Electronic Presentation by Douglas Cloud Pepperdine University Chapter 5 Accounting for Merchandise Operations Electronic Presentation by Douglas Cloud Pepperdine University

After studying this chapter, you should be able to: Learning Goals 1. Distinguish the operating activities of a service business from those of a merchandising business. 2. Describe and illustrate the financial statements of a merchandising business. 3. Describe the accounting for the sale of merchandise. 4. Describe the accounting for the purchase of merchandise. After studying this chapter, you should be able to: Continued

Learning Goals 5. Describe the accounting for transportation costs and sales taxes. 6. Illustrate the dual nature of merchandising transactions. 7. Describe the accounting for merchandise shrinkage. 8. Describe and illustrate the effects of inventory misstatements on the financial statements. Continued

Learning Goals 9. Describe and illustrate the use of gross profit and operating income in analyzing a company’s operations.

Learning Goal 1 Distinguish the operating activities of a service business from those of a merchandising business.

In prior chapters, you were introduced to how to report the financial condition and changes in financial condition for a service business.

In this chapter, you will be exposed to the accounting for merchandise operations.

Condensed Income Statement Home Depot Inc. Condensed Income Statement For the Year Ending December 28, 2001 (in millions) Net sales $45,738 Cost of merchandise sold 32,057 Gross profit $13,681 Operating expenses 9,490 Operating income $ 4,191 Other income 26 Income before taxes $ 4,217 Income taxes 1,636 Net income $ 2,581 Net sales is the revenue received from selling merchandise less any merchandise returned or any discounts reported. The revenue account for merchandise is Sales. The cost of merchandise sold is matched against net sales. Revenue minus cost provides gross profit. What’s different on a merchandising income statement?

Learning Goal 2 Describe and illustrate the financial statements of a merchandising business.

Multiple-Step Income Statement Online Solutions Income Statement For the Year Ended December 31, 2007 Net sales $708,255 Cost of merchandise sold 525,305 Gross profit $182,950 Operating expenses 105,710 Operating income $ 77,240 Other income and expense (net) (1,840) Operating income before taxes $ 75,400 Income taxes 15,000 Net income $ 60,400

Multiple-Step Income Statement Sales $720,185 Less sales returns and allowances $6,140 Less sales discounts 5,790 11,930 Net sales $708,255 Sales is the total amount the customers are charged for merchandise sold, including cash sales and sales on account. Detailed Revenue Section

Multiple-Step Income Statement Sales $720,185 Less sales returns and allowances $6,140 Less sales discounts 5,790 11,930 Net sales $708,255 Sales returns and allowances are granted by the seller for damaged or defective merchandise.

Multiple-Step Income Statement Sales $720,185 Less sales returns and allowances $6,140 Less sales discounts 5,790 11,930 Net sales $708,255 Sales discounts are granted by the seller to customers for early payment of amounts owed.

Multiple-Step Income Statement Purchases $521,980 Less: Purchases returns and allowances $9,100 Purchases discounts 2,525 11,625 Net purchases $510,355 Add transportation-in 17,400 Cost of merchandise purchased $527,755 Purchases is the full cost of buying merchandise for resale. Detailed Cost of Merchandise Purchased Section

Multiple-Step Income Statement Purchases $521,980 Less: Purchases returns and allowances $9,100 Purchases discounts 2,525 11,625 Net purchases $510,355 Add transportation-in 17,400 Cost of merchandise purchased $527,755 A Purchase allowance is a reduction in purchase price because the item has a defect or was the wrong item ordered. A Purchase return is the cost of the merchandise returned to the seller.

Multiple-Step Income Statement Purchases $521,980 Less: Purchases returns and allowances $9,100 Purchases discounts 2,525 11,625 Net purchases $510,355 Add transportation-in 17,400 Cost of merchandise purchased $527,755 A Purchase discount is a reduction in the initial cost of the merchandise. Usually, it is due to early payment of the debt.

Multiple-Step Income Statement Purchases $521,980 Less: Purchases returns and allowances $9,100 Purchases discounts 2,525 11,625 Net purchases $510,355 Add transportation-in 17,400 Cost of merchandise purchased $527,755 Transportation-in is the shipping cost paid by the buyer for merchandise. Note that this freight payment increases the cost of the merchandise. It is not an expense.

Multiple-Step Income Statement “Cost of merchandise purchased” is a major portion of the cost of merchandise sold section, which follows the revenue section.

Multiple-Step Income Statement Note on the next slide that the only change is that the section begins by adding the beginning inventory and ends by subtracting the ending inventory.

Multiple-Step Income Statement Merchandise inventory, Jan. 1, 2007 $ 59,700 Purchases $521,980 Less: Pur. returns and allow. $9,100 Purchases discounts 2,525 11,625 Net purchases $510,355 Add transportation-in 17,400 Cost of merchandise purchased 527,755 Merchandise available for sale $587,455 Less merchandise inventory, Dec. 31, 2007 62,150 Cost of merchandise sold $525,305 Detailed Cost of Merchandise Sold Section

Multiple-Step Income Statement This income statement was prepared using the periodic inventory method. The number of units on hand was determined by a physical count.

Multiple-Step Income Statement In contrast, a perpetual inventory system keeps a running amount for each item as it is bought and sold. A physical count is still necessary for verification purposes.

Single-Step Income Statement Online Solutions Income Statement For the Year Ended December 31, 2007 Revenue: Net sales $708,255 Expenses: Cost of merchandise sold $525,305 Operating expenses 105,710 Income taxes 15,000 Other income and expense (net) 1,840 647,855 Net income $ 60,400

Retained Earnings Statement Online Solutions Retained Earnings Statement For the Year Ended December 31, 2007 Retained earnings, January 1, 2007 $128,800 Net income for the year $60,400 Less dividends 18,000 Increase in retained earnings 42,400 Retained earning, December 31, 2007 $171,200

Balance Sheet Online Solutions Balance Sheet Assets Current assets: December 31, 2007 Assets Current assets: Cash $ 52,950 Accounts receivable 76,080 Merchandise inventory 62,150 Office supplies 480 Prepaid insurance 2,650 Total current assets $194,310 Continued

Property, plant, and equipment: Land $ 20,000 Store equipment $27,100 less accumulated depr. 5,700 21,400 Office equipment $15,570 less accumulated depr. 4,720 10,850 Total property, plant, and equip. 52,250 Total assets $246,560 Liabilities Current liabilities: Accounts payable $ 22,420 Note payable 5,000 Salaries payable 1,140 Unearned rent 1,800 Total current liabilities $ 30,360 Continued

Long-term liabilities: Note payable (final payment due 2017) 20,000 Total liabilities $ 50,360 Stockholders’ Equity Capital stock $ 25,000 Retained earnings 171,200 196,200 Total liabilities and stockholders’ equity $246,560

Statement of Cash Flows Online Solutions Statement of Cash Flows For the Year Ended December 31, 2007 Cash flows from operating activities: Net income $ 60,400 Add: Depreciation expense—store equipment $ 3,100 Depreciation expense—office equipment 2,490 Decrease in office supplies 120 Decrease in prepaid insurance 350 Increase in accounts payable 8,150 14,210 Continued

Deduct: Increase in accounts receivable $(24,080) Increase in merchandise inventory (2,450) Decrease in salaries payable (360) Decrease in unearned rent (600) (27,400) Net cash flow form operating activities $47,120 Cash flows from investing activities: Purchase of store equipment $ (7,100) Purchase of office equipment (5,570) Net cash flows used in investing activities (12,670) Cash flows from financing activities: Payment of note payable $ (5,000) Payment of dividends (18,000) Net cash flows used in financing activities (23,000) Net increase in cash $11,450 January 1, 2007 cash balance 41,500 December 31, 2007 cash balance $ 52,950

Learning Goal 3 Describe the accounting for the sale of merchandise.

Transactions involving MasterCard or Visa are treated as cash sales. On January 3 Online Solutions sells merchandise costing $1,200 for $1,800. The customer charges the purchase on a MasterCard. Transactions involving MasterCard or Visa are treated as cash sales.

Jan. 3 Cash 1,800 Sales 1,800 This entry is made whether the company uses the periodic or perpetual system. An additional entry is made if the firm uses a perpetual inventory system. Jan. 3 Cost of Merchandise Sold 1,200 Merchandise Inventory 1,200

During January Online Solutions sold merchandise costing $68,000 to American Express customers for $100,000. Online Solutions uses a perpetual inventory. Transactions involving American Express are recorded as sales on account.

Jan. 31 Accounts Receivable— American Express 100,000 Sales 100,000 31 Cost of Merchandise Sold 68,000 Merchandise Inventory 68,000 Online receives cash from American Express of $100,000, less a 4% service fee on February 15.. Feb. 15 Cash 96,000 Credit Card Expense 4,000 Accounts Receivable– American Express 100,000

2/10, n/30 Sales Discounts Credit Terms The net (full) amount is due by the 30th day. The buyer is allowed a 2% discount if… …the account is paid within 10 days.

Sales Discounts On January 12 Online Solutions sells merchandise costing $850 on account to Omega Tech for $1,500. Credit terms are 2/10, n/30. Payment is received on January 22. Jan. 12 Accounts Receivable— Omega Tech 1,500 Sales 1,500 12 Cost of Merchandise Sold 850 Merchandise Inventory 850

Contra (offsetting) account to Sales Sales Discounts On January 12 Online Solutions sells merchandise costing $850 on account to Omega Tech for $1,500. Credit terms are 2/10, n/30. Payment is received on January 22. Contra (offsetting) account to Sales Jan. 22 Cash 1,470 Sales Discounts 30 Accounts Receivable— Omega Tech. 1,500

Sales Returns and Allowances On January 13 Online Solutions issues a $2,000 credit memorandum to Krier Company for merchandise that was returned. The merchandise (cost $1,200) was sold on account. Contra (offsetting) account to Sales Jan. 13 Sales Returns and Allowances 2,000 Accounts Receivable— Krier Company 2,000 13 Merchandise Inventory 1,200 Cost of Merchandise Sold 1,200

Learning Goal 4 Describe the accounting for the purchase of merchandise.

On January 3 Online Solutions purchased $2,500 of merchandise for cash On January 3 Online Solutions purchased $2,500 of merchandise for cash. Recall that Online Solutions uses the perpetual system. Jan. 3 Merchandise Inventory 2,500 Cash 2,500 If this transaction had been on account from Max Corporation (terms: 1/15, n/30), the entry would have been: Jan. 3 Merchandise Inventory 2,500 Accounts Payable—Max Corporation 2,500

Purchase Discounts On January 17 Online Solutions pays Max Corporation the invoice amount less the discount. The asset account is reduced. Jan. 17 Accounts Payable—Max Corp. 2,500 Merchandise Inventory 25 Cash 2475 Instead, assume the payment is made on Feb. 1 . Feb. 1 Accounts Payable—Max Corp. 2,500 Cash 2,500

Purchases Returns and Allowances On January 22 Online Solutions returns $5,000 of merchandise purchased from Quantum Inc. Jan. 22 Accounts Payable—Quantum Inc. 5,000 Merchandise Inventory 5,000 If the above return represents only part of the total purchase and credit terms are 2/10, n/45, the discount, if taken on the balance of the order, only applies to the merchandise kept.

Learning Goal 5 Describe the accounting for transportation costs and sales taxes.

Transportation Costs Phil’s Trucking

Transportation Costs On January 19 Online Solutions buys merchandise from Data Max on Account, $2,900, terms FOB shipping point, and prepays the transportation cost of $150. Jan. 19 Merchandise Inventory 2,900 Accounts Payable—Data Max 2,900 19 Merchandise Inventory 150 Cash 150

Transportation Costs On January 24 Online Solutions sells merchandise to Miller Company on account, $4,700, terms FOB destination. The cost of the merchandise sold is $2,750, and Online Solutions pays the transportation cost of $350. Jan. 24 Accounts Receivable—Miller Co. 4,700 Sales 4,700 24 Cost of Merchandise Sold 2,750 Merchandise Inventory 2,750

Transportation Costs On January 24 Online Solutions sells merchandise to Miller Company on account, $4,700, terms FOB destination. The cost of the merchandise sold is $2,750, and Online Solutions pays the transportation cost of $350. Jan. 24 Transportation Out 350 Cash 350 An expense

Transportation Costs On January 14 Online Solutions sells merchandise to Golden Company on account, $8,000, terms 2/10, n/30, FOB shipping point. The cost of the merchandise sold is $4,800, and Online pays the transportation cost of $500. Jan. 14 Accounts Receivable—Golden Co. 8,000 Sales 8,000 14 Cost of Merchandise Sold 4,800 Merchandise Inventory 4,800

Transportation Costs On January 14 Online Solutions sells merchandise to Golden Company on account, $8,000, terms 2/10, n/30, FOB shipping point. The cost of the merchandise sold is $4,800, and Online pays the transportation cost of $500. Jan. 14 Accounts Receivable—Golden Co. 500 Cash 500 Online prepaid the transportation cost although it is Golden’s responsibility. This debit sets up the reimbursement.

Sales Taxes On March 19 Tom’s Meat Market had cash sales totaling $1,700. The local sales tax is 7%, which is collected on each sale. The entry to record the day’s sales is as follows: Mar. 19 Cash 1,819 Sales 1,700 Sales Taxes Payable 119

Learning Goal 6 Illustrate the dual nature of merchandising transactions.

July 1. Scully Company sold merchandise on account to Burton Co July 1. Scully Company sold merchandise on account to Burton Co., $7,500, terms FOB shipping point, n/45. The cost of the merchandise sold was $4,500 Scully Co. (Seller) Accounts Receivable—Burton Co. 7,500 Sales 7,500 Cost of Merchandise Sold 4,500 Merchandise Inventory 4,500

July 1. Scully Company sold merchandise on account to Burton Co July 1. Scully Company sold merchandise on account to Burton Co., $7,500, terms FOB shipping point, n/45. The cost of the merchandise sold was $4,500 Burton Co. (Buyer) Merchandise Inventory 7,500 Accounts Payable—Scully Co. 7,500

July 2. Burton Co. paid transportation charges of $150 on July 1 purchase of Scully Company. Scully Co. (Seller) No entry. Burton Co. (Buyer) Merchandise Inventory 150 Cash 150

July 5. Scully Company sold merchandise on account to Burton Co July 5. Scully Company sold merchandise on account to Burton Co., $5,000, terms FOB destination, n/45. The cost of the merchandise sold was $3,500 Scully Co. (Seller) Accounts Receivable—Burton Co. 5,000 Sales 5,000 Cost of Merchandise Sold 3,500 Merchandise Inventory 3,500

July 5. Scully Company sold merchandise on account to Burton Co July 5. Scully Company sold merchandise on account to Burton Co., $5,000, terms FOB destination, n/45. The cost of the merchandise sold was $3,500 Burton Co. (Buyer) Merchandise Inventory 5,000 Accounts Payable—Scully Co. 5,000

July 7. Scully Co. paid transportation charges of $250 for delivery of merchandise sold to Burton Co. on July 5. Scully Co. (Seller) Transportation Out 250 Cash 250 Burton Co. (Buyer) No entry

July 13. Scully Company issued Burton Co July 13. Scully Company issued Burton Co. a credit memorandum for merchandise returned, $1,000. The merchandise had been purchased by Burton Co. on account on July 5. The cost of the merchandise returned was $700. Scully Co. (Seller) Sales Return and Allowances 1,000 Accounts Receivable—Burton Co. 1,000 Merchandise Inventory 700 Cost of Merchandise Sold 700

July 13. Scully Company issued Burton Co July 13. Scully Company issued Burton Co. a credit memorandum for merchandise returned, $1,000. The merchandise had been purchased by Burton Co. on account on July 5. The cost of the merchandise returned was $700. Burton Co. (Buyer) Accounts Payable—Scully Co. 1,000 Merchandise Inventory 1,000

July 15. Scully Company received payment from Burton Co July 15. Scully Company received payment from Burton Co. for purchase of July 5. Scully Co. (Seller) Cash 4,000 Accounts Receivable—Burton Co. 4,000 Burton Co. (Buyer) Accounts Payable—Scully Co. 4,000 Cash 4,000

The full amount is due by the end of the month. July 18. Scully Co. sold merchandise on account to Burton Co., $12,000, terms FOB shipping point, 2/10, n/eom. Scully Co. prepaid transportation costs of $500, which were added to the invoice. The cost of the merchandise sold was $7,200. The full amount is due by the end of the month. Scully Co. (Seller) Accounts Receivable—Burton Co. 12,000 Sales 12,000 Accounts Receivable—Burton Co. 500 Cash 500

July 18. Scully Co. sold merchandise on account to Burton Co July 18. Scully Co. sold merchandise on account to Burton Co., $12,000, terms FOB shipping point, 2/10, n/eom. Scully Co. prepaid transportation costs of $500, which were added to the invoice. The cost of the merchandise sold was $7,200. Scully Co. (Seller) Cost of Merchandise Sold 7,200 Merchandise Inventory 7,200

July 18. Scully Co. sold merchandise on account to Burton Co July 18. Scully Co. sold merchandise on account to Burton Co., $12,000, terms FOB shipping point, 2/10, n/eom. Scully Co. prepaid transportation costs of $500, which were added to the invoice. The cost of the merchandise sold was $7,200. Burton Co. (Buyer) Merchandise Inventory 12,500 Accounts Payable—Scully Co. 12,500

July 28. Scully Company received payment from Burton Company for purchase of July 18, less discount (2% x $12,000). Scully Co. (Seller) Cash 12,260 Sales Discount 240 Accounts Receivable—Burton Co. 12,500 Burton Co. (Buyer) Accounts Payable—Scully Co. 12,500 Merchandise Inventory 240 Cash 12,260

Learning Goal 7 Describe the accounting for merchandise shrinkage.

When a company uses a perpetual inventory, a physical count is taken at the end of the accounting period to determine the accuracy of the perpetual records and to record any inventory shrinkage.

Inventory shrinkage is $1,800 Online Solutions’ inventory records indicate that $63,950 of merchandise should be available for sale on December 31, 2007. The physical inventory taken on that date indicates that only $62,150 of merchandise is available for sale. Inventory shrinkage is $1,800 Cost of Merchandise Sold 1,800 Merchandise Inventory 1,800

Learning Goal 8 Describe and illustrate the effects of inventory misstatements on the financial statements.

Effects of Inventory Misstatements Income Statement Effects Physical Inventory Misstatement Inventory Shrinkage Misstated Cost of Merchandise Sold Misstated Gross Profit Misstated Net Income Misstated Balance Sheet Effects Net Income Misstated Physical Inventory Misstatement Adjusted Mer. Inv. Misstated Current Assets Misstated Total Assets Misstated Retained Earnings Misstated

Amount of Misstatement Overstated (Understated) On December 31, 2007, Sapra Company incorrectly counted its physical inventory as $115,000 instead of $125,000. Amount of Misstatement Overstated (Understated) 2007 Financial Statements Balance Sheet as of December 31, 2007: Merchandise inventory $(10,000) Current assets (10,000) Total assets (10,000) Total stockholders’ equity (retained earnings) (10,000) Income Statement for Year Ended December 31, 2007: Cost of merchandise sold $10,000 Gross profit (10,000) Net income (10,000)

Amount of Misstatement Overstated (Understated) On December 31, 2007, Sapra Company incorrectly counted its physical inventory as $115,000 instead of $125,000. Amount of Misstatement Overstated (Understated) 2008 Financial Statements Balance Sheet as of December 31, 2008: Merchandise inventory Correct Current assets Correct Total assets Correct Total stockholders’ equity (retained earnings) Correct Income Statement for Year Ended December 31, 2008: Cost of merchandise sold $(10,000) Gross profit 10,000 Net income 10,000

Learning Goal 9 Describe and illustrate the use of gross profit and operating income in analyzing a company’s operations.

…the efficiency and effectiveness of a merchandiser’s operations. Gross profit and operating income are two important profitability measures analyst use in assessing…

Gross Profit Percent Net sales $32,004 Cost of merchandise sold 22,789 Operating expenses 8,459 Operating income $ 756 $9,2l5 = 28.8% $32,004

Gross Profit Percent J. C. Penny’s gross profit percentage went from 28.8% to 27.7%, then recovered back to 29.8%.

Gross Profit Percent The recovery in the third year was attributed to better merchandise assortment, improved inventory productivity, and centralized buying.

Operating Income Percent Net sales $32,004 Cost of merchandise sold 22,789 Gross profit $ 9,215 Operating expenses 8,459 Operating income $ 756 $756 = 2.4% $32,004

Operating Income Percent The company’s operating income percentage dropped from 2.4% to 0.6%, then recovered back to 2.7%.

Operating Income Percent This recovery was attributed to lower catalog and marketing costs, lower telemarketing costs, and a shift from development to maintenance of JCPenny.com.

Chapter 5 The End