Week 3, Retail Operations 1/7

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1 Week 3 Horngren, Chapter 5, Retailing Operations So far we have looked at businesses that supply services. Now we will deal with the purchase and sale of goods for both wholesale and retail operations. The learning objectives are to: Account for the purchase and sale of inventory, including the impact of GST, Using sales and gross profit to evaluate a business, Adjusting and closing the accounts of a retailing business, Preparing a retailer s financial statements, Using the gross profit percentage and inventory turnover to evaluate a business, And in the appendices, seeing how retail businesses accounted for inventory, before the introduction of computer based running balance perpetual inventory systems, under the periodic inventory system. Inventory will include all those goods that a business has bought, or made, with the intention of selling in the ordinary course of business. It does not include those items which are purchased for consumption within the business, eg office supplies or cleaning supplies, as these items are described as supplies. Have a look at Exhibit 5-1 on page 204. This contrasts a Service Firm s Financials with those of a Retailing Firm. Note the new terms that are used, Sales Revenue, Cost of Goods Sold, Gross Profit, Operating Expenses, and the place where Inventory is recorded in Current Assets. Have a look at Exhibit 5-2 on page 205. This contrasts the operating cycle of a retail business that is a cash based operation with one that sells its goods on credit. The operating cycle is extended by the time that it takes to collect the monies due from the accounts receivable. Goods and Services Tax (GST) If a business has a turnover in excess of $75,000 then it should be registered for GST, unless it is exempt. The law requires that businesses with a turnover in excess of $75,000 must collect GST on sales that they have made and pay the GST over to the ATO. These businesses are usually allowed to claim from the ATO the GST that they have paid on their purchases and expenses. When a business makes a GST return to the ATO on a Business Activity Statement, (BAS Return) the amount on sales, the GST liability, is set against the amount on purchases and expenses, the GST receivable, and the net amount is paid over to the ATO, as it is usual for retail businesses to have more sales than purchases. The current rate of GST is 10%. As the business is only acting as a collecting agency for Government, it means that the GST component of their sales and purchases are not part of the Sales Revenue, Cost of Goods Sold and Expenses that appear in the Income Statement, but are merely current liabilities or current assets in the Balance Sheet. 1/7

2 Goods that are priced in a shop at $110 would have a sale revenue component of $100 and a GST component of $10. So, if you are looking at the sale price, inclusive of GST, of $110, just divide by 11 and that will give you the GST of $10. You might ask why 11 as GST is 10%. Well the Sales Revenue is $100 and GST of 10% is calculated on the 100 and added to it to give you the price that has to be paid, inclusive of tax = 110 and 10 as a proportion of the price paid is 10/110 or 1/11. Not all goods are subject to GST so the 1/11 trick only works when all goods sold are taxable. If you go to a supermarket there will be a mixture of taxable goods, where things are done to them to put them into a saleable condition, eg cakes, and fresh vegetables, which are free of tax, as nothing has been done to them, other than harvest them. When you look at your till receipt you will notice that because you have bought a mixed supply of goods the exact amount of GST contained in the total will be printed at the bottom, because it isn t a simple 1/11 th calculation. As a business when accounting for GST a GST payable account and a GST receivable account are created, or you can combine the two in a GST clearing account. Any balances left over at the end of the financial period will appear on the Balance Sheet. For businesses that are not registered for GST there will be no GST component in the Sales Price that they charge their customers. Heavy fines and possible imprisonment is possible if they collect GST and are not registered. When a non-registered business makes a purchase or incurs an expense then that business will pay the supplier, who is GST registered, the full GST inclusive price, but will not be able to reclaim the GST from the ATO, like a registered business. So in this case the GST component will be regarded as part of the Cost of Goods Sold and Expenses and will appear in the Income statement. Inventory Systems There are two methods of accounting for inventory, the perpetual inventory system and the periodic inventory system. Which method you use will depend upon the size of the business, the information needs, the nature of the business and the cost/benefit trade off. The periodic system is used by small businesses with a relatively inexpensive inventory and no computer scanning and stock bar code systems. The amount and value of the inventory on hand within the business is only calculated when a physical count is made of the inventory and the purchase invoices are examined to identify the relevant prices. This might happen at the end of the financial year to enable a calculation of the cost of goods sold to take place and to put a value on the inventory in current assets. The perpetual system keeps a running balance of inventory and of the cost of goods that are sold. It has up-to-date information and enables a business to prepare a set of financials at any time that they might wish to. It is a good idea to have a physical stock count at least once a year to check on the accuracy of the inventory records. Does what the computer tells us is in stock actually exist? This system uses scanners and bar code systems. With an integrate system it can also be linked to purchasing, ordering, cash, GST systems. For each class of stock there should be maintained a separate record. In the past this used to be recorded on an inventory record card or stock card. Eg a record for 3cm brass screws, another for 3.5cm brass screws etc. A separate record for each different inventory line is kept. This is usually maintained on a computer record, where after every transaction the 2/7

3 cost of goods sold and the inventory record is updated to reflect the change, with the balance showing how many item of that stock line are in stock and what the cost is of them. Have a look at Exhibit 5-3, with the invoice from HVC to Albury Hi-Fi, and examine the explanations for the different parts of the invoice. Accounting for the purchase of inventory and GST under the perpetual inventory system. When inventory is purchased, that is when the ownership of the inventory is transferred from the seller to the buyer, the purchase is recorded in the books of account. The time of the cash payment to the suppliers for goods supplied on credit is irrelevant. The entry is recorded by Debiting the Inventory Account with the purchase price (exclusive of GST), Debiting the GST Clearing Account with the GST component, and by Crediting Accounts Payable with the total amount due to the supplier. Don t forget that it will be the supplier s job to collect the GST from the purchaser, and to account for it to the ATO. In the purchaser s books the GST will be an asset which will be either refunded from the ATO or set against GST collected on the purchaser s own sales. Follow the Sporting Store example in the PowerPoints. Discounts can be given by the supplier to the purchaser for two reasons. Firstly to acknowledge that the purchaser is bulk buying where volume/quantity discounts can be given by reducing the price of items as greater numbers of items are purchased. The price on the invoice will already reflect this discount and no adjustment has to be made in the purchaser s books. See the Quantity discount example on page 208 & 209. Secondly, the supplier needs to encourage the purchasers to pay their bills promptly to improve the supplier s cash flow and to reduce the time spent waiting for their accounts receivable to settle their debts. One of the ways of doing this is to offer a settlement Discount. This will state that if the purchaser pays off the debt within a certain time, eg 15 days that an amount can be deducted from the bill, eg 3%. As the invoice has already been received and the entries have been made in the Inventory, GST Clearing and the Accounts Payable Accounts, if the purchaser is only required to pay a smaller sum when settling this debt, then an adjustment will need to be made to: 1, Reduce the cost of the inventory, 2, to reduce the amount that is reclaimable in the GST Clearing Account, and 3, to show that the full amount of the Account Payable has been settled, partly by cash and partly by the discount which reduces the cost of the Inventory. Follow the Albury Hi-Fi example on page 209 Purchase returns and allowances. If a purchaser has been sent incorrect goods that they didn t order, or if the goods are defective or damaged in any way, then the purchaser may wish to return the goods to the supplier, or to have the purchase price of the goods reduced by being given an allowance from the supplier. The accounting entries are very simple. They reverse the original purchase. Dr accounts Payable, Credit Inventory, and Credit GST Clearing Account. Continue the Albury Hi-Fi example on page /7

4 Transport costs These will normally be borne by the purchaser as part of the cost of getting the inventory to its present location and in a condition in which it can be used for its intended purpose. FOB (Free On Board) Delivery Point means that the title transfers when the goods are delivered and the buyer pays for the freight.in any event it is Debit Inventory, Debit GST Clearing and Credit either Cash at Bank, or Accounts Payable. Settlement discounts do not apply to freight charges. Freight charges paid when delivering goods to customers are part of the operating costs of the business and will appear as delivery expenses. Continue the Albury Hi-Fi example on page 210 & 211 Sale of Inventory So a business has purchased inventory and now sells it. There are two sets of entries that need to be made. 1 to record the sale, and 2 to transfer the cost of that sale from inventory to cost of goods sold so that there is a proper match of costs to sales revenues. To record the sale Dr Cash/Accounts Receivable, and Cr Sales Revenue, Cr GST Clearing with the revenue, To record the cost of the sales, Dr Cost of Goods Sold, Cr Inventory with the cost. When goods are returned then the return is entered in a Sales Returns and Allowances Account, though when we prepare a set of financials there will be a netting off of the balance on the returns account and the sales revenue account. So Dr Sales Returns and Allowances, Dr GST Clearing Account, as we won t now have to pay that to the ATO, and Cr Accounts Receivable. Because the goods have been returned we will also need to transfer out of Cost of Goods Sold the cost of the goods that have been returned and put them back in inventory. Dr Inventory, Cr Cost of Good Sold. Where the goods are not returned but an allowance is given for damage and delay the entry will be Dr Sales Returns and Allowances, Dr GST Clearing Account, and Cr Accounts Receivable. There will be no transfer from Cost of Goods Sold to Inventory. Continue the Albury Hi-Fi example on page 211, 212 and 213. Sales Discounts When we grant purchasers settlement discounts for paying promptly we will need to account for the discount, the reduction in the GST liability, to show the amount of cash received and to settle the debt in Accounts Receivable. This is done by Dr Cash at Bank, with the amount received, Dr Sales Discounts with the amount of the discount, Dr GST Clearing Account with the GST on the Discount, and Credit Accounts Receivable with the full amount of the debt that is being settled. Continue the Albury Hi-Fi example on page 212 & 213 Have a look at the summary problem on pages 215 & 216. Adjusting and closing the accounts of a retailer Just like any other type of business a retailer will need to adjust and close accounts at the end of the financial year and worksheets are the perfect tool for this. With perpetual inventory systems it is important to have a physical stock count at the end of the year to check the validity of the electronic accounting system. Do we actually have the amount and value of items that the books say that we have? 4/7

5 When adjusting the book value to the amount of the stock count there is a choice of entries depending upon the reasons for the differences. If the reason for the difference is a recording error then if the book entry is overstated the entry would be to Dr Cost of Goods Sold and Cr Inventory with the difference or if it is understated Dr Inventory, Dr GST Clearing Account and Cr Cash or Accounts Payable. It is important here to identify the invoice that hasn t been recorded as GST can only be reclaimed if you have a supporting tax invoice from the supplier. If the reason for the stock loss is shrinkage due to theft or damage then the reduction in inventory is adjusted by Dr Inventory Losses (which are an expense) and Cr Inventory. By showing the adjustment this way it highlights the reason for the loss and doesn t enable management to hide it as part of an adjustment to Cost of Goods Sold. Have a look at the adjustments on pages 216, 217& 218 including exhibits 5-5 & 5-6 and don t forget that adjustments and closing entries have to be journalised and posted for the effect to be shown n the accounts in the general ledger. Financial Statements Businesses have a choice of income statement formats, descriptive, where the nature of the expenses are highlighted, and the functional format, where it is the function of the expenses that are shown. Retailers and manufacturers tend to opt for the functional format, examples of which are given on pages 220, 221 & 222. Make certain that you are familiar with both types of format, and also the statement of changes in equity and the balance sheet, and that you can reproduce them from memory. Two Key Ratios for Decision Making Evaluation of business performance is frequently measured by the change that takes place in the Gross Profit Percentage/Margin. The sales figure that is used is the Net Sales, which is Sales Revenues less Sales Discounts and Sales Returns and Allowances. The Gross Profit is the difference between the Net Sales and the Cost of Goods Sold (cost of sales). The ratio is calculated by dividing the Gross Profit by the Net Sales and then by multiplying by 100. Comparing this ratio with last year/s, with the industry average figure, the industry leader s result will provide management with an indication of the businesses profitability and competitiveness. On its own it doesn t mean very much, other than to say that for every dollar of sales that is made so many cents will be the gross profit, but to compare it with the industry average we can see whether we are out performing many of our competitors, with the industry leader it gives us something to aim for in terms of improving our performance, and by comparing it with the past few years results we can work out a trend to see whether we are improving or going backwards. The type of industry can have a dramatic impact on the gross profit Percentage. If you are in an industry where profit margins are small then you will need to sell a lot of them to make a reasonable profit. You will have to have a high inventory turnover to survive. If you are selling baked beans you don t make a lot of profit in each can but you sell a lot of cans. If on the other hand you sell very expensive jewellery the gross profit margin will be very big, but you won t be selling them at the same rate as a can of beans! You can afford to have a slower inventory turnover because each time that you make a sale you will be earning a larger profit per item sold. 5/7

6 So inventory turnover can vary with industries, but what is it and how is it measured and what does it tell us? Inventory turnover is calculated by dividing the average inventory into the cost of goods sold. The average inventory is the average of the opening and the closing inventory. We divide the year s cost of sales by the average inventory. That tells us how many times in he year we have replaced the inventory. Why is this important? We need to sell our goods to earn profits and also to have cash coming into the business so that we can pay the expenses such as wages etc. As mentioned earlier the rate of turnover will differ from industry to industry. Some industries will have a higher turnover than others. We need to judge our efficiency by comparing our rate with the industry average, the industry leader and with our performance over the previous few years. It is better to take this turnover rate and to turn it into days. Albury Hi-Fi held turned over inventory 2.3 times a year, see page 222. If we divide that into 365 it tells us that on average the inventory was held for 159 days. How does that compare? What is the change from last year? Why has the change taken place? Does our sales staff have the right incentives? When using ratios you can end up with more questions than answers, but it is good to go looking for answers. See page 214 and pages 222 & 223 On page 224 and then in the Appendices from pages 244 to 245 you will be introduced to the periodic inventory system. Here we do not have a running balance. We only find out what value the inventory has placed on it by physically counting the inventory and looking up the costs on the suppliers invoices. How else does this differ from the perpetual system? Firstly when inventory is purchased and account called Purchases is debited and not inventory. GST Clearing will be debited and the credit will be cash or accounts payable. If the purchase is on credit and a settlement discount is due because the cash is paid within he due time Accounts Payable will be debited, Cash at Bank will be Credited with the amount paid, and Purchase Discounts Account will be credited with the discount and GST Clearing will be credited with the GST we can no longer claim back. Purchase returns and allowances will involve the debit to accounts payable to reduce the debt, a credit to Purchase Returns and Allowances and a credit to the GST Clearing Account. At the en of the accounting period the Net Purchases is calculated by taking the balance on the Purchases Account and deducting from it the balances on the Purchases Discount Account and the Purchases Returns and Allowances Account. Of course GST doesn t appear as it is purely a Balance Sheet item. When Sales are made the Accounts Receivable will be debited, Sales Revenue will be credited as will the GST Clearing Account. There are no other entries in the periodic system, unlike the perpetual system which has a transfer from inventory to cost of goods sold. In the periodic system this does not happen. Calculating the cost of good sold. The Cost of Sales is only calculated in the periodic system at the end of the accounting period when the inventory is physically counted. The inventory that is available for the Cost of Sale is made up of the Opening Inventory plus any Purchases that have taken place during the period, together with the costs of Inward Freight, less any Purchase Returns and Allowances. If you then deduct from that the value of the Closing Inventory you are then left with the value of the Cost of Sales. 6/7

7 Have a look at pages 245 & 246 Like any other business at the end of the year there are adjusting and closing entries to be made. Because the periodic system does not have a running balance of inventory the only value that appears in the books for inventory is the result of an inventory count that takes place at the end of each accounting period. The closing inventory of one period becomes the opening inventory of the next period. This figure then stays in the inventory account throughout the accounting period until the next count, when it is removed by including it in the calculation of the Cost of Goods Sold, and the closing inventory is then introduced into the books in the same calculation of the COGS. Go through the summary problem on pages 226 to 229. Please attempt the tutorial exercises as stated in the Unit Outline, Ch5 S5-2, 5-3, 5-4, 5-5, E5-4, 5-8, 5-9, P5A-1 page /7