Chapter 5 Notes: Accounting for Merchandising Businesses (Merchandising, Inventory, and Periodic/Perpetual Methods)

Nature of Merchandising Businesses

  • Merchandising businesses do not produce their own goods; they buy and resell merchandise. Distinctions: wholesalers vs retailers
    • Wholesalers sell to other businesses, not to final consumers (e.g., Sysco, UNFI).
    • Retailers sell directly to the final consumer (e.g., Target, Walmart).
    • Business-to-business (B2B) vs business-to-consumer (B2C) terminology for transactions.
  • Service vs merchandising differences are reflected in operating cycles and financial statements.
  • Objectives emphasized in the chapter: distinguish service vs merchandising activities; describe accounting for merchandise; adjust and present retail financial statements; close and report equity changes.

The Operating Cycle and Financial Statements (Merchandising)

  • Operating Cycle (merchandising) involves purchasing merchandise, selling it, and collecting cash from customers; differs from a service business because merchandisers must manage inventory.

  • Exhibit: The Operating Cycle for a Merchandising Business shows cash -> purchases of merchandise -> merchandise in inventory -> sales -> collections.

  • Income Statement presentation differences between service and merchandising businesses:

    • Service: Fees earned, less operating expenses, equals operating income.
    • Merchandising: Sales minus Cost of Goods Sold (COGS) = Gross Profit; then subtract operating expenses to reach operating income.

  • Key terms: inventory or merchandise inventory is reported as a current asset on the balance sheet.

  • Example condensed income statement (service vs merchandising):

    • Service: Fees earned – Operating expenses = Operating income; no COGS.
    • Merchandising: Sales – Cost of Goods Sold = Gross Profit; Gross Profit – Operating expenses = Operating income.

Chart of Accounts and Subsidiary Ledgers (Merchandising)

  • Three-digit chart of accounts in NetSolutions example; first digit = major class (assets=1, liabilities=2, stockholders’ equity=3, revenues=4, etc.), second digit = sub-classification, third digit = specific account.
  • Subsidiary ledgers:
    • Accounts Receivable subsidiary ledger (customers ledger) with a controlling account in the general ledger (Accounts Receivable).
    • Accounts Payable subsidiary ledger (creditors ledger) with a controlling account (Accounts Payable).
    • Inventory subsidiary ledger lists inventory by item; Inventory is the controlling account in the general ledger.
  • Special journals exist (purchases, sales, inventory reports), but examples in this chapter illustrate using a two-column general journal.

Inventory Systems: Perpetual vs Periodic

  • Perpetual inventory system:
    • Each merchandise transaction (purchase/sale) updates Inventory and the related subsidiary ledgers in real time.
    • Typical in computerized systems with barcodes or RFID; continuous update of inventory on hand and cost of goods sold (COGS).
    • Journal entries example under perpetual:
    • Cash purchase of merchandise: Debit Inventory, Credit Cash for the purchase amount.
    • Purchase on account: Debit Inventory, Credit Accounts Payable for the purchase amount.
    • If discount is taken, use the Inventory account to reflect the net cost (for perpetual system).
  • Periodic inventory system:
    • Inventory is not updated with each purchase/sale. A physical count at period end determines ending inventory and COGS.
    • Purchases, Purchases Discounts, Purchases Returns and Allowances are tracked separately from Inventory.
    • Freight-in is recorded as Freight In (or similar) under the period’s purchases.
    • At period end, COGS is calculated using beginning inventory, net purchases, freight-in, ending inventory, and estimated returns.
  • Exhibit 9 (summary of recording under perpetual) vs Exhibit 20 (COGS calculation under periodic) illustrate differences.

Purchases Transactions (Perpetual System)

  • Two systems to record purchases: perpetual and periodic. This section focuses on perpetual entries and the impact on accounts.
  • Cash purchases of merchandise under perpetual:
    • Debit Inventory; Credit Cash for the purchase amount (e.g., Inventory 2,510; Cash 2,510).
  • Purchases on account under perpetual:
    • Debit Inventory; Credit Accounts Payable for the amount (e.g., Inventory 9,250; Accounts Payable—Thomas 9,250).
  • Credit terms and invoice example: Alpha Technologies invoice example shows terms 2/10, n/30 and the effect of early payment on net cost of inventory when discounts are taken.
  • Terms clarity:
    • Credit terms specify the discount period (e.g., 2/10, n/30 means 2% discount if paid within 10 days; otherwise, net amount due in 30 days).
    • If discount is taken, the buyer saves cash and the inventory cost is effectively reduced in the perpetual system (via Inventory reduction for the discount).

Purchases Returns and Allowances; Debit Memos

  • When inventory is returned or allowances granted, entries typically debit Accounts Payable and credit Inventory for the cost of the returned merchandise (at original invoice cost).
  • Debit memo: a document that informs the seller of the buyer’s request for a return or an allowance; the buyer can record the return/allowance based on the memo or await seller approval.
  • Example from NetSolutions: Return of inventory (e.g., 900) debited to Accounts Payable—Maxim Systems; Inventory credited.

Purchase Discounts (Purchases Discounts)

  • Discounts may be offered by suppliers to encourage early payment (e.g., 2/10, n/30).
  • Two methods to record sales discounts from the buyer’s perspective: gross method vs net method (for purchases, analogous terms apply to buyers).
  • Gross Method (for purchases): Record the invoice at its full amount; if paid within discount period, reduce cash by the discounted amount and recognize a purchase discount as a contra to Purchases (or to Inventory under perpetual; see diagrammatic entries).
  • Net Method (for purchases): Record the invoice net of the discount; if discount is taken, Cash received equals the net amount, and the discount is captured in the discount account; if not taken, the difference is recorded via additional accounts.
  • Example (Alpha Technologies): 2/10, n/30; if paid within 10 days, effective cost is $2,940 for a $3,000 invoice (after 2% discount).
  • Calculation for the cost savings from discouting and the equivalent interest rate comparisons (e.g., 6% annual rate vs implied rate if discount not taken).

Purchases Returns and Allowances (Detailed Examples)

  • NetSolutions example: Return of inventory (e.g., $900) is recorded by debiting Accounts Payable—Maxim Systems and crediting Inventory; the Debit Memo Exhibit 5 is used to document the return.
  • Example of a purchase with a return and discount: May 2 purchase of $5,000 on account; May 4 return of $1,000; May 12 payment of the remainder within discount period (2%)
    • The return reduces Inventory and Accounts Payable by the invoice amount; then the discount is applied to the remaining payable balance.
  • The concept of “Estimated Returns Inventory” and how returns reduce COGS when adjusting period-end entries.

Shipping Terms and Freight (FOB terms)

  • FOB shipping point vs FOB destination:
    • FOB shipping point: Buyer bears freight costs from the shipping point; freight is added to the cost of Inventory (delivered to buyer).
    • FOB destination: Seller bears freight costs; Transportation or Delivery Expense is used to record freight by the seller.
  • Examples:
    • June 10: Purchases from Magna Data $1,200; freight $50; inventory increases by $1,200; cash decreases by $50; then inventory increases by the freight cost when the buyer pays it (if prepaid) or when freight is paid by the buyer later.
    • June 15: Sale to Kranz Company with FOB destination; seller pays freight; the seller records Delivery Expense (Freight Out) if freight is paid by him.
  • Prepaid freight on merchandise: If the seller pre-pays freight costs and adds them to the invoice, the buyer records the total invoice (including freight) as Inventory; discounts would not apply to the prepaid freight.
  • Exhibit 8 summarizes freight terms with a visual guide to how journal entries would be recorded depending on who pays freight and when title passes.

Sales Transactions (Merchandising)

  • Sales revenue recognition typically recorded as Sales (or Sales Revenue). Costs of the goods sold are recorded as COGS when using a perpetual inventory system.
  • Cash Sales: Sales recorded with cash receipts; cash register entries used to reflect the sale.
  • Credit Card and Debit Card Sales: Usually recorded as cash sales since the clearinghouse transfers cash to the retailer’s account; service charges (processing fees) are recorded as an expense.
  • Sales on Account: Debit Accounts Receivable; Credit Sales; later, receipt entries (cash received) debit Cash; credit Accounts Receivable.
  • The NetSolutions example: sale on account to Digital Technologies for $18,000; cost of goods sold $10,800; subsequent collection in cash on April 9; the cash receipt is recorded as Cash $18,000; Accounts Receivable $18,000.
  • The article notes that Dollar Tree often processes credit-card income as cash sales; the processing fees are recorded as an expense.
  • Sales incentives such as coupons and rebates affect revenue or create liabilities depending on when they are issued and redeemed (see Coupon accounting below).

Sales Incentives, Promotions, and Discounts (Coupons and Rebates)

  • Coupons and rebates require careful timing and recognition:

    • Point-of-sale coupons issued at time of sale reduce revenue immediately (no liability is recognized when the coupon is issued; reduction occurs at sale).
    • Coupons appearing on receipts that can be redeemed later create a liability (Estimated Coupons Payable) and reduce revenue at the time of sale; when redeemed, the liability is debited.
    • Rebate programs are similar—instant rebates reduce revenue at sale; mail-in rebates create a liability and are later recognized as cash rebates when redeemed.

  • Example: A $3 off coupon on a $45 purchase reduces revenue to $42; cost of goods sold is charged for the actual cost of the inventory (not the coupon amount), and a separate entry may be needed for the reduction in gross revenue if the coupon is issued for future redemption.

  • If coupons are redeemable later, the retailer estimates redemption and records Estimated Coupons Payable (a current liability) and reduces Sales accordingly; when coupons are redeemed, Estimated Coupons Payable is debited.

  • If coupons expire, the liability can be transferred to Sales (to adjust revenue) or reversed based on the remaining balance.

  • May include an illustrative Grande Stores example where coupons of $3 redeemable for purchases over $20 are estimated to be redeemed at 20% probability; the entry reduces Sales by the estimated amount and records Estimated Coupons Payable; when coupons are redeemed, the liability is debited and cash is paid to customers.

  • Rebates (cash refunds by mail) follow the same logic as coupons, with adjustments at redemption and at expiration if unredeemed.

Sales Returns, Refunds, and Allowances (End-of-Period Adjustments)

  • Returns/refunds/allowances are estimated at period end; two adjusting entries are normally made:
    1) Debit Sales and credit Customer Refunds Payable for the estimated refunds/allowances.
    2) Debit Estimated Returns Inventory and credit Cost of Goods Sold for the expected returns inventory.
  • Customer Refunds Payable is a current liability; Estimated Returns Inventory is a current asset.
  • Example: NetSolutions December 31, 20Y8 adjustment: Sales 7,154; Customer Refunds Payable 7,154; Estimated Returns Inventory 5,000; Cost of Goods Sold 5,000.
  • The first entry reduces year 20Y8 sales to reflect expected future refunds; the second entry recognizes inventory expected to be returned and reduces COGS accordingly.
  • If returns occur, Inventory is debited; Estimated Returns Inventory is credited; if there is a sale on account, Customer Refunds Payable is debited and Accounts Receivable is adjusted; if a cash refund occurs, Cash is credited and Customer Refunds Payable is debited.
  • Illustrative exhibits (Exhibit 7, Exhibit 11) summarize the journal entries for various customer returns, refunds, and allowances.

Adjusting Process for Retail (End-of-Period Adjustments)

  • Inventory shrinkage (loss of inventory due to theft, error, or damage) is common and must be recorded as an adjusting entry when the physical inventory on hand differs from the accounting records under a perpetual system.
    • Example: Inventory balance $63,950; physical inventory on hand $62,150; shrinkage = $1,800.
    • Entry: Cost of Goods Sold 1,800; Inventory 1,800 (to align book with physical count).
    • This shrinkage is considered a normal cost of operations unless unusually large, in which case it could be disclosed separately or shown as a separate loss.
  • The unit uses both beginning and ending inventory in calculating COGS for the period; the adjustments ensure the ending inventory reflects physical counts.
  • E-commerce example: Shopping cart checkout processes typically automate the recording of the sale, the cost of goods sold, and the inventory reduction.

Financial Statements and Closing Entries (Retail/Merchandising)

  • Two main formats for income statements: Multi-step and Single-step
    • Multi-step includes gross profit and subtotals for operating expenses; shows a more detailed view of gross profit and operating income.
    • Single-step presents total revenues and total expenses in one section; easier but less detail about gross profit.
  • NetSolutions example (multi-step):
    • Sales: 708,255; COGS: 520,305; Gross profit: 187,950;
    • Operating expenses: Selling 70,820; Administrative 34,890; Total operating expenses: 105,710; Operating income: 82,240;
    • Other revenue: Rent revenue 600; Interest expense (2,440); Net income: 80,400.
  • NetSolutions example (single-step):
    • Total revenues: 708,855; Total expenses: 628,455; Net income: 80,400.
  • Closing entries for a merchandising business:
    • Close revenue accounts to Retained Earnings; close expense accounts to Retained Earnings; close Cost of Goods Sold as part of the closing process.
    • Example: Closing entries show debit Sales, credit each expense account, and credit Retained Earnings for net income; and debit Retained Earnings and credit Dividends for the dividends balance.
  • Post-closing trial balance includes only asset, liability, and stockholders’ equity accounts; all revenue and expense accounts are closed to Retained Earnings.
  • Asset Turnover Ratio (performance metric):
    • Definition: Asset Turnover Ratio =
      ext{Asset Turnover Ratio}= rac{ ext{Sales}}{ ext{Average Total Assets}}
    • Average Total Assets = rac{( ext{Total Assets at Beginning} + ext{Total Assets at End})}{2}.
    • Example (Dollar Tree): Year 2 and Year 1 data show Sales and Total Assets; the ratio is computed as follows:
    • Year 2: Sales = 28332, Beginning Assets = 21722, End Assets = 23022; Average Assets = \frac{21722+23022}{2} = 22387; Asset Turnover = \frac{28332}{22387} ≈ 1.27.
    • Year 1: Sales = 26321, Beginning Assets = 20696, End Assets = 21722; Average Assets = \frac{20696+21722}{2} = 21259; Asset Turnover = \frac{26321}{21259} ≈ 1.24.
    • Dollar Tree’s asset turnover improved from Year 1 to Year 2, indicating more efficient use of assets to generate sales.

Appendix 1: Sales Discounts (Gross vs Net Method)

  • When offering sales discounts on credit sales, two methods exist:
    • Gross Method: Record revenue at gross invoice price; if customer pays within discount period, record Cash received and Sales Discounts; Accounts Receivable is reduced for the full amount of the invoice.
    • Net Method: Record revenue net of expected discounts; if the discount is not taken, you may need to adjust; GAAP allows either method as long as the financial statements reflect the chosen method.
  • Example (Gross Method): NetSolutions sells $18,000 on 2/10, n/30; if paid within discount period, Cash received is $17,640; Sales Discounts is 360; Accounts Receivable reduced by 18,000 upon sale; later receipt reduces AR by 18,000 and recognizes 360 as Sales Discounts if discount is taken.
  • Example (Net Method): The sale is recorded at $17,640 (net of 2% discount). If the customer pays within the discount period, Cash = 17,640 and Accounts Receivable = 0; if not, Cash = 18,000 and Accounts Receivable = 18,000 with Sales 18,000; the difference is recorded as Sales Discounts if applicable.
  • Exhibit 17–Gross vs Net Methods illustrate the effects on revenue, inventory, and cost of goods sold.

Appendix 2: The Periodic Inventory System

  • Under periodic inventory, ending inventory is determined by a physical count; cost of goods sold is determined at period end.
  • Chart of Accounts under periodic system includes: Purchases, Purchases Discounts, Purchases Returns and Allowances, Freight In; no separate COGS account exists in the period until closing.
  • Typical journal entries under periodic:
    • Purchases: Debit Purchases; Credit Accounts Payable or Cash.
    • Purchases Discounts: Credit Purchases Discounts; Debit Cash when discount is taken.
    • Purchases Returns and Allowances: Credit Purchases Returns and Allowances; Debit Inventory (or credit Purchases).
    • Freight In: Debit Freight In; Credit Cash.
  • Exhibit 18 shows the periodic inventory chart of accounts, and Exhibit 19 demonstrates transaction flow under the periodic system with a sample June sequence.
  • End-of-period closing under periodic: Close Purchases, Purchases Discounts, Purchases Returns and Allowances, and Freight In to prepare for the ending inventory; adjust Inventory for beginning balance and ending inventory; move remaining balances to Retained Earnings.
  • Exhibit 20 shows the calculation of Cost of Goods Sold under the periodic system, including beginning inventory, net purchases, freight in, ending inventory, and estimated returns.

The Dual Nature of Merchandise Transactions (Sellers vs Buyers)

  • Every merchandise transaction affects both a buyer and a seller. Exhibit 10 demonstrates journal entries for (a) sales by Scully Company (Seller) and (b) purchases by Burton Co. (Buyer) under various terms (FOB shipping point, FOB destination), including the impact on Inventory, Cost of Goods Sold, and related accounts.
  • Sales Taxes:
    • The seller records Sales Tax Payable as a liability when the sale occurs (e.g., Sales 100; Sales Tax Payable 6; Accounts Receivable 106 for a sale on account with 6% tax).
    • The seller remits sales tax to the taxing authority periodically (e.g., Sales Tax Payable 2,900; Cash 2,900).
  • Trade Discounts:
    • Trade discounts are reductions off list prices given to government agencies or large buyers; buyers and sellers record the sale/purchase at the net price after the trade discount; the list price is not typically recorded in the accounts.

Check Up Corner and Worked Solutions (Representative Problems)

  • Check Up Corner 5-1 (Knopfler Co. purchase from Fray Co., 2/10, n/30; August returns; August 18 payment):
    • a) Purchase: Aug. 10 Inventory 11,500; Accounts Payable—Fray Co. 11,500
    • b) Return: Aug. 14 Accounts Payable—Fray Co. 2,500; Inventory 2,500
    • c) Payment (within discount period): Aug. 18 Accounts Payable—Fray Co. 9,000; Inventory 180; Cash 8,820
    • Note: The return reduces Inventory and Accounts Payable at invoice price; the discount is calculated on the net of return price (before discount).
  • Check Up Corner 5-2 (NetSolutions, Dollar Tree scenario; buyer and seller interactions with returns and discounts):
    • a) December 30 sale on account: Accounts Receivable—Wall Company 12,000; Sales 12,000; Cost of Goods Sold 8,000; Inventory 8,000
    • b) January 3 return: Customer Refunds Payable 3,000; Accounts Receivable—Wall Company 3,000; Inventory 2,000; Estimated Returns Inventory 2,000
    • c) January 6 cash receipt: Cash 9,000; Accounts Receivable—Wall Company 9,000
  • Check Up Corner 5-3 (Laser-Tek Company):
    • a) Prepare a multiple-step income statement:
    • Sales 912,500; COGS 512,400; Gross profit 400,100; Selling expenses 196,820; Administrative expenses 105,250; Total operating expenses 302,070; Operating income 98,030; Other revenue: Interest revenue 1,425; Net income 99,455
    • b) Prepare a single-step income statement: Total revenues 913,925; Total expenses 814,470; Net income 99,455

Key Terms (glossary-style highlights)

  • Inventory: Merchandise on hand; current asset.
  • Estimated Returns Inventory: Current asset for estimated future returns.
  • Customer Refunds Payable: Current liability for refunds/allowances.
  • Estimated Coupons Payable: Current liability for estimated coupon redemptions.
  • FOB shipping point: Buyer bears freight costs; inventory cost includes freight.
  • FOB destination: Seller bears freight costs; Delivery Expense (Freight Out) recorded by seller.
  • Sales Tax Payable: Liability for collected sales taxes.
  • Trade Discounts: Reductions off list prices; recorded at net price by buyer and seller.
  • Purchases Discounts (for buyers): Reductions in cost when paying early; recorded via Purchases Discounts (periodic) or reflected in Inventory under perpetual.
  • Gross Method vs Net Method (Sales Discounts): Two methods for recording revenue and discounts; gross records gross revenue with a separate Sales Discounts account; net records net revenue and may record the discount directly in revenue.
  • Perpetual vs Periodic Inventory: Perpetual updates Inventory with every purchase/sale; Periodic updates inventory only at period-end through a physical count; COGS in periodic is computed via ending/ beginning inventories and purchases.
  • Cost of Goods Sold (COGS): The expense representing the cost of inventory that was sold during the period.
  • Asset Turnover Ratio: A measure of how efficiently a company uses its assets to generate sales, computed as
    ext{Asset Turnover Ratio}= rac{ ext{Sales}}{ ext{Average Total Assets}}
    with Average Total Assets = rac{ ext{Beginning Total Assets} + ext{Ending Total Assets}}{2}.
  • Consolidated closing entries: Close revenue and expense accounts to Retained Earnings; then close Dividends to Retained Earnings; produce a post-closing trial balance containing only asset, liability, and equity accounts.

Quick Reference: Selected Exhibits and Examples Mentioned

  • Exhibit 2: NetSolutions’ Chart of Accounts (three-digit accounts; 1-assets, 2-liabilities, 3-stockholders’ equity; 4 revenues; 5 costs and expenses; 6 other revenues and expenses).
  • Exhibit 3–4: Alpha Technologies invoice showing 2/10, n/30 terms; discount calculations and the impact on the ledger; graphical representation of discount timing.
  • Exhibit 5–7: Debit Memo and journal entries for returns, allowances, and refunds; customer refunds payable and inventory adjustments.
  • Exhibit 8: Freight terms and their impact on entries under FOB shipping point vs FOB destination.
  • Exhibit 9–10: Recording inventory transactions; dual nature of transactions from seller and buyer perspectives.
  • Exhibit 11–12: NetSolutions’ adjusted trial balance and two income statement formats (multi-step and single-step).
  • Exhibit 14–16: Statement of Stockholders’ Equity, Balance Sheet, and Post-Closing Trial Balance; asset turnover discussion.
  • Exhibit 18–19: Periodic inventory system charts and transaction illustrations under periodic method.
  • Exhibit 20–21: Cost of Goods Sold under periodic system and closing entries for the periodic system.

Quick Connect: Real-World Relevance and Practical Implications

  • For merchandising businesses, accurate inventory management is critical for COGS and profitability analysis.
  • Perpetual inventory systems provide real-time insight into inventory levels and COGS, enabling better pricing and promotional decisions.
  • Understanding FOB terms and freight costs is essential for proper inventory costing and the recognition of Delivery Expense vs. Inventory.
  • Sales discounts and promotions have a direct impact on revenue recognition and cash flow; correct application of gross vs net methods affects reported revenue and expenses.
  • End-of-period estimates for returns, refunds, and coupons ensure that revenues and assets are not overstated and that liabilities reflect expected future outflows.
  • The asset turnover ratio is a useful metric for comparing efficiency across retailers (e.g., Dollar Tree vs. peers) and for evaluating management of receivables, inventory, and other assets in generating sales.

Exercise Prompts for Practice (based on Check Up Corner themes)

  • You’re given a purchase with 2/10, n/30 terms and a subsequent return and payment within the discount window. Prepare the journal entries under perpetual inventory for the initial purchase, the return, and the payment within the discount period.
  • Prepare a multi-step income statement for a merchandising company given Sales, COGS, and operating expenses, and then convert to a single-step format.
  • Given a company’s beginning inventory, purchases, freight-in, and ending inventory, calculate COGS under a periodic system and show the year-end adjusting entries for estimated returns.

Notes: All formulas and numerical examples in this summary reflect the material presented in the transcript (Chapter 5: Accounting for Merchandising Businesses). The LaTeX-formatted equations are included for clarity and to aid exam preparation.