Understanding Merchandising Operations

BAT4M Grade 12 Accounting Chapters 5 and 6 Test Study Notes Merchandising Operations – Sales are the end consequence of product sales. – Cost of Goods Sold is the cost of merchandise sold during a period – Gross Profit = Sales – COGS – Net income is then determined by subtracting operating expenses from gross profit – Merchandising operations often have a longer operating cycle because there are more steps required to produce revenue than a service business Perpetual Inventory System – Detailed records of every purchase/sale is kept – Continuously shows the quantity and cost of inventory on hand, sold, or purchased – Along with the routine entry of Cash/Accounts Receivable and Sales, COGS and goods inventories are modified at the time of a sale to reflect the sale. – Provides strong internal control – Amounts in the books should reflect what is physically on hand at all times – Physical inventory should still be done at least once a year – Allows for knowledge of merchandise availabilities in stores Periodic Inventory System – Records of inventory on hand are not kept updated throughout the period – Cost of Goods Sold = Beginning Inventory + Cost of Goods Purchased(Purchases) – Ending Inventory – Does not provide consistently up-to-date records of inventory Purchases – Needs to be supported by documentation – Purchase invoices and cash receipts suffice as documentation – Merchandise Inventory is only for purchases made for resale – Merchandise Inventory is a subsidiary ledger control account Sales Taxes – GST imposed on purchases can be offset by the GST collected from customers – PST is not imposed on purchases with the intent to resell merchandise – PST is only paid for by the final customer Freight Costs – The business/person that owns the good during transportation must pay for the charges – FOB Shipping Point means shipment is the responsibility of the buyer – FOB Destination means shipment is the responsibility of the seller until the merchandise/goods are delivered to the buyer –Because shipping is included in the price of the acquired goods, in the buyer's books, shipping charges are added to the merchandise inventory account. Purchase Returns and Allowances – Purchase returns and allowances made by buyers result in the return of damaged, or unsatisfactory quality items – Cash or accounts payable are often debited while merchandise inventory is often credited Discounts – Quantity discounts are rewarded to customers with bulk purchases – Early payments of amounts due are often rewarded with purchase discounts – E.g. 2/10, n/15 means 2% discount if balance paid in 10 days, net amount due in 15 days – Purchase discounts are not recorded with quantity discounts – Because earned purchase discounts lower the cost of the product purchased, merchandise inventories are reduced. Sales of Merchandise – Sales revenue must be recorded whenever it is earned – Transactions should be supported with a business document that gives evidence of the sale – Perpetual inventory systems require an additional entry at the time of a sale to account for the COGS and merchandise inventory changes Sales Taxes – GST and PST are collected from customers through sales – They are recorded as a payable to be submitted to the government typically every month Freight Costs – Same concepts with FOB Shipping Point and FOB Destination Sales Returns and Allowances – Occurs whenever there are price reductions or returns from the customer – A contra revenue account is used whenever a return/allowance happens – DR Sales Returns and Allowances, CR A/R or Cash – If resalable goods are returned, the seller needs to DR Inventory and CR COGS Discounts – Offered to customers for early payment of accounts – A contra revenue account is used whenever this discount occurs – DR Cash, Sales Discounts, CR A/R Adjusting Entries – Physical inventories are used to ensure the books match the actual inventory – If inventory is missing, the COGS account is debited while inventory is credited Multi-Step Income Statement – Consists of 5 main parts 1. Net Sales – Sales less Sales Returns and Allowances less Sales Discounts 2. Gross Profit – Net Sales less COGS 3. Income From Operations – Gross Profit less Operating Expenses 4. Non-Operating Activities – Other Revenues less Other Expenses (e.g. income from investments) 5. Net Income – Income From Operations added/deducted by Total Non-Operating Activities Ratios – Profitability ratios measure a company’s income or operating success for a specific period of time – Gross Profit Margin: Gross Profit / Net Sales = Gross Profit Margin (percentage) – Shows how much net sales of a company is actually profit – Shows how much more the selling price is than COGS – Profit Margin: Net Income / Net Sales = Profit Margin (percentage) – Shows how much net sales of a company is actually income – Shows how much the selling price covers all expenses – Gross Profit = Revenue – COGS – Net Sales = Revenue – Returns/Allowances/Discounts Periodic System Merchandising – COGS is calculated at the end of the period – Purchases is used instead of updating inventory – Inventory is calculated at the end of the period – To calculate COGS: Determine COGP (cost of goods purchased) by subtracting Returns/Allowances/Discounts and by adding Freight-in, Determine the COG on hand at the beginning and end of the period by physically counting inventory, Add beginning inventory to COGP (results in cost of goods available for sale), Subtract ending inventory from COG available for sale to find COGS – Closing Entries: Extra entries required to adjust merchandise inventory because it is not changed until the end of the period 1. DR Income Summary by beginning inventory 2. CR Merchandise Inventory by beginning inventory to zero the account 3. DR Merchandise Inventory by ending inventory 4. CR Income Summary by ending inventory Ownership of Goods – Whoever is paying for FOB is the legal owner of the goods during transit – FOB shipping point – buyer’s ownership which must be added to inventory – FOB destination – seller’s ownership which remains in their inventory until the shipment arrives – Consignees do not own inventory but sell it for a fee – Consignors own the inventory until it is sold by the consignee – Consignee does not record consigned goods in inventory and consignors record these goods in their inventory – Goods on approval are added to physical inventory – Goods sold that are kept on hold should not be added to inventory Specific Identification – Tracks physical flow of goods – Tags are applied to inventory to track their location – Does not allow for manipulation of net income First-In, First-Out (FIFO) – The purchase price of goods purchased earliest is used to determine the COGS whenever goods are sold – Often matches actual physical flow of goods – Good business practice to sell the older goods before the newer ones Average Cost – Used when it is impossible to measure the physical flow of inventory – Uses a weighted average to determine the cost of each good available for sale – To determine cost of each unit: Weighted Average Unit Cost = Cost of Goods Available for Sale – Total Units Available for Sale Last-In, First-Out (LIFO) – The purchase price of goods purchased the latest is used to determine the COGS whenever goods are sold – Almost never matches actual physical flow of goods – Used by gas companies to better match expenses with revenues – Not allowed for use in Canada – Cost of goods often rises with time, which means this method results in a higher COGS – Higher COGS results in lower net income, which means the company pays less income tax to the government **All goods purchased during a period under the periodic inventory system are assumed available for sale regardless of when they were purchased. ** Lower of Cost and Market (LCM) – When the value of inventory is written down to the lower of cost and market value – Because assets are never overstated, which would cause net income to be overstated, inventory is kept in accordance with the conservative principle. – Net Realizable Value: Selling price less any costs on the good – Compare the market value vs the cost of the good and select the lower amount – Under a perpetual inventory system, an entry is needed to adjust inventory from cost to market – DR COGS by the difference between market and cost – CR Merchandise Inventory by the difference between market and cost Ratios – Inventory Turnover Ratio: measures the number of times on average inventory is sold during the period – Inventory Turnover = COGS / Average Inventory ((Beginning inventory + Ending inventory) / 2) – Days Sales in Inventory : on average, how long inventory is kept before it is all sold – Days Sales in Inventory = Days in Year (365) / Inventory Turnover Ratio