Merchandising Activities Chapter 6 Chapter 6: Merchandising Activities

Operating Cycle of a Merchandising Company The operating cycle of a business is the time it takes a business to start with cash, purchase inventory, sell the inventory, and finally collect cash from customers. The operating cycle of a business that sells inventory on credit is typically longer than that of a business that sells only on a cash basis. This is due to additional time between when a customer buys inventory and when the customer pays off the accounts receivable.

Comparing Merchandising Activities with Manufacturing Activities Manufacture inventory and have a longer and more complex operating cycle. Purchase inventory in ready-to-sell condition. Manufacturing companies use raw materials to make the inventory they sell. Their operating cycles are typically longer and more complex because of the time it takes to make and sell the inventory and then to collect the accounts receivable. Merchandising companies purchase the inventory they sell in a ready-to-sell condition. Since they do not have to make the inventory, their operating cycle is typically shorter. Merchandising Company Manufacturing Company

Income Statement of a Merchandising Company Cost of goods sold represents the expense of goods that are sold to customers. Gross profit is a useful means of measuring the profitability of sales transactions. The income statements of merchandising companies have an additional expense item called Cost of Goods Sold. The Cost of Goods Sold account represents the cost of merchandise sold during the period to help earn revenue. Cost of Goods Sold is presented as a separate expense item on the income statement. Net Sales minus Cost of Goods Sold equals Gross Profit. Gross Profit is the amount left, after subtracting the cost of the inventory sold, to cover all other expenses and a profit.

Accounting System Requirements for Merchandising Companies Control Account Subsidiary Ledgers In the General Ledger, the control account for Accounts Receivable indicates that customers owe seven thousand dollars. But, it does not indicate how much each customer owes. To find out the amount due from each customer, we must look at the Accounts Receivable Subsidiary Ledger. Detail information for each specific customer can be found by looking in the subsidiary ledgers. By looking at the subsidiary ledgers, it’s clear that Sparks, Inc. owes $2,000 and that Heather Jacobs Company owes $5,000. Notice that the total of the balances in the subsidiary accounts equals the total balance in the control account, $7,000.

Perpetual Inventory Systems Purchased 10 Regent 21-inch computer monitors on account from Okawa Wholesale Co. The monitors cost $600 each, for a total of $6,000; payment is due in 30 days. In the perpetual inventory system, the inventory account is continuously updated to reflect purchases, sales, and returns of inventory. On September 1, Computer City purchased on account from Okawa Wholesale Co. ten computer monitors for $600 each. Computer City would debit Inventory and credit Accounts Payable for $6,000.

Perpetual Inventory Systems On September 7, Computer City sold 2 computer monitors for $1,000 per unit on account to RJ Travel Agency. Retail 2 ´ $1,000 = $2,000 On September 7th, Computer City sold two monitors on account to RJ Travel Agency at a retail sales price of $1,000 each, for a total of $2,000. Payment is due in 30 days. Under the perpetual inventory system, a sale of inventory requires two entries. One entry is a debit to Accounts Receivable and a credit to Sales for the retail amount of the sale, which in this case is $2,000. Another entry is a debit to Cost of Goods Sold and a credit to Inventory for the cost of the inventory sold, which in this case is $1,200. The retail amount is the selling price to the customer and the cost amount is the cost paid for the inventory sold. 2 ´ $600 = $1,200 Cost

Taking a Physical Inventory In order to ensure the accuracy of their perpetual records, most businesses take a complete physical count of the merchandise on hand at least once a year. Reasonable amounts of inventory shrinkage are viewed as a normal cost of doing business. Examples include breakage, spoilage and theft. On December 31, Computer City counts its inventory. An inventory shortage of $2,200 is discovered. Most companies take a physical count of inventory at least once a year. Theoretically, the physical count should match the number of items in the inventory records. In reality, this is not the case. The physical count does not match the records due to spoilage, breakage, damage, obsolescence, and theft. The physical count helps get the records up to date to reflect what is actually on hand. When a physical count identifies inventory shrinkage, an entry is made to debit Cost of Goods Sold and credit Inventory. This entry increases Cost of Goods Sold, an expense account, and decreases the Inventory account.

Closing Entries in a Perpetual Inventory System The closing entries are the same! Close Revenue accounts (including Sales) to Income Summary. Close Expense accounts (including Cost of Goods Sold) to Income Summary. Close Income Summary account to Retained Earnings. Close Dividends to Retained Earnings. The steps for closing entries in a perpetual inventory system are the same as discussed earlier. Step 1 is to close Revenue to Income Summary. Since Revenue has a credit balance, a debit is made to close it and a credit is made to Income Summary. Step 2 is to close all expense accounts to Income Summary. This includes the Cost of Goods Sold expense account. Since these accounts have a debit balance, they are credited and a debit is made to Income Summary for their total. Step 3 is to close Income Summary to Retained Earnings. Step 4, the final step, is to close Dividends to Retained Earnings. Since the Dividend account has a debit balance, a credit is made to close it and a debit is made to the Retained Earnings account.

Periodic Inventory System On January 6, Wagner Office Supplies purchased merchandise amounting to $2,000 on account from Ink Jet Solutions. Notice that no entry is made to Inventory. Under the periodic inventory system, no effort is made to keep the inventory account or the cost of goods sold account up to date. Only on a periodic basis are these two accounts updated. To illustrate, assume that one of Computer City’s suppliers, Wagner Office Products, has a periodic inventory system. Wagner Office Supplies made many purchases of merchandise on account during 2015. The first purchase on January 6th, was a purchase of merchandise amounting to $2,000 with Ink Jet Solutions. Payment is due in 30 days. Wagner would debit Purchases and credit Accounts Payable for $2,000. Notice that an entry is not made to the Inventory account. Instead, the purchase is debited to a new account called Purchases.

Computing Cost of Goods Sold The accounting records of Wagner Office Supplies show the following: Inventory, Jan. 1 $ 14,000 Purchases (during year) 130,000 Inventory, Dec. 31 12,000 The year-end inventory is determined by taking a complete physical count of the merchandise on hand. Because the periodic system does not maintain a cost of goods sold account, cost of goods sold must be calculated at the end of the period. Once the ending inventory is known, the cost of goods sold for the entire year can be determined by a short computation, shown here. Here is some information for Wagner Office Supplies. On January 1st, they have beginning inventory of $14,000. They have purchases during the year totaling $130,000. On December 31st, the physical inventory count was $12,000. To calculate the cost of goods sold for Wagner, start with the beginning inventory and add the purchases during the year. This provides the cost of goods available for sale during the period. From this, subtract the ending inventory and arrive at the cost of goods sold during the period.

Selecting an Inventory System Which inventory system should a company use? This table suggests some characteristics to consider when selecting an inventory system. If a company has a professional management team, needs timely information about items in inventory, and has a computerized accounting system, then a perpetual inventory system is likely the better option. However, if a company is run by its owners, does not need timely information about items in inventory, uses a manual accounting system, and maintains merchandise on site, then a periodic inventory may be the solution. Many companies can find an accounting software package that is able to handle a perpetual inventory system very effectively.

Credit Terms and Cash Discounts When manufacturers and wholesalers sell their products on account, the credit terms are stated in the invoice. Percentage of Discount # of Days Discount Is Available Otherwise, the Full Amount Is Due # of Days when Full Amount Is Due Read as: “Two ten, net thirty” 2/10, n/30 Cash discounts are provided to customers as an incentive for them to pay early. The credit period is the normal period of time a company allows for customers to extend their account receivable, typically 30 or 60 days. The discount period is a much shorter period of time, typically 10 or 15 days. If payment is received during the discount period, a discount may be taken. If payment is made after the discount period expires, then the full payment is due on or before the end of the credit period. Cash discount terms are typically written as this slide shows. This particular discount term would be read as “two ten, net thirty.” The first number represents the discount percentage. The second number represents the discount period. The letter “n” stands for the word net. The last number represents the entire credit period. In this case, if the customer pays within 10 days, then a 2% discount may be taken. If not, then the full amount is due within 30 days.

Recording Purchases at Net Cost On November 3, Computer City purchases 100 spreadsheet programs for $100 each from PC Products, credit terms 2/10, n/30. Prepare the journal entry for Computer City. Many companies plan to take advantage of cash discounts offered, so they record their purchases net of the discount. Since they typically take the discount, this process simplifies future entries. If a cash discount is not taken in the future, then a purchase discounts lost account is used. Assume that on November 3, Computer City purchases 100 spreadsheet programs from PC Products. The cost of these programs is $100 each, for a total of $10,000. However, PC Products offers credit terms of 2/10, n/30. If Computer City pays for this purchase within the discount period, it will have to pay only $9,800, or 98 percent of the full invoice price. Computer City debits Inventory and credits Accounts Payable for $9,800, which is net of the two percent cash discount. $10,000 ´ 98% = $9,800

Recording Purchases at Gross Invoice Price On November 3, Computer City purchased $10,000 of merchandise on credit with terms of 2/10, n/30 from PC Products. Prepare the journal entry for Computer City. Other companies use the gross method to record their purchases. Under the gross method, the purchases are originally recorded at the full amount of the inventory purchased. If a cash discount is taken in the future, then a purchase discounts account is used. On November 3rd, Computer City purchased $10,000 of merchandise on account from PC Products with terms two ten net thirty. Computer City debits Inventory and credits Accounts Payable for $10,000, which is the gross amount of the purchase.

End of Chapter 6 End of Chapter 6.