Chapter 5Accounting for Merchandising Operations

Study Objectives: 1. Identify the differences between a service enterprise and a merchandising company. 2. Explain the entries for purchases under a perpetual inventory system. 3. Explain the entries for 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. Explain the computation and importance of gross profit. 7. Determine cost of goods sold under a periodic system.

I. Merchandising Operations
A. Introduction 1. A merchandising company is an enterprise that buys and sells goods to earn a profit. a) Wholesalers sell to retailers such as grocery stores, drugstores, and restaurants. Examples of retailers would be WalMart, Safeway, and Toys R Us. b) Retailers sell to consumers and usually are those who purchase goods in bulk from manufacturers and sell them to retailers, other wholesalers, schools and other not-for-profit institutions, and, at times, directly to consumers. For example, retailer Walgreens might buy goods from wholesaler McKesson HBOC; Office Depot might buy office supplies from wholesaler United Stationers. 2. Define merchandise (or merchandise inventory)goods held for sale to customers in the normal course of business. Note that this includes only goods held for resale. For example, if a grocery store decided to sell an old display case, this would not be merchandise because grocery stores do not normally sell display cases. But a display case would be merchandise for a furniture store. Merchandise for one firm may be an asset for another. The merchandise (display cases) for the furniture store is an asset for the grocery store. 3. A merchandisers primary source of revenue is sales revenue or sales. 4. Expenses for a merchandising company are divided into two categories: a) cost of goods sold (COGS)total cost of merchandise sold during the period and b) Operating expenses (OP)expenses incurred in the process of earning sales revenue that are deducted from gross profit in the income statement). Examples are sales salaries and insurance expense. 5. Gross profit (GP) is equal to Sales Revenue less Cost of Goods Sold.

Sales

6. Income measurement process for a merchandiser: COGS = Gross Profit - Operating Exp. = Net Income (Loss) B. Operating CyclesOperating Cycles for a service company and a merchandiser: 1. Service Company operating cycle (to go from cash to cash) involves performing services which may be on account involving accounts receivable and finally receiving the cash. 2. Merchandising Company operating cycle (cash to cash) involves: a) Buy Inventory, b) Sell Inventory, c) Obtain Accounts Receivable, and d) Receive Cash. C. Inventory SystemsMerchandising entities may use either of the following inventory systems: a) Perpetual SystemDetailed records of the cost of each item are maintained, and the cost of each item sold is determined from records when the sale occurs. For example, a Ford dealership has separate inventory records for each vehicle on the lot. b) Record purchase of Inventory. c) Record revenue and record cost of goods sold when the item is sold. d) At the end of the period, no entry is needed except to adjust inventory for losses, etc. 2. Periodic SystemCost of goods sold is determined only at the end of an accounting period. This system involves: a) Record purchase of Inventory. b) Record revenue only when the item is sold. c) At the end of the period, you must compute cost of goods sold (COGS): 1) Determine the cost of goods on hand at the beginning of the accounting period (Beginning Inventory = BI), 2) Add it to the cost of goods purchased (COGP), 3) Subtract the cost of goods on hand at the end of the accounting period (Ending Inventory = EI) illustrated as follows: COGP = Cost of goods available for sale - EI = COGS 3. Additional Considerations a) Perpetual systems have traditionally been used by companies that sell merchandise with high unit values such as automobiles, furniture, and major home appliances. But with the

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use of computers and scanners, many companies now use the perpetual inventory system. b) The perpetual inventory system is named because the accounting records continuouslyperpetuallyshows the quantity and cost of the inventory that should be on hand at any time. The periodic system only periodically updates the cost of inventory on hand. c) A perpetual inventory system provides better control over inventories than a periodic inventory since the records always show the quantity that should be on hand and then any shortages from the actual quantity and what the records show can be investigated immediately. II. Recording Purchases and Sales of Merchandise under the

Perpetual System A. PURCHASES OF MERCHANDISE: MERCHANDISE

PURCHASE ENTRIES FOR A MERCHANDISER (PERPETUAL SYSTEM): 1. When merchandise is purchased for resale to customers, the account, Merchandise Inventory, is debited for the cost of goods purchased. 2. Like sales, purchases may be made for cash or on account (credit). 3. The purchase is normally recorded by the purchaser when the goods are received from the seller. a) Each credit purchase should be supported by a purchase invoice. b) A purchase invoice received by the buyer is actual a sales invoice prepared by the seller. c) Note that only purchases of merchandise are debited to Merchandise Inventory. Purchases if other assets: supplies, equipment, and similar items) are debited to their respective accounts. B. PURCHASE RETURNS AND ALLOWANCES 1. A purchaser may be dissatisfied with merchandise received because the goods a) 1) are damaged or defective, b) 2) are of inferior quality, or c) 3) are not in accord with the purchasers specifications. 2. The purchaser initiates the request for a reduction of the balance due through the issuance of a debit memorandum. 3. The debit memorandum is a document issued by a buyer to inform a seller that the sellers account has been debited because of unsatisfactory merchandise.

4. A purchase return or a purchase allowance (a deduction from the purchase price when unsatisfactory goods are kept) is shown by the entry where Accounts Payable is debited and Merchandise Inventory is credited to show that the cost of the Merchandise Inventory is reduced with a return or an allowance. C. ACCOUNTING FOR FREIGHT COSTS 1. The sales agreement should indicate whether the seller or the buyer is to pay the cost of transporting the goods to the buyers place of business. FOB SHIPPING POINT AND FOB DESTINATION: a) FOB Shipping Point 1) Goods placed free on board (FOB) the carrier by seller. 2) Buyer pays freight costs. a. Merchandise Inventory is debited if buyer pays freight. b. Cash is a credit if the goods come COD, for example, and paid immediately. Accounts Payable would be credited if on account. b) FOB Destination 1) Goods placed free on board (FOB) at buyers business. 2) Seller pays freight costs. 2. Freight-out (or Delivery Expense) is debited if seller pays freight on outgoing merchandise to a buyer which is an operating expense to the seller. D. PURCHASE DISCOUNTS: 1. Credit terms (specify the amount of cash discount and time period during which a discount is offered) may permit the buyer to claim a cash discount for the prompt payment of a balance due. If the credit terms show 2/10, n/30 means a 2% is paid within 10 days (called the discount period); otherwise the invoice is due in 30 days. 2. The buyer calls this discount a purchase discount. 3. Like a sales discount, a purchase discount is based on the invoice cost less returns and allowances, if any. 4. A buyer should usually take all available discounts. a) Refer to the example: 1) If Sauk Stereo takes the discount, it pays $70 less in cash ($3,500 x 2%). 2) If it forgoes the discount and invests the $3,500 for 20 days at 10% interest, it will earn only $19.06 in interest. 3) The savings obtained by taking the discount is calculated as follows: Discount of 2% on $3,500 $70.00

Interest received on $3,430 (for 20 days @ 10%) Savings by taking the discount

(19.06) $50.94

E. SALES TRANSACTIONS: REVENUE ENTRIES FOR A MERCHANDISER: 1. Revenues are reported when earned in accordance with the revenue recognition principle, and in a merchandising company, revenues are earned when the goods are transferred from seller to buyer. 2. All sales should be supported by a document such as a cash register tape (provide evidence of cash sales) or sales invoice. 3. Two entries are made with each sale: a) The first entry records the sale: 1) DebitAccounts Receivable (if a credit sale) or Cash (if a cash sale) which increases assets for the sales amount. 2) CreditSales which increases revenues b) The second entry records the cost of the merchandise sold: 1) DebitCost of Goods Sold which increases expenses. 2) CreditMerchandise Inventory which decreases assets. 4. The sales account is credited only for sales of good held for resale. Sales of assets not held for resale (such as equipment, buildings, land, etc.) are credited directly to the asset account. F. FREIGHT TERMS: FOB DESTINATIONSELLER PAYS FREIGHT 1. An entry is made when seller pays the freight to deliver goods to a customer or buyer. 2. DebitFreight Out or Delivery Expense and credit Cash or Accounts Payable. G. SALES RETURNS AND ALLOWANCES: 1. Sales Returns result when customers are dissatisfied with merchandise and are allowed to return the goods to the seller for credit or a refund. 2. Sales Allowances result when customers are dissatisfied, and the seller allows a deduction from the selling price. 3. To grant the return or allowance, the seller prepares a credit memorandum to inform the customer that a credit has been made to the customers account receivable.

4. Sales Returns and Allowances is a contra revenue account to the Sales account. a) A contra account is used, instead of debiting sales, to disclose in the accounts the amount of sales returns and allowances. b) This information is important to management as excessive returns and allowances suggest inferior merchandise, inefficiencies in filling orders, errors in billing customers, and mistakes in delivery or shipment of goods. 5. The normal balance of Sales Returns and Allowances is a debit. 6. Two entries are made with each sale return and allowance: a) The first entry records the sales return or allowance:: 1) DebitSales Return and Allowances which decreases revenues for the amount of the sale. 2) CreditAccounts Receivable (if a credit sale) or Cash (if a cash sale) which decreases assets. b) The second entry records the increase in Merchandise Inventory: 1) DebitMerchandise Inventory which increases assets. 2) CreditCost of Goods Sold which decreases expenses. H. SALES DISCOUNTS: 1. A sales discount is the offer of a cash discount to a customer for the prompt payment of a balance due. 2. Example: If a credit sale has the terms 3/10, n/30, a 3% discount is allowed if payment is made within 10 days. After 10 days there is no discount, and the balance is due in 30 days. 3. Sales Discounts is a contra revenue account with a normal debit balance. 4. Credit terms specify the amount and time period for the cash discount. 5. They also indicate the length of time in which the purchaser is expected to pay the full invoice price.

III.

Completing the Accounting Cycle A. Adjusting Entries

1. A merchandiser has the same adjusting entries as a service company. 2. But a merchandiser will have one additional adjustment to make the records agree with the actual inventory on hand.

a) The perpetual inventory records may be incorrect due to a variety of causes such as recording errors, theft, or waste. b) The adjusting entry involves adjusting Merchandise Inventory and Cost of Goods Sold. 1) An example follows of the adjusting entry to adjust if book amount is higher than the inventory amount determined to be on hand. 2) The entry is a debit Cost of Goods Sold and credit Merchandise Inventory. B. Closing Entries are completed at the end of the fiscal year are journalized into the general journal and posted to the general ledger to: 1. Reduce the temporary owner's equity accounts (revenues, expenses, and drawing) to zero; and 2. To update the balance in the owner's equity capital account to begin the next fiscal year. 3. Recall from chapter 4 that this is a 4-step process following the acronym REID (Revenue, Expenses, Income Summary, and Drawing). Refer to the work sheet on page 221 which is a tool to help complete the closing entries. A merchandising company also uses the 4step (4 entries) process for the closing entries but the descriptions of REID will be expanded to include all the accounts in a particular column: a) The first step for the "R" is to close the revenue accounts and those accounts that act as revenues (meaning they have "credit" balances on the credit column of the Income Statement columns of the work sheet) into the Income Summary account. b) The second step for the "E" is to close the expense accounts and those accounts that act as expenses (meaning they have "debit" balances on the debit column of the Income Statement columns of the work sheet) into the Income Summary account. c) The third step for the "I" is to close the Income Summary account. If the Income Summary account has a "credit balance," then the company has a NET INCOME or if the balance in the account is a "debit balance," then the company has a NET LOSS. The balance in the INCOME SUMMARY account should be compared with the net income figure on the work sheet or the net loss figure on the work sheet as they should be the same number if you properly closed all the revenue and expense accounts. Compare the "credit" balance of $30,000 in the Income Summary account below to the $30,000 net income figure on the Work Sheet.

INCOME

SUMMARY

Total expenses Entry to close acct. Final bal. of acct.

450,000 30,000 -----

a) account by debiting the owner's capital account and crediting the owner's drawing account.

480,000 Total revenues Balance of Inc. Sum. acct. 30,000 Final bal. of acct. ----The fourth step for the "D" is to close the drawing

IV.

Forms of Financial Statements

A. MULTIPLE-STEP INCOME STATEMENT 1. Includes sales revenue, cost of goods sold and gross profit sections. a) Net Sales = Sales Sales returns and allowances and Sales Discounts.

Note: Freight-out is a selling expensenot a contra account to sales.

b) Gross Profit = Net sales Cost of goods sold. An example showing the determination of gross profit as follows:

Net sales - Cost of goods sold = Gross profit

2. a) b)

460,000 - 316,000 144,000

Operating expenses may be subdivided into: Selling Expenses. Administrative Expenses. 3. Additional nonoperating sections may be added for: a) Nonoperating sections are reported after income from operations and are classified in two sections. b) Revenues and expenses resulting from secondary or auxiliary operations. 1) Other revenues and gains. 2) Other expenses and losses. c) Gains and losses unrelated to operations. Other Revenues and Gains in one column and Other Expenses and Losses in the other column. 4. MULTIPLE-STEP VS. SINGLE-STEP INCOME STATEMENT showing the formulas for the multiple-step income statement: a) Net sales Cost of goods sold = Gross profit b) Operating expenses = Income from operations c) + Other revenues/gains Other expenses/losses = Net income or Net loss. 5. An example for the determination of net incomefrom gross profit as follows:

Gross profit - Total operating expenses = Income from operations + Other revenues and gains - Other expenses and losses = Net income

144,000 - 114,000 30,000 + 3,600 - 2,000 $31,600

B. SINGLE-STEP INCOME STATEMENT 1. All data are classified under two categories: a) (1) Revenues b) (2) Expenses 2. Only one step is required in determining net income or net lossRevenues Expenses = Net Income. 3. Two primary reasons for using a single step format: a) (1) A company does not realize any type of profit or income until total revenues exceed total expenses, so it makes sense to divide the statement into two categories. b) (2) The format is simpler and easier to read than the multiple-step format. C. CLASSIFIED BALANCE SHEET. 1. Current assets are listed in the order of liquidity. 2. Merchandise Inventory is less liquid than accounts receivable because the goods must first be sold and then collection must be made from the customer. 3. Merchandise Inventory is reported as a current asset immediately below accounts receivable.

V. Determining Cost of Goods Sold Under a Periodic System

A. An important Cost of Goods Sold calculation that is tested backwards and forwards (but on exam that is sent in so does NOT have to be memorized) on the certified bookkeeper's (CB) exam): B. Under the Periodic system, separate accounts are used to record freight costs, returns, and discounts. C. Under the Perpetual system all transactions affecting the cost of merchandise purchased is recorded directly into Merchandise Inventory account. D. Also under the Periodic system, a running account of changes in inventory is not maintained. Therefore, the balance in ending inventory (done by taking a physical inventory), as well as the cost of goods sold for the period, is calculated at the end of the period. E. To memorize the cost of goods sold calculation, it is helpful to first learn the OUTLINE OF THE COST OF GOODS SOLD SECTION (also helpful to use acronyms for the words that are used):

1. Beginning inventory (BI) 2. + Cost of goods Purchased (COGP) Gross purchases - Purchase returns & allowances - Purchase discounts + Freight-in) 3. = Goods available for sale (GAFS) 4. - Ending inventory (EI) 5. = Cost of goods sold (COGS) Note below the outline of the Cost of goods sold is bolded: Cost of goods sold: Inventory, January 1 Purchases $325,000 Less: Purchases returns and $10,400 allowances Purchases discounts 6,800 17,200 Net purchases 307,800 Add: Freight in 12,200 Cost of goods purchased Cost of goods available for sale Inventory, December 31 Cost of goods sold

$36,000

320,000 356,000 40,000 316,000

A helpful tip to memorize the COGS calculation is to practice with 4 columns where you just use the acronyms in the columns as well as the plus and minus signs so you can visualize where the different numbers go as you move from the beginning of the year to the end of the year (NOTE that the format moves in a stair-step arrangement backwards to purchases returns and allowances and then forwards down to cost of goods sold) (the xxx's represent a number that does not have a word to describe it): Cost of goods sold: BI P P R&A + PD - xxx NP + FI +COGP GAFS - EI COGS

VI.

Periodic Inventory System

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A. Perpetual vs. Periodic Inventory systems comparisons: 1. With both systems, revenues from the sale of merchandise are recorded when sales are made. 2. But with the periodic system, no attempt is made on the date of sale to record the cost of the merchandise sold. 3. Under the periodic system, a physical inventory is taken at the end of the period and this count determines: a) (1) the cost of merchandise on hand and b) (2) the cost of goods sold during the period as ending inventory is part of the cost of goods sold calculation. 4. Under the periodic system, purchases of merchandise are recorded in a Purchases account rather than a Merchandise Inventory account. 5. Under the periodic system, it is customary to record the following in separate accounts: a) Purchase Returns and Allowances, b) Purchase Discounts c) Freight-in B. Recording Transactions Under a Periodic Inventory System 1. Recording Purchases of Merchandise a) PurchasesPurchases is a temporary account whose normal balance is a debit and located under the Expense section of the accounting equation. b) Purchase Returns and AllowancesPurchases Returns and Allowances is a temporary contra expense account with a normal credit balance. c) Freight CostsFreight-in is a temporary account whose normal balance is a debit balance under the expense section along with the Purchases account. This account is used with the term are FOB Shipping Point and a cost paid by the buyer to bring the goods to the purchaser. d) Purchase DiscountsPurchases Discounts is a temporary contra expense account with a normal credit balance.

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2.

a) the periodic inventory system is NO second entry to record the cost of goods sold. Sales is a revenue account with a normal credit balance. b) Sales Returns and Allowancesthe same entry made under the perpetual system. Note there is NO second entry to record the return of the Merchandise Inventory with the cost of goods sold as done under the perpetual system. Sales Returns and Allowances is a contra revenue account with a normal debit balance. c) Sales Discountsto record the payment from a customer within the discount period would be the same entry under the perpetual system. Sales Discounts is a contra revenue account with a normal debit balance

Recording Sales of Merchandise Salesthere is just one entry to record the sale. Under

VII. Work Sheet for a Merchandiser

A. Introductionas indicated in Chapter 4, a work sheet is prepared to: 1. To help with the adjusting process; 2. To help with the preparation of the financial statements; and 3. To help with preparing of the closing entries. B. Trial Balance Columns: 1. Data from the trial balance are obtained from the ledger balances of PW Audio Supply at December 31. 2. The amount shown for Merchandise Inventory, $40,500, is the year-end inventory amount which results from the application of a perpetual inventory system. 3. Note the accounts in red that are the new accounts used for the merchandising company under the perpetual inventory system. 4. As was covered in chapter 4, a separate trial balance is not prepared as we use the first two columns of the worksheet for this initial trial balance (a listing of all ledger accounts to test the equality of debits and credits). 5. Also recall that the format #2 will include all accounts that will be needed for the adjusting process are also included in this listing of the general ledger accounts that are listed in chart of account (general ledger) order. 6. Remember that the work sheet is started by entering the heading as shown on page 208 which has the answers to the questions, "who," "what," and "when," where the answer to the "when" must be a period of time as the work sheet's bottom line is to disclose the amount of net income or net loss for the period.

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C. Adjustments Columns 1. A merchandising company usually has the same types of adjustments as a service company 2. Work sheet adjustments (b), (c), and (d) are for insurance, depreciation, and salaries. 3. Adjustment (a) was required to adjust the perpetual inventory carrying amount to the actual count. 4. The Adjustments columns like the Trial Balance columns, must be proved before the work sheet can be continued by adding the debit and credit columns so see that they balance. D. Adjusted Trial Balance 1. The adjusted trial balance shows the balance of all accounts after adjustment at the end of the accounting period. 2. Review and describe how adjustments are carried to the

Adjusted Trial Balance columns: a) Accounts without adjustments. If an account does not have an
adjustment, simply carry over the Trial Balance figure to the appropriate Adjusted Trial Balance column. b) Accounts without balances on the trial balance. If an account does not have a balance in the Trial Balance columns, but there is an adjustment, the amount of the adjustment becomes the balance on the adjusted trial balance. c) Merchandise Inventory. On the adjusted trial balance, the Merchandise Inventory account shows the December 31 Inventory count as adjusted to agree with the physical inventory count. d) Accounts that had adjustments to their previous balance. When extending amounts to the adjusted trial balance from the trial balance, a debit with a debit adjustment has the two debits added together. Likewise an account with a credit balance on the trial balance is added to a credit adjustment when extended to the adjusted trial balance. A debit balance on the trial balance with a credit adjustment will be subtracted to extend to the adjusted trial balance or a credit balance with a debit adjustment will be subtracted to extend to the adjusted trial balance. E. Income Statement Columns 1. The accounts and balances that affect the income statement are transferred from the adjusted trial balance columns to the income statement columns for PW Audio Supply at December 31. 2. All of the amounts in the income statement credit column should be totaled and compared to the total of the amounts in the income statement debit column. F. Balance Sheet Columns 1. The major difference between the balance sheets of a service company and a merchandising company is inventory.

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2. For PW Audio Supply, the ending Merchandise Inventory amount of $40,000 is shown in the balance sheet debit column. 3. The information to prepare the owners equity statement is also found in these columns. G. Review the determination of net income or loss and completion of the work sheet. Recall from Chapter 4 that after the amounts are extended to the income statement and balance sheet columns that you add the columns down, and rule them. As you can see, a net income figure appears on the debit column of the income statement and the credit column of the balance sheet. The reason it shows on the credit column of the balance sheet is that a net income increases owners capital and owners capital increases on the credit side. Note that owners capital is bolded to emphasize why the net income appears on the credit side of the balance sheet columns. Below is the work sheet for PW Audio Supply showing format #2: where the balance sheet accounts are above the bold line and the income statement below it: PW Audio Supply Work Sheet For the Year Ended December 31, 20-Account Titles Cash AcctsRec. MerchInv Prepd Ins. Str.Equip
A/D StrEq Accts.Pay. Sal. Pay. RAL, Cap.. RAL, Draw Sales. Sales R&A Sales Disc COGS Freight Out Adv.Exp. AdmSal.xp. StrSalExp Util.Exp. Ins.Exp. DepEx. SE Net Income

Trial Balance Debit Credit 9,500 16,100 40,500 3,800 80,000 16,000 20,400 0 83,000 15,000
480,000

12,000 8,000
315,500

7,000 16,000 19,000 40,000 17,000 0 0

599,400

599,400

Adjustments Debit Credit (a) 500 (b)2000 (c)8000 (d)5000 a) 500 (d)5000 (b2000 (c)8000 15,500 15,500

Adj. Trial Balance Debit Credit 9,500 16.100 40,000 1,800 80,000 24,000 20,400 5,000 83,000 15,000 480,000 12,000 8,000 316,000 7,000 16,000 19,000 45,000 17,000 2,000 8,000
612,400 612,400

Income Statement Debit Credit 480,000 12,000 8,000

316,000

Balance Sheet Debit Credit 8,485 300 40,000 1,800 80,000 24,000 20,400 5,000 83,000 15,000

800 50 1,260 45,000 17,000 2,000 8,000

450,000 480,000 162,400 132,400

30,000
480,000

480,000

162,400

30,000
162,400

H. Note that in an Excel template, you can use IF functions to automatically calculate a net income or a net loss depending on whether revenues are greater than expenses or vice versa. Also you can set an IF function to automatically writes the words, Net income or Net loss depending on whether revenues are greater than expenses or vice versa. Having these formulas in a work sheet along with others can aid the

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preparation of a work sheet in just a few minutes and allow for quick changes to be made. I. Also spreadsheets can be used to link the financial statements to the work sheet so that they can be prepared instantly when a work sheet is prepared.

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