Accounting Chapter 5 Outline PDF

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Beverley Alleyne...

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Chapter 5: Handout for Student Notes LO 1. What are merchandising operations? Merchandiser: business that sells merchandise, or goods, to customers Merchandise Inventory: merchandise that a business sells to customers Two Types of Merchandisers: Wholesalers and Retailers Wholesalers: type of merchandiser who buys goods from manufacturers and then sells them to retailers ➢ Retailers: type of merchandiser who buys merchandise either from a manufacturer or a wholesaler and then sells those goods to customers ➢ ➢ ➢ ➢

○ The operating cycle of a merchandising business 1. Begins when company purchases inventory from individual or business called a vendor 2. Company then sells inventory to a customer 3. Finally company collects cash from customers Merchandiser Income Statement: Sales Revenue, Cost of Goods Sold (cost of merchandise inventory that the business has sold to customers) aka Cost of Sales, Gross Profit (excess of Net Sales Revenue over Cost of Goods Sold) aka Gross Margin, Operating Expenses (expenses other than COGS that are incurred in entity’s major ongoing operations) ➢ Merchandiser Balance Sheet: includes Merchandise Inventory in Current Assets section (inventory business has on hand to sell) which is listed below Accounts Receivable but before prepaid assets

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○ Merchandise inventory systems: Perpetual and periodic inventory systems ➢ Two main types of inventory accounting systems that are used: Periodic Inventory and Perpetual Inventory System ➢ Periodic Inventory System: requires businesses to obtain a physical count of inventory to determine the quantities on hand, normally used for relatively inexpensive goods (restaurants, small retail stores, less and less popular) ➢ Perpetual Inventory System: keeps a running computerized record of merchandise inventory, the number of inventory units and dollar amounts associated with the inventory are perpetually (constantly) updated, better control of inventory, modern system records units purchased and cost amounts, units sold and sales and cost amounts, and the quantity of merchandise inventory on hand and its cost ➢ In perpetual inventory system merchandise inventory and purchasing systems are integrated with records for Accounts Receivable and Sales Revenue (e.g. bar codes); “cash register” at store is computer terminal that records sales and updates inventory records ➢ Even in perpetual inventory business must count inventory at least once a year, captures inventory transactions that are not recorded by the electronic system (such as misplaced, stolen, or damaged inventory), establishes correct amount of ending inventory for the financial statements and serves as check on perpetual records

LO 2. How are purchases of merchandise inventory recorded in a perpetual inventory system? ➢ Invoice: seller’s request for payment from the buyer, aka the bill

○ Purchase of merchandise inventory ➢ Merchandise Inventory asset account used only for goods purchased that the business owns and intends to resell to customers ➢ Example: Purchase of Merchandise Inventory -> Merch. Inv. Debited and Cash Credited ➢ Example: Receives Merchandise Inventory on Account -> Merch. Inv. Debited and Accounts Payable Credited

○ Purchase discounts

➢ Purchase Discount: discount that businesses offer to purchasers as an incentive for early payment ➢ Credit Terms: the payment terms of purchase or sale as stated on the invoice. Example: “3/15, NET 30 DAYS” -> Company can deduct 3% from total bill (excluding freight charges if applicable) if the company pays within 15 days of the invoice date. Otherwise the full amount (NET) is due in 30 days. Also can be expressed as “3/15, n/30” (n/30 means no discount is offered and payment is due 30 days after the invoice date) ➢ Most credit terms express discount, discount time period, and final due date. Occasionally credit terms are expressed as EOM, which means payment is due at end of the current month ➢ After purchasing inventory on account, if company pays within discount period -> Accounts Payable Debited, Cash (Original Amount - Discount) Credited, Merchandise Inventory (Original Amount x Deduction Percentage) Credited

○ Purchase returns and allowances ➢ Purchase Return: situation in which sellers allow purchasers to return merchandise that is defective, damaged, or otherwise unsuitable ➢ Purchase Allowance: amount granted to the purchaser as an incentive to keep goods that are not “as ordered” ➢ Purchase Returns and Allowances decrease buyer’s cost of the merchandise inventory ➢ Example: Return inventory to seller before bill has been paid -> Accounts Payable Debited, Merchandise Inventory (Number of units x Price per unit) Credited ➢ Same entry for purchase allowance ➢ Example: Return Merchandise Inventory or receive allowance before payment made and before discount period -> Merchandise Inventory Debited, Accounts Payable Credited (“Purchased Inventory on account”); Accounts Payable Debited, Merchandise Inventory (“Returned Inventory To Seller”); Accounts Payable (Original - Returned) Debited, Cash (Original - Returned - Discount) Credited, Merchandise Inventory ((Original - Returned) x Discount Percentage) Credited (“Paid within discount period net of return”)

○ Transportation costs ➢ Either buyer or seller pays transportation cost of shipping merchandise inventory ➢ Purchase Agreement specifies FOB (Free on Board) terms to determine when title to goods transfers to purchaser and who pays the freight ➢ FOB Shipping Point: buyer takes ownership (title) to the goods after the goods leave the seller’s place of business (shipping point). Most cases buyer (owner of the goods while in transit) also pays freight ➢ FOB Destination: buyer takes ownership (title) to the goods at the delivery destination point. Most cases seller (owner of goods while in transit) also pays freight. When merchandisers are required to pay for shipping costs those costs are classified as either freight in or freight out ➢ Freight In: transportation cost to ship goods into the purchaser’s warehouse; freight in on purchased goods ➢ Freight Out: transportation cost to ship goods out of the seller’s warehouse and to the customer; freight on goods sold to customer

■ Freight in ➢ With terms FOB Shipping Point: freight in becomes part of the cost of merchandise inventory (because freight is a cost that must be paid to acquire inventory) ➢ Merchandise Inventory Debited, Cash Credited (“Paid a Freight Bill”)

■ Freight in within discount period ➢ Discounts only computed on merchandise purchased from seller.

Discounts not computed on transportation costs because there is no discount on freight ➢ With terms FOB Shipping Point: seller sometimes prepays transportation cost as a convenience and lists this cost on invoice -> Merchandise Inventory (Purchase of Goods + Freight Charge) Debited, Accounts Payable (Purchase of Goods + Freight Charge) Credited (“Purchased Inventory on account including freight”) ➢ If buyer pays within discount period the discount will be computed only on purchase of merchandise cost not on total invoice of Purchase of Goods + Freight Charge (Freight charge not eligible for discount) -> Accounts Payable (Purchase of Goods + Freight Charge) Debited, Cash (POG + FC - Discount) Credited, Merchan. Inv (Purchase of Goods x Discount Percentage) Credited (“Paid within discount period including freight)

○ Cost of inventory purchased ➢ Net Cost of Inventory Purchased = Purchase Cost of Inventory - Purchase Returns and Allowances - Purchase Discounts + Freight In ➢ Purchases, Less: Purchase Returns and Allowances, Purchase Discounts, Plus: Freight In, Net Cost of Inventory Purchased

LO 3. How are sales of merchandise inventory recorded in a perpetual inventory system? ○ Cash and credit card sales ➢ Credit Card sales are recorded as cash sales ➢ Sales Revenue: amount a business earns from selling merchandise inventory ➢ At time of sale -> entry crediting Sales Revenue and debiting Cash (or A/R) at time of sale, another entry debiting Cost of Goods Sold and crediting Merchandise Inventory ➢ Cost of Goods Sold account keeps current balance throughout period in a perpetual inventory system of cost of merchandise inventory sold, always based on company’s cost

○ Sales on account ➢ First entry: Accounts Receivable Debited, Sales Revenue Credited ➢ Second entry: Cost of Goods Sold Debited, Merchandise Inventory Debited

○ Sales discounts ➢ Sales Discounts: decrease the net amount of revenue earned on sales ➢ Sales recorded at net amount or amount of sale less any sales discounts ➢ First entry: A/R Debited, Sales Revenue (Original - (Original x Discount Percentage)) Credited ➢ Second entry: Cost of Goods Sold Debited, Merchan. Inv. Credited ➢ When customer pays within discount period -> Cash (from A/R value) Debited, A/R Credited ➢ If customer does not pay within discount period -> Cash (Original Amount) Debited, A/R (discounted price) Credited, Sales Discounts Forfeited (Original x Discount Percentage)

○ Sales returns and allowances ➢ Sales Returns and Allowances: customer’s return of merchandise or an allowance granted to the customer

■ Estimating sales returns ➢ Sales Revenue x Estimated Percentage of merchandise sold will be returned; Merchandise Inventory x Estimated Percentage of merchandise sold will be returned ➢ First entry: Sales Revenue Debited, Refunds Payable Credited ➢ Second entry: Estimated Returns Inventory Debited, Cost of Goods Sold

Credited

■ Actual return of inventory ➢ First entry: Refunds Payable Debited, Cash Credited ➢ Second entry: Merchandise Inventory Debited, Estimated Returns Inventory Credited

■ Sales allowance ➢ Sales allowance: when customers requests a refund of some portion owed but does not return inventory ➢ Refunds Payable Debited, A/R Credited

○ Transportation costs—Freight out ➢ Freight out is a delivery expense to the seller so it is an operating expense and debited to the Delivery Expense account ➢ Delivery Expense Debited, Cash Credited

LO 4. What are the adjusting and closing entries for a merchandising business? ➢ Adjusts and closes the same way a service entity does but also adjust for inventory shrinkage

○ Adjusting merchandise inventory based on a physical count ➢ Actual amount of inventory on hand may differ from what the books show because of theft, damage, and errors ➢ Inventory Shrinkage: loss of inventory that occurs because of theft, damage, and errors ➢ Businesses take physical count of inventory at least once a year because of this ➢ Most common time to count inventory is at the end of fiscal year, business adjusts Merchandise Inventory account based on physical count, record adjusting entry to account for loss inventory ➢ Adjusting Entry = Merchandise Inventory Balance Before Adjustment - Actual Merchandise Inventory on Hand ➢ Cost of Goods Sold Debited (from adjusting entry calculation), Merch. Inv. Credited

○ Closing the accounts of a merchandiser ➢ Step 1: Make revenue accounts equal zero via Income Summary account ➢ Step 2: Make expense accounts equal zero via Income Summary account ➢ Step 3: Make Income Summary account equal zero via Retained Earnings account, transfers net income/loss to Retained Earnings ➢ Step 4: Make Dividends account equal zero via Retained Earnings account

LO 5. How are a merchandiser’s financial statements prepared? ○ Income statement ■ Single-step income statement ➢ Single-Step Income Statement: groups all revenues together and all expenses together without calculating other subtotals, clearly distinguishes revenues from expenses and works well for service entities because no gross profit to report

■ Multi-step income statement ➢ Multi-Step Income Statement: lists several important subtotals to highlight significant relationships, reports net income, gross profit, and operating income ➢ Selling Expenses: expenses related to marketing and selling company’s goods and services, include sales salaries, sales commissions, advertising, depreciation on store buildings and equipment, store rent, utilities on store buildings, property taxes on store buildings, and delivery expense ➢ Administrative Expenses: expenses incurred that are not related to marketing the company’s goods and services, include office expenses,

depreciation on office buildings and equipment, rent other than on stores (rent on admin office), utilities other than on stores (utilities on admin office), property taxes on admin office building ➢ Operating Income: measures results of entity’s major ongoing activities. Gross Profit - Operating Expenses ➢ Other Income and Expenses: reports revenues and expenses that fall outside business’ main day to day regular operations, include interest revenue, sales discounts forfeited, interest expense, gains and losses on sale of plant assets ➢ Income Tax Expense: reports federal and state income taxes that are incurred by corporation

○ Statement of retained earnings and the balance sheet ➢ Statement of retained earnings exactly the same as service business ➢ Balance sheet same as service business but merchandisers have additional current asset accounts, Merchandise Inventory and Estimated Returns Inventory, and additional current liability account, Refunds Payable (represents estim. amount of refunds that are due)

LO 6. How do we use the gross profit percentage to evaluate business performance? ➢ Gross Profit Percentage: measures profitability of each sales dollar above cost of goods sold. Gross Profit Percentage = Gross Profit / Net Sales Revenue ➢ Reflects business’ ability to earn profit on merchandise inventory, must be high enough to cover the remaining operating expenses and to earn net income

LO 7. How are multiple performance obligations recorded in a perpetual inventory system? (Appendix 5A) ➢ When contracts involve multiple performance obligations the company is required to allocate the transaction price to each performance obligation separately ➢ Company should only recognize revenue when or as it satisfies each performance obligation (two year contract as Unearned Revenue) ➢ First entry: Cash debited, Sales Revenue and Unearned Revenue Credited ➢ Second entry: COGS Debited, Merchandise Inventory Credited

LO 8. How are merchandise inventory transactions recorded in a periodic inventory system? (Appendix 5B) ➢ Businesses must obtain a physical count of inventory to determine quantities on hand

○ Purchases of merchandise inventory ➢ All inventories use Merchandise Inventory account but in periodic inventory system, purchases, purchase discounts, purchase returns and allowances, and freight in costs are recorded in separate accounts during the year and then the Merchandise Inventory account is updated in closing process ➢ Receipt of Goods on Account: Purchases Debited, A/P Credited ➢ Payment of Goods: A/P Debited, Cash (Original - Discount) Credited, Purchase Discounts Credited

■ Recording purchase returns and allowances ➢ Company returning products to vendor: A/P Debited, Purchase Returns and Allowances Credited ➢ Instead of recording return to Merchandise Inventory, a separate account “Purchase Returns and Allowances” is used. Both Purchase Discounts and Purchase Returns and Allowances are contra expense accounts to the Purchases account ➢ Net Purchases: remainder after subtracting contra accounts from Purchases. Net Purchases = Purchases - Purchase Returns and Allowances - Purchase Discounts

■ Recording transportation costs ➢ Freight in is debited to a separate Freight In account (an adjunct expense account) as opposed to debiting Merchandise Inventory account ➢ Freight In Debited, Cash Credited

○ Sale of merchandise inventory ➢ Sale of inventory involves recording only the Sales Revenue portion ➢ Example: Company sold 10 units for a total sale of $5,000 on account with terms 2/10, n/30 ➢ A/R Debited, Sales Revenue ($5,000 - ($5,000 x .02)) Credited ➢ Accounting for sales discounts and sales returns and allowances is the same as in a perpetual inventory system except there are no entries for merchandise inventory

○ Preparing financial statements ➢ Similar to perpetual inventory system but periodic requires an additional calculation Cost of Goods Sold (must be computed separately) ➢ At end of each period the company combines a number of accounts to compute COGS for the period and calculation is shown on income statement ➢ Beginning Merch. Inv. + Purchases - Less: Purchase Returns and Allowances - Less: Purchase Discounts = Net Purchases + Plus: Freight In = Net Cost of Purchases + Begin. Merch. Inv. = Cost of Goods Available for Sale - Less: Ending Inventory (includes Estimated Returns Inventory) = Cost of Goods Sold

○ Adjusting and closing entries ➢ No need to record inventory shrinkage ➢ Determines ending Merchandise Inventory amount by taking a physical account of inventory ➢ Step 1: Sales Revenue and Sales Discount Forfeited are closed with debit via Income Summary account and all other temporary accounts with credit balances (Purchase Returns and Allowances and Purchase Discounts) are also closed. Ending Merchandise Inventory (determined from physical count) and Estimated Returns Inventory are recorded as debits ➢ Step 2: Expense accounts and other temporary accounts with debit balances are closed via Income Summary account and beginning Merch. Inv., Purchases, and Freight In are also closed via Income Summary account. Ending inventory is recorded with a debit entry and beginning inventory is removed with credit entry during closing process ➢ Step 3 and 4 are the same under both methods

LO 9. How are sales of merchandise inventory recorded in a perpetual inventory system using the gross method? (Appendix 5C) ○ Cash and credit card sales ○ Sales on account ○ Sales Discounts ■ Gross Method ■ Net Method...