Nature of Retail Businesses

(Learning Objective 1)
• Retail businesses sell merchandise that they have purchased from other
companies to consumers.
• Companies selling the merchandise to retailers are called suppliers or
vendors.
• The transactions between suppliers and retailers are called business-to-
business (B2B) transactions.
• Transactions between retailers and consumers are called business-to-
consumer (B2C) transactions.

SUPPLIE RETAILE
R R CUSTOMER
B2B B2C
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 Financial Statements
(2 of 2)
• The revenue activities of a service business involve providing services to
customers.
• When merchandise is sold, the revenue is reported as sales, and its cost is
recognized as an expense.
• This expense is called the cost of goods sold or cost of merchandise sold.
• The cost of goods 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.
• The operating expenses are subtracted from
gross profit to arrive at operating income.
• Merchandise on hand (not sold) at the end of an accounting period is called
inventory or merchandise inventory.
• Inventory is reported as a current asset on the balance sheet.

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 Gross Profit Calculation

During the current year, merchandise is sold

for $4,885. The cost of the merchandise sold
is $3,028. The company also had operating
expenses of $1,150 and a tax rate of 22%.
What is the amount of gross profit, and what
is the gross profit percentage?

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 Gross Profit Calculation

During the current year, merchandise is sold for $4,885. The cost of the
merchandise sold is $3,028. The company also had operating expenses
of $1,150 and a tax rate of 22%. What is the amount of gross profit, and
what is the gross profit
Sales – Cost percentage?
of Goods Sold = Gross
Profit
$4,885 - $3,028 = Gross Profit
$1,857
Gross Profit/ Sales = GP %
$1,857/$4,885 = GP %
38.01%
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 Merchandiser wears two hats
Buyer versus Seller

Buyer Seller
Sales
Uses only three accounts:
Inventory Cost of Goods Sold
Accounts Payable Delivery Expense (freight)
Cash Customer Refunds Payable
Inventory
Estimated Returns Inventory
 Purchases Transactions
(1 of 4)
• There are two systems for accounting for merchandise transactions:
perpetual and periodic.
• In a perpetual inventory system, each purchase and sale of
merchandise is recorded in the inventory account and related
subsidiary ledger (continuously updated)
• In a periodic inventory system, the inventory does not show
the amount of merchandise available for sale and the amount sold
(no up-to-date records until the end of the
period)
• Instead, a listing of inventory on hand, called a physical inventory,
is prepared at the end of the accounting period.
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 Purchase Discounts
Interpreting Credit Terms

Read/ say: “Two – thirty – net – sixty”

 Purchases Discounts
(1 of 6)
• B2B (business-to-business) purchases may include a discount
by the supplier (vendor) to encourage the buyer to pay before
the end of the credit period.
• For example, a supplier 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.
• These 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.”
• Discounts taken by the buyer for early payment of an invoice
are called purchases discounts.
• Purchases discounts taken by a buyer reduce the cost of the
merchandise purchased.

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 Recording Inventory Sales 2

Every merchandise sale has two components, each of

which requires an entry in a perpetual inventory system.
 Sales Returns, Refunds, and Allowances
(1 of 6)

A buyer may return merchandise that is defective, damaged during

shipment, or does not meet the buyer’s expectations.

1. If the buyer has already paid for the merchandise, the seller may
pay the buyer a cash refund.
2. If the buyer has an outstanding accounts receivable with the seller,
the buyer may request an offset against the accounts receivable.
3. A buyer could also keep the merchandise and request a partial
refund or price allowance.

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 Sales Returns, Refunds, and Allowances
(2 of 6)
• At the end of the accounting period, a seller must estimate the amount of
returns, refunds, and allowances that may have to be issued to customers
in the future.
• Based upon this estimate, sellers record two adjusting entries:
1. The first adjusting entry decreases (debits) Sales and increases
(credits) Customer Refunds Payable for the estimated refunds and
allowances that will be granted to customers in the future.
• Customer Refunds Payable is a current liability for refunds and
allowances that will be granted to customers.

2. The second adjusting entry increases (debits) Estimated Returns

Inventory for merchandise that is expected to be returned and
decreases (credits) Cost of Goods Sold.
• Estimated Returns Inventory is a current asset for merchandise that is
expected to be returned by customers.

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 Sales Returns, Refunds, and Allowances
(2 of 6)
At the end of the accounting period, a seller must estimate the amount of returns,
refunds, and allowances that may have to be issued to customers in the future.
Based upon this estimate, sellers record two adjusting entries:

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Exhibit 7 – Journal Entries for Customer Sales
Returns, Refunds, and Allowances

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 Freight
(1 of 6)

• Purchases and sales of merchandise often involve freight.

• The ownership of the merchandise may pass to the buyer when the
seller delivers the merchandise to the freight carrier.
• In this case, the terms are said to be FOB
(free on board) shipping point, meaning that
the buyer pays the freight costs from the
shipping point to the final destination.

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 Freight
(3 of 6)
• The ownership of the merchandise may pass to the buyer when the buyer
receives the merchandise.
• In this case, the terms are said to be FOB (free on
board) destination, meaning the seller pays the
freight costs from the shipping point to the buyer’s
final destination.
• To illustrate, assume that NetSolutions sells merchandise as follows:
June 15. Sold merchandise to Kranz Company on account, $700,
terms
FOB destination. The cost of the goods sold is $480
NetSolutions pays freight of $40 on the sale of June 15.
• NetSolutions records the sale, the cost of the sale, and the freight
cost as shown in the next
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 Exhibit 8 – Freight Terms

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 Sales Taxes and Trade Discounts

• Sales of merchandise often involve sales taxes. Also,

the seller may offer buyers trade discounts.
• Almost all states levy a tax on sales of merchandise.
• The liability for the sales tax is incurred when the sale is
made.
• At the time of a cash sale, the seller collects the sales tax.
• When a sale is made on account, the seller charges the tax to
the buyer by debiting Accounts Receivable.
• The seller credits the sales account for the amount of the sale
and credits the tax to Sales Tax Payable.
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 Sales Taxes
(1 of 2)

• The seller would record a sale of $100 on account, subject to a tax

of 6%, as follows:

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 Sales Taxes
(2 of 2)

• On a regular basis, the seller pays to the taxing authority (state) the
amount of the sales tax collected.
• The seller records such a payment as follows:

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 Checkpoint question

If Walmart sells a TV for a price of $1,000 and the sale is subject

to 5% sales tax:
1. What is the total amount collected from the customer?
2. What is the total amount Walmart records as “sales revenue”?
3. What is the difference between #1 and #2? What other account
should Walmart record and for how much?

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 Checkpoint question

If Walmart sells a TV for a price of $1,000 and the sale is subject

to 5% sales tax:
1. What is the total amount collected from the customer?
Walmart collects $1,050 from the customer
2. What is the total amount Walmart records as “sales revenue”?
Walmart records $1,000 for sales revenue
What is the difference between #1 and #2? What other account
should Walmart record and for how much?
The difference is $50 ($1,050 – 1,000)
This is recorded as “Sales Tax Payable”
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Exhibit 12 – Multiple-Step Income Statement

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 Sales, Cost of Goods Sold, and Gross Profit

• Sales to customers for cash and on account are reported in the

sales section.
• Cost of goods sold are reported next and may also be reported as
cost of merchandise sold or cost of sales.
• The excess of sales over cost of goods sold is gross profit.

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 Operating Income
(1 of 2)

• Operating income, sometimes called income

from operations, is determined by subtracting
operating expenses from gross profit.
• Operating expenses are normally classified as either selling expenses
or administrative expenses.
• Selling expenses are incurred directly in the selling of merchandise
• Administrative expenses, sometimes called general expenses, are
incurred in the administration or general operations of the business.
• Each selling and administrative expense may be reported separately.

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 Operating Income
(2 of 2)

• Many companies report selling, administrative, and operating

expenses as single line items, shown as follows for NetSolutions:

Gross profit $ 187,950

Operating expenses:
Selling expenses $ 70,820
Administrative expenses 34,890
Total operating expenses (105,710)
Operating income $ 82,240

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Exhibit 13 – Single-Step Income Statement

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 Control of Inventory
(Learning Objective 1)

Two primary objectives of

control over inventory are
as follows:
1. Safeguarding the
inventory from
damage or theft.
2. Reporting inventory in
the financial
statements.

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 Safeguarding Inventory
Controls for safeguarding inventory begin as soon as the inventory is
ordered.
The following documents are often used for inventory control:
• The purchase order authorizes the purchase of the inventory from
an approved vendor.
• The receiving report establishes an initial record of the receipt of the
inventory.
• The vendor’s invoice
• The subsidiary inventory ledger provides a record of the amount of
inventory available and helps keep inventory quantities at proper
levels.
Controls for safeguarding inventory should include security measures to
prevent damage and customer or employee theft.
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 Reporting Inventory

• A physical inventory or count of inventory should be

taken near year-end to make sure that the quantity of
inventory reported in the financial statements is
accurate.
• After the quantity of inventory on hand is determined,
the cost of the inventory is assigned for reporting in the
financial statements.

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 Inventory Cost Flow Assumptions
(1 of 4) (Learning Objective 2)
• An accounting issue arises when identical units of
merchandise are acquired at different unit costs
during a period.
• In such cases, when an item is sold, it is necessary to
determine its cost using a cost flow assumption and
related inventory costing method.

Remember….
Perpetual –records are updated continuously
Periodic –records are updated once at the end of the period
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How Inventory works
 Inventory Cost Flow Assumptions
(4 of 4)
• Under the specific identification inventory cost flow method, the unit sold
is identified with a specific purchase. The ending inventory is made up of the
remaining units on hand.
• Under the first-in, first-out (FIFO) inventory cost flow method, the first
units purchased are assumed to be sold and the ending inventory is made up
of the most recent purchases (Example: produce, milk, perishable goods)
• Under the last-in, first-out (LIFO) inventory cost flow method, the last
units purchased are assumed to be sold and the ending inventory is made up
of the first purchases (Example: technology; primarily used for tax purposes)
• Under the weighted average inventory cost flow method, sometimes
called the average cost flow method, the cost of the units sold and in ending
inventory is a weighted average of the purchase costs (Example: gasoline at
gas station)
• The purchase costs are weighted by the quantities purchased at each cost,
thus the term weighted average.
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 First-in, First-out FIFO
Cost flow is in the order in which costs were incurred. The first
goods purchased will be the first goods sold.
The following information is available.
Unit
Units Cost Total Cost
October 1 inventory 250 $10 2,500
October 15 purchase 400 $9 3,600
October 25 purchase 350 $13 4,550
1,000 $ 10,650

600 units were sold on October 20

Compute the October 31 inventory and cost of goods sold for the month of October.
 First-in, First-out FIFO
Periodic and Perpetual
The following information is available.
Units Unit Cost Total Cost
October 1 inventory 250 $10 2,500
October 15 purchase 400 $9 3,600
October 25 purchase 350 $13 4,550
1,000 $ 10,650

600 units were sold on October 20

Compute the October 31 inventory and cost of goods sold for the month of October.

Using the FIFO method:

250 * 10 =
2,500 50 * 9 = 450
350 * 9 = 3,150 350 * 13 = 4,550
600 COGS
$5,650 400 Ending $5,000
 Last-in, First-out LIFO
Periodic
Cost flow is in the reverse order in which costs were incurred.
The last goods purchased will be the first goods sold.
The following information is available.
Unit
Units Cost Total Cost
October 1 inventory 250 $10 2,500
October 15 purchase 400 $9 3,600
October 25 purchase 350 $13 4,550
1,000 $ 10,650

600 units were sold on October 20

Compute the October 31 inventory and cost of goods sold for the month of October.
 Last-in, First-out LIFO
Periodic
The following information is available.
Units Unit Cost Total Cost
October 1 inventory 250 $10 2,500
October 15 purchase 400 $9 3,600
October 25 purchase 350 $13 4,550
1,000 $ 10,650

600 units were sold on October 20

Compute the October 31 inventory and cost of goods sold for the month of October.

LIFO Periodic 350 * 13 = 4,550 150 * 9 = 1,350

250 * 9 = 2,250 250 * 10 = 2,500

600 COGS $6,800 400 Ending $3,850

 Last-in, First-out LIFO
Perpetual
Cost flow is in the reverse order in which costs were incurred.
The last goods purchased will be the first goods sold.
The following information is available.
Unit
Units Cost Total Cost
October 1 inventory 250 $10 2,500
October 15 purchase 400 $9 3,600
October 25 purchase 350 $13 4,550
1,000 $ 10,650

600 units were sold on October 20

Compute the October 31 inventory and cost of goods sold for the month of
October.
 Last-in, Last-out LIFO
Perpetual
The following information is available.
Units Unit Cost Total Cost
October 1 inventory 250 $10 2,500
October 15 purchase 400 $9 3,600
October 25 purchase 350 $13 4,550
1,000 $ 10,650

600 units were sold on October 20

Compute the October 31 inventory and cost of goods sold for the month of October.

LIFO Perpetual 400 * 9 =3,600 50 * 10 = 500

200 * 10 =2,000 350 * 13 = 4,550

600 COGS $5,600 400 Ending $5,050

 Weighted Average Cost
Cost flow is an average of all costs.

The following information is available.

Unit
Units Cost Total Cost
October 1 inventory 250 $10 2,500
October 15 purchase 400 $9 3,600
October 25 purchase 350 $13 4,550
1,000 $ 10,650

600 units were sold on October 20

Compute the October 31 inventory and cost of goods sold for the month of
October.
 Weighted Average Cost

The following information is available.

Units Unit Cost Total Cost
October 1 inventory 250 $10 2,500
October 15 purchase 400 $9 3,600
October 25 purchase 350 $13 4,550
1,000 $ 10,650

600 units were sold on October 20

Compute the October 31 inventory and cost of goods sold for the month of October.

Average Cost
$ 10,650 = $10.65 Weight average per unit cost
1,000

600 COGS =$10.65*600 = $6,390 Income Statement

400 Ending =$10.65*400 = $4,260 Balance Sheet
Exhibit 9 – Effects of Changing Costs (Prices):
FIFO and LIFO Cost Methods

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 Analysis for Decision Making:
Inventory Turnover and Days’ Sales in Inventory
(1 of 5) (Learning Objective 7)
• A merchandising business should keep enough inventory on hand to meet
its customers’ needs.
• Two measures to analyze inventory management are:
• Inventory turnover
• Days’ sales in inventory

Inventory turnover measures the number of times

inventory is turned into sold goods during the year. It is computed
as follows:
Cost of Goods Sold
Inventory Turnover =
Average Inventory
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 Analysis for Decision Making:
Inventory Turnover and Days’ Sales in Inventory
(2 of 5)
• To illustrate, inventory turnover for Best Buy Co., Inc. (BBY) is computed
from the following data (in millions) from two recent annual reports:

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 Analysis for Decision Making:
Inventory Turnover and Days’ Sales in Inventory
(3 of 5)

Generally, the larger the inventory turnover, the more efficient and effective
the company is in managing inventory.

The day’s sales in inventory measures the length of time it

takes to acquire, sell, and replace the inventory. It is computed as follows:
Average Inventory
Days' Sales in Inventory =
Average Daily Cost of Goods Sold

OR…. 365 DAYS/Inventory Turnover

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 Analysis for Decision Making:
Inventory Turnover and Days’ Sales in Inventory
(4 of 5)
• The average daily cost of goods sold is determined by dividing the cost of
goods sold by 365.
• Based upon the preceding data, the days’ sales in inventory for Best Buy
is computed as follows:

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 Analysis for Decision Making:
Inventory Turnover and Days’ Sales in Inventory
(5 of 5)
• As with most financial ratios, differences exist among industries.
• To illustrate, The Kroger Co. (KR) is the world’s largest grocery store
chain.
• Because food is perishable, it will sell more rapidly than Best Buy’s
consumer electronics.
• Thus, Kroger’s inventory management should be significantly more
efficient than Best Buy’s.
• For a recent year, this is confirmed as follows:
Best Buy Kroger
Inventory turnover 6.2 14.2
Days’ sales in inventory 58.9 days 25.7 days

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 Sarbanes-Oxley Act
(Learning Objective 1)
• The purpose of the Sarbanes-Oxley Act is to maintain public
confidence and trust in the financial reporting of companies.
• Sarbanes-Oxley applies only to companies whose stock is traded on
public exchanges, referred to as publicly held companies.
• Sarbanes-Oxley emphasizes the importance of effective
internal control.
• Internal control is defined as the procedures and
processes used by a company to:
• Safeguard its assets.
• Process information accurately.
• Ensure compliance with laws and regulations.

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Exhibit 1 – Effect of Sarbanes-Oxley

NOTE: Effective
internal controls can
help prevent or
detect fraud and
theft, but internal
controls cannot
eliminate fraud
and theft

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 Internal Control
(Learning Objective 2)

• Internal Control—Integrated Framework is the standard by which

companies design, analyze, and evaluate internal control.
• Internal control can safeguard assets by preventing theft, fraud,
misuse, or misplacement.
• A serious concern of internal control is preventing employee fraud.
• Employee fraud is the intentional act of deceiving an employer for
personal gain.

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Exhibit 3 – Objectives of Internal Control

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Exhibit 4 – Elements of Internal Control
1. Control Environment
 “Tone at the top”
2. Risk Assessment
 Economic factors, competition,
regulatory changes
 Identify the risk – likelihood and
magnitude
 Action plan
3. Control procedures
 Competent personnel, rotate duties,
mandatory vacations
 Separate out responsibilities and
operations
 Security measures
4. Monitoring
 Observe process and correct problems
5. Information and Communication
 Sharing information – internally and
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 Cash Controls over Receipts and Payments
(Learning Objective 3)

• Cash includes coins, currency (paper

money), checks, and money orders.
• Money on deposit with a bank or other financial institution that
is available for withdrawal is also considered cash.
• Normally, you can think of cash as anything that a bank would
accept for deposit in your account.

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 Control of Cash Receipts

• To protect cash from theft and misuse, a

business must control cash from the time it is
received until it is deposited in a bank.
• Businesses normally receive cash from two main
sources.
• Customers purchasing products or services
• Customers making payments on account

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 Control of Cash Payments
• The control of cash payments should provide reasonable
assurance that:
• Payments are made for only authorized transactions.
• Cash is used effectively and efficiently.
• In a small business, an owner/manager may authorize
payments based on personal knowledge.
• In a large business, however, purchasing goods, inspecting the
goods received, and verifying the invoices are usually
performed by different employees.

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 Bank Statement
(3 of 4)

• A bank makes credit entries (issues credit memos) for the

following:
• Deposits made by electronic funds transfer (EFT)
• Collections of notes receivable for the company
• Proceeds for a loan made to the company by the bank
• Interest earned on the company’s account
• Correction (if any) of bank errors
• A bank makes debit entries (issues debit memos) for the
following:
• Payments made by electronic funds transfer (EFT)
• Service charges
• Customer checks returned for not sufficient funds
• Correction Warren/Jones/Tayler,
(if any) of bank errors
Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved.
May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Bank Reconciliation
(1 of 4) (Learning Objective 5)
• A bank reconciliation is an analysis of the items and amounts
creating the difference between the cash balance reported on
the bank statement and the balance of the cash account in the
ledger.
• The adjusted cash balance determined in the bank reconciliation is
reported on the balance sheet.
• A bank reconciliation is usually divided into two sections as follows:
1. The bank section (“BANK”) begins with the cash balance
according to the bank statement and ends with the adjusted
balance.
2. The company section (“BOOK”) begins with the cash balance
according to the company’s records and ends with the adjusted
balance.
Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved.
May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Bank Reconciliation 1

Your Bank May Not Know You (the COMPANY) May Not
About Know About
1. Errors made by the bank 3. Interest the bank has put into
2. Time lags your account
a. Deposits that you made 4. Electronic funds transfers (E F
recently Ts)
b. Checks that you wrote 5. Service charges taken out of
recently your account
6. Customer checks you deposited
for which the customer did not
have sufficient funds (NSF)
7. Errors made by you
 Bank Reconciliation
(2 of 4)
• The adjusted balance from bank and company sections must be
equal.
• The format of the bank reconciliation follows:

Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved.
May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Exhibit 12 – How to Prepare a Bank Reconciliation
(1 of 2)

Bank Section of Reconciliation

▪ Step 1. Enter the Cash balance according to bank from the ending cash balance
according to the bank statement.
▪ Step 2. Add deposits not recorded by the bank.
Identify deposits not recorded by the bank by comparing each deposit listed on
the bank statement with unrecorded deposits appearing in the preceding
period’s reconciliation and with the current period’s deposits.
Examples: Deposits in transit at the end of the period.
▪ Step 3. Deduct outstanding checks that have not been paid by the bank.
Identify outstanding checks by comparing paid checks with outstanding checks
appearing on the preceding period’s reconciliation and with recorded checks.
Examples: Outstanding checks at the end of the period.
▪ Step 4. Determine the Adjusted balance by adding Step 2 and deducting Step 3.

Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved.
May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Exhibit 12 – How to Prepare a Bank Reconciliation
(2 of 2)

Company Section of Reconciliation

▪ Step 5. Enter the Cash balance according to company from the ending cash balance in
the ledger.
▪ Step 6. Add credit memos that have not been recorded.
Identify the bank credit memos that have not been recorded by comparing the
bank statement credit memos to entries in the journal.
Examples: A note receivable and interest that the bank has collected for the
company.
▪ Step 7. Deduct debit memos that have not been recorded.
Identify the bank debit memos that have not been recorded by comparing the
bank statement debit memos to entries in the journal.
Examples: Customers’ not sufficient funds (NSF) checks; bank service charges.
▪ Step 8. Determine the Adjusted balance by adding Step 6 and deducting Step 7.
Verify That Adjusted Balances Are Equal
▪ Step 9. Verify that the adjusted balances determined in Steps 4 and 8 are equal.

Warren/Jones/Tayler, Financial & Managerial Accounting, 16th Edition. © 2023 Cengage. All Rights Reserved.
May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
How to prepare a bank reconciliation
Summary
Bank Reconciliation Goals
1.Identify the deposits in transit.
2.Identify the outstanding checks.
3.Record other transactions on the
bank statement and correct your
errors.