Prepared by: Keri Norrie, Camosun College ACCOUNTING PRINCIPLES Third Canadian Edition Prepared by: Keri Norrie, Camosun College

ACCOUNTING FOR MERCHANDISING OPERATIONS CHAPTER 5 ACCOUNTING FOR MERCHANDISING OPERATIONS

MERCHANDISING COMPANY A merchandising company is an enterprise that buys and sells goods to earn a profit. 1. Wholesalers sell to retailers. 2. Retailers sell to consumers. A merchandiser’s primary source of revenue is sales, whereas a service company’s primary source of revenue is service revenue.

MERCHANDISING COMPANY Making A Profit Customers are charged a sales price for the merchandise which is sales revenue to the merchandising company. The cost paid by the merchandising company for the goods purchased is referred to as the cost of goods sold. The difference between the sales revenue and the cost of goods sold is referred to as gross profit.

INCOME MEASUREMENT PROCESS FOR A MERCHANDISING COMPANY (Illustration 5-1) Sales Revenue Cost of Goods Sold Less Gross Profit Equals Operating Expenses Less Net Income (Loss) Equals

OPERATING CYCLES FOR A SERVICE COMPANY AND A MERCHANDISING COMPANY Accounts Receivable Cash Service Company Receive Cash Perform Services Cash Merchandising Company Sell Inventory Buy Inventory Merchandise Inventory Accounts Receivable Receive Cash

INVENTORY SYSTEMS Merchandising entities may use either (or both) of the following inventory systems: 1. Perpetual – where detailed records of each inventory purchase and sale are maintained. Cost of goods sold is calculated at the time of each sale. 2. Periodic – detailed records are not maintained. Cost of goods sold is calculated only at the end of the accounting period. The chapter discusses the perpetual method while the periodic method is discussed in Appendix 5A.

CALCULATING COST OF GOODS SOLD (Illustration 5-3) Beginning Inventory Cost of Goods Purchased Goods Available For Sale Ending Inventory Cost of Goods Sold + = - = The equation for calculating cost of goods sold is the same for perpetual and periodic inventory systems. The difference is when cost of goods is calculated. For perpetual systems, cost of goods sold is calculated at the time of each sale while it is calculated at the end of the accounting period for periodic systems.

RECORDING COST OF GOODS PURCHASED When merchandise is purchased for resale to customers, the account, Merchandise Inventory, is debited for the cost of the goods. Purchases may be made for cash or on account (credit). The purchase is normally recorded by the purchaser when the goods are received from the seller.

PURCHASES OF MERCHANDISE For purchases on account, Merchandise Inventory is debited and Accounts Payable is credited. For cash purchases, Merchandise Inventory is debited and Cash is credited.

FREIGHT COSTS 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. FOB Shipping Point 1. Goods delivered to shipping point by seller 2. Buyer pays freight costs from shipping point to destination FOB Destination 1. Goods delivered to destination by seller 2. Seller pays freight costs

ACCOUNTING FOR FREIGHT COSTS Merchandise Inventory is debited by the buyer, if the buyer pays the freight bill (FOB shipping point). Freight Out (or Delivery Expense) is debited by the seller, if the seller pays the freight bill (FOB destination).

ACCOUNTING FOR FREIGHT COSTS When the purchaser directly incurs the freight costs, the account Merchandise Inventory is debited and Cash is credited.

PURCHASE RETURNS AND ALLOWANCES A purchaser may be dissatisfied with merchandise received because the goods 1. are damaged or defective, 2. are of inferior quality, or 3. are not in accord with the purchaser’s specifications.

PURCHASE RETURNS AND ALLOWANCES For purchases returns and allowances that were originally made on account, Accounts Payable is debited and Merchandise Inventory is credited. For cash returns and allowances, Cash is debited and Merchandise Inventory is credited.

QUANTITY DISCOUNTS Volume purchase terms may permit the buyer to claim a quantity discount. The merchandise inventory is simply recorded at the discounted cost.

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. A purchase discount is based on the invoice cost less any returns and allowances granted. The accounting entries for purchase discounts are presented in Appendix 5B.

SALES TRANSACTIONS Revenues are reported when earned in accordance with the revenue recognition principle. In a merchandising company. revenues are earned when the goods are transferred from seller to buyer.

SALES TRANSACTIONS 1. The first entry records the sale of goods to a customer at the retail (selling) price. 2. The second entry releases the goods from inventory at cost and charges the goods to cost of goods sold.

SALES TAXES Sales tax is expressed as a percentage of the sales price on selected goods sold to customers by a retailer. They are collected on most revenues, and paid on many costs. Sales taxes may include the federal goods and services tax (GST) and the provincial sales tax (PST), if any. These two taxes have been combined into one harmonized sales tax (HST) in some Atlantic Provinces.

SALES TAXES ON REVENUES The retailer collects the tax from the customer when the sale occurs, and periodically (usually monthly) remits the collections to the Receiver General. Sales taxes are not revenue but are a current liability until remitted.

SALES RETURNS AND ALLOWANCES Sales Returns occur when customers are dissatisfied with merchandise and are allowed to return the goods to the seller for credit or a refund. Sales Allowances occur when customers are dissatisfied, and the seller allows a deduction from the selling price.

SALES RETURNS AND ALLOWANCES The normal balance of Sales Returns and Allowances is a debit. Sales Returns and Allowances is a contra revenue account to the Sales account.

RECORDING SALES RETURNS AND ALLOWANCES 1. The first entry reduces the balance owed by the customer and records the goods returned at retail price. 2. The second entry records the physical return of goods to inventory at cost and removes the goods from the cost of goods sold account.

QUANTITY DISCOUNTS A quantity discount is the offer of a cash discount to a customer in return for a volume sale. Quantity discounts result in a sales price reduction. They are not separately journalized. Instead the sale is recorded at the reduced price.

SALES DISCOUNTS A sales discount is the offer of a cash discount to a customer in exchange for the prompt payment of a balance due. Similar to Sales Returns and Allowances, Sales Discounts is also a contra revenue account with a normal debit balance. The accounting entries for sales discounts are presented in Appendix 5B.

COMPLETING THE ACCOUNTING CYCLE A merchandising company requires the same types of adjusting entries as a service company, with one additional adjustment for inventory to ensure the recorded inventory amount agrees with the actual quantity on hand. A physical count is an important control feature since a perpetual system indicates what should be there but a count will determine what is actually there.

COMPLETING THE ACCOUNTING CYCLE A merchandising company also requires the same types of closing entries as a service company. The additional accounts that need to be closed out in a merchandising account include Sales, Sales Returns and Allowances, Cost of Goods Sold, and Freight Out. Merchandise Inventory is an asset account and is not closed at the end of the period.

STATEMENT PRESENTATION OF SALES REVENUE SECTION Illustration 5-10 As contra revenue accounts, sales returns and allowances (and sales discounts, if any) are deducted from sales in the income statement to arrive at Net Sales.

CALCULATION OF GROSS PROFIT Illustration 5-10 Gross profit is calculated by deducting cost of goods sold from net sales as follows: Gross profit is often expressed as a percentage of sales.

CALCULATION OF NET INCOME Illustration 5-10 Income from operations is calculated by deducting operating expenses from gross profit as follows: Net income is the “bottom line” of a company’s income statement, calculated after net non-operating revenue is added, or subtracted if net non-operating expense, to income from operations.

MULTI-STEP INCOME STATEMENT Illustration 5-10 A multi-step income statement with operating and non-operating activities. As shown, non-operating activities are reported immediately after the company's primary operating activities.

SINGLE-STEP INCOME STATEMENT Illustration 5-11 A single-step income statement. As shown, only one step, the subtraction of total expenses from total revenues, is required in determining net income.

CLASSIFIED BALANCE SHEET On the balance sheet, merchandise inventory is reported as a current asset and appears immediately below accounts receivable. This is because current assets are listed in the order of their liquidity.

USING THE INFORMATION IN THE FINANCIAL STATEMENTS Illustration 5-13 and 5-14 Gross profit margin measures the amount by which the selling price exceeds the cost of goods sold. Profit margin measures the extend by which the selling price covers all expenses (including cost of goods sold). Gross Profit Margin Gross Profit Net Sales Gross Profit Margin ÷ = ÷ = $144,000 $460,000 31.3% Profit Margin Net Income Net Sales Profit Margin ÷ = ÷ = $31,600 $460,000 6.9%

PERIODIC INVENTORY SYSTEM SALES TRANSACTIONS Appendix 5A Only one entry is required to record a sale under a periodic method. Cost of goods sold is not recorded at the time of the sale.

PERIODIC INVENTORY SYSTEM RECORDING SALES RETURNS AND ALLOWANCES Appendix 5A The normal balance of Sales Returns and Allowances is a debit. Sales Returns and Allowances is a contra revenue account to the Sales account.

PERIODIC INVENTORY SYSTEM PURCHASES OF MERCHANDISE Appendix 5A For purchases on account, Purchases is debited and Accounts Payable is credited. For cash purchases, Purchases is debited and Cash is credited.

PERIODIC INVENTORY SYSTEM ACCOUNTING FOR FREIGHT COSTS Appendix 5A When the purchaser directly incurs the freight costs, the account Freight In is debited and Cash is credited.

PERIODIC INVENTORY SYSTEM PURCHASE RETURNS AND ALLOWANCES Appendix 5A For purchases returns and allowances that were originally made on account, Accounts Payable is debited and Purchase Returns and Allowances is credited. The Purchase Returns and Allowances account is a contra account to the purchases account.

COST OF GOODS SOLD Appendix 5A-2 The multi-step income statement under the periodic system requires more detail in the cost of goods sold section, as shown above.

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