Financial and Managerial Accounting
The Basis for Business Decisions
14th Edition
Williams Haka Bettner Carcello
Chapter 6: Merchandising Activities
Learning objective number 1 is to describe the operating cycle of a merchandising company.
The operating cycle of a business is the time it takes a business to start with cash, purchase inventory, sell the inventory, and finally collect cash from customers.
The operating cycle of a business that sells inventory on credit is typically longer than that of a business that sells only on a cash basis. This is due to additional time between when a customer buys inventory and when the customer pays off the account receivable.
Manufacturing companies use raw materials to make the inventory they sell. Their operating cycles are typically longer and more complex because of the time it takes to make and sell the inventory and then to collect the account receivable.
Merchandising companies purchase the inventory they sell in a ready-to-sell condition. Since they do not have to make the inventory, their operating cycle is typically shorter.
After making their inventory, manufacturing companies sell the inventory to wholesalers who then sell it to retailers to sell directly to the public.
Learning objective number 2 is to understand the components of a merchandising company’s income statement.
The income statements of merchandising companies have an additional expense item called Cost of Goods Sold. The Cost of Goods Sold account represents the cost of merchandise sold during the period to help earn revenue.
Cost of Goods Sold is presented as a separate expense item on the income statement. Net Sales minus Cost of Goods Sold equals Gross Profit. Gross Profit is the amount left, after subtracting the cost of the inventory sold, to cover all other expenses and a profit.
In the General Ledger, the control account for Accounts Receivable indicates that customers owe seven thousand dollars. But, it does not indicate how much each customer owes. To find out, we must look at the Accounts Receivable Subsidiary Ledger for each customer.
Detail for each specific customer can be found by looking in the subsidiary ledgers. By looking there, it’s clear that Jake Sparks owes two thousand dollars and that Heather Jacobs owes five thousand dollars.
Notice that the total of the balances in the subsidiary accounts equals the total balance in the control account.
There are two approaches used to account for merchandise transactions: the perpetual inventory system and the periodic inventory system. Let’s first look at the perpetual inventory system.
Learning objective number 3 is to account for purchases and sales of merchandise in a perpetual inventory system.
In the perpetual inventory system, the inventory account is continuously updated to reflect purchases, sales, and returns of inventory. Let’s look at how entries are made in the perpetual inventory system.
On September 5th, Worley Company purchased on account from Electronic City one hundred laser lights for thirty dollars each. Worley Company would debit Inventory and credit Accounts Payable for three thousand dollars.
Now, let’s look at how to record a sale using the perpetual inventory system.
Part I
On September 10th, Worley Company sold 10 laser lights for fifty dollars each to ABC Radios on account. Under the perpetual inventory system, a sale of inventory requires two entries. One entry is a debit to Accounts Receivable and a credit to Sales for the retail amount of the sale, which in this case is five hundred dollars. Another entry is a debit to Cost of Goods Sold and a credit to Inventory for the cost of the inventory sold, which in this case is three hundred dollars.
Part II
The retail amount is the selling price to the customer and the cost amount is the cost paid for the inventory sold.
Now, let’s look at the payment entries for Worley Company’s purchase and sale of inventory.
On September 15th, Worley Company paid Electronic City three thousand dollars for the September 5th purchase. Worley Company would debit Accounts Payable and credit Cash for three thousand dollars.
On September 22nd, Worley Company received five hundred dollars from ABC Radios for their purchase on September 10th. Worley Company would debit Cash and credit Accounts Receivable for five hundred dollars.
Most companies take a physical count of inventory at least once a year. Theoretically, the physical count should match the number of items in the inventory records. In reality, this is not the case. The physical count does not match the records due to spoilage, breakage, damage, obsolescence, and theft. The physical count helps get the records up to date to reflect what is actually on hand.
When a physical count identifies inventory shrinkage, an entry is made to debit Cost of Goods Sold and credit Inventory. This entry increases Cost of Goods Sold, an expense account, and decreases the Inventory account.
The steps for closing entries in a perpetual inventory system are the same as discussed earlier.
Step 1 is to close Revenue to Income Summary. Since Revenue has a credit balance, a debit is made to close it and a credit is made to Income Summary.
Step 2 is to close all expense accounts to Income Summary. This includes the Cost of Goods Sold expense account. Since these accounts have a debit balance, they are credited and a debit is made to Income Summary for their total.
Step 3 is to close Income Summary to Retained Earnings.
Step 4, the final step, is to close Dividends to Retained Earnings. Since the Dividend account has a debit balance, a credit is made to close it and a debit is made to the Retained Earnings account.
Learning objective number 4 is to explain how a periodic inventory system operates.
Under the periodic inventory system, no effort is made to keep the inventory account or the cost of goods sold account up to date. Only on a periodic basis are these two accounts updated.
Now, let’s look at some entries for a periodic inventory system.
On September 5th, Worley Company purchased on account from Electronic City one hundred laser lights for thirty dollars each. Worley Company would debit Purchases and credit Accounts Payable for three thousand dollars.
Notice that an entry is not made to the Inventory account. Instead, the purchase is debited to a new account called Purchases.
Now, let’s look at how to record a sale using the periodic inventory system.
On September 10th, Worley Company sold 10 laser lights for fifty dollars each to ABC Radios on account. Under the periodic inventory system, a sale of inventory requires only one entry: a debit to Accounts Receivable and a credit to Sales for the retail amount of the sale, which in this case is five hundred dollars.
The cost entry that was made under the perpetual inventory system is not required because the periodic system does not attempt to keep the inventory and cost of good sold accounts up to date.
On September 15th, Worley Company paid Electronic City three thousand dollars for the September 5th purchase. This entry is the same as under the perpetual inventory system. Worley Company debits Accounts Payable and credits Cash for three thousand dollars.
On September 22nd, Worley Company received five hundred dollars from ABC Radios for their purchase on September 10th. This entry is also the same as under the perpetual inventory system. Worley Company debits Cash and credits Accounts Receivable for five hundred dollars.
Because the periodic system does not maintain a cost of goods sold account, cost of goods sold must be calculated at the end of the period.
Here is some information for Party Supply. On January 1st, they have beginning inventory of fourteen thousand dollars. They have purchases during the year totaling one hundred thirty thousand dollars. On December 31st, the physical inventory count was twelve thousand dollars.
Now, let’s see how to calculate the cost of goods sold for Party Supply.
To calculate the cost of goods sold for Party Supply, start with the beginning inventory and add the purchases during the year. This provides the cost of goods available for sale during the period. From this, subtract the ending inventory and arrive at the cost of goods sold during the period.
So now, what is done with this number?
First, create the Cost of Goods Sold. This is accomplished by zeroing out the balances in the related accounts that have a debit balance, namely the beginning inventory balance and the Purchases account.
Credit the Purchases account for its balance and credit the Inventory account for its beginning balance. This part of the entry creates a zero balance in each of these accounts. The related debit is for the total to the Cost of Goods Sold account.
There is still one more entry to make to finish this process.
The second entry records the physical count in the Inventory account and adjusts the balance in the Cost of Goods Sold account.
After this entry, the Inventory account balance reflects the ending inventory amount and the Cost of Goods Sold balance reflects the calculated cost of goods sold amount.
The steps for completing closing entries in a periodic inventory system are the same as discussed earlier for the perpetual inventory system.
Learning objective number 5 is to discuss the factors to be considered in selecting an inventory system.
Which inventory system should a company use? This table suggests some characteristics to consider when selecting an inventory system. If a company has a professional management team, needs timely information about items in inventory, and has a computerized accounting system, then a perpetual inventory system is likely the better option. However, if a company is run by its owners, does not need timely information about items in inventory, uses a manual accounting system, and maintains merchandise on site, then a periodic inventory may be the solution.
Many companies can find an accounting software package that is able to handle a perpetual inventory system very effectively.
Learning objective number 6 is to account for additional merchandise transactions related to purchases and sales.
Cash discounts are provided to customers as an incentive for them to pay early.
The credit period is the normal period of time a company allows for customers to extend their account receivable, typically 30 or 60 days. The discount period is a much shorter period of time, typically 10 or 15 days. If payment is received during the discount period, a discount may be taken. If payment is made after the discount period expires, then the full payment is due on or before the end of the credit period.
Cash discount terms are typically written as this slide shows. This particular discount term would be read as “two ten net thirty.”
The first number represents the discount percentage.
The second number represents the discount period.
The letter “n” stands for the word net.
The last number represents the entire credit period.
In this case, if the customer pays within 10 days, then a 2% discount may be taken. If not, then the full amount is due within 30 days.
Many companies plan to take advantage of cash discounts offered, so they record their purchases net of the discount. Since they typically take the discount, this process simplifies future entries. If a cash discount is not taken in the future, then a purchase discounts lost account is used.
Let’s see how these entries work.
On July 6th, Play Clothes purchased four thousand dollars of merchandise on account from Kid’s Clothes with terms two ten net thirty.
Play Clothes debits Inventory and credits Accounts Payable for three thousand nine hundred twenty dollars, which is net of the two percent cash discount.
On July 15th, Play Clothes pays the full amount due to Kid’s Clothes.
In this entry, Play Clothes debits Accounts Payable and credits Cash for three thousand nine hundred twenty dollars. Since Accounts Payable was originally recorded for the net amount, this entry completely takes care of the balance in the Accounts Payable account.
Now, assume that Play Clothes waited until July 20th to pay Kid’s Clothes. This is outside the discount period.
Play Clothes will have to pay the full amount of four thousand dollars since they did not pay within the discount period. This is recorded as a credit to Cash. The debit to Accounts Payable can only be for the originally recorded amount of three thousand nine hundred twenty dollars. The difference is a debit to Purchase Discounts Lost, a nonoperating expense account, for eighty dollars.
Other companies use the gross method to record their purchase. Under the gross method, the purchases are originally recorded at the full amount. If a cash discount is taken in the future, then a purchase discounts account is used.
Let’s see how these entries work.
On July 6th, Play Clothes purchased four thousand dollars of merchandise on account from Kid’s Clothes with terms two ten net thirty.
Play Clothes debits Inventory and credits Accounts Payable for four thousand dollars, which is the gross amount of the purchase.
On July 15th, Play Clothes pays the full amount due to Kid’s Clothes.
Play Clothes does not have to pay the full amount of four thousand dollars since the are paying within the discount period. As a result, the credit to Cash is for three thousand nine hundred twenty dollars, which is the net amount. This payment removes the entire accounts payable of four thousand dollars and is recorded as a debit to Accounts Payable for four thousand dollars. The difference is a credit to Purchase Discounts Taken, an account that reduces the cost of goods sold for the period.
Now, assume that Play Clothes waited until July 20th to pay Kid’s Clothes. This is outside the discount period. Let’s look at this entry.
In this entry, Play Clothes debits Accounts Payable and credits Cash for four thousand dollars. This payment must be for the gross amount since it is made outside of the discount period.
Now, let’s see how to record inventory returns.
On August 5th, Play Clothes returned five hundred dollars of unsatisfactory merchandise to Kid’s Clothes. The inventory was originally purchased on credit with terms of two ten net thirty, and the purchase was originally recorded at net cost.
To record the return, Play Clothes would debit Accounts Payable and credit Inventory for the net cost of the goods returned, which in this case would be four hundred ninety dollars.
In general, the cost of any asset includes any transportation costs related to getting the asset to the buyer’s place of business. This is also the case for inventory. Transportation costs incurred by the buyer are included in the cost of Inventory.
Now, let’s switch our thinking to the sales side of these transactions.
Just as inventory returns and cash discounts impact a buyer’s entries, they also impact a seller’s entries.
Sellers use the Sales Returns and Allowances account to record inventory returned to the seller, or adjustments in prices sellers allow due to customer dissatisfaction.
Sellers use the Sales Discounts account to record cash discounts taken by customers who pay within the discount period.
Net sales equals Sales minus Sales Returns and Allowances and Sales Discounts.
Let’s see how these accounts are treated in journal entries.
Kid’s Clothes sold two thousand dollars of merchandise to Play Clothes on credit terms of two ten net thirty. Kid’s Clothes originally paid one thousand dollars for the merchandise.
Because Kid’s Clothes uses a perpetual inventory system, two entries are required to record this sale. One entry is a debit to Accounts Receivable and a credit to Sales for the retail amount of the sale, which in this case is two thousand dollars.
Another required entry is a debit to Cost of Goods Sold and a credit to Inventory for the cost of the inventory sold, which in this case is one thousand dollars.
On August 5th, Play Clothes returned five hundred dollars of merchandise to Kid’s Clothes. The cost of this inventory to Kid’s Clothes is two hundred fifty dollars.
Because Kid’s Clothes uses a perpetual inventory system, two entries are required to record this return. One entry is a debit to Sales Returns and Allowances and a credit to Accounts Receivable for the retail amount of the sale, which in this case is five hundred dollars.
Sales Returns and Allowances is a contra-revenue account that is subtracted from Sales to arrive at Net Sales for the period.
Another required entry is a debit to Inventory and a credit to Cost of Goods Sold for the cost of the inventory returned, which in this case is two hundred fifty dollars.
Now, let’s look at some more sale entries.
On July 6th, Kid’s Clothes sold four thousand dollars of merchandise to Play Clothes on credit terms of two ten net thirty. Kid’s Clothes originally paid two thousand dollars for the merchandise.
Because Kid’s Clothes uses a perpetual inventory system, two entries are required to record this sale. One entry is a debit to Accounts Receivable and a credit to Sales for the retail amount of the sale, which in this case is four thousand dollars.
Another required entry is a debit to Cost of Goods Sold and a credit to Inventory for the cost of the inventory sold, which in this case is two thousand dollars.
On July 15th, Kid’s Clothes receives the full payment due from Play Clothes.
Kid’s Clothes debits Cash for three thousand nine hundred twenty dollars, which is the net amount due since payment was made within the discount period. Accounts Receivable is credited for the entire original amount of four thousand dollars. The difference is debited to Sales Discounts, a contra-revenue account, for eighty dollars.
Now assume that payment was not received until July 20th, which is outside the discount period.
Kid’s Clothes would debit Cash and credit Accounts Receivable for the full amount of four thousand dollars.
When sellers incur transportation costs, they are debited to an operating expense account called Delivery Expense. This is considered a cost of doing business and is treated as a regular operating expense of the business.
When a business makes a sale, in most cases it collects more than the selling price of the goods sold. This extra amount is the sales tax on the transaction. Sellers do not get to keep this amount. They must remit it to the proper taxing authority.
The entry to record the collection of sales tax includes a debit to Cash for the entire amount of cash collected, a credit to Sales for the retail amount of the sale, and a credit to Sales Tax Payable for the amount of the sales tax to be remitted to the proper taxing authority.
Learning objective number 7 is to define special journals and explain their usefulness.
Most businesses use special journals to help streamline the recording of routine entries. When companies use special journals, similar entries are recorded together. Companies may have several special journals such as a Cash Receipts Journal, Cash Payments Journal, Sales Journal, and several others. When using special journals, the General Journal is used only for a few entries that do not fit in a special journal.
Learning objective number 8 is to measure the performance of a merchandising business.
Analysts and investors use many different measures to gain insights about a company. Looking at the trends in net sales and gross profit margins over time can provide information on how well a company is doing.
Reviewing net sales for stores may help identify individual stores that are struggling or that are doing extremely well. Sales per square foot of selling space helps measure how efficiently stores are generating sales with the space they have to use.
Reviewing gross profit margins for departments or products may help identify individual departments or products that are not performing as expected or that are exceeding expectations.
Sales discounts and allowances are contra-revenue accounts. Sales discounts and allowances reduce gross sales. As such, net income will be incorrect if discounts and allowances are not properly recorded.
The pressure brought to bear on subordinates to implement fraudulent schemes developed by top management can often be intense. Top management can threaten employees with termination if they fail to participate in the fraud. Unfortunately, employees who acquiesce to such pressure face tremendous legal risks.
