5.

1 - Merchandising Operations

Objective: Describe the differences between service and merchandising companies.

● A merchandising company is an enterprise that purchases products to resell to customers to

earn a profit.
● Merchandising companies can be classified as wholesalers/distributors or retailers.

1. Wholesalers sell to retailers.

2. Retailers sell to consumers

Revenue
● A merchandiser’s primary source of revenue is sale of merchandise.
○ Called Sales Revenue, or simply Sales.
● Contrast with a service company’s main source of revenue which is through the provision of
services.
○ Called Service Revenue.
Expenses
● Cost of Goods Sold: cost to acquire merchandise to sell.
● Operating Expense: Incurred in the process of earning sales revenue.

GROSS PROFIT: Difference between Sales Revenue and Cost of Goods Sold.

Perpetual Inventory:
● Maintain records of all transactions at the time of the transactions.
○ Cost of Goods Sold is calculated and recorded at the time of each sale.
Periodic Inventory:
● Inventory records not kept throughout the period.
○ Cost of Goods Sold is calculated only at the end of the period.
 5.2 - Recording Purchase of Merchandise

Objective: Prepare entries for purchases under a perpetual inventory system.

● When Merchandise is purchased for resale to customers, Merchandise Inventory is debited

for the cost of the goods sold.
● Purchases may be for cash or on account
DR. Merchandise Inventory
CR. Cash/Accounts Payable
● Recorded by purchaser when goods are received.

Merchandise Inventory is recorded at the price it was paid for ( following cost principle ).
Sales Tax
● Collected by merchandising companies on the goods that they sell.
● Periodically collected ( at end of accounting period ) by the government ( remitted ).
NOT REVENUE
● Treated as a liability until paid to the Receiver General
● Sales tax is expressed as a percentage of the sales price on selected goods sold to customers
by a retailer

● Sales taxes include the federal Goods & Services Tax (GST), the Provincial Sales Tax (PST),
and in several provinces, the Harmonized Sales Tax (HST), which is a combination of GST &
PST.
● GST or HST are paid by merchandising companies on goods purchased for resale. However,
this cost is rarely part of the cost of the merchandise because most businesses can
offset/deduct GST/HST paid out against GST/HST collected from customers.
● PST is not paid by a merchandiser—it is paid only by the final consumer. Thus, we retail
businesses do not have to pay PST on any merchandise they purchase for resale.
● HST would normally be added to the invoice price for a business operating in Ontario. For
simplicity, we are not including HST in accounting transactions presented here.

Subsidiary Inventory Record

● The subsidiary inventory record is used to organize and track individual inventory.
● It frees up the general ledger.
○ The general ledger account that summarizes the subsidiary ledger data is a control
account.
● The detailed individual data from the inventory subsidiary ledger are summarized in the
Merchandise Inventory control account in the general ledger.
● At all times, the control account balance must equal the total of all the individual inventory
account balances.

Freight Cost
● The sales agreement indicates whether the seller or buyer is required to pay the cost for the
transportation of goods.

FOB ( Free on Board ) Shipping Point

● Ownership changes from seller to buyer when the
goods are placed on a carrier - the “shipping point”
BUYER PAYS freight costs and is incharge of
transportation

FOB Destination
● Ownership changes from the seller to buyer when
goods are deviled to buyer’s place of business - the
“destination”
 SELLER PAYS freight cost and in charge of
transportation
Accounting for Freight Costs
FOB SHIPPING POINT
● Buyer debits merchandise Inventory for cost of shipping
● Buyer pays the freight bill
DR. Merchandise Inventory
CR. Cash/Accounts Payable
FOB DESTINATION
● Seller debits Freight Out ( Delivery Expense ) for cost of shipping
● Seller pays the freight bill

Purchase Returns and Allowances

● A purchaser may be dissatisfied with goods received because
○ Damages or defective
○ Quality
○ Not in accordance with specifications
■ Goods can be returned or purchase price may we see be reduced ( allowance
)
DR. Cash/Accounts Payable GIVEN BACK AS ORIGINALLY PURCHASED
CR. Merchandise Inventory ( for amount of return oe adjustment )
Quantity Discount
● Volume purchases may reduce purchase price
● Quantity discount: reduction in price due to the quantity being purchased
● The merchandise inventory is simply recorded at the discounted cost.
● No separate entry for a quantity discount, the original entry simply reflects the volume
discount.

Purchase Discount
● Credit terms may allow a claim of a cash discount due to when payment is due
● Purchase discount: Reduction in price due to early payment of amount due.
● A purchase discount is based on the invoice cost less any returns and allowances granted.
DR. Accounts Payable
CR. Merchandise Inventory ( for amount of discount )
CR. Cash ( for amount paid )

The discount is calculated by multiplying the effective discount (in this case 2%) by the amount of
the purchases (less any returns or allowances granted):
= 0.02 x $3,500 = $70
Thus, we only pay the difference of $3,430 ($3,500 - $70) and not the original full invoice price.
The value or cost of the merchandise inventory decreases by the amount of the discount.
● As a general rule, a company should usually take all available discounts.
● Not taking a discount is viewed as paying interest for use of the money not yet paid to the
seller.
● For example, if Chelsea Electronics passed up the discount, it would have paid 2% for the
use of $3,500 for 20 days. This equals an annual interest rate of 36.5% (2% × 365 ÷ 20).
● It would be better for Chelsea Electronics to borrow at bank interest rates than to lose the
purchase discount.
 5.3 - Recording Sales of Merchandise

Objective: Prepare entries for sales under a perpetual inventory system.

● Revenues are reported when they are earned ( REVENUE RECOGNITION PRINCIPLE )
○ Reported when goods transferred from seller to buyer

● The first entry records the sale of goods to a customer at the retail (selling) price.
● The second entry releases the goods from inventory at cost and charges the goods to the
cost of goods sold.

Sales Returns and Allowances

Sales Return: Credit or a refund

Sales Allowances: Deduction from selling price
● Sales returns and allowances is a contra revenue account to the sales account
○ Used to provide information about returns, etc
● The normal balance of Sales return and allowances is debit
 1. The first entry reduces the balance to owed by the customer and records the goods returned
at retail price.
2. If the goods are physically returned, a second entry is needed to record the return of goods
to inventory at cost and removes the goods from the cost of goods sold account.

Quantity Discount
● Sale is recorded with discount initially. NO CHANGE

Sales Discount
● A sales discount is the offer of a cash discount to a customer in exchange for the prompt
payment of a balance due.
● Similar to Sales Returns and Allowances, Sales Discounts is also a contra revenue account
with a normal debit balance.

Summary of Sales Transactions

● These three accounts are combined to determine net sales.
● Net sales is the balance in the Sales account (a credit) minus the balances in Sales Discounts
and in Sales Returns and Allowances (both debits).
● Total sales, before deducting the contra revenue accounts, is also known as gross sales.
● There is no ledger account called Net Sales. It is a calculation only.

Net Sales = Gross Sales − Sales Returns and Allowances − Sales Discounts
 5.4 - Completing the Accounting Cycle

Objective: Perform the steps in the accounting cycle for a merchandising company.

● A merchandising company requires the same types of adjusting entries as a service

company, with one additional adjustment for inventory to ensure the recorded inventory
amount agrees with the actual quantity on hand.
● A physical count is an important control feature since a perpetual system indicates what
should exist but an inventory count will determine what does exist

● A merchandising company also requires the same types of closing entries as a service
company.
● The additional accounts that need to be closed out in a merchandising account include: –
Sales – Sales Returns and Allowances – Sales Discounts – Cost of Goods Sold, and – Freight
Out.
● Merchandise Inventory is an asset account and is not closed at the end of the period.
● Afterwards, prepare Post-Closing Trial Balance
 5.5 - Merchandising Financial Statements

Objective: Prepare single-step and multiple-step income statements.

Merchandisers widely use the classified balance sheet and one of two
forms of income statements.
1. Single-step income statement: Used previously and similar to
I/S of a service business.
2. Multiple-step income statement.

SINGLE-STEP INCOME STATEMENT

● The statement is so named because only one step ( subtracting
total expenses from total revenues ) is required in determining
profit.
● In a single-step income statement, all data are classified under
two categories: (1) revenues and (2) expenses.
● Notice that:
○ Sales is “Net sales”.
○ Other revenues are shown separately.
○ Cost of Goods Sold (COGS) and interest expense (and
income tax expense for Corporations) are and must be
shown separately
● There are two main reasons for using the single step format:
○ a company does not realize any profit until total
revenues exceed total expenses, so it makes sense to
divide the statement into these two categories
○ the single-step format is simple and easy to read

MULTIPLE-STEP INCOME STATEMENT

● The multiple-step income statement is so named because it shows several steps in
determining profit (or loss).
● Considered more useful than a single-step income statement because the steps give
additional information about a company's profitability and distinguish between the
company's operating and non-operating activities.
The primary steps in completing a multiple step income statement are as follows:
1. Net Sales
a. Sales - Sales Returns and Allowances - Sales Discount
2. Gross Profit
a. Net Sales - Cost of Good Sold
3. Operating Expenses
 a. Operating expenses are the recurring expenses associated with the central
operations of the company (other than cost of goods sold) that are incurred in the
process of earning sales revenue.
b. These expenses are similar in service and merchandising companies.
c. Under ASPE (Canadian Accounting Standards for Private Enterprises), companies do
not have to list their expenses in any particular order.
d. Under IFRS (International Financial Reporting Standards), companies must classify
operating and other expenses based on either the nature of the expenses or their
function within the company
e. Classifying expenses by nature:
i. Expenses are reported based on what the resources were spent on (e.g.,
depreciation, employee costs, transportation, and advertising).
f. Classifying expenses by function:
i. Expenses are reported based on which business function the resources were
spent on.
ii. Examples include costs of sales, administration, and selling.
1. Selling expenses are associated with making sales. They include
expenses for advertising and sales promotion, as well as the
expenses of completing the sale (such as freight costs).
2. Administrative expenses relate to general operating activities such
as management, accounting, and legal costs.
g. Companies select the method, either nature or function, that provides the most
relevant information.
h. If a company chooses to classify expenses according to function on the income
statement, it has to report additional information about the nature of the expenses
in the notes to the financial statements.
i. This classification method can be used in both multiple and single-step income
statements.
4. Profit from Operations
a. Gross profit - operating expenses
5. Non-Operating Activities
a. Other Revenues + Other Expenses
6. Profit
a. Profit from operations - non-operating activities
● As shown, the non-operating activities are reported immediately after the company’s
primary operating activities.
● The expenses in this multiple-step income statement are classified by FUNCTION. The NON
OPERATING expenses activities can also include gains and losses.

● On the balance sheet, merchandise inventory is reported as a current asset and appears
immediately below accounts receivable.
● This is because current assets are listed in the order of their liquidity.
 5.6 - Information from the Statements

Objective: Calculate the gross profit margin and profit margin.

PROFITABILITY RATIOS
● Profitability ratios measure profit or operating success for a specific time period.
● We will look at the following profitability ratios:
○ Gross Profit Margin
○ Profit Margin

Gross profit margin (GPM) measures the effectiveness of a company’s purchasing and pricing
policies (measures merchandise profit).

● Considered more useful than the gross profit amount because GPM shows the relationship
between net sales and gross profit.
○ For example, a gross profit amount of $1 million may sound impressive. But, if net
sales are $50 million, then the gross profit margin is only 2%, which is not so
impressive.
● Amount and trend of gross profit are closely watched by management and other interested
parties.
○ Compare current GPM with past periods' GPM.
○ Compare the company's GPM with the GPM of competitors and with industry
averages.
○ Comparisons give information about the effectiveness of a company's purchasing
and the soundness of its pricing policies

In general, a higher gross profit margin is seen as being more favourable than a lower gross profit
margin.

Important because inventory has a significant effect on a company's profitability.

● Cost of goods sold is usually the largest expense on the income statement.
● Gross profit represents a company's merchandising profit.
● Not a measure of the overall profitability, because operating expenses have not been
deducted.

Profit Margin margin measures the % of each dollar of sales that results in profit
A measure of a company’s ability to cover all expenses and provide a return to owners.
 ● The profit margin measures by how much the selling price covers all expenses (including
the cost of goods sold).

● A company can improve its profit margin by increasing its gross profit margin, or by
controlling its operating expenses (and non-operating activities), or by doing both.

NOTE THAT:

- Service and Retail companies have same way of calculating profit

- Goods sold are called cost of goods sold