Warren Reeve Duchac Accounting 26e Accounting for Merchandising Businesses 6 C H A P T E R human/iStock/360/Getty Images

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Operating Cycle

©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

• The operating cycle is 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.

• The operating cycle of a service and merchandising business differs in that a merchandising business must purchase merchandise for sale to customers.

Financial Statements(slide 1 of 2)

• The differences between service and merchandising businesses are also reflected in their financial statements.

• The revenue activities of a service business involve providing services to customers.o On the income statement for a service

business, the revenues from services are reported as fees earned.

o The operating expenses incurred in providing the services are subtracted from the fees earned to arrive at net income.


Financial Statements(slide 2 of 2)

• In contrast, the revenue activities of a merchandising business involve the buying and selling of merchandise.o A merchandising business first purchases

merchandise to sell to its customers.o When this merchandise is sold, the revenue is

reported as sales, and its cost is recognized as an expense called cost of merchandise sold.

o The cost of merchandise sold is subtracted from sales to arrive at gross profit, which is the profit before deducting operating expenses.

o Merchandise on hand (not sold) at the end of an accounting period is called merchandise inventory (current asset).


Purchases Transactions(slide 1 of 3)

• There are two systems for accounting for merchandise transactions: perpetual and periodic.o In a perpetual inventory system, each

purchase and sale of merchandise is recorded in the inventory account and related subsidiary ledger.

o In a periodic inventory system, the inventory does not show the amount of merchandise available for sale and the amount sold.




• Under the perpetual inventory system, cash purchases of merchandise are recorded as follows:

• Purchases of merchandise on account are recorded as follows:



• The terms of purchases on account are normally indicated on the invoice or bill that the seller sends the buyer.

• The terms for when payments for merchandise are to be made are called the credit terms.o If payment is required on delivery, the terms

are cash or net cash.o Otherwise, the buyer is allowed an amount of

time, known as the credit period, in which to pay. The credit period usually begins with the date of the

sale as shown on the invoice.

Purchases Discounts(slide 1 of 2)

• To encourage the buyer to pay before the end of the credit period, the seller may offer a discount. o For example, a seller may offer a 2% discount

if the buyer pays within 10 days of the invoice date. If the buyer does not take the discount, the total invoice amount is due within 30 days. The terms are expressed as 2/10, n/30 and are read

as “2% discount if paid within 10 days, net amount due within 30 days.”


Purchases Discounts(slide 2 of 2)

• Discounts taken by the buyer for early payment of an invoice are called purchases discounts. o Purchases discounts taken by a buyer reduce

the cost of the merchandise purchased.

• Since buyers normally take all purchases discounts, Merchandise Inventory is debited for the net purchase price under the perpetual inventory system.o That is, the buyer debits Merchandise

Inventory for the amount of the invoice less the discount.



Purchases Returns and Allowances(slide 1 of 2)

• A buyer may request an allowance for merchandise that is returned (purchases return) or a price allowance (purchases allowance) for damaged or defective merchandise. From a buyer’s perspective, such returns and allowances are called purchases returns and allowances.o In both cases, the buyer normally sends the

seller a debit memorandum, often called a debit memo, to notify the seller of reasons for the return (purchase return) or to request a price reduction (purchase allowance).


Purchases Returns and Allowances(slide 2 of 2)

• The buyer may use the debit memo as the basis for recording the return or allowance or wait for approval from the seller (creditor).

• In either case, the buyer debits Accounts Payable and credits Merchandise Inventory.

• Before paying an invoice, a buyer may return merchandise or be granted a price allowance for an invoice with a purchase discount. o In this case, the amount of the return is

recorded at its invoice amount less the discount.


Sales Transactions

• Revenue from merchandise sales is usually recorded as Sales.o Sometimes a business may use the title Sales

of Merchandise.

• Assume that on March 3, NetSolutions sells merchandise for $1,800. These cash sales are recorded as a debit to Cash and a credit to Sales.


Cash Sales

• Using the perpetual inventory system, the cost of merchandise sold and the decrease in merchandise inventory are also recorded.o In this way, the merchandise inventory account

indicates the amount of merchandise on hand (not sold).

• Sales may be made to customers using credit cards such as MasterCard or VISA. o Such sales are recorded as cash sales.

• Any processing fees charged by the clearinghouse or issuing bank are periodically recorded as a debit to Credit Card Expense and a credit to Cash.

Sales on Account

• NetSolutions sold merchandise on account for $18,000. The cost of the merchandise sold was $10,800.



Customer Discounts

• A seller may grant customers a variety of discounts, called customer discounts, to encourage customers to act in a way benefiting the seller.

• A sales discount encourages customers to pay their invoice early. o For example, a seller may offer credit terms of

2/10, n/30, which provides a 2% sales discount if the invoice is paid within 10 days.

Customer Returns and Allowances

• Merchandise sold may be returned to the seller (returns). In other cases, the seller may reduce the initial selling price (allowances).

• From a seller’s perspective, these are termed customer returns and allowances, sometimes called sales returns and allowances.

• In some cases, a customer that is due a refund has an outstanding account receivable balance. o In this case, the seller may credit the

customer’s accounts receivable rather than pay cash.



Freight

• The ownership of the merchandise may pass to the buyer when the seller delivers the merchandise to the freight carrier.o In this case, the terms are said to be FOB (free on

board) shipping point. This term means that the buyer pays the freight costs from the shipping point to the final destination.

• The ownership of the merchandise may pass to the buyer when the buyer receives the merchandise.o In this case, the terms are said to be FOB (free on

board) destination. This term means that the seller pays the freight costs from the shipping point to the buyer’s final destination.

• The seller may prepay the freight, even though the terms are FOB shipping point. The seller will then add the freight to the invoice.


Sales Taxes

• Almost all states levy a tax on sales of merchandise.

• The liability for the sales tax is incurred when the sale is made.o At the time of a cash sale, the seller collects

the sales tax.o When a sale is made on account, the seller

charges the tax to the buyer by debiting Accounts Receivable.

o The seller credits the sales account for the amount of the sale and credits the tax to Sales Tax Payable.

o The seller pays to the taxing authority (state) the amount of the sales tax collected by debiting Sales Tax Payable and crediting Cash.


Trade Discounts

• Wholesalers are companies that sell merchandise to other businesses rather than to the public. Many publish sales catalogs with periodic price updates.o These updates may include large discounts

from the catalog list prices.

• In addition, wholesalers often offer special discounts to government agencies or businesses that order large quantities. Such discounts are called trade discounts.

• Sellers and buyers do not normally record the list prices of merchandise and trade discounts in their accounts.

Multiple-Step Income Statement



Single-Step Income Statement

Balance Sheet

• The balance sheet may be presented with assets on the left-hand side and the liabilities and owner’s equity on the right-hand side.o This form of the balance sheet is called the

account form.

• The balance sheet may also be presented in a downward sequence in three sections.o This form of the balance sheet is called the

report form.


Adjusting Entry for Inventory Shrinkage

• Under the perpetual inventory system, the merchandise inventory account is continually updated for purchase and sales transactions.

• As a result, the balance of the merchandise inventory account is the amount of merchandise available for sale at that point in time.

• However, retailers normally experience some loss of inventory due to shoplifting, employee theft, or errors.

• Thus, the physical inventory on hand at the end of the accounting period is usually less than the balance of Merchandise Inventory. o This difference is called inventory shrinkage or

inventory shortage.©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Closing Entries

• The four closing entries for a merchandising business are as follows:

1. Debit each temporary account with a credit balance, such as Sales, for its balance and credit Income Summary.

2. Credit each temporary account with a debit balance, such as the various expenses, and debit Income Summary. Since Cost of Merchandise Sold is a temporary account with a debit balance, it is credited for its balance.

3. Debit Income Summary for the amount of its balance (net income) and credit the owner’s capital account. The accounts debited and credited are reversed if there is a net loss.

4. Debit the owner’s capital account for the balance of the drawing account and credit the drawing account.

• After the closing entries are posted to the accounts, a post-closing trial balance is prepared, which includes the asset, contra asset, liability, and owner’s capital accounts.


Financial Analysis and Interpretation:Ratio of Sales to Assets

• The ratio of sales to assets measures how effectively a business is using its assets to generate sales.

• A high ratio indicates an effective use of sales.

• The ratio of sales to assets is computed as follows:

Ratio of Sales to Assets =Sales

Average Total Assets

Appendix: Periodic Inventory System

• Under the periodic inventory system, purchases are normally recorded at their invoice amount in a Purchases account. o If the invoice is paid within the discount period,

the discount is recorded in a separate account called Purchases Discounts.

o Likewise, purchase returns are recorded in a separate account called Purchase Returns and Allowances.

o The sales of merchandise are not recorded in the inventory account. At the end of the period, a physical count of merchandise inventory on hand is taken and used to determine the cost of merchandise sold.

o Freight paid is recorded in a Freight-In account.©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Appendix: Closing Entries Under the Periodic Inventory System

• The four closing entries under the periodic inventory system are as follows:

1. Debit each temporary account with a credit balance, such as Sales, for its balance and credit Income Summary. Since Purchases Discounts and Purchases Returns and Allowances are temporary accounts with credit balances, they are debited for their balances. In addition, Merchandise Inventory is debited for its end-of-period balance based on the end-of-period physical inventory.

2. Credit each temporary account with a debit balance, such as the various expenses, and debit Income Summary. Since Freight In is a temporary account with a debit balance, it is credited for its balance. In addition, Merchandise Inventory is credited for its balance as of the beginning of the period.

3. Debit Income Summary for the amount of its balance (net income) and credit the owner’s capital account. The accounts debited and credited are reversed if there is a net loss.

4. Debit the owner’s capital account for the balance of the drawing account and credit the drawing account.©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Warren Reeve Duchac Accounting 26e Accounting for Merchandising Businesses 6 C H A P T E R human/iStock/360/Getty Images