Principles of Financial Accounting 2002e

Principles of Financial Accounting 2002e
Belverd E. Needles, Jr. Marian Powers Susan Crosson Multimedia Slides by: Harry Hooper Santa Fe Community College Copyright © by Houghton Mifflin Company. All rights reserved.

Chapter 5 Merchandising Operations

Copyright © by Houghton Mifflin Company. All rights reserved.
LEARNING OBJECTIVES 1. Identify the management issues related to merchandising businesses. 2. Compare the income statements for service and merchandising concerns, and define the components of the merchandising income statement. 3. Define and distinguish the terms of sale for merchandising transactions. Copyright © by Houghton Mifflin Company. All rights reserved.

LEARNING OBJECTIVES (continued…)
Prepare an income statement and record merchandising transactions under the perpetual inventory system. Copyright © by Houghton Mifflin Company. All rights reserved.

Learning Objectives (continuted…)
SUPPLEMETAL OBJECTIVES Prepare an income statement and record merchandising transactions under the periodic inventory system. Prepare a work sheet and closing entries for a merchandising concern using the perpetual inventory system. Prepare a work sheet and closing entries for a merchandising concern using the periodic inventory system. Apply sales and purchases discounts to merchandising transactions. Copyright © by Houghton Mifflin Company. All rights reserved.

Management Issues in Merchandising Businesses
OBJECTIVE 1 Identify the management issues related to merchandising businesses. Copyright © by Houghton Mifflin Company. All rights reserved.

Merchandising Businesses
Merchandising businesses differ from service businesses in that they have goods on hand for sale to customers, called merchandise inventory, and engage in a series of transactions called the operating cycle. Copyright © by Houghton Mifflin Company. All rights reserved.

The Operating Cycle of Merchandising Concerns
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Cash Flow Management The Merchandising Operating Cycle. Purchase inventory for cash or on credit. Pay for purchases made on credit. Sell merchandise for cash or on credit. Collect cash from credit sales. Copyright © by Houghton Mifflin Company. All rights reserved.

Cash Flow Management Since purchases of merchandise are usually made on credit, the merchandiser must plan for cash flows from within the company or from borrowing to finance the inventory until it is sold and resulting revenue is collected. Operators of a merchandising business must carefully manage cash flows or liquidity. If a company can’t pay its bills when due, it may be forced out of business. Copyright © by Houghton Mifflin Company. All rights reserved.

Profitability Management
A company must sell its merchandise at a price that exceeds its cost by a sufficient margin to pay operating expenses and have enough left to provide sufficient net income or profitability. Copyright © by Houghton Mifflin Company. All rights reserved.

Profitability Management (continued…)
Profitability management includes: Setting appropriate prices for merchandise to achieve an adequate gross margin. Purchasing merchandise at favorable prices and terms. Maintaining acceptable levels of operating expenses. An effective tool for controlling expenses is the operating budget. Copyright © by Houghton Mifflin Company. All rights reserved.

Features of the Perpetual Inventory System
Continuous records are kept of the quantity and, usually, the cost of individual items as they are bought and sold. More effective for providing information about quantities and ensuring optimal customer service. Copyright © by Houghton Mifflin Company. All rights reserved.

Features of the Periodic Inventory System
Physically count inventory, usually at the end of the accounting period. No detailed records of the actual inventory are maintained during the accounting period. Less costly than perpetual inventory method, but provides less information. Copyright © by Houghton Mifflin Company. All rights reserved.

Perpetual vs. Periodic System
Because of computers, use of the perpetual system has increased greatly, although the periodic system is still widespread. Copyright © by Houghton Mifflin Company. All rights reserved.

Control of Merchandising Operations
Principal transactions of merchandising businesses are vulnerable to theft and embezzlement. Cash and inventory are easy to steal. These asset accounts are usually involved in a large number of transactions. Copyright © by Houghton Mifflin Company. All rights reserved.

Control of Merchandising Operations (continued…)
Management’s responsibility is to establish an environment, accounting systems, and control procedures that will protect the company’s assets. These systems and procedures are called the internal controls. Taking a physical inventory is a key element of a merchandising company’s internal control. Copyright © by Houghton Mifflin Company. All rights reserved.

Discussion Q. What four issues must be faced by managers of merchandising businesses? A. The four issues that must be faced by managers of merchandising businesses are (1) cash flow management, (2) profitability management, (3) choosing between the inventory systems, and (4) establishing internal controls that protect the business’s assets. Copyright © by Houghton Mifflin Company. All rights reserved.

Income Statement for a Merchandising Concern
OBJECTIVE 2 Compare the income statements for service and merchandising concerns, and define the components of the merchandising income statement. Copyright © by Houghton Mifflin Company. All rights reserved.

Merchandising Income Statement
Income statement consists of three major parts. 1. Net sales. 2. Cost of goods sold. 3. Operating expenses. Gross margin represents net sales minus cost of goods sold. Copyright © by Houghton Mifflin Company. All rights reserved.

Net Sales Net Sales consists of gross sales less sales returns and allowances. Gross sales is the total cash and credit sales occurring during the period. Sales Returns and Allowances is a contra-revenue account used to accumulate cash refunds, credits on account, and allowances to customers for defective merchandise. Copyright © by Houghton Mifflin Company. All rights reserved.

Gross Margin Gross margin, or gross profit, is the difference between net sales and cost of goods sold. To be successful a firm must have gross margin sufficient enough to pay operating expenses and provide an adequate income. Copyright © by Houghton Mifflin Company. All rights reserved.

Operating Expenses Operating expenses represent the expenses other than cost of goods sold that are incurred in running a business. Operating expenses are classified as either: 1. Selling expenses. 2. General and administrative expenses. Copyright © by Houghton Mifflin Company. All rights reserved.

Operating Expenses Selling expenses include the costs of storing goods and preparing them for sale, displaying, advertising, and otherwise promoting sales and delivering goods to the buyer (freight out expense). General and Administrative expenses include expenses for accounting, personnel, credit and collections, and any other expenses that apply to overall operation. Copyright © by Houghton Mifflin Company. All rights reserved.

Net Income Net income is the final figure or “bottom line” of the income statement. Net income is what remains after operating expenses are deducted from gross margin. Net income represents the amount of business earnings that accrue to the owners during a period of time. Copyright © by Houghton Mifflin Company. All rights reserved.

Discussion Q. What are the three major parts of a merchandiser’s income statement? A. The three major parts are (1) net sales, (2) cost of goods sold, and (3) operating expenses. Copyright © by Houghton Mifflin Company. All rights reserved.

Sales Terms Trade discount. A reduction of the list price. Use agreed price in accounting records. Do not show trade discounts. Sales discount. Discount given for early payment. Taken if payment is made within the terms of sale. For example, “2/10, n/30.” Practice of giving sales discounts has been declining. Copyright © by Houghton Mifflin Company. All rights reserved.

Sales Terms (Continued)
FOB shipping point. Title passes at origin. Buyer pays the freight. FOB destination. Title passes at destination. Seller pays the freight. Copyright © by Houghton Mifflin Company. All rights reserved.

Applying the Perpetual Inventory System
OBJECTIVE 4 Prepare an income statement and record merchandising transactions under the perpetual inventory system. Copyright © by Houghton Mifflin Company. All rights reserved.

Perpetual Inventory System
Cost of Goods Sold is continually updated during the accounting period, as purchases, sales and other inventory transactions take place. The Merchandise Inventory account is updated at the same time. Freight is included in Cost of Goods Sold. Copyright © by Houghton Mifflin Company. All rights reserved.

Perpetual Inventory System Transactions Related to Purchases of Merchandise Purchases of Merchandise on Credit The cost of merchandise purchased is placed in the Merchandise Inventory account at the time of purchase. Transportation Costs on Purchases Accumulated in a Freight In /Transportation In account. In some cases, the seller pays the freight charges and bills them to the buyer as a separate item on the invoice. Purchases Returns and Allowances Returned merchandise is removed from the Merchandise Inventory account. Payments on Account Reduce the Accounts Payable account. Copyright © by Houghton Mifflin Company. All rights reserved.

Perpetual Inventory System Transactions Related to Sales of Merchandise At the time of sale, the cost of merchandise is transferred from the Merchandise Inventory account to the Cost of Goods Sold account. In the case of a return, the cost of the merchandise is transferred from Cost of Goods Sold back to Merchandise Inventory. Copyright © by Houghton Mifflin Company. All rights reserved.

Perpetual Inventory System Transactions Related to Sales of Merchandise (continued) Sales of Merchandise on Credit Two entries are necessary Record the sale Update the Cost of Goods sold by transferring cost from Merchandise Inventory Payment of Delivery Costs Accumulated in the Freight Out Expense account Shown as a selling expense on the income statement Copyright © by Houghton Mifflin Company. All rights reserved.

Perpetual Inventory System Transactions Related to Sales of Merchandise (continued) Returns of Merchandise Sold Accumulated in the Sales Return and Allowances account A contra-revenue account, with a normal debit balance, deducted from Sales the income on statement The cost of merchandise must also be transferred from the COGS account back into the Merchandise Inventory account Receipts on Account Reduce the Accounts Receivable account. Copyright © by Houghton Mifflin Company. All rights reserved.

Discussion Q. When are merchandising transactions recorded under the perpetual inventory system? A. Merchandising transactions are recorded during the accounting periods, as purchases, sales, and other inventory transactions take place. Copyright © by Houghton Mifflin Company. All rights reserved.

Credit Card Sales Credit card discount paid to credit card company by retailer recorded as an expense. Inventory Losses Losses from theft or spoilage are not identifiable under periodic inventory system. Perpetual system indicates loss by comparing physical count with Merchandise Inventory account balance. Loss is usually added to Cost of Goods Sold. Copyright © by Houghton Mifflin Company. All rights reserved.

Applying the Periodic Inventory System
SUPPLEMENTAL OBJECTIVE 5 Prepare an income statement and record merchandising transactions under the periodic inventory system. Copyright © by Houghton Mifflin Company. All rights reserved.

Periodic Inventory System
Cost of Goods Sold must be computed, because it is not updated for purchases, sales and other transactions during the accounting period. To calculate costs of goods sold: Net purchases = total purchases less purchases, returns and allowances Net cost of purchases = net purchases + freight in Goods available for sale = Net cost of purchases + beginning inventory Cost of goods sold = goods available for sale – ending inventory Copyright © by Houghton Mifflin Company. All rights reserved.

Periodic Inventory System Transactions Related to Purchases of Merchandise Physical inventory is recorded in the Merchandise Inventory account at the end of the period. A Purchases account is used to accumulate the purchases of merchandising during the accounting period. A Purchases Returns and Allowances account is used to accumulate returns of and allowances on purchases. Copyright © by Houghton Mifflin Company. All rights reserved.

The Components of Cost of Goods Sold
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Periodic Inventory System Transactions Related to Purchases of Merchandise Purchases of Merchandise on Credit Purchases, a temporary account, used to accumulate the total cost of merchandise purchased for resale during the accounting period. It does not indicate whether merchandise has been sold or is still on hand. Transportation Costs on Purchases Usually accumulated in a Freight In account. In some cases, the seller pays the freight charges and bills them to the buyer as a separate item on the invoice. Copyright © by Houghton Mifflin Company. All rights reserved.

Periodic Inventory System Transactions Related to Purchases of Merchandise (continued…) Purchases, Returns and Allowances Recorded in the Purchases Returns and Allowances account. A contra-purchases account with a normal credit balance, deducted form Purchases on the income statement. Payments on Account Reduce the Accounts Payable account. Copyright © by Houghton Mifflin Company. All rights reserved.

Periodic Inventory System Transactions Related to Sales of Merchandise
Sales of Merchandise on Credit Debit the Accounts Receivable account for the amount of the sale. Cash Sales of Merchandise Debit Cash for the amount of the sale. Payment of Delivery Costs Accumulated in the Freight Out/Delivery Expense account. Shown as a selling expense on the income statement. Copyright © by Houghton Mifflin Company. All rights reserved.

Periodic Inventory System Transactions Related to Sales of Merchandise (continued…) Returns of Merchandise Sold Accumulated in the Sales Return and Allowances account. A contra-revenue account, with a normal debit balance deducted from Sales on the income statement. Receipts on Account Reduce the Accounts Receivable account. Copyright © by Houghton Mifflin Company. All rights reserved.

Discussion Q. When are merchandising transactions recorded under the periodic system? A. Merchandising transactions are recorded at the end of the accounting period, therefore, Costs of Goods Sold must be computed at that time. Copyright © by Houghton Mifflin Company. All rights reserved.

The Merchandising Work Sheet and Closing Entries
SUPPLEMENTAL OBJECTIVE 6 Prepare a work sheet and closing entries for a merchandising concern using the perpetual inventory system. Copyright © by Houghton Mifflin Company. All rights reserved.

Merchandising Work Sheet and Closing Entries
The work sheet for a merchandiser is basically the same as for a service business. Differences exist due to the handling of merchandise inventory and the additional accounts required and whether a company is using the periodic or perpetual system. Copyright © by Houghton Mifflin Company. All rights reserved.

The Perpetual Inventory System
Under the perpetual inventory system, the Merchandise Inventory account is up to date at the end of the accounting period and therefore is involved in the closing process. The reason for this is that purchases are recorded directly in the Merchandise Inventory account and costs are transferred from the inventory account to the Cost of Goods Sold account. Copyright © by Houghton Mifflin Company. All rights reserved.

Work Sheet: Perpetual Inventory System
Accounts used in the perpetual inventory system include: Sales Sales Returns and Allowances Cost of Good Sold Freight In Copyright © by Houghton Mifflin Company. All rights reserved.

Work Sheet: Perpetual Inventory System (continued…)
The ending Merchandise Inventory account balance is placed in the trial balance and balance sheet columns (debit) on a work sheet. Copyright © by Houghton Mifflin Company. All rights reserved.

Closing Entries: Perpetual Inventory System
Closing entries involve closing the Cost of Goods Sold account to the Income Summary account along with other expense accounts since it has a normal debit balance. Revenue accounts and the Income Summary account are closed in the same manner as a service firm. Copyright © by Houghton Mifflin Company. All rights reserved.

Discussion Q. What is the difference between a trade discount and a sales discount? A. When manufacturers and wholesalers quote prices of merchandise at a discount (usually 30% or more) off a list price printed in a catalogue, the discounts are called trade discounts. Small discounts given for early payment for purchases of merchandise are called sales discounts. Copyright © by Houghton Mifflin Company. All rights reserved.

The Merchandising Work Sheet and Closing Entries
SUPPLEMENTAL OBJECTIVE 7 Prepare a work sheet and closing entries for a merchandising concern using the periodic inventory system. Copyright © by Houghton Mifflin Company. All rights reserved.

Work Sheet: Periodic Inventory System
Accounts used in the periodic inventory system include: Sales Sales Returns and Allowances Purchases Purchase Returns and Allowances Freight In Merchandise Inventory Copyright © by Houghton Mifflin Company. All rights reserved.

Work Sheet: Periodic Inventory System (continued…)
Except for Merchandise Inventory, all accounts are extended to the income statement columns of a work sheet similar to revenue and expense accounts for a service business. The Merchandise Inventory beginning balance is extended to the debit column of the income statement columns and the ending balance is extended to the credit column of the income statement columns. Copyright © by Houghton Mifflin Company. All rights reserved.

Closing Entries: Periodic Inventory System
Since no changes are made during the period in the Merchandise Inventory account, the balance represents the beginning balance. Copyright © by Houghton Mifflin Company. All rights reserved.

Closing Entries: Periodic Inventory System
To calculate net income, the closing entries must: Remove the beginning inventory from the Merchandise Inventory account (credit). Enter the ending inventory in the Merchandise Inventory account (debit). Transfer both the inventory amounts to the Income Summary account. Copyright © by Houghton Mifflin Company. All rights reserved.

Discussion Q. During the closing process what entries are required to be made to the Merchandise Inventory account under a periodic inventory system? A. A credit entry is made in the amount of the beginning balance and a debit entry is made in the amount of the ending balance. As a result, net income is correctly calculated and the balance sheet presents the ending inventory balance. Copyright © by Houghton Mifflin Company. All rights reserved.

Discussion Q. The ending balance of the Merchandise Inventory account is placed in which column(s) of the work sheet? A. The ending balance of the Merchandise Inventory account is placed in the debit column of the balance sheet columns and the credit column of the income statement columns of a work sheet. Copyright © by Houghton Mifflin Company. All rights reserved.

Sales Discounts Sales discounts may be given for early payment from credit customers. Discount terms are typically stated as 2/10, n/60. where: 2 is the % discount available. 10 is the discount period in days. n/60 means the full invoice amount is due in 60 days if discount is not taken. Thus, if payment is received within 10 days then the customer can take a 2% discount and satisfy the Accounts Receivable with 98% of the amount owed (or due). Copyright © by Houghton Mifflin Company. All rights reserved.

Sales Discounts Example: A company sells merchandise on September 20 for $300, with terms of 2/10, n/60. Day of sale: Accounts Receivable 300 Sales Sold merchandise on credit Copyright © by Houghton Mifflin Company. All rights reserved.

Sales Discounts (continued…)
Payment received on September 29: Cash Sales Discounts Accounts Receivable Received payment within discount period The Sales Discount account is a contra revenue account and is deducted from gross sales on the income statement. Copyright © by Houghton Mifflin Company. All rights reserved.

Sales Discounts (continued…)
Payment received after the discount period on November 19: Cash Accounts Receivable Received payment after discount period Since the discount period (10 days) has passed the customer must pay the full amount. Copyright © by Houghton Mifflin Company. All rights reserved.

Purchases Discounts Purchase discounts are discounts taken for early payment for merchandise purchased for resale on credit. They are to the buyer what sales discounts are to the seller. Copyright © by Houghton Mifflin Company. All rights reserved.

Purchases Discounts (continued…)
Example: A company purchases merchandise on November 12 for $1,500, on terms of 2/10, n/30. Day of purchase: Purchases ,500 Accounts Payable 1,500 To record Purchased merchandise on credit Copyright © by Houghton Mifflin Company. All rights reserved.

The company returns $200 in merchandise on November 14. Accounts Payable Purchases Returns and allowances 200 Returned defective merchandise Copyright © by Houghton Mifflin Company. All rights reserved.

Payment made on November 22 Accounts Payable 1,300 Purchases Discounts Cash ,274 Paid invoice within the discount period Purchase Nov 12 $1,500 Less return Nov Net purchase $1,300 Discount 2% Cash paid $1,274 Copyright © by Houghton Mifflin Company. All rights reserved.

Payment made after the discount period on December 12: Accounts Payable ,300 Cash ,300 Paid invoice after discount period Since the discount period (10 days) has passed the full amount must be paid. Copyright © by Houghton Mifflin Company. All rights reserved.

OK, LET’S REVIEW… Identify the management issues related to merchandising businesses. Compare the income statements for service and merchandising concerns, and define the components of the merchandising income statement. Define and distinguish the terms of sale for merchandising transactions. Copyright © by Houghton Mifflin Company. All rights reserved.

CONTINUING OUR REVIEW…
Prepare an income statement and record merchandising transactions under the perpetual inventory system. Prepare an income statement and record merchandising transactions under the periodic inventory system. Prepare a work sheet and closing entries for a merchandising concern using the periodic inventory system. Copyright © by Houghton Mifflin Company. All rights reserved.

AND FINALLY… Prepare a work sheet and closing entries for a merchandising concern using the perpetual inventory system. Apply sales and purchases discounts to merchandising transactions. Copyright © by Houghton Mifflin Company. All rights reserved.

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