Lesson Notes Lesson 6 Accounting for Merchandising Activities Learning Objectives Describe merchandising activities and identify business types. Identify and explain the important components of income for a merchandising company. Record and compare merchandising transactions using both periodic and perpetual inventory systems. Analyze and record transactions for merchandising purchases using a perpetual system. Analyze and record transactions for sales of merchandise using a perpetual system. Prepare adjustments entries for a merchandising company. Prepare closing entries for a merchandising company. Teaching Hours Students major in accounting: 6 hours Other students: 3 hours Teaching Contents Scandals in stock market occur now and then. Among them, financial frauds or income manipulation are common. Income manipulation typically starts from making up sales revenues as well as purchases, for example, GuangXia (Yinchuan). In this lesson you are required to think about, Why these income statement numbers are so important? How they are recorded in accounting system? Merchandising company The main activity for a merchandising company is to purchase merchandise inventory and then sell them to generate profit. Wholesalers and retailers are examples of merchandising companies. Service revenue vs. merchandising revenue Both service and merchandising businesses generate sales. Service organizations sell time to earn revenue. Merchandising companies sell merchandise to earn revenue. Operating Cycle of Merchandise Companies In order for it to generate sales, the merchandiser must first purchase merchandise inventory that it then sells. The operating cycle of merchandise companies involves the purchase and subsequent sale of merchandise inventory. Revenue from selling merchandise is called sales revenue, and the expense of buying and preparing merchandise inventory for resale is cost of goods sold (COGS). Merchandise inventory represents the goods held for resale in the normal course of business. Two common equations used in the reporting of merchandising activities are: Net sales revenue – Cost of goods sold = Gross profit Gross profit – Operating expenses = Net income (or Net loss) Periodic and perpetual inventory systems Some businesses update inventory records periodically while others keep inventory records up-to-date on a daily basis. A periodic inventory system provides inventory and cost of goods sold data only when inventory is counted (for example, at year end). This differs from the perpetual inventory system, which provides inventory and cost of goods sold data on a continuous, up-to-date basis. As a result, how the purchase and sale of merchandise inventory is recorded differs between the periodic and perpetual inventory systems. For example, the periodic inventory system uses a temporary Purchases account to record the cost of merchandise purchased. When financial statements are prepared under the periodic system, the cost of goods sold and merchandise inventory are determined, in part, by conducting a physical count of inventory on-hand. In contrast, a perpetual inventory system updates the Merchandise inventory and Cost of goods sold accounts each time an item is purchased or sold. A physical inventory count must also be performed under a perpetual system to reconcile any difference between actual merchandise on hand and the balance reported in the accounting records. Advances in technology have made it feasible for a growing number of merchandisers to use a perpetual inventory system. Therefore, the perpetual inventory system of accounting is the initial focus of this lesson. Merchandise purchases — Perpetual inventory system Gross purchases Under a perpetual inventory system, all purchases of merchandise inventory on credit are debited to the Merchandise inventory account at the time of purchase, as follows: Merchandise inventory XXX Accounts payable XXX Note that net purchases differ from gross purchases. To calculate net purchases, you adjust gross purchases for any purchase discounts provided by suppliers and any purchase returns and allowances for unsatisfactory items received from suppliers. Purchase returns and allowances The general format used to record the journal entry for a purchase return or purchase allowance is: Accounts payable XXX Merchandise inventory XXX Trade discounts A trade discount is a reduction below a list price or catalogue price that is negotiated in setting the selling price of goods. The actual price (invoice price) is determined by deducting the trade discount from the list price. Neither the list price nor the trade discount is recorded on the books of either the buyer or seller. The transaction is recorded at the invoice price. For example, if T-Mart purchases merchandise listed in the seller’s catalogue at $1,000 and receives a 25% trade discount, the credit purchase would be recorded by T-Mart as: Merchandise inventory 750 Accounts payable 750 1,000 less 25% The use of trade discounts saves manufacturers and wholesalers the cost of frequently republishing their catalogues. Instead, customers receive a new set of trade discounts to apply to the catalogue prices when prices are revised. Purchase discounts A purchase discount is a deduction from the invoice price granted to induce early payment of the amount due. Credit terms dictate when payment is due (the credit period) and clarify the nature of any discounts offered to customers who pay their accounts early. By encouraging customers to make early payment, cash discounts reduce the amount a supplier has invested in its accounts receivable, and thus provides it with cash for other uses. This type of incentive also tends to decrease any significant loss that could be incurred from accounts that are uncollectible. Credit terms depend on practice, which vary from industry to industry. The following credit terms are common: n/30 means that payment for a credit sale is due 30 days after the invoice date. n/10 EOM means that payment is due 10 days after the end of the month in which the sale occurred. 2/10, n/30 means that the credit period is 30 days but the debtor may deduct 2% from the invoice amount if payment is made within 10 days of the invoice date. The 10 days is known as the discount period. 2/10, 1/15, n/30 means a 2% discount can be taken if the invoice is paid during the first 10day discount period, or a 1% discount can be taken if the invoice is paid during the next five days, or the full invoice amount must be paid after the second discount period and within the 30-day credit period. When a purchaser takes advantage of a cash discount, the discount is credited to the Merchandise inventory account under the perpetual inventory system. Good cash management requires that no invoice be paid until the last day of its discount period. This is because money has a time value and interest can be earned on cash before it is used to pay bills. Invoices should be filed by due dates to avoid missing a discount. Transportation costs Transportation costs (often called transportationin or freightin) are added to the cost of Merchandise inventory. Goods may be shipped FOB destination or FOB shipping point. FOB means free on board. It is the point that determines when legal title passes and realization of revenue occurs. When goods are in transit between a seller and a buyer, either party can hold title, depending on the terms of the sale. For FOB destination, the seller pays for transportation. While the goods are in transit they still belong to the seller, and ownership rights are transferred upon arrival at the buyer’s premises. For FOB shipping point (also called FOB factory), the buyer pays the freight and records the shipping cost as part of Merchandise inventory. Goods are loaded on board the means of transportation at the factory free of charge, and the transfer of ownership occurs when the goods leave the seller’s premises. Revenue from sales and cost of goods sold— Perpetual inventory system Sales For a business engaged in a merchandising activity, revenue takes the form of sales. Gross sales revenue from cash and credit sales is recorded when earned, which is usually when title to the goods changes hands. This occurs when the goods are physically transferred from the seller to the buyer. The entry to record the sale of merchandise on credit under a perpetual inventory system requires two entries, as follows: Accounts receivable XXX Sales XXX Cost of goods sold XXX Merchandise inventory XXX Recall that under the perpetual inventory system, any events affecting the cost of goods sold or merchandise inventory are recorded immediately. Sales returns and allowances Many businesses allow customers to return merchandise (sales return) or to keep the merchandise and deduct an amount from the sales price (sales allowance). A sales allowance is usually given on merchandise due to minor defects, breakages, spoilage, inferior quality, or shortages in shipments, for example. In both cases, the original sale is negated — that is, an entry is made to reverse all or part of the sale. For a sales return, the total amount is debited, whereas for a sales allowance, a lesser amount is debited. Sales discounts It is common for businesses to sell their merchandise on account. According to accrual accounting, sales revenue is recorded at the point of sale. This means a business typically recognizes sales revenue prior to collecting cash; therefore, it may later need to make adjustments that are deducted from gross sales. A sales discount is a cash discount taken by customers against an amount owed to the seller. Since at the time of sale it is not known if the customer will take advantage of a cash discount, sales discounts are typically recorded when payment is received, as follows: Cash 98 Sales discount 2 Accounts receivable 100 The sales discount account is a contra revenue account — an offset to the Sales account. Gross Profit Accurate gross profit figures are an important tool for managers to assess the firm’s performance. For example, it is common for businesses to calculate the gross profit percentage (gross profit ( net sales) and to compare this percentage with previous periods and with that of other firms. Net income for a merchandising operation can be calculated from gross profit as follows: Net sales=Sales – Sales returns and allowances – Sales discounts Gross profit=Net sales – Cost of goods sold Net income (loss) =Gross profit – Operating expenses Shrinkage Inventory losses that occur as a result of theft or deterioration are known as inventory shrinkage. Shrinkage is measured differently under the perpetual and periodic inventory systems. Under the perpetual inventory system, shrinkage is calculated by comparing a physical count with recorded quantities. Under the periodic inventory system, only the cost of goods on hand and the cost of goods sold are calculated and a direct measure of shrinkage is not provided. The cost of goods sold figure includes the actual cost of goods sold plus the cost of goods stolen or destroyed. Summary of merchandising cost flows Regardless of whether a perpetual or periodic inventory system is in place, the transactions affecting Cost of goods sold on the income statement and Merchandise inventory on the balance sheet are identical. Under both systems, the ending merchandise inventory of one accounting period is the beginning merchandise inventory of the next period. These events can be summarized through the following equations, which apply under either a perpetual or periodic inventory system: Net purchases=Purchases––Purchase discounts Cost of goods purchased = Net purchases + Transportation-in =Beginning inventory+Cost of goods purchased Cost of goods sold*=Cost of goods available for sale–Ending inventory* *Under a perpetual inventory system, shrinkage, the difference between ending merchandise inventory per the physical count and ending merchandise inventory per the accounting records, is subtracted from ending inventory and added to cost of goods sold as an adjustment at the end of the accounting period. Under a periodic system, ending inventory is determined based on a physical count; therefore, both ending inventory and the resulting cost of goods sold are inclusive of shrinkage. Closing entries The closing process is accomplished for a merchandising company by crediting those accounts that appear on the worksheet in the income statement’s debit column (including Sales returns and allowances, Sales discounts, and Cost of goods sold) and by debiting those accounts that appear on the worksheet in the income statement’s credit column (including Sales). Discussion case: CIMC CIMC is the number one stock in China, mainly due to its “excellent” operating performance. However, in early 2005, the operating performance of CIMC was challenged. Analysts argued that, the surprisingly high operating performance is questionable. Specifically, abnormal growth was found in the following items, Sales revenue Gross profits Accounts receivable Inventory However, no growth was found in cash collected from customers. Required: How to calculate the growth rates in sales, gross profits, inventory, accounts receivables, and cash? Are there are relationships between the above items? How to verify the growth in above items? Summary The operating cycle of merchandise companies begins with the purchase of merchandise and end with the collection of cash from the sale of merchandise. Perpetual method and periodic method are two inventory systems. Today perpetual method is more and more adopted. Accounting for merchandise purchases records purchases, trade discount, cash discounts, purchase returns and allowance, transportation costs. Accounting for sales transactions records sales, sales discount, sales returns and allowance, etc. Under perpetual inventory system, adjustments must be made for shrinkage at the end of period. Closing entries transfer balances in sales, sales returns and allowance, sales discounts and cost of goods sold into income summary account. Key Points components of income for merchandising company periodic vs. perpetual inventory system merchandising purchase transactions merchandising sales transactions Reading material Larson, K.D., T. Jensen, and R. Carroll, 2002, Fundamental Accounting Principles, McGraw-Hill Ryerson. Libby, R., P.A. Libby, D.G. Short, G. Kanaan, and M. Gowing, 2003, Financial Accounting, McGraw-Hill Ryerson.