Chapter 5. Accounting for merchandising operations

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2 Chapter 5 Accounting for merchandising operations 2

3 Learning objectives 1. Differentiate between a service business and a merchandising business 2. Identify the differences between the perpetual and the periodic inventory system 3. Record purchase transactions under the perpetual inventory system 4. Record sales transactions under the perpetual inventory system 3

4 Learning objectives 5. Prepare adjusting and closing entries under the perpetual inventory system 6. Describe and prepare the multiple-step and single-step income statements 4

5 Learning objective 1 Differentiate between a service business and a merchandising business 5

6 Merchandising operations Merchandiser - a business that derives their earnings from buying and then selling products to customers Service business derives earnings from providing services to customers Merchandise inventory - the goods purchased by a merchandiser for resale to customers Also known as merchandise or inventory 6

7 Merchandising operations Two types of merchandising businesses: 1. Wholesalers - businesses that purchase products and sell them to other wholesalers or retailers 2. Retailers - businesses that purchase their products from manufacturers or wholesalers and sell them to the end customer 7

8 Merchandising and service businesses The main differences between a merchandising business and a service business can be seen by comparing the income statements of the two Merchandiser's Income Statement For the month ended May 31, 2011 Sales 1,000 Cost of Goods Sold (400) Gross Profit 600 Expenses (100) Net income/(net loss) 500 $ Service Business Income Statement For the month ended May 31, 2011 Revenues 1,000 Expenses (500) Net income/(net loss) 500 $ 8

9 Merchandising and service businesses The merchandiser uses a Sales or Sales Revenues account to record sales of merchandise Service business uses a Revenues account to record earnings from providing services to customers Two new line items unique to merchandisers 1. Cost of goods sold 2. Gross profit 9

10 Accounts unique to merchandisers Cost of goods sold The cost of the inventory sold by the business during the accounting period Also known as cost of sales or cost of merchandise sold Gross profit Net sales revenues minus the cost of goods sold Represents the amount of earnings the business has made from selling its goods Also known as gross margin 10

11 Accounts unique to merchandisers Merchandisers also report the value of merchandise inventory purchased for resale in the Merchandise Inventory account Also known as just Inventory Reported as a current asset in the balance sheet 11

12 Operating cycle The duration of time between when the business acquires materials or services, uses them in their operations, and finally receives cash from selling their goods or services Length of time varies between business types E.g. Fruit seller may be a few weeks E.g. Car seller may be months 12

13 Cost flow of inventory Operating cycle of a merchandiser can be translated into the cost flow of inventory over an accounting period Net purchases: purchases less any purchases that are returned 13

14 Learning objective 2 Identify the differences between the perpetual and the periodic inventory system 14

15 Perpetual and periodic inventory systems Perpetual inventory system continuously keeps track of the value of inventory available for sale and cost of goods sold as each transaction occurs Periodic inventory system updates the value of inventory available for sale and the cost of goods sold only at the end of the accounting period 15

16 Perpetual and periodic inventory systems Inventory transactions are demonstrated using the perpetual inventory system Periodic inventory system is illustrated in the appendix 16

17 Learning objective 3 Record purchase transactions under the perpetual inventory system 17

18 Invoice A bill created by the seller and sent to the buyer that contains the details of the sale It is a source document used by the seller to record the sale and by the buyer to record the purchase 18

19 Invoice Seller Invoice date Invoice number Buyer Purchase order number Credit terms Shipping terms Merchandise details Invoice total 19

20 Purchase of merchandise for cash Example: Purchased 10 snowboards for $300 each (10 x $300 = $3,000) and paid for them in cash Purchase of merchandise for cash: Aug. 4 Merchandise Inventory 3,000 Cash 3,000 (Purchased merchandise for cash.)

21 Purchase of merchandise on credit A credit sale credits the Accounts Payable account instead of the Cash account Purchase of merchandise for cash: Aug. 4 Merchandise Inventory 3,000 Accounts Payable 3,000 (Purchased merchandise on credit.)

22 Purchase returns and allowances Sometimes when an order of merchandise is received by the buyer it may need to be returned to the supplier A purchase return or allowance is an adjustment of the purchase price of merchandise recorded in the accounts of the buyer The difference between a purchase return and a purchase allowance is that the merchandise is not returned to the seller in a purchase allowance 22

23 Purchase returns and allowances Example: Returned 3 snowboards for a full refund of (3 x $300 = $900) Purchase return: Aug. 6 Accounts Payable 900 Merchandise Inventory 900 (Returned merchandise purchased on credit.)

24 Trade discounts on purchases Sellers may grant customers a reduction to the price of the goods if a minimum quantity is purchased A trade discount is a reduction of the list price of merchandise that is granted to the buyer The list price is the full price of an item listed in the catalog of the seller before deducting any trade discounts The value of the trade discount is not separately recorded in the accounts 24

25 Trade discounts on purchases Example: Supplier offers 10% trade discount on snowboarding pants if total purchase is greater than $3,000 Purchased 30 pairs at a list price of $120 (30 x $120 = $3,600) Eligible for 10% discount (10% x $3,600 = $360) Amount recorded in Merchandise Inventory account ($3,600 - $360 = $3240) 25

26 Trade discounts on purchases Remember: Amount of trade discount is not recorded in the accounts! Trade discount on purchase: Aug. 7 Merchandise Inventory 3,240 Cash 3,240 (Cash purchase of inventory with trade discount.)

27 Purchase discounts Purchase discounts: Discounts received for payment of an account within the discount period Recorded in the accounts of the buyer 27

28 Credit terms Credit terms: Specify when the full amount of an invoice is due to be paid, including: Percentage discount Discount period Credit period of an invoice 28

29 Credit terms Credit terms may be stated as: 2/14, n/30 2 = percentage discount 14 = discount period, the time that a customer has to take advantage of the purchase discount n/30 = net 30 = credit period, the time that a customer has to pay an invoice by the due date Where no discount is given terms are stated as n/30 29

30 Credit terms Example: 2/14, n/30 The customer gets a 2% discount on the purchase price if the invoice is paid in full within 14 days of the invoice, otherwise they are liable to pay the full balance within 30 days of the invoice 30

31 Credit period 31

32 Credit terms Alternatively credit terms could be stated n/eom (net end of month) n/15 EOM means that the invoice is to be paid in full 15 days after the end of the month in which the invoice was issued 32

33 Example calculating purchase discounts Steps to calculate purchase discounts: 1. Calculate the outstanding amount of the invoice to be paid 2. Calculate the amount of the discount 3. Calculate the amount of cash to be paid 4. Record the journal entry 33

34 Example calculating purchase discounts Example: Purchases = $3,000 Purchase returns = $900 Credit terms = 2/10 n/30 Paid invoice within discount period 34

35 Example calculating purchase discounts Step 1: Calculate the outstanding amount of the invoice to be paid Accounts Payable = Invoice total - purchase returns & allowances = $3,000 - $900 = $2,100 35

36 Example calculating purchase discounts Step 2: Calculate the amount of the discount Discount = Accounts payable x discount (%) = $2,100 x 2% = $2,100 x 0.02 = $42 36

37 Example calculating purchase discounts Step 3: Calculate the amount of cash to be paid Cash payment = Accounts payable - discount ($) = $2,100 - $42 = $2,058 37

38 Example calculating purchase discounts Step 4: Record the journal entry Purchase discount: Aug. 1 Accounts Payable 2,100 Merchandise Inventory 42 Cash 2,058 (Payment of accounts payable within discount period.) If the invoice was paid after the discount period then the journal entry for the repayment debits Accounts Payable and credits Cash for the full amount of the invoice less the purchase return

39 Transportation costs There are usually additional costs associated with transporting purchased goods Buyer and seller must agree who pays for these costs The party that owns the title of the goods is responsible for paying the costs incurred to transport the goods Shipping terms determine when the title passes from the seller to the buyer 39

40 Shipping terms The FOB point (free on board) determines when the ownership passes from the seller to the buyer There are two FOB points: 1. FOB shipping point 2. FOB destination 40

41 FOB shipping point FOB shipping point: Title of the goods passes to the buyer when the merchandise leaves the shipping point The buyer is responsible for paying transport costs and bears the risk of damage to the goods while they are in transit 41

42 FOB destination FOB destination: Title of the goods passes to the buyer when the merchandise arrives at the buyers The seller is responsible for paying transport costs and bears the risk of damage to the goods while they are in transit 42

43 Shipping Terms 43

44 Example transportation costs $90 charge to transport snowboards from the seller to the buyer Different journal entries depending on whether it is the seller or the buyer that pays for these costs 44

45 Example transportation costs FOB shipping point: Buyer records the payment as part of inventory because it is a cost incurred to transport the inventory and prepare it so it is ready to be sold FOB shipping point transportation charges (in the books of the buyer): Aug. 4 Merchandise Inventory 90 Cash 90 (Paid transportation charges with cash.)

46 Example transportation costs FOB destination: Seller records the payment in the Delivery Expense account This is because transport charges are considered costs incurred in order to sell the merchandise, not a cost of the merchandise itself FOB destination transportation charges (in the books of the seller): Aug. 4 Delivery Expense 90 Cash 90 (Paid transportation charges with cash.)

47 Learning objective 4 Record sales transactions under the perpetual inventory system 47

48 Sale of merchandise on credit Perpetual inventory system requires two journal entries One records the revenue earned The other transfers the cost of the merchandise sold to an expense account and records the reduction of the value of the inventory held

49 Sale of merchandise on credit Example: Sold 5 Slopestyle jackets on credit for $450 each (5 x $450 = $2,250) Cost $200 each (5 x $200 = $1,000)

50 Sale of merchandise on credit Sale of merchandise on credit (record revenue earned): Aug. 17 Accounts Receivable 2,250 Sales Revenues 2,250 (Sold merchandise on credit.) Sale of merchandise on credit (transfer asset to expense account): Aug. 17 Cost of Goods Sold 1,000 Merchandise Inventory 1,000 (Cost of merchandise sold.)

51 Sales returns and allowances A sales return or allowance is an adjustment to the selling price of merchandise recorded in the accounts of the seller The difference between a sales return and a sales allowance is that the merchandise is not returned to the seller in a sales allowance Different journal entries for the sales return and the sales allowance 51

52 Sales returns and allowances A sales return must record two journal entries: 1. The reduction in the revenue earned and associated asset, either Cash or Accounts Receivable 2. The increase in the merchandise inventory held by the business and the reduction in the expense of the cost of merchandise sold A sales allowance only records the first entry because the merchandise is not returned 52

53 Sales returns and allowances Reduction in revenue is recorded in an account called Sales Returns and Allowances Sales Returns and Allowances is a contra revenue account that has a normal debit balance It is reported as a reduction in sales revenue in the income statement 53

54 Example sales return Example: Customer returned 2 Slopestyle jackets Originally sold for $450 each (2 x $450 = $900) Cost $200 each (2 x $200 = $400) Jackets were in good condition so can be returned to inventory at full cost

55 Example sales return Sales return (reduction in revenue and asset): Aug. 21 Sales Returns and Allowances 900 Accounts Receivable 900 (Customer returned merchandise purchased on credit.) Sales return (merchandise returned to inventory): Aug. 21 Merchandise Inventory 400 Cost of Goods Sold 400 (Cost of merchandise returned to inventory.)

56 Sales returns damaged goods If the goods are returned damaged then an estimate is made as to how much they can be sold for If they are estimated to be sold for lower than their original cost, then they must be recorded in inventory at this lower value The difference in the new selling price and the cost of the merchandise is recorded as a debit to an expense account called Loss from Defective Merchandise

57 Sales returns damaged goods Example: Customer returned 2 Slopestyle jackets Cost $200 each (2 x $200 = $400) Estimated can only be sold for $150 each (2 x $150 = $300) Difference is loss from defective merchandise ($400 - $300 = $100)

58 Sales returns damaged goods First journal entry to record the reduction in revenue and asset is the same Second journal entry to record the merchandise returned to inventory recognizes the loss from the damaged goods Sales return (damaged merchandise returned to inventory): Aug. 21 Merchandise Inventory 300 Loss from Defective Merchandise 100 Cost of Goods Sold 400 (Cost of damaged merchandise returned to inventory.)

59 Sales allowance A sales allowance may refund part or all of the purchase price The buyer keeps the merchandise, so the seller only needs to record the first journal entry

60 Example - sales allowance Example: The goods arrived damaged at the buyers Seller agreed to a $340 reduction in the price of the goods Sales allowance (only records the reduction in revenue and asset): Aug. 21 Sales Returns and Allowances 340 Accounts Receivable 340 (Sales allowance for damaged merchandise.) The buyer kept the goods so the seller does not record the return of the merchandise to inventory

61 Trade discounts on sales Sellers may grant customers a reduction to the price of the goods if a minimum quantity is purchased The value of the trade discount is not separately recorded in the accounts 61

62 Example - trade discounts on sales Example: The list price of snow mittens is $100 A 20% trade discount is given for purchases of 10 or more, so discount price is $80 each A customer purchases 10 for $80 each Seller records revenue of $800 based on the discounted price (not the list price) 62

63 Sales discounts Sales discounts: Discounts offered to customers to encourage payment of their account within the discount period Recorded in the accounts of the seller Sales returns and allowances and any transport costs on the invoice do not receive the discount 63

64 Example calculating sales discounts Steps to calculate sales discounts: 1. Calculate the outstanding amount of the invoice to be received from customer 2. Calculate the amount of the discount 3. Calculate the amount of cash to be received 4. Record the journal entry 64

65 Example calculating sales discounts Example: Invoice total = $ 4,500 Sales returns = $850 Transport costs = $250 (included in invoice total) Credit terms = 3/14 n/60 Customer paid invoice within discount period 65

66 Example calculating sales discounts Step 1: Calculate the outstanding amount of the invoice to be received from customer Accounts Receivable = Invoice total = $4,500 - $850 - $250 = $3,400 - Sales returns & allowances - Transport costs 66

67 Example calculating sales discounts Step 2: Calculate the amount of the discount Discount = Accounts receivable x discount (%) = $3,400 x 3% = $3,400 x 0.03 = $102 67

68 Example calculating sales discounts Step 3: Calculate the amount of cash to be received Cash receipt = Accounts receivable - discount ($) = $3,400 - $102 = $3,298 68

69 Example calculating sales discounts Step 4: Record the journal entry Sales discount: Aug. 27 Cash 3,298 Sales Discounts 102 Accounts Receivable 3,400 (Receipt of accounts receivable within discount period.) If the invoice was paid after the discount period then the journal entry for the cash receipt debits Cash and credits Accounts Receivable for the full amount of the invoice less the sales return

70 Sales Taxes Most states and many other taxation authorities impose a tax on the sale of merchandise to the final consumer Seller collects tax at time of sale, incurring a liability to forward the tax to the taxation authority Recorded in the Sales Tax Payable account Sales taxes usually stated as a % of the sales price 70

71 Example sales taxes Example: Sales price = $100 Sales tax = 5% = $5 Price charged to customer = $105 Credit sale with sales tax: Aug. 30 Cash 105 Revenues 100 Sales Tax Payable 5 (Credit sale with sales tax.)

72 Example sales taxes Periodically, the seller remits the tax collected over a period to the taxation authority in one lump sum Payment of sales tax to taxation authority: Jan. 15 Sales Tax Payable 7,000 Cash 7,000 (Paid sales tax collected to taxation authority.)

73 Sales taxes Taxation authorities normally exempt businesses from paying sales taxes on merchandise purchased if that merchandise is to be resold to customers and they hold a resellers certificate Generally only the final consumer that pays the sales taxes on their purchases 73

74 Learning objective 5 Prepare adjusting and closing entries under the perpetual inventory system 74

75 Adjusting entries for a merchandiser At the end of the accounting period a physical inventory count is taken This is used to calculate the dollar value of the inventory on hand The value of inventory on hand is compared to the balance of the Merchandise Inventory account These values are rarely equal due to inventory shrinkage 75

76 Inventory shrinkage Inventory shrinkage (or shortage) is the reduction in the value of inventory due to: Theft Deterioration Breakage Errors in the Merchandise Inventory account Calculated as the difference between the value of Inventory reported in the Merchandise Inventory account and the value of inventory revealed through the inventory count 76

77 Inventory shrinkage An adjusting entry is recorded to make the balance of the Merchandise Inventory account equal to the value of inventory physically on hand Inventory shrinkage is recorded in the Cost of Goods Sold account when not material 77

78 Example - inventory shrinkage Example: Balance of Merchandise Inventory account before adjustment = $70,000 Inventory count = $68,000 worth of inventory on hand Shrinkage = $70,000 - $68,000 = $2,000

79 Example - inventory shrinkage Journal entry: Inventory shrinkage: Aug. 31 Cost of Goods Sold 2,000 Merchandise Inventory 2,000 (Adjusting entry for inventory shrinkage.)

80 Inventory shrinkage If the shrinkage is material, then may need to be disclosed as a separate line item on the income statement Debit Loss on Inventory Shrinkage rather than Cost of Goods Sold 80

81 Closing entries of a merchandiser At the end of the accounting period closing entries are recorded Same steps for both service businesses and merchandisers: Step 1: Close all temporary accounts with a credit balance to the Income Summary account Step 2: Close all temporary accounts with a debit balance to the Income Summary account. Step 3: Close the Income Summary account to equity Step 4: Close the Withdrawals account to equity 81

82 Closing entries of a merchandiser First two steps include closing the additional temporary accounts unique to merchandising operations Last two steps are the same as for service businesses so will not be shown Accounts unique to merchandisers are highlighted 82

83 Step 1: Close accounts with credit balance Merchandiser uses the Sales Revenues account rather than the Revenues account used by the service entity Journal entry to close all temporary accounts with a credit balance: Dec. 31 Sales Revenues 200,000 Income Summary 200,000 (To close temporary accounts with a credit balance.)

84 Step 2: Close accounts with debit balance Merchandiser has additional expense accounts that need to be closed at the end of the accounting period Journal entry to close all temporary accounts with a debit balance: Dec. 31 Income Summary 110,000 Sales Returns and Allowances 2,000 Sales Discounts 4,000 Cost of Goods Sold 70,000 Delivery Expense 6,000 Other Expenses 28,000 (To close temporary accounts with a debit balance

85 Learning objective 6 Describe and prepare the multiple-step and single-step income statements 85

86 Multiple step income statement Multiple-step income statement is an income statement format that presents revenues and expenses of the business under several categories Highlights the relation between categories through the use of subtotals 86

87 Multiple step income statement There are three main sections of the multiple-step income statement: 1. Calculation of gross profit 2. Income from operations 3. Nonoperating items Together these sections result in the net income or net loss for the period 87

88 Calculation of gross profit Gross profit shows the amount of gross profit earned through the principle revenue generating activities of the business Extremely Board Income Statement (extract) For the month ended December 31, 2011 $ $ Sales Revenues 200,000 Sales returns and allowances (2,000) Sales discounts (4,000) (6,000) Net sales 194,000 Cost of goods sold (70,000) Gross profit 124,000 88

89 Income from operations Income from operations represents the income earned from the central operations of the business For a merchandiser or manufacturer it is calculated as gross profit less the operating expenses of the business For a service business it is calculated as operating revenues less operating expenses 89

90 Income from operations Operating expenses of the business are further subdivided into two expense categories Selling expenses are the expenses incurred in selling the merchandise of the business Include: Advertising costs Display costs Storage costs Selling and delivery costs 90

91 Income from operations General and administrative expenses are the expenses incurred to support the running of the business Include expenses incurred for business support services such as human resource management and the accounting and finance departments 91

92 Income from operations $ $ $ Gross profit 124,000 Operating expenses: Selling expenses: Wages expense - sales staff (11,000) Delivery expense (6,000) Advertising expense (5,000) Total selling expenses (22,000) General and administrative expenses: Salaries expense - office staff (10,000) Depreciation expense - office equipment (2,000) Total general and administrative expenses (12,000) Total operating expenses (34,000) Income from operations 90,000 92

93 Nonoperating items and net income Nonoperating items are items that are not involved in the central operations of the business Generally either: Small in value so as not to be considered part of the main operations of the business Items that do not recur each period Nonoperating items may be divided into two classifications 93

94 Nonoperating items and net income 1. Other revenues and gains may include: Interest revenue Dividend revenue Rent revenue Gains made by selling an item of property, plant or equipment 94

95 Nonoperating items and net income 2. Other expenses and losses may include: Interest expense Losses from the sale of property, plant and equipment You will learn about some of these items later 95

96 Nonoperating items and net income Finally, the net income earned or the net loss incurred during the period is calculated as the final bottom line of the income statement 96

97 Income from operations $ $ $ Income from operations 90,000 Other revenues and gains: Dividend revenues 2,000 Gain on sale of equipment 5,000 Total other revenues and gains 7,000 Other expenses and losses: Interest expense (1,000) Total other expenses and losses (1,000) Net income / (Net loss) 96,000 97

98 Single-step income statement Single-step income statement is an income statement format that presents all of the revenues of the business together and then subtracts all of the expenses in one step to arrive at the net income or loss of the business More difficult for users to compare and analyze the gross profit or income from operations of the business No breakdown of expense categories But is simpler to prepare 98

99 Single-step income statement $ $ Revenues Net sales 194,000 Dividend revenues 2,000 Gain on sale of equipment 5,000 Total revenues 201,000 Expenses Cost of goods sold (70,000) Selling expenses (22,000) General and administrative expenses (12,000) Interest expense (1,000) Total Expenses (105,000) Net income / (Net loss) 96,000 99