Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD Chapter 6 Accounting for Merchandising Activities

Remaining course context Balance Sheet Current Assets Cash Chapter 9, Current Liabilities Accounts Payable Chapter 6, Accounts Receivable Wages Payable Notes Receivable Utilities Payable32000 Marketable Securities Long-Term Debt Inventory6, Notes Payable13, Capital Assets Bonds Payable Equipment4, Owner’s Equity Buildings4, Common Stock15, Goodwill Retained Earnings Total Assets Total Liabilities + OE Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

In this chapter… Balance Sheet Current Assets Cash Chapter Current Liabilities Accounts Payable Chapter 6, Accounts Receivable20000 Wages Payable25000 Notes Receivable15000 Utilities Payable2000 Marketable Securities25000Long-Term Debt Inventory6, Notes Payable20000 Capital Assets Bonds Payable Equipment250000Owner’s Equity Buildings Common Stock Goodwill60000 Retained Earnings48000 Total Assets Total Liabilities + OE Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Merchandising Activities Until now we have most examined the activities of a services based company. Now we will consider how companies which engage in the resale of goods track, record and report on matters relating to their inventory Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Merchandising vs. Services A merchandiser may earn net income by buying and selling goods to end customers. –They may deliver goods in addition to services –They may add services to raw materials to produce finished goods which they sell. The cost of the goods is an expense used to generate revenue – Cost of Goods Sold (CGS) –CGS includes the cost of the raw material, plus other costs needed to bring the product to market (shipping, handling, etc) Sales – a word used to generically describe revenue from the sale of goods Gross Margin (aka Gross Profit = Sales – CGS) is the amount remaining after sales used to cover operating expenses Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Inventory Merchandise Inventory, or Inventory, is a current asset balance sheet account used to hold the value of the inventory As we will see in future chapters, there are several ways to determine the value of the Inventory Two general inventory accounting conventions –Perpetual inventory – provides a continuous record of the amount of inventory on hand. At any time, a reader can examine the inventory account to determine the value of inventory on hand. The remainder of the chapter concerns Perpetual inventory –Periodic inventory – requires updating the inventory account only at the end of a period to reflect the quantity and cost of both goods on hand and goods sold. The Inventory account is only accurate after adjustments are made at the end of the period Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Accounting for Merchandise Purchases Inventory is a current asset balance sheet account When purchasing inventory, the following journal entry would be made: –Inventory is debited (increased) –Either cash or Accounts Payable is credited depending on whether buying on cash or credit The cost is includes the actual cost of the material, plus shipping, handling, discounts, allowances for returns, etc DateAccount Titles and explanationPRDebitCredit Jan 1Inventory1000 Cash1000 Jan 2Inventory750 Accounts Payable750 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Accounting for Merchandise Purchases Purchase returns are merchandise received by a purchaser but returned to the supplier. A purchase allowance is a reduction in the cost of the merchandise to accommodate for defects, even though the inventory is still sellable The purchaser can inform the seller of the defects by issuing a Debit Memorandum. This would trigger the seller and the buyer each reducing their respective accounts for the inventory. From the purchaser’s perspective: DateAccount Titles and explanationPRDebitCredit Jan 2Accounts Payable100 Inventory100 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Accounting for Merchandise Purchases Trade Discounts – a certain percentage reducing the price of inventory when sold to trade partners, or channel partners –when a manufacturer sells on volume to a distributor/wholesaler, or when a wholesaler sells to a retailer –A manufacturer may offer a percentage discount off of list price to a wholesaler who buys or more of their product –Bic sells pens to Grand & Toy at $0.001 per pen. If G&T buys a million or more pens they may get 25% off list = $750 (.001*1,000,000 – (.25*.001*1,000,000)) Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Accounting for Merchandise Purchases Purchase Discounts - a certain percentage reducing the price for adhering to credit terms –Credit Terms – are a listing of amounts and timing of payments between buyer and seller. –It is a reward system used by sellers to encourage early payment Examples –2% 10, net 30 – means purchaser gets a 2% discount if they pay within 10 days of invoice date, or pays the full amount before 30 days –So say someone purchases $1000 worth of pens, on terms of 2% 10, net 30. –Look how powerful the incentive is: 2% discount over the remaining 20 days = 36.5% annual interest (365/20 x 2%) –Lets look at the transactions on the next slide…. Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Accounting for Merchandise Purchases First, the inventory is purchased on credit in full Second, payment is made within 9 days –AP is debited the full amount (the credit is completely honoured) –But cash is not credited at the full amount (the discount is desired) –Inventory value is reduced to show the impact of the discount –Lets look at it through the T-account view…. DateAccount Titles and explanationPRDebitCredit Jan 5Inventory1000 Accounts Payable1000 Accounts Payable1000 Jan 14 Inventory20 Cash980 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Accounting for Merchandise Purchases Through T-accounts we see the result is that –the Payable is completely exhausted –The inventory is reduced to reflect the discount –The actual cash paid reflects the value of the inventory InventoryAccounts Payable Jan 5(a) (a) Jan 1420 (b)(b) 1000 Balance9800 Cash Jan (b) Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Transfer of Ownership The point where ownership transfers from seller to buyer is important as it determines who must pay transportation and other shipping related costs. FOB (Free On Board) – the point of transfer –FOB factory means the buyer is responsible for shipping –FOB destination means the seller is responsible for shipping Transportation-In Costs – are shipping costs paid on purchases Transportation-Out Costs – are costs paid on sales. If the seller sells on FOB destination terms, the Delivery Expense account is debited to cover these costs Example… Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Transportation costs Company purchases raw materials for $1000 from supplier Supplies are FOB factory (purchaser covers costs) So, on the purchaser’s books, the value of the inventory is the cost of the purchase plus what it cost to get the goods to the purchaser’s site. InventoryCash Original Purchase (a) (a) Shipping(b) 5050 (b) Balance1050 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Accounting for Merchandise Sales So now we’ve bought raw materials, how do we sell them… The sales transactions for a merchandiser are similar to those of a service company –Below, the first transaction is a sale on credit –The second is a sale on cash –We’ve seen this many times before… DateAccount Titles and explanationPRDebitCredit Apr 1Accounts Receivable1000 Sales1000 Apr 2Cash750 Sales750 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Accounting for Merchandise Sales But what about the expense side. How do we recognize the Cost of Goods Sold? Cost of Goods Sold (CGS) is an expense account used to monitor the cost of the goods sold – The transaction below reduces the inventory to acknowledge the goods that were just sold DateAccount Titles and explanationPRDebitCredit Apr 2Cost of Goods Sold980 Inventory980 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Sales Discounts Just like what we saw earlier, we can not only buy on terms (say 1% 15, net 60), we can also sell on them. When our customer takes advantage of the terms we offer, we must reduce the revenue to acknowledge the discount –The Sales Discount account is a “contra revenue” account, which will be used to reduce inventory on the Income Statement DateAccount Titles and explanationPRDebitCredit Apr 1Accounts Receivable1000 Sales1000 Apr 14Cash990 Sales Discounts10 Accounts Receivable1000 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Sales Returns and Allowances Sales returns refer to merchandise that customers return to the seller after a sale. Sales allowances refer to reductions in price to reflect damage or some dissatisfaction on the part of the customer We can use the Sales Returns and Allowances “contra revenue” account to reduce Sales Revenue DateAccount Titles and explanationPRDebitCredit Apr 1Accounts Receivable1000 Sales1000 Apr 14Sales Returns and Allowances500 Accounts Receivable500 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Sales Returns and Allowances If the merchandise is still sellable, the merchandise can be put back into inventory Or, if the goods are not sellable, they should be scrapped. This can be done by just leaving them on COGS account or to a Loss from Defective Merchandise account DateAccount Titles and explanationPRDebitCredit Apr 2Inventory490 Cost of Goods Sold490 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Mid-chapter Demo Problem Lets look at the Mid-chapter demo problem –Consider the transactions –Complete the journal entries –What do these look like from the T-account perspective Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Adjusting Entries Similar to the service company we studied earlier, merchandising companies will have adjusting entries at the end of period –(you know, to reflect amortization, reduction in prepaid assets, accrued expenses, accrued revenues, etc) Merchandising companies may also see a adjustment for shrinkage Shrinkage reflects a loss due to –Deterioration of goods (food, weatherable items) –Theft –Damage while in storage Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Adjusting Entries To adjust for shrinkage, the company will debit COGS and credit Inventory –In a perpetual inventory system shrinkage can really only be assessed through a physical count/assessment of the inventory Once the adjustment to inventory is complete, the ending inventory balance for period 1 becomes the beginning inventory balance for period 2 DateAccount Titles and explanationPRDebitCredit Apr 2Cost of Goods Sold80 Inventory (shrinkage)80 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Closing Entries Closing entries for a merchandising company are the same as those for a service company. We must close the additional temporary accounts used by a merchandising company –Sales Discounts –Sales Returns and Allowances –Cost of Goods Sold Exhibit 6.21 shows a good example of the closing process Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Financial Statements The financial statements for a merchandiser are similar to those of a service company –The Balance Sheet has an additional asset account for Inventory –The Income Statement will show Sales, COGS that produce a Gross Profit (Sales – COGS). –The Income Statement may also break out selling expenses from operating expenses Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Sample Problems Try Exercise 6-3 and 6-5 –Complete the journal entries Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Demonstration Problem Lets try the demonstration problem –Calculate the total cost of merchandise inventory purchases –Complete the Multi-Step Income Statement –Complete the Single Step Income Statement –Enter the closing entries –Bonus Complete the Statement of Owner’s Equity Classified Balance Sheet Chapter 7 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD