Chapter 5. Merchandising Operations

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1 Merchandising Operations Chapter 5 When a service business earns fees they record revenue from the services rendered. In the case of the merchandising business you still have the revenue transaction, but you also have a second cost transaction because you have produced your revenue from selling an asset. The cost or expense generated from the sale of merchandise is called Cost of Goods Sold. The Cost of Goods Sold is treated the same as an expense in the journal entries, but it can be treated differently in an income statement. Often, Sales Revenue and Cost of Goods Sold is reported at the top of an income statement, and the net difference is labeled Gross Profit or Gross Margin. Inventory Systems There are two methods of handling inventories: The periodic inventory system, and The perpetual inventory system Periodic Inventory System With the periodic inventory system, the firm finds out its cost of goods sold at the end of the accounting period. Throughout the accounting period, the firm keeps track of its purchases. To find out what the firm sold, the firm takes its beginning inventory adds its purchases for the period. This gives the firm all the goods that pass through the firm for the period (the goods available for sale). The firm then takes a physical inventory. This gives the firm what is left at the end of the period. The ending inventory is then subtracted from the available goods figure to get the cost of goods sold. The periodic inventory system assumes anything not there was sold, but the goods could have been stolen. The lack of information on the theft or spoilage of goods is a major disadvantage of the periodic system. In addition, unless a physical inventory is taken, the firm does not know what its cost of goods sold is during the period (as opposed to the end of the period). An advantage of the periodic inventory system is that it is easy to maintain. Perpetual Inventory System With the perpetual inventory system, the firm keeps track of its cost of goods sold on a continual basis. Thus, at any given time, the firm can estimate its current inventory levels. At the end of the period, a physical inventory is taken. Any discrepancy with the estimated inventory level and the actual inventory level is then attributed to theft and spoilage.

2 It used to be very expensive to maintain this type of system, but with the use of computers & scanners, this is no longer the case, and the perpetual inventory system is increasing in popularity. What we have discussed to date is the perpetual inventory system, and we will continue to use it in this chapter. Recording Purchases of Merchandise When you purchase inventory with cash: D. Merchandise Inventory $5,000 Cr. Cash $5,000 When you purchase inventory on credit: D. Merchandise Inventory $5,000 Cr. Accounts Payable $5,000 A cash purchase should be supported with a cancelled check. A credit purchase should be supported with an invoice from the supplier. Purchase Returns & Allowances When you return merchandise inventory (Purchases Return) or get a price reduction on the merchandise (Purchases Allowance) after they are delivered, you write down the price of the Merchandise Inventory to the price actually paid. The journal entry, in effect, reverses in whole (return) or in part (allowance) the purchase journal entry: A return of entire $5,000 purchase: D. Accounts Payable $5,000 Cr. Merchandise Inventory $5,000 The receipt of a $1,000 purchase allowance on the prior purchase: D. Accounts Payable $1,000 Cr. Merchandise Inventory $1,000 Cost of Inventory Inventory cost is defined as the price paid to acquire the inventory and generally includes invoice price less purchases discounts, freight, insurance in transit,

3 taxes, tariffs, inspection costs and preparation costs. It is basically everything that is paid in order to get the inventory ready to sell. Transportation Costs The term, FOB, stands for Free On Board. "FOB shipping point" means that the seller transfers title to the goods at the seller s place of business. The buyer pays shipping costs. For example, if you order a car from Ford and the invoice says FOB Detroit, then you pay the shipping costs and the car belongs to you as soon as it leaves the factory. If something goes wrong during shipment, it is your problem. The term "FOB destination" means that the seller transfers title to the goods at the buyer s place of business. The seller pays shipping costs. For example, if you order a car from Ford and the invoice says FOB Los Angeles, then Ford pays the shipping costs and the car belongs to you when it arrives. Transportation Costs on purchases are part of the cost of our inventory. These costs are referred to as Freight in or Transportation In. Under the perpetual inventory system, you write up the cost of the inventory: D. Merchandise Inventory $150 Cr. Accounts Payable/Cash $150 Transportation Costs on our sales are an expense. They are called Transportation Out or Freight Out: D. Freight Out $150 Cr. Accounts Payable $150 Purchases Discounts When we purchase inventory, we are often provided with credit terms that encourage us to pay quickly. These are called purchase discounts. When we offer these terms to our customers they are called sales discounts. A typical purchase/sales discount notation (credit terms) is 2/10 n/30 ( two-ten, net thirty ). This notation says that if the purchaser pays within 10 days, then the purchaser may take 2 percent off the price of the goods. Otherwise, the entire bill is due in 30 days. Another example would be 1/10 EOM. This notation says that the purchaser may take a 1 percent discount if he or she pays the invoice during the first 10 days of the next month. Otherwise, the entire bill is due by the end of the next month.

4 If seller does not wish to offer a discount, then the seller indicates when payment is due. For example, n/30 says that the entire amount is due in 30 days. The notation n/10 EOM says that the invoice amount is due in the first 10 days of the next month. Usually, passing up the purchase discount is thought to be very unwise because the interest cost for delaying the payment for 20 days is very high. For example, with 2/20 n/30, you are paying 2% for a 20-day loan. This is an annualized rate of 36.5% per annum. Assume you bought inventory for $3,500 and the supplier offered you 2/10 n/30. When you receive the inventory, ignore the potential purchase discount: D. Merchandise Inventory $3,500 Cr. Accounts Payable $3,500 If the payment is made during the discount period, you write down the price paid for the Merchandise Inventory to the cash actually paid: D. Accounts Payable $3,500 Cr. Cash $3,430 Merchandise Inventory 70 If the payment is not made during the discount period: D. Accounts Payable $3,500 Cr. Cash $3,500 Cash Sales When you make a cash sale, you have the following general journal entry reflecting the revenue side of the transaction: D. Cash $2,200 Cr. Sales Revenue $2,200 The cost side of the transaction is recorded as follows: D. Cost of Goods Sold $1,400 Cr. Merchandise Inventory $1,400

5 Sales on Account When a company makes a credit sale, the general journal entry is as follows: D. Accounts Receivable $2,200 Cr. Sales Revenue $2,200 The cost side of the transaction is recorded as noted above: Credit Card Sales Companies that allow customers to use a national credit card (such as Master Card) must follow special accounting procedures. Operationally, the credit card company reimburses the company for the sale, less a service charge (e.g., 2% - 3%). The credit company levies a service charge because it is responsible for establishing credit and collecting the money from the customer. There are two ways to handle credit card sales depending on the credit card company. Some credit card companies make the vendor wait for payment. This isn't done by the major credit card companies. This was the way that American Express used to operate. The general journal entry looks like a credit sale, except that the Account Receivable is from the Credit Card Company -- not the customer: At the time of the sale: D. Accounts Receivable Credit Card Company $1,000 Cr. Sales Revenue $1,000 At the time payment is received from the credit card company: D. Cash $970 Credit Card Discount/Service Charge Expense 30 Cr. Accounts Receivable Credit Card Company $1,000 Most major credit card companies make the cash available to the vendor immediately. Your book only discusses this situation. Because the funds are made available within a few hours, there is no need to record an account receivable from the credit card company. Instead, the transaction is treated as a cash sale with a fee being paid to the credit card company: D. Cash $970 Credit Card Discount/Service Charge Expense 30 Cr. Sales Revenue $1,000

6 The Credit Card Discount can be handled as either a selling expense or as a contra revenue, which is deducted before getting Net Sales. Your book takes the position that the credit card fees are treated as a selling expense. Sales Returns and Allowances If a customer returns merchandise that he or she has purchased, you want to undo the sale. You debit a contra-revenue account (Sales Returns & Allowances) that will be deducted from Sales Revenue in order to compute Net Sales. This gives management important information about what kind of returns the company is experiencing. Undo the sales revenue: D. Sales Returns and Allowances $300 Cr. Accounts Receivable $300 Undo the cost side of the sale: D. Merchandise Inventory $140 Cr. Cost of Goods Sold $140 Sales Discounts If you offer customers a reduction in price if they pay the invoice quickly, these discounts are referred to as sales discounts or a cash discount. You would use the same credit terms/discount notation discussed under Purchase Discounts (e.g., 2/10 n/30). The entry at the time of sale: D. Accounts Receivable $3,500 Cr. Sales/Sales Revenue $3,500 If the payment is received during the discount period: D. Cash $3,430 Sales Discounts 70 Cr. Accounts Receivable $3,500 If the payment is not received during the discount period, then the general journal entry when the payment is made is: D. Cash $3,500 Cr. Accounts Receivable $3,500

7 Sales Discounts are treated as a contra revenue account (offsets Revenue in order to get Net Sales. Sales Taxes Most states and many cities levy a sales tax on retail transactions, and the federal government also charges an excise tax on some products. The merchant must collect the taxes from the customer at the time of the sale and record the receipt of cash and the proper tax liabilities. The merchant is not paying the tax, he or she is collecting it from the customer on behalf of the government. D. Cash $1,080 Cr. Sales $1,000 Sales Tax Payable 80 When the sales tax is paid: D. Sales Tax Payable $80 Cr. Cash $80 Trade Discounts A trade discount is when you offer customer a reduction from your regular prices. The reduction is not tied to paying the invoice early. A good example would be a volume discount. For example, the price of one unit may be $5.00 a unit, but if the customer buys 10 units, then the unit price drops to $4.00. An After Christmas Sale is a trade discount. The sale is reported at the discounted price (the lower price), and there is no account for trade discounts. Net Sales Net Sales is Sales Revenue reduced by the contra-revenue accounts: Sales Revenue $480,000 Less: Sales Returns and Allowances -12,000 Sales Discounts -8,000 Credit Card Discounts (if treated as a contra-revenue account) -6,000 Net Sales $454,000 Classified Income Statements In a single-step income statement, the revenues section lists all revenues, including other income, and the operating costs section lists all expenses, including other expenses.

8 Many companies, however, use multiple-step income statement that is more detailed, containing several subtractions and subtotals. Often, corporations present condensed financial statements with only major categories of the financial statement. Gross Margin/Profit Income Statement For Year Ending December 31, 20XX Net Sales $460,000 Less: Cost of Goods Sold -316,000 Gross Margin/Profit $144,000 Less: Operating Expenses -114,000 Income From Operations $30,000 Other Revenue & Gains 3,600 Less: Other Expenses & Losses -2,000 Income Before Income Taxes $31,600 Less: Income Tax Expense -10,100 Net Income $21,500 Net Sales less Cost of Goods Sold gives you a company s Gross Margin. This is also called the Gross Profit. This profit or margin gives you the merchandising profit. Analysts look at this figure because it gives information about the company s market. High gross margins indicate that the sector isn t very competitive. The personal computer market in the 1970s & 1980s was characterized by high gross margins. During the 1990s, the personal computer market became very competitive and was characterized by shrinking gross margins. Operating Expenses Operating Expenses are: sales expenses and general & administrative expenses Unlike Gross Margins, which may be viewed as a function of the marketplace, Operating Expenses are a direct result of the management of the company. (How good is the company in controlling its expenses?) If you subtract the Operating Expenses from the Gross Margin and, you have Income From Operations. Financial Analysts consider Income From Operations very important because it represents the major operations of the company. It is

9 viewed as sustainable, and analysts consider it a good indication of future performance. Nonoperating Activities Although your book treats Nonoperating Activities as two different items on a classified income statement, most companies treat it as one item called Other Revenues and Expenses. Nonoperating activities are made up of nonoperating revenues & gains (e.g., dividends income, interest income, and gains from sales of assets) and nonoperating expenses & losses (e.g., interest expense and losses from sales of assets). After Income From Operations, you subtract Other Revenues and Expenses. Remainder of Classified Income Statement Income From Operations less Other Revenues and Expenses gives you Income Before Income Taxes. Income Taxes (Income Tax Expense or Provision For Income Taxes) represent the taxes owed on the income appearing on the financial statement. After Income Taxes are deducted, you have Net Income. Below Net Income, a corporation also reports the Net Income earned for each share of common stock (Earnings Per Share). Example of Multiple-Step Income Statement Shafer Auto Parts Corporation Income Statement For the Year Ended December 31, 20XX Revenues from Sales $289,656 Cost of Goods Sold -181,260 Gross Margin from Sales $108,396 Operating Expenses Selling Expenses $ 54,780 General and Administrative Expenses 34,504 Total Operating Expenses -89,284 Income from Operations $19,112 Other Revenues and Expenses Interest Income $1,400 Less: Interest Expense -2,631 Excess of Other Expenses over Other Revenues -1,231 Income Before Income Taxes $17,881 Income Taxes -3,381

10 Net Income $14,500 Earnings per share $ 2.90 Example of Single-Step Income Statement Shafer Auto Parts Corporation Income Statement For the Year Ended December 31, 20XX Revenues Net Sales $289,656 Interest Income $1,400 Total Revenues $291,056 Costs & Expenses Cost of Goods Sold $181,260 Selling Expenses 54,780 General and Administrative Expenses 34,504 Interest Expense 2,631 Income Tax Expense 1,231 Total Costs and Expenses -276,556 Net Income $14,500 Earnings per share $ 2.90 Additional Profitability Ratios Your book notes that there are two additional profitability ratios: Gross Profit Rate (Gross Margin Percentage) Operating Expenses to Sales Ratio Gross Profit Rate This ratio is also called the Gross Margin Percentage. As noted above, a company s gross margin is an important indicator of the competitiveness of the company s markets. Gross Margin is a raw number, and financial analyst s prefer a ratio that can be compared to the figures from other years within a company, and figures from other companies. This ratio is obtained by dividing the Gross Margin by Net Sales: Gross Profit/Margin Net Sales

11 Profit Margin Ratio This ratio divides the net income by the Net Sales. Net Income Net Sales The ratio allows you to compare the profitability of different firms of different sizes. Operating Expenses To Sales Ratio This ratio indicates how well the company s management is able to control its operating expenses: Operating Expenses Net Sales

12 Illustration Sportcraft. a wholesaler of sporting goods, had the following trial balance at December 31 of the current year: Sportcraft Trial Balance December 31, 20XX Debit Credit Cash $ 6,200 Accounts Receivable 28,000 Inventory, January 1 45,000 Office Supplies 800 Prepaid Insurance 2,100 Land 34,000 Building 82,000 Less: Accumulated Depreciation-Building $ 16,000 Office Equipment 21,300 Accumulated Depreciation--Office Equipment 5,300 Accounts Payable 19,000 Common Stock 161,200 Dividends 10,000 Sales 252,000 Sales Discounts 3,500 Purchases 151,000 Purchases Returns and Allowances 2,400 Transportation In 8,200 Sales Salaries Expense 27,600 Transportation Out 7,800 Advertising Expense 6,100 Office Salaries Expense 22, $455,900 $455,900 ======= ======= The following information is available at December 31: a. Office supplies on hand at December 31 are $250. b. Prepaid insurance at December 31 is $1,500. c. Depreciation for the year is building, $2,000; office equipment, $2,400. d. Salaries payable (but not yet accrued) at December 31 are sales salaries, $300; office salaries, $200. e. Inventory at December 31 is $43,500.

13 Required: Prepare adjusting entries in general journal form. Prepare closing entries in general journal form. Prepare a classified income statement for the year. Prepare a classified balance sheet at December 31. Adjusting Entries: D. Office Supplies Expense 550 Cr. Office Supplies on Hand 550 D. Insurance Expense 600 Cr. Prepaid Insurance 600 D. Depreciation Expense--Building 2,000 Depreciation Expense--Office Equipment 2,400 Cr. Accumulated Depreciation--Building 2,000 Accumulated Depreciation--Equipment 2,400 D. Sales Salaries Expense 300 Office Salaries Expense 200 Cr. Salaries Payable 500 Closing entries: D. Income Summary 277,550 Cr. Inventory (January 1) 45,000 Sales Discounts 3,500 Purchases 151,000 Transportation In 8,200 Sales Salaries 27,900 Transportation Out 7,800 Advertising Expense 6,100 Office Salaries Expense 22,500 Office Supplies Expense 550 Insurance Expense 600 Depreciation Expense -- Building 2,000 Depreciation Expense -- Equipment 2,400 D. Inventory (December 31) 43,500 Sales 252,000 Purchases Returns and Allowances 2,400 Cr. Income Summary 297,900

14 D. Income Summary 20,350 Cr. Retained Earnings 20,350 D. Retained Earnings 10,000 Cr. Dividends 10,000 Sportcraft Income Statement For Year Ending December 31, 20XX Revenue Sales $252,000 Less: Sales Discounts 3,500 Net Sales $248,500 Cost of Goods Sold Inventory, January 1 $ 45,000 Add: Net Cost of Purchases Purchases $151,000 Less: Purch. Ret & Allow 2,400 $148,600 Add: Freight In 8,200 Net Cost of Purchases 156,800 Cost of Goods Available for Sale $201,800 Less: Inventory, December 31-43,500 Cost of Goods Sold -158,300 Gross Margin $ 90,200 Operating Expenses Selling Expenses Sales Salaries Expense $27,900 Transportation Out 7,800 Advertising Expense 6,100 Total Selling Expenses $41,800 General and Admin. Expenses Office Salaries Expense $ 22,500 Office Supplies Expense 550 Insurance Expense 600 Depreciation Expense--Building 2,000 Depreciation Expense--Equip. 2,400 Total Gen. and Adm. Exp. $28,050 Total Operating Expenses -$69,850 Net Income $ 20,350

15 Assets Sportcraft Balance Sheet December 31, 20XX Current Assets Cash $ 6,200 Accounts Receivable 28,000 Inventory 43,500 Office Supplies 250 Prepaid Insurance 1,500 Total Current Assets $ 79,450 Long-term Assets: Land $34,000 Building $82,000 Less: Accum. Depre. -18,000 64,000 Office Equipment $21,300 Less: Accum. Depre. -7,700 13,600 Total Long-term Assets 111,600 Total Assets $191,050 ======= Liabilities & Shareholders Equity Current Liabilities: Accounts Payable $19,000 Salaries Payable 500 Total Current Liabilities $19,500 Shareholders Equity: Common Stock $161,200 Retained Earnings 10,350 Total Shareholders Equity 171,550 Total Liabilities & Shareholders Equity $191,050 =======

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