Chapter 4 :Accounting for Merchandising Transactions

Chapter in a Nutshell:

Focus on accounting for the goods that Merchandising organizations purchase for resale.

Objective 1: Identify the components of profit and loss account of a merchandising organization.
Merchandising(or trading) organizations earn revenue by selling goods or merchandise. Net profit results from matching expenses to revenues(same as that of service organizations). Major components of merchandising organizations: Revenue from Sales (top line) Cost of goods sold, and (middle line) Operating Expenses (bottom line)

Terminology: gross profit, gross profit ration(gp expressed as %age of sales), profit before interest and tax(PBIT) or Operating Profit, Net Profit or Profit after Tax(PAT). The statement of retained earnings is same in both service and merchandising organization. The balance sheet of a merchandising business has ending inventory as an additional asset

item.

Key relationships: Gross profit = Net Sales - Cost of Goods Sold Operating expenses = Selling Expenses + Administrative Expenses Profit before Interest and Tax = Gross Profit - Operating Expenses Profit before Tax = Profit before Interest and Tax - Interest Expense Net profit= Profit before Tax - Income Tax

Objective 2: Recording Transactions related to sales of Merchandise

The amount of sales for each period is compared with sales of preceding period as well as sales of competitors on a regular basis. These comparisons help to spot major trends in sales. Cash sales and Credit Sales. Accrual accounting - recognizes revenue at the time of sales, even though it may collect the cash later. In practice, accountant consider revenue from sales if a transaction meets all the following conditions: 1. The seller has passed the legal or economic ownership of the goods to the buyer. 2. The seller and the buyer have agreed on the price of the goods 3. The buyer has paid the purchase price of the goods or it is certain that he will pay the price. Invoice is a document that contains the details of a sale, such as the name of the product, number of units sold, unit price, total price, taxes and duties, total amount billed, terms of sale, and manner of shipment. The seller prepares invoice at the time of sale and sends it to the buyer. A retailer prepares the invoice at the point of sale A wholesaler who supplies goods to retailers prepares the invoice after the shipping department notifies the accounting department that it has shipped the goods to the customers.

Invoice:

Since the seller may collect amounts due on credit sales in subsequent period, there may be a significant difference between cash collections from sales and the amount of sales. Jan 1. Debtors(or Cash) 1000 Sales 1000 Sold merchandise for credit(or for cash)

Sales Return: A sales return is a merchandise returned by a buyer. Sales Allowance : Sometimes customer allows for minor defects, and may agree to keep the goods if seller allows a reduction of sales price, called sales allowance High sales return could be an indication of low quality of goods or of high pressure selling. Jan 1. Sales Returns and Allowances 200 Debtors(or Cash) 200 Allowance for unsatisfactory merchandise sold on Jan 1.

Sales Returns and Allowances:

Credit Memo:

note, which indicates that the balance in the customer's account is being reduced. Trade Discount:

In case of sales return or sales allowance, seller sends the buyer a document called credit

A trade discount is a percentage reduction granted to a customer from the specified list price or catalogue price. No need to change catalogue, and these are not noted down in the document.(hence they are invisible) Discount value is determined dynamically based on economic conditions prevailing at the time. Trade discounts: are invisible reflected as reduction in sale price, not recorded explicitly

Sales Discounts:

A cash discount is called sales discount by the seller, and purchase discount by the buyer. Payment Terms: net 45 or n/45 : entire amount of invoice is due 45 days from transaction date. 2/10 : the buyer will get 2% discount of the invoice amount for paying within 10 days.

Sales Discounts: recorded as an expense at the time of collection and disclosed as part of selling expenses (example: 2/10, n/45) Jan 1. Debtors Sales 1000 Sold merchandise on credit 20 980 1000

Jan 22.Cash Sales Discount Debtors

1000 Collected from debtors less discount

For presentation in Profit and Loss account, the seller deducts sales returns and allowances, trade discounts, and taxes and duties(eg. value added tax, sales tax, goods and service tax), and reports only Net Sales.
Freight charges on shipment are part of selling expenses and not deducted from the selling price

Objective 3: Calculate the Cost of Goods Sold using periodic inventory system: Merchandise Inventory: important part of a Profit and Loss Account

The quantity of goods on hand available for sale at a given time - Beginning(opening) and Ending(closing) inventory. The ending inventory appears on balance sheet as an asset. Cost of Goods Available for Sale(COGAS) = Beginning inventory or opening inventory + Net Purchases Cost of goods sold(COGS) = Cost of Goods Available for Sale(COGAS) - Ending inventory or closing inventory = Beginning inventory or opening inventory + Net Purchases - Ending inventory or closing inventory Periodic Inventory Method: the Merchandise inventory account is updated only periodically after a physical count has been made. Perpetual Inventory Method : in chapter 6, provides better information about inventory losses

Objective 4: Record transactions related to purchase of merchandise: Net Cost of Purchases: The term net purchases refer to purchases less discounts, returns, and
allowances. Net Purchases = Gross Purchases Purchase Discounts Purchase Returns + Freight Inward

Purchases: Think of Purchases Account as an expense account, or a temporary asset account. It appears in the expense section int he chart of accounts. It is used only for goods acquired for resale. Jan 1. Purchases 1000 Creditors(or Cash) 1000 Purchased merchandise on credit(or for cash) Purchases Returns and Allowances: Buyer sends a debit note to notify the seller that his balance is being reduced. Depending on the terms of purchase and trade practice, the buyer may either debit seller's account immediately, or wait for sellers acceptance of debit note. Purchases Returns and Allowances Account - helpful for monitoring efficiency of purchase function, and the quality and reliability of suppliers. High rates of purchase returns indicate the need for reviewing purchasing practices and eliminating certain vendors.

Jan 15. Creditors 200 Purchases Returns and allowances 200 Returned unsatisfactory merchandise to supplier Purchase Discounts: If buyer pays the invoice within a specified time period, a stated cash discount will be given to buyer. Jan 1. Purchases 1000 Creditors Purchased merchandise on terms 2/10, n/30 1000

Jan 11. Creditors 1000 Cash 980 Purchase Discount 20 Paid creditors for merchandise within discount period Net price method: recording discount directly - if buyer avails discount as a matter of policy Based on the amount of discount earned. If the discount amount returns higher annual rate of interest than the borrowing rate for the buyer. No. of days in year(360) / No. of days payment is advanced * Discount(%)/(100Discount%). 360/20 * 2/98*100 = 36.73%.

Deciding on discounts:

Objective 5: Describe the common freight terms and record transportation expenses:

Freight Inward Account: Account used to record inward freight charges incurred on merchandise purchased. Jan 11. Freight in Cash 150

150 Paid freight on merchandise purchased This is an adjunct account, account whose balance is added to the balance of another account. Freight paid on purchases is added to net purchases to get the net cost of purchases. Adjunct account is opposite of Contra account, such as accumulated depreciation, the balance of which is deducted from another account.

FOB Shipping and Destination Points:

If the terms are : FOB Shipping Point(free on board at shipping point): buyer pays the freight Legal title passes from seller to buyer at shipping point Buyer bears transportation costs after shipping point FOB Destination Point(free on board at destination point): seller pays the freight Legal title passes from seller to buyer at destination Seller bears transportation costs up to destination Ownership of the goods pass from buyer to seller at the FOB point. FOB Shipping Point : buyer should include goods in transit at the year end in its inventory

inventory

FOB Destination Point: seller should include goods in transit at the year end in its ending

Inventory Losses: spoilage, employee theft, shoplifting

Expenses other than cost of goods sold, interest, income tax, and are incurred in running the normal business of the company. These are often grouped into Selling expenses, which include: storing and preparing goods for sale promoting sales actually making sales delivering goods to customers Eg: Salaries, sales commission, sales staff travel, advertising, store rent, and delivery expenses. Administrative expenses: Incurred in overall management of business Eg: Expenses on salaries, rent, telephone, and depreciation pertaining to head office, accounting and personal functions.

Operating Expenses:

Objective 6: Worksheet for Merchandising Organization Prepare a worksheet and closing Objective 7: Classified Financial Statements
Accountants group items that appear on the financial statements into meaningful categories so that users can understand the information with realtive ease. Financial statements that contain such categories are called classified financial statements. Classified Profit and Loss Account (Multiple-step profit and loss account): Profit and Loss Statement that contain the three parts - revenue from sales, cost of goods sold, and operating expenses is called classified profit and loss account. In contrast, in a single step profit and loss account, cost of goods sold and expenses are added together, and then subtracted from net sales in one step to get net profit. Key relationships: Net sales = Sales - Sales Returns and Allowances Net purchases = Purchases - Purchases Returns and Allowances - Purchase Discount Net cost of purchases = Net Purchases + Frieght In Cost of goods sold = Beginning Inventory + Net Cost of Purchases - Ending Inventory Gross profit = Net Sales - Cost of Goods Sold Operating expenses = Selling Expenses + Administrative Expenses Profit before Interest and Tax = Gross Profit - Operating Expenses Profit before Tax = Profit before Interest and Tax - Interest Expense Net profit= Profit before Tax - Income Tax Classified Balance Sheet A classified balance sheet has items that are grouped into meaningful categories such as shareholder's funds, loan funds, fixed assets, current assets, and current liabilities.

Shareholder's Funds: Share capital + Retained earnings(plus reserves) Loan Funds: Amount of loan payable by a company. Loans are classified as: Secured Loans : taken on security of company's assets. Debentures and loans from banks and financial institutions are generally secure. Unsecured Loans: taken on strength of company's general credit standing and are not backed by its assets. Public deposits, and short term loans from banks are usually taken on unsecure terms. Fixed Assets: Assets that are held for business, and are not for sale(Land, building, plant, machinery, furniture, fittings, and vehicles) Balance sheet shows cost of acquisition(or gross block), accumulated depreciation, and book value(or net block). It discloses separately construction work-in-progress, such as a plant being installed. Investments: Investments in form of government securities, shares, debentures, immovable properties and partnership firms. Current assets, loans and advances: Assets used by business for its day-to-day operations Current assets include items such as store and spare parts, inventories, debtors for goods and services provided on credit, and cash and bank balances. Loans and advances include items such as loans given to various parties, bills receivable, prepaid expenses, and deposits with government authorities(customs, port trust) Current liabilities and Provisions: Obligations incurred in day-to-day operations of the business Current liabilities include bills payable, creditors for purchase of goods and services, and advances received from customers Provisions are amounts that are shown on the basis of estimates because precise quantification is not possible. IT Payable, pension obligations Contingent Liabilities: These may become payable depending on some event. Eg: lawsuit regarding defective product, unsatisfactory service. Because of their uncertain nature, these liabilities are not recognized in the financial statements, but only disclosed in the notes.