Lecture 5:

Merchandising Operations
I. Merchandising Operations
- Retailers: merchandising companies that purchase and sell directly to consumers.
- Wholesalers: merchandising companies that sell to retailers.
Ex: retailer Walgreens (USA) might buy goods from wholesaler Grupo Casa SA de CV
(MEX)
- The primary source of revenue for merchandising companies is the sale of merchandise, often
referred to simply as sales revenue or sales. A merchandising company has two categories of
expenses: cost of goods sold and operating:
 Cost of goods sold: the total cost of merchandise sold during the period.

 Note: Items in the two blue boxes are unique to a merchandising company; they are not used
by a service company.

1. Operating Cycles
- The operating cycle of a merchandising company ordinarily is longer than that of a service
company. The purchase of merchandise inventory and its eventual sale lengthen the cycle.

- The added asset account for a merchandising company is the Inventory account. Companies
report inventory as a current asset on the statement of financial position.
2. Flow of Costs
- The flow of costs for a merchandising company is as follows: Beginning inventory + the cost of
goods purchased is the cost of goods available for sale.

 Goods are sold -> they are assigned to the cost of goods sold.
 Goods that are not sold by the end of the accounting period -> represent ending inventory.
- Companies use one of two systems to account for inventory: a perpetual inventory system or a
periodic inventory system.

a. Perpetual inventory system

- Companies keep detailed records of the cost of each inventory purchase and sale
 Continuously – perpetually - show the inventory that should be on hand for every
item.
 Under a perpetual inventory system, a company determines the cost of goods sold
each time a sale occurs.

 Note: For control purposes, companies take a physical inventory count under the perpetual
system even though it is not needed to determine the cost of goods sold.


b. Periodic inventory system

- Company determine the cost of goods sold only at the end of the accounting period—that is,
periodically

- At that point, the company takes a physical inventory count to determine the cost of goods on
hand.

- 3 steps to determine the cost of goods sold under a periodic inventory system:
1. Determine the cost of goods on hand at the beginning of the accounting period.
2. Add to it the cost of goods purchased.
3. Subtract the cost of goods on hand at the end of the accounting period.
c. Additional considerations
- The perpetual inventory system is so named because the accounting records continuously -
perpetually - show the quantity and cost of the inventory that should be on hand at any time.

- A perpetual inventory system provides better control over inventories than a periodic system.

- Some businesses find it either unnecessary or uneconomical to invest in a computerized

perpetual inventory system. Many small merchandising businesses, in particular, find that a
perpetual inventory system costs more than it is worth. Managers of these businesses can control
their merchandise and manage day-to-day operations using a periodic inventory system.

II. Recording Purchases of Merchandise

- Companies purchase inventory using cash or credit (on account). They normally record
purchases when they receive the goods from the seller.

- Companies record cash purchases by an increase in Inventory and a decrease in Cash.

- A purchase invoice should support each credit purchase. This invoice indicates the total
purchase price and other relevant information. However, the purchaser does not prepare a
separate purchase invoice. Instead, the purchaser uses as a purchase invoice a copy of the sales
invoice sent by the seller

Ex: Sauk Stereo (the buyer) uses as a purchase invoice the sales invoice prepared by PW Audio
Supply, Inc. (the seller). Sauk Stereo makes the following journal entry to record its purchase
from PW Audio Supply. The entry increases (debits) Inventory and increases (credits) Accounts
Payable.

- Under the perpetual inventory system, companies record purchases of merchandise for sale in
the Inventory account.

- Not all purchases are debited to Inventory. Companies record purchases of assets acquired for
use and not for resale as increases to specific asset accounts rather than to Inventory.
Ex: To record the purchase of materials used to make shelf signs or for cash register receipt
paper, Carrefour would increase Supplies.
1. Freight Costs
- Freight terms are expressed as either FOB shipping point or FOB destination (FOB: Free on
board)
 FOB shipping point: Buyers have to pay the freight costs.
 FOB destination: Sellers have to pay the freight costs.

a. Freight costs incurred by the buyer

- When the buyer incurs the transportation costs, these costs are considered part of the cost of
purchasing inventory. Therefore, the buyer debits (increases) the account Inventory.

Ex: if upon delivery of the goods on May 6, Sauk Stereo (the buyer) pays Acme Freight Company
€150 for freight charges, the entry on Sauk Stereo’s books is:

- Any freight costs incurred by the buyer are part of the cost of merchandise purchased because
inventory cost should include all costs to acquire the inventory, including freight necessary to
deliver the goods to the buyer. Companies recognize these costs as cost of goods sold when the
inventory is sold

b. Freight cost incurred by the seller

- Freight costs incurred by the seller on outgoing merchandise are an operating expense to the
seller. These costs increase an expense account titled Freight-Out or Delivery Expense.

Ex: If the freight terms on the invoice had required PW Audio Supply (the seller) to pay the
freight charges, the entry by PW Audio Supply would be:

- When the seller pays the freight charges, it will usually establish a higher invoice price for the
goods to cover the shipping expense
2. Purchase Returns and Allowances
- Purchase return: the purchaser may return the goods to the seller for credit if the sale was
made on credit, or for a cash refund if the purchase was for cash.

- Purchase allowance: the purchaser chose to keep the merchandise if the seller is willing to
grant an allowance (deduction) from the purchase price.

Ex: Assume that on May 8 Sauk Stereo returned goods costing €300 to PW Audio Supply. The
following entry by Sauk Stereo for the returned merchandise decreases (debits) Accounts Payable
and decreases (credits) Inventory.

- Because Sauk Stereo increased Inventory when the goods were received, Inventory is decreased
when Sauk Stereo returns the goods (or when it is granted an allowance).

- But if Sauk Stereo chose to keep the goods after being granted a €50 allowance (reduction in
price), it would reduce (debit) Accounts Payable and reduce (credit) Inventory for €50

3. Purchase Discounts
- Purchase discount: Credit terms may permit buyer to claim a cash discount for prompt
payment.

- Bring advantages to both parties: The purchaser saves money, and the seller shortens the
operating cycle by more quickly converting the accounts receivable into cash.

- Credit terms specify the amount of the cash discount and time period in which it is offered.
 Denoted: 2/10, n/30, read “two-ten, net thirty” = buyer may take a 2% cash discount
on the invoice price less any returns or allowances, if payment is made within 10
days of the invoice date. Otherwise, the invoice price, less any returns or
allowances, is due 30 days from the invoice date.

- The discount period may extend to a specified number of days following the month in which
the sale occurs
Ex: 1/10 EOM (end of month) = 1% discount is available if the invoice is paid within the first
10 days of the next month.
- When the seller elects not to offer a cash discount for prompt payment, credit terms will specify
only the maximum time period for paying the balance due.
Ex: n/30, n/60, or n/10 EOM. This means, respectively, that the buyer must pay the net
amount in 30 days, 60 days, or within the first 10 days of the next month.

- Buyer pays an invoice within the discount period, the amount of the discount decreases
Inventory. Because companies record inventory at cost and, by paying within the discount
period, the merchandiser has reduced that cost.

Ex: assume Sauk Stereo pays the balance due of €3,500 (gross invoice price of €3,800 less
purchase returns and allowances of €300) on May 14, the last day of the discount period. The
cash discount is €70 (€3,500 x 2%), and Sauk Stereo pays €3,430 (€3,500 - €70). The entry
Sauk Stereo makes to record its May 14 payment decreases (debits) Accounts Payable by the
amount of the gross invoice price, reduces (credits) Inventory by the €70 discount, and reduces
(credits) Cash by the net amount owed

If Sauk Stereo failed to take the discount, and instead made full payment of €3,500 on June 3,
it would debit Accounts Payable and credit Cash for €3,500 each

- A merchandising company usually should take all available discounts. Passing up the discount
may be viewed as paying interest for use of the money.

4. Summary of Purchasing Transactions

III. Recording Sales of Merchandise
- Sales may be made on credit or for cash. Normally recorded when earned, usually when goods
transfer from seller to buyer.
- A business document should support every sales transaction, to provide written evidence of the
sale:
 Cash register tapes provide evidence of cash sales.
 Sales invoice provides support for a credit sale.

- The seller makes two entries for each sale.

1. Records the sale: The seller debits Cash (or Accounts Receivable, if a credit sale),
and also credits Sales Revenue.
2. Records the cost of the merchandise sold: The seller increases (debits) Cost of
Goods Sold, and also decreases (credits) Inventory for the cost of those goods.

Ex: PW Audio Supply records its May 4 sale of €3,800 to Sauk Stereo (see Illustration 5-6) as
follows (assume the merchandise cost PW Audio Supply €2,400)

1. Sales Returns and Allowances

- “Flipside” of purchase returns and allowances.

- The seller either accepts goods back from the buyer (a return) or grants a reduction in the
purchase price (an allowance) so the buyer will keep the goods.

Ex: PW Audio Supply’s entries to record credit for returned goods involve (1) an increase (debit)
in Sales Returns and Allowances (a contra account to Sales Revenue) and a decrease (credit) in
Accounts Receivable at the €300 selling price, and (2) an increase (debit) in Inventory (assume a
€140 cost) and a decrease (credit) in Cost of Goods Sold, as shown below (assuming that the
goods were not defective).
- If the goods are not returned but the seller grants the buyer an allowance by reducing the
purchase price: the seller debits Sales Returns and Allowances and credits Accounts Receivable
for the amount of the allowance.

- Sales Returns and Allowances is a contra revenue account to Sales Revenue.

- Companies use a contra account, instead of debiting Sales Revenue, to disclose in the accounts
and in the income statement the amounts of sales returns and allowances because a decrease
(debit) recorded directly to Sales Revenue would:
 Obscure the relative importance of sales returns and allowances as a percentage of sales.
 Distort comparisons between total sales in different accounting periods.

2. Sales Discounts
- Cash discount offered to customers to promote prompt payment.

- “Flipside” of purchase discount.

- The seller increases (debits) the Sales Discounts account for discounts that are taken.

Ex: PW Audio Supply makes the following entry to record the cash receipt on May 14 from Sauk
Stereo within the discount period:
- Sales Discounts is a contra revenue account to Sales Revenue. PW Audio Supply uses this
account, instead of debiting Sales Revenue, to disclose the amount of cash discounts taken by
customers.

- If Sauk Stereo does not take the discount, PW Audio Supply increases (debits) Cash for €3,500
and decreases (credits) Accounts Receivable for the same amount at the date of collection.

- Three sales-related transactions and their combined effect on net sales:

IV. Completing the Accounting Cycle

1. Adjusting Entries
- Merchandising company generally has the same types of adjusting entries as service company.

- But merchandiser using a perpetual system will require one additional adjustment to make the
records agree with the actual inventory on hand, because the perpetual inventory records may be
incorrect due to recording errors, theft, or waste.

- The company needs to adjust the perpetual records to make the recorded inventory amount
agree with the inventory on hand, involves adjusting Inventory and Cost of Goods Sold

Ex: Suppose that PW Audio Supply has an unadjusted balance of €40,500 in Inventory. Through
a physical count, PW Audio Supply determines that its actual merchandise inventory at year-end
is €40,000. The company would make an adjusting entry as follows
2. Closing Entries
- General the same as a service company: Close to Income Summary all accounts that affect net
income.

- After closing, all temporary accounts have zero balances.

- Retained Earnings has a balance that is carried over to the next period.

V. Forms of Financial Statements

1. Income Statement
- Primary source of information for evaluating a company’s performance.

- Format is designed to differentiate between the various sources of income and expense.
2. Income Statement Presentation of Sales
3. Classified Statement of Financial Position
- In the statement of financial position, merchandising companies report inventory as a current
asset immediately above accounts receivable.

- Inventory is less close to cash than accounts receivable because the goods must first be sold and
then collection made from the customer.