Chapter 6: Accounting for Merchandising Business
Comparison of Net and Gross Method
-Both are Acceptable under GAAP. Gross method: more complex in that it requires an adjusting entry and contra asset account.
Customer Discount
A seller may grant a variety of discounts, called ________ _________ (may offer discount to encourage customers to purchase in volume or order bulk). Example: assume NetSolutions sold $18,000 of merch to Digital Technologies on Mar 10 with credit terms 2/10, n/30. The cost of Merchandise Sold was $10,800. -recorded in 2 separate entries (1 for revenue received and 1 for cost of merchandise inventory). -payment of balance on Mar 19 recorded as debit to cash and credit to AR of Digital Technologies. -if Digital Technologies did not pay back within discount period, NetSolutions would receive $18,000 and Sales would be credited for the amount of discount. -journal entry would debit Cash 18,000, credit AR for 17,640, and credit sales for $360 (discount)
Invoice
A seller's request for payment from the purchaser (terms of purchases on accounts are normally indicated here or bill that the seller sends to the buyer).
Purchases returns and allowances-periodic inventory system
A separate purchases returns and allowances account is used to record returns and allowances. -purchases returns and allowances are reported as a deduction from the purchases for the period. -thus, purchases returns, and allowances is a contrat account to purchases Credit balance
Chart of accounts
Merchandising transactions are recorded in the accounts using rules of debits/credits. Accounts consist of 3 digital account numbers: see attached for all #'s -1st digit: indicates major financial statement classification (1: assets, 2: liabilities, etc) -2nd digit: indicates sub classification (11: current assets, 12: non current assets) -3rd digit: identifies specific account (ex: 110: cash, 123: for store equipment) Most merchandising companies use accounting systems with computerized reports (similar to special journals and subsidiary ledgers). -a merchandising accounting system typically produces sales and inventory reports.
Net method
Method of recording purchases at the full invoice price less any discounts for early payment
Example purchases discount
NetSolutions places order from Alpha Technologies on Jan 5 w/ credit terms 2/10, n/30. They borrow $2940 ($3000 less the discount) with an annual interest rate of 6% and a 360 day year is assumed. Calculate interest rate: $2940 x 6% x 20 days divided by 360 days = 9.8 Net savings calculated in attached image. It NetSolutions does not take the discount, it pays an estimated interest rate of 36% for using the $2940 for the remaining 20 days of the credit period.
Other Revenues and Expenses
Other Revenue: revenue from sources other than the primary operating activity of a business (ex: revenue from interest, rent, or gains resulting from sales of fixed assets). Other expenses: an expense that cannot be traced directly to the normal operations of the business (ex: interest expense and losses from disposing of fixed assets). These are offset against each other on the Income Statement. -if revenue exceeds expenses: difference is added to income from operations to determine net income. -if expenses exceed revenues: the difference is subtracted from Income from Operations to determine net income.
Freight
Purchases and sales of merchandise often involve freight (goods carried place to place). The terms of a sale indicate when ownership of the merchandise passes from the seller to the buyer. -this point determines whether buyer or seller pays the freight costs.
Purchases discount-periodic inventory system
Purchases discounts are normally recorded in a separate purchases discount account. -the balance of this account is deducted from from the purchases account for the period. -thus, purchases discounts is a contra account to Purchases. Credit balance
Purchases-periodic inventory system
Purchases of inventory are recorded in the purchases account rather than the merchandise inventory account. -purchases is debited for the invoice amount of the purchase. Debit balance
Nature of the merchandise businesses
The activities of a service business differ from those of a merchandising business, these differences are reflected in the operating cycles of a service and merchandising business as well as their financial statements
Credit terms
The terms for when payments of merchandise are to be made. -if payment is required on delivery, terms are cash or net cash. -otherwise, buyer is allowed the amount of time (known as credit period) in which to pay. Credit Period: Time period that can pass before a customer's payment is due. -usually begins with the date of the sale (shown in invoice). -if payment is due within stated number of days after invoice date (ex. 30 days), the terms are net 30 days (n/30). -if statement is due by end of month, written as n/EOM
Purchases transactions
There are 2 systems for accounting for merchandise transactions: -perpetual inventory system -periodic inventory system
Delivery expense account
This account records the expenses incurred by the business from delivering products to consumers. -reported on sellers income statement as selling expense. Normal balance: debit Debited in case of FOB destination (when seller pays cost of delivery)
Freight in-periodic inventory system
Under the periodic inventory system, freight paid when purchasing merchandise FOB shopping point is debited to Freight In, Transportation in, or a similar account. Debit balance
Dual Nature of Merchandise Transactions
each merchandising transaction affects a buyer and a seller. Attached is a series of merchandise transactions, the journal entries for the seller (Scully Company) and the buyer (Burton Co.) are shown.
perpetual inventory system
each purchase and sale of merchandise is recorded in the inventory account and related subsidiary ledger. -in this way, the amount of merchandise available for sales and the amount sold are continuously perpetuated (updated) in the inventory records. See attached photo for example of cash purchases of merchandise and purchases on account
Customer refunds payable account
A liability account for estimated refunds and allowances that will be paid or granted customers in the future. Normal balance: credit Attached is example of adjusting entry to record this liability
Report form
A balance sheet format that lists classifications one under another.
Cash sales
A business may sell merchandise for cash (also applies for Credit Cards). Example: assume on Mar 3, NetSolutions sells merchandise for $1,800 (recorded as in attached image) When using perpetual inventory system, the cost of merchandise sold and the decrease in merchandise inventory are also recorded. Journalized as: Debit to Cost of Merchandise Sold and Credit to Merchandise Inventory.
Sales on account
A business may sell merchandise on account. -seller records sales as a Dr to Accounts Receivable and a Cr to Sales. Example: NetSolutions sold merchandise on account for $6000, the cost of merchandise sold was $3500. -see attached image for journal entry -includes Dr to AR/Cr to sales -includes Dr to Cost of Merchandise Sold/Cr to Merchandise inventory
Cash Refunds and Allowances
A buyer may receive merchandise that is defective, damaged, or does not meet buyers expectation. In this case, the seller may pay a cash refund or grant a customer allowance that reduces the account receivable owed on the original selling price. -A seller estimates customer refunds and allowances for each years sales (estimate is used to record an adjusting entry that reduces current period sales and creates a liability for future refunds and allowances).
Allowance for sales discounts account
A contra asset account similar to Accumulated depreciation. -just as accumulated depreciation is a contra asset account for a fixed asset, allowance for sales discounts is a contra asset account to Accounts Receivable. After the adjusting entry is posted, allowance for sales discounts will have a credit balance and should be reported on the balance sheet as in attached photo
Purchases return
A credit given to the business to refund the purchase price of returned merchandise. Example attached, NetSolutions returned purchase to Maxim Systems. Involves a debit to the sellers accounts payable and a credit to merchandise inventory.
estimated returns inventory
A current asset account created by an adjusting entry for Returned Merchandise. It is for the estimated amount of merchandise that will be returned by customers. -in the adjusting entry, this account is debited. -reported as a current asset after Merchandise Inventory.
debit memo
A form filled out by the buyer sent to the seller that notifies the seller of reasons for the return (purchase return) or to request a price reduction (purchases allowance). -informs the seller of the amount the buyer proposes to debit to the account payable due the seller. The buyer may use this as the basis for recording the return or wait for the approval from the seller. -either way, the buyer debits Accounts Payable and credits Merchandise Inventory.
Sales taxes
Almost all states levy a tax on sales of merchandise, the liability for this is incurred when the sale is made. -at time of a cash sale, the seller collects this. -when sale is on account, seller charges tax by debiting the Accounts Receivable. -seller credits the sales account for amount of the sale and credits Sales Tax Payable for the tax. Example: Seller records sale of $100 on account, subject to 6% tax, to Lemon Co as shown in first journal entry. -on a regular basis, the seller pays to the taxing authority (state) the amount of sales tax collected (see second journal entry).
Financial statements
Also differ between service and merchandising businesses (ex. Income statement differences in attached photo). Service Business: -revenue activity of a service business involves providing services to customers (reported as fees earned). -operating expenses incurred in providing services are subtracted from fees earned to arrive at operating income. Merchandising Business: -revenue activities involve buying and selling of merchandise. -first purchases merchandise. -sales: when merchandise is sold to customers (revenue). -cost of merchandise sold: cost of merchandise (expense). -gross profit: cost of merchandise sold subtracted from sales (profit before deducting operating expenses). -merchandise inventory: merchandise on hand at the end of the accounting period (reported as current asset).
Adjusting entry for inventory shrinkage
Although (under perpetual inventory system) the Merchandise Inventory Account is continuously updated, the balance at the end of the accounting period is often more than the actual inventory due to theft or error (difference is called inventory shrinkage or shortage). Adjusting entry recorded as: Dr to Cost of Merchandise Sold and Cr to Merchandise Inventory. After entry is recorded: balance of Merchandise agrees with physical inventory (since inventory shrinkage cannot be eliminated, it is considered normal cost) -if shrinkage is unusually large, it may be disclosed separately in income statement (may be recorded in separate account such as Loss from Inventory Shrinkage).
Financial Statements for Merchandising Business
Although merchandising transactions affect the balance sheet in reporting inventory, they primarily affect the Income Statement. Income statement usually prepared using: -Multi-Step format -Single-Step format Statement of Owners Equity: prepared in the same manner as a service business. Balance Sheet: Merchandise Inventory is reported as a Current Asset and the current portion of the Note Payable is a current liability.
Sales Tax Payable account
An account in the general ledger that accumulates the amount of sales tax owed. Normal balance: credit Credited when sales tax is incurred, debited when seller pays the taxing authority.
Single-Step income statement
An alternate form of Income Statement that deducts the total expenses from the total revenues in one step. -single step form emphasizes total revenues and total expenses in determining net income. Criticism: gross profit and income from operations are not reported.
Merchandise inventory account
An asset account that shows the value of goods (inventory) on hand at a given moment (usually at the beginning or end of the accounting period). -normal balance: debit Credited (in terms of buyer) when returned, debited by seller in case of return.
multiple-step income statement
An income statement that contains several sections, subsections, and subtotals. Including: -Sales: total amount of sales to customers for cash/on account in this section. -Cost of Merchandise Sold: (aka cost of goods sold or cost of sales) the amount of merchandise sold to customers in this section. -Gross Profit: the excess of sales over cost of merchandise sold. -Income from Operations: (aka operating income) determined by subtracting operating expenses from gross profit (classified as selling expenses or administrative expenses) -Other Revenue and Expense: see separate card.
Journal Entries to Record Customer Refunds and Allowances
Attached are examples of how to record customer refunds and allowances, assuming that the customer did not return the merchandise. Cash refund: Dr to Customers Refund Payable and Cr to Cash Credit Memo Issued: Dr to Customer Refunds payable and Cr to Accounts Receivable
Recording merchandise inventory transactions
Attached is a T Account that shows the recording of merchandise inventory transactions under the perpetual inventory system. Transactions include: purchases, purchases returns and allowances, freight, and cost of merchandise sold (from sales)
Adjusting Entries for Return of Merchandise
Because sellers are required to estimate returns at the end of the accounting period, adjusting entries are required for the Return of Merchandise. -the adjusting entries ensure that the current period sales are matched with the related cost of merchandise sold on the income statement. The adjusting entries are as follows: 1st: -Sales is debited (decreased) for the estimated amount to be returned in the next year. -Customer Refunds Payable is credited (increased) for the estimated amount to be returned. 2nd: -Estimated Returns Inventory is debited for the estimated cost of merchandise returned in the year. -Cost of Merchandise Sold is credited for the estimated cost of merchandise returned in the year. See attached image for example, includes data prior to adjustments.
Price allowance with purchase discount
Before paying an invoice, a buyer may return or be granted a price allowance for an invoice with a purchase discount. -in this case, amount of the return is recorded at its invoice amount less the discount. Example: NetSolutions purchase merch from Delta Data Link (credit terms: 2/10, n30) -purchased $5000 merch on account. -returned $1000. -paid for purchase see less return and discount. ATTACHED IS JOURNAL ENTRIES
Free On Board (FOB) Shipping Point
Buyer pays freight costs from the shipping point to the final destination (costs are part of the buyers total cost of purchasing inventory and are added to the cost of the inventory by debiting merchandise inventory). -buyer pays the shipping costs Example: assume on Jun 10 that NetSolutions purchased merchandise as follows: -purchased merch from Magna Data, $900, terms FOB shipping point. -paid freight of $50 on Jun 10 from Magna Data. Attached are how NetSolutions records the two transactions 1st: Dr to Merchandise Inventory and Cr to Accounts payable 900 2nd: Dr to Merchandise Inventory, Cr to Cash 50
Chart of accounts-periodic inventory system
Chart of accounts for a periodic inventory system, red highlighted accounts are unique to this system
Selling and Administrative expenses
Classifications of Operating Expenses: Selling Expense: incurred during selling of merch (ex. Sales salaries, store supplies used, depreciation of store equipment, delivery expense, and advertising). Administrative Expense: (aka general expenses) are incurred in the administration or general operations of a business (ex. Office salaries, depreciation of office equipment, and office supplies used). Sub section of Multi-Step Income Statement
Sales discount
Common discount that encourages customers to pay their invoice early. Ex: a seller may offer credit terms of 2/10, n/30 that provides 2% sales discount if the invoice is paid within 10 days.
Returns or Merchandise
Customers may return merchandise for a cash refund or allowance, when this happens the following 2 journal entries are required. First Journal Entry: records the cash refund or allowance. Seller entries: -debits Customer Refunds Payable for amount paid for merch. -credits Cash (If the customer has an outstanding Accounts Receivable balance, Accounts Receivable would be credited instead of Cash) Second Journal Entry: records the receipt of the returned inventory. Sellers Entries: -debits merchandise inventory for merch original cost. -credits Estimated Return Inventory. Example: July 15 Bormann Enterprises returned merchandise that was purchased from Schultz Company for $3,000. The merchandise originally cost $2,100. Schultz Company records the cash refund and the return as in the attached image.
Subsequent period
Customers with outstanding balances in one year will pay their balances in the next year, if a customer pays within the discount period then Allowance for Sales Discounts is debited instead of Sales. Example: Assume that Jay Smith pays his Dec 31, 20Y8 AR balance of $2000 on Jan 4, 20Y9 and takes 2/10 sales discount. -Payment would be recorded as a Dr to Cash, a Dr to Allowance for Sales Discounts, and a Cr to Accounts Receivable. If he did not take the discount and paid on Jan 20, the payment would be recorded as attached photo shows. At the end of the year, Allowance for Sales Discounts will be adjusted for expected sales discounts related to 20Y9 sales that will be taken in the next year.
Purchases discount
Discount taken by the buyer for early payment of an invoice. -To encourage the buyer to pay before the end of the credit period. -ex. A seller may offer a 2% discount if the buyer pays within 10 days of invoice date (if buyer does not take the discount, invoice amount is due within 30 days). 2/10, n/30: read as "2% discount if paid within 10 days, net amount due within 30 days"
Transactions using periodic inventory system
Examples of transactions using the periodic inventory system are attached.
Cost of merchandise sold account
Expense account that shows the cost or price of merchandise that has been sold to customers. Normal balance: debit Debited when merchandise is sold (records the cost of merchandise sold)
Freight terms
FOB shipping point: buyer pays freight (adds to merchandise inventory) FOB destination: seller pays freight (adds to delivery expense)
The closing process
For a merchandise business, the closing process is similar to a service business. 2 entries for merchandising business: 1: debit each revenue account for its balance, credit each expense account for its balance, and debit or credit the capital account (depending on net loss or income). 2: debit the owners capital account for balance of drawing account, credit the drawing account. After closing entries are posted on the accounts: prepare post-closing trial balance -only accounts that should appear on this are: assets, contra assets, liability, and owners capital accounts.
Customer refund
If a buyer is paid a refund, the seller debits Customer Refunds Payable and credits cash. Example: assume that on Mar 4, NetSolutions pays Jones & Hunt a refund of $400 for damaged merchandise. Jones & Hunt has agreed to keep the merch. NetSolutions would record the payment of the refund: -Dr to Customer Refunds Payable -Cr to Cash In some cases: a customer who is due a refund may have an outstanding Accounts Receivable balance. In this case, instead of paying cash, the seller may grant the customer an allowance against the accounts receivable.
Credit Card sales
If a customer uses credit card to purchase, the journal entry is the same as cash sales. -because these sales are normally processed by a clearinghouse that contacts the bank that issued the card (issuing bank then electronically transfers cash directly to retailers bank account). Any processing fees charged by clearinghouse or issuing back are periodically recorded (generally monthly) as an expense (normally reported on the income statement as an administrative (credit card) expense). Example: assume NetSolutions paid credit card processing fees of $4150 on Mar 31: fees recorded as in attached image. -dr to Credit Card expense -cr to cash (To record service charges on credit card sales for the month).
If discount not taken
If the invoice is not paid within the discount period, the full amount of the invoice would be due, and the discount lost would be debited to merchandise inventory.
Closing entries-periodic inventory system
In the periodic inventory system, the purchases, purchases discounts, purchases returns and allowances, and freight in accounts are closed to the Capital Account. -in addition, the merchandise inventory account is adjusted to the end-of-period physical inventory count during the closing process. 2 entries are as follows: 1st entry: 1: debit Merch Inventory for the end of period balance based on physical inventory. 2: debit each revenue account and the following temporary periodic inventory accounts for their balances (purchases discounts/returns and allowances). 3. credit merchandise inventory for its balance at the beginning of the period. 4. Credit each expense account and the following temporary periodic inventory accounts for their balances (purchases and freight in). 5. Credit or debit the owners capital account for the net income/loss 2nd entry: -debit the owners capital and credit the owners drawing account for its balance.
Customer allowance
Returns to the seller by the customer or reductions from the initial selling price due to defective or damaged merchandise or goods that did not meet the customer's expectations. Example: assume that NetSolutions granted Blake and Sons a customer allowance of $900 against its outstanding Accounts Receivable. NetSolutions notified Blake & Sons of the allowance by issuing the credit memo (indicating that NetSolutions intends to reduce Blake & Sons Accounts Receivable by $900 due to damaged merch). Recorded as in attached image: -Dr to Customer Refunds Payable. -Cr to Accounts Receivable.
Sales transactions
Revenue from merchandise sales is usually recorded as Sales (sometimes business may use title Sales of Merchandise). -cash sales -sales on accounts -customer discounts -cash refund and allowances
Gross profit
Sales - cost of merchandise sold = _____ _____.
Adjusting entry for customer refunds and allowances
Sellers are required to estimate refunds/allowances at the end of the period and make adjusting entries. Adjusting entry: reduces Sales Account (Dr) and creates a Customer Refund Liability Account for estimated refunds/allowances in the future. Example: Assume that Sales for the end of the year are $715,409 and the estimated percent of refunds is 1%, and the balance of Customer Refunds Payable is $800 (credit). The adjusting entry: Dr to Sales (for Sales x Estimated % of Refunds) and Cr to Customer Refunds Payable.
If discount taken
Since buyers normally take all purchases discounts, merchandise inventory is debited for the net purchase price under perpetual inventory system. -that is, the buyer debits merchandise inventory for the amount of the invoice less the discount.
Adjusting entry for Gross Method
Since the GAAP requires revenue (sales) to be recorded in the amount most likely to be received, the gross method requires an adjusting entry at the end of the accounting period. Adjusting entry: reduces Sales for estimated sales discounts related to the current periods sales that are expected to be taken in the next period. Example: Assume that NetSolutions has the following data on Dec 31, 20Y9: Sales: Cr of 709,955 Accounts Receivable: 92,880 Dr allowance for sales discounts: 100 Cr Estimated sales discounts that will be taken in 20Y9: 1700 Cr The adjusting journal entry is attached: debits Sales and Credits allowance for sales discounts
Asset Turnover
Sometimes called the ratio of sales to assets, measures how effectively a business is using its assets to generate sales. -high ratio: indicates effective use of assets. Computed as: sales/average total assets Average total assets: computed by adding the beginning of the year assets to the end of year assets and dividing by 2
Adjusting entries under periodic inventory system
The adjusting process is the same under the periodic and perpetual inventory system except for inventory shrinkage adjustment and customer refunds and allowances. Perpetual: -under perpetual, the ending physical inventory count is compared to balance of the Merchandise Inventory Account (the difference is the amount of Inventory Shrinkage). -Inventory Shrinkage is then recorded as Dr to Cost of Merch Sold and cr to Merch Inventory. Periodic: -the merchandise inventory account is not kept up to date for purchases and sales (inventory shrinkage cannot be directly determined). -Instead, any inventory shrinkage is included indirectly in the computation of cost of merchandise sold (MAJOR DISADVANTAGE) Major disadvantage: inventory shrinkage cannot be separately determined. Adjusting entry: -debits Sales and credits Customer Refunds Payable for the estimated customer refunds and allowances.
Financial statements-periodic inventory system
The financial statements are similar under the perpetual and periodic inventory systems. -when the multi-step format of the income statement is used, the cost of merchandise sold can be reported as shown in attached image
free on board (FOB) destination
The ownership of the merchandise passes to the buyer when the buyer receives the merchandise. -means the seller pays the delivery charges. -when the seller pays the charges, the seller debits Delivery Expense or Freight Out. Example: NetSolutions sells merch as follows: -sold merch to Kranz Company on account, $700, terms FOB destination. Cost of Merch Sold $480. -NetSolutions pays freight of $40.
Operating cycle
The process by which a company spends cash, generates revenues, and receives cash either at the time the revenues are generated or later by collecting an accounts receivable. -a service and merchandising business differ in that a merchandising business must purchase merchandise for sales to customers. -time in days to complete an operating cycle differs between merchandising businesses (ex. Grocery items must be sold within expiration date while jewelry can be displayed for months) Attached is operating cycle for merchandising business.
Prepay Freight
The seller may _____the ______, even though the terms are FOB shipping point. The seller will then add the freight to the invoice. -buyer debits Merchandise Inventory for the total amount of the invoice, including freight (any discount terms would not apply to the prepaid freight). Example: assume NetSolutions sells merch as follows: -Sold Merch to Plantar Company on account, $800, terms FOB shipping point. NetSolutions paid freight of $45, which was added to the invoice. The cost of Merch Sold was $360.
Recording transactions under periodic inventory system
Using the periodic inventory system, purchases of inventory are not reported in the Merchandise Inventory account (instead, purchases, purchase discounts, and purchases returns and allowances accounts are used). -sales of merchandise is not recorded in the inventory account (thus, there is no detailed record of the amount of inventory in hand). -at the end of the period, the physical count of merchandise inventory is taken (physical count is used to determine the cost of merchandise sold).
Trade discounts
Wholesalers (companies that sell merch to other businesses) often publish or upload sales catalogs online. They often offer special discounts to government agencies or businesses that large order quantities. This discount is called a _____ _______. sellers and buyers do not normally record the list prices of merchandise in their accounts (instead, they record the sale at the price less the discount). For example: list price is $1000, 40% off. Would be recorded as $600 by the seller and the buyer.
Purchases returns and allowances
a buyer may request an allowance for merchandise that is returned (purchase return) or a price allowance (purchases allowance) for damaged or defective merchandise. -in both cases the buyer normally sends the seller a debit memorandum (often called a debit memo)
Credit memo
a document, approved by the credit manager, authorizing the billing department to credit a customer's account (accounts receivable) in the case of a refund when the customer has an outstanding Accounts Receivable balance.
Sales account
a revenue account for recording the sale of merchandise. Normal balance: credit Credited when sale of merchandise occurs
Gross method
a sales invoice with credit terms granting a discount for early payment is recorded at the gross amount of the invoice. -if customer pays within discount period, cash is debited for the amount received, the discount is recorded as a Debit to Sales, and the Accounts Receivable is credited for the invoice amount. Attached is an example of a transaction recorded via the gross method -REQUIRES adjusting entry at the end of the accounting period.
Periodic inventory system
the inventory does not show the amount of merchandise available for sale and the amount sold. -instead, a listing of inventory on hand (called a physical inventory) is prepared at the end of the accounting period. -physical inventory is used to determine cost of merchandise on hand at the end of the period and cost of merchandise sold during the period. -purchases normally recorded at invoice amount. -Small businesses may use the manual accounting system, in this case a perpetual inventory system is time consuming and costly to maintain. Better to use a ______ inventory system. -if paid in discount period, discount is recorded in a separate account account called Purchase Discounts. -likewise, purchases returns are recorded in a separate account called Purchases Returns and Allowances.
