500 each on account. Sales terms are 2/10, n/30. The cost of those tablets was $3,500.
Cash sales are fairly simple to record. If the sale is on credit and has associated sales terms, the recording of the transaction will be subtly different. Let’s assume a second sale on June 21 of 10 tablets for $500 each. Also assume that, as before, each tablet has a cost associated with it of $350.
The first thing we would record is a debit to Accounts Receivable for $5,000 along with a parallel credit to Sales Revenue for the same $5,000.
The second thing we need to do is credit Merchandise Inventory and debit Cost of Goods Sold for an amount equal to $3,500 ($350 x 10).
Credit Sale
Cost of Goods Sold

25. Sales Returns
Requires an entry to Sales Returns and Allowances (contra account to Sales) and to Merchandise Inventory.
A customer returns 3 tablets that sold for $1,500 and originally cost $1,050.
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.

26. Sales Allowances Requires an entry to Sales Returns and Allowances.
Smart Touch Learning grants a customer $100 for goods damaged in transit.
There is no inventory to receive or record.
If we are granting a sales allowance, then there is no merchandise inventory to receive, so we only make one journal entry.

27. Sales Discounts
The customer pays Smart Touch Learning on June 30, 9 days after the invoice date, and after the return and the allowance. Sales discounts is a contra account to Sales.
If the June 21 customer pays Smart Touch Learning on June 30, the entry must be recorded. Smart Touch Learning will credit Accounts Receivable to “wipe out” the receivable. They will then record the amount of cash received. The difference, which can be computed as (Accounts Receivable x 3% discount), is recorded as a debit to Sales Discounts, a contra-revenue account.

28. Freight Out The freight in is part of the inventory cost.
The freight out is a selling expense.
Smart Touch Learning pays $30 to ship the June 21 sale to the customer.
Earlier, we discussed that Freight-In is recorded as part of the merchandise inventory cost. When we are purchasing the inventory, it is considered a product cost. However, if we are selling goods and must pay for shipment to get the goods to the buyer, the related Freight-Out costs would generally be considered a “selling cost.”

29. Net Revenue
For the year, Smart Touch Learning sells $297,500 of merchandise inventory. They process $11,200 of sales returns and allowances, and they award $5,600 of sales discounts. What is Net Sales Revenue for the year?
Net sales revenue is a term that summarizes total revenues after backing out certain items. This term will become the denominator in many ratios involving sales revenue.

30. Gross Profit
The difference between Net Sales Revenues and Cost of Goods Sold
Indicates the amount available to cover operating expenses
By subtracting Sales Returns and Allowances and Sales Discounts from the Revenues line, we can arrive at an important interim sub-total called Net Sales Revenue.
COGS assumed for this example

31. Adjusting Merchandise Inventory
Actual inventory at the end of the period may differ from what is expected from the accounting records
Theft
Damage
Errors
Inventory must be adjusted at the end of the period
If actual less than accounting records
Reduce inventory on books
Increase COGS
The results of accounting for the inventory will provide a mathematical measure of the dollar amount of inventory that should be on hand. However, actual inventory on hand often does not match the amount that the accounting systems says should be there. Inventory “leakage” can occur due to theft, damage, donation, 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 they accurately reflect the actual numbers.

32. Closing the Accounts of a Merchandiser
Close revenues to Income Summary
Close expenses and contra-revenues to Income Summary
Close Income Summary to Retained Earnings
Close Dividends to Retained Earnings
After the accounts have been adjusted, the temporary accounts of the merchandiser are closed, in the same way as done for any other company. Using the four steps in the Closing Process, the income statement accounts and the Dividends account are closed.

33. Closing the Accounts of a Merchandiser1 2
The entries are fairly straightforward, with revenues being closed to Income Summary. In the same way, expenses are closed to Income Summary. Note that the contra-revenue accounts Sales Returns and Allowances and Sales Discounts are closed at the same time as the expense accounts are closed.

34. Closing the Accounts of a Merchandiser
At this point, the Income Summary account has a $25,200 balance.
Next, we need to close Income Summary to the Retained Earnings account.
After closing the income statement accounts, the Income Summary account will have a balance of $25,200, which is equivalent to the Income Statement Net Income number. Next, Income Summary is closed to Retained Earnings.

35. Closing the Accounts of a Merchandiser
Close Dividends to Retained Earnings

36. Prepare a merchandiser’s financial statements
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37. Single-Step Income Statement
Revenues and Expenses are separated into two reported sub-groupings.
There are two primary approaches to preparing an income statement. The Single-Step Income Statement separates the income statement accounts into two primary sub-groupings—revenues and expenses.

38. Multi-Step Income Statement
We break our Operating Expenses into Selling Expenses & Admin Expenses.
After Gross Profit, Operating Expenses are listed. They are often broken into two or more sub-groupings. Generally, the two most common sub-groupings for Operating Expenses are Selling Expenses and Administrative Expenses. Both of these are subtracted from Gross Margin to arrive at Operating Income.

39. Most companies will use a multi-step income statement.
Finally, Net Income is determined by subtracting Other Revenues and Expenses from Operating Income.
Most companies will use a multi-step income statement.
We are not quite yet done. 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.

40. Gross Profit Percentage
Measures the profitability of each sales dollar.
When this number is trending downward, it can indicate a significant problem.
One of the more useful of the financial statement profitability ratios is Gross Profit Percentage. Simply stated, Gross Profit is divided by Net Sales Revenue. The resulting Gross Profit Percentage can be used to measure the company’s profitability. In addition, watching the “trend” in the Gross Profit Percentage can provide important evidence of the direction of the company’s business.

41. Gross Profit Percentage—Example
In this case, we can see that the Gross Profit Percentage is 34.1%. This is determined by computing first the Gross Profit amount. In this case it is $904,625 ($2,650,899 - $1,746,274). The Gross Profit amount is then divided by the Net Sales Revenue ($2,650,899).

42. Gross Profit Percentage—Example

43. Gross Profit Percentage—Example
CISCO

44. Purchasing Merchandise Inventory in a Periodic System
Inventory-related expenses are recorded in separate accounts DURING the year, and combined at the end of the period.
Purchases
Purchase Discounts
Purchase Returns and Allowances
Freight-In
Closed at end of Period
Correct ending inventory balance updated at the end of the period during the closing process
Cost of Goods sold determined at end of period
There are four primary types of costs that are collectively used to determine the “cost” of our inventory:
Purchases
Purchase Discounts
Purchase Returns and Allowances
Freight-In

45. Example to calculate COGS
Assume the following balances on the December 31 Adjusted Trial Balance:
Merchandise Inventory (beginning) = $0
Merchandise Inventory (ending) = $31,290
Purchases = $281,750
Purchase Returns and Allowances = $61,250
Purchase Discounts = $4,410
Freight In = $14,700
At this point, we have five accounts with balances related to the inventory transactions during the period. Let’s assume the following balances can be found in the General Ledger for Smart Touch Learning:
Merchandise Inventory (beginning balance) = $0
Purchases = $281,750 debit
Purchase Returns and Allowances = $61,250 credit
Purchase Discounts = $4,410 credit
Freight In = $14,700
In addition, our physical count of the inventory tells us that we have $31,290 in inventory still on hand during the period.

46. Reporting Cost of Goods Sold
Note that we have not posted any entries during the month to account for inventory actually moving out the door to customers. There is no Cost of Goods Sold account to put on the Income Statement. We will “back into” the Cost of Goods Sold amount by closing the above accounts to Income Summary. When we prepare the Income Statement, we will compute Cost of Goods Sold by using the following formulas:
Net Purchases = Purchases – Purchase Returns and Allowances – Purchase Discounts
Net Cost of Purchases = Net Purchases + Freight In
Cost of Goods Sold = Beginning Merchandise Inventory + Net Cost of Purchases – Ending Merchandise Inventory