Chapter 6 Lecture and Notes

Compare and Contrast Merchandising versus Service Activities and Transactions

 

 

Merchandising and service companies differ from each other in what they sell, their financial transactions, how their income is measured and by their operating cycle. An operating cycle is the amount of time it takes a company to use its cash to provide a product or service and collect payment from the customer. As you can see from the image below, the operating cycle of a service organization is shorter. In other words, they collect payment from customers sooner.

 

Income Statement Differences

The calculation of net income or net loss is simpler for a service organization than for a merchandising organization. A merchandising organization first needs to calculate their gross margin, which is the difference between sales and cost of goods sold. Then subtract expenses from gross margin tp determine net income or loss. The service organization, since they do not buy products to sell, there are no cost of goods and therefore, no need to calculate gross margin.

 

 

 

Service Organization (0ne Step)

• • • • • • • • • • • • • • • • • • • • • • • • Sales-Expenses = Net Income (Loss)

 

 

 

 

Merchandising Organization (Two Steps)

1. 1. 1. 1. 1. 1. 1. 1. 1. 1. 1. 1. 1. 1. 1. 1. 1. 1. 1. 1. 1. 1. 1. 1. Sales - Cost of Goods Sold (COGS)
                                                                     2. COGS - Expenses = Net Income (Loss)

 

 

 

 

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Characteristics of Merchandising Transactions

Purchasing Inventory with Cash or on Account

 

Gross Purchases - purchase discounts - purchase returns - purchase allowance = Net purchases

 

 

 

Gross purchases: original amount of the purchase without considering reductions for purchase discounts, returns, or allowances

Net purchases: equals gross purchases less purchase discounts, purchase returns, and purchase allowances

• Purchase return occurs when merchandise is returned and a full refund is issued.
• Purchase allowance occurs when merchandise is kept and a partial refund is issued.

 

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Two Steps in Recording Sale of Merchandise

Step 1: Record the sale as it occurs in accordance with the revenue recognition principle.

Step 2: An entry is made for the cost of items sold. The cost of sales entry includes decreasing Merchandise Inventory and increasing Cost of Goods Sold (COGS).

 

Gross Sales - Sales discounts - Sales returns - Sales allowance = Net Sales

 

 

 

Gross sales: original amount of the sale without factoring in any possible reductions for discounts, returns, or allowances

Net sales: gross sales less sales discounts, sales returns, and sales allowances

Compare and Contrast Perpetual versus Periodic Inventory Systems

 There are two ways in which a company may account for their inventory:

• A perpetual inventory system automatically updates and records the inventory account every time a sale, or purchase of inventory, occurs. You can consider this “recording as you go.” The recognition of each sale or purchase happens immediately upon sale or purchase.
• A periodic inventory system updates and records the inventory account at certain, scheduled times at the end of an operating cycle. The update and recognition could occur at the end of the month, quarter, and year. There is a gap between the sale or purchase of inventory and when the inventory activity is recognized.

 

Adjusting and Closing Entries for a Perpetual Inventory System

At the end of the period, a perpetual inventory system will have the Merchandise Inventory account up-to-date:

• A physical count of inventory is taken to compare to what is on the books.
• Differences could occur due to mismanagement, shrinkage, damage, or outdated merchandise.
• The adjusting entry to show this difference is shown here. This example assumes merchandise inventory is overstated in the accounting records and needs to be adjusted downward to reflect the actual value on hand.

 

Adjusting and Closing Entries for a Periodic Inventory System

For a periodic inventory system, the end of the period adjustments require an update to COGS, but first COGS must be calculated.

COGS = Beginning Inventory + Net Purchases - Ending inventory

where:

Net Purchases = (Gross) Purchases - Purchase Discounts - Purchase Returns and Allowances

Once the COGS balance has been established, an adjustment is made to Merchandise Inventory and COGS, and COGS is closed to prepare for the next period.

 

 

 

Perpetual and Periodic Transaction Comparison

Transaction	Perpetual Inventory System	Periodic Inventory System
Purchase of Inventory	Record cost to Inventory account	Record cost to Purchases account
Purchase Return or Allowance	Record to update Inventory	Record to Purchase Returns and Allowances
Purchase Discount	Record to update Inventory	Record to Purchase Discounts
Sale of Merchandise	Record two entries: one for sale and one for cost of sale	Record one entry for the sale
Sales Return	Record two entries: one for sales return, one for cost of inventory returned	Record one entry: sales return, cost not recognized
Sales Allowance	Same under both systems	Same under both systems
Sales Discount	Same under both systems	Same under both systems

Analyze and Record Transactions for Merchandise Purchases Using the Perpetual Inventory System

 

   

 

 

Summary of Purchases Transactions: Perpetual Method

Analyze and Record Transactions for the Sale of Merchandise Using the Perpetual Inventory System

 

 

Summary of Sales Transactions: Perpetual Method

  

Discuss and Record Transactions Applying the Two Commonly Used Freight-In Methods

  

Shipping terms are an important component of the recording of inventory purchases and sales.

• Shipping terms are determined by the contract terms between buyer and seller.

The transfer point of ownership indicates:

• who pays the shipping charges
• who is responsible for the merchandise (i.e., if damaged, lost, or stolen)
• on whose balance sheet the assets would be recorded
• how to record the transaction for the buyer and seller

Goods in transit refers to the time in which the merchandise is transported from the seller to the buyer.

Freight-in refers to the shipping costs for which the buyer is responsible when receiving shipment from a seller, such as delivery and insurance expenses. When the buyer is responsible for shipping costs, they recognize this as part of the purchase cost.

 

NOTE: This means that the shipping costs stay with the inventory until it is sold. The cost principle requires this expense to stay with the merchandise as it is part of getting the item ready for sale from the buyer’s perspective. The shipping expenses are held in inventory until sold, which means these costs are reported on the balance sheet in Merchandise Inventory. When the merchandise is sold, the shipping charges are transferred with all other inventory costs to Cost of Goods Sold on the income statement.

 

Freight-out refers to the costs for which the seller is responsible when shipping to a buyer, such as delivery and insurance expenses. When the seller is responsible for shipping costs, they recognize this as a delivery expense.

NOTE: The delivery expense is specifically associated with selling and not with daily operations; thus, delivery expenses are typically recorded as a selling and administrative expense on the income statement in the current period.

 

  FOB destination point means the seller pays the shipping charges (freight-out).

• • • • • • • • • • • • • • • Goods in transit belong to, and are the responsibility of, the seller.
                            • The point of transfer is when the goods reach the buyer’s place of business.

 

 

FOB shipping point means the buyer pays the shipping charges (freight-in).

• • • • • • • • • • • • • • • Goods in transit belong to, and are the responsibility of, the buyer.
                            • The point of transfer is when the goods leave the seller’s place of business.

 

 

The following video walks through solving a series of transactions using everything you've learned abut the perpetual inventory system

 

Describe and Prepare Multi-Step and Simple Income Statements for Merchandising Companies

A multi-step income statement is more detailed than a simple income statement. Because of the additional detail, it is the option selected by many companies whose operations are more complex.

  

 

Gross profit margin ratio shows the margin of revenue above the cost of goods sold that can be used to cover operating expenses and profit. 

The larger the margin, the more availability the company has to reinvest in the business, pay down debt, and return dividends to shareholders.

$Gross\:Profit\:Margin\:Ratio\:=\left(Net\:sales\:-\:COGS\right)\div Net\:sales$

 

Appendix: Analyze and Record Transactions for Merchandise Purchases and Sales Using the Periodic Inventory System

 

Summary of Purchases Transactions: Periodic Method

  

Summary of Sales Transactions: Periodic Method

  

 

• Merchandising companies resell goods to consumers. Their operating cycle begins with cash-on-hand, purchasing inventory, selling merchandise, and collecting customer payments.
• A purchase discount is an incentive for a retailer to pay their account early. Credit terms establish the percentage discount, and Merchandise Inventory decreases if the discount is taken.
• A retailer receives a full or partial refund for returning or keeping defective merchandise. This can reduce the value of the Merchandise Inventory account.
• A customer receives an incentive for paying on their account early. Sales Discounts is a contra revenue account that will reduce Sales at the end of a period.
• A customer receives a refund for returning or keeping defective merchandise. Sales returns and allowances is a contra revenue account that will reduce Sales at the end of a period.
• A perpetual inventory system inventory updates purchase and sales records constantly, particularly impacting Merchandise Inventory and COGS.
• A periodic inventory system only records updates to inventory and costs of sales at scheduled times throughout the year, not constantly. Merchandise Inventory and COGS are updated at the end of a period.
• Cost of goods sold (COGS) includes all elements of cost related to the sale of merchandise. The formula to determine COGS, if one is using the periodic inventory system, is Beginning Inventory + Net Purchases – Ending Inventory.
• In FOB Destination, the seller is responsible for the shipping charges and like expenses. The point of transfer is when the merchandise reaches the buyer’s place of business, and the seller owns the inventory in transit.
• In FOB Shipping Point, the buyer is responsible for the shipping charges and like expenses. The point of transfer is when the merchandise leaves the seller’s place of business, and the buyer owns the inventory in transit.
• Multi-step income statements provide greater detail than simple income statements. The format differentiates sales costs from operating expenses and separates other revenue and expenses from operational activities. This statement is best used internally by managers to make pricing and cost reduction decisions.
• The gross profit margin ratio can show a company if they have a significant enough margin after sales revenue and cost data are computed to cover operational costs and profit goals. If a company is not meeting their target for this ratio, they may consider increasing prices or decreasing costs.