Accounting For Merchandising Businesses.docx

Accounting for Merchandising Businesses Overview Description Merchandising businesses, also known as retailers, purchase goods and then sell the goods to customers. So, unlike businesses that manufacture goods or sell services, retailers simply buy and resell goods. This means they have slight accounting differences in their financial statements and have a keen focus on their key business asset: their inventory. Merchandising businesses use a multiple-step income statement, which is an income statement with sections, subsections, and subtotals. Merchandising businesses also use balance sheets, just as any business would. They have a particular interest, however, in the inventory found on the balance sheet, as it is a crucial asset. Two systems are commonly used to track inventory—the periodic system and the perpetual system. At A Glance    

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The operating cycle of a merchandising business involves three steps: purchasing merchandise from a supplier, selling the merchandise to a consumer, and collecting payment. Periodic inventory systems require a physical inventory count in order to update inventory records and to calculate the cost of merchandise sold. Perpetual inventory systems are updated each time a transaction occurs, providing real-time information on inventory levels and cost of merchandise sold. There are a number of differences between periodic inventory systems and perpetual inventory systems, including the accuracy of real-time inventory data, the entries used to record transactions, and the required physical counts of merchandise. Merchandising businesses record their transactions much like any other type of business. They do, however, have a few accounts and transactions that are unique to their business type in order to record the purchase of merchandise and freight charges, make entries to track inventory, and record the cost of the merchandise when it is sold. Inventory lost to theft or damage and inventory returned by the customer require the use of adjusting entries, which involve updating the accounting records to document inventory shrinkage and customer returns and allowances. The balance sheet of a merchandising business has only slight variations as compared to the balance sheets of other types of businesses. The financial statements of a merchandising business involve a multiple-step income statement which separates the cost of the goods the business sells from the cost of running the business.

Vocabulary  

cash refund - money that is returned to a customer in the form of a cash payment cost of merchandise sold - cost associated with the goods sold to consumers

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customer refunds payable - account used to document refund payments to customers as a result of returned or damaged merchandise free on board (FOB) destination point - shipping term indicating the seller is paying for shipping costs and that the title of ownership does not pass from the seller to the buyer until the item arrives at the buyer's place of business free on board (FOB) shipping point - shipping term indicating that the buyer is paying for freight costs for the shipping and that the title of ownership passes from the seller to the buyer when the item has been picked up by a third-party shipper gross profit - income from cost of merchandise sold subtracted from the sales inventory shrinkage - difference in the amount of inventory on hand per a count from what is recorded merchandise inventory - merchandise on hand; a current asset multiple-step income statement - income statement with multiple sections, subsections, and subtotals, including gross profit operating cycle - process that involves spending cash to generate revenues and receive cash payments in the present or in the future operating income - income earned from normal business operations periodic inventory system - inventory system that involves a periodic physical inventory count to determine the quantity of goods on hand perpetual inventory system - inventory system in which each sale and purchase transaction related to merchandise is recorded directly to the inventory account and corresponding subsidiary ledger purchase returns and allowances - merchandise returned by the buyer or cost modification due to a product defect sales - revenue generated from the sale of goods to consumers sales discounts - early payment discount provided to the buyer from the seller single-step income statement - income statement that shows only revenues less expenses, and does not include gross profit

Nature of Merchandising Businesses The operating cycle of a merchandising business involves three steps: purchasing merchandise from a supplier, selling the merchandise to a consumer, and collecting payment. The operating cycle is defined as the process by which a company spends cash to generate revenues and receives cash payments at the time of sale or in the future by collection on an account receivable. Depending on the nature of the business, the process and length of the operating cycle will vary. For example, a small business that makes arts and crafts to sell at a local market may have a very short operating cycle if it makes its crafts and sells them for cash shortly afterward at the market. A business that builds homes may have a longer operating cycle, as it takes longer to buy all the supplies to build a home, actually build it, and then sell the home and collect cash from the buyer.

The operating cycle of a merchandising business involves three transactions: 1. Purchase of merchandise from suppliers 2. Sale of merchandise to consumers on account or for cash at the time of sale 3. Collection of payments from accounts receivable customers It is important to note that there are several types of businesses, such as merchandising, manufacturing, or service businesses. Manufacturers use materials to make things that they then sell. Service businesses generally don't make things; rather, they provide services. The operating cycles of a service business, manufacturing business, and merchandising business all differ slightly. For example, a merchandising business must purchase goods to resell to consumers, while service businesses deliver expertise, advice, or a professional skill set. The operating cycle length will vary from one business to another, depending upon the nature and shelf life of the products being sold. For example, grocery retailers tend to have a shorter operating cycle due to the shelf life of their merchandise. On the other hand, car dealers can display vehicles for months until they are sold, as vehicles do not have an immediate expiration date.

The operating cycle for a merchandising business involves purchases of merchandise, sales, and collection, with activities often occurring in a regular order.

Business Inventory Systems It is important for businesses to maintain an accurate reflection of both the inventory on hand and the cost associated with goods sold to consumers. The goods on hand are identified as merchandise inventory, and the cost associated with goods sold to consumers is known as cost of merchandise sold, or cost of goods sold. To ensure the accuracy of their inventory on hand and the cost associated with the goods sold, businesses use one of two inventory systems: a periodic inventory system or a perpetual inventory system.

Periodic Inventory System Periodic inventory systems require a physical inventory count in order to update inventory records and to calculate the cost of merchandise sold. The periodic inventory system is an inventory system that involves a periodic physical inventory count to determine the quantity of goods on hand. Ideal for small businesses with a limited amount of inventory, the periodic inventory system is a more traditional approach to managing inventory. Businesses using periodic inventory systems do not have an accurate record of the goods on hand in real time because quantities are not updated with every transaction. Rather, they are updated periodically using a physical count— thus the system's name, the periodic system. Conducting a physical inventory count can be costly, so most businesses using a periodic inventory system conduct a physical inventory count only quarterly or annually. A number of challenges are associated with the use of a periodic inventory system, including estimation errors, limited information between inventory counts, and increased adjustments for inventory shrinkage. Perpetual Inventory System Perpetual inventory systems are updated each time a transaction occurs, providing real-time information on inventory levels and cost of merchandise sold. The perpetual inventory system is a system in which each sale and purchase transaction related to merchandise is recorded directly to the inventory account and corresponding subsidiary ledger. As one of the most widely used inventory systems, the perpetual inventory system mandates a continuous updating of inventory records with each sale and purchase. As a result, the perpetual inventory system provides the most accurate real-time reflection of inventory in that both the quantity and value of the inventory are perpetually updated. The perpetual inventory system requires more effort on a day-to-day basis than the periodic inventory system, as each time inventory moves it must be recorded. However, advances in technology have made this process much easier. Merchandising businesses are able to track inventory items in a cost-effective manner using a computerized system that utilizes bar codes. For example, Walmart uses bar codes to account for its inventory items. Car dealerships utilize a unique vehicle identification number (VIN) to keep up with their inventory. As items' bar codes are scanned, inventory records are reduced for sold items, providing better inventory controls. Periodic versus Perpetual Inventory System There are a number of differences between periodic inventory systems and perpetual inventory systems, including the accuracy of real-time inventory data, the entries used to record transactions, and the required physical counts of merchandise. The periodic and perpetual inventory systems differ in several key ways. One example is a timing difference. The perpetual inventory system records transactions as they occur. Under this system,

inventory balances can be seen in real time. For example, if you were to ask a sales associate at Happy T's if they had a particular T-shirt in stock, they would be able to tell you exactly how many they have. However, if the business uses the periodic inventory system, they would not have the ability to pull up the inventory records of a particular T-shirt and know for sure what the current inventory level is because it is possible the inventory level of that T-shirt has changed since the last physical count. The journal entries used to record transactions under each system are also different. When a sale occurs, the inventory and relevant costs are recorded under the perpetual inventory method. However, no entry is made under the periodic inventory method. Under the periodic inventory method, a physical count must be done in order to determine how much inventory is left. The beginning and ending inventory balances and purchases can then be used to determine cost of merchandise sold. The physical count and cost of merchandise sold calculations are not necessary under the perpetual inventory system because this data is recorded throughout the period each time a transaction takes place. Perpetually recording each transaction means that the ending inventory balance should be correct at the end of the period and all cost of merchandise sold should already be recorded. It is worth noting that even businesses using the perpetual inventory method must still do a physical count of their inventory from time to time, generally once a year at a minimum. The physical count is done to ensure the accounting records are accurate. Merchandising Transactions Merchandising businesses record their transactions much like any other type of business. They do, however, have a few accounts and transactions that are unique to their business type in order to record the purchase of merchandise and freight charges, make entries to track inventory, and record the cost of the merchandise when it is sold. The purchase of inventory items for sale to consumers is recorded in the merchandise inventory account. Merchandise inventory is the merchandise on hand and is a current asset. For example, Happy T's, a local retailer, buys and resells T-shirts. When the business purchases an order of T-shirts on account from their supplier for $1,000, it would make an entry to properly record the purchase.

Inventory Purchase Journal Entry Date June 18

General Ledger Account Title Merchandise Inventory Accounts Payable To record the purchase of merchandise inventory

Debit $1,000

Credit $1,000

Happy T's has successfully recorded the cost of the inventory it purchased. However, the shirts did not get shipped for free. When goods are shipped, either the supplier or the retailer has to pay for the shipping. Shipping terms are established to clarify who is responsible for the cost of shipment. Shipping

terms also clarify who owns and is responsible for the goods while they are in transit. There are two types of shipping used by merchandising businesses: 1. Free on board (FOB) shipping point 2. Free on board (FOB) destination point Free on board (FOB) shipping point is a shipping term indicating the buyer is paying for freight costs for the shipping and that the title of ownership passes from the seller to the buyer when the item has been picked up by a third-party shipper. As a result, the shipping costs are added to the cost of inventory (see the journal entry below). Free on board (FOB) destination point is a shipping term indicating the seller is paying for shipping costs and that the title of ownership does not pass from the seller to the buyer until the item arrives at the buyer's place of business. Happy T's purchased its T-shirts with FOB shipping point terms. This means that Happy T's owned the Tshirts as soon as the carrier picked up the T-shirts from the supplier and that Happy T's is responsible for paying for the shipping. Happy T's would make an entry to record the $50 cost of shipping.

Shipping Costs Entry Date June 5

General Ledger Account Title Merchandise Inventory Cash

Debit $50

Credit $50

If Happy T's had purchased its T-shirts with FOB destination terms, it would have owned the T-shirts when they arrived rather than when the seller shipped them. Happy T's also would not be responsible for the cost of shipping and would not make a journal entry. Sales are the primary source of revenue for merchandising businesses. Merchandising businesses can generate cash sales or sales on account. If cash is collected at the time of the sale, this is known as a cash sale. For example, if Happy T's sells a T-shirt to a customer for $10 and the customer pays them in cash, the business would make an entry to record the transaction.

Cash on Account Entry Date June 15

General Ledger Account Title Cash Sales To record a cash sale

Debit $10

Credit $10

If cash is not collected at the time of the sale and the customer agrees to pay for the sale at a later time, this is known as a sale on account. If Happy T's sells a large order of shirts for $500 to a local customer

for its company picnic and agrees to let the customer pay in 30 days, it would make an entry for accounts receivable.

Sale on Account Entry Date June 15

General Ledger Account Title Accounts Receivable Sales To record a sale on account

Debit $500

Credit $500

Later, when the customer pays Happy T's the $500 they owe them, Happy T's would make an entry to record the payment.

Payment on Account Entry Date June 30

General Ledger Account Title Cash Account Receivable To record payment of account

Debit $500

Credit $500

Under the periodic inventory system, no additional entry would be made at the time of sale because inventory is not tracked on a real-time basis. Under the perpetual inventory system, a second entry would be made at the time of sale to record the inventory and cost of merchandise sold. The shirts that Happy T's just sold for $500 to their customer actually cost Happy T's $400 when they purchased the shirts for resale. When Happy T's sold the $500 order to a local customer for their company picnic, it would also have to make an entry.

Cost of Merchandise Sold Entry Date June 15

General Ledger Account Title Cost of Merchandise Sold Merchandise Inventory To record the cost of merchandise sold

Debit $400

Credit $400

Notice that Happy T's recorded sales of $500 and costs of $400. This means that on this particular sale, Happy T's has a gross margin, which is revenue minus cost of goods sold, of $100 ($500 − $400). Sales discounts are early payment discounts provided to the buyer from the seller, offered to encourage customers to make early payments. This incentive is recorded in the sales discounts account. Sales

discounts is a contra revenue account and is used to reduce the total sales to arrive at net sales in the multiple-step income statement. A contra account is an account that has a balance opposite of the normal balance. Revenue accounts normally have a credit balance. The sales discount contra revenue account has a normal debit balance and reduces total sales. In order to determine the amount of the discount provided, the seller will issue credit terms to the buyer. For example, in the sale to the local business having a company picnic, Happy T's might have offered a 2% 10-day, net 30 (2/10, n/30) discount. This means that if the customer pays Happy T's within 10 days of the invoice date, they can take advantage of a 2% discount; otherwise, the full amount is due 30 days from the invoice date. In this case, the customer would pay $490 if they pay within 10 days or pay the full $500 if they pay in 11 to 30 days. If the customer paid within the 10-day discount period, Happy T's would make an entry to record the transaction.

Sales Discount Entry Date June 21

General Ledger Account Title

Debit $490 $10

Cash Sales Discounts Account Receivable To record payment of account

Credit

$500

Merchandise businesses may also be offered discount terms from their suppliers, just like the discount terms they could offer to their customers. Any discounts related to prompt payment will be recorded in an account titled "purchases discounts" (contra account). For example, if Happy T's had received 1% 10day, net 30 terms on the purchase of a shipment of T-shirts costing $2,000, the business would record two entries—the first when the order is placed and the second when the amount due is paid within the discount period.

Merchandise Purchase Entry Date June 5

General Ledger Account Title Merchandise Inventory Accounts Payable

Debit $2,000

Credit $2,000

Payment on Account with Discount Entry Date June 10

General Ledger Account Title Accounts Payable Purchases Discounts Cash

Debit $2,000

Credit $20 $1,980

Adjusting Process for Inventory Inventory lost to theft or damage and inventory returned by the customer require the use of adjusting entries, which involve updating the accounting records to document inventory shrinkage and customer returns and allowances. Inventory shrinkage is the difference in the amount of inventory on hand per a count from what is recorded. Errors, obsolescence, shoplifting, and damage are all possible contributors to the occurrence of shrinkage. To assess the level of shrinkage, a physical inventory count is required. To ensure that inventory on hand and inventory per the accounting records are harmonized, periodic physical inventory or cycle counts are necessary. In the event that the physical inventory count determines that the inventory on hand is less than the inventory per the accounting records, an adjusting entry must be made to update the accounting records. Shrinkage can be a costly expense that erodes net income, as its occurrence directly impacts cost of merchandise sold. For example, Happy T's counted its T-shirt inventory at the end of the month and determined that it has 600 T-shirts on hand with a value of $6,000. The inventory account, however, shows a balance of 610 T-shirts valued at $6,100. This means Happy T's has experienced an inventory shrinkage of $100. The $100 shrinkage could be caused by several things, including shoplifters, inaccurate entries or errors made during the checkout process, or damaged T-shirts. Happy T's would make an entry to record the shrinkage.

Shrinkage Entry Date Apr. 30

General Ledger Account Title Cost of Merchandise Sold Merchandise Inventory

Debit $100

Credit $100

Merchandising businesses realize that customer loyalty is important for future sales, so they offer refunds or other concessions to customers in anticipation of their customers returning to purchase more goods. When these events occur, such as refunds, adjustments must be made to reduce the customer account or provide a cash refund of the purchase price, returning money to the customer in the form of a cash payment. When goods have been returned, the customer is entitled to a refund of the purchase price. Additionally, the revenue associated with the sale is reduced. Customer returns are recorded in an account titled "sales returns and allowances." The sales returns and allowances account is a contra revenue account that holds customer returns of merchandise or price adjustments for discounts, vouchers for future visits, or other similar offerings. For example, the customer that purchased T-shirts for the company picnic comes back to Happy T's and says that several of the shirts are the wrong size and cannot be used. Happy T's wants to make the customer happy and rectify the situation, so it offers a refund for the shirts in the amount of $100. Happy T's would record an entry if the customer accepted the refund.

Customer Return Entry Date June 18

General Ledger Account Title Sales Returns and allowances Customer Refunds Payable

Debit $100

Credit $100

If Happy T's was using the periodic inventory system, no additional entry would be required. If Happy T's was using the perpetual inventory system, the returned T-shirts would need to be recorded back into inventory, and an entry would be made.

Perpetual Inventory Merchandise Return Entry Date May 12

General Ledger Account Title Merchandise Inventory Cost of Merchandise Sold

Debit $80

Credit $80

Purchase returns and allowances reflect merchandise returned by the merchandising business or a cost modification due to a product defect. In the example above, a customer returns goods to Happy T's. However, when Happy T's purchases the T-shirts from their supplier, it also may have a difficulty with damaged T-shirts or another problem with the order and request a purchase return or allowance from the supplier. Merchandising Financial Statements Balance Sheet The balance sheet of a merchandising business has only slight variations as compared to the balance sheets of other types of businesses. At the end of the accounting cycle, all businesses prepare financial statements to communicate information regarding the financial well-being of the business entity. Merchandising businesses, manufacturers, and service businesses all prepare an income statement and a balance sheet, and all are very similar. A merchandising business, however, has a few slight differences in its income statement and balance sheet. The balance sheet of the merchandising business expands its assets section to include merchandise inventory and sometimes estimated returns inventory. Merchandise inventory is the merchandise purchased to be sold to consumers. Merchandise inventory is categorized as a current asset. Estimated returns inventory is a current asset and is the account used to document the return of merchandise for either dissatisfaction or damage. Depending on the materiality of estimated returns, sometimes it may

be reflected as a separate account on the balance sheet or it may be part of the inventory account and reflected only in the notes to the financial statements. In addition to the inclusion of merchandise inventory, the balance sheet for the merchandising business includes a new liability, customer refunds payable. Customer refunds payable is the account used to document refund payments to customers as a result of returned or damaged merchandise. Customer refunds payable is a current liability. Income Statement The financial statements of a merchandising business involve a multiple-step income statement which separates the cost of the goods the business sells from the cost of running the business. Merchandising businesses use the multiple-step income statement, as it provides more information for financial statement users on the profits made from the actual merchandise versus the costs of running the business. With a simplistic format for preparing an income statement, the single-step income statement shows only revenues less expenses, and does not include gross profit. It contains fewer subsections or subtotals than the multiple-step income statement, which is an income statement with sections, subsections, and subtotals, including gross profit, operating income, other income, and other expenses, as well as net income. The first step in a multiple-step income statement is to calculate gross profit. To compute gross profit, the cost of merchandise sold is subtracted from the sales. Revenues from the sale of goods to consumers are sales and are recorded in the sales account. The cost associated with the goods sold is recorded in an expense account titled "cost of merchandise sold." Gross profit shows how much profit was made purely on the merchandise that was sold. The next step in a multiple-step income statement is operating income. Gross profit is reduced by operating expenses to arrive at operating income, which is the income earned from normal business operations. To successfully buy and sell merchandise, most merchandising businesses have a support staff and other expenses that are necessary to make their business run. Examples include marketing, sales staff, advertising, purchasing agents, and more. The final step in a multiple-step income statement is net income. Operating income is adjusted by other revenues or expenses that do not directly relate to the business's day-to-day operations. These costs are called nonoperating expenses. Examples include interest expense or income, taxes, lawsuits, or gains and losses from the sale of investments. By breaking down the income statement into steps, statement users can now see three key elements: gross profit, operating income, and net income. This allows for analysis on how much profit is made directly on the merchandise that is sold, how much is spent on expenses to support the business (operating expenses), and how much is spent on expenses that do not directly relate to daily operations (nonoperating expenses). For example, in the income statement for Unique Products, Inc., the gross profit is $25,000. This means that on $100,000 of sales, the company has $25,000 left over to cover the

operating costs. For every dollar in sales generated, 25 cents were left to pay for the cost of daily operations. Operating expenses totaled $13,000. So after paying for the daily cost of doing business, Unique Products was left with $12,000 of operating income. Finally, nonoperating income was reported at $6,000, giving the business a total of $18,000 net income. By breaking the information down into steps, users can see that of $18,000 of net income, $12,000 of it is from daily operations and $6,000 was contributed by other elements, such as interest revenue, that do not directly relate to the company's daily business.

Income Statement

A multiple-step income statement is broken down into components-gross profit, operating income, and net income-to better analyze business operations.