Chapter 5. Merchandising Operations

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Chapter 5

Merchandising Operations

When a service business earns fees they record revenue from the services rendered. In the case of the merchandising business you still have the revenue transaction, but you also have a second cost transaction because you have produced your revenue from selling an asset. The cost or expense generated from the sale of merchandise is called Cost of Goods Sold.

The Cost of Goods Sold is treated the same as an expense in the journal entries, but it can be treated differently in an income statement. Often, Sales Revenue and Cost of Goods Sold is reported at the top of an income statement, and the net difference is labeled Gross Profit or Gross Margin.

Inventory Systems

There are two methods of handling inventories:

• The periodic inventory system, and

• The perpetual inventory system Periodic Inventory System

With the periodic inventory system, the firm finds out its cost of goods sold at the end of the accounting period. Throughout the accounting period, the firm keeps track of its purchases. To find out what the firm sold, the firm takes its beginning inventory adds its purchases for the period. This gives the firm all the goods that pass through the firm for the period (the goods available for sale). The firm then takes a physical inventory. This gives the firm what is left at the end of the period.

The ending inventory is then subtracted from the available goods figure to get the cost of goods sold.

The periodic inventory system assumes anything not there was sold, but the goods could have been stolen. The lack of information on the theft or spoilage of goods is a major disadvantage of the periodic system. In addition, unless a physical inventory is taken, the firm does not know what its cost of goods sold is during the period (as opposed to the end of the period). An advantage of the periodic inventory system is that it is easy to maintain.

Perpetual Inventory System

With the perpetual inventory system, the firm keeps track of its cost of goods sold on a continual basis. Thus, at any given time, the firm can estimate its current inventory levels. At the end of the period, a physical inventory is taken. Any discrepancy with the estimated inventory level and the actual inventory level is then attributed to theft and spoilage.

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It used to be very expensive to maintain this type of system, but with the use of computers & scanners, this is no longer the case, and the perpetual inventory system is increasing in popularity.

What we have discussed to date is the perpetual inventory system, and we will continue to use it in this chapter.

Recording Purchases of Merchandise When you purchase inventory with cash:

D. Merchandise Inventory $5,000

Cr. Cash $5,000

When you purchase inventory on credit:

Cr. Accounts Payable $5,000

A cash purchase should be supported with a cancelled check. A credit purchase should be supported with an invoice from the supplier.

Purchase Returns & Allowances

When you return merchandise inventory (Purchases Return) or get a price reduction on the merchandise (Purchases Allowance) after they are delivered, you write down the price of the Merchandise Inventory to the price actually paid.

The journal entry, in effect, reverses in whole (return) or in part (allowance) the purchase journal entry:

A return of entire $5,000 purchase:

D. Accounts Payable $5,000

Cr. Merchandise Inventory $5,000

The receipt of a $1,000 purchase allowance on the prior purchase:

Cost of Inventory

Inventory cost is defined as the price paid to acquire the inventory and generally includes invoice price less purchases discounts, freight, insurance in transit,

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taxes, tariffs, inspection costs and preparation costs. It is basically everything that is paid in order to get the inventory ready to sell.

Transportation Costs

The term, “FOB”, stands for Free On Board. "FOB shipping point" means that the seller transfers title to the goods at the seller’s place of business. The buyer pays shipping costs. For example, if you order a car from Ford and the invoice says FOB Detroit, then you pay the shipping costs and the car belongs to you as soon as it leaves the factory. If something goes wrong during shipment, it is your problem.

The term "FOB destination" means that the seller transfers title to the goods at the buyer’s place of business. The seller pays shipping costs. For example, if you order a car from Ford and the invoice says FOB Los Angeles, then Ford pays the shipping costs and the car belongs to you when it arrives.

Transportation Costs on purchases are part of the cost of our inventory. These costs are referred to as Freight in or Transportation In. Under the perpetual inventory system, you write up the cost of the inventory:

D. Merchandise Inventory $150

Cr. Accounts Payable/Cash $150

Transportation Costs on our sales are an expense. They are called Transportation Out or Freight Out:

D. Freight Out $150

Cr. Accounts Payable $150

Purchases Discounts

When we purchase inventory, we are often provided with credit terms that encourage us to pay quickly. These are called purchase discounts. When we offer these terms to our customers they are called sales discounts.

A typical purchase/sales discount notation (credit terms) is 2/10 n/30 (“two-ten, net thirty”). This notation says that if the purchaser pays within 10 days, then the purchaser may take 2 percent off the price of the goods. Otherwise, the entire bill is due in 30 days.

Another example would be 1/10 EOM. This notation says that the purchaser may take a 1 percent discount if he or she pays the invoice during the first 10 days of the next month. Otherwise, the entire bill is due by the end of the next month.

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If seller does not wish to offer a discount, then the seller indicates when payment is due. For example, n/30 says that the entire amount is due in 30 days. The notation n/10 EOM says that the invoice amount is due in the first 10 days of the next month.

Usually, passing up the purchase discount is thought to be very unwise because the interest cost for delaying the payment for 20 days is very high. For example, with 2/20 n/30, you are paying 2% for a 20-day loan. This is an annualized rate of 36.5% per annum.

Assume you bought inventory for $3,500 and the supplier offered you 2/10 n/30.

When you receive the inventory, ignore the potential purchase discount:

Cr. Accounts Payable $3,500

If the payment is made during the discount period, you write down the price paid for the Merchandise Inventory to the cash actually paid:

Cr. Cash $3,430

Merchandise Inventory 70

If the payment is not made during the discount period:

Cr. Cash $3,500

Cash Sales

When you make a cash sale, you have the following general journal entry reflecting the revenue side of the transaction:

D. Cash $2,200

Cr. Sales Revenue $2,200

The cost side of the transaction is recorded as follows:

D. Cost of Goods Sold $1,400

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Sales on Account

When a company makes a credit sale, the general journal entry is as follows:

D. Accounts Receivable $2,200

The cost side of the transaction is recorded as noted above:

Credit Card Sales

Companies that allow customers to use a national credit card (such as Master Card) must follow special accounting procedures. Operationally, the credit card company reimburses the company for the sale, less a service charge (e.g., 2% - 3%). The credit company levies a service charge because it is responsible for establishing credit and collecting the money from the customer.

There are two ways to handle credit card sales depending on the credit card company. Some credit card companies make the vendor wait for payment. This isn't done by the major credit card companies. This was the way that American Express used to operate. The general journal entry looks like a credit sale, except that the Account Receivable is from the Credit Card Company -- not the customer:

At the time of the sale:

D. Accounts Receivable – Credit Card Company $1,000

At the time payment is received from the credit card company:

D. Cash $970

Credit Card Discount/Service Charge Expense 30

Cr. Accounts Receivable – Credit Card Company $1,000 Most major credit card companies make the cash available to the vendor

immediately. Your book only discusses this situation. Because the funds are made available within a few hours, there is no need to record an account

receivable from the credit card company. Instead, the transaction is treated as a cash sale with a fee being paid to the credit card company:

D. Cash $970

Credit Card Discount/Service Charge Expense 30

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The Credit Card Discount can be handled as either a selling expense or as a contra revenue, which is deducted before getting Net Sales. Your book takes the position that the credit card fees are treated as a selling expense.

Sales Returns and Allowances

If a customer returns merchandise that he or she has purchased, you want to undo the sale. You debit a contra-revenue account (Sales Returns &

Allowances) that will be deducted from Sales Revenue in order to compute Net Sales. This gives management important information about what kind of returns the company is experiencing.

Undo the sales revenue:

D. Sales Returns and Allowances $300

Cr. Accounts Receivable $300

Undo the cost side of the sale:

D. Merchandise Inventory $140

Cr. Cost of Goods Sold $140

Sales Discounts

If you offer customers a reduction in price if they pay the invoice quickly, these discounts are referred to as sales discounts or a cash discount. You would use the same credit terms/discount notation discussed under Purchase Discounts (e.g., 2/10 n/30).

The entry at the time of sale:

D. Accounts Receivable $3,500

Cr. Sales/Sales Revenue $3,500

If the payment is received during the discount period:

D. Cash $3,430

Sales Discounts 70

Cr. Accounts Receivable $3,500

If the payment is not received during the discount period, then the general journal entry when the payment is made is:

D. Cash $3,500

Cr. Accounts Receivable $3,500

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Sales Discounts are treated as a contra revenue account (offsets Revenue in order to get Net Sales.

Sales Taxes

Most states and many cities levy a sales tax on retail transactions, and the

federal government also charges an excise tax on some products. The merchant must collect the taxes from the customer at the time of the sale and record the receipt of cash and the proper tax liabilities. The merchant is not paying the tax, he or she is collecting it from the customer on behalf of the government.

D. Cash $1,080

Cr. Sales $1,000

Sales Tax Payable 80

When the sales tax is paid:

D. Sales Tax Payable $80

Cr. Cash $80

Trade Discounts

A trade discount is when you offer customer a reduction from your regular prices.

The reduction is not tied to paying the invoice early. A good example would be a volume discount. For example, the price of one unit may be $5.00 a unit, but if the customer buys 10 units, then the unit price drops to $4.00. An “After

Christmas Sale” is a trade discount. The sale is reported at the discounted price (the lower price), and there is no account for trade discounts.

Net Sales

Net Sales is Sales Revenue reduced by the contra-revenue accounts:

Sales Revenue $480,000

Less: Sales Returns and Allowances -12,000

Sales Discounts -8,000

Credit Card Discounts (if treated as a contra-revenue account) -6,000

Net Sales $454,000

Classified Income Statements

In a single-step income statement, the revenues section lists all revenues, including other income, and the operating costs section lists all expenses, including other expenses.

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Many companies, however, use multiple-step income statement that is more detailed, containing several subtractions and subtotals. Often, corporations present condensed financial statements with only major categories of the financial statement.

Income Statement

For Year Ending December 31, 20XX

Net Sales $460,000

Less: Cost of Goods Sold -316,000

Gross Margin/Profit $144,000

Less: Operating Expenses -114,000 Income From Operations $30,000 Other Revenue & Gains 3,600 Less: Other Expenses & Losses -2,000 Income Before Income Taxes $31,600 Less: Income Tax Expense -10,100

Net Income $21,500

Gross Margin/Profit

Net Sales less Cost of Goods Sold gives you a company’s Gross Margin. This is also called the Gross Profit. This profit or margin gives you the merchandising profit. Analysts look at this figure because it gives information about the

company’s market. High gross margins indicate that the sector isn’t very competitive. The personal computer market in the 1970s & 1980s was

characterized by high gross margins. During the 1990s, the personal computer market became very competitive and was characterized by shrinking gross margins.

Operating Expenses Operating Expenses are:

• sales expenses and

• general & administrative expenses

Unlike Gross Margins, which may be viewed as a function of the marketplace, Operating Expenses are a direct result of the management of the company.

(How good is the company in controlling its expenses?)

If you subtract the Operating Expenses from the Gross Margin and, you have Income From Operations. Financial Analysts consider Income From Operations very important because it represents the major operations of the company. It is

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viewed as sustainable, and analysts consider it a good indication of future performance.

Nonoperating Activities

Although your book treats Nonoperating Activities as two different items on a classified income statement, most companies treat it as one item called Other Revenues and Expenses. Nonoperating activities are made up of nonoperating revenues & gains (e.g., dividends income, interest income, and gains from sales of assets) and nonoperating expenses & losses (e.g., interest expense and losses from sales of assets).

After Income From Operations, you subtract Other Revenues and Expenses.

Remainder of Classified Income Statement

Income From Operations less Other Revenues and Expenses gives you Income Before Income Taxes.

Income Taxes (Income Tax Expense or Provision For Income Taxes) represent the taxes owed on the income appearing on the financial statement.

After Income Taxes are deducted, you have Net Income.

Below Net Income, a corporation also reports the Net Income earned for each share of common stock (Earnings Per Share).

Example of Multiple-Step Income Statement

Shafer Auto Parts Corporation Income Statement

For the Year Ended December 31, 20XX

Revenues from Sales $289,656

Cost of Goods Sold -181,260

Gross Margin from Sales $108,396

Operating Expenses

Selling Expenses $ 54,780

General and Administrative Expenses 34,504

Total Operating Expenses -89,284

Income from Operations $19,112

Other Revenues and Expenses

Interest Income $1,400

Less: Interest Expense -2,631

Excess of Other Expenses over Other Revenues -1,231

Income Before Income Taxes $17,881

Income Taxes -3,381

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Net Income $14,500

Earnings per share $ 2.90

Example of Single-Step Income Statement

Shafer Auto Parts Corporation Income Statement

For the Year Ended December 31, 20XX Revenues

Net Sales $289,656

Interest Income $1,400

Total Revenues $291,056

Costs & Expenses

Cost of Goods Sold $181,260

Selling Expenses 54,780

General and Administrative Expenses 34,504

Interest Expense 2,631

Income Tax Expense 1,231

Total Costs and Expenses -276,556

Net Income $14,500

Earnings per share $ 2.90

Additional Profitability Ratios

Your book notes that there are two additional profitability ratios:

• Gross Profit Rate (Gross Margin Percentage)

• Operating Expenses to Sales Ratio

Gross Profit Rate

This ratio is also called the Gross Margin Percentage. As noted above, a company’s gross margin is an important indicator of the competitiveness of the company’s markets. Gross Margin is a raw number, and financial analyst’s prefer a ratio that can be compared to the figures from other years within a company, and figures from other companies. This ratio is obtained by dividing the Gross Margin by Net Sales:

Gross Profit/Margin ---

Net Sales

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Profit Margin Ratio

This ratio divides the net income by the Net Sales.

Net Income --- Net Sales

The ratio allows you to compare the profitability of different firms of different sizes.

Operating Expenses To Sales Ratio

This ratio indicates how well the company’s management is able to control its operating expenses:

Operating Expenses ---

Net Sales

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Illustration

Sportcraft. a wholesaler of sporting goods, had the following trial balance at December 31 of the current year:

Sportcraft Trial Balance December 31, 20XX

Debit Credit

Cash $ 6,200

Accounts Receivable 28,000

Inventory, January 1 45,000

Office Supplies 800

Prepaid Insurance 2,100

Land 34,000

Building 82,000

Less: Accumulated Depreciation-Building $ 16,000

Office Equipment 21,300

Accumulated Depreciation--Office Equipment 5,300

Accounts Payable 19,000

Common Stock 161,200

Dividends 10,000

Sales 252,000

Sales Discounts 3,500

Purchases 151,000

Purchases Returns and Allowances 2,400

Transportation In 8,200

Sales Salaries Expense 27,600

Transportation Out 7,800

Advertising Expense 6,100

Office Salaries Expense 22,300

--- ---

$455,900 $455,900

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The following information is available at December 31:

a. Office supplies on hand at December 31 are $250.

b. Prepaid insurance at December 31 is $1,500.

c. Depreciation for the year is building, $2,000; office equipment, $2,400.

d. Salaries payable (but not yet accrued) at December 31 are sales salaries,

$300; office salaries, $200.

e. Inventory at December 31 is $43,500.

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Required:

• Prepare adjusting entries in general journal form.

• Prepare closing entries in general journal form.

• Prepare a classified income statement for the year.

• Prepare a classified balance sheet at December 31.

Adjusting Entries:

D. Office Supplies Expense 550

Cr. Office Supplies on Hand 550

D. Insurance Expense 600

Cr. Prepaid Insurance 600

D. Depreciation Expense--Building 2,000

Depreciation Expense--Office Equipment 2,400

Cr. Accumulated Depreciation--Building 2,000

Accumulated Depreciation--Equipment 2,400

D. Sales Salaries Expense 300

Office Salaries Expense 200

Cr. Salaries Payable 500

Closing entries:

D. Income Summary 277,550

Cr. Inventory (January 1) 45,000

Sales Discounts 3,500

Purchases 151,000

Transportation In 8,200

Sales Salaries 27,900

Office Salaries Expense 22,500

Office Supplies Expense 550

Insurance Expense 600

Depreciation Expense -- Building 2,000

Depreciation Expense -- Equipment 2,400

D. Inventory (December 31) 43,500

Sales 252,000

Purchases Returns and Allowances 2,400

Cr. Income Summary 297,900

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D. Income Summary 20,350

Cr. Retained Earnings 20,350

D. Retained Earnings 10,000

Cr. Dividends 10,000

Sportcraft Income Statement

For Year Ending December 31, 20XX Revenue

Sales $252,000

Less: Sales Discounts 3,500

Net Sales $248,500

Cost of Goods Sold

Inventory, January 1 $ 45,000

Add: Net Cost of Purchases

Purchases $151,000

Less: Purch. Ret & Allow 2,400

$148,600

Add: Freight In 8,200

Net Cost of Purchases 156,800

Cost of Goods Available for Sale $201,800 Less: Inventory, December 31 -43,500

Cost of Goods Sold -158,300

Gross Margin $ 90,200

Operating Expenses Selling Expenses

Sales Salaries Expense $27,900

Total Selling Expenses $41,800

General and Admin. Expenses

Office Salaries Expense $ 22,500

Office Supplies Expense 550

Insurance Expense 600

Depreciation Expense--Building 2,000 Depreciation Expense--Equip. 2,400

Total Gen. and Adm. Exp. $28,050

Total Operating Expenses -$69,850

Net Income $ 20,350

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Sportcraft Balance Sheet December 31, 20XX Assets

Current Assets

Cash $ 6,200

Accounts Receivable 28,000

Inventory 43,500

Office Supplies 250

Prepaid Insurance 1,500

Total Current Assets $ 79,450

Long-term Assets:

Land $34,000

Building $82,000

Less: Accum. Depre. -18,000

64,000

Office Equipment $21,300

Less: Accum. Depre. -7,700

13,600

Total Long-term Assets 111,600

Total Assets $191,050

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Liabilities & Shareholders’ Equity Current Liabilities:

Accounts Payable $19,000

Salaries Payable 500

Total Current Liabilities $19,500

Shareholders’ Equity:

Common Stock $161,200

Retained Earnings 10,350

Total Shareholders’ Equity 171,550

Total Liabilities & Shareholders’ Equity $191,050 =======