Accounting for Merchandising Businesses

Prepared by: C. Douglas Cloud Professor Emeritus of AccountingPepperdine University

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 6Chapter 6

Learning Objectives

Distinguish between the activities and financial statements of service and merchandising businesses.

Describe and illustrate the financial statements of a merchandising business.

Describe and illustrate the accounting for merchandise transactions including: sale of merchandise; purchase of merchandise; freight; sales taxes and trade discounts; dual nature of merchandising transactions.

Describe the adjusting and closing process for a merchandising business.

Learning Objectives

5. Describe and illustrate the use of the ratio of net sales to assets in evaluating a company’s operating performance.

Learning Objective 1

Service Business

Fees earned

$XXXOperating expenses

–XXXNet income

Nature of Merchandising Businesses

LO 1LO 1

Merchandising Business

Sales $XXXCost of Merchandise Sold –XXXGross Profit $XXXOperating Expenses –XXXNet Income $XXX

LO 1LO 1

When merchandise is sold, the revenue is reported as sales, and its cost is recognized as an expense called cost of merchandise sold.

GrossProfit

LO 1LO 1Nature of Merchandising Businesses The cost of merchandise sold is

subtracted from sales to arrive at gross profit. It is the profit before deducting operating expenses.

GrossProfit

LO 1LO 1

Merchandise on hand (not sold) at the end of an accounting period is called merchandise inventory.

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LO 1LO 1Nature of Merchandising Businesses

LO 2LO 2

Multiple-Step Income Statement

The multiple-step income statement contains several sections, subsections, and subtotals.

LO 2LO 2

Revenue from Sales

LO 2LO 2

Revenue from Sales

Sales is the total amount charged customers for merchandise sold, including cash sales and sales on account.

LO 2LO 2

Revenue from Sales

Sales returns and allowances are granted by the seller to customers for damaged or defective merchandise.

LO 2LO 2

Revenue from Sales

Sales discounts are granted by the seller to customers for early payment of amounts owed.

LO 2LO 2

Revenue from Sales

Net sales is determined by subtracting sales returns and allowances and sales discounts from sales.

LO 2LO 2

Cost of Merchandise Sold

The cost of merchandise sold is the cost of the merchandise sold to customers. Merchandise costs consist of all the costs of acquiring the merchandise and readying it for sale, such as purchase and freight costs.

LO 2LO 2

The buyer may return merchandise to the seller (purchase return), or the buyer may receive a reduction in the initial price at which the merchandise was purchased (purchase allowance).

LO 2LO 2

You have seen that sellers may offer customers sales discounts for early payment of their bills. From the buyer’s perspective, such discounts are referred to as purchase discounts.

LO 2LO 2

If merchandise inventory at the end of the period is determined by taking a physical count of inventory on hand, a periodic inventory system is being used.

LO 2LO 2

Under the perpetual inventory system, the amounts of inventory purchased, available for sale, and sold are continuously (perpetually) updated in the inventory records.

LO 2LO 2

Gross Profit

Gross profit is computed by subtracting the cost of merchandise sold from net sales.

GrossProfit

LO 2LO 2

Income from Operations

Selling expenses are incurred directly in the selling of merchandise.

Sales salaries Store supplies

used Depreciation of

store equipment Delivery

expense Advertising

expense

Income from Operations

Administrative expenses, sometimes called general expenses, are incurred in the administration or general operations of the business.

Office salaries Depreciation of

office equipment

Office supplies used

LO 2LO 2

Income from operations, sometimes called operating income, is determined by subtracting operating expenses from gross profit.

LO 2LO 2

Other Income and Expense

Other income is revenue from sources other than the primary operating activity of a business.

Other expense is an expense that cannot be traced directly to the normal operations of the business.

LO 2LO 2

Single-Step Income Statement

An alternative form of income statement is the single-step income statement. As shown in the next slide, the income statement for NetSolutions deducts the total of all expenses in one step from the total of all revenues.

LO 2LO 2

Single-Step Income Statement

LO 2LO 2

Statement of Owner’s Equity

Balance Sheet

The form of balance sheet with the assets on the left-hand side and the liabilities and owner’s equity on the right-hand side is called the account form.

LO 2LO 2

Balance Sheet

When the balance sheet is presented in a downward sequence in three sections, it has been prepared using the report form. This is the form used in the next two slides.

LO 2LO 2

Balance Sheet

(continued)

LO 2LO 2

Balance Sheet

Describe and illustrate the accounting for merchandising transactions including: sale of merchandise; purchase of merchandise; freight; sales taxes and trade discounts; dual nature of merchandising transactions.

Chart of Accounts

LO 3LO 3

On January 3, NetSolutions sold $1,800 of merchandise for cash.

Cash Sales

LO 3LO 3

Using the perpetual inventory system, the cost of merchandise sold and the decrease in merchandise inventory are also recorded. The cost of merchandise sold on January 3 is $1,200.

LO 3LO 3

Cash Sales

Sales made to customers using credit cards are recorded as cash sales. Assume that NetSolutions paid credit card processing fees of $48 on January 31.

Cash Sales

LO 3LO 3

On January 12, NetSolutions sold merchandise on account for $510. The cost of merchandise sold was $280.

Sales on Account

LO 3LO 3

The terms for when payments for merchandise are to be made are called credit terms. If payment is required on delivery, the terms are cash or net cash. Otherwise, the buyer is allowed an amount of time, known as the credit period, in which to pay.

Sales Discounts

LO 3LO 3

Invoice

LO 3LO 3

Credit Terms

To encourage the buyer to pay before the end of the credit period, the seller may offer a discount. Credit terms of 2/10, n/30 are summarized in the next slide (Exhibit 7).

LO 3LO 3

On January 17, NetSolutions receives the amount due within ten days, so the buyer deducted $30 ($1,500 x 2%) from the invoice amount.

Receipts on Account

LO 3LO 3

Credit Memo

LO 3LO 3

A credit memorandum, often called a credit memo, authorizes a credit to (decreases) the buyer’s account receivable. An example of a credit memo issued by NetSolutions is shown in Exhibit 8 (next slide).

Credit Memo

LO 3LO 3

On January 13, issued Credit Memo No. 32 to Krier Company for merchandise returned to NetSolutions. Selling price, $225; cost to NetSolutions, $140.

Credit Memo

LO 3LO 3

EE 6-2EE 6-2

Purchase Transactions

LO 3LO 3

On January 3, NetSolutions purchased merchandise for cash.

NOTE: We will assume a perpetual NOTE: We will assume a perpetual inventory system is used.inventory system is used.

LO 3LO 3

On January 4, NetSolutions purchased merchandise on account from Thomas Corporation.

Purchases Discounts

A buyer may receive a discount from the seller (sales discount) for early payment of the amount owed. From the buyer’s perspective, such discounts are called purchases discounts.

LO 3LO 3

Alpha Technologies issues an invoice for $3,000 to NetSolutions dated March 12, with terms 2/10, n/30. NetSolutions is trying to determine if it should pay the invoice within the discount period.

LO 3LO 3

Purchase TransactionsLO 3LO 3

If NetSolutions can borrow cash at an annual interest rate of 6%, should the firm borrow cash to pay the invoice within the discount period?

Discount of 2% on $3,000 $60.00Interest for 20 days at the rate

of 6% on $2,940 – 9.80Savings from borrowing $50.20

LO 3LO 3

Alpha Technologies issued an invoice for $3,000 to NetSolutions dated March 12, with terms 2/10, n/30. Based on the calculation in the previous slide, NetSolutions pays the amount due, less the discount, on March 22.

Assume that, instead of paying the invoice within the discount period, NetSolutions pays the invoice on April 11.

Discount Not Taken

LO 3LO 3

Purchases Returns and Allowances

A purchases return involves actually returning merchandise that is damaged or does not meet the specifications of the order. From a buyer’s perspective, such returns are called purchases returns and allowances.

LO 3LO 3

Debit Memo

A debit memorandum, often called a debit memo, informs the seller of the amount the buyer proposes to debit to the account payable due the seller.

LO 3LO 3

Debit Memo

NetSolutions receives a delivery from Maxim Systems and determines that $900 of the items are not the merchandise ordered. Debit memorandum #18 is issued to Maxim Systems.

LO 3LO 3

Debit Memo

LO 3LO 3

NetSolutions records the return of the merchandise indicated in the debit memo in Exhibit 9 as follows:

Debit Memo

On May 2, NetSolutions purchased $5,000 of merchandise on account from Delta Data Link, terms 2/10, n/30.

Merchandise Purchased

LO 3LO 3

On May 4 , NetSolutions returned $3,000 of the merchandise purchased from Delta Data Link.

LO 3LO 3

Merchandise Returned

On May 12, NetSolutions paid for the purchase of May 2 less the return and discount.

Invoice Paid

LO 3LO 3

EE 6-3EE 6-3

Freight

If ownership of the merchandise passes to the buyer when the seller delivers the merchandise to the freight carrier, the terms are said to be FOB (free on board) shipping point.

LO 3LO 3

On June 10, NetSolutions buys merchandise from Magna Data on account, $900, terms FOB shipping point and pays the shipping cost of $50.

LO 3LO 3

Freight

LO 3LO 3

Freight

If ownership of the merchandise passes to the buyer when the buyer receives the merchandise, the terms are said to be FOB (free on board) destination.

On June 15, NetSolutions sells merchandise to Kranz Company on account, $700, terms FOB destination. The cost of the merchandise sold is $480.

Sale Plus Freight Cost

LO 3LO 3

On June 15, NetSolutions pays freight of $40 on the sale of June 15.

Sale Plus Freight CostLO 3LO 3

On June 20, NetSolutions sells merchandise to Planter Company on account, $800, terms FOB shipping point. NetSolutions paid freight of $45, which was added to the invoice. The cost of the merchandise sold is $360.

LO 3LO 3

Seller Prepays Freight

LO 3LO 3

Seller Prepays Freight

Freight Terms

LO 3LO 3

Freight TermsLO 3LO 3

EE 6-4EE 6-4

Summary: Recording Merchandise Inventory

LO 3LO 3

On August 12, merchandise is sold on account to Lemon Company, $100. The state has a 6% sales tax.

Sales Taxes

LO 3LO 3

On a regular basis, the seller pays to the taxing authority (state) the amount of the sales taxes collected.

Sales Taxes

LO 3LO 3

Trade Discounts

When wholesalers offer special discounts to certain classes of buyers who order large quantities, these discounts are called trade discounts.

LO 3LO 3

Each merchandising transaction affects a buyer and a seller. In the following illustrations, we show how the same transactions would be recorded by both the seller and the buyer.

Dual Nature of Merchandise Transactions

LO 3LO 3

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 Company (Seller)

Accounts Receivable—Burton Co. 7,500Sales 7,500

Cost of Merchandise Sold 4,500Merchandise Inventory 4,500

Burton Company (Buyer)

Merchandise Inventory 7,500Accounts Payable—Scully Co. 7,500

LO 3LO 3Dual Nature of Merchandise Transactions

July 2. Burton Company paid transportation charges of $150 on the July 1 purchase from Scully Company.

No entry.

Burton Company (Buyer)Merchandise Inventory 150

Cash 150

LO 3LO 3

July 5. Scully Company sold merchandise on account to Burton Co., $5,000, terms FOB destination, n/30. The cost of the merchandise sold was $3,500.

Merchandise Inventory. 5,000Accounts Payable—Scully Co. 5,000

July 7. Scully Company paid transportation costs of $250 for delivery of merchandise sold to Burton Company on July 5.

Delivery Expense 250Cash 250

No entry.

July 13. Scully Company issued Burton Company a credit memorandum for merchandise returned, $1,000. The cost of the merchandise returned was $700.

Sales Returns and Allowances 1,000Accounts Receivable—Burton Co. 1,000

Merchandise Inventory 700Cost of Merchandise Sold 700

Accounts Payable—Scully Co. 1,000Merchandise Inventory 1,000

July 15. Scully Company received payment from Burton Company for purchase of July 5.

Cash 4,000Accounts Receivable—Burton Co. 4,000

Accounts Payable—Scully Co. 4,000Cash 4,000

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

Accounts Receivable—Burton Co. 500Cash 500

Burton Company (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% × $12,000).

Cash 12,260Sales Discounts 240

Accounts Receivable—Burton Co. 12,500

Accounts Payable—Scully Co. 12,500Merchandise Inventory 240Cash 12,260

EE 6-5

Describe and illustrate the accounting for merchandising transactions including: sale of merchandise, purchase of merchandise; freight, sales taxes, and trade discounts; dual nature of merchandising transactions.

Describe the adjusting and closing process for a merchandising business.

LO 4LO 4Adjusting Entry for Inventory ShrinkageMerchandising businesses may

experience some loss of inventory due to shoplifting, employee theft, or errors in recording or counting inventory.

LO 4LO 4Adjusting Entry for Inventory Shrinkage If the balance of the Merchandise

Inventory account is larger than the total amount of the merchandise count, the difference is often called inventory shrinkage or inventory shortage.

NetSolutions’ inventory records indicate the following on December 31, 2013:

Dec. 31, 2013Account balance of Merchandise Inventory $63,950Physical merchandise inventory on hand 62,150Inventory shrinkage $ 1,800

LO 4LO 4

Inventory Shrinkage

At the end of the accounting period, inventory shrinkage is recorded by the following adjusting entry:

LO 4LO 4

Inventory Shrinkage

EE 6-6

Debit each temporary account with a credit balance, such as Sales, for its balance and credit Income Summary.

LO 4LO 4

Step 1: Closing Entries

Credit each temporary account with a debit balance, such as an expense, for its balance and debit Income Summary.

LO 4LO 4

Debit Income Summary for the amount of its balance (net income) and credit the owner’s capital account.

LO 4LO 4

Debit the owner’s capital account for the balance of the drawing account and credit the drawing account.

LO 4LO 4

NetSolutions’ Income Summary account after the closing entries have been posted is as follows:

Closing Entries

LO 4LO 4

5. Describe and illustrate the use of the ratio of net sales to assets in evaluating a company’s operating performance.

Ratio of Net Sales to Assets

The ratio of net sales to assets measures how effectively a business is using its assets to generate sales.

Ratio of Net Sales to

Assets

Net Sales

Average Total Assets=

LO 5LO 5

LO 4LO 4

The following data (in millions) were taken from the annual reports of Dollar Tree, Inc.:

LO 4LO 4

The ratio of net sales to assets for each year are as follows:

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Appendix

The Periodic Inventory System

Periodic Inventory System

AppendixAppendix

App 1App 1

Recording Merchandise TransactionsPurchases. Purchases of inventory

are recorded in a purchases account rather than in the merchandise inventory account.

AppendixAppendix

Recording Merchandise Transactions Purchases Discounts. Purchases

discounts are normally recorded in a separate purchases discounts account. The balance of the purchases discounts account is reported as a deduction from Purchases for the period.

AppendixAppendix

Recording Merchandise Transactions Purchases Returns and Allowances.

Purchases returns and allowances are recorded in a similar manner as purchase discounts.

AppendixAppendix

Recording Merchandise Transactions Freight In. When merchandise is

purchased FOB shipping point, the buyer pays for the freight. Under the periodic inventory system, freight paid when purchasing merchandise FOB shipping point is debited to Freight In.

AppendixAppendix

(continued)

AppendixAppendix

(concluded)

Closing Entries

(continued)

AppendixAppendix

Closing Entries

(continued)

AppendixAppendix

Closing Entries

(concluded)

AppendixAppendix

Accounting for Merchandising Businesses

The EndThe End

Accounting for Merchandising Businesses

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