Chapter 5: Merchandising Operations

Merchandising Operations

Operating Cycle for A Merchandising Company

The operating cycle of a merchandising company starts with the purchase of inventories from a producer or an individual, called a vendor. Then these inventories are sold to customers, either in cash or on account. When the cash is collected from customers, the operating cycle ends the first round. By purchasing new inventories the other round starts and the same processes recur continuously; that is why it is called a cycle.

Cost Flow for Merchandising Companies

Revenue activities of a merchandising company involve the buying and selling of merchandise. A merchandising company must first purchase merchandise inventory to sell to its customers. Merchandise on hand (not sold) is called merchandise inventory asset. When this merchandise inventory is sold, the revenue is reported as sales revenue, and its cost is recognized as an expense called the cost of merchandise sold. The cost of merchandise sold is subtracted from sales to arrive at gross profit. This amount is called gross profit because it is the profit before deducting operating expenses.

When the companies purchase merchandise inventory to resell, it is an expenditure. All expenditures that the companies incur until the goods become ready to be sold are included in the cost of merchandise inventory. That cost is kept in the balance sheet until the goods are sold. When they are sold, the cost in balance sheet is transferred to income statement as an expense (COGS).

What Accounting Information a Merchandising Company Needs

In terms of financial reporting, the primarily important information are the amounts of “Sales Revenue” and “Cost of Goods Sold” accounts, as the main activities of a merchandising company are purchasing goods from suppliers and selling them back to customers. Sales revenue is the gross amount that the company charges from its customers as sales price, and Cost of Goods Sold (COGS), on the other hand, represents the cost that the company incurs for purchasing the goods they sold. In order to provide outsiders a complete perspective to assess the performance of a company, other types of revenues (gains on sale of machines, interest revenues, gains on sale of marketable securities, etc.) and expenses (operating expenses, losses from other ordinary activities etc.) must also be recorded.

Income Statement of a Merchandising Company

During the operating cycle, companies generate revenues which is called the “Sales Revenue” and this item is recorded on the top of income statement to be the basis for net income. On the way to calculate net income number, the first item that is deducted from revenue is Cost of Goods Sold (COGS), which represents the total cost that the company had incurred to acquire the sold products.

When cost of goods sold is deducted from revenues, gross profit is calculated. Gross profit represents the profit that a company generates only from sales activities. But it is not only purchasing and selling activities that a merchandising company has. They also have other operating activities such as marketing, research and development, etc. and these activities incur expenditures too. These expenditures are recorded as operating expenses in income statement and deducted from gross profit to reach net income at the end.

Companies may prepare either single-step or multiple-step income statement, depending on the level of details they need. If income numbers at different levels are required, multiple-step income statement is preferred.

Inventory Systems

In accounting for inventories, these companies have two options:

a. Periodic inventory system and
b. Perpetual inventory system

Periodic inventory system is used by the companies with inexpensive inventories and manual accounting systems. In periodic inventory system, companies use “Purchase” account to record their purchases of inventories and there is no record for Cost of Goods Sold (COGS) until the end of accounting period. At the end of a period, companies take a physical count of inventories to determine the amount of ending inventories and considering the balances of beginning Periodic inventory system is used by the companies with inexpensive inventories and manual accounting systems. In periodic inventory system, companies use “Purchase” account to record their purchases of inventories and there is no record for Cost of Goods Sold (COGS) until the end of accounting period Accounting I inventory, total purchases and ending inventory, companies calculate the cost of goods sold during the period.

Companies prefer perpetual inventory system to have continuous control over inventories. Under periodic inventory system, any broken, stolen or wasted goods are not detected, because a merchandise is assumed to be sold if it is not in the warehouse at the end of the period.

Accounting for Purchase Transactions in a Perpetual Inventory System

The cycle of a merchandising company begins with the purchase of merchandise inventory. They normally record purchases when they receive the goods from the seller. Business documents provide written evidence of the transaction. An invoice is a seller’s request for payment from a purchaser. Invoices are also called bills. A company must determine the cost of purchases. So, measuring the cost of purchases is the first step in recording the inventories. The cost includes the price that a merchandising company pays to its supplier for the goods, after taking into account all discounts received.

Additionally, transportation costs, custom duties and other relevant (irrecoverable) taxes should be included in the cost as they incur in order to make the inventory ready for sale.

Transportation costs can take place in accounting records in two ways. If two parties agree on the shipment as FOB shipping point, transportation is the buyer’s responsibility. It is also called “Freight-in”, because freight cost is included in the cost of purchased goods. If the shipment type is FOB destination, transportation is under the seller’s responsibility. Freight cost is not included in the cost of goods; therefore, this type of shipment is called “freight out”. The freight cost is recognized as delivery expense, in the accounting records of the seller.

Purchase of Merchandising Inventory on Cash

The Merchandise Inventory account increases when a purchase is made, so use the debit side of Merchandise Inventory account.

Fright in (Transportation Cost)

When the purchaser incurs the freight costs, it debits (increases) the account Merchandise Inventory for those costs. Thus, any freight costs incurred by the buyer are part of the cost of merchandise purchased.

Purchase of Merchandising Inventory on Account

Purchased merchandise inventory is recorded in the Merchandise Inventory account at the time of purchase weather on cash or on account.

Purchase Returns and Allowances

Usually, customers are allowed to return the goods to the sellers in any unsatisfactory situation, such as defective, damaged or under-performing products, etc. Purchase returns exist when sellers allow purchasers to return merchandise that is defective, damaged, or underperforming. When the purchaser returned the goods to the seller for credit if the sale was made on credit, or for a cash refund if the purchase was for cash. Alternatively, the purchaser may prefer keeping the unsatisfactory merchandise if the seller is willing to grant an allowance (deduction) from the purchase price. This transaction is known as a purchase allowance. In these cases, cost of the merchandise to the buyer decreases.

Purchase Returns

If the cash discount is taken before any return, effect of the discount should be reflected in the cost of remaining units. If the cash discount is taken after the return, discount will be applied to the remaining liability.

Purchase Discount

A lot of companies offer purchasers a discount for early payments. A purchase discount is a discount that businesses offer to purchasers as an incentive for early payment. The cash discount is related to the timing of payment. If the buyer pays the invoice price within a certain number of days before the maturity, a predetermined rate of discount is applied on invoice amount by mentioning credit terms. Such a discount or credit terms is shown as %/d1. n/d2 ¹⁰ , where.

%= discount rate
d ₁ = number of days discount can be applied
n = net payment
d ₂ = maturity

Most credit terms specify the discount rate, the discount time period, and the final due date. Credit terms are the payment terms of purchase or sale as stated on the invoice. For example, “2/10, n/30” means a 2% discount if paid within 10 day; otherwise, the full amount is due in 30 days.

Knowing the net cost of inventory allows a business to determine the actual cost of the merchandise purchased. Net cost of inventory is calculated as follows:

Net Cost of Inventory Purchased = Purchase cost inventory – Purchase returns and allowances – Purchase discounts + Freight in

Accounting for Sales Transactions in a Perpetual Inventory System

The amount a business earns from selling merchandise inventory is called Sales Revenue. Two entries are required to record sale transactions:

• The first entry is necessary to record the earned sales revenue: The seller increases (debits) Cash (or Accounts Receivable, if a credit sale), and also increases (credits) Sales Revenue for the invoice price of the goods.
• The second entry records the expense side of the sales event (the cost of the merchandise sold): The seller increases (debits) Cost of Goods Sold, and also decreases (credits) Merchandise Inventory for the cost of those goods.

Sale of Merchandise Inventory on Cash

Sales may be made on credit or for cash. A business document should support every sales transaction, to provide written evidence of the sale. Cash register tapes provide evidence of cash sales. A sales invoice provides support for a credit sale. The original copy of the invoice goes to the customer, and the seller keeps a copy for use in recording the sale. The invoice shows the date of sale, customer name, total sales price, and other relevant information.

Sale of Merchandise Inventory on Account

A merchandising company may sell merchandise on account. The seller records such sales as a debit to Accounts Receivable and a credit to Sales Revenue. The cost of merchandise sold and the reduction in merchandise inventory should also be recorded same as cash sales.

Transportation for the Sold Merchandise Inventory

Another point to account for in sales transactions is the transportation. In FOB shipping point type of transportations, the seller is responsible from the goods only up to the shipment point, and these agreements are freight-in agreements from the buyer’s perspective. For the seller, since the transportation cost (freight) is not under the seller’s responsibility, these agreements are called freight-out. If the seller pays the transportation cost on behalf of the buyer, the amount is debited to accounts receivable and credited to cash account.

Transportation cost is treated as delivery expense (a kind of marketing expense) for seller if the shipment is FOB destination, in which the seller is responsible from the merchandise until the destination point.

Sales Returns and Allowances

Sales returns and allowances decrease the net amount of revenue earned on sales. When goods are returned from the buyer, this can be accepted as a partial cancellation of the sales. Therefore, receivables should be decreased to the extent sales are cancelled. On the other hand, return of sold goods is recorded under an account called “Sales Returns & Allowances”. This contra-sales revenue account is reported below the “Sales Revenue” in income statement to calculate “Net Sales”. Under the perpetual inventory system, another entry should also be prepared to present the increase in inventories and decrease in/cancellation of COGS as a result of the return.

If customers are unsatisfied with the goods they purchased, because of defects or for other reasons, seller may reduce the initial price at which the goods were sold to pursue the customers to keep the goods. It is sales allowance. This type of reductions is recorded in “Sales Returns and Allowances” which is a contra account to Sales Revenue.

Sales Discounts

As a means of encouraging the buyer to pay before the end of the credit period, the seller may offer the customer a cash discount—called by the seller a sales discount. “Sales Discounts” account is a contra-sales revenue account, and it is deducted from the gross sales revenue to reach net sales revenue in the income statement.

Net Sales Revenue, and Gross Profit

Net sales revenue, cost of goods sold, and gross profit are key elements of profitability. Net sales revenue is calculated as Sales Revenue less Sales Returns and Allowances and Sales Discounts. After determining net sales revenue, gross profit can be calculated. Net sales revenue less Cost of goods sold is called Gross profit, or Gross margin. Profitability of company can also be better evaluated with the help of representing the total income in different subparts, such as gross profit, operating profit and income before tax, etc. Because, operating income is a good performance indicator as it stems from main operations of merchandising companies. Income resulting from sales and operations are expected to recur every period with almost the same amounts. Therefore, it provides the outsiders an opportunity to better predict the future profitability.

Closing Entries for Merchandising Companies

After recording the revenue -and expense- related entries, to complete the accounting cycle and prepare the financial statements, companies should prepare closing entries. The key item used in closing process is “income summary” account, as revenues and expenses are all pooled in it. The final balance of this item, either debit or credit balance, is transferred to another account; retained earnings. If companies declare to distribute dividends, dividends payable is credited and retained earnings is debited with the amount declared. This process is applied by every company in the closing phase of accounting cycle, however to keep it simple the closing entries for buyer and seller will be considered separately, assuming that both companies apply perpetual inventory system.

Closing Entries for the Buyer

In merchandising activities, the buyer recognizes no revenue or expense item. When the goods are purchased, the amount to be paid is a cost and it is presented in balance sheet as inventories until the goods are sold to a third party. Any discount, taken or lost, is reflected in inventories, as well as purchase returns.

Only the inventory shrinkage is related to the closing process. If the physical counts show that the inventory account balance in trial balance is more than the amount of inventory in warehouse, then an account is established with the name “inventory shrinkage”. This account represents an inventory loss. This account can be represented in income statement either under the Cost of Goods Sold or as a separate operating expense.

Closing Entries for the Seller

In merchandising activities, when the goods are sold, the merchandising companies recognize Sales Revenue and Cost of Goods Sold accounts. Also, these accounts are adjusted for cases such as returns, discounts and allowances, as presented in the earlier parts of this chapter. In order to prepare the financial statements, merchandising companies should close all of these income statement accounts. The process is almost the same for all industries, but differs for perpetual and periodic inventory systems. Closing process is explained with the example used throughout this chapter, assuming that perpetual inventory system is applied.

In the closing process at first all revenues and expenses are closed to a pool account, called “income summary”. Then the net balance in income summary account is transferred to owner’s capital account.

Appendix: Periodic Inventory System

Opposite to the case in perpetual inventory system, in periodic inventory system inventory accounts are not up- to-date and do not provide information on inventory whenever needed. By performing physical counts, companies measure the amount of inventory on hand at the end of each accounting period. Any goods that are not counted are assumed to be sold.

Accounting for Purchase Transactions

In periodic inventory system, inventory account is not updated very time the purchase occurs.

Purchases on Discount

When a merchandise inventory is purchased, it is recorded in an account called “Purchases” (not inventory) with its net cost to company. Net cost is the amount that the buyer is suggested to pay considering any trade discount received.

Transportation

Depending on the terms of shipment, transportation cost (i.e. freight) may be a component of purchases. If FOB shipping point is the shipment term, freight cost is under buyer’s responsibility so it is included in the purchase cost, with FOB destination buyer has no cost for transportation. The first case is called freight-in, and the latter is freight-out.

Purchase Returns

When the buyers are not satisfied with the goods they have purchased, they are usually allowed to return the goods. If this happens, buyers use another contra-purchase account, called “Purchase Returns & Allowances” to record the decrease in amount of purchases.

Purchase Allowances

Unsatisfactory goods are not always returned back to sellers, in some cases buyers may keep them in exchange for a reduction in price. This price reduction causes a decrease in the liability of buyer and is deducted from the cost of purchases, with the help of “Purchase Returns & Allowances” account.

Payment of Liability

In calculating the purchase cost at the beginning, trade discount (%10) is considered. But the sales agreement states that although the payment is due in 60 days, if Smart Company pays in the first 15 days, 4% cash discount will be applied additional to trade discount.

Accounting for Sales Transactions

Most of the differences between the periodic and perpetual inventory systems are recognized by the buyers. Accounting records almost totally differ between two systems for the buyer, but from the seller’s perspective, the only difference is the absence of COGS entry after each sales record. Considering this fact, accounting for sales transactions are represented using the example without any additional explanations. In periodic inventory system, balance of inventory account is not decreased after each sale. The ending balances of COGS and Inventory account are determined by closing process.