Topic 5

Retailing operations

Contents
Introduction ................................................................................................................... 3
Objectives ...................................................................................................................... 3
Objective 1: What are retailing operations? .................................................................. 4
The operating cycle of a retailing business ................................................................... 4
Goods and services tax (GST) ....................................................................................... 4
Objective 2: Accounting for the purchase of inventory using a perpetual system ........ 5
Objective 3: Accounting for the sale of inventory using perpetual system ................... 8
Objective 4: Adjusting and closing the accounts of a retailer ..................................... 10
Adjusting inventory based on a physical count ...................................................... 10
Objective 5: Preparing a retailers financial statements .............................................. 11
Objective 6: Three ratios for decision making ............................................................ 11
Objective 7: Accounting for inventory in a periodic inventory system ...................... 12
Purchase of inventory.............................................................................................. 12
Calculating cost of sales.......................................................................................... 12
Adjusting and closing the accounts in a periodic inventory system ....................... 13
Conclusion ................................................................................................................... 14
Review questions......................................................................................................... 14
References ................................................................................................................... 15

Introduction
In Topic 4 we reached the end of the accounting cycle, and the end of our very basic
accounting. Basic accounting terms (debits/credits, T-accounts, various accounts in
the financial accounting system) have been introduced and then expanded for you to
practice the accounting learnt. The remaining modules in this unit will look at further
topics in financial accounting.
So far we have only considered firms supplying services. In this topic we move on to
the specific issue of accounting for merchandise that a firm may hold. Merchandising
firms buy and resell goods at both the wholesale and retail levels. In this topic we will
look at the retailing business overall and in the next topic we will concentrate on the
more complex issues regarding retail inventory. Accounting for manufacturing firms
falls outside the scope of this unit and is covered in depth in Management
Accounting.

Objectives
On completion of this module you should be able to:
1. Describe retailing operations, perpetual and periodic inventory systems and
understand how to account for GST
2. Account for the purchase of inventory using a perpetual system
3. Account for the sale of inventory using a perpetual system
4. Adjust and close the accounts of a retailing business
5. Prepare a retailer's financial statements
6. Use gross profit percentage and inventory turnover and days in inventory to
evaluate a business
7. Account for the sale of inventory using a periodic system
Set reading

Source
Textbook

Horngren et al. 2013

Chapter 5, (including Appendix)

Objective 1: What are retailing operations?

Textbook

Horngren et al. 2013

pp. 227230

The operating cycle of a retailing business

Before we look at the actual accounting for inventory, lets consider what the
differences are between a service firm and a retailing firm. Exhibit 5.1 on page 224
shows the financial statements of both and you can clearly see an additional current
asset, "Inventory" in the retailing firm's balance sheet. Also, accounting for the
inventory sold (i.e. cost of goods sold/cost of sales) is included in the income
statement as an expense before all other operating expenses.
So what is inventory? As per AASB102, Inventories 1; inventories are assets:
(a) held for sale in the ordinary course of business;
(b) in the process of production for such sale; or
(c) in the form of materials or supplies to be consumed in the production process or
in the rendering of services.
We will cover the accounting issues regarding assets that meet the definition for (a)
above. The more complex inventories as per definitions (b) and (c) are, as mentioned
in the introduction, outside the scope of this course and are covered in Management
Accounting.

Goods and services tax (GST)

We will briefly look at the issue of GST and the impact on the financial statements.
In Australia a GST of 10% is levied on most goods and services at the point of sale. If
a firm is registered for GST, then the firm financial accounts are generally depicted as
excluding GST. Essentially the firm is acting as a 'collection agency' for the
Australian Taxation Office (ATO) and the impact on the accounts for GST is only
temporary. The balance sheet will reflect an amount (usually a liability) of GST that
has been collected (on behalf of the ATO) and paid, but the net balance has not yet
been remitted to the ATO.
Some small firms are not registered for GST, and they record purchases of inventory
and expenses as including the GST (the gross amount), as they pay the GST at the
time of purchase and they can not claim the GST back from the government. They
are paying their GST as part of their business expenses. The goods and services sold
by the firm do not include any GST. There would, therefore, be no GST accounts
shown in the general ledger.

View the standard at:

http://www.aasb.gov.au/admin/file/content105/c9/AASB102_07-04_COMPjun09_01-09.pdf

Please go through the text from pages 225-226 to ensure your full understanding of
the basic mechanics of GST.

Suggested Further Reading

An interesting overview of GST that highlights the importance of the correct
accounting for GST and some of the complexities of the system, including the
definitions of supplies can be found in a professional article entitled, "Accounting for
the GST" (Hilton, 2004) 2. The recap of how to deal with a purchase is as follows:
record the expense or purchase, net of GST
record the GST paid (either as a debit of the GST liability account or as a
separate debit account which is then netted against the GST liability account).
The accounts payable (creditor) will be paid the total purchase price - an amount
which includes the GST paid.

Inventory systems: Perpetual and periodic

A perpetual inventory system records inventory acquisitions and disposals in the
inventory account at the time the transactions occur. It provides a continuous
inventory record showing the physical quantity of trading stock and its equivalent
value, which is available as stock in hand. Inventory disposals and losses are
transferred to the cost of sales account from the inventory account. (Butterworths
Business and Law Dictionary, 2002).

A periodic inventory system records inventory acquisitions as purchases in an

expense account rather than in an inventory account. The cost of inventory on hand
is calculated and recorded in an inventory account after the periodic physical
inventory count or stock-take at the end of the period. The cost of goods available for
sale is computed by adding the inventory on hand at the beginning of the period to
purchases made during the period. The cost of sales is determined by deducting the
cost of the physical inventory at the end of the period from the cost of the goods
available for sale (Butterworths Business and Law Dictionary, 2002).

Objective 2: Accounting for the purchase of

inventory using a perpetual system
Textbook

Horngren et al. 2013

pp. 230236

The balance of this topic is based on the perpetual inventory system, however a
periodic inventory system is still a valid and useful method of accounting for
inventory and we will look at this briefly at the end of this topic. Which system we

The article is available on the unit website (CloudDeakin).

5

use depends on the nature of the business, the information needs of managers, the
costs and benefits of the two systems, and the capabilities of the recording system.

Purchase of inventory
At the heart of the perpetual inventory system is the inventory record card or stock
card. Nowadays it is probably a computer record, but the principle is the same. There
is a separate record for each different line of inventory. Because the inventory record
is updated after each transaction, the last line in the balance column will tell us how
many of the particular item are on hand, and the cost. As well as being recorded in
the relevant inventory subsidiary ledger, inventory transactions are recorded in the
Inventory account. The Inventory account is an asset account, so when we purchase
inventory (i.e. increase an asset balance) we debit the Inventory account.
A purchase is recorded when the ownership of the inventory passes from the seller to
the purchaser. When the cash for a credit purchase is paid is irrelevant as far as the
recording of the purchase is concerned.
The purchase of inventory, for a GST registered firm is shown below.
DR
Sep

10

Inventory [Asset account]

800

GST Clearing

80

Accounts Payable

CR

880

(Purchase of inventory)

Purchase returns and allowances

Now lets assume that 50% of the stock was returned (wrong size/colour), the journal
for recording that is as follows:
Sep

12

Accounts Payable

440

Inventory

400

GST Clearing

40

(Return of 50% of Goods Purchased)

Finally, the payment of Account to Creditor with no discount:

Sep

20

Accounts Payable
Cash at Bank

440
440

(Payment of account)

Purchase discounts
On the purchase of goods, two types of discounts can apply; quantity discount and
settlement discount. A quantity (or trade) discount may be negotiated at the time of
6

purchase, and often is not disclosed on the purchase invoice. The journal entry will be
based on the net price of the purchase (recorded in inventory) and GST (in the GST
clearing account) after the quantity (or trade) discount has been subtracted.
Discounts given to buyers of goods and services on credit for prompt payment, within
the discount period, may be offered a settlement discount, sometimes called cash
discount. For the seller this is a discount allowed, and for the buyer this is reflected
in a reduction in the balance recorded in inventory (as per AASB 102, Inventories)
and eventually in cost of sales (when the stock is finally sold to a customer).
Lets assume that the above payment was made within the discount period. A
discount of 5% is offered. The journal entry is as follows:

Sep

20 Accounts Payable
Cash at Bank (440 x 0.95)

440
418

GST Clearing (440 x 0.05 x 1/11)

Inventory (440 x 0.05 x 10/11)

20

(Payment of account with 5% discount

received)

Thus the net cost of the inventory on hand is $380. The amount of GST related to
this transaction is $38 (i.e. 10% of cost of the purchase being $380).

Transport costs
The general principle is that the total cost of an asset is the cost of getting the asset to
the point of its intended use. The intended use of inventory is to have it ready for sale
to the customers, so in addition to the actual cost of the inventory, we add any costs
incurred in getting to the point where the inventory is ready for sale.
When we are responsible for the cost of freight from the suppliers premises to our
premises, either the seller will pay the freight on our behalf, and it will appear as a
separate item on the invoice, or else we will pay the carrier directly. The freight is
part of the total cost of inventory, so we may find an account called Freight Inwards
(sometimes Transportationin), and in the income statement the cost of freight
inwards is added to cost of sales.
If the freight charge appears on the suppliers invoice, we either debit Inventory with
the invoice total, or we may debit Inventory with the actual cost of the goods and
debit Freight Inwards with the freight. If we pay the carrier directly, we always
debit Freight Inwards. However, the way which we treat the transport cost depends
on the accounting system requirements in each entity.
Freight Outwards or Delivery Expense if paid by the seller is not part of the cost of
inventory, so it is reported as an expense, under the sub-heading of Selling Expenses,
after the determination of gross profit. See pages 229 to 231 of your textbook for
further details of accounting for freight.

Objective 3: Accounting for the sale of

inventory using perpetual system
In our work so far, when we performed a service, we earned the revenue, and we
debited either Cash at Bank or Accounts Receivable and credited Service Revenue.
This time we are selling inventory. The debit will be the same, but we credit Sales. A
sale is recorded when ownership of the inventory passes from the seller to the
purchaser. When the sale is complete we have earned the revenue. When the cash for
a credit sale is received is irrelevant as far as the recording of the sale is concerned.
In Topic 3 when we were considering adjusting entries, we looked at the concept of
transferring prepaid expenses which had expired, from an asset account (for example,
Prepaid Insurance) to an expense account (for example, Insurance Expense). The
same principle applies under the perpetual inventory system. When we make a sale,
the inventory has left our premises, so it is no longer an asset. We record the sale as
revenue and at the same time we transfer the relevant asset (Inventory) to an expense
account (Cost of Sales) to be matched against the sales revenue.
Work through the discussion and illustration of the sale of inventory using the
perpetual inventory system in your textbook on pages 232-236.
Note that for each sale two entries are required. First to record the sale at selling
price, and the second to move the goods from Inventory to Cost of Sales at cost
price. Similarly, sales returns require two entries.
DR
Sep

16

Accounts Receivable

CR

1100

Sales

1000

GST Clearing

100

(Sold goods)

Cost of Sales

600

Inventory

600

(Recording cost of goods

sold)

Sales returns and allowances - Assume 10% of the goods sold are returned and the
goods are put back into the inventory records (assuming that the goods are okay to be
sold to another customer and that they were not returned due to damage).
Sep

20

Sales Returns and Allowances

100

GST Clearing

10

Accounts Receivable

110

(Goods returned unsuitable)

Sep

20

Inventory
Cost of Sales

60
60
8

(Cost of goods returned)

As mentioned above, if the goods returned are in their original condition we can put
them back on the shelf ready for someone else to buy them, so we can debit
Inventory, as illustrated above. But what are we going to do if the returned goods are
damaged or defective and cannot go back into inventory? The term damaged
embraces any reason why the inventory is not suitable for immediate resale. We must
credit Cost of Sales account because the goods are no longer sold. We also debit an
expense account called Damaged Inventory Expense.

DR
Sep

20

Damaged Inventory Expense

CR
60

Cost of Sales

60

(Recording damaged returns)

The second entry for a sales return will always be a credit to Cost of Sales, but the
debit will be either to Inventory (if the goods can be resold), or to Damaged Inventory
Expense (if the goods cannot be resold). At the end of the period the Damaged
Inventory Expense account may either be added to cost of sales or reported as a
selling expense.
Receipt of an account after the discount period

Sep

25

Cash

1 100

Accounts Receivable

1 100

(Cash payment from debtor)

Receipt of an account within the discount period with 2% discount

2014
Sep

25

Cash (1100 x 0.98)

Discount allowed (1000 x .02)
GST Clearing (100 x .02)
Accounts Receivable

1 078
20
2
1 100

(Cash payment from debtor

within discount period)

Objective 4: Adjusting and closing the

accounts of a retailer
Textbook

Horngren et al. 2013

pp. 243-245

The adjusting entries for a retailing firm will not differ to those of a service firm. For
closing entries, the same principles apply as discussed in earlier work. Revenue and
expense accounts are closed to the Income summary account. Income summary
account is closed to the capital of the owners. Drawings are closed to the capital of
the owners. In a retailing firm there will be some additional accounts, specifically
those relating to the purchase and sale of inventory.
In the work sheet of a retailing business, compared with that of a service business,
there will be an Inventory account, and other accounts relating to the purchase and
sale of inventory. There will be different treatment in the work sheet depending on
whether the firm has used a perpetual or periodic inventory.
Under the perpetual inventory system, the balance in the Inventory account will be
the ending inventory, so on the work sheet we transfer that figure straight from the
adjusted trial balance to the debit balance sheet column. The figure for inventory in
the adjusted trial balance may be different from the figure in the unadjusted trial
balance, for example if there has been an adjusting entry for inventory shortage, after
a stock-count.

Adjusting inventory based on a physical count

In a perpetual system, during the period it is assumed that the number of items on
hand as shown on the inventory record will be the same as the number of items
actually on the shelf for sale. After a stock-count, it may be evident that the actual
count differs from the number on the inventory record. An adjusting entry will be
prepared to correct this discrepancy. If the difference is caused by loss, theft or
damage of inventory, debit an Inventory Losses expense account, and credit
Inventory, to record discrepancies.
If the difference is caused by a recording error, so that Cost of Sales had been
understated (balance in the accounts is less than what it should be), then the Cost of
Sales will be debited, and Inventory credited.
If the difference shows the amount on hand to be greater than shown in the records,
because of recording errors, debit Inventory and GST Clearing Account (with GST),
and credit Cash or Accounts Payable. If the reason for the difference is not known,
Inventory will be debited and Cost of Sales credited.
At the end of the period the Inventory Losses expense account may be reported in the
income statement as either added to the cost of sales or reported as a selling expense.

10

Objective 5: Preparing a retailers financial

statements
Textbook

Horngren et al. 2013

pp. 245-248

The information to be presented in the income statement is set out in AASB 101,
Presentation of Financial Statements and as a minimum must include the following
line items: revenue, finance costs, tax expense, profit or loss. Additional items are
recommended but are outside the scope of this unit (MPA701-Accounting). The
standard then goes onto states that an analysis of expenses using a classification
based on either the nature of expenses or their function within the entity is required.
These two formats are discussed further in the text on pages 245-248.

Financial expenses include interest expense and discount allowed.

The statement of changes in equity for a retailing firm will be no different to that of a
service firm. There is nothing in the statement to identify whether the firm sells goods
or services.
In the balance sheet for a retailing firm, the asset Inventory will be shown as a major
current asset.

Objective 6: Three ratios for decision making

Textbook

Horngren et al. 2013

pp. 248-249

The Gross Profit (or gross margin) percentage is a key measure of the profitability
of a retail firm.
Gross profit percentage =

Gross Profit
Net Sales Revenue

The inventory turnover shows the number of times a company sells (or turns over)
its average inventory in one year. Clearly, the more often you turn over your
inventory, the higher your sales, and presumably the higher your profit will be.
Furthermore, there is a cost associated with inventory (e.g. the cost of money tied up,
handling, warehousing, theft, shrinkage, and obsolescence) which can seriously affect
profits. So as long as customer demands are satisfied, the less inventory held, the
better.

Average Inventory =

Beginning inventory + Ending inventory

2

Inventory turnover =

Cost of Goods Sold

Average inventory

Review the example of ratio calculations in the relevant section in your textbook.

11

Objective 7: Accounting for inventory in a

periodic inventory system
Textbook

Horngren et al. 2013

pp. 272-275

In some businesses it is too expensive (in relation to the benefit) to maintain the
detailed inventory records as outlined under the perpetual inventory system, and a
periodic inventory system is used. In the periodic system the only entries made into
the inventory account will be to record the physical stock-take figure (at cost price) at
the end of the period, with a closing entry; and to remove the existing inventory
figure from the inventory account, with another closing entry.

Purchase of inventory
When goods are bought, the debit entry goes to a 'Purchases' account (expense
account) rather than the asset account called Inventory. Likewise, purchase
discounts, purchase returns and allowances are all recorded in separate accounts (net
of GST, for those businesses registered for GST).

Calculating cost of sales

In a periodic inventory system, at the time of sale, only one entry is made, that being
a debit to Cash at Bank or Accounts Receivable and a credit to Sales.
Cost of sales is always the cost of inventory that the business has sold to customers
during the period, but in a periodic inventory system, it can only be calculated at the
end of the period once the cost of ending inventory has been calculated. We do not
have a Cost of Sales account in our ledger under the periodic inventory system. Cost
of sales is a calculated amount in the statement of financial performance at the end of
the period. It is this cost which is the expense to be matched against the sales
revenue from goods sold.
Beginning inventory (as per last periods closing
stock take)
+

Purchases (Account)

Purchases Returns and Allowances (Account)

Freight in (Account)

Cost of goods available for sale

Ending inventory (as per the closing stocktaking)

Cost of sales

The main accounting features of the periodic system are that we debit our purchases
to a Purchases account instead of to the Inventory account, we use a Purchases
Returns account, and we determine cost of sales in the income statement. We do not
use a Cost of Sales account.
12

Work through the discussion and illustration of the periodic inventory system in
pages 268 to 271 of your text.
The following summary of transactions under a periodic inventory system may also
be useful:
Purchase of Goods on Credit:
Purchases

DR

GST Clearing

DR

Accounts Payable

CR

Purchases Returns:
Accounts Payable

DR

Purchase Returns and Allowances

CR

GST Clearing

CR

Payment for Purchase on Credit within a discount period:

Accounts Payable

DR

Cash at Bank

CR

Discount Received

CR

GST Clearing

CR

Recording Freight Inwards:

Freight in

DR

GST Clearing

DR

Cash at Bank

CR

Sale of Inventory on credit:

Accounts Receivable

DR

Sales Revenue

CR

GST Clearing

CR

Adjusting and closing the accounts in a periodic

inventory system
To remove opening inventory from the Inventory account and leave a zero balance:
Income Summary

DR

Inventory (Opening Balance)

CR

Then record the closing inventory in the inventory account:

Inventory (Closing Balance)
Income Summary

DR
CR

13

To debit Income Summary for the opening inventory amount will be necessary
because this figure is needed in the calculation of cost of sales in the income
statement. The credit to Income Summary for the ending inventory amount will also
be necessary in the calculation of cost of sales. Refer to the Study Guide pages 5 to 9
to review the calculation of cost of sales.

Conclusion
We have covered the operation of a merchandising firm. This has been a fairly
comprehensive module because the merchandising process recurs in this course. We
have also done some reinforcing of adjusting and closing entries and financial
reports. Make sure you can record the transactions and that you understand the end of
period process. It is extremely important you understand how cost of sales is
calculated in a periodic inventory system and what cost of sales represents in a
perpetual inventory system.

Review questions
Review question 51
Starters 5-2 & 5-3 (p. 259).

Review question 52
Starters 5-8 (p. 260).

Review question 53
Starters 5-10 (p. 260).

Review question 54
Exercises 5-1 (p. 261).

Review question 55
Exercises 52 (p. 261).

Review question 56
Exercises 513 (p. 264).

Review question 57
Starters (Appendix) 5A1 (p. 276).

Review question 58
Exercise (Appendix) E5A-1 & E5A2 (p. 276).

14

References
CPA Australia and the Institute of Chartered Accountants in Australia 2012,
Accounting Handbook, Pearson Australia Group Pty Limited
Hilton, Ian 2004, "Accounting for the GST", National Accountant, Vol. 20, No 5,
pp.52-54.
Horngren, C, Harrison, W, Oliver, M.S, Best, P, Fraser, D, Tan, R, & Willett, R 2013,
Financial accounting, 7th edn, Pearson Australia.

15