Merchandising Operations
Chapter 5
When a service business earns fees they record revenue from the services
rendered. In the case of the merchandising business you still have the revenue
transaction, but you also have a second cost transaction because you have
produced your revenue from selling an asset. The cost or expense generated
from the sale of merchandise is called Cost of Goods Sold.
The Cost of Goods Sold is treated the same as an expense in the journal entries,
but it can be treated differently in an income statement. Often, Sales Revenue
and Cost of Goods Sold is reported at the top of an income statement, and the
net difference is labeled Gross Profit or Gross Margin.
Inventory Systems
There are two methods of handling inventories:
•
•
The periodic inventory system, and
The perpetual inventory system
Periodic Inventory System
With the periodic inventory system, the firm finds out its cost of goods sold at the
end of the accounting period. Throughout the accounting period, the firm keeps
track of its purchases. To find out what the firm sold, the firm takes its beginning
inventory adds its purchases for the period. This gives the firm all the goods that
pass through the firm for the period (the goods available for sale). The firm then
takes a physical inventory. This gives the firm what is left at the end of the period.
The ending inventory is then subtracted from the available goods figure to get the
cost of goods sold.
The periodic inventory system assumes anything not there was sold, but the
goods could have been stolen. The lack of information on the theft or spoilage of
goods is a major disadvantage of the periodic system. In addition, unless a
physical inventory is taken, the firm does not know what its cost of goods sold is
during the period (as opposed to the end of the period). An advantage of the
periodic inventory system is that it is easy to maintain.
Perpetual Inventory System
With the perpetual inventory system, the firm keeps track of its cost of goods sold
on a continual basis. Thus, at any given time, the firm can estimate its current
inventory levels. At the end of the period, a physical inventory is taken. Any
discrepancy with the estimated inventory level and the actual inventory level is
then attributed to theft and spoilage.
It used to be very expensive to maintain this type of system, but with the use of
computers & scanners, this is no longer the case, and the perpetual inventory
system is increasing in popularity.
What we have discussed to date is the perpetual inventory system, and we will
continue to use it in this chapter.
Recording Purchases of Merchandise
When you purchase inventory with cash:
D. Merchandise Inventory
Cr. Cash
$5,000
$5,000
When you purchase inventory on credit:
D. Merchandise Inventory
Cr. Accounts Payable
$5,000
$5,000
A cash purchase should be supported with a cancelled check. A credit purchase
should be supported with an invoice from the supplier.
Purchase Returns & Allowances
When you return merchandise inventory (Purchases Return) or get a price
reduction on the merchandise (Purchases Allowance) after they are delivered,
you write down the price of the Merchandise Inventory to the price actually paid.
The journal entry, in effect, reverses in whole (return) or in part (allowance) the
purchase journal entry:
A return of entire $5,000 purchase:
D. Accounts Payable
Cr. Merchandise Inventory
$5,000
$5,000
The receipt of a $1,000 purchase allowance on the prior purchase:
D. Accounts Payable
Cr. Merchandise Inventory
$1,000
$1,000
Cost of Inventory
Inventory cost is defined as the price paid to acquire the inventory and generally
includes invoice price less purchases discounts, freight, insurance in transit,
taxes, tariffs, inspection costs and preparation costs. It is basically everything
that is paid in order to get the inventory ready to sell.
Transportation Costs
The term, “FOB”, stands for Free On Board. "FOB shipping point" means that
the seller transfers title to the goods at the seller’s place of business. The buyer
pays shipping costs. For example, if you order a car from Ford and the invoice
says FOB Detroit, then you pay the shipping costs and the car belongs to you as
soon as it leaves the factory. If something goes wrong during shipment, it is your
problem.
The term "FOB destination" means that the seller transfers title to the goods at
the buyer’s place of business. The seller pays shipping costs. For example, if you
order a car from Ford and the invoice says FOB Los Angeles, then Ford pays the
shipping costs and the car belongs to you when it arrives.
Transportation Costs on purchases are part of the cost of our inventory. These
costs are referred to as Freight in or Transportation In. Under the perpetual
inventory system, you write up the cost of the inventory:
D. Merchandise Inventory
Cr. Accounts Payable/Cash
$150
$150
Transportation Costs on our sales are an expense. They are called
Transportation Out or Freight Out:
D. Freight Out
Cr. Accounts Payable
$150
$150
Purchases Discounts
When we purchase inventory, we are often provided with credit terms that
encourage us to pay quickly. These are called purchase discounts. When we
offer these terms to our customers they are called sales discounts.
A typical purchase/sales discount notation (credit terms) is 2/10 n/30 (“two-ten,
net thirty”). This notation says that if the purchaser pays within 10 days, then the
purchaser may take 2 percent off the price of the goods. Otherwise, the entire
bill is due in 30 days.
Another example would be 1/10 EOM. This notation says that the purchaser
may take a 1 percent discount if he or she pays the invoice during the first 10
days of the next month. Otherwise, the entire bill is due by the end of the next
month.
If seller does not wish to offer a discount, then the seller indicates when payment
is due. For example, n/30 says that the entire amount is due in 30 days. The
notation n/10 EOM says that the invoice amount is due in the first 10 days of the
next month.
Usually, passing up the purchase discount is thought to be very unwise because
the interest cost for delaying the payment for 20 days is very high. For example,
with 2/20 n/30, you are paying 2% for a 20-day loan. This is an annualized rate
of 36.5% per annum.
Assume you bought inventory for $3,500 and the supplier offered you 2/10 n/30.
When you receive the inventory, ignore the potential purchase discount:
D. Merchandise Inventory
Cr. Accounts Payable
$3,500
$3,500
If the payment is made during the discount period, you write down the price paid
for the Merchandise Inventory to the cash actually paid:
D. Accounts Payable
Cr. Cash
Merchandise Inventory
$3,500
$3,430
70
If the payment is not made during the discount period:
D. Accounts Payable
Cr. Cash
$3,500
$3,500
Cash Sales
When you make a cash sale, you have the following general journal entry
reflecting the revenue side of the transaction:
D. Cash
Cr. Sales Revenue
$2,200
$2,200
The cost side of the transaction is recorded as follows:
D. Cost of Goods Sold
Cr. Merchandise Inventory
$1,400
$1,400
Sales on Account
When a company makes a credit sale, the general journal entry is as follows:
D. Accounts Receivable
Cr. Sales Revenue
$2,200
$2,200
The cost side of the transaction is recorded as noted above:
Credit Card Sales
Companies that allow customers to use a national credit card (such as Master
Card) must follow special accounting procedures. Operationally, the credit card
company reimburses the company for the sale, less a service charge (e.g., 2% 3%). The credit company levies a service charge because it is responsible for
establishing credit and collecting the money from the customer.
There are two ways to handle credit card sales depending on the credit card
company. Some credit card companies make the vendor wait for payment. This
isn'
t done by the major credit card companies. This was the way that American
Express used to operate. The general journal entry looks like a credit sale,
except that the Account Receivable is from the Credit Card Company -- not the
customer:
At the time of the sale:
D. Accounts Receivable – Credit Card Company
Cr. Sales Revenue
$1,000
$1,000
At the time payment is received from the credit card company:
D. Cash
Credit Card Discount/Service Charge Expense
Cr. Accounts Receivable – Credit Card Company
$970
30
$1,000
Most major credit card companies make the cash available to the vendor
immediately. Your book only discusses this situation. Because the funds are
made available within a few hours, there is no need to record an account
receivable from the credit card company. Instead, the transaction is treated as a
cash sale with a fee being paid to the credit card company:
D. Cash
Credit Card Discount/Service Charge Expense
Cr. Sales Revenue
$970
30
$1,000
The Credit Card Discount can be handled as either a selling expense or as a
contra revenue, which is deducted before getting Net Sales. Your book takes the
position that the credit card fees are treated as a selling expense.
Sales Returns and Allowances
If a customer returns merchandise that he or she has purchased, you want to
undo the sale. You debit a contra-revenue account (Sales Returns &
Allowances) that will be deducted from Sales Revenue in order to compute Net
Sales. This gives management important information about what kind of returns
the company is experiencing.
Undo the sales revenue:
D. Sales Returns and Allowances
Cr. Accounts Receivable
$300
$300
Undo the cost side of the sale:
D. Merchandise Inventory
Cr. Cost of Goods Sold
$140
$140
Sales Discounts
If you offer customers a reduction in price if they pay the invoice quickly, these
discounts are referred to as sales discounts or a cash discount. You would use
the same credit terms/discount notation discussed under Purchase Discounts
(e.g., 2/10 n/30).
The entry at the time of sale:
D. Accounts Receivable
Cr. Sales/Sales Revenue
$3,500
$3,500
If the payment is received during the discount period:
D. Cash
Sales Discounts
Cr. Accounts Receivable
$3,430
70
$3,500
If the payment is not received during the discount period, then the general journal
entry when the payment is made is:
D. Cash
Cr. Accounts Receivable
$3,500
$3,500
Sales Discounts are treated as a contra revenue account (offsets Revenue in
order to get Net Sales.
Sales Taxes
Most states and many cities levy a sales tax on retail transactions, and the
federal government also charges an excise tax on some products. The merchant
must collect the taxes from the customer at the time of the sale and record the
receipt of cash and the proper tax liabilities. The merchant is not paying the tax,
he or she is collecting it from the customer on behalf of the government.
D. Cash
Cr. Sales
Sales Tax Payable
$1,080
$1,000
80
When the sales tax is paid:
D. Sales Tax Payable
Cr. Cash
$80
$80
Trade Discounts
A trade discount is when you offer customer a reduction from your regular prices.
The reduction is not tied to paying the invoice early. A good example would be a
volume discount. For example, the price of one unit may be $5.00 a unit, but if
the customer buys 10 units, then the unit price drops to $4.00. An “After
Christmas Sale” is a trade discount. The sale is reported at the discounted price
(the lower price), and there is no account for trade discounts.
Net Sales
Net Sales is Sales Revenue reduced by the contra-revenue accounts:
Sales Revenue
Less: Sales Returns and Allowances
Sales Discounts
Credit Card Discounts (if treated as a contra-revenue account)
Net Sales
$480,000
-12,000
-8,000
-6,000
$454,000
Classified Income Statements
In a single-step income statement, the revenues section lists all revenues,
including other income, and the operating costs section lists all expenses,
including other expenses.
Many companies, however, use multiple-step income statement that is more
detailed, containing several subtractions and subtotals. Often, corporations
present condensed financial statements with only major categories of the
financial statement.
Income Statement
For Year Ending December 31, 20XX
Net Sales
$460,000
Less: Cost of Goods Sold
-316,000
Gross Margin/Profit
$144,000
Less: Operating Expenses
Income From Operations
-114,000
$30,000
Other Revenue & Gains
Less: Other Expenses & Losses
Income Before Income Taxes
3,600
-2,000
$31,600
Less: Income Tax Expense
Net Income
-10,100
$21,500
Gross Margin/Profit
Net Sales less Cost of Goods Sold gives you a company’s Gross Margin. This is
also called the Gross Profit. This profit or margin gives you the merchandising
profit. Analysts look at this figure because it gives information about the
company’s market. High gross margins indicate that the sector isn’t very
competitive. The personal computer market in the 1970s & 1980s was
characterized by high gross margins. During the 1990s, the personal computer
market became very competitive and was characterized by shrinking gross
margins.
Operating Expenses
Operating Expenses are:
•
•
sales expenses and
general & administrative expenses
Unlike Gross Margins, which may be viewed as a function of the marketplace,
Operating Expenses are a direct result of the management of the company.
(How good is the company in controlling its expenses?)
If you subtract the Operating Expenses from the Gross Margin and, you have
Income From Operations. Financial Analysts consider Income From Operations
very important because it represents the major operations of the company. It is
viewed as sustainable, and analysts consider it a good indication of future
performance.
Nonoperating Activities
Although your book treats Nonoperating Activities as two different items on a
classified income statement, most companies treat it as one item called Other
Revenues and Expenses. Nonoperating activities are made up of nonoperating
revenues & gains (e.g., dividends income, interest income, and gains from sales
of assets) and nonoperating expenses & losses (e.g., interest expense and
losses from sales of assets).
After Income From Operations, you subtract Other Revenues and Expenses.
Remainder of Classified Income Statement
Income From Operations less Other Revenues and Expenses gives you Income
Before Income Taxes.
Income Taxes (Income Tax Expense or Provision For Income Taxes) represent
the taxes owed on the income appearing on the financial statement.
After Income Taxes are deducted, you have Net Income.
Below Net Income, a corporation also reports the Net Income earned for each
share of common stock (Earnings Per Share).
Example of Multiple-Step Income Statement
Shafer Auto Parts Corporation
Income Statement
For the Year Ended December 31, 20XX
Revenues from Sales
Cost of Goods Sold
Gross Margin from Sales
Operating Expenses
Selling Expenses
General and Administrative Expenses
Total Operating Expenses
Income from Operations
Other Revenues and Expenses
Interest Income
Less: Interest Expense
Excess of Other Expenses over Other Revenues
Income Before Income Taxes
Income Taxes
$289,656
-181,260
$108,396
$ 54,780
34,504
$1,400
-2,631
-89,284
$19,112
-1,231
$17,881
-3,381
Net Income
$14,500
Earnings per share
$ 2.90
Example of Single-Step Income Statement
Shafer Auto Parts Corporation
Income Statement
For the Year Ended December 31, 20XX
Revenues
Net Sales
Interest Income
Total Revenues
Costs & Expenses
Cost of Goods Sold
Selling Expenses
General and Administrative Expenses
Interest Expense
Income Tax Expense
Total Costs and Expenses
Net Income
$289,656
$1,400
$181,260
54,780
34,504
2,631
1,231
Earnings per share
$291,056
-276,556
$14,500
$ 2.90
Additional Profitability Ratios
Your book notes that there are two additional profitability ratios:
•
•
Gross Profit Rate (Gross Margin Percentage)
Operating Expenses to Sales Ratio
Gross Profit Rate
This ratio is also called the Gross Margin Percentage. As noted above, a
company’s gross margin is an important indicator of the competitiveness of the
company’s markets. Gross Margin is a raw number, and financial analyst’s
prefer a ratio that can be compared to the figures from other years within a
company, and figures from other companies. This ratio is obtained by dividing
the Gross Margin by Net Sales:
Gross Profit/Margin
------------------------------------Net Sales
Profit Margin Ratio
This ratio divides the net income by the Net Sales.
Net Income
---------------Net Sales
The ratio allows you to compare the profitability of different firms of different
sizes.
Operating Expenses To Sales Ratio
This ratio indicates how well the company’s management is able to control its
operating expenses:
Operating Expenses
------------------------------------Net Sales
Illustration
Sportcraft. a wholesaler of sporting goods, had the following trial balance at
December 31 of the current year:
Sportcraft
Trial Balance
December 31, 20XX
Cash
Accounts Receivable
Inventory, January 1
Office Supplies
Prepaid Insurance
Land
Building
Less: Accumulated Depreciation-Building
Office Equipment
Accumulated Depreciation--Office Equipment
Accounts Payable
Common Stock
Dividends
Sales
Sales Discounts
Purchases
Purchases Returns and Allowances
Transportation In
Sales Salaries Expense
Transportation Out
Advertising Expense
Office Salaries Expense
Debit
$ 6,200
28,000
45,000
800
2,100
34,000
82,000
21,300
10,000
3,500
151,000
8,200
27,600
7,800
6,100
22,300
-----------$455,900
=======
Credit
$ 16,000
5,300
19,000
161,200
252,000
2,400
------------$455,900
=======
The following information is available at December 31:
a. Office supplies on hand at December 31 are $250.
b. Prepaid insurance at December 31 is $1,500.
c. Depreciation for the year is building, $2,000; office equipment, $2,400.
d. Salaries payable (but not yet accrued) at December 31 are sales salaries,
$300; office salaries, $200.
e. Inventory at December 31 is $43,500.
Required:
•
•
•
•
Prepare adjusting entries in general journal form.
Prepare closing entries in general journal form.
Prepare a classified income statement for the year.
Prepare a classified balance sheet at December 31.
Adjusting Entries:
D. Office Supplies Expense
Cr. Office Supplies on Hand
550
D. Insurance Expense
Cr. Prepaid Insurance
600
D. Depreciation Expense--Building
Depreciation Expense--Office Equipment
Cr. Accumulated Depreciation--Building
Accumulated Depreciation--Equipment
D. Sales Salaries Expense
Office Salaries Expense
Cr. Salaries Payable
2,000
2,400
300
200
550
600
2,000
2,400
500
Closing entries:
D. Income Summary
Cr. Inventory (January 1)
Sales Discounts
Purchases
Transportation In
Sales Salaries
Transportation Out
Advertising Expense
Office Salaries Expense
Office Supplies Expense
Insurance Expense
Depreciation Expense -- Building
Depreciation Expense -- Equipment
277,550
D. Inventory (December 31)
Sales
Purchases Returns and Allowances
Cr. Income Summary
43,500
252,000
2,400
45,000
3,500
151,000
8,200
27,900
7,800
6,100
22,500
550
600
2,000
2,400
297,900
D. Income Summary
Cr. Retained Earnings
20,350
D. Retained Earnings
Cr. Dividends
10,000
20,350
10,000
Sportcraft
Income Statement
For Year Ending December 31, 20XX
Revenue
Sales
Less: Sales Discounts
Net Sales
Cost of Goods Sold
Inventory, January 1
Add: Net Cost of Purchases
Purchases
Less: Purch. Ret & Allow
Add: Freight In
Net Cost of Purchases
Cost of Goods Available for Sale
Less: Inventory, December 31
Cost of Goods Sold
Gross Margin
$252,000
3,500
$248,500
$ 45,000
$151,000
2,400
$148,600
8,200
156,800
$201,800
-43,500
-158,300
$ 90,200
Operating Expenses
Selling Expenses
Sales Salaries Expense
Transportation Out
Advertising Expense
Total Selling Expenses
General and Admin. Expenses
Office Salaries Expense
Office Supplies Expense
Insurance Expense
Depreciation Expense--Building
Depreciation Expense--Equip.
Total Gen. and Adm. Exp.
Total Operating Expenses
Net Income
$27,900
7,800
6,100
$ 22,500
550
600
2,000
2,400
$41,800
$28,050
-$69,850
$ 20,350
Assets
Sportcraft
Balance Sheet
December 31, 20XX
Current Assets
Cash
Accounts Receivable
Inventory
Office Supplies
Prepaid Insurance
Total Current Assets
$ 6,200
28,000
43,500
250
1,500
Long-term Assets:
Land
Building
Less: Accum. Depre.
$82,000
-18,000
Office Equipment
Less: Accum. Depre.
$21,300
-7,700
Total Long-term Assets
Total Assets
$34,000
64,000
13,600
Liabilities & Shareholders’ Equity
Current Liabilities:
Accounts Payable
Salaries Payable
Total Current Liabilities
Shareholders’ Equity:
Common Stock
Retained Earnings
Total Shareholders’ Equity
Total Liabilities & Shareholders’ Equity
$ 79,450
$19,000
500
$161,200
10,350
111,600
$191,050
=======
$19,500
171,550
$191,050
=======