GOALS
Your goals for this "merchandising" chapter are to learn about:
- Merchandising businesses and related sales recognition issues.
- Purchase recognition issues for the merchandising business.
- Alternative inventory system: The perpetual method.
- Enhancements of the income statement.
- The control structure.
DISCUSSION
THE MERCHANDISING OPERATION -- SALES
MERCHANDISING: The discussion and illustrations in the earlier chapters were all based on businesses that generate their revenues by providing services (like law firms, lawn services, architects, etc.). Service businesses are a large component of an advanced economy. However, we also spend a lot of time in the stores or on the internet, buying the things we want or need. Such businesses are generally referred to as "merchants," and their business models are generally based upon purchasing inventory and reselling it at a higher price to customers. Therefore, this chapter shifts focus from the service business to the merchandising business. Measuring income and reporting it on the income statement involves unique considerations. The most obvious issue is the computation and presentation of an amount called "gross profit." Gross profit is the difference between sales and cost of goods sold, and is reported on the income statement as an intermediate amount. Observe the income statement for Chair Depot at right. The gross profit number indicates that the company is selling merchandise for more than cost ($200,000 in sales was generated from goods that cost $120,000 to buy). Of course, you can see that the company also incurred other operating expenses; advertising, salaries, and rent. Nevertheless, the gross profit was sufficient to easily cover those costs and leave a tidy profit to boot. The presentation of the gross profit information is very important for users of the financial statements to get a clear picture of operating success. Obviously, if the gross profit rate is small, the business might have trouble making a profit, even if sales improved. Quite the reverse is true if the gross profit rate is strong; improved sales can markedly improve the bottom-line net income (especially if operating expenses like rent, etc., don't change with increases in sales)! It is easy to see why separating the gross profit number from the other income statement components is an important part of reporting for the merchandising operation.
SALES: The Sales account is a revenue account used strictly for sales of merchandise. Sales are initially recorded via one of the following entries, depending on whether the sale is for cash or on account:
CASH SALE:
| 1-5-X5 | Cash | 4,000 | ||
| Sales | 4,000 | |||
| Sold merchandise for cash |
SALE ON ACCOUNT:
| 1-5-X5 | Accounts Receivable | 4,000 | ||
| Sales | 4,000 | |||
| Sold merchandise on account |
SALES RETURNS AND ALLOWANCES: Occasionally, a customer returns merchandise. When that occurs, the following entry should be made:
| 1-9-X5 | Sales Returns and Allowances | 1,000 | ||
| Accounts Receivable | 1,000 | |||
| Customer returned merchandise previously purchased on account |
Notice that the above entry included a debit to Sales Returns and Allowances (rather than canceling the sale). The Sales Returns and Allowances account is a contra-revenue account that is deducted from sales; sales less sales returns and allowances is sometimes called "net sales." This approach is deemed superior because it allows interested parties to easily track the level of sales returns in relation to overall sales. Importantly, this presentation reveals information about the relative level of returns and provides a measure of customer satisfaction or dissatisfaction. Sales returns (on account) are typically documented by the creation of an instrument known as a credit memorandum. The credit memorandum indicates that a customer's account receivable balance has been credited (reduced), and that payment for the returned goods is not expected. If the preceding transaction involved a cash refund, the only difference in the entry would involve a credit to cash instead of accounts receivable. The calculation of net sales would be unaffected.Note that use of the word "allowances" in the account title "Sales Returns and Allowances." What is the difference between a return and an allowance? Perhaps a customer's reason for wishing to return an item is because of a minor defect; they may be willing to keep the item if the price is slightly reduced. The merchant may give them an allowance (e.g., a reduction in the price they previously agreed to) to induce them not to return the item. The entry to record an allowance would be identical to that above for the agreed amount of the price reduction, and the customer would keep the inventory item. (Of course, one could use a separate account for returns and another for allowances if they wished to track information about each of these elements.)
TRADE DISCOUNTS: Product catalogs often provide a "list price" for an item. Oftentimes those list prices bear little relation to the actual selling price. A merchant may offer customers a trade discount that involves a reduction from the catalog or list price. Ultimately, the purchaser is responsible for the invoice price, that is, the list price less the applicable trade discount. Trade discounts are not entered in the accounting records. They are not considered to be a part of the sale because the exchange agreement was based on the reduced price level. Remember the general rule: sales are recorded when an exchange takes place, based on the exchange price. Therefore, the amount recorded as a sale is the invoice price. The entries above (for the $4,000 sale) would still be appropriate if the list price was $5,000, subject to a 20% trade discount.
CREDIT CARDS: In the retail trade, merchants often issue credit cards. Why? Because they induce people to spend, and interest charges that may be assessed can themselves provide a generous source of additional profit. However, these company issued cards introduce lots of added costs: customers that don't pay (known as bad debts), maintenance of a credit department, periodic billings, and so forth. To avoid the latter, many merchants accept other forms of credit cards like American Express, Master Card, and so forth. When a merchant accepts these cards, they are usually paid instantly by the credit card company (net of a service charge that is negotiated in the general range of 1% to 3% of the sale). The subsequent billing and collection is handled by the credit card company. Many merchants will record the full amount of the sale as revenue, and then recognize an offsetting expense for the amount charged by the credit card companies.
CASH DISCOUNTS: Merchants often sell to other businesses. For example, assume that Barber Shop Supply sells equipment to various barber shops on open account (i.e., a standing agreement to extend credit for purchases). In these settings, the seller would like to be paid promptly after billing, and may encourage prompt payment by offering a cash discount (also known as a sales discount). There is a catch, though. To receive the cash discount, the buyer must pay the invoice promptly. The amount of time one has available to pay is expressed in a unique manner, such as 2/10, n/30 -- these terms mean that a 2% discount is available if the invoice is paid within 10 days, otherwise the net amount is expected to be paid within 30 days. Barber Shop Supply issued the invoice at right, and would record the following entry. Please take note of the invoice date, terms, and invoice amount.
| 5-11-X4 | Accounts Receivable | 1,000 | ||
| Sales | 1,000 | |||
| Sold merchandise on account, terms 2/10,n/30 |
If Hair Port Landing pays the invoice in time to receive the discount, the check
at right for $980 would be received by Barber Shop Supply, and recorded via the
following entry. This entry reflects that the customer took advantage of the
discount terms by paying within the 10-day window. Notice that the entry reduces
Accounts Receivable for the full invoice amount because the payment satisfied the
total obligation. The discount is recognized in a special Sales Discount account.
The discount account would be reported in like manner to the Sales Returns and
Allowance account presented earlier in this chapter.
at right for $980 would be received by Barber Shop Supply, and recorded via the
following entry. This entry reflects that the customer took advantage of the
discount terms by paying within the 10-day window. Notice that the entry reduces
Accounts Receivable for the full invoice amount because the payment satisfied the
total obligation. The discount is recognized in a special Sales Discount account.
The discount account would be reported in like manner to the Sales Returns and
Allowance account presented earlier in this chapter.
| 5-19-X4 | Cash | 980 | ||
Sales Discounts | 20 | |||
| Accounts Receivable | 1,000 | |||
| Collected outstanding receivable within discount period, 2% discount granted |
If the customer pays too late to get the discount, then the payment receivedshould be for the full invoice amount, and it would be recorded as follows:
| 5-29-X4 | Cash | 1,000 | ||
| Accounts Receivable | 1,000 | |||
| Collected outstanding receivable outside of the discount period |
Having looked at several of the important and unique issues for recognizing sales
transactions of merchandising businesses, it is now time to turn to the accounting
for purchasing activities.
transactions of merchandising businesses, it is now time to turn to the accounting
for purchasing activities.
PURCHASE CONSIDERATIONS FOR MERCHANDISING BUSINESSES
MERCHANDISE INVENTORY: A quick stroll through most any retail store will reveal a substantial investment in inventory. Even if a merchant is selling goods at a healthy profit, financial difficulties can creep up if a large part of the inventory remains unsold for a long period of time. Goods go out of style, become obsolete, and so forth. Therefore, a prudent business manager will pay very close attention to inventory content and level. There are many detailed accounting issues that pertain to inventory, and a separate chapter is devoted exclusively to inventory issues. This chapter's introduction is brief, focusing on elements of measurement that are unique to the merchant's accounting for the basic cost of goods. MERCHANDISE ACQUISITION: The first phase of the merchandising cycle occurs when the merchant acquires goods to be stocked for resale to customers. The appropriate accounting for this action requires the recording of the purchase. Now, there are two different techniques for recording the purchase -- depending on whether a periodic system or a perpetual system is in use. Generalizing, the periodic inventory system is easier to implement but is less robust than the "real-time" tracking available under a perpetual system. Conversely, the perpetual inventory system involves more "systemization" but is a far superior business management tool. Let's begin with the periodic system; we'll then return to the perpetual system.
PERIODIC INVENTORY SYSTEM: When a purchase occurs and a periodic inventory system is in use, the merchant should record the transaction via the following entry:
| 7-7-X1 | Purchases | 3,000 | ||
| Accounts Payable | 3,000 | |||
| Purchased inventory on account |
The Purchases account is unique to the periodic system. The Purchases account is not an expense or asset, per se. Instead, the account's balance represents total inventory purchased during a period, and this amount must ultimately be apportioned between cost of goods sold on the income statement and inventory on the balance sheet. The apportionment is based upon how much of the purchased goods are resold versus how much remains in ending inventory. Soon, you will see the accounting mechanics of how this occurs. But, for the moment, simply focus on the concepts portrayed by this graphic:
PURCHASE RETURNS AND ALLOWANCES: Recall the earlier discussion of sales returns and allowances. Now, the shoe is on the other foot. Let's see how a purchaser of inventory would handle a return to its vendor/supplier. First, it is a common business practice to contact the supplier before returning goods. Unlike the retail trade, transactions between businesses are not so easily undone. A supplier may require that you first obtain an "RMA" or "Return Merchandise Authorization." This indicates a willingness on the part of the supplier to accept the return. When the merchandise is returned to a supplier a debit memorandum may be prepared to indicate that the purchaser is to debit their Accounts Payable account; the corresponding credit is to Purchases Returns and Allowances:
| 7-19-X1 | Accounts Payable | 1,000 | ||
| Purchase Returns & Allowances | 1,000 | |||
| To record the return of defective inventory to vendor |
Purchase returns and allowances are subtracted from purchases to calculate the amount of net purchases for a period. The specific calculation of net purchases will be demonstrated after a few more concepts are introduced.
CASH DISCOUNTS: Recall the previous discussion of cash discounts (sometimes called purchase discounts from the purchaser's perspective). Discounts are typically very favorable to the purchaser, as they are designed to encourage early payment. While discounts may seem slight, they usually represent a substantial savings and should usually be taken. Consider the calendar at right, assuming a purchase was made on May 1, terms 2/10,n/30. The discount can be taken if payment is made within the "green shaded" days (or potentially one additional day, depending on the agreement). The discount cannot be taken during the yellow shaded days (of which there are twenty, as noted). The bill becomes past due during the "red shaded days." What is important to note here is that skipping past the discount period will only achieve a 20-day deferral of the payment. If you consider that you are "earning" a 2% return by paying 20 days early, it is indeed a large savings. Consider that there are more than 18 twenty-day periods in a year (365/20), and, at 2% per twenty-day period, this equates to over a 36% annual interest cost equivalent.Discount terms vary considerably. Here are some examples:
- 1/15,n/30 -- 1% if paid within 15 days, net in 30 days
- 1/10,n/eom -- 1% if paid within 10 days, net end of month
- .5/10,n/60 -- ½% if paid within 10 days, net in 60 days
Occasionally, a company may opt to skip a discount. In the case of the half-percent discount example, notice that the net amount is not due until the 60th day. Perhaps the purchaser would conclude that the additional 50 days is worth forgoing the half-percent savings, as the annual interest cost equivalent is only about 3.65% (365/50 = 7.3 "periods" per year -- times 0.5% per "period"). But, this is the exception rather than the rule. In short, taking the discounts usually makes good economic sense!
A business should set up its accounting system to timely process and take advantage of all reasonable discounts. In a small business setting, this might entail using a hanging-file system where invoices are filed for payment to match the discount dates. A larger company will usually have an automated payment system where checks are scheduled to process concurrent with invoice discount dates. Very large payments, and global payments, are frequently set up as "wire transfers." This method enables the purchaser to retain use of funds (and the ability to generate investment income on those funds) until the very last minute. This is considered to be a good business practice.
However, there is an ethical issue for you to consider. Many vendors will accept a "discounted payment" outside of the discount period. In other words, a purchaser might wait 30, 60, or 90 days and still take the discount! Some vendors are glad to receive the payment and will still grant credit for the discount. Others will return the payment and insist on the full amount due. Is it a good business practice to "bend the terms" of the agreement to take a discount when you know that your supplier will stand for this practice? Is it ethical to "bend the terms" of the agreement? If you discuss this with your classmates, you will find a diversity of opinion.
GROSS RECORDING OF PURCHASES/DISCOUNTS: A fundamental accounting issue is how to account for purchase transactions when discounts are offered. One technique is the gross method of recording purchases. This technique records purchases at their total gross or full invoice amount:
| 11-5-X7 | Purchases | 5,000 | ||
| Accounts Payable | 5,000 | |||
| Purchased inventory on account, terms 2/10,n/30 |
If payment is made within the discount period, the purchase discount is recognized in a separate account. The Purchase Discounts account is similar to Purchases Returns & Allowances, as it is deducted from total purchases to calculate the net purchases for the period:
| 11-13-X7 | Accounts Payable | 5,000 | ||
| Purchase Discounts | 100 | |||
| Cash | 4,900 | |||
| Paid outstanding payable within discount period, 2% discount taken ($5,000 X 2% = $100) |
If payment is made outside the discount period, the entry is quite straightforward:
| 11-29-X7 | Accounts Payable | 5,000 | ||
| Cash | 5,000 | |||
| Paid outstanding payable outside of the discount period |
NET RECORDING OF PURCHASES/DISCOUNTS LOST: Rather than recording purchases gross, a company may elect to record the same transaction under a net method. With this technique, the initial purchase is again recorded by debiting Purchases and crediting Accounts Payable, but only for the net amount of the purchase (the purchase less the available discount):
| 11-5-X7 | Purchases | 4,900 | ||
| Accounts Payable | 4,900 | |||
| Purchased $5,000 of inventory on account, terms 2/10,n/30 ($5,0000 - ($5,000 X 2%) = $4,900) |
If payment is made within the discount period, the entry is quite straightforward because the payable was initially established at net of discount amount:
| 11-13-X7 | Accounts Payable | 4,900 | ||
| Cash | 4,900 | |||
| Paid outstanding payable within discount period |
If payment is made outside the discount period, the lost discounts are recorded in a separate account. The Purchase Discounts Lost account is debited to reflect the added cost associated with missing out on the available discount amount:
| 11-29-X7 | Accounts Payable | 4,900 | ||
| Purchase Discounts Lost | 100 | |||
| Cash | 5,000 | |||
| Paid outstanding payable outside of the discount period |
COMPARISON OF GROSS VS. NET: In evaluating the gross and net methods, notice that the Purchase Discounts Lost account (used only with the net method) indicates the total amount of discounts missed during a particular period. The presence of this account draws attention to the fact that discounts are not being taken; frequently an unfavorable situation. The Purchase Discounts account (used only with the gross method) identifies the amount of discounts taken, but does not indicate if any discounts were missed. For reporting purposes, purchases discounts are subtracted from purchases to arrive at net purchases, while purchases discounts lost are recorded as an expense following the gross profit number for a particular period.
The following diagram contrasts the gross and net methods for a case where the discount is taken. Notice that $4,900 is accounted for under each method. The Gross method reports the $5,000 gross purchase, less the applicable discount. In contrast, the net method only shows the $4,900 purchase amount.
The next diagram contrasts the gross and net methods for the case where the discount is lost. Notice that $5,000 is accounted for under each method. The gross method simply reports the $5,000 gross purchase, without any discount. In contrast, the net method shows purchases of $4,900 and an additional $100 charge pertaining to lost discounts.
_______________________________________________________________________________________________________________
FREIGHT CHARGES: A potentially significant inventory-related cost pertains to freight. The importance of considering this cost in any business transaction cannot be overstated. The globalization of commerce, rising energy costs, and the increasing use of overnight delivery via more expensive air transportation vehicles all contribute to high freight costs. Freight costs can easily exceed 10% of the value of a transaction. As a result, business negotiations relate not only to matters of product cost, but must also include consideration of freight terms. Freight agreements are often described by abbreviations that describe the place of delivery, when the risk of loss shifts from the seller to the buyer, and who is to be responsible for the cost of shipping. One very popular abbreviation is F.O.B. This abbreviation stands for "free on board." Its historical origin apparently related to a seller's duty to place goods on some shipping vessel without charge to the buyer. Whether that historical explanation is exactly correct or not is unclear. What is important to know is that F.O.B. terms are common jargon in the shipping trade.
The F.O.B. point is normally understood to represent the place where ownership of goods transfers. Along with shifting ownership comes the responsibility for the purchaser to assume the risk of loss, a duty to pay for the goods, and the understanding that freight costs beyond the F.O.B. point will be borne by the purchaser.
In the drawing at left, notice that money is paid by the seller to the transport company in the top illustration. This is the case where the terms called for F.O.B. Destination -- the seller had to get the goods to the destination. This situation is reversed in the middle illustration: F.O.B. Shipping Point -- the buyer had to pay to get the goods delivered. The third illustration calls for the buyer to bear the freight cost (F.O.B. Shipping Point). However, the cost is prepaid to the trucker by the seller as an accommodation. Notice that the buyer then sends a check (in blue) to the seller to reimburse for the prepaid freight; ultimately the buyer is still bearing the freight cost. Of course, other scenarios are possible. For example, terms could be F.O.B. St. Louis, in which case the seller would pay to get the goods from New York to St. Louis, and the buyer would pay to bring the goods from St. Louis to Los Angeles.
Take a moment and look at the invoice presented earlier in this chapter for Barber Shop Supply. You will notice that the seller was in Chicago and the purchaser was in Dallas. Just to the right of the invoice date, you will note that the terms were F.O.B. Dallas. This means that Barber Shop Supply is responsible for getting the goods to the customer in Dallas. That is why the invoice included $0 for freight; the purchaser was not responsible for the freight cost. Had the terms been F.O.B. Chicago, then Hair Port Landing would have to bear the freight cost; the cost might be added to the invoice by Barber Shop Supply if they prepaid the cost to a transportation company, or Hair Port might be expected to prepare a separate payment to the transport company. Next are presented appropriate journal entries to deal with alternative scenarios.
- If goods are sold F.O.B. destination, the seller is responsible for costs incurred in moving the goods to their destination. Freight cost incurred by the seller is called freight-out, and is reported as a selling expense that is subtracted from gross profit in calculating net income.
Seller's entry:
| 5-11-X4 | Accounts Receivable | 7,000 | ||
| Freight-out | 400 | |||
| Cash | 400 | |||
| Sales | 7,000 | |||
| Sold merchandise on account for $7,000, terms F.O.B. destination, and paid the freight bill of $400 |
Buyer's entry:
| 5-11-X4 | Purchases | 7,000 | ||
| Accounts Payable | 7,000 | |||
| Purchased $7,000 of inventory, terms F.O.B. destination |
- If goods are sold F.O.B. shipping point, the purchaser is responsible for paying freight costs incurred in transporting the merchandise from the point of shipment to its destination. Freight cost incurred by a purchaser is called freight-in, and is added to purchases in calculating net purchases:
Seller's entry:
| 6-6-X4 | Accounts Receivable | 8,000 | ||
| Sales | 8,000 | |||
| Sold merchandise on account for $8,000, terms F.O.B. shipping point |
Buyer's entry:
| 6-6-X4 | Purchases | 8,000 | ||
| Freight-in | 1,500 | |||
| Cash | 1,500 | |||
| Accounts Payable | 8,000 | |||
| Purchased $8,000 of inventory, terms F.O.B. shipping point, and paid the shipping freight bill of $1,500 |
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