CHAPTER 5
Merchandising Operations and the Accounting Cycle
Chapter Outline
The chapter begins with defining what a merchandising company is by naming many well-known
Canadian retailers as examples and contrasts them to the service company. Exhibit 5-1 presents the
differences between a service company and a merchandise company’s financial statements.
Learning Objective 1: Use sales and gross margin to evaluate a company
A.
Key terms are introduced:
a.
Products sold are called inventory.
b.
The revenue from the sale of the product is called Sales Revenue, or simply Sales.
c.
The cost of goods sold, or cost of sales, is the major expense of a merchandising
company.
d.
The gross margin or gross profit is calculated as follows:
Sales revenue – Cost of goods sold = Gross margin
B.
Expenditures that can be included in the cost of inventory are explained using the purchase of a
leather handbag by Danier Leather Inc. The guiding principle is: “The cost of any asset is the sum
of all the costs incurred to bring the asset to its intended use”. In the case of inventory the
intended use is to sell the asset, so costs incurred to bring the inventory to “ready for sale” – NOT
the cost of selling the inventory, including costs such as advertising and sales staff salaries.
C.
The operating cycle is the length of time that is required for a business to purchase inventory,
sell the inventory, and collect the cash from the sale so that the cycle can begin again. For most
retailers, this cycle is less than a year, as the more inventory they can sell, the more money they
can make.
D.
Two different inventory systems are used by businesses.
1.
The periodic system is used by businesses that sell relatively inexpensive goods, and/or
cannot afford a computerized inventory system. A big bin of nails in the local hardware
store is most likely accounted for using the periodic system. Under the periodic system,
inventory is counted periodically, but the level of inventory between inventory counts is
not maintained.
2.
The perpetual system maintains a running count of the amount of inventory on hand.
This system is often combined with a computerized inventory system. The use of
computers in business has made this system the most widely used. This system ensures
information regarding inventory is current, which is very useful for decision makers.
3.
The text illustrates both methods, but the emphasis is placed on the perpetual system.
Appendix A is dedicated the periodic system.
Learning Objective 2: Account for the purchase and sale of inventory under the perpetual inventory
system
A.
The purchase of inventory involves a new account, Inventory.
1.
The purchase transaction is initiated with a source document called a purchase order.
The purchase order lists the merchandise to be ordered from the supplier and is sent to the
supplier.
2
B.
2.
A purchase invoice (illustrated the Exhibit 5-3) is the supplier’s request for payment
from the purchaser. The purchase of inventory on credit is recorded as follows:
Inventory
XX
Accounts Payable
XX
3.
The following discounts may be available to the purchaser:
a.
A quantity discount may be offered for bulk purchases but is not recorded in the
accounts. The purchase is recorded at the list price less the quantity discount.
b.
An invoice contains terms of payment that may include a purchase discount
and the date by which the invoice must be paid.
(1)
A purchase discount is a reward for prompt payment. The discount
reduces the cost of the purchase.
(2)
The terms 3/15 n/30 indicate to the purchaser that a 3% discount is
offered if the invoice is paid within 15 days, or the full amount of the
invoice is due in 30 days.
(3)
The discount is recorded when the payment is made:
Accounts Payable
XX
Inventory (discount)
XX
Cash
XX
(4)
If the discount is not taken, the entry is:
Accounts Payable
XX
Cash
XX
4.
Merchandise returned to the seller and allowances granted to the purchaser for
damaged goods decreases the liability and decrease the cost of inventory. Thus, it is
recorded as follows:
Accounts Payable
XX
Inventory
XX
5.
The purchase agreement specifies FOB terms (free on board) to indicate who pays the
shipping charges on purchased merchandise. Exhibit 5-4 summarizes these terms.
a.
FOB shipping point indicates that the buyer bears the shipping costs. Title
passes to the buyer upon shipment of the goods. This method is more common
than FOB destination.
b.
FOB destination indicates that the seller bears the shipping costs. Title passes to
the buyer upon receipt of the goods. This is less common.
c.
Transportation costs, often called freight in, are added to the cost of the
inventory and are not subject to the purchase discount.
Inventory
XX
Cash X
XX
d.
Freight out (Delivery Expense) on inventory sold is not added to the inventory
but is considered an expense. Therefore, it would not be included in COGS or in
the gross margin calculation studied earlier in the chapter.
Delivery Expense
XX
Cash
XX
The sale of inventory is the next step in the operating cycle and can be for cash or on account. In
this step, the merchandiser has changed roles from purchaser to seller.
1.
A sale requires two entries.
a.
The entry to record the sale:
Cash (or Accounts Receivable) XX
Sales Revenue
XX
3
b.
The entry to update the inventory:
Cost of Goods Sold
Inventory
XX
XX
2.
A sales discount is a cash incentive granted to the customer to encourage prompt
payment (this is the same thing as a purchase discount but from the seller’s perspective –
the one offering the discount). Sales discounts are recorded in the contra revenue account,
Sales Discounts, when the account receivable is collected.
Cash
XX
Sales Discounts
XX
Accounts Receivable
XX
3.
Merchandise returned by customers and allowances granted to customers are recorded in
the contra revenue account, Sales Returns and Allowances. (Note sales discounts are
not taken on returned merchandise.)
a.
Both returns and allowances require this first entry:
Sales Returns and Allowances XX
Accounts Receivable (or Cash) XX
b.
4.
Only when merchandise is returned is this second entry needed:
Inventory
XX
Cost of Goods Sold
XX
Net sales is computed as follows:
Sales revenue – Sales discounts – Sales returns and allowances = Net sales
Learning Objective 3: Adjust and close the accounts of a merchandising business under the perpetual
inventory system
A.
Adjusting entries are prepared as in Chapter 4 with the addition of an adjusting entry for
inventory.
Even though a perpetual inventory system continuously records increases and decreases in
inventory, what is recorded in the ledger doesn’t always match the actual amount of inventory
physically in the warehouse or the stores. The reason is due to accounting errors, theft, or
damage. Thus, one additional adjusting entry is required to adjust the ledger balance of Inventory
to match the physical count of the inventory. Any difference is adjusted through Cost of Goods
Sold and Inventory.
1.
2.
B.
To reduce Inventory to its physical count:
Cost of Goods Sold
Inventory
XX
Or, to increase Inventory to its physical count:
Inventory
XX
Cost of Goods Sold
XX
XX
The closing entries in this chapter are prepared as in Chapter 4 with the addition of some new
temporary accounts that must be closed— Sales Discounts, Sales Returns and Allowances, and
Cost of Goods Sold. Exhibit 5-6 illustrates the closing entries for a merchandiser.
Learning Objective 4: Prepare a merchandiser’s financial statements under the perpetual inventory
system
4
A.
The income statement for a merchandising company shows classification of income statement
accounts in the following order (as illustrated in Exhibit 5-7):
1.
Net sales
2.
Cost of goods sold
3.
Gross margin
4.
Operating expenses
5.
Income from operations, or operating income, equals gross margin less operating
expenses.
6.
Other revenue and expense are revenues and expenses outside the main operations of
the business, such as interest expense, interest revenue, and gains and losses on the sale
of assets.
7.
Net income equals income from operations plus other revenues and minus other
expenses.
B.
The statement of owner’s equity is the same as in Chapter 4.
C.
The balance sheet is similar to the one in Chapter 4 except for the addition of Inventory, a
current asset.
D.
Two formats of the income statement are the multiple-step and the single-step.
1.
The income statement presented thus far in the chapter is a multiple-step income
statement, which presents gross margin and income from operations—two key
measures of operating performance.
2.
The advantage of a single-step format is that it groups all revenues together and then
deducts all expenses together. This format is popular with service companies.
Learning Objective 5: Use the gross margin percentage and the inventory turnover ratio to evaluate a
business
A.
The gross margin percentage expresses the relationship of an entity’s gross margin to its sales.
1.
The gross margin percentage is important to retail businesses. A change in the gross
margin percentage may be an indication that the business must take corrective action.
2.
Exhibit 5-9 illustrates the gross margin percentage for Slopes Ski Shop and Wal-Mart.
Wal-Mart’s is much lower. The computation is:
Gross margin percentage = Gross margin / Net Sales Revenue
B.
The inventory turnover indicates how rapidly inventory is being sold.
1.
A business desires to sell its inventory as quickly as possible.
2.
Exhibit 5-10 illustrates inventory turnover for Slopes Ski Shop and Wal-Mart. Wal-Mart
turns over its inventory much faster. The computation is:
Inventory turnover = Cost of goods sold / Average inventory
Average inventory = (Beginning inventory + Ending inventory) ÷ 2
Drawing an overall conclusion about a merchandiser using only these two ratios is not advisable
as they do not provide enough information. However, these ratios do illustrate how accounting
information is used to manage a business.
Learning Objective 6: Describe the merchandising-operations effects of international financial
reporting standards (IFRS).
The procedures explained in this chapter also apply to companies reporting under IFRS.
5
Two concepts from earlier chapters remain important:
1.
The recognition of revenue—Goods have must have been delivered and the likelihood
of the goods being returned is small. For companies with a generous return policy,
estimates must be made for returns before revenue can be recognized. This policy is
explicitly stated in the IFRS guidelines and it applies equally to companies reporting
under ASPE.
2.
The matching of costs to sales—to ensure that the gross margin can be properly
determined. This is key for helping users of the financial statements in evaluating the
profitability of the company.
Appendix A
Learning Objective A1: Account for the purchase and sale of inventory under the periodic inventory
system
A.
The periodic system is used by businesses that cannot justify the expense of using a perpetual
system. The inventory account is not updated when inventory is sold.
1.
An expense account called Purchases is used to accumulate the cost of all merchandise
purchased.
2.
The entry to record the purchase of merchandise is:
Purchases
XX
Accounts Payable (or Cash)
XX
3.
A purchase discount is recorded when the invoice is paid. A contra expense account,
Purchase Discounts, is used to accumulate the amount of discounts taken. Note with the
periodic inventory system discounts are tracked separately in their own account unlike
the perpetual inventory system.
Accounts Payable
XX
Cash
XX
Purchase Discounts
XX
4.
Merchandise that is returned or allowances granted for damaged merchandise are
recorded in the contra expense account, Purchase Returns and Allowances.
Accounts Payable
XX
Purchase Returns and Allowances XX
5.
Net Purchases is the remainder after subtracting the contra accounts from Purchases.
Purchases (debit balance) – Purchases discounts (credit balance) – Purchase returns and
allowances (credit balance) = Net purchases
6.
The costs of transporting the merchandise from the seller to the buyer are debited to an
expense account called Freight In. Freight charges increase the cost of purchasing
inventory.
Freight In
XX
Cash
XX
B.
Recording sales in a periodic inventory system is more streamlined as it requires only one entry to
record the sale.
Accounts Receivable or Cash XX
Sales Revenue
XX
Learning Objective A2: Compute the cost of goods sold under the periodic inventory system
A.
Exhibit 5A-1 shows the computation for cost of goods sold in the periodic inventory system.
6
Beginning inventory + Net purchases (Purchases less discounts and less returns and allowances)
+ Freight in = Cost of goods available for sale - Ending inventory = Cost of goods sold
B.
Because there is no Cost of Goods Sold account in the periodic inventory system, such a
calculation is necessary for decision making and for creating the income statement.
C.
Exhibit 5A-2 shows an Income Statement with detailed calculations for Net sales and Cost of
goods sold reporting results of operations to Gross margin. Note in real life most companies
would not show this much detail on the face of the income statement. They might choose to show
it in the financial statement notes or they might choose not to show it at all.
Learning Objective A3: Adjust and close the accounts of a merchandising business under the periodic
inventory system
A.
The end-of-the-period procedures begin with preparation of the work sheet. Exhibit 5A-3 is a
trial balance with accounts that will be used to illustrate the adjusting and closing entries.
B.
The adjusting entries are the same as for a service type business as demonstrated in Chapter 4.
C.
The closing entries under the periodic inventory system are similar to those studied in Chapter 4.
Two additional closing entries (see number 3 and 4 below) are required to adjust the inventory
balance and to include all components of the COGS equation in the income summary. Exhibit
5A-4 illustrates the closing entries for Slopes Ski Shop.
1.
The first closing entry debits all accounts in the credit column of the income statement on
the work sheet. These accounts include Purchase Discounts, Purchase Returns and
Allowances, and Inventory (ending balance).
2.
The second closing entry credits all accounts in the debit column of the income statement
on the work sheet. These accounts include Sales Returns and Allowances, Sales
Discounts, Freight in, and Inventory (beginning balance).
3.
The third closing entry debits Income Summary and credits Inventory for the amount of
the beginning balance of the Inventory.
4.
The fourth closing entry debits Inventory and credits Inventory for the amount of the
ending balance of Inventory.
5.
The fifth closing entry closes Net Income to the Capital account.
6.
The sixth closing entry closes the owner Withdrawals into the Capital account.
Learning Objective A4: Prepare a merchandiser’s financial statements under the periodic inventory
system
A.
The financial statements are prepared after the work sheet is completed. Exhibit 5A-5 illustrates
the financial statements.
B.
The income statement is the same as studied earlier in Chapter 4 except for the Cost of Goods
Sold. In fact virtually all companies show COGS in a streamlined fashion as shown in Exhibit 57.
C.
The statement of owner’s equity is the same as in Chapter 4.
D.
The balance sheet is similar to the one in Chapter 4..
Appendix B
Learning Objective B1 – Compare the perpetual and periodic inventory systems
Exhibit 5B-1 provides a detailed comparison of the perpetual versus periodic Inventory systems. The key
differences are:
1)
Purchases of inventory are recorded as expenses throughout the year
7
2)
3)
Journalizing sale transactions only requires 1 journal entry
Inventory on the balance sheet is not adjusted until the end of the accounting period and
COGS sold has been determined.
Appendix C
Learning Objective C1 – Describe the basic elements of sales taxes, HST, GST, and PST
A.
Goods and Services Tax (GST) - The GST is a consumption tax (passed on to the final
purchaser) levied on most goods and services sold in Canada. Basically, a business pays GST on
purchases, collects GST on goods sold and remits the net amount to the Receiver General at the
Canada Revenue Agency (CRA). There are various ways to account for GST. The text has
adopted the following approach:
1.
2.
3.
To record the purchase of Inventory
Inventory
GST Recoverable
Accounts Payable
XX
XX
To record the sale of Inventory
Cash
GST Payable
Sales Revenue
XX
XX
XX
To reconcile GST accounts at end of reporting period
GST Payable
XX
GST Receivable
Cash
XX
XX
XX
The above scenario reflects GST collected on sales being greater than GST paid on purchases;
therefore, the business is liable to remit the net GST owing to the Receiver General.
B.
Provincial Sales Tax (PST) - The PST is an end-user tax thus the merchandiser does not pay PST.
They are responsible for charging and collecting PST on behalf of the provincial government.
Many provinces have combined the collection of their PST with GST and call it HST
(harmonized sales tax). In those cases HST is collected and accounted in the same manner as
GST (described above).