Unit 3 Accounting For Merchandising Business Show 3.1 Introduction In the previous chapters, you saw how to record transactions of a service business. The steps that we go through to prepare the financial statements of other types of businesses (such as a merchandising business) are basically the same. Transactions are first journalized, and then posted to the ledger; a worksheet is prepared and completed…. But, there are some transactions in merchandising companies that you don’t find in a service giving business, like the purchase of goods for sale and the sale of those goods. The first section of this chapter, therefore, discusses the nature of a merchandising business and how to record merchandising transactions. The next section discusses about the preparation of financial statements for merchandising companies. Section-One: Recording Merchandising Transactions 3.2 Nature of a Merchandising Business 3.2.1 What is a Merchandising Business? A merchandising business buys goods in finished form for resale to customers. A merchandising business sells tangible goods to its customers. When we say goods it can be anything that has physical characteristics that you can see and touch (i.e., tangible). These can be goods ranging from television sets, cars, office table and chair (furniture), to chewing gums, toothbrushes and various stationery. These goods that a merchandising company sells to its customers are called merchandise inventory. (A customer is an individual or a firm to whom a business sells its products.) One final thing that you should know about a merchandising business is that a merchandising company does not produce the goods that it sells. Instead, it buys these goods from manufacturers, which produce the goods using raw materials. The following diagram can help you to better visualize the flow of goods from a manufacturer to the final consumer: sells goods goods A wholesaler is a trader, which buys goods from manufacturers and sells them to a retailer or another wholesaler. It is the retailer who sells the goods to the final consumer by buying them from wholesalers (or sometimes from a manufacturer). When you want to buy a soap to wash your clothes, where do you buy it? Who is the manufacturer of the soap? Are there any wholesalers of that soap in your area? Can the wholesaler be taken as the customer of the manufacturer? And finally, can we say the shop from which you buy the soap is a merchandising business? 3.2.2 Comparison of Financial Statements for Merchandising and Service Businesses Income Statement A model income statement for a merchandising business and another one for a service business are shown below. Compare them carefully.
As you can see from the above Income Statements, merchandising companies have to pay to buy the goods that they sell. Therefore, they have to deduct this cost of goods sold in addition to other operating expenses from their sales revenue to determine their net income. The difference between sales revenue and cost of goods sold is referred to as gross profit. Why ‘gross’? Because other expenses have yet to be deducted to arrive at the net profit or net income of the business. Balance Sheet The Balance Sheet of a service business and that of a merchandising business are similar in every aspect except one thing. The current assets section of the Balance Sheet of a merchandising business includes one asset that service companies do not have. That is merchandise inventory. Merchandise inventory refers to goods bought by a merchandising business for resale to customers. So, if a merchandising business has some unsold goods (merchandise) on hand at the end of the year this would be reported as one asset on the Balance Sheet. 3.3 The periodic and the perpetual inventory systems The value of goods (merchandise) on hand at the end of the year for resale would be reported on the Balance Sheet as one asset as described above. This means that we need to open a separate ledger account in which to record merchandise inventory information. The two alternatives in dealing with this account are:
3. 3.1 The Periodic Inventory System Under this system, as the name periodic suggests, the inventory account is updated only periodically i.e., only at the end of a period. When goods are bought, a temporary purchases account is debited instead of the inventory account itself. Likewise, when goods are sold revenue is recorded, but the fact that there is a reduction in merchandise inventory is not recognized. This is because the Merchandise Inventory account is not credited every time goods are sold. Therefore, if one wants to know the cost of goods on hand, it is a must that a physical inventory be conducted first. The account doesn’t reflect the value of goods on hand because it was not up dated when merchandise was bought and sold. Physical inventory means counting the quantity of goods on hand. Once the quantity of goods on hand has been determined, it is multiplied by the unit price of those goods to determine the cost of goods on hand. In conclusion, under the periodic system, since the merchandise inventory account is not continually updated, the cost of merchandise on hand is determined only at the end of the period after carrying out a physical inventory. Companies such as department stores or ‘super markets’, which sell small items, use periodic systems.
A perpetual inventory system continuously records the amount of inventory on hand (perpetual =continuous). Under this system, the merchandise inventory account is debited or credited every time (goods) are bought or sold. When an item is sold, its cost is recorded in a separate cost of goods sold account in addition to recording sales. The cost of merchandise on hand can be looked up from the merchandise Inventory account any time, without conducting a physical inventory. 3.4 Recording purchases and sales Transactions The following discussions in the remainder of this chapter all assume the use of a periodic inventory system. The perpetual system will be discussed in part two of this course. 3.4.1 Recording Sales When a merchandising company transfers goods to the buyer, in exchange for cash or a promise top at a later date, revenue is produced to the company. This revenue is recorded in a Sales account. However, the sales revenue, which is reported on the Income Statement is Net Sales. That is, Net Sales = Gross Sales – Sales Discounts- Sales Returns and Allowances Recording Gross Sales The gross sales amount is obtained from sales invoices. An invoice is a document, prepared by the seller of merchandise to notify to the buyer the details of the sale. These details can include number of items sold, unit price of items, total price, terms of sale and manner of shipment. When goods are delivered to the customer, the Sales account is credited because revenues are increased by credits. A company can sell goods either for cash or on account. Recording Cash SalesWhen merchandise is sold on cash, the Cash account is debited and the revenue account Sales is credited. Example – Ika Company based in Bahir Dar, buys and sells used commodities. On January 14. 2001. Ika sold goods for Birr 20,000. Record the transaction. Answer: January 14, Dr. Cash………………………………..20,000.00 Cr. Sales……………………………………20,000.00 Recording Credit Sales The Accounts Receivable account is debited when goods are sold on account (for credit). Example - Ika sold goods worth Birr 35,000 on account on January 15, 2001. Record the transaction. Solution January 15. Accounts Receivable…………………..35,000.00 Sales…………………………………………35,000.00 Determining Gross Sales when there are trade discounts A trade discount is a percentage deduction from the specified list price or catalogue price of merchandise. Trade discounts allow us:
Trade discounts are not recorded in the seller’s accounting records; they are only used to calculate the gross selling price. Example: IKA sold 500 T.V. sets, each with a list price of Birr 80, on January 17, 2001 for cash. It gave the customer a 30% trade discount, as the customer was a very loyal one. Record the sale. Answer: List price of goods ( 80 X 500) Birr 40,000 Less: Trade discount (30 % of 40,000) (12,000) Invoice price 28,000 Journal entry: Cash……………………..28,000 Sale………………………28,000 Recording Deductions from Gross Sales Go back to illustration 1- and have a look at the model Income Statement of a merchandising company. You will see that the sales reported on the income statement is net sales, i.e., after deduction of sales discounts and sales returns and allowances. Gross sales (from invoice)…………………..XXX Less: Sales discounts…………………………….(XX) Sales returns and allowances ………….…..(XX) Net sales……………………………….XX Sales DiscountsSales Discounts are deductions from invoice price to customers who pay early when goods are sold on credit. As a seller, you would usually want to be paid as soon as possible. This is because, as you can imagine, you can use the money for various purposes once you have been paid. If you want your customers to pay you early the customary practice is to offer them a (deduction) discount from the invoice price if they pay early. How much discount is given usually depends on the credit terms. These terms (agreements) are usually stated on the invoice. The most frequently used terms are stated below:
Sales discounts are purchase discounts from the side of the buyer. Sales discounts and purchase discounts are the same thing seen from different sides. They are generally called cash discountstogether. A cash discount is, therefore, deduction from original invoice price for early payment when goods are sold on credit (on account). Example: On January 21, 2001 IKA Company sold merchandise for birr 20,000 on account. The credit terms are 2/30, n/30. The customer paid on January 31, (10 days after invoice date).
Solution:
Invoice price……………………..20,000 Less: Sales Discount (2% X 20,000)………(400) Cash collected …………. 19,600
January 21 A/R…………………..20,000 Sales……………………..20,000 January 31, Cash………………….19600 Sales Discounts ………...400 A/R………………..20,000 You might initially have thought of debiting the Sales account for Birr 400 on January 31, since the actual cash collected from the sales of those goods is birr 400 less than what was recorded as Sales on January 21. But it is better to record the reduction in sales in a separate contra Sales account. A contra account reduces another account. In this case, the amount in the Sales Discount account will be deducted from (Gross) Sales on the income statement. That way, we can disclose how much sales discount was offered and taken during the year on the income statement, separately. Sales Returns and AllowancesCustomers can return merchandise they have bought if they find it to be defective or of the wrong model, or unsatisfactory for a variety of reasons. A sales return is merchandise returned by a buyer. The buyer would be paid back her money if she has already paid. A sales allowance is a deduction from the original invoice price when the customer keeps the merchandise but is dissatisfied. If, for example, a customer buys an item worth birr 100 and finds it to be of the wrong color after receiving it, she may still want to retain the item even if she is dissatisfied with its color. In that case the seller may let her pay only, say, Birr 95 by giving her an allowance of Birr 5. Example: IKA Company sold merchandise worth Birr 15, 000 on February 3, 2001 on account terms 2/10, n/30. On February 5, the buyer returned a portion of the goods worth Birr 5,000 as they were found to be of the wrong model. The buyer then paid on February 13, 2001. Record the necessary journal entries on February 3,5 and 13. Solution: February 3 A/R…………………….15,000 Sales …………………….15,000 February 5 Sales Returns and Allowances ………5,000 A/R………………………………….5,000 February 13 Cash…………………………………..9800 Sales Discount ……………………….. 200 A/R…………………………10,000 Here, the buyer paid with in the discount period. Therefore, the amount that would be collected is: 15,000 – 5,000 = 10,000 Deduct: 2% Cash discount (200) Cash collected 9800 Go back to illustration (1) once again on page and you will see that we have so far been dealing with what net sales is composed of. You should by now be able to figure out how the net sales figure on the income statement is arrived at. In the following section, we will see how to record purchase transactions. Keep in mind that a merchandising company both buys and sells goods. 3.4.2 Recording Purchases Under the periodic inventory system a merchandising company uses the Purchases account to record the cost of goods bought for resale to customers. Example: IKA Company bought goods worth Birr 43,000 from Saba Co., which is based in Addis Ababa, on account on January 4, 2001, terms 20/10, n/30. Record the transaction. Solution: January 4 – Purchases …………………..43,000 Accounts payable………………………..43,000 Deductions from Purchases Purchase Discounts A merchandising company can buy goods under credit terms that permit it to get a discount if it pays with in a specified period of time. The deduction from the original purchase price is recorded in a separate contra Purchase account called Purchase Discounts. Example: IKA Company bought goods worth Birr 50,000 from Gibir Company on account on January 14, 2001, terms 1/10,n/60. Ika Company paid on January 24, 2001. Record the transactions on both dates. Solution: Jan. 14. Purchases………………..50,000 A/P………………………50,000 Jan. 24. A/P…………………… …50,000 Purchase Discounts …….......500 Cash…………………….. 49,500 Purchase Returns and allowances A purchase return occurs when a buyer returns merchandise to a seller. A purchase allowance is a reduction on the price of goods bought for dissatisfaction on the side of the buyer. Both purchase returns and purchase allowances are recorded in a contra purchase account called Purchase Returns and Allowances. Example:In the previous example for IKA Company, a portion of the goods worth birr 5,000 bought on January 14 from Gibir Company were of the wrong size. Gibir Company acknowledged this and gave IKa Company a 5% price allowance on January 17. What should IKA Company record on January 17? Solution: January 17 A/P…………………………………250 Purchase Returnes and Allowance…………250 When both purchase discounts and purchase returns and allowances are deducted from purchases what is obtained is called Net purchase. That is, Gross Purchase…………………………XX Less: Purchase discounts…………………….(XX) Purchase returns and allowances………(XX) Net Purchases…………………….XX Transportation costsOnce merchandise has been bought it has to be moved from the seller’s place to the buyer’s place. A third party comes in to the scene here: the transportation company who moves the goods between the two places. That is: Seller Goods goods goods Buyer Freighter So, the question is, who is going to pay to the freighter (transportation) company. Who covers the transportation costs depends, as you might have guessed, on the agreement between the buyer and seller. The agreements are usually stated in the either of these two terms:
Transportation costs paid by a buyer of merchandise increase the cost of merchandise. They are recorded in a separate Transportation-In account that is used to record freight costs incurred in the acquisition of merchandise. Example IKA Company bought goods worth Birr 85,000 on account, terms 2/10,n/60 FOB shipping point on March 2, 2001.Transportoin cost of Birr 1,500 was paid on March 2. Ika Company paid on March 31, 2001. Record the necessary journal entries Solution: Here, since the terms are FOB Shipping Point, the buyer (Ika) pays transportation. March 2 -Purchase…………………..85,000 A/P………………………..85,000 -Transportation In……….....1500 Cash………………………1500 March 31 A/P…………………………85,000 Cash………………………..85,000 Example:IKA Company sold goods worth Birr 135,000 terms 1/15, n/EOM on February 1, 2001. FOB Destination. It also paid transportation costs of Birr 800 on Feb. 1. The customer paid IKA on February 16, 2001. Record the relevant Journal entries. Answers:Feb 1 A/R…………………………..135,000 Sales…………………………..135,000 Feb 16 Sales discount ………………….1,350 Cash………………………….133,650 A/R…………………………135,000 Delivery Expense…………………800 Cash……………………………800 The Delivery Expense account shows how much was incurred to deliver goods sold to customers. It is, therefore, shown on the income statement as a selling expense. Sometimes, the seller prepays the freight as a convenience to the buyer and later collects it on the due date of the invoice even though the terms are FOB shipping Point. ExampleRaey Co. sold goods worth Birr 40,000 on April 1, 2001 to IKA company terms 2/10, n/30 FOB Shipping Point. It also paid Birr 2,500 to Ergib Movers for transporting the goods and added the amount to the invoice. What would each of these companies record assuming IKA paid on April 31, 2001
If the buyer pays the transportation costs for the seller (when the terms are FOB Destination) the buyer simply deducts the freight paid from the amount to be paid to the seller. Example:X Company bought merchandise worth Birr 14,000 terms FOB destination from Y Co. on account. It paid Birr 350 transportation costs. What would be recorded on the books of the buyer and seller on the date of the sale? Buyer (X Co) Seller Y Co. -Purchase……….14,000 -. A/R……………….14,000 -A/P………………14,000 Sales………………….14,000 -A/P……………350 -Delivery exp……….350 Cash………..350 A/R………………350 Transfer of Title Shipping terms determine not only determine who pays for transportation. They also determine at what point ownership title of the goods sold transfers to the buyer. Put briefly, whose property is it when merchandise is in transit? 1. When terms are FOB Destination we have seen that the seller covers transportation costs. By implication the seller takes the responsibility of safely moving and delivering the goods to the buyer. The buyer is not responsible for any damage that can happen to these goods in transit. Therefore, the goods become the buyer’s property only when they are delivered to him /her. Conclusion: Ownership title of the goods transfers to the buyer at destination when the terms are FOB destination. 2. When the terms are FOB shipping point the buyer pays freight costs. The buyer takes the responsibility of safely moving these goods to his /her own place. The merchandise, therefore, becomes his/her property as soon as they are loaded on a truck or a train. Conclusion: Ownership title of goods transfers to the buyer at shipping point when terms are FOB shipping point. The following table summarizes it all.
Summary of Section One Lets once again present the model Income Statement that we saw at the beginning of this chapter. This time around, however, it is a bit detailed. Please study the relationship between each item on the Income Statement carefully. Also try to remember how each item was recorded in journal entry form when the transactions affecting these accounts happened. XYZ Merchandising Co. Income statement For the year ended Dec. 31,2001 Gross Sales ………………………………………………… 400,000 Less: Sales Discounts (15,000) Sales Ret &All (25,000)……… ……………………. (40,000) Net sales………………………………………………………….360,000 Cost of goods sold: Beginning merchandise inventory (January 1, 2001)…10,000 Add: Purchases…………………..210,000 Less: Purchase Disc………..(5,000) Purchase Ret & All…(5,000) Net purchase…………………………..200,000 Add: Transportation –In……………………….66,000 Total cost of goods Available for sale………………...276,000 Less: Ending M.I (Dec. 31,2001)………………………(20.000) Cost of goods sold……………………………………………… (256,000) Gross profit……………………………………………………………… 104,000 Less: Various Selling and Administrative Expenses ………………………(79,400) Net Income………………………………………………… 24,600 Note: Under a periodic inventory system, the cost of goods sold during a period is determined only indirectly after comparing what was on hand at the beginning of the period, and the cost of goods purchased during the period with what is left on hand at the end of the period. That is, Beg inventory + Total cost of purchase –Ending inventory=Cost of Goods Sold. Under periodic inventory procedures no attempt is made to determine the cost of goods sold at the time of each sale. Instead, the cost of all the goods sold during the accounting period is determined at the end of the period. Summary of Important Relationships on the Income Statement
Section Two: Reporting Merchandising Transactions In the previous section, we saw how purchase and sales transactions are recorded. In this section, we will see how those transactions are summarized and reported on the financial statements. 3.5 Completing The worksheet for a merchandising company The use of a worksheet, as you remember, assists in preparing adjusting and closing entries. In addition it contains all of the information needed for the preparation of the financial statements. Except for the merchandise – related accounts, the work sheet for a merchandising Co. is the same as for a service company. The following illustration, therefore, assumes that all selling and administrative expenses have been adjusted. That accomplished, the only account, which remains to be adjusted, is the Merchandise Inventory account. IllustrationThe following is the trial balance of Hard Works, a merchandising business owned by Yibeltal. All accounts have been adjusted except the Merchandise Inventory account. Hard Works Trial Balance December 31, 2002
Required: A- Prepare a worksheet for Hard Works. B- Prepare financial statements from the worksheet C- Record the necessary adjustment journal entry in relation to merchandise inventory D- Record closing entries Hard Works Co. The merchandise inventory account before adjustment shows the inventory on hand at the beginning of the period. This is because, since purchases and sales of merchandise have not been debited or credited to the merchandise inventory account, this account would still show the beginning inventory amount at the end of the period. Therefore, an adjustment journal entry is needed to update this account. At the end of the period, a physical inventory would be conducted to determine the amount of inventory on hand. The adjustment journal entry removes beginning inventory amount from the merchandise inventory account and replaces it with the (ending) actual value of merchandise inventory on hand as determined by the physical inventory. An adjustment journal entry for Hard Works is presented latter in (c). We will discuss financial statements as we work on requirement (b) of our illustration. Once the worksheet has been completed, the financial statements are prepared. Next, any adjusting and closing entries are entered in the journal and posted to the ledger. There are two widely used formats of the income statement. These are: This format is shown below for Hard Works Co. It shows cost of goods sold and operating expense but has only one subtotal for total expenses. Hard Works Co. Hard Works Co. Gross Sales……………………………………………… Br. 14600 Beg. Inventory (Jan 1)…………………..7,000 Admin. Exp…………………….1,150 Total operating expenses……………….. (3800) Hard Works Co. Hard Works Co. Merch. Inventory…….10,000 Yibeltal Capital … 30843 Total Assets………….31,843 Total Liab. & O/E……31,843 Purchase Ret. &All……………………………...100 Even though the steps and procedures that we go through to prepare the financial statements of merchandising companies are the same with that of service businesses, there are transactions peculiar to merchandising companies. These include the purchase and sale of merchandise. You should be able to record these transactions by now. Go back and study the relationships between financial statement items summarized at the end of section one of this unit. Which accounts are used in a merchandising business?However, the Merchandising worksheet will include the following account titles and amount: accounts receivable, merchandise inventory, accounts payable, sales tax and purchases.
What is the accounting cycle for a merchandising business?The eight steps of the accounting cycle are as follows: identifying transactions, recording transactions in a journal, posting, the unadjusted trial balance, the worksheet, adjusting journal entries, financial statements, and closing the books.
Why is accounting important in merchandising?Many companies earn profits by buying merchandise and selling it to customers. Accounting helps managers to determine the amount of income earned by these companies and the cost of the inventory they have on hand.
What type of account is merchandising?Merchandise inventory is an asset account. Merchandise inventory is reported as a current asset on a retailer's balance sheet. A current asset is one that will provide an economic benefit during a given accounting period, typically a year.
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