CHAPTER 5

Merchandise operations
WHAT ARE MERCHANDISING OPERATIONS?
A merchandiser is a business that sells merchandise, goods, to customers. The
merchandise that this type of business sells is called merchandise inventory.

There are two types of merchandisers: wholesaler and retailer.

A wholesaler is a merchandiser that buys goods from a manufacturer and

then sells them to retailers.

A retailer buys merchandise from a manufacturer or a wholesalerand then

sells goods to customers.

THE OPERATING CYCLE OF A MERCHANDISING BUSINESS

1. Begins when the company purchases inventory

from an individual or a business, called vendor
2. Then the company sells the inventory to a
customer
3. The company collects cash from customers

The operating cycle of a merchandiser is different than

that of a service company, the financial statements are
going to differ as well.

On the income statement, merchandisers report

revenues in an account called Sales Revenue.

A merchandiser also reports the

cost of merchandise inventory
that’s been sold: cost of good
sold.

Because COGS is usually the main

expense, another calculation is
determined before calculating the
net income: gross profit, (sales
revenues- cogs), is the extra
amount the company receives from
customers over what the company
paid to the vendor.

You have expenses when you sell

the inventory, you’ll have the cost
of inventory sold.
After calculating the gross profit, other operating expenses are deducted to
determine the net income.

Operating expenses are expenses that occur in the entity’s major ongoing
operations

On the balance sheet, a merchandiser includes Merchandise Inventory in the

current assets section, that represents the value of inventory that the business
has on hand to sell.

PERPETUAL AND PERIODIC INVENTORY SYSTEMS

There are two main types of inventory accounting systems:

- Periodic inventory system

- Perpetual inventory system

The periodic system requires a physical count of inventory to determine the

quantities on hand. This is typically used in small local stores or restaurants.

The perpetual system keeps a running computerized record of merchandise

inventory on hand. This system achieves better control over the inventory.

For example, large department stores’ computers use bar codes to update the
records in real time. However, even in a perpetual system, the business must
count the inventory at least once a year since there could be errors.

How are purchases of Merchandise inventory recorded in a perpetual

inventory system?

The cycle of a merchandiser begins with the purchase of merchandise inventory.

The vendor ships the inventory the the business and sends an invoice the same
day.

The invoice is the seller’s

request for payment from
the buyer, it’s also called
a bill. After the
merchandise is received,
then the company pays
the vendor.

Sellers have sales

invoices; the purchasers
have purchase invoices.
We assume that we pay in cash on that day. The entry is:

If we instead assume that the business receives the merchandise on

account, then the entry will be:

Purchase returns and allowances

Sellers allow purchasers to return merchandise that is defective,

damaged or unsuitable —> purchase return.

The seller could also deduct an allowance from the amount the buyer
owes, the purchaser as an incentive to keep goods that are not as ordered
—> purchase allowances.

In case of returns, the seller has the merchandise sent back, once they
receive it, they check if they can repair it and put it in stock
Assume that the
company hasn’t paid the
original bill yet. During
the shipment of
merchandise, 20 tablets
were damaged. The
business returns the
goods valued at $7.000
to the vendor and this
will be recorded as:

Purchase discounts

Many businesses offer purchasers a discount for early payment —>

purchase discount.

The vendor’s credit terms are the payment terms of purchase or sale as
stated on the invoice. Ex. 3/15, n/30 means a 3% discount if paid within
15 days, otherwise the full amount is due in 30 days. It’s up the the
purchaser the decision to pay early or after.

Assume that the business pays within the discount period, then the
business will receive a discount
on the balance owed of $28.000

The cash payment entry is:

After posting the entry to the

accounts,

- Merchandise inventory reflects a balance of exactly what the

company paid for its merchandise: $27.160
- Accounts payable
balance shows the
invoice has been paid
in full with no
remaining balance
Transportation costs

Either the seller or the buyer pays for transportation cost of shipping
the merch. The purchase agreement specifies FOB (free on board)
terms to determine when the title of the good transfers to the
purchaser and who pays the freight.

- The FOB shipping point: it means that the buyer takes ownership to
the goods after the goods leave the seller’s place
- The FOB destination: it means that the buyer takes ownership to the
goods at the delivery destination point

When merchandisers are required to pay for shipping costs, those costs
are classified as freight in or freight out.

- Freight in is the transportation cost to ship goods into the

purchaser’s warehouse
- Freight out is the transportation costo to ship goods out of the
seller’s warehouse and to the customer

Freight in

With the terms FOB shipping point, the buyer owns the good while they
are in transit, so he pays the freight. Since the freight is a cost that must
be paid to acquire inventory, it becomes part of the cost of merchandise
inventory.

Suppose that the company pays $60 freight charge:

Freight in within the discount period

Discounts are computed only on merchandise purchased, not on the

transportation costs.
Under the FOB shipping point, the seller sometimes prepays the
transportation cost as a convenience and lists this cost on the invoice.

Assume the business purchases on account $5.000 of good, with freight

charge of $400, with the terms 3/5, n/30.

The purchase is recorded as:

If the business pays writhing the discount period, the discount is applied
only on the $5.000 merchandise cost, the $400 is not eligible for the
discount. So, the 3% of 5.000 is 150, and the entry will be:

The net cost of inventory purchased:

Knowing the net cost of inventory allows a business to determine the

actual cost of the merchandise purchased and is calculated as follow:

Net cost of inventory purchased= purchase cost of inventory- purchase

returns and allowances- purchase
discounts+ freight in

How are sales of merchandise inventory recorded in a perpetual

inventory system?

After a company buys merchandise inventory, the next step is to sell the
goods.

Suppose the business sells two tablets for cash to a customer and issued
the sales invoice.
The amount a business earns from selling merchandise inventory is called
Sales Revenue. Two entries are required to record sale transactions in a
perpetual inventory system:

- Record sales revenue (sales revenue and cash received)

- Record inventory sold (cost of goods sold and reduction of
inventory)

To record the sale by the business, two journal entries must be recorded.

First, we record the cash sale by debiting cash and crediting sales
revenue. The we have to record the expense and decrease the
merchandise inventory.

Retailers often sell merchandise inventory and receive a payment with a

credit card.

Credit card sales are recorded in the same way as cash sales because the
payment is usually received via an electronic transfer within a few days.

The retailer will have to pay a fee associated with credit card sales; they
won’t get the full amount of the price.
Sales on account, with no discount

Assume the company sells 5 tablets for $2.500 and goods cost is $1.750.

Sales returns and allowances

After making a sale, some customers may return the goods, asking for a
refund or credit to the customer’s account, or the company may grant a
sales allowance to encourage the customer to accept the nonstandard
goods.

Sales returns and allowances account is a contra account to sales

revenues and has a normal debit balance.

Sales return

Sales returns reduce the future cash collected from the customer or
require a refund be made to the customer.

Under the new revenue recognition standards, during the adjusting

process, companies estimate the amount of sales returns from customers
that will occur.

Estimated return inventory is an asset account used to estimate the cost

of merchandise inventory a company will receive in returns

Refunds payable is a liability account used to estimate the amount of

refund that will be paid to customers in the future

The company estimates that approximately $10.000 of estimated refunds

will be paid and $6.000 of cost merchandise inventory will be returned.
On June 22, a customer returned merchandise purchased with cash with a
sales price of $2.000, and the cost of goods was $800.

Sales allowances

A sales allowance occurs when the seller reduces the amount owed by a
customer, but the customer does not return the merchandise.

When a seller grants a sales allowance, the company issues a credit

memo, indicating that the company will reduce the accounts receivable of
the customer or issue a cash refund. The company also reduces the
estimated refunds payable account.

Sales on account with discount

Many sellers offer customers a discount for early payment. Sales

discounts decrease the net amount of revenue earned on sales. The sales
discounts account is a contra account to sales revenue, so it has the
opposite normal balance.

The new revenue recognition standards require sales to be recorded at the

net amount (with discount) or the amount of the sale less any sales
discounts. There is a conservative estimation.

Ex. The company sells 15 tablets for $500 each on account with terms
2/10, n/30, the goods cost is $5.250.

We assume the payment will occur within the 10 days, as if we know

already the customer is going to pay with discount.
If the customer will make the payment within the discount period, then
the company will record the receipt of cash and decrease the accounts

receivable, no adjustment needed because we had already recorded the

“worst case scenario.”

But if the customer does not pay within the discount period, then the
customer will no longer receive the $150 discount, and the customer must
pay the full amount of $7.500.

The company will record the discount loss as:

The sales discounts

forfeited equals to a
financial income/
revenue, that is
different from service
or sales revenue.

Transportation costs—freight out

Remember that a freight out expense is one in which the seller pays
freight charges to ship goods to the customer, it’s a delivery expense to
the seller.

Delivery expense is an operating expense and is debited to the delivery

expense account.

Assume that the company pays $30 to ship goods to customers. The entry
will be:
ADJUSTING AND CLOSING ENTRIES FOR A MERCHANDISER

The adjusting and closing entries for a merchandiser are similar to what a
service entity does.

If the company uses a perpetual system, there aren’t much adjustments

to make.

However, merchandisers must check and adjust for inventory shrinkage

and estimated sales returns.

Inventory shrinkage is loss of inventory occurring from theft,

damage, errors

For that businesses take a physical count of inventory at least once

a year, most commonly it happens at the end of the fiscal year.

The company’s merchandise inventory account shows an unadjusted

balance of $31.530, but a physical count on Dec.31 shows that the
inventory on hand is only $30.000.

To calculate the adjusting entry:

Merchandise inventory balance before adj-actual merchandise inventory

on hand

To adjust the estimated sales returns:

The company estimates that approximately $4.000 of sales revenue and

$1.600 of inventory will be returned.

The entry will be:

We don’t know if the

estimation is correct
but the company
prefers lower before it
happens cause we
want to estimate the
sales conservatively
This entry reduces the sales revenue by the amount of estimated refunds
for the year

The second entry records the cost of estimated returns inventory for the
year

CLOSING THE ACCOUNTS OF A MERCHANDISER

Closing still means to zero out all temporary accounts (all the accounts
that aren’t on the balance sheet)

There are four steps in the closing process:

1. Make revenues accounts equal zero via the Income summary

account
2. Make expense accounts and other temporary accounts with a debit
balance equal zero via Income summary (including cost of goods
sold)
3. Make the income summary account equal zero via the retained
earnings accounts. This entry transfers net income or loss to
retained earnings
4. Make the dividends account equal zero via the retained earnings
account

The only difference with the service company is that we have new items
and accounts specifically for a merchandiser
MERCHANDISER’S FINANCIAL STATEMENTS PREPARATION

The financial statements we’ve learned before for a service business are
also used by merchandisers, just with some additional accounts.

- Income statement

There are two formats for income statements:

Single step: group all revenues together and then deduct all expense to
calculate the net income without any subtotals. This format works well for
service entities since they have no gross profit to report, but we will not
use this.

Multi step: contains subtotals to highlight significant relationships, it

reports the net income, gross profit and operating income

This income statement begins with net sales revenue, cost of good sold
and gross profit; then the operating expenses, those other than cost of

goods sold, are listed.

The operating expenses are reported in two categories, that explains the
functions:

Selling expenses: those related to marketing and selling the

company’s goods and services. Include salaries, advertising, depreciation
on store building and equipments, store rent, utilities on store buildings,
property tax on store buildings and delivery expense

Administrative expenses: those NOT related to marketing the

company’s goods and services. Include office expenses, such as salaries
of office employees, depreciation on office buildings and equipment, rent,
utilities and taxes of office buildings.

The next section of the income statement is other revenues and expenses.
In this category there are reported revenues or expenses that are not in
the main regular operations, for example interest revenue, interest
expense.

At the end, corporations are required to pay income tax. The section
report the federal and state income taxes incurred by the corporation

The operating income measures the results of the entity’s major ongoing
activities (normal operations)

Gross profit – operating expense

The operating income is also kwown as EBIT —> earnings before interest
and tax

The name explains how to calculate it

The higher the interest the lower income tax

It’s not affected by the financial structure (how assets are financed)

The net income depends on the financial structure cause it includes

interest and taxes.

How are merchandise inventory transactions recorded in a

periodic inventory system?

Perpetual inventory systems are too expensive for smaller businesses.

Periodic inventory systems require physical counts of inventory to

determine quantities on hand

Merchandise inventory is updated at the end of the period during

the closing process

When we buy merchandise, we debit an account called Purchases, instead

of inventory, it’s a temporary account recording an expense (it’s not an
asset since we don’t record it in the inventory account).

If we return items to the vendor, then we debit the account payable (so its
lower) and we credit an item called purchase returns and allowance: it’s a
contra expense, an adjustment to the expense. We don’t credit purchase
cause we want to keep accounts separated.

If we buy items with a discount then the difference will be recorded in a

purchase discounts account, another contra expense

To journalize the transportation cost we debit the expense into a separate

freight in account (an adjunct account).
We then get the net cost of inventory purchased:

When we sell the inventory, there is no need to record merchandise

inventory or COGS, instead we debit accounts receivable/ cash and credit
sales revenues,

The process of recording the ending merchandise inventory and the COGS
is completed during the closing process.

Example of a periodic journal

THEN JOURNAL ENTRIES