1 C H A P T E R 6 Accounting for Merchandising Businesses Susan Van Etten D O L L A R T R E E S T O R E S, I N C. When you are low on cash but need to pick up party supplies, housewares, or other consumer items, where do you go? Many shoppers are turning to Dollar Tree Stores, Inc., the nation s largest single price point dollar retailer with over 3,400 stores in 48 states. For the fixed price of $1 on all merchandise in its stores, this retailer has worked hard on its concept to provide new treasures every week for the entire family. Despite the fact that every item costs only $1, the accounting for a merchandiser, like Dollar Tree, is more complex than for a service company. This is because a service company sells only services and has no inventory. With Dollar Tree s locations and merchandise, the company must design its accounting system to not only record the receipt of goods for resale, but also to keep track of what merchandise is available for sale as well as where the merchandise is located. In addition, Dollar Tree must record the sales and costs of the goods sold for each of its stores. Finally, Dollar Tree must record such data as delivery costs, merchandise discounts, and merchandise returns. In this chapter, we focus on the accounting principles and concepts for a merchandising business. ln doing so, we highlight the basic differences between merchandiser and service company activities. We then describe and illustrate the financial statements of a merchandising business and accounting for merchandise transactions.
2 252 Chapter 6 Accounting for Merchandising Businesses After studying this chapter, you should be able to: 1 Distinguish between the activities and financial statements of service and merchandising businesses Describe and illustrate the financial statements of a merchandising business. Describe and illustrate the accounting for merchandise transactions including: sale of merchandise purchase of merchandise freight, sales taxes, and trade discounts dual nature of merchandising transactions Describe the adjusting and closing process for a merchandising business. Nature of Merchandising Businesses EE 6-1 (page 253) Financial Statements for a Merchandising Business Multiple-Step Income Statement EE 6-2 (page 257) Single-Step Income Statement Statement of Owner s Equity Balance Sheet Merchandising Transactions Chart of Accounts for a Merchandising Business Sales Transactions EE 6-3 (page 265) Purchase Transactions EE 6-4 (page 268) Freight, Sales Taxes, and Trade Discounts EE 6-5 (page 271) The Adjusting and Closing Process Adjusting Entry for Inventory Shrinkage EE 6-7 (page 274) Closing Entries Dual Nature of Merchandise Transactions EE 6-6 (page 273) At a Glance Menu Turn to pg Distinguish between the activities and financial statements of service and merchandising businesses. Nature of Merchandising Businesses The activities of a service business differ from those of a merchandising business. These differences are illustrated in the following condensed income statements: Service Business Merchandising Business Fees earned $XXX Sales $XXX Operating expenses XXX Cost of merchandise sold XXX Net income $XXX Gross profit $XXX Operating expenses XXX Net income $XXX 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.
3 Chapter 6 Accounting for Merchandising Businesses 253 In contrast, the revenue activities of a merchandising business involve the buying and selling of merchandise. A merchandising Cost of Gross Sales Merchandise Profit business first purchases merchandise to sell to its customers. When Sold this merchandise is sold, the revenue is reported as sales, and its cost is recognized as an expense. This expense is called the cost of Gross Operating Net merchandise sold. The cost of merchandise sold is subtracted from Profit Expenses Income sales to arrive at gross profit. This amount is called gross profit because it is the profit before deducting operating expenses. Merchandise on hand (not sold) at the end of an accounting period is called merchandise inventory. Merchandise inventory is reported as a current asset on the balance sheet. Example Exercise 6-1 Gross Profit During the current year, merchandise is sold for $250,000 cash and for $975,000 on account. The cost of the merchandise sold is $735,000. What is the amount of the gross profit? 1 Follow My Example 6-1 The gross profit is $ 490,000 (250,000 $975,000 $735,000). For Practice: PE 6-1A, PE 6-1B The operations of a merchandising business involve the purchase of merchandise for sale (purchasing), the sale of the products to customers (sales), and the receipt of cash from customers (collection). This overall process is referred to as the operating cycle. Thus, the operating cycle begins with spending cash, and it ends with receiving cash from customers. The operating cycle for a merchandising business is shown to the right. Operating cycles for retailers are usually shorter than for manufacturers because retailers purchase goods in a form ready for sale to the customer. Of course, some retailers will have shorter operating cycles than others The Operating Cycle Collection Accounts Receivable The Operating Cycle Sales Cash Purchasing Products because of the nature of their products. For example, a jewelry store or an automobile dealer normally has a longer operating cycle than a consumer electronics store or a grocery store. Businesses with longer operating cycles normally have higher profit margins on their products than businesses with shorter operating cycles. For example, it is not unusual for jewelry stores to price their jewelry at 30% 50% above cost. In contrast, grocery stores operate on very small profit margins, often below 5%. Grocery stores make up the difference by selling their products more quickly. 2 Describe and illustrate the financial statements of a merchandising business. Financial Statements for a Merchandising Business In this section, we illustrate the financial statements for NetSolutions after it becomes a retailer of computer hardware and software. During 2009, Chris Clark implemented the second phase of NetSolutions business plan. In doing so, Chris notified clients that beginning July 1, 2010, NetSolutions would no longer offer consulting services. Instead, it would become a retailer.
4 254 Chapter 6 Accounting for Merchandising Businesses NetSolutions business strategy is to offer personalized service to individuals and small businesses who are upgrading or purchasing new computer systems. NetSolutions personal service includes a no-obligation, on-site assessment of the customer s computer needs. By providing personalized service and follow-up, Chris feels that NetSolutions can compete effectively against such retailers as Best Buy and Office Depot, Inc. Multiple-Step Income Statement The 2011 income statement for NetSolutions is shown in Exhibit 1. 1 This form of income statement, called a multiple-step income statement, contains several sections, subsections, and subtotals. Revenue from Sales This section of the multiple-step income statement consists of sales, sales returns and allowances, sales discounts, and net sales. This section, as shown in Exhibit 1, is as follows: Revenue from sales: Sales $720,185 Less: Sales returns and allowances..... $6,140 Sales discounts ,790 11,930 Net sales $708,255 Exhibit 1 Multiple-Step Income Statement NetSolutions Income Statement For the Year Ended December 31, 2011 Revenue from sales: Sales Less: Sales returns and allowances Sales discounts Net sales Cost of merchandise sold Gross profit Operating expenses: Selling expenses: Sales salaries expense Advertising expense Depreciation expense store equipment Delivery expense Miscellaneous selling expense Total selling expenses Administrative expenses: Office salaries expense Rent expense Depreciation expense office equipment Insurance expense Office supplies expense Misc. administrative expense Total administrative expenses Total operating expenses Income from operations Other income and expense: Rent revenue Interest expense Net income $ 6,140 5,790 $53,430 10,860 3,100 2, $21,020 8,100 2,490 1, $720,185 11,930 $ 70,820 34,890 $708, ,305 $182, ,710 $ 77,240 $ 600 (2,440) (1,840) $ 75,400 1 We use the NetSolutions income statement for 2011 as a basis for illustration because, as will be shown, it allows us to better illustrate the computation of the cost of merchandise sold.
5 Chapter 6 Accounting for Merchandising Businesses 255 Sales is the total amount charged customers for merchandise sold, including cash sales and sales on account. During 2011, NetSolutions sold merchandise of $720,185 for cash or on account. Sales returns and allowances are granted by the seller to customers for damaged or defective merchandise. In such cases, the customer may either return the merchandise or accept an allowance from the seller. NetSolutions reported $6,140 of sales returns and allowances during Sales discounts are granted by the seller to customers for early payment of amounts owed. For example, a seller may offer a customer a 2% discount on a sale of $10,000 if the customer pays within 10 days. If the customer pays within the 10-day period, the seller receives cash of $9,800, and the buyer receives a discount of $200 ($10,000 2%). NetSolutions reported $5,790 of sales discounts during Net sales is determined by subtracting sales returns and allowances and sales discounts from sales. As shown above, NetSolutions reported $708,255 of net sales during Some companies report only net sales and report sales, sales returns and allowances, and sales discounts in notes to the financial statements. For many merchandising businesses, the cost of merchandise sold is usually the largest expense. For example, the approximate percentage of cost of merchandise sold to sales is 61% for JCPenney and 67% for The Home Depot. Cost of Merchandise Sold The cost of merchandise sold is the cost of the merchandise sold to customers. NetSolutions reported cost of merchandise sold of $525,305 during To illustrate how cost of merchandise sold is determined, we use data from when NetSolutions began its merchandising operations on July 1, Purchases July 1 December 31, 2010 $340,000 Merchandise inventory on December 31, ,700 Since NetSolutions had only $59,700 of merchandise left on December 31, 2010, it must have sold merchandise that cost $280,300 during 2010 as shown below. Purchases $340,000 Less merchandise inventory, December 31, ,700 Cost of merchandise sold $280,300 To continue, assume the following 2011 data for NetSolutions: Purchases of merchandise $521,980 Purchases returns and allowances 9,100 Purchases discounts 2,525 Freight in on merchandise purchased 17,400 Sellers may grant a buyer sales returns and allowances for returned or damaged merchandise. From a buyer s perspective, such allowances are called purchases returns and allowances. Likewise, sellers may grant a buyer a sales discount for early payment of the amount owed. From a buyer s perspective, such discounts are called purchases discounts. Purchases returns and allowances and purchases discounts are subtracted from purchases to arrive at net purchases as shown below for NetSolutions. Purchases $521,980 Less: Purchases returns and allowances $9,100 Purchases discounts 2,525 11,625 Net purchases $510,355 Freight costs incurred in obtaining the merchandise increase the cost of the merchandise purchased. These costs are called freight in. Adding freight in to net purchases yields the cost of merchandise purchased as shown below for NetSolutions. Net purchases $510,355 Add freight in 17,400 Cost of merchandise purchased $527,755 The beginning inventory is added to the cost of merchandise purchased to determine the merchandise available for sale for the period. The ending inventory of
6 256 Chapter 6 Accounting for Merchandising Businesses NetSolutions on December 31, 2010, $59,700, becomes the beginning (January 1, 2011) inventory for Thus, the merchandise available for sale for NetSolutions during 2011 is $587,455 as shown below. Merchandise inventory, January 1, 2011 $ 59,700 Cost of merchandise purchased 527,755 Cost of merchandise available for sale $587,455 The ending inventory is then subtracted from the merchandise available for sale to yield the cost of merchandise sold. Assuming the ending inventory on December 31, 2011, is $62,150, the cost of merchandise sold for NetSolutions is $525,305 as shown in Exhibit 1 and below. Cost of merchandise available for sale $587,455 Less merchandise inventory, December 31, ,150 Cost of merchandise sold $525,305 Retailers, such as Best Buy, Sears Holding Corporation, and Wal-Mart, and grocery store chains, such as Winn- Dixie Stores, Inc. and Kroger, use bar codes and optical scanners as part of their computerized inventory systems. In the preceding computation, merchandise inventory at the end of the period is subtracted from the merchandise available for sale to determine the cost of merchandise sold. The merchandise inventory at the end of the period is determined by taking a physical count of inventory on hand. This method of determining the cost of merchandise sold and the amount of merchandise on hand is called the periodic inventory system. Under the periodic inventory system, the inventory records do not show the amount available for sale or the amount sold during the period. Instead, the cost of merchandise sold is computed and reported as shown in Exhibit 2. Under the perpetual inventory system of accounting, each purchase and sale of merchandise is recorded in the inventory and the cost of merchandise sold accounts. As a result, the amounts of merchandise available for sale and sold are continuously (perpetually) updated in the inventory records. Because many retailers use computerized systems, the perpetual inventory system is widely used. For example, such systems may use bar codes, such as the one on the back of this textbook. An optical scanner reads the bar code to record merchandise purchased and sold. Businesses using a perpetual inventory system report the cost of merchandise sold as a single line on the income statement. An example of such reporting is illustrated in Exhibit 1 for NetSolutions. Because of its wide use, we use the perpetual inventory system in the remainder of this chapter. The periodic inventory system is described and illustrated in Appendix 2 of this chapter. Exhibit 2 Cost of Merchandise Sold Merchandise inventory, January 1, $ 59,700 Purchases $521,980 Less: Purchases returns and allowances $9,100 Purchases discounts ,525 11,625 Net purchases $510,355 Add freight in ,400 Cost of merchandise purchased ,755 Merchandise available for sale $587,455 Less merchandise inventory, December 31, ,150 Cost of merchandise sold $525,305
7 Chapter 6 Accounting for Merchandising Businesses 257 Gross Profit Gross profit is computed by subtracting the cost of merchandise sold from net sales, as shown below. Net sales $708,255 Cost of merchandise sold 525,305 Gross profit $182,950 As shown above and in Exhibit 1, NetSolutions has gross profit of $182,950 in Income from Operations Income from operations, sometimes called operating income, is determined by subtracting operating expenses from gross profit. Operating expenses are normally classified as either selling expenses or administrative expenses. Selling expenses are incurred directly in the selling of merchandise. Examples of selling expenses include sales salaries, store supplies used, depreciation of store equipment, delivery expense, and advertising. Administrative expenses, sometimes called general expenses, are incurred in the administration or general operations of the business. Examples of administrative expenses include office salaries, depreciation of office equipment, and office supplies used. Each selling and administrative expense may be reported separately as shown in Exhibit 1. However, many companies report selling, administrative, and operating expenses as single line items as shown below for NetSolutions. Gross profit $182,950 Operating expenses: Selling expenses $70,820 Administrative expenses 34,890 Total operating expenses 105,710 Income from operations $ 77,240 Other Income and Expense Other income and expense items are not related to the primary operations of the business. Other income is revenue from sources other than the primary operating activity of a business. Examples of other income include income from interest, rent, and gains resulting from the sale of fixed assets. Other expense is an expense that cannot be traced directly to the normal operations of the business. Examples of other expenses include interest expense and losses from disposing of fixed assets. Other income and other expense are offset against each other on the income statement. If the total of other income exceeds the total of other expense, the difference is added to income from operations to determine net income. If the reverse is true, the difference is subtracted from income from operations. The other income and expense items of NetSolutions are reported as shown below and in Exhibit 1. Income from operations $77,240 Other income and expense: Rent revenue $ 600 Interest expense (2,440) (1,840) Net income $75,400 Example Exercise 6-2 Cost of Merchandise Sold Based on the following data, determine the cost of merchandise sold for May. Follow the format used in Exhibit 2. Merchandise inventory, May $121,200 Merchandise inventory, May ,000 Purchases ,000 Purchases returns and allowances ,500 Purchases discounts ,000 Freight in ,300 2 (continued)
8 258 Chapter 6 Accounting for Merchandising Businesses Follow My Example 6-2 Cost of merchandise sold: Merchandise inventory, May $ 121,200 Purchases $985,000 Less: Purchases returns and allowances..... $23,500 Purchases discounts ,000 44,500 Net purchases $940,500 Add freight in ,300 Cost of merchandise purchased ,800 Merchandise available for sale $1,073,000 Less merchandise inventory, May ,000 Cost of merchandise sold $ 931,000 For Practice: PE 6-2A, PE 6-2B Single-Step Income Statement An alternate form of income statement is the single-step income statement. As shown in Exhibit 3, the income statement for NetSolutions deducts the total of all expenses in one step from the total of all revenues. The single-step form emphasizes total revenues and total expenses in determining net income. A criticism of the single-step form is that gross profit and income from operations are not reported. Statement of Owner s Equity The statement of owner s equity for NetSolutions is shown in Exhibit 4. This statement is prepared in the same manner as for a service business. Balance Sheet The balance sheet may be presented with assets on the left-hand side and the liabilities and owner s equity on the right-hand side. This form of the balance sheet is called the account form. The balance sheet may also be presented in a downward sequence in three sections. This form of balance sheet is called the report form. The report form Exhibit 3 Single-Step Income Statement NetSolutions Income Statement For the Year Ended December 31, 2011 Revenues: Net sales Rent revenue Total revenues Expenses: Cost of merchandise sold Selling expenses Administrative expenses Interest expense Total expenses Net income $525,305 70,820 34,890 2,440 $708, $708, ,455 $ 75,400
9 Chapter 6 Accounting for Merchandising Businesses 259 Exhibit 4 Statement of Owner s Equity for Merchandising Business Chris Clark, capital, January 1, 2011 Net income for the year Less withdrawals Increase in owner s equity Chris Clark, capital, December 31, 2011 NetSolutions Statement of Owner s Equity For the Year Ended December 31, 2011 $75,400 18,000 $153,800 57,400 $211,200 of balance sheet for NetSolutions is shown in Exhibit 5. In Exhibit 5, merchandise inventory is reported as a current asset and the current portion of the note payable of $5,000 is reported as a current liability. Exhibit 5 Report Form of Balance Sheet NetSolutions Balance Sheet December 31, 2011 Assets Current assets: Cash Accounts receivable Merchandise inventory Office supplies Prepaid insurance Total current assets Property, plant, and equipment: Land Store equipment Less accumulated depreciation Office equipment Less accumulated depreciation Total property, plant, and equipment Total assets Liabilities Current liabilities: Accounts payable Note payable (current portion) Salaries payable Unearned rent Total current liabilities Long-term liabilities: Note payable (final payment due 2021) Total liabilities Owner s Equity Chris Clark, capital Total liabilities and owner s equity $27,100 5,700 $15,570 4,720 $52,950 91,080 62, ,650 $20,000 21,400 10,850 $22,420 5,000 1,140 1,800 $209,310 52,250 $261,560 $ 30,360 20,000 $ 50, ,200 $261,560
10 260 Chapter 6 Accounting for Merchandising Businesses H&R BLOCK VERSUS THE HOME DEPOT H&R Block is a service business that primarily offers tax planning and preparation to its customers. The Home Depot is a large home improvement retailer. The differences in the operations of a service and merchandise business are illustrated in their income statements, as shown below. H&R Block Condensed Income Statement For the Year Ending April 30, 2007 (in millions) Revenue $4,021 Operating expenses ,361 Operating income $ 660 Other income (expense) (24) Income before taxes $ 636 Income taxes Net income $ 374 As discussed in a later chapter, corporations are subject to income taxes. Thus, the income statements of H&R Block and The Home Depot report income taxes as a deduction from income before income taxes in arriving at net income. This is in contrast to a proprietorship such as NetSolutions, which is not subject to income taxes. The Home Depot Condensed Income Statement For the Year Ending January 28, 2007 (in millions) Net sales $90,837 Cost of merchandise sold ,054 Gross profit $29,783 Operating expenses ,110 Operating income $ 9,673 Other income (expense) (365) Income before taxes $ 9,308 Income taxes ,547 Net income $ 5,761 3 Describe and illustrate the accounting for merchandise transactions including: sale of merchandise purchase of merchandise freight, sales taxes, and trade discounts dual nature of merchandising transactions Merchandising Transactions In the prior section, we described and illustrated the financial statements of a merchandising business, NetSolutions. In this section, we describe and illustrate the recording of merchandise transactions. We begin by describing the chart of accounts for a merchandising business. Chart of Accounts for a Merchandising Business The chart of accounts for a merchandising business should reflect the elements of the financial statements. The chart of accounts for NetSolutions is shown in Exhibit 6. The accounts related to merchandising transactions are shown in color. As shown in Exhibit 6, NetSolutions chart of accounts consists of three-digit account numbers. The first digit indicates the major financial statement classification (1 for assets, 2 for liabilities, and so on). The second digit indicates the subclassification (e.g., 11 for current assets, 12 for noncurrent assets). The third digit identifies the specific account (e.g., 110 for Cash, 123 for Store Equipment). Using a three-digit numbering system makes it easier to add new accounts as they are needed. Sales Transactions Merchandise transactions are recorded using the rules of debit and credit that we described and illustrated in Chapter 2. Exhibit 3, shown on page 55 of Chapter 2, summarizes these rules. Special journals may be used, or transactions may be entered, recorded, and posted using a computerized accounting system. To simplify, we will use a two-column general journal in this chapter. 2 Cash Sales A business may sell merchandise for cash. Cash sales are normally entered (rung up) on a cash register and recorded in the accounts. To illustrate, assume 2 Special journals and computerized accounting systems for merchandising businesses are described in Appendix 1 at the end of this chapter.
11 Chapter 6 Accounting for Merchandising Businesses 261 Exhibit 6 Chart of Accounts for NetSolutions, a Merchandising Business Balance Sheet Accounts Income Statement Accounts 100 Assets 400 Revenues 110 Cash 410 Sales 112 Accounts Receivable 411 Sales Returns and Allowances 115 Merchandise Inventory 412 Sales Discounts 116 Office Supplies 500 Costs and Expenses 117 Prepaid Insurance 510 Cost of Merchandise Sold 120 Land 520 Sales Salaries Expense 123 Store Equipment 521 Advertising Expense 124 Accumulated Depreciation 522 Depreciation Expense Store Store Equipment Equipment 125 Office Equipment 523 Delivery Expense 126 Accumulated Depreciation 529 Miscellaneous Selling Expense Office Equipment 530 Office Salaries Expense 200 Liabilities 531 Rent Expense 210 Accounts Payable 532 Depreciation Expense Office 211 Salaries Payable Equipment 212 Unearned Rent 533 Insurance Expense 215 Notes Payable 534 Office Supplies Expense 300 Owner s Equity 539 Misc. Administrative Expense 310 Chris Clark, Capital 600 Other Income 311 Chris Clark, Drawing 610 Rent Revenue 312 Income Summary 700 Other Expense 710 Interest Expense that on January 3, NetSolutions sells merchandise for $1,800. These cash sales are recorded as follows: Journal Page 25 Date Description Post. Ref. Debit Credit 2011 Jan. 3 Cash 1,800 Sales To record cash sales. 1,800 Using the perpetual inventory system, the cost of merchandise sold and the decrease in merchandise inventory are also recorded. In this way, the merchandise inventory account indicates the amount of merchandise on hand (not sold). To illustrate, assume that the cost of merchandise sold on January 3 is $1,200. The entry to record the cost of merchandise sold and the decrease in the merchandise inventory is as follows: Jan. 3 Cost of Merchandise Sold 1,200 Merchandise Inventory To record the cost of merchandise sold. 1,200
12 262 Chapter 6 Accounting for Merchandising Businesses Sales may be made to customers using credit cards such as MasterCard or VISA. Such sales are recorded as cash sales. This is because these sales are normally processed by a clearing-house that contacts the bank that issued the card. The issuing bank then electronically transfers cash directly to the retailer s bank account. 3 Thus, the retailer normally receives cash within a few days of making the credit card sale. If the customers in the preceding sales had used MasterCards to pay for their purchases, the sales would be recorded exactly as shown in the preceding entry. Any processing fees charged by the clearing-house or issuing bank are periodically recorded as an expense. This expense is normally reported on the income statement as an administrative expense. To illustrate, assume that NetSolutions paid credit card processing fees of $48 on January 31. These fees would be recorded as follows: Jan. 31 Credit Card Expense 48 Cash To record service charges on credit card sales for the month. 48 A retailer may accept MasterCard or VISA but not American Express. Why? The service fees that credit card companies charge retailers are the primary reason that some businesses do not accept all credit cards. For example, American Express Co. s service fees are normally higher than MasterCard s or VISA s. As a result, some retailers choose not to accept American Express cards. The disadvantage of this practice is that the retailer may lose customers to competitors who do accept American Express cards. Instead of using MasterCard or VISA, a customer may use a credit card that is not issued by a bank. For example, a customer might use an American Express card. If the seller uses a clearing-house, the clearing-house will collect the receivable and transfer the cash to the retailer s bank account similar to the way it would have if the customer had used MasterCard or VISA. Large businesses, however, may not use a clearing-house. In such cases, nonbank credit card sales must first be reported to the card company before cash is received. Thus, a receivable is created with the nonbank credit card company. However, since most retailers use clearing-houses to process both bank and nonbank credit cards, we will record all credit card sales as cash sales. Sales on Account A business may sell merchandise on account. The seller records such sales as a debit to Accounts Receivable and a credit to Sales. An example of an entry for a NetSolutions sale on account of $510 follows. The cost of merchandise sold was $280. Jan. 12 Accounts Receivable Sims Co. 510 Sales Invoice No Cost of Merchandise Sold Merchandise Inventory Cost of merch. sold on Invoice No Sales Discounts The terms of a sale are normally indicated on the invoice or bill that the seller sends to the buyer. An example of a sales invoice for NetSolutions is shown in Exhibit 7. 3 CyberSource is one of the major credit card clearing-houses. For a more detailed description of how credit card sales are processed, see the following CyberSource Web page: payment_services/credit_card_processing/howitworks.xml.
13 Chapter 6 Accounting for Merchandising Businesses 263 Exhibit 7 Invoice Invoice NetSolutions 5101 Washington Ave. Cincinnati, OH Made in U.S.A. SOLD TO CUSTOMER S ORDER NO. & DATE Omega Technologies 412 Jan.10, Matrix Blvd. San Jose, CA DATE SHIPPED HOW SHIPPED AND ROUTE TERMS INVOICE DATE Jan. 12, 2011 US Express Trucking Co. 2/10, n/30 Jan. 12, 2011 FROM Cincinnati F.O.B. Cincinnati QUANTITY DESCRIPTION UNIT PRICE AMOUNT 10 3COM Megahertz , COM Wireless PC Card The terms for when payments for merchandise are to be made are called the credit terms. If payment is required on delivery, the terms are cash or net cash. Otherwise, the buyer is allowed an amount of time, known as the credit period, in which to pay. 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 invoice date, such as 30 days, the terms are net 30 days. These terms may be written as n/30. 4 If payment is due by the end of the month in which the sale was made, the terms are written as n/eom. To encourage the buyer to pay before the end of the credit period, the seller may offer a discount. For example, a seller may offer a 2% discount if the buyer pays within 10 days of the invoice date. If the buyer does not take the discount, the total amount is due within 30 days. These terms are expressed as 2/10, n/30 and are read as 2% discount if paid within 10 days, net amount due within 30 days. The credit terms of 2/10, n/30 are summarized in Exhibit 8, using the invoice in Exhibit 7. Exhibit 8 Credit Terms If invoice is paid within 10 days of invoice date $1,470 Paid 2% of invoice amount is allowed as a cash discount Invoice for $1,500 Terms: 2/10, n/30 If invoice is NOT paid within 10 days of invoice date Full amount is due within 30 days of invoice date $1,500 Paid 4 The word net as used here does not have the usual meaning of a number after deductions have been subtracted, as in net income.
14 264 Chapter 6 Accounting for Merchandising Businesses Discounts taken by the buyer for early payment are recorded as sales discounts by the seller. Managers usually want to know the amount of the sales discounts for a period. For this reason, sales discounts are recorded in a separate sales discounts account, which is a contra (or offsetting) account to Sales. To illustrate, assume that NetSolutions receives $1,470 on January 22 for the invoice shown in Exhibit 7. Since the invoice was paid within the discount period (10 days), the buyer deducted $30 ($1,500 2%) from the invoice amount. NetSolutions would record the receipt of the cash as follows: Jan. 22 Cash Sales Discounts Accounts Receivable Omega Technologies Collection on Invoice No , less 2% discount. 1, ,500 Book publishers often experience large returns if a book is not immediately successful. For example, 35% of adult hardcover books shipped to retailers are returned to publishers, according to the Association of American Publishers. Sales Returns and Allowances Merchandise sold may be returned to the seller (sales return). In other cases, the seller may reduce the initial selling price (sales allowance). This might occur if the merchandise is defective, damaged during shipment, or does not meet the buyer s expectations. If the return or allowance is for a sale on account, the seller usually issues the buyer a credit memorandum, often called a credit memo. A credit memo authorizes a credit to (decreases) the buyer s account receivable. A credit memo indicates the amount and reason for the credit. An example of a credit memo issued by NetSolutions is shown in Exhibit 9. Like sales discounts, sales returns and allowances reduce sales revenue. Also, returns often result in additional shipping and handling expenses. Thus, managers usually want to know the amount of returns and allowances for a period. For this reason, sales returns and allowances are recorded in a separate sales returns and allowances account, which is is a contra (or offsetting) account to Sales. The seller debits Sales Returns and Allowances for the amount of the return or allowance. If the sale was on account, the seller credits Accounts Receivable. Using a perpetual inventory system, the seller must also debit (increase) Merchandise Inventory and decrease (credit) Cost of Merchandise Sold for the cost of the returned merchandise. To illustrate, we use the credit memo shown in Exhibit 9. The selling price of the merchandise returned in Exhibit 9 is $225. Assuming that the cost of the Exhibit 9 Credit Memo NetSolutions 5101 Washington Ave. Cincinnati, OH No. 32 CREDIT MEMO TO DATE Krier Company January 13, Melton Avenue Los Angeles, CA WE CREDIT YOUR ACCOUNT AS FOLLOWS 1 Graphic Video Card
15 Chapter 6 Accounting for Merchandising Businesses 265 merchandise returned is $140, the sales return and allowance would be recorded as follows: Jan. 13 Sales Returns and Allowances 225 Accounts Receivable Krier Company Credit Memo No Jan. 13 Merchandise Inventory 140 Cost of Merchandise Sold Cost of merchandise returned, Credit Memo No A buyer may pay for merchandise and then later return it. In this case, the seller may do one of the following: 1. Issue a credit that is applied against the buyer s other receivables. 2. Issue a cash refund. If the credit is applied against the buyer s other receivables, the seller records the credit with entries similar to those shown above. If cash is refunded, the seller debits Sales Returns and Allowances and credits Cash. Example Exercise 6-3 Sales Transactions Journalize the following merchandise transactions: a. Sold merchandise on account, $7,500 with terms 2/10, n/30. The cost of the merchandise sold was $5,625. b. Received payment less the discount. 3 Follow My Example 6-3 a. Accounts Receivable ,500 Sales ,500 Cost of Merchandise Sold ,625 Merchandise Inventory ,625 b. Cash ,350 Sales Discounts Accounts Receivable ,500 For Practice: PE 6-3A, PE 6-3B THE CASE OF THE FRAUDULENT PRICE TAGS One of the challenges for a retailer is policing its sales return policy. There are many ways in which customers can unethically or illegally abuse such policies. In one case, a couple was accused of attaching Marshalls store price tags to cheaper merchandise bought or obtained elsewhere. The couple then returned the cheaper goods and received the substantially higher refund amount. Company security officials discovered the fraud and had the couple arrested after they had allegedly bilked the company for over $1 million.
16 266 Chapter 6 Accounting for Merchandising Businesses Purchase Transactions Under the perpetual inventory system, cash purchases of merchandise are recorded as follows: Journal Page 24 Date Description Post. Ref. Debit Credit 2011 Jan. 3 Merchandise Inventory 2,510 Cash Purchased inventory from Bowen Co. 2,510 Purchases of merchandise on account are recorded as follows: Jan. 4 Merchandise Inventory 9,250 Accounts Payable Thomas Corporation Purchased inventory on account. 9,250 Purchases Discounts Purchases discounts taken by a buyer reduce the cost of the merchandise purchased. Even if the buyer has to borrow to pay within a discount period, it is normally to the buyer s advantage to do so. For this reason, accounting systems are normally designed so that all available discounts are taken. To illustrate, assume that NetSolutions purchased merchandise from Alpha Technologies as follows: Invoice Date Invoice Amount Terms March 12 $3,000 2/10, n/30 The last day of the discount period is March 22 (March days). Assume that in order to pay the invoice on March 22, NetSolutions borrows $2,940, which is $3,000 less the discount of $60 ($3,000 2%). If we also assume an annual interest rate of 6% and a 360-day year, the interest on the loan of $2,940 for the remaining 20 days of the credit period is $9.80 ($2,940 6% 20/360). The net savings to NetSolutions of taking the discount is $50.20, computed as follows: Discount of 2% on $3,000 $60.00 Interest for 20 days at a rate of 6% on $2, Savings from taking the discount $50.20 The savings can also be seen by comparing the interest rate on the money saved by taking the discount and the interest rate on the money borrowed to take the discount. The interest rate on the money saved in the prior example is estimated by converting 2% for 20 days to a yearly rate, as follows: 2% 360 days 2% 18 36% 20 days NetSolutions borrowed $2,940 at 6% to take the discount. If NetSolutions does not take the discount, it pays an estimated interest rate of 36% for using the $2,940 for the remaining 20 days of the credit period. Thus, buyers should normally take all available purchase discounts.
17 Chapter 6 Accounting for Merchandising Businesses 267 Should you pay your bills, such as utility bills and credit card bills, as soon as they are received? Probably not. Most bills that you receive do not offer discounts for early payment. Rather, the bills normally indicate only a due date and perhaps a penalty for late payment. Many times you receive bills weeks before their due date. In such cases, it is to your advantage to file the bill by its due date in a folder or other organizer, such as a desk calendar, and mail the payment a few days before it is due. This way, you can use your money to earn interest on your checking or savings account. Under the perpetual inventory system, the buyer initially debits Merchandise Inventory for the amount of the invoice. When paying the invoice within the discount period, the buyer credits Merchandise Inventory for the amount of the discount. In this way, Merchandise Inventory shows the net cost to the buyer. To illustrate, NetSolutions would record the Alpha Technologies invoice and its payment at the end of the discount period as follows: Mar Merchandise Inventory Accounts Payable Alpha Technologies Accounts Payable Alpha Technologies Cash Merchandise Inventory 3,000 3,000 3,000 2, Assume that NetSolutions does not take the discount, but instead pays the invoice on April 11. In this case, NetSolutions would record the payment on April 11 as follows: Apr. 11 Accounts Payable Alpha Technologies 3,000 Cash 3,000 Purchases Returns and Allowances A buyer may return merchandise (purchases return) or request a price allowance (purchases allowance) from the seller. In both cases, the buyer normally sends the seller a debit memorandum. A debit memorandum, often called a debit memo, is shown in Exhibit 10. A debit memo informs the seller of the amount the buyer proposes to debit to the account payable due the seller. It also states the reasons for the return or the request for the price allowance. The buyer may use the debit memo as the basis for recording the return or allowance or wait for approval from the seller (creditor). In either case, the buyer debits Accounts Payable and credits Merchandise Inventory. Exhibit 10 Debit Memo NetSolutions 5101 Washington Ave. Cincinnati, OH No. 18 DEBIT MEMO TO Maxim Systems 7519 East Willson Ave. Seattle, WA WE DEBIT YOUR ACCOUNT AS FOLLOWS 10 Server Network Interface Cards, your Invoice No. 7291, are being returned via parcel post. Our order specified No. 825X. DATE March 7,
18 268 Chapter 6 Accounting for Merchandising Businesses To illustrate, NetSolutions records the return of the merchandise indicated in the debit memo in Exhibit 10 as follows: Mar. 7 Accounts Payable Maxim Systems 900 Merchandise Inventory Debit Memo No A buyer may return merchandise or be granted a price allowance before paying an invoice. In this case, the amount of the debit memo is deducted from the invoice. The amount is deducted before the purchase discount is computed. To illustrate, assume the following data concerning a purchase of merchandise by NetSolutions on May 2: May 2. Purchased $5,000 of merchandise on account from Delta Data Link, terms 2/10, n/ Returned $3,000 of the merchandise purchased on March Paid for the purchase of May 2 less the return and discount. NetSolutions would record these transactions as follows: May 2 Merchandise Inventory Accounts Payable Delta Data Link Purchased merchandise. 5,000 5,000 4 Accounts Payable Delta Data Link Merchandise Inventory Returned portion of merch. purchased. 3,000 3, Accounts Payable Delta Data Link Cash Merchandise Inventory Paid invoice [($5,000 $3,000) 2% $40; $2,000 $40 $1,960]. 2,000 1, Example Exercise 6-4 Purchase Transactions Rofles Company purchased merchandise on account from a supplier for $11,500, terms 2/10, n/30. Rofles Company returned $3,000 of the merchandise and received full credit. a. If Rofles Company pays the invoice within the discount period, what is the amount of cash required for the payment? b. Under a perpetual inventory system, what account is credited by Rofles Company to record the return? Follow My Example 6-4 a. $8,330. Purchase of $11,500 less the return of $3,000 less the discount of $170 [($11,500 $3,000) 2%]. b. Merchandise Inventory 3 For Practice: PE 6-4A, PE 6-4B
19 Chapter 6 Accounting for Merchandising Businesses 269 The buyer bears the freight costs if the shipping terms are FOB shipping point. Freight, Sales Taxes, and Trade Discounts Purchases and sales of merchandise often involve freight and sales taxes. Also, the seller may offer buyers trade discounts. Freight The terms of a sale indicate when ownership (title) of the merchandise passes from the seller to the buyer. This point determines whether the buyer or the seller pays the freight costs. 5 The ownership of the merchandise may pass to the buyer when the seller delivers the merchandise to the freight carrier. In this case, the terms are said to be FOB (free on board) shipping point. This term means that the buyer pays the freight costs from the shipping point to the final destination. Such costs are part of the buyer s total cost of purchasing inventory and are added to the cost of the inventory by debiting Merchandise Inventory. To illustrate, assume that on June 10, NetSolutions purchased merchandise as follows: June 10. Purchased merchandise from Magna Data, $900, terms FOB shipping point. 10. Paid freight of $50 on June 10 purchase from Magna Data. NetSolutions would record these two transactions as follows: Sometimes FOB shipping point and FOB destination are expressed in terms of the location at which the title to the merchandise passes to the buyer. For example, if Toyota Motor Corporation s assembly plant in Osaka, Japan, sells automobiles to a dealer in Chicago, FOB shipping point could be expressed as FOB Osaka. Likewise, FOB destination could be expressed as FOB Chicago. June Merchandise Inventory Accounts Payable Magna Data Purchased merchandise, terms FOB shipping point. Merchandise Inventory Cash Paid shipping cost on merchandise purchased The ownership of the merchandise may pass to the buyer when the buyer receives the merchandise. In this case, the terms are said to be FOB The seller bears the freight (free on board) destination. This term means that the seller pays the freight costs if the shipping terms costs from the shipping point to the buyer s final destination. When the are FOB destination. seller pays the delivery charges, the seller debits Delivery Expense or Freight Out. Delivery Expense is reported on the seller s income statement as a selling expense. To illustrate, assume that NetSolutions sells merchandise as follows: June 15. Sold merchandise to Kranz Company on account, $700, terms FOB destination. The cost of the merchandise sold is $ NetSolutions pays freight of $40 on the sale of June 15. NetSolutions records the sale, the cost of the sale, and the freight cost as follows: 5 The passage of title also determines whether the buyer or seller must pay other costs, such as the cost of insurance, while the merchandise is in transit.
20 270 Chapter 6 Accounting for Merchandising Businesses June 15 Accounts Receivable Kranz Company Sales Sold merchandise, terms FOB destination Cost of Merchandise Sold Merchandise Inventory Recorded cost of merchandise sold to Kranz Company Delivery Expense Cash Paid shipping cost on merch. sold The seller may prepay the freight, even though the terms are FOB shipping point. The seller will then add the freight to the invoice. The buyer debits Merchandise Inventory for the total amount of the invoice, including the freight. Any discount terms would not apply to the prepaid freight. To illustrate, assume that NetSolutions sells merchandise as follows: June 20. Sold merchandise to Planter Company on account, $800, terms FOB shipping point. NetSolutions paid freight of $45, which was added to the invoice. The cost of the merchandise sold is $360. NetSolutions records the sale, the cost of the sale, and the freight as follows: June 20 Accounts Receivable Planter Company Sales Sold merch., terms FOB shipping point Cost of Merchandise Sold Merchandise Inventory Recorded cost of merchandise sold to Planter Company Accounts Receivable Planter Company Cash Prepaid shipping cost on merch. sold Shipping terms, the passage of title, and whether the buyer or seller is to pay the freight costs are summarized in Exhibit 11. Exhibit 11 Freight Terms
21 Chapter 6 Accounting for Merchandising Businesses 271 Example Exercise 6-5 Freight Terms Determine the amount to be paid in full settlement of each of invoices (a) and (b), assuming that credit for returns and allowances was received prior to payment and that all invoices were paid within the discount period. Freight Returns and Merchandise Paid by Seller Freight Terms Allowances a. $4,500 $200 FOB shipping point, 1/10, n/30 $ 800 b. 5, FOB destination, 2/10, n/30 2,500 3 Follow My Example 6-5 a. $3,863. Purchase of $4,500 less return of $800 less the discount of $37 [($4,500 $800) 1%] plus $200 of shipping. b. $2,450. Purchase of $5,000 less return of $2,500 less the discount of $50 [($5,000 $2,500) 2%]. For Practice: PE 6-5A, PE 6-5B The six states with the highest state sales tax (including the local option) are Tennessee, Louisiana, Washington, New York, Arkansas, and Alabama. Some states have no sales tax, including Alaska, Delaware, Montana, New Hampshire, and Oregon. Sales Taxes Almost all states levy a tax on sales of merchandise. 6 The liability for the sales tax is incurred when the sale is made. At the time of a cash sale, the seller collects the sales tax. When a sale is made on account, the seller charges the tax to the buyer by debiting Accounts Receivable. The seller credits the sales account for the amount of the sale and credits the tax to Sales Tax Payable. For example, the seller would record a sale of $100 on account, subject to a tax of 6%, as follows: Aug. 12 Accounts Receivable Lemon Co. 106 Sales Sales Tax Payable Invoice No Business collects sales tax from customers On a regular basis, the seller pays to the taxing authority (state) the amount of the sales tax collected. The seller records such a payment as follows: Customer Sep. 15 Sales Tax Payable 2,900 Cash Payment for sales taxes collected during August. 2,900 State Business remits sales tax to state Trade Discounts Wholesalers are companies that sell merchandise to other businesses rather than to the public. Many wholesalers publish sales catalogs. Rather than updating their catalogs, wholesalers may publish price updates. These updates may include large discounts from the catalog list prices. In addition, wholesalers often offer special discounts to government agencies or businesses that order large quantities. Such discounts are called trade discounts. Sellers and buyers do not normally record the list prices of merchandise and trade discounts in their accounts. For example, assume that an item has a list price of $1,000 and a 40% trade discount. The seller records the sale of the item at $600 [$1,000 less the trade discount of $400 ($1,000 40%)]. Likewise, the buyer records the purchase at $ Businesses that purchase merchandise for resale to others are normally exempt from paying sales taxes on their purchases. Only final buyers of merchandise normally pay sales taxes.