Chapter 04 - Accounting for Merchandising Operations
Chapter Outline
I.
Notes
Merchandising Activities
Products that a company acquires to resell to customers are referred to
as merchandise (also called goods). A merchandiser earns net
income by buying and selling merchandise. A wholesaler is an
intermediary that buys products from manufacturers or other
wholesalers and sells them to retailers or other wholesalers.
A. Reporting Income for a Merchandiser
Revenue (net sales) from selling merchandise minus the cost of
goods sold (the expense of buying and preparing the merchandise)
to customers is called gross profit (also called gross margin). This
amount minus expenses (generally called operating expenses)
determines the net income or loss for the period.
B. Reporting Inventory for a Merchandiser
1. A merchandiser's balance sheet is the same as a service
business with the exception of one additional current asset,
merchandise inventory, or simply inventory.
2. The cost of this asset includes the cost incurred to buy the
goods, ship them to the store, and make them ready for sale.
C. Operating Cycle for a Merchandiser
A merchandising company’s operating cycle begins by purchasing
merchandise and ends by collecting cash from selling the
merchandise. Companies try to keep their operating cycles short
because assets tied up in inventory and receivables are not
productive.
D. Inventory Systems
1. Merchandise available for sale consists of beginning inventory
and what it purchases (net purchases). The merchandise
available is either sold (cost of goods sold) or kept for future
sales (ending inventory).
2. Two alternative inventory systems are used to collect
information about cost of goods sold and the cost of inventory:
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Chapter 04 - Accounting for Merchandising Operations
a. Perpetual inventory system—continually updates
accounting records for merchandise transactions,
specifically, for those records of inventory available for
sale and inventory sold.
b. Periodic inventory system—updates the accounting
records for merchandise transactions only at the end of a
period.
c. Some companies use a hybrid system where the perpetual
system is used for tracking units available and the periodic
system is used to compute cost of sales.
Chapter Outline
Notes
The following sections of this outline use the perpetual inventory system.
Appendix 4A uses the period system (with perpetual results on the side). An
instructor can choose to cover either one or both inventory systems.
II.
Accounting for Merchandise Purchases
The invoice serves as a source document for this event.
A. Trade Discounts
1. In catalogs, each item has a list price or catalog price. An
item’s intended selling price equals list price minus a given
percent called a trade discount.
2. A buyer records the net amount of list price minus trade
discount.
B. Purchases Discounts
Credit terms for a purchase include the amounts and timing of
payments from a buyer to a seller. The amount of time before full
payment is due is called the credit period.
1. Sellers can grant a cash discount to encourage the buyer to
pay earlier. A seller views a cash discount as a sales discount
and a buyer views a cash discount as a purchase discount.
This reduced payment applies only for the discount period.
2. Example: credit terms, 2/10 n/30, offers a 2 % discount if the
invoice is paid within 10 days of invoice date.
3. Entry for buyer for purchase of merchandise on credit: debit
Merchandise Inventory, credit Accounts Payable.
4. Entry for buyer to record payment within discount period:
debit Accounts Payable (full invoice amount), credit Cash
(amount paid = invoice – discount), credit Merchandise
Inventory (amount of discount).
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Chapter 04 - Accounting for Merchandising Operations
C. Purchase Returns and Allowances
1. Purchase returns refer to merchandise a buyer acquires but
then returns to the seller.
2. A purchase allowance is a reduction in the cost of defective or
unacceptable merchandise that a buyer acquires.
3. The buyer issues a debit memorandum to inform the seller of
a debit made to the supplier's account.
4. Entry for buyer to record purchase return or allowance: debit
Accounts Payable or Cash (if refund given) and credit
Merchandise Inventory.
5. When goods are returned, a buyer can take a purchase
discount on only the remaining balance of the invoice.
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Chapter 04 - Accounting for Merchandising Operations
Chapter Outline
III.
Notes
D. Transportation Costs and Ownership Transfer
The buyer and seller must agree on who is responsible for paying
any freight costs and who bears the risk of loss during transit for
merchandising transactions. The point of transfer is called the
FOB (free on board) point.
1. FOB shipping point—buyer accepts ownership when goods
depart sellers’ place of business; buyer pays shipping costs.
a. Shipping costs increase the cost of merchandise acquired
(cost principle).
b. Entry for buyer to record shipping costs: Debit
Merchandise Inventory, credit Cash or Accounts Payable
(if to be paid with merchandise later).
2. FOB destination—ownership of goods transfers to buyer when
goods arrive at buyer’s place of business; seller pays shipping
costs.
a. Shipping costs are an operating (selling) expense for seller
b. Entry for seller to record shipping costs: Debit Delivery
Expense (or Transportation-Out or Freight-Out), credit
Cash.
Accounting for Merchandise Sales
A. Sales of Merchandise
Each sales transaction involves two parts and will therefore
require two entries:
1. Recognize revenue received —entry for seller to record: debit
Accounts Receivable (or cash), credit Sales (for the invoice
amount).
2. Recognize cost of merchandise sold— entry for seller to
record: debit Cost of Goods Sold, credit Merchandise
Inventory (for the cost of the merchandise sold).
B. Sales Discounts
Sales discounts are usually not recorded until a customer actually
pays with the discount period.
1. Entry for seller to record collection after discount period—
Debit Cash, Credit Accounts Receivable (full invoice amount).
2. Entry for seller to record collection within discount period—
debit Cash (invoice amount less discount), debit Sales
Discounts (discount amount), credit Accounts Receivable
(invoice amount).
3. Sales Discounts is a contra-revenue account; it is subtracted
from Sales when computing a company’s net sales.
4. Sales discounts are monitored to assess the effectiveness and
cost of its discount policy.
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Chapter 04 - Accounting for Merchandising Operations
Chapter Outline
IV.
Notes
C. Sales Returns and Allowances
1. Sales returns—merchandise that a customer returns to the
seller after a sale.
2. Sales allowances—reductions in the selling price of
merchandise sold to customers (usually for damaged or
defective merchandise that a customer is willing to keep at a
reduced price).
3. Entry for seller to record sales returns or allowances: debit
Sales Returns and Allowances and credit Accounts
Receivable; additional entry if returned merchandise is
salable: debit Merchandise Inventory, credit Cost of Goods
Sold.
4. Seller prepares a credit memorandum to inform buyer of the
seller’s credit to the buyer’s Accounts Receivable (on the
seller’s books).
Completing the Accounting Cycle
A. Adjusting Entries for Merchandisers
Generally same as discussed in chapter 3 for a service business.
1. Additional adjustment needed to update inventory to reflect
any loss of merchandise, including theft and deterioration, is
referred to as shrinkage.
2. Shrinkage is determined by comparing a physical count of the
inventory with recorded quantities.
3. Entry to record shrinkage: debit Cost of Goods Sold, credit
Merchandise Inventory.
B. Preparing Financial Statements
The financial statement for a merchandiser are similar to those for
a service company described in chapters 2 and 3.
1. The income statement mainly differs by the inclusion of cost
of goods sold and gross profit. Net sales is affected by
discounts, returns, and allowances, and some additional
expenses are possible such as delivery expense and loss from
defective merchandise.
2. The balance sheet mainly differs by the inclusion of
merchandise inventory as part of current assets.
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Chapter 04 - Accounting for Merchandising Operations
C. Closing Entries
Closing entries are similar to a service business except that some
new temporary accounts that arise from merchandising activities
must be closed (e.g., Sales Discount, Sales Returns and
Allowances, and Cost of Goods Sold). These debit balance
accounts are closed with the expense accounts to Income
Summary.
Chapter Outline
V.
Notes
Financial Statement Formats—No specific format is required in
practice. Two common income statement formats:
A. Multiple-Step Income Statement
1. A multiple-step income statement has three main parts:
a. Gross profit—net sales minus cost of goods sold),
b. Income from operations—gross profit less operating
expenses, and
c. Net income—income from operations adjusted for
nonoperating items.
2. Operating expenses are classified into two sections:
a. Selling expenses—the expenses of promoting sales,
making sales, and delivering goods to customers, and
b. General and administrative expenses—expenses related
to accounting, human resource management, and financial
management.
3. Nonoperating activities—consist of other expenses, revenues,
losses, and gains that are unrelated to a company’s operations;
reported in two sections:
a. Other revenues and gains—interest revenue, dividend
revenue, rent revenue, and gains from asset disposals.
b. Other expenses and losses—interest expense, losses from
asset disposals, and casualty losses.
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Chapter 04 - Accounting for Merchandising Operations
B. Single-Step Income Statement
A single-step income statement includes cost of goods sold as an
operating expense and shows only one subtotal for total expenses,
one subtraction to arrive at net income.
C. Classified Balance Sheet
The merchandiser’s classified balance sheet reports merchandise
inventory as a current asset, usually after accounts receivable.
D. Global View
1. Accounting and Reporting for Merchandising Purchases
and Sales – Both GAAP and IFRS include similar guidance in
accounting for merchandise purchases and sales. All of the
transactions presented in this chapter, including the closing
process, are accounted for identically under the two systems.
2. Income Statement Presentation – IFRS tends to use the term
profit more than any other term. GAAP statements use neet
income the most. Both GAAP and IFRS income statements
begin with net sales (or net revenue) followed by cost of goods
sold for merchandisers/manufacturers.
a. GAAP offers little guidance about the presentation or order
of expenses. IFRS requires separate disclosures for
Chapter Outline
Notes
financing costs, income tax expense and other special
items.
b. Both systems require separate disclosure of items when
their size, nature or frequency are important for proper
interpretation.
c. IFRS permits expenses to be presented by their function
or nature. GAAP provides no direction but the SEC
requires presentation by function.
d. Neither GAAP nor IFRS define operating income, so
classification of expenses into operating or nonoperating
reflects management discretion.
e. IFRS permits alternative measures of income; US GAAP
prohibits disclosure of alternative income measures.
3. Balance Sheet Presentation – GAAP balance sheets report
current items first, with assets listed from most liquid to least
liquid and liabilities are listed from nearest to maturity to
furthest from maturity.
IFRS balance sheets present
noncurrent items first but this is not a requirement.
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Chapter 04 - Accounting for Merchandising Operations
VI.
VII.
Decision Analysis—Acid-Test and Gross Margin Ratios
A. Acid-Test Ratio
1. The acid-test ratio is used to assess the company's liquidity or
ability to pay its current debts; it differs from the current ratio
by excluding less liquid current assets.
2. It is calculated by dividing quick assets by current liabilities;
quick assets are cash, short-term investments, and current
receivables.
3. Rule of thumb is that the acid-test ratio should have a value of at
least 1.0 to conclude that a company is unlikely to face near-term
liquidity problems.
B. Gross Margin Ratio
1. The gross margin ratio (also called gross profit ratio) is used
to assess a company’s profitability before considering
operating expenses.
2. It is calculated by dividing gross margin (net sales – cost of
goods sold) by net sales.
Periodic Inventory System (Appendix 4A)
A. Records merchandise acquisitions, discounts and returns in
temporary accounts (Purchases, Purchase Returns, Purchases
Discounts) rather than the merchandise inventory account.
B. Records only the revenue aspect of sales-related events; updates
inventory and determines cost of goods sold only at the end or the
accounting period.
C. The Merchandise Inventory account can be updated as part of the
adjusting or closing process.
Chapter Outline
Notes
D. Requires closing additional temporary accounts.
VIII.
Work Sheet—Perpetual System (Appendix 4B)
Differs slightly from the work sheet layout for a service company in
Chapter 3; includes additional accounts used by a merchandiser:
Merchandise Inventory, Sales, Sales Returns and Allowances, Sales
Discounts, and Cost of Goods Sold.
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Chapter 04 - Accounting for Merchandising Operations
VISUAL #4-1
COMPONENTS OF NET INCOME (FROM OPERATIONS)
(a)
(b)
(c)
(d)
(e)
Steps:
X
– X
X
– X
X
Net Sales
– Cost of Goods Sold*
Gross Profit on Sales
– Operating Expenses
Net Income (Loss) from Operations
COMPONENTS OF COST OF GOODS SOLD
Steps:
X
+ X
X
– X
X
(a) Merchandise Inventory, Beginning of Period
(b) + Total Cost of Merchandise Purchases
(c) Available for Sale
(d) – Merchandise Inventory, End of Period
(e) Cost of Goods Sold
COMPONENTS COST OF GOODS PURCHASED
(a) Purchases
(b) – Purchase Returns & Allowances
and Purchases Discounts
(c) Net Purchases
(d) + Transportation-In
(e) Total Cost of Merchandise Purchases
Steps:
X
+
X
X
–
+
X
X
X
X
* Perpetual inventory systems have a cost of goods sold account that
continuously accumulates costs as items are sold. In a periodic inventory system
this amount is calculated at the end of period.
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Chapter 04 - Accounting for Merchandising Operations
VISUAL #4-2
THE OUTDOOR STORE
Income Statement
For the Year Ended December 31, 20xx
Sales revenues
Sales ...............................................
Less: Sales returns and allowances ..............
Sales discounts ............................
Net sales .............................................
Cost of goods sold
Merchandise inventory, January 1...............
Purchases ............................................
Less: Purchase discounts .......... $12,000
Purchase returns and
Allowances .......................
6,400
Net purchases .......................................
Add: Freight-in .....................................
Total cost of merchandise purchased ...........
Goods available for sale ..........................
Merchandise inventory, December 31 ..........
Cost of goods sold.......................................
Gross profit ..............................................
Operating expenses
Selling expenses
Sales salaries expense ....................
Sales commission expense ..............
Depreciation expense - Display equip.
Utilities expense ..........................
Insurance expense ........................
Total selling expenses ...................
General and administrative expenses
Office salaries expense ..................
Depreciation expense – building .......
Property tax expense .....................
Utilities expense ..........................
Insurance expense ........................
Total administrative expenses
Total operating expenses ................
Income from operations ................................
Other revenues and gains
Interest revenue.....................................
Other expenses and losses
Interest expense ....................................
Net income ...............................................
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$
5,000
3,000
462,000
18,400
443,600
3,600
76,000
14,500
13,300
6,600
4,320
32,000
10,400
4,800
4,400
2,880
$700,000
8,000
$692,000
40,300
447,200
487,500
70,000
417,500
274,500
114,720
54,480
169,200
105,300
4,000
11,000
7,000
$ 98,300