CHAPTER 5 ACCOUNTING FOR MERCHANDISING OPERATIONS

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1 CHAPTER 5 ACCOUNTING FOR MERCHANDISING OPERATIONS LEARNING OBJECTIVES 1. IDENTIFY THE DIFFERENCES BETWEEN SERVICE AND MERCHANDISING COMPANIES. 2. EXPLAIN THE RECORDING OF PURCHASES UNDER A PERPETUAL INVENTORY SYSTEM. 3. EXPLAIN THE RECORDING OF SALES REVENUES UNDER A PERPETUAL INVENTORY SYSTEM. 4. EXPLAIN THE STEPS IN THE ACCOUNTING CYCLE FOR A MERCHANDISING COMPANY. 5. DISTINGUISH BETWEEN A MULTIPLE-STEP AND A SINGLE-STEP INCOME STATEMENT. *6. PREPARE A WORKSHEET FOR A MERCHANDISING COMPANY. *7. EXPLAIN THE RECORDING OF PURCHASES AND SALES OF INVENTORY UNDER A PERIODIC INVENTORY SYSTEM. Copyright 2013 John Wiley & Sons, Inc. Weygandt, Accounting Principles, 11/e, Instructor s Manual (For Instructor Use Only) 5-1

2 CHAPTER REVIEW Merchandising Operations 1. (L.O. 1) A merchandising company is an enterprise that buys and sells merchandise as their primary source of revenue. Merchandising companies that purchase and sell directly to consumers are retailers, and those that sell to retailers are known as wholesalers. 2. The primary source of revenue for a merchandising company is sales revenue. Expenses are divided into two categories: (1) cost of goods sold and (2) operating expenses. 3. Sales less cost of goods sold is called the gross profit. For example, if sales are $5,000 and cost of goods sold is $3,000, gross profit is $2, After gross profit is calculated, operating expenses are deducted to determine net income (or loss). 5. Operating expenses are expenses incurred in the process of recognizing sales revenue. Operating Cycles 6. The operating cycle of a merchandising company is as follows: Flow of Costs 7. A merchandising company may use either a perpetual or a periodic inventory system in determining cost of goods sold. a. In a perpetual inventory system, detailed records of the cost of each inventory item are maintained and the cost of each item sold is determined from the records when the sale occurs. b. In a periodic inventory system, detailed inventory records are not maintained and the cost of goods sold is determined only at the end of an accounting period. Purchase Transactions 8. (L.O. 2) Under the perpetual inventory system, purchases of merchandise for sale are recorded in the Inventory account. For a cash purchase, Cash is credited; for a credit purchase, Accounts Payable is credited. 9. FOB shipping point means that goods are placed free on board the carrier by the seller, and the buyer must pay the freight costs. FOB destination means that goods are placed free on board at the buyer s place of business, and the seller pays the freight. 5-2 Copyright 2013 John Wiley & Sons, Inc. Weygandt, Accounting Principles, 11/e, Instructor s Manual (For Instructor Use Only)

3 10. When the purchaser pays the freight, Inventory is debited and Cash is credited. When the seller pays the freight, Freight-Out (Delivery Expense) is debited and Cash is credited. This account is classified as an operating expense by the seller. 11. A purchaser may be dissatisfied with the merchandise received because the goods may be damaged or defective, of inferior quality, or not in accord with the purchaser s specifications. The purchaser may return the merchandise, or choose to keep the merchandise if the supplier is willing to grant an allowance (deduction) from the purchase price. When merchandise is returned, Inventory is credited. 12. When the credit terms of a purchase on account permit the purchaser to claim a cash discount for the prompt payment of a balance due, this is called a purchase discount. If a purchase discount has terms 3/10, n/30, then a 3% discount is taken on the invoice price (less any returns or allowances) if payment is made within 10 days. If payment is not made within 10 days, then there is no purchase discount, and the net amount of the bill is due within 30 days. 13. When an invoice is paid within the discount period, the amount of the discount is credited to Inventory. When an invoice is not paid within the discount period, then the usual entry is made with a debit to Accounts Payable and a credit to Cash. Sales Transactions 14. (L.O. 3) In accordance with the revenue recognition principle, companies record sales revenues when the performance obligation is satisfied. Typically the performance obligation is satisfied when the goods are transferred from the seller to the buyer. 15. All sales transactions should be supported by a business document. Cash register documents provide evidence of cash sales; sales invoices provide support for credit sales. 16. A sale on credit is recorded as follows: Accounts Receivable... Sales Revenue... Cost of Goods Sold... Inventory... After the cash payment is received by the seller, the following entry is recorded: Cash... Accounts Receivable... A cash sale is recorded by a debit to Cash and a credit to Sales Revenue, and a debit to Cost of Goods Sold and a credit to Inventory. Sales Returns and Allowances 17. A sales return results when a customer is dissatisfied with merchandise and is allowed to return the goods to the seller for credit or for a cash refund. A sales allowance results when a customer is dissatisfied with merchandise and the seller is willing to grant an allowance (deduction) from the selling price. Copyright 2013 John Wiley & Sons, Inc. Weygandt, Accounting Principles, 11/e, Instructor s Manual (For Instructor Use Only) 5-3

4 18. To give the customer a sales return or allowance, the seller normally makes the following entry if the sale was a credit sale (the second entry is made only if the goods are returned): Sales Returns and Allowances... Accounts Receivable... Inventory... Cost of Goods Sold... For a sales return or allowance on a cash sale, a cash refund is made and Cash is credited instead of Accounts Receivable. The second entry is the same as above. 19. Sales Returns and Allowances is a contra revenue account and the normal balance of the account is a debit. Sales Discounts 20. A sales discount is the offer of a cash discount to a customer for the prompt payment of a balance due. If a credit sale has terms 2/10, n/30, then a 2% discount is taken on the invoice price (less any returns or allowances) if payment is made within 10 days. If payment is not made within 10 days, then there is no sales discount, and the net amount of the bill, without discount, is due within 30 days. Sales Discounts is a contra revenue account and the normal balance of this account is a debit. 21. Both Sales Returns and Allowances and Sales Discounts are subtracted from Sales Revenue in the income statement to arrive at net sales. The Accounting Cycle 22. (L.O. 4) Each of the required steps in the accounting cycle applies to a merchandising company. Adjusting Entries and Closing Entries 23. A merchandising company generally has the same types of adjusting entries as a service company but a merchandiser using a perpetual inventory system will require an additional adjustment to reflect the difference between a physical count of the inventory and the accounting records. In addition, like a service company, a merchandising company closes all accounts that affect net income to Income Summary. Multiple-Step vs. Single-Step Income Statement 24. (L.O. 5) A multiple-step income statement shows several steps in determining net income: (1) cost of goods sold is subtracted from net sales to determine gross profit and (2) operating expenses are deducted from gross profit to determine net income. In addition, there may be nonoperating sections for: a. Revenues and expenses that result from secondary or auxiliary operations, and b. Gains and losses that are unrelated to the company s operations. 5-4 Copyright 2013 John Wiley & Sons, Inc. Weygandt, Accounting Principles, 11/e, Instructor s Manual (For Instructor Use Only)

5 Gross Profit and Operating Expenses 25. Gross profit is net sales less cost of goods sold. The gross profit rate is expressed as a percentage by dividing the amount of gross profit by net sales. Operating expenses are the third component in measuring net income for a merchandising company. 26. Nonoperating sections are reported in the income statement after income from operations and are classified as (a) Other revenues and gains and (b) Other expenses and losses. 27. The income statement is referred to as a single-step income statement when all data are classified under two categories: (a) Revenues and (b) Expenses, and only one step is required in determining net income or net loss. Classified Balance Sheet 28. A merchandising company generally has the same type of balance sheet as a service company except inventory is reported as a current asset. Using a Worksheet *29. (L.O. 6) As indicated in Chapter 4, a worksheet enables financial statements to be prepared before the adjusting entries are journalized and posted. The steps in preparing a worksheet for a merchandising company are the same as they are for a service company except the additional merchandising accounts are included. Determining Cost of Goods Sold Under a Periodic System *30. (L.O. 7) Under a periodic system separate accounts are used to record freight costs, returns, and discounts. In addition, a running account of changes in inventory is not maintained. Instead, the balance in ending inventory, as well as cost of goods sold for the period, is calculated at the end of the period. The determination of cost of goods sold for Tsutsui Co. using a periodic inventory system, is as follows: TSUTSUI COMPANY Cost of Goods Sold For the Year Ended December 31, 2014 Cost of goods sold Inventory, January 1... $ 28,000 Purchases... $234,000 Less: Purchases returns and allowances... $8,200 Purchase discounts... 4,600 12,800 Net purchases ,200 Add: Freight-in... 10,800 Cost of goods purchased ,000 Cost of goods available for sale ,000 Inventory, December ,000 Cost of goods sold ,000 Copyright 2013 John Wiley & Sons, Inc. Weygandt, Accounting Principles, 11/e, Instructor s Manual (For Instructor Use Only) 5-5

6 *31. To determine the cost of goods sold under a periodic inventory system, three steps are required: (1) Record purchases of merchandise; (2) Determine the cost of goods purchased; and (3) Determine the cost of goods on hand at the beginning and end of the accounting period. *32. In determining cost of goods purchased, (a) contra-purchase accounts are subtracted from purchases to produce net purchases, and (b) freight-in is then added to net purchases. *33. Cost of inventory on hand under the periodic inventory method is obtained from a physical inventory. *34. Cost of goods sold is determined by two steps: a. The cost of goods purchased is added to the cost of goods on hand at the beginning of the period to obtain the cost of goods available for sale. b. The cost of goods on hand at the end of the period is subtracted from the cost of goods available for sale. Recording Purchases and Sales of Merchandise *35. (S.O. 7) In a periodic inventory system revenues from the sale of merchandise are recorded when sales are made in the same way as in a perpetual system. But, no attempt is made on the date of sale to record the cost of the merchandise sold. Instead, a physical inventory count is taken at the end of the period to determine (1) the cost of the merchandise then on hand and (2) the cost of the goods sold during the period. *36. Under the periodic inventory system, purchases of merchandise for sale are recorded in a Purchases account. For a cash purchase, Cash is credited; for a credit purchase, Accounts Payable is credited. *37. A purchase return and allowance is recorded by debiting Accounts Payable or Cash and crediting the account Purchase Returns and Allowances. Purchase Returns and Allowances is a temporary account whose normal balance is a credit. *38. If payment is made within a discount period, the amount of the discount is credited to the account Purchases Discounts. When an invoice is not paid within the discount period, then the usual entry is made with a debit to Accounts Payable and a credit to Cash. 5-6 Copyright 2013 John Wiley & Sons, Inc. Weygandt, Accounting Principles, 11/e, Instructor s Manual (For Instructor Use Only)

7 LECTURE OUTLINE A. Merchandising Operations. 1. The primary source of revenues for merchandising companies is the sale of merchandise, referred to as sales revenue or sales. 2. A merchandising company has two categories of expenses: a. Cost of goods sold is the total cost of merchandise sold during the period. b. Operating expenses are expenses incurred in the process of earning sales revenues. 3. Gross profit is the difference between sales revenue and cost of goods sold. INVESTOR INSIGHT Morrow Snowboards implemented a perpetual inventory system to improve its control over inventory. It also stated that it would perform a physical inventory count every quarter until it felt that the perpetual inventory system was reliable. If a perpetual system keeps track of inventory on a daily basis, why do companies ever need to do a physical count? Answer: A perpetual system keeps track of all sales and purchases on a continuous basis. This provides a constant record of the number of units in the inventory. However, if employees make errors in recording sales or purchases, the inventory value will not be correct. As a consequence, all companies do a physical count of inventory at least once a year. Copyright 2013 John Wiley & Sons, Inc. Weygandt, Accounting Principles, 11/e, Instructor s Manual (For Instructor Use Only) 5-7

8 B. Recording Purchases and Sales of Merchandise. 1. In a perpetual inventory system, companies keep detailed records of the cost of each inventory purchase and sale. These records continuously (perpetually) show the inventory that should be on hand for every item. 2. Under a perpetual inventory system: a. Companies record purchases of merchandise for sale in the Inventory account. Companies record purchases of assets acquired for use, such as supplies and equipment, as increases to specific asset accounts rather than to Inventory. b. The company debits the Inventory account for all purchases of merchandise and freight-in, and credits it for purchase discounts and purchase returns and allowances. Freight terms are expressed as either FOB shipping point or FOB destination. (1) FOB shipping point means that the seller places the goods free on board the common carrier, and the buyer pays the freight costs. (2) FOB destination means that the seller places the goods free on board to the buyer's place of business, and the seller pays the freight. Freight costs incurred by the seller on outgoing merchandise are an operating expense to the seller and are debited to Freight- Out (Delivery Expense). c. A purchaser may return goods to the seller for credit because the goods are damaged or defective, or of inferior quality. The return of goods to the seller is known as a purchase return. d. The credit terms of a purchase on account may permit the buyer to claim a cash discount for prompt payment. The buyer calls this cash discount a purchase discount. 5-8 Copyright 2013 John Wiley & Sons, Inc. Weygandt, Accounting Principles, 11/e, Instructor s Manual (For Instructor Use Only)

9 TEACHING TIP Emphasize the accounts used by a merchandising company Sales Revenue, Sales Returns and Allowances, and Sales Discounts. (3) In accordance with the revenue recognition principle, companies record sales revenues when the performance obligation is satisfied. Typically the performance obligation is satisfied when goods transfer from the seller to the buyer. (4) Sales may be made on credit or for cash. Companies record sales by debiting Accounts Receivable (or Cash) and crediting Sales Revenue for the selling price of the merchandise. (5) The cost of goods sold is recognized for each sale by debiting Cost of Goods Sold and crediting Inventory. (6) Sales Returns and Allowances is a contra revenue account (offset against a revenue account) to Sales Revenue. Companies use a contra account, instead of debiting Sales Revenue, to disclose in the accounts and in the income statement the amount of sales returns and allowances. (7) Companies record the cost of goods returned by decreasing Cost of Goods Sold and increasing the Inventory account. (8) A sales discount occurs when the seller offers a cash discount for prompt payment of the balance due. (9) Like Sales Returns and Allowances, Sales Discounts is a contra revenue account to Sales Revenue and its normal balance is a debit. Copyright 2013 John Wiley & Sons, Inc. Weygandt, Accounting Principles, 11/e, Instructor s Manual (For Instructor Use Only) 5-9

10 ACCOUNTING ACROSS THE ORGANIZATION Costco Wholesale Corp. has always had a generous return policy, but adopted a new policy requiring that certain electronics be returned within 90 days of their purchase. The reason for the change was that returned electronics cut an estimated 8 per share off Costco s earnings per share. If a company expects significant returns, what are the implications for revenue recognition? Answer: If a company expects significant returns, it should make an adjusting entry at the end of the year reducing sales by the estimated amount of sales returns. This is necessary so as not to overstate the amount of revenue recognized in the period. C. Adjusting Entries. 1. A merchandiser using a perpetual system will require one additional adjusting entry to make the records agree with the actual inventory on hand. 2. At the end of each period, for control purposes, a merchandising company that uses a perpetual system will take a physical count of its goods on hand. A company s unadjusted balance in Inventory usually does not agree with the actual amount of inventory on hand. 3. The company may need to adjust the perpetual inventory records to make the recorded inventory amount agree with the inventory on hand. This involves debiting (or crediting) Inventory and crediting (or debiting) Cost of Goods Sold. D. Closing Entries. 1. The temporary accounts with credit balances are closed to Income Summary. 2. The temporary accounts with debit balances are closed to Income Summary. 3. Income Summary is closed to the Owner s Capital account. 4. The Owner s Drawings account is closed to the Owner s Capital account Copyright 2013 John Wiley & Sons, Inc. Weygandt, Accounting Principles, 11/e, Instructor s Manual (For Instructor Use Only)

11 E. Forms of Income Statements. Merchandising companies use one of two forms for the income statement: 1. Multiple-step income statement. a. Includes sales revenues, cost of goods sold, and operating expenses. b. Two nonoperating activities sections: Other revenues and gains and other expenses and losses. 2. The multiple-step income statement reports gross profit (net sales less cost of goods sold). a. A company s gross profit can be expressed as a percentage, called the gross profit rate. b. The gross profit rate is computed by dividing the gross profit amount by net sales. c. Analysts generally consider the gross profit rate to be more useful than the gross profit amount. 3. Single-step income statement. a. All data are classified into two categories: (1) Revenues include both operating revenues and other revenues and gains. (2) Expenses include cost of goods sold, operating expenses, and other expenses and losses. Copyright 2013 John Wiley & Sons, Inc. Weygandt, Accounting Principles, 11/e, Instructor s Manual (For Instructor Use Only) 5-11

12 *F. Using a Worksheet. 1. The steps in preparing a worksheet for a merchandising company are the same as they are for a service company. 2. The Inventory account is extended from the adjusted trial balance column to the balance sheet debit column. 3. Sales Revenue, Sales Returns and Allowances, and Sales Discounts are extended from the adjusted trial balance column to the income statement columns. Sales Revenue is placed in the credit column while Sales Returns and Allowances and Sales Discounts are entered in the debit column. 4. Cost of Goods Sold is extended from the adjusted trial balance column to the income statement debit column. TEACHING TIP Emphasize that all the unique accounts for a merchandising company appear in the income statement column except for the Inventory account. *G. Determining Cost of Goods Sold Under a Periodic System. 1. Determining cost of goods sold is different under the periodic system than under the perpetual system. 2. Under a periodic system, the company uses separate accounts to record freight costs, returns, and discounts. 3. At the end of the period, a company calculates the balance in ending inventory, and cost of goods sold for the period Copyright 2013 John Wiley & Sons, Inc. Weygandt, Accounting Principles, 11/e, Instructor s Manual (For Instructor Use Only)

13 4. The steps in determining cost of goods sold are: a. Record the purchases of merchandise. b. Determine the cost of goods purchased: Purchases less purchase returns and allowances and purchase discounts plus freight-in. c. Determine the cost of goods on hand at the beginning and end of the accounting period. *H. Periodic Inventory System. 1. Companies record revenues from the sale of merchandise when sales are made, just as in a perpetual system. But companies do not attempt on the date of sale to record the cost of the merchandise sold. 2. Companies record purchases of merchandise in the Purchases account rather than the Inventory account. 3. Freight costs are recorded in a Freight-In account which is a temporary account whose normal balance is a debit. 4. When a purchaser returns merchandise for credit or receives a discount for prompt payment, it is called purchase returns and allowances or purchase discounts. Purchase Returns and Allowances and Purchase Discounts are contra accounts to Purchases and have normal credit balances. Copyright 2013 John Wiley & Sons, Inc. Weygandt, Accounting Principles, 11/e, Instructor s Manual (For Instructor Use Only) 5-13

14 A Look at IFRS The basic accounting entries for merchandising are the same under both GAAP and IFRS. The income statement is a required statement under both sets of standards. The basic format is similar although some differences do exist. KEY POINTS Under both GAAP and IFRS, a company can choose to use either a perpetual or a periodic system. Inventories are defined by IFRS as held-for-sale in the ordinary course of business, in the process of production for such sale, or in the form of materials or supplies to be consumed in the production process or in the providing of services. Under GAAP, companies generally classify income statement items by function. Classification by function leads to descriptions like administration, distribution, and manufacturing. Under IFRS, companies must classify expenses by either nature or function. Classification by nature leads to descriptions such as the following: salaries, depreciation expense, and utilities expense. If a company uses the functional-expense method on the income statement, disclosure by nature is required in the notes to the financial statements. Presentation of the income statement under GAAP follows either a singlestep or multiple-step format. IFRS does not mention a single-step or multiple-step approach. Under IFRS, revaluation of land, buildings, and intangible assets is permitted. The initial gains and losses resulting from this revaluation are reported as adjustments to equity, often referred to as other comprehensive income. The effect of this difference is that the use of IFRS results in more transactions affecting equity (other comprehensive income) but not net income. IAS 1, Presentation of Financial Statements, provides general guidelines for the reporting of income statement information. Subsequently, a number of international standards have been issued that provide additional guidance to issues related to income statement presentation Copyright 2013 John Wiley & Sons, Inc. Weygandt, Accounting Principles, 11/e, Instructor s Manual (For Instructor Use Only)

15 Similar to GAAP, comprehensive income under IFRS includes unrealized gains and losses (such as those on so-called non-trading securities ) that are not included in the calculation of net income. IFRS requires that two years of income statement information be presented, whereas GAAP requires three years. LOOKING TO THE FUTURE The IASB and FASB are working on a project that would rework the structure of financial statements. Specifically, this project will address the issue of how to classify various items in the income statement. A main goal of this new approach is to provide information that better represents how businesses are run. In addition, this approach draws attention away from just one number net income. It will adopt major groupings similar to those currently used by the statement of cash flows (operating, investing, and financing), so that numbers can be more readily traced across statements. For example, the amount of income that is generated by operations would be traceable to the assets and liabilities used to generate the income. Finally, this approach would also provide detail, beyond that currently seen in most statements (either GAAP or IFRS), by requiring that line items be presented both by function and by nature. The new financial statement format was heavily influenced by suggestions from financial statement analysts. Copyright 2013 John Wiley & Sons, Inc. Weygandt, Accounting Principles, 11/e, Instructor s Manual (For Instructor Use Only) 5-15

16 20 MINUTE QUIZ Circle the correct answer. / 1. Measuring net income for a merchandising company is conceptually the same as for a service company. 2. The cost of goods sold is determined only at the end of the accounting period under a perpetual inventory system. 3. Under the perpetual inventory system, the purchase of merchandise is recorded with a debit to the Purchases account. 4. Sales Discounts is a contra revenue account and has a debit balance. 5. A customer may receive a sales discount for goods that are damaged or defective. 6. In a single-step income statement, gross profit and operating income are shown on the income statement. 7. In the balance sheet, inventory is reported as a current asset immediately below accounts receivable. 8. Income from operations is determined by subtracting other expenses and losses from gross profit. 9. Merchandising companies report nonoperating activities in the income statement immediately after the company s primary operating activities. *10. In preparing a worksheet for a merchandising firm, all income statement column debits represent expenses Copyright 2013 John Wiley & Sons, Inc. Weygandt, Accounting Principles, 11/e, Instructor s Manual (For Instructor Use Only)

17 Multiple Choice 1. Sales Discounts a. is a contra revenue account. b. has a normal debit balance. c. appears on the income statement. d. all of the above. 2. When a company uses the perpetual method of accounting for inventories the a. Inventory account does not change until the end of the year. b. Inventory account is debited when inventory is purchased and Cost of Goods Sold is debited when inventory is sold. c. sale of inventory requires a credit to Cost of Goods Sold. d. acquisition of merchandise requires a debit to Purchases. 3. The recording of a sale requires a a. credit to a sales account and a debit to an asset account. b. debit to Cash and a credit to Owner s Capital. c. debit to a sales account and credit to an asset account. d. credit to Sales Revenue and a debit to Sales Discounts. 4. Which of the following would not be considered an operating expense? a. Cost of goods sold b. Rent expense c. Freight-out d. Office expense 5. Which of the following is reported on both a multiple-step and a single-step income statement? a. Gross profit b. Income from operations c. Other revenues and gains d. Net sales Copyright 2013 John Wiley & Sons, Inc. Weygandt, Accounting Principles, 11/e, Instructor s Manual (For Instructor Use Only) 5-17

18 ANSWERS TO QUIZ / *10. Multiple Choice 1. d. 2. b. 3. a. 4. a. 5. d Copyright 2013 John Wiley & Sons, Inc. Weygandt, Accounting Principles, 11/e, Instructor s Manual (For Instructor Use Only)