CHAPTER 6 ACCOUNTING FOR MERCHANDISING BUSINESSES

LEARNING OBJECTIVES
After studying this chapter, you should be able to: 1. Distinguish the activities and financial statements of service and merchandising businesses. 2. Describe and illustrate the financial statements of a merchandising business.

3. Describe and illustrate the accounting for merchandise transactions including: sales of merchandise; purchase of merchandise; transportation costs, sales taxes, and trade discounts; dual nature of merchandise transactions. 4. Describe the adjusting and closing process of a merchandising business.

TYPES OF INVENTORY SYSTEMS: 1. Periodic Inventory system 2. Perpetual Inventory System PERIODIC VS PERPETUAL: Periodic: 1. When Inventory is acquired, it is recorded in a temporary account called Purchases. This account goes on the Income Statement. Therefore during the year, the inventory account remains unchanged- it shows the beginning balance. 2. Inventory is NOT removed from the accounting records during the year when it is sold; instead an adjustment is made at the end of the year after a physical count is made the amount of ending inventory is determined. 3. Disadvantages: You don't know how much inventory you should have on hand at any point in time during the period, so you don't know if you have an inventory shortage. Cost of Merchandise Sold cannot be computed until ending inventory is physically counted at the end of the period. The perpetual system overcomes these problems!

 Perpetual: 1. Purchases of merchandise for resale to a customer are recorded in the merchandise inventory account. It is an asset account on the Balance Sheet. 2. You perpetually (continuously) update the merchandise inventory account with each transaction (i.e., when we purchase merchandise, when we return merchandise, when we sell merchandise, and when customers return merchandise). So the merchandise inventory account balance will always reflect the current amount of inventory.; however, we still need to periodically count inventory to be sure that we actually have on hand what we should have. 3. The inventory account is perpetually updated and shows the current level of inventory on hand during the year. Requires more accounting entries but provides more up-to-date information on managing inventory. CHARACTERISTICS OF A PERPETUAL SYSTEM It provides a continuous record of inventory on hand and cost of merchandise sold throughout the period. It provides more internal control over inventory since we always know how much inventory we should have on hand. It requires more clerical effort (more record keeping) since it continuously updates the inventory account. 1. Every time you make a sale, you must keep up not only with how much you sold the merchandise FOR, but ALSO how much the merchandise you sold COST you. 2. Its use is becoming more prevalent with advent of computers, scanning, etc.

OBJECTIVE 1 Distinguish the activities of a service business from those of a merchandising business.

MERCHANDISERS VERSUS SERVICE COMPANIES

KEY TERMS:
Cost of Merchandise Sold Gross Profit Fees Earned Merchandise Inventory

SERVICE COMPANIES:
What we have covered up to this point; they perform a service for a fee. Income statement- Very basic! Fees earned $XXX - Operating expenses $XXX =Net income $XXX

MERCHANDISERS (new in this chapter)

They buy merchandise (merchandise/inventory) and resell them to customers. This presents a new problem for us- the business has to acquire the merchandise to sell to its customers and we have to learn how to account for those merchandise (called Inventory); Includes wholesalers and retailers. What is Merchandise Inventory? Merchandise that we are holding to sell to customers; It is shown as a current asset on the Balance Sheet. The accounting methods are the same as those for service company, but accounting for their transactions is more complicated because they buy and sell merchandise.

WHY DO WE NEED A NEW INCOME STATEMENT FORMAT?

What is the largest expense incurred by a retail store, such as Target or Old Navy? (Answer: the cost of the merchandise that is sold to the customer); Because this cost is the retailers major expense, it is shown separately from the operating expenses when preparing the income statement. Income statement needs to be expanded since we have a new type of revenue (sales) and corresponding expenses! Sales - Cost of merchandise sold =Gross profit - Operating expenses =Net income $XXX XXX $XXX XXX $XXX

Objective 2: Describe and illustrate the financial statements of a merchandising business. MULTI-STEP INCOME STATEMENT FOR A MERCHANDISING BUSINESS
KEY TERMS:
Account Form Administrative Expenses Income from Operations Merchandise Available for Sale Multiple-Step Income Statement Net Purchases Net Sales Other Expense Other Income Periodic Method Perpetual Method Purchase Discount Purchases Returns and Allowances Report Form Sales Sales Discount Sales Returns and Allowances Selling Expenses Single-Step Income Statement Transportation In Transportation Out (Delivery)

NEW TYPE OF BUSINESS MEANS A LOT OF NEW TERMS!

Need to learn a lot of new terms and accounts! Here a quick list with definitions-we will cover in detail later! 1. Sales: the amount charged customers for merchandise. (This is a new revenue account.) NOTE: There is no income, revenue, or earned added to the name- just plain sales! 2. Sales Returns: the amount refunded to customers who return merchandise. This is an adjustment to gross sales. 3. Sales Allowances: a reduction in price given to a customer to compensate for a problem, such as damaged merchandise. This is an adjustment to gross sales.

4. Sales Discount: a reduction in price given to a customer for paying early, such as giving a 2% discount on the price of merchandise if the customer pays in 10 days. This is adjustment to gross sales. 5. Net sales: Gross sales less any sale returns and allowances or sales discounts. 6. Cost of Merchandise Sold: The cost (to us) of the merchandise we sold this period; for merchandisers it represents the LARGEST cost of doing business! 7. Gross Profit: Net sales less the cost of merchandise sold is deducted from sales to get the subtotal gross profit. Why? We need to know how much profit we have made BEFORE deducting all of the other expenses of the business. It must be used to "pay" the retailer's operating expenses, such as salaries, rent, utilities, and advertising. 8. Selling Expenses: costs incurred in selling the merchandise, such as the cost of advertising or commissions paid to salespersons. 9. Administrative Expenses: costs incurred in the administration or general operations of the business, such as the cost of office supplies or the salary paid to an accountant. 10. 11. Income from Operations: profit earned by the conducting the companys primary business of buying and selling merchandise. Other Income: income earned from activities other than the companys primary business, such as interest revenue on a checking account or rent revenue from leasing unused space. Other Expense: costs incurred from activities other than the companys primary business of buying and selling its product, such as interest expense on business loans.

12.

EXPANDED INCOME STATEMENT FOR A MERCHANDISER

WHY IS THE FORMAT DIFFERENT? Income Statement still performs same function: to determine net income (or loss) in order to assess profitability. The new format is more informative for merchandisers. It gives more information, provides helpful subtotals, and is usually more useful to management and creditors.

This format of Income Statement is called Multi-step Income Statement, since there are multiple steps involved in determining Net income.

WHY DO WE USE THREE DIFFERENT COLUMNS FOR NUMBERS ON THE STATEMENT?

Dont panic - putting the numbers in a specific column is not critical! We use multiple columns just so the statement is easier to read and to help us add/subtract the appropriate numbers. 1. If you add two numbers together, they must be in the same column! And put the TOTAL in the column to the right! 2. If you SUBTRACT one number from another, they must both be in the SAME column! And put the DIFFERENCE in the column to the right! Remember: there are no debit or credit columns on the financial statements!!!

NET SALES
WHAT IS NET SALES? The net amount of revenue we generate from selling merchandise during the period. Remember, Sales is the name of the revenue account used by a merchandiser. It has TWO contra accounts associated with it: Sales Returns and Allowances and Sales Discounts which we will discuss in more detail later.

HOW DO WE COMPUTE NET SALES REVENUE?

Gross Sales - Sales Returns and Allowances - Sales Discounts = Net Sales Memory Tip: George Reads Daily Newspapers

OPERATING EXPENSES
WHAT ARE OPERATING EXPENSES?
All of the expenses (other than cost of merchandise sold) incurred in running the business; similar to the expenses of a service company - rent, salaries, utilities, insurance, etc. We divide operating expense into two categories: 1. SELLING EXPENSES those that are incurred to package, market, display, advertise, deliver, and sell the product 2. GENERAL/ADMINISTRATIVE EXPENSES those that are related to the overall management of the business, like accounting, personnel, etc. Some expenses relate both to selling AND general/administrative functions, and must be prorated between them.

OTHER REVENUE AND EXPENSES

WHAT ARE "OTHER REVENUES" AND "OTHER EXPENSES"?
Revenues and expenses that are not directly related to the principal activity of the business (buying and selling merchandise).

 Examples: Revenue from investments (Dividend Income, Interest Income, etc.), Interest Expense, Gains/Losses from Sale of Assets. Shown separately so users can clearly see Income from OPERATIONS (which should be normal, recurring) SEPARATE from income/loss from activities NOT related to operations (which typically is NOT normal, recurring)

WHERE DO "OTHER REVENUES" AND "OTHER EXPENSES" GO ON THE STATEMENT?

At the bottom between Operating Expenses and Net Income Revised Income Statement: Revenues from Sales - Cost of Merchandise Sold = Gross Profit - Operating Expenses = Income from Operations (NOTE: this is a new subtotal!) + Other Revenues - Other Expenses = Net Income

MULTI-STEP INCOME STATEMENT

STEPS TO PREPARING THE INCOME STATEMENT
STEP 1 - COMPUTE NET SALES Gross Sales - Sales Returns and Allowances - Sales Discounts = Net Sales Memory Tip: George Reads Daily Newspapers

STEP 2 - DEDUCT COST OF MERCHANDISE SOLD (this will be given-no computation!) STEP 3 - COMPUTE GROSS PROFIT: subtract cost of merchandise sold from net sales. Gross profit: what we made by selling an item for MORE than it cost us! STEP 4 - COMPUTE TOTAL OPERATING EXPENSES: add selling expenses and general/administrative expenses STEP 5 - COMPUTE INCOME FROM OPERATIONS: subtract total operating expenses from gross profit STEP 6 COMPUTE NET INCOME BY ADDING OTHER REVENUES AND SUBTRACTING OTHER EXPENSES:

SUMMARIZING THE MERCHANDISER'S INCOME STATEMENT

NET SALES Sales - Sales Discounts - Sales Returns and Allowances = Net Sales

- COST OF MERCHANDISE SOLD = GROSS PROFIT - OPERATING EXPENSES Selling Expenses + General Administrative Expenses = Total Operating Expenses

= INCOME FROM OPERATIONS + OTHER REVENUES - OTHER EXPENSES = NET INCOME (OR NET LOSS)

SINGLE STEP INCOME STATEMENT

WHAT IS MISSING FROM THE SINGLE-STEP STATEMENT?

The helpful subtotals from the multi-step statement (like gross profit and income from operations)! Also, need to use the net sales figure under revenue- do not show computation on the face of the statement.

SINGLE-STEP INCOME STATEMENT FORMAT:

Revenues: Net Sales Other Revenues Expenses: Cost of Merchandise Sold Selling Expenses Administrative Expenses Other Expenses Net Income

BALANCE SHEET and STATEMENT OF OWNERS EQUITY

DOES THE BALANCE SHEET CHANGE?

Remember that we will have Inventory listed as a current asset! Two formats can be used as we mentioned earlier: 1. Account Form: List Assets on left and Liabilities and Equity on the right. 2. Report Form: List Assets first, Liabilities second and Equity third in a column form.

DOES THE STATEMENT OF OWNERS EQUITY CHANGE?

Good News! No it doesnt!.

REVISED CHART OF ACCOUNTS

WHATS DIFFERENT?
A merchandising business has additional accounts: Inventory, Sales Discounts, Sales Returns/Allowance, Transportation-Out, Cost of Merchandise Sold. All of these will be included in the businesses chart of accounts!