The business activities of a service organization involve providing services to customers and earning fees for those services. A merchandising organization involves the buying and selling of products.
A merchandising business purchases goods to be sold to customers. When the merchandise is sold, the revenue is reported as sales, and its cost is recognized as an expense. This expense is call Cost of Merchandise Sold. The cost of merchandise sold is subtracted from sales to arrive at gross profit. A service business income statement will not have a cost of goods sold.
A Multiple-Step Income Statement contains several sections, subsections, and subtotals. The revenue section is expanded to include Sales and Sales Returns and allowances and Sales discounts. Net sales represents the revenue generated by NetSolutions after taking into account customer returns of merchandise and sales discounts that may have been granted to customers. A multiple-step income statement makes it easier for a stakeholder to analyze the operations of an organization. The gross profit subtotal represents the difference between sales revenue generated from selling products minus the cost of those products. Operating income measures the organization’s results from their total operations and takes into account selling and administrative expenses. Net income is the final measurement of an organization’s performance. Not only does net income measure the profit or loss from business operations, it also measure the impact of any other peripheral income activities or expenses. Net Solutions is using a perpetual inventory system. This is indicated by the fact that Cost of merchandise sold is a one-line item on the income statement. Under a perpetual system, each purchase and sale of merchandise is recorded in the inventory and cost of merchandise sold account. The next slide explores Cost of Merchandise sold in more detail under a periodic inventory system.
If a company utilizes a periodic inventory system, the calculation of Cost of merchandise sold may be a bit more complex. Any merchandise not sold at the end of an accounting period is called merchandise inventory and reported as an asset on the company’s balance sheet. The inventory balance at the beginning of an accounting period is the starting point for the calculation of cost of merchandise sold. Purchases of inventory are added to the beginning inventory balance. These purchases are adjusted by any necessary purchase returns, allowances or discounts. Any freight paid to acquire the inventory is added to the net purchases to arrive at Cost of merchandise purchased. A count and valuation is made of inventory at the end of the accounting period and that amount is subtracted from cost of merchandise purchased in order to arrive at Cost of merchandise sold.
A Single-Step Income Statement deducts the total of all expenses in one step from the total of all revenues. This emphasizes total revenues and total expenses of a company in determining net income.
The Retained Earnings Statement for a merchandising company does not differ from a service company.
The balance sheet of a merchandising organization will include the account Merchandise Inventory in the Current Asset section. This amount represents the value of any products that remain unsold at the end of an accounting period.
On the Statement of Cash Flows for NetSolutions, the positive cash from operating activities is used to fund cash paid out for equipment under investing activities and cash paid out to shareholders in the form of dividends and creditors to pay off notes payable.
Normally, sales are recorded by increasing cash or accounts receivable and increasing sales revenue. In a perpetual inventory system, the cost of merchandise sold is also recorded at the time of sale. Under this method, the merchandise inventory account will always reflect the value of the amount of merchandise on hand (not sold).
Terms to the customer are normally indicated on the invoice and are called credit terms. Normally, cash or net cash mean cash is expected on delivery. A credit period gives the buyer a period of time to pay in full. Discounts encourage the buyer to pay before the end of the credit period.
The credit period usually begins with the date of the sale as shown on the invoice. On the example invoice from NetSolutions, terms are listed as 2/10, n/30. As a means of encouraging the buyer to pay before the end of the credit period, NetSolutions is offering a 2% discount if the invoice is paid within 10 days. Otherwise, the balance is due in full 30 days after the invoice date.
Discounts taken by customers for early payment are recoded as sales discounts by the seller when the invoice is paid and recorded in a separate account that is an offsetting (or contra) account to sales.
Merchandise may be returned to the seller (sales return). The seller may also reduce the initial price of the goods due to defects or other reasons (sales allowances). Credit memorandums are issued to the buyer to track the goods returned. This memorandum shows the amount and reason for the seller’s credit to accounts receivable.
Like sales discounts, sales returns and allowances offset sales revenue and the accounts receivable account is reduced by the amount listed on the credit memo, in this example $225. Since the merchandise is returned to the seller, the cost of the returned merchandise must be added back to the Merchandise Inventory account, in this case $140. The seller must also decrease the cost of merchandise returned from the Cost of merchandise sold account, since this account was increase when the goods were sold. If sales are reduced by $225 and cost of merchandise sold is decreased by $140, the net impact to Retained Earnings is the net income effect of $85 decrease.
Computers make perpetual inventory systems the norm in most organizations. Under the perpetual inventory system, merchandise inventory is increased as purchases are made. If cash is paid for the purchase, cash is reduced for the cost of the merchandise. Merchandise purchases are also often made on account, which would require and increase to accounts payable for the cost of the purchase instead of a reduction to cash.
Purchase discounts are taken by the buyer for early payment of an invoice. The effect of a purchase discount is to reduce the cost of merchandise purchased. As the invoice is paid, the merchandise inventory account is decreased for the amount of the discount taken. In this way, merchandise inventory shows the net cost to the buyer.
A Purchase return occurs when merchandise is returned to the seller. A purchase allowance is a price adjustment requested by the buyer and granted by the seller. The Buyer sends a debit memorandum to the sellerto make these invoice/account adjustment requests.
The buyer will decrease accounts payable, the amount owed to the seller. An additional decrease will be made to merchandise inventory to reflect the value of the merchandise returned.
Terms of sale should indicate when ownership passes from seller to buyer. This point determines who must pay the transportation costs. If the shipping terms are FOB (free on board) shipping point, the title passes from seller to buyer when the goods ship and the buyer pays the freight. If the shipping terms are FOB (free on board) destination, the title passes from seller to buyer at the destination point and the seller will pay the freight charges. Transportation costs paid by the buyer become part of the merchandise cost.
NetSolutions incurs $50 of transportation costs on $900 of merchandise purchased. The shipping terms are FOB shipping point, which means the title transferred to NetSolutions when the merchandise shipped from the seller and NetSolutions will pay for the shipping charges. The total $950 of cost recorded in Merchandise Inventory represents the sellers’ $900 cost plus $50 freight charges.
Most states and other taxing units levy a tax on sales of merchandise. A liability for sales tax is incurred by the seller when a sale is made. The liability is relieved when the tax collected is paid to the proper entity.
Each transaction affects a buyer and a seller. When Company A sells merchandise to Company B, Company A has a sale and Company B has a purchase for the same amount.
Merchandising businesses could experience loss of inventory due to… Shoplifting Employee theft Errors in recording or counting inventory Even in a perpetual inventory system, a physical inventory should be taken at the end of each accounting period to determine if the inventory physically on hand equals what is shown in the accounting records as the balance in Merchandise Inventory. There is often a difference called inventory shrinkage.
The effect of the shrinkage is recorded as a reduction to the Merchandise Inventory account and an increase to Cost of Merchandise sold. Some companies record inventory losses or shrinkage to a separate account on the Income Statement in order to better track the dollar value of shrinkage. After the shrinkage is recorded, the balance of Merchandise Inventory agrees with the physical inventory on hand.
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Chapter 4 Accounting for Merchandising Businesses
Learning ObjectivesAfter studying this chapter, you should be able to… Distinguish the activities and financial statements of a service business from those of a merchandising business Describe and illustrate the financial statements of a merchandising business Describe the accounting for the sale of merchandise Describe the accounting for the purchase of merchandise Describe the accounting for transportation costs and sales taxes Illustrate the dual nature of merchandising transactions Describe the accounting for merchandise shrinkage
Learning Objective 1 Distinguish the activities and financial statements of a service business from those of a merchandising business
Service Businesses vs. Merchandise Operations • Service Businesses – Revenue activities involve providing services to customers. – Example: Family Health Care, P.C.• Merchandise Operations – Revenue activities involve the buying and selling of merchandise. – Example: Home Depot Inc.
Gross Profit for a Merchandise Operation Gross Profit = Net Sales – COGS• Net Sales: revenue less returns and discounts• Cost of Goods Sold: cost paid for merchandise
Learning Objective 2 Describe and illustrate the financial statements of a merchandising business
NetSolutions – Multiple-Step Income Statement Considers customerreturns and Assume a perpetual discounts inventory system Measures income/loss from the core operations of the business
NetSolutions – Cost of Merchandise Sold – PeriodicInventory