FABM2 04 Merchandising-Operations PDF

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Unit 2: Accounting For Merchandising Business CHAPTER 4: MERCHANDISING OPERATIONS FUNDAMENTALS OF ACCOUNTANCY, BUSINESS AND MANAGEMENT 2

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MERCHANDISING OPERATIONS Measuring net income for a merchandising company is conceptually the same for a service enterprise. That is, net income (or loss) results from the matching of expenses with revenues. In merchandising company, the primary source of revenues is the sale of merchandise, often referred to simply as sales revenue or sales. Unlike expenses for a service company, expenses for a merchandising company are divided into two categories: (1) cost of goods sold and (2) operating expenses. The cost of goods sold is the total cost of merchandise sold during the period. This expense is directly related to the revenue recognized from the sale of the goods. Merchandising companies report gross profit on sales in the income statement The income measurement process for a merchandiser ay be diagrammed as shown below:

Operating Cycles While measuring income for a merchandising company is conceptually the sale as for a service company, their operating cycle differ. The operating cycle of a merchandising company ordinarily is longer that of a service company. The purchase of merchandise inventory and its eventual sale lengthens the cycle. Note that the added asset account for a merchandising company is an inventory account. Merchandise inventory is reported as a current asset on the balance sheet. Operating System Either of two systems may be used in accounting for merchandising transactions: (1) a perpetual inventory system or (2) a periodic inventory system. In perpetual inventory system, detailed records of the cost of each inventory purchase and sale are maintained and continuously show the inventory that should be on hand for every item. A perpetual inventory keeps track of both quantities and costs. Under a perpetual inventory system the cost of goods sold is determined and recorded each time a sale occurs. In a periodic inventory system, no attempt is made to keep detailed inventory records of the goods on hand throughout the period. The cost of goods sold is determined only at the end of the accounting period when a physical inventory count is taken to determine the cost of goods on hand. To determine the cost of goods sold under a periodic inventory system, it is necessary to (1) record purchased merchandise, (2) determine the cost of goods purchased, and (3) determine the cost of goods on hand at the beginning and end of the accounting period.

MERCHANDISING TRANSACTIONS Recording merchandising transactions requires the analysis of purchases and sales of merchandise. Related to both purchases and sales are returns and allowances, discounts and transportation costs.

Recording Purchases

Purchases may be made for cash or on account (credit). Purchases are normally recorded when the goods are received from the supplier. Every purchase should be supported by business documents that provide written evidence of the transaction. Cash purchases should be supported by canceled checks or cash register receipts indicating the items purchased and amounts paid. Credit purchases should be supported by an invoice that indicates the items purchased and the total purchase price. An invoice is a document prepared by the seller that shows the relevant information about a sale. From the seller’s perspective this document is a sales invoice, and from the buyer’s perspective it is a purchase invoice. When merchandise is purchased for resale to customers, the temporary account Purchases is debited for the cost of the goods. However, not all purchases are debited to Purchases. Purchases of assets acquired for use and not for resale, such as supplies, equipment and similar items, should be debited to specific asset accounts rather than to Purchases. Like sales, purchases may be made for cash or on account. Cash purchases are recorded by a debit to Purchases and credit to Cash. Each credit purchase should be supported by a purchase invoice indicating the total purchase price and other relevant information. A sales invoice was prepared by Highpoint Electronic to document a sale to Chelsea Video with a total amount of $3,800, terms 2/10, n/30, FOB shipping point. Chelsea Video will use the purchase invoice to document the purchase from Highpoint. The entry of Chelsea Video for the purchase on account from Highpoint Electronic for the amount of $3,800: Purchases Accounts Payable (To record goods purchase on account, term 2/10,n/30)

3,800 3,800

Purchase Returns and Allowances A purchaser may be dissatisfied with the merchandise received because goods are damaged or defective, of inferior quality, or not in accord with the purchaser’s specification. In such cases, the purchaser may return the goods to the supplier for credit if the sale was made on credit, or for cash refund I the purchase was originally for cash. This transaction is known as purchase return. Alternative, the purchaser may choose to keep the merchandise if the supplier is willing to grant an allowance (deduction) from the purchase price. This transaction is known as a purchase allowance. The purchaser initiates the request for deduction of the balance due through the issuance of a debit memorandum. A debit memorandum is a document issued by a buyer to inform a seller that a debit has been made to the seller’s account. The entry by Chelsea Video for the merchandise returned is: Accounts Payable Purchase Returns and Allowances (To record return of damaged goods)

300 300

Purchase Returns and Allowances represents a reduction in the cost of goods purchased for resale. It is a contra account to Purchases and its normal balance is a credit. Credit memorandum and debit memorandums derive their names from the action that the issuer takes on the accounts receivable or payable carried on its books. The purchaser sends a debit memorandum to indicate a debit to Accounts Payable and a credit to Purchase Returns and Allowances. Similarly, a seller issues a credit memorandum to indicate a credit to Accounts Receivable and a debit to Sales Returns and Allowances. Purchase Discounts Credit terms may permit the buyer to claim a cash discount for the prompt payment of a balance due. The buyer calls this discount a purchase discount. This incentive offers advantage to both parties: the purchaser saves money, and the supplier is able to convert the accounts receivable into cash earlier. The credit term specify the amount and time period for the cash discount. They also indicate the length of time in which the purchaser is expected to pay the full invoice price. In the sales invoice, credit terms are 2/10, n/30, which is read “two-ten, net thirty.” This means that a 2% cash discount may be taken on the invoice price (less any returns and allowances) if payment is made within 10 days of the invoice date (the discount period); otherwise, the invoice price less any returns or allowances is due 30 days from the invoice date. Alternatively, the discount period may extend to a specific number of days following the month in which the

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sale occurs. For example, 1/10 EOM (End-of-month) means that a 1% discount is available if the invoice is paid within the first 10 days of the next month. When the supplier elects not to offer a cash discount for prompt payment, credit terms will specify only the maximum time period for paying the balance due. When an invoice is paid within the discount period, the amount of discount is credited to Purchase Discounts. To illustrate, assume Chelsea Video pays the balance due of $3,500 (gross invoice price $3,800 less purchase returns and allowances of $300) at the last day of the discount period. The cash discount is $70 ($3,500 x 2%) and the amount paid by Chelsea Video is $3,430. The entry to record the payment of Chelsea Video to highpoint Electronics is as follows: Accounts Payable Purchase Discounts Cash (To record payment within discount period)

3,500 70 3,430

Like Purchase Returns and Allowances, Purchase Discounts represents a reduction in the cost of goods purchased for resale. Purchase Discounts is a contra account to Purchases. Its normal balance is credit. If Chelsea Video fails to take the discount and full payment is made beyond discount period, Chelsea makes the following entry: Accounts Payable Cash (To record payment with no discount taken)

3,500 3,500

Freight Cost The sales agreement should indicate whether the seller or the buyer is to pay the cost of transporting the goods to the buyer’s place of business. When a common carrier such as a railroad, trucking company, or airline is used, the transportation company prepares a freight bill (oftencalled a bill of lading) in accordance with the sales agreement. Freight terms are expressed as either FOB shipping point or FOB destination. The letters FOB means free on board. Thus, FOB shipping point means that goods are placed free on board the carrier by the seller and the buyer pays the freight costs. Conversely, FOB destination means that the goods are placed free on board at the buyer’s place of business, and the seller pays the freight. When the purchaser directly incurs the freight costs, the account Freight-in (or Transportation-in) is debited. For example, if upon delivery of the goods, Chelsea Video pays Acme Freight Company $150 for freight charges, the entry on Chelsea books is: Freight-in Cash (to record payment of freight, terms FOB shipping point)

150 150

Like Purchases, Freight-in is a temporary account whose normal balance is a debit. Freight in is a part of goods purchased. In contrast, freight costs incurred by the seller on outgoing merchandise are an operating expense to the seller. These costs are debited to Freight-out or Delivery Expense. For example, if the freight term is FOB destination and Highpoint Electronic paid the $150 freight charges, the entry by Highpoint would be: Freight-out Cash (To record payment of freight on goods Sold FOB destination)

150 150

Sales Sales revenue, like service revenues, are recorded when earned. Sales may be made on credit or for cash. Every sales transaction should be supported by a business document that provides written evidence o the sale. Cash register tapes provide evidence of cash sales.

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For cash sales, the Cash account is debited and the Sales account is credited. For credit sales, Account Receivable is debited and Sales is credited. To illustrate a credit sales transaction, Highpoint Electronic’s sale of $3,800 to Chelsea Video would be recorded as follows: Accounts Receivable Sales (To record credit sales)

150 150

Sales Returns and Allowances The customer may return the goods to the seller for credit if the sale was made on credit, or for a cash refund if the sale was originally for cash. This transaction is known as sales return. Alternatively, the customer may choose to keep the merchandise if the seller is willing to grant an allowance (deduction) from the selling price. This transaction is known as sales allowance. For accounting purposes, sales returns and allowances are combined into one account, Sales Returns and Allowances. To give the customer a sales return or allowance, the seller normally prepares a credit memorandum. This document informs a customer that a credit has been made to the customer’s account receivable for a sales return or allowance. A seller’s entry to record a credit memorandum involves a debit to the Sales Returns and Allowances account and a credit to Accounts Receivable. If Sales Returns and Allowances Accounts Receivable (To record allowance for damage goods)

300 300

For a sales return or allowance on a cash sale, a cash refund is normally made. In such case, Sales Returns and Allowances is debited and Cash is credited. Sales Returns and Allowances is a contra revenue account to Sales. The normal balance of Sales Returns and Allowances is a debit. Sales Discounts The terms of a credit sale may include an offer of a cash discount, called a sales discount, to the customer for prompt payment of the balance due. This incentive offers advantages to both parties: the purchaser saves money, and the seller is able to convert the accounts receivable into cash earlier. The credit terms specify the amount and time period for cash discount. They also indicate the length of time in which the purchaser is expected to pay the full invoice price. When cash discounts are taken by customers, the seller debits Sales Discounts. To illustrate, assume Chelsea Video pays the balance due to Highpoint Electronic of $3,500 on May 14, the last day of the discount period. The discount term is 2/10, n/30. The entry is: Cash Sales Discount Accounts Receivable (To record collection within 2/10,n/30 discount period)

3,430 70 3,500

Sales Discounts is a contra revenue account to Sales. Its normal balance is debit.

MEASURING NET INCOME Net Sales As contra revenue accounts, sales returns and allowances and sales discounts are deducted from sales in the income statement to arrive at net sales. The sales revenue section of the income statement is as follows:

Sal esRevenue

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Sal es Less:Sal esr e t ur nsandal l owance s Sal esdi sc ount s NetSal es

$480, 000 $12, 000 8, 000

20, 000 $460, 000

Cost of Goods Sold The cost of goods sold may be determined each time a sale occurs or at the end of an accounting period. To make the determination when the sale occurs, a company uses a perpetual inventory system. Under this system, detailed records of the cost of each inventory item are maintained and continuously show the inventory that should be on hand. Perpetual inventory systems have traditionally been used by companies that sell high unitvalue items such as automobiles, furniture, television sets and large home appliances. When cost of goods sold is determined only at the end of an accounting period, a company is said to be using a periodic inventory system. This system is widely used by companies that sell thousands of low unit-value items. Most business employ the periodic inventory system because they can control merchandise and manage day-to-day operations without detailed inventory records. To determine the cost of goods sold under a periodic inventory system, it is necessary to (1) record purchases of merchandise, (2) determine the cost of goods purchased, and (3) determine the cost of goods on hand at the beginning and end of the accounting period. Determining Cost of Goods Purchased In explaining the accounting for goods purchased for resale, the following temporary accounts were discussed: Account Purchases Purchase Returns and Allowances Purchase Discounts Freight-in

Normal Balance Debit Credit Credit Debit

The procedure for determining the cost of goods purchased is as follows: 1. The accounts with credit balances (Purchase returns and Allowances and Purchase Discounts) are subtracted from Purchases to produce net purchases. 2. Freight-in is then added to net purchases to produce cost of goods purchased. To illustrated, assume that Highpoint Electronic shows the following balances for the accounts above: Purchases $325,000; Purchase Returns and Allowances $10,400; Purchase Discounts $6,800; and Freight-in $12,200. Net purchases and cost of goods purchased are $307,800 and $320,000, respectively. Pur c hases Less:Pur chaser et ur nsandal l owances Pur c hasedi scount s Netpur chases Add:Fr ei ght i n Costofgoodspur chased

$325, 000 $10, 400 6, 800

17, 200 307, 800 12, 200 $320, 000

Determining Cost of Goods on Hand To determine the cost of inventory on hand, it is necessary to take a physical inventory. The account Merchandise Inventory is used to record the cost of inventory on hand at the balance sheet date. This amount becomes the beginning inventory for the next accounting period. Computing Cost of Goods Sold We have now reached the point where we can compute cost of goods sold. Doing so involves two steps:

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1. Add the cost of goods purchased to the cost of goods on hand at the beginning of the period (beginning inventory) to obtain the cost of goods available for sale. 2. Subtract the cost of goods on hand at the end of the period (ending inventory) from the cost of goods available for sale to arrive at the cost of goods sold. For Highpoint Electronic the cost of goods available for sale and the cost of goods sold are $356,000 and $316,000, respectively, as shown below.

Beginning inventory Add: Cost of goods purchased Cost of goods available for sale Less: Ending inventory Cost of goods sold

$ 36,000 320,000 356,000 40,000 $316,000

Gross Profit Cost of goods sold is deducted from sales revenue to determine gross profit. Sales revenue used for this computation is net sales (which takes into account sales returns and allowances and sales discounts). Net sales Cost of goods sold Gross profit

$ 460,000 316,000 $144,000

Gross profit represents the merchandising profit of a company. It is not a measure of the overall profitability of a company, because operating expenses have not been deducted.

Operating Expenses Operating expenses are the third component in measuring the net income for a merchandising company. At Highpoint Electronic, operating expenses were $114,000. The firm’s net income is determined by subtracting operating expenses from gross profit. Thus, net income is $30,000 as shown below:

Gross Profit Operating expenses Net income

$ 144,000 114,000 $ 30,000

The net income is the “bottom line” of a company’s income statement.

Problem 1. Aerosmith Company’s accounting records shows that the following at yearend: Purchases Discounts $3,400; Freight-in $6,100; Sales $240,000; Purchases $162,500; Beginning Inventory $18,000; Ending Inventory $20,000; Sales Discounts $10,000; Purchase Returns $5,200; and Operating Expenses $57,000. Compute the following amounts for Aerosmith Company: net sales, cost of goods purchased, cost of goods sold, gross profit and net income. Income Statement The income statement for retailers and wholesalers contains three features not found in the income statement of a service enterprise. These features are: (1) a sales revenue section, (2) a cost of goods sold section, and (3) gross profit. Using the assumed data for specific operating expenses, the income statement for Highpoint Electronic is shown below:

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