Chapter 5 Merchandising Operations

Chapter 5 Merchandising Operations Financial Statements of a Service Company and a Merchandiser: - Service Companies: Revenues earned through performance of services. Examples: Dentists, Accounting Firms, Attorneys. - Merchandising Companies: Revenues earned through sales of merchandise. Examples: Restaurants, Dept. Stores. Income Statement: Service Company Century 21 Real Estate Income Statement Year Ended December June 30, 2008 Merchandising Company General Motors Corporation Income Statement Year Ended December 31, 2008 Service revenue $ x,xxx Sales revenue $ x,xxx Expenses: Cost of goods sold x Salary expense x Gross profit x,xxx Depreciation expense x Operating expenses: x Rent expense x Salary expense x Net income $ x,xxx Depreciation expense x Rent expense x Net income $ x,xxx Balance Sheet: Service Company Century 21 Real Estate The balance sheet Year Ended December June 30, 2008 Merchandising Company General Motors Corporation The balance sheet Year Ended December 31, 2008 Current assets: $ x Current assets: $ x Cash x Cash x Short-term investments x Short-term investments x Accounts receivable, net x Accounts receivable, net x Prepaid expenses x Inventory x Prepaid expenses x What Are the Merchandising Operations? Merchandising consists of buying and selling products rather than the services. Merchandisers have some new balance sheet and income statement items. Balance Sheet Income Statement Inventory, an asset. Sales revenue (often abbreviated as Sales). Cost of good sold, an expense Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 1

Account for the purchase of inventory The operating Cycle of a Merchandising Business 1- Begins when the company purchases inventory. 2- Then sells the inventory. 3- And, last, collect cash from customers. Inventory Accounting Systems: 1. Periodic system: - Does not keep a running record of all goods bought and sold. - Inventory counted at least once a year - Used for inexpensive goods 2. Perpetual system: - Keeps a running record of all goods bought and sold. - Used for all types of goods. Perpetual Inventory System The accounting inventory system in which the business keeps a running record of all inventory as it is bought and sold. The inventory account is continuously updated to reflect items on hand. Record of quantity of goods is constantly updated. Better control of inventory. Popular now due to bar codes and computer scanning. Periodic Inventory System A system in which the business does not keep a running or continuous record of inventory on hand. At the end of the period, it makes a physical count of on-hand inventory and uses this information to prepare the financial statements. Goods counted periodically to determine quantity. Used by small businesses. Less popular now because of computerized inventory systems. Accounting for Inventory - Inventory (balance sheet) = Number of units of inventory on hand Cost per unit of inventory. - Inventory (income statement) = Number of units of inventory sold Cost per unit of inventory. Purchase of Inventory: Purchase Discounts: - Discount for early payment. - A deduction from the invoice price granted to encourage early payment of the amount due. - Expressed as follows 1/10, n/30 (Credit terms 1/10, n/30 means 1% discount if paid within 10 days. If the discount period is missed, the full amount is due within 30 days. This decreases the cost of the inventory). Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 2

Purchase Returns and Allowances: - Purchase Return: Merchandise returned by the purchaser to the supplier. - Purchase Allowance: A reduction in the cost of defective merchandise received by a purchaser from a supplier. Transportation Costs: Someone must pay the transportation cost of shipping inventory from seller to buyer. The purchase agreement specifies FOB (free on board) to indicate who pays the freight. - FOB shipping point: means Title passes at origin and buyer pays the freight. - FOB destination: means Title passes at destination and Seller pays the freight. Freight costs are either freight in or freight out: - Freight in: is the transportation cost on purchased goods. Amount paid to have merchandise shipped from the supplier. Additional cost of the merchandise inventory. Transportation cost on purchased goods. Inward freight costs of acquiring merchandise. Transportation-In is part of cost of goods sold. Debit inventory. - Freight out: is the transportation cost on goods sold. Transportation Out/Delivery Expense. Outgoing freight costs that must be paid by the seller. Transportation cost on goods sold. Debit an expense (delivery expense). Delivery Expense is a selling expense on the income statement! Transportation Costs: FOB Shipping Point Buyer takes ownership of inventory when goods leave seller s place of business. Purchaser normally pays freight charges Freight-in. Increases cost of inventory. FOB Destination Buyer takes ownership of inventory when goods arrive. Seller normally pays freight Freight-out. Selling expense. Computing the Cost of Inventory: Net cost of inventory = Purchases of inventory Purchase returns and Allowances Purchase Discounts + Freight in. Applying the Perpetual Inventory System: Inventory and cost of Goods Sold are continually updated during the accounting period, as purchases, sales, and other inventory transactions take place. Transactions Related to Purchases of Merchandise: Purchases of Merchandise on Credit: The cost of merchandise purchased is placed in the Merchandise Inventory account at the time of purchase. Transportation Costs on Purchases: Accumulated in a Freight In / Transportation In account. In some cases, the seller pays the freight charges and bills them to the buyer as a separate item on the invoice. Purchases Returns: A return of the goods from the buyer or seller for cash or credit. Purchases Allowances: A reduction made in the selling price of the merchandise, granted by the seller so that the buyer will keep the goods. Payments on Account. Payments by cash (or checks) to suppliers. Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 3

Account for the sale of inventory: Sale of Inventory: Sales Revenue: - Amount earned from selling inventory. - Revenue account Cost of Goods Sold: - Cost of inventory that has been sold to customers. - Expense account. Sales Returns & Allowances : - When customer returns goods or the seller grants a reduction in price to customer - Contra-revenue account (debit balance). Sales Discounts: - If customer pays within the discount period allowed by the seller: - Contra-revenue account (debit balance). Delivery Expense (Freight Out). - Net Sales Revenue = Sales Revenue Sales returns and Allowances Purchase Discounts. - Net Sales - Cost of Goods Sold = Gross profit. Remember, there are always two entries to record a sale when using the perpetual inventory system. One to record the selling price to the customer and the second to remove the inventory from your books at the amount your company paid to acquire it. Transactions Related to Sales of Merchandise: At the time of sale, the cost of merchandise is transferred from the Merchandise Inventory account to the Cost of Goods Sold account. In the case of a return, the cost of the merchandise is transferred from Cost of Goods Sold back to Merchandise Inventory. Sales of Merchandise on Credit: Two entries are necessary. Record the sale as a debit to Accounts Receivable. Update the Cost of Goods sold by transferring from Merchandise Inventory. Cash sales of Merchandise: Debit Cash for the amount of the sale. Payment of Delivery Costs: Accumulated in the Freight Out Expense account. Shown as a selling expense on the income statement. Returns of Merchandise Sold: Accumulated in the Sales Return and Allowances account, a contra-revenue account, with a normal debit balance, deducted from Sales in the income statement. The cost of merchandise must also be transferred from the COGS account back into the Merchandise Inventory account. Receipts on Account. Receipts of cash (or checks) from credit customers recorded as credits to Accounts Receivable. Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 4

Example (p. 269): Suppose liberty Sales Co. engaged in the following transactions during June of current year: June 3 Purchased inventory on credit terms of 1/10 net eom (end of month), $1,600. 9 Returned 40% of the inventory purchased on June 3. It was defective. 12 Sold goods for cash, $920 (cost, $550). 15 Purchased goods for $5,000. Credit terms were 3/15, net 30. 16 Paid a $260 freight bill on goods purchased. 18 Sold inventory for $2,000 on credit terms of 2/10, n/30 (cost, $1,180). 22 Received returned goods from the customer of the June 18 sale, $800 (cost, $480). 24 Borrowed money from the bank to take advantage of the discount offered on the June 15 purchase. Signed a note payable to the bank for the amount, $4,850. 24 Paid supplier for goods purchased on June 15, less the discount. 28 Received cash in full settlement of the account from the customer who purchased inventory on June 18, less the return on June 22, and less the discount. 29 Paid the amount owed on account from the purchase of June 3, less the June 9 return. Requirements: 1- Journalize the preceding transactions for Liberty. 2- Set up T-accounts and post the journal entries to show the ending balances in the Inventory and the Cost of Good Sold accounts. 3- Assume that the note payable signed on June 24 requires the payment of $90 interest expense. Was borrowing funds to take the cash discount a wise or unwise decision? Solution: Requirement 1: Journalizing: June 3 Inventory 1,600 Accounts Payable 1,600 Purchased inventory on account. 9 Accounts Payable ($1,600 0.40) 640 Inventory 640 Returned inventory. 12 Cash 920 Sales Revenue 920 Cash sale. 12 Cost of Good Sold 550 Inventory 550 Recorded the cost of good sold 15 Inventory 5,000 Accounts Payable 5,000 Purchased inventory on account. 16 Inventory 260 Cash 260 Paid a freight bill. 18 Accounts Receivable 2,000 Sales Revenue 2,000 Sales on account. 18 Cost of Good Sold 1,180 Inventory 1,180 Recorded the cost of goods sold. Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 5

22 Sales Returns and Allowances 800 Accounts Receivable 800 Received returned goods. 22 Inventory 480 Cost of Good Sold 480 Placed goods back in inventory. 24 Cash 4,850 Note Payable 4,850 Borrowed money from the bank. 24 Accounts Payable 5,000 Inventory ($5,000 0.03) 150 Cash ($5,000 0.97) or ($5,000 - $150) 4,850 Paid within discount period. 28 Cash [($2,000 - $800) 0.98] 1176 Sales Discounts [($2,000 - $800) 0.02] or ($2,000 - $1,176) 24 Accounts Receivable 1,200 Cash collection within the discount period. 29 Accounts Payable ($1,600 - $640) 960 Cash 960 Paid after discount period. Requirement 2: Preparing T- accounts: Inventory Cost of Good Sold June 3 1,600 June 9 640 June 12 550 June 22 480 15 5,000 12 550 18 1,180 16 260 18 1,180 Bal. 1,250 22 480 24 150 Bal. 4,820 Requirement 3: Liberty s decision to borrow funds was wise because the discount received ($150) exceeded the interest paid ($90). Thus liberty was $60 better off. Adjusting and Closing the Accounts of a Merchandiser: Adjusting Inventory: If physical count of inventory is different from amount on the books Inventory Shrinkage Debit Cost of Goods Sold Credit Inventory Closing Entries: 1. Close all income statement accounts with credit balances to Income Summary 2. Close all income statement accounts with debit balances to Income Summary 3. Close Income Summary to Capital 4. Close Withdrawals to Capital Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 6

Preparing a Merchandiser s Financial Statements: Inventory vs. Cost of Goods Sold: Inventory Beginning Inventory Sold Inventory Sold Purchases Ending Cost of Goods Sold As Inventory is Sold we remove it s cost from the Asset side of A=L+E and Insert it s cost into an Expense on the Equity side of A = L + E. This property exists for all Assets: As they are used up or sold the cost transfers from the balance sheet as a future economic resource (asset) to the income statement as an expense incurred to generate revenue. Relationship between Balance Sheet and Income Statement: Income Statement Items: - Sales revenue is based on sale price of inventory sold. - Cost of goods sold is based on cost of inventory sold. - Gross profit (gross margin) is sales revenue less cost of goods sold. Balance Sheet Item: - Inventory on the balance sheet is based on cost. Income Statement Formats: There are two basic formats for the income statement: 1. Single-Step: Total revenues minus total expenses; simple, easy to read. XYZ, Inc. Income Statement For the Year Ended Dec. 31, 2008 Revenues: Sales revenue Less: Sales discounts Sales returns and allowances Net sales revenue Interest revenue Total Revenue Expenses: Cost of Good Sold Wage expense Rent expense Insurance expense Depreciation Expense Supplies expense Total Expenses Net income Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 7

2. Multiple-Step: - Contains key subtotals; highlights components and distinguishes activities. More useful than single-step income statement. - Gives 3 useful line items: Gross Profit. Operating Expenses. Total from Non-Operating Activities. XYZ, Inc. Income Statement For the Year Ended Dec. 31, 2008 Sales revenue: Less: Sales discounts Sales returns and allowances Net sales revenue Cost of Good Sold Gross Profit Operating Expenses: Wage expense Rent expense Insurance expense Depreciation Expense Supplies expense Operating income Other revenues and expenses: Interest revenue Interest expense Net income Non-Operating Activities: - Any revenue &/or expense not relating to the company s main business operations. - Include: Gains/Losses from Sale of Investments, Sale of Equipment, etc. Interest Income. Interest Expense. Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 8

Using gross profit percentage and inventory turnover to evaluate a business: The Gross Profit Percentage (or the gross margin percentage): - Percentage of dollar sales available to cover expenses and provide a profit. - Carefully watched measure. - Small increase may indicate rise in income. - Small decrease may indicate trouble. Example: Net sales $65 Cost of sales (33) Gross profit $32 Gross profit percentage = Gross profit percentage = Gross Profit Net Sales revenue $32 $65 = 49% The Rate of Inventory Turnover: - Measures how rapidly inventory is sold. - The higher the turnover, the more quickly inventory is sold. - Ending inventory from the preceding period. Inventory turnover = Cost of Good Sold Cost of Good Sold = Average inventory (Beginning inventory* + Ending inventory) / 2 =. Times per year Example: Rate of Inventory Turnover for Three Merchandisers: Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 9

Cost of Goods Sold in a Periodic Inventory System: Inventory and Cost of Goods Sold: - Inventory: Products purchased or manufactured for Sale to Customers. - Beginning Inventory: Quantities of Merchandise on hand. - Purchases: New Purchases or Manufactured products. - Ending Inventory: Remaining Unsold Merchandise. - Cost of Goods Sold: Cost of Inventory Sold during accounting Period. - Most that a company can sell during an accounting period. Available for Sale = Beginning Inventory + Purchases. Goods Available for Sale = Beginning Inventory + Purchases. Cost of Goods Sold = Goods Available for Sale - Ending Inventory. Cost of Goods Sold: Beginning Inventory $38,600 + Purchases $91,400 Less: Purchase discounts (3,000) Purchase returns and allowances (1,200) Net purchases 87,200 Freight in 5,200 Cost of Goods Available for Sale 131000 Less: Ending Inventory (40,200) Cost of Goods Sold $90,800 Notes: - No detailed records. - Cost of goods sold determined at end of the period by taking a physical count and pricing it. - Inventory account does not change during the year. - Purchases, purchase discounts, purchase returns and allowances are recorded in their respective accounts. - No entry is made to record the cost of merchandise sold. - Inventory is counted at year-end and records are adjusted at that time. Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 10