ACCT 1235: Introduction to Financial

Accounting I & II

Chapter 5

Merchandising Operations

Copyright ©2020 John Wiley & Sons, Inc.

Learning Objectives
LO 1: Identify the differences between service and merchandising
companies.

LO 2: Record purchases under a perpetual inventory system.

LO 3: Record sales under a perpetual inventory system.

LO 4: Prepare a single-step and multiple-step statement of income.

LO 5: Calculate the gross profit margin and profit margin.

Differences Between Service and
Merchandising Companies
• Service companies perform services as their primary
source of revenue
• Merchandising companies buy and sell inventory (e.g.
Loblaws):
o Retailers sell to consumers
o Wholesalers sell to retailers
o Manufacturers produce goods for sale to wholesalers
or others
Operating Cycle
• The time it takes to go from cash to cash in producing
revenues
• Longer for a merchandising company than for a service
company:
o Merchandise must first be purchased
o Then it is held in stores or warehouses
o Finally sold to customers
• Adds additional steps to the operating cycle
Income Measurement Process
• Revenue:
o Revenue from the sale of merchandise is the main source.
o Simply referred to as sales.
• Expenses are divided into two categories:
o Cost of goods sold: total cost of merchandise sold in a period
o Operating expenses: incurred in the process of earning sales
• Gross profit
= Sales less cost of goods sold
Income Measurement Process for a
Merchandising Company
Inventory Systems
• Flow of costs for a merchandising company:
o Beginning inventory + cost of goods purchased = cost of
goods available for sale
o Once sold, these costs are assigned to cost of goods sold.
o Goods left over are ending inventory
• One of two systems is used to account for inventory and
cost of goods sold:
o Perpetual inventory system
o Periodic inventory system
Perpetual Inventory System
• Detailed records are kept for the cost of each product purchased
and sold
• These records are updated continuously (perpetually) for
purchases and sales
o The cost of goods sold and the reduction in inventory – both
quantity and cost – are recorded each time a sale occurs
• A physical count is done at least once a year to adjust perpetual
records to actual
• This system enables the effective control of inventory which is
an important asset
Periodic Inventory System

• Detailed records of merchandise are not kept

throughout the period
• Cost of goods sold is only determined at the end of the
accounting period:
o Once inventory is counted
o Cost of goods available for sale = beginning inventory
+ cost of goods purchased
o Cost of goods sold = cost of goods available for sale
less ending inventory
Purchases of Merchandise

• Purchases are recorded in the Inventory account

• Includes all costs to get merchandise to place of
business and ready for resale:
o Includes freight and applicable taxes
o Less purchase returns, allowances, discounts
o Total of all costs is called cost of goods purchased
• Can be made for cash or credit (on account)
Sales Taxes and Freight
• GST and HST paid does not form part of the cost of goods (as it
is refunded)
• Generally no PST on goods purchased for resale
• FOB (Free on Board) – refers to where title or ownership of
goods transfers:
o FOB destination: buyer’s place of business; seller pays for
shipping
o FOB shipping point: seller’s place of business; buyer pays for
shipping
• Freight paid by buyer (FOB shipping point) is part of the cost of
merchandise purchased
FOB Destination
Ownership of the goods does not pass from the seller to
the buyer until the goods are received by the buyer (i.e.
destination point)
FOB Shipping Point
Ownership of the goods passes from the seller to the buyer
as soon as the goods are shipped
Purchase Returns and Allowances
• A purchaser returns the goods to the seller and receives a
cash refund or credit
• The buyer may choose to keep the merchandise if the seller
is willing to give an allowance (deduction) from the
purchase price
• In both cases, the result is a decrease to the cost of goods
purchased
Discounts
• A quantity discount gives a price reduction according to
the volume of the purchase:
o Not recorded separately – discounted price is recorded as
cost of purchase
• A purchase discount is offered to encourage early
payment of a balance due. Example: 2 / 10, n 30
o Recorded separately when payment made. Results in a
decrease to Inventory account
Adjusting Entry at End of Period
• Inventory counts must be done at the end of the period
• Normally any differences result in less inventory on hand
when compared to inventory records
• This is often referred to as shrinkage and should be
investigated
• Adjustments for shortages result in a debit (increase) to C
OGS and a credit (decrease) to inventory
Summary of Purchase Transactions
Sales of Merchandise (1 of 2)

• Recording of sales (perpetual inventory system):

o Two entries required: one to record sales revenue and
one to record cost of sale
• Sales taxes are not recorded as revenue
• When freight is FOB destination, seller records cost of
freight as an operating expense
• Sales are recorded net of discount (IFRS); under ASPE,
sales discounts are a contra revenue account to Sales
Sales of Merchandise (2 of 2)

• Under IFRS, sales are recorded net of estimated

returns
• No revenue is recognized for the portion of sales for
which returns are anticipated
• A Refund Liability (deferred revenue) account is used
to track expected sales returns and allowances
• An asset account, Estimated Inventory Returns, is
used to record the cost of goods expected to be
returned
Recording Inventory Sales
Statement of Income Presentation
• Two different forms of statement of income:
o Single-step: all data classified into two categories: revenues and
expenses
o Multiple-step: shows several steps in determining net income or
loss
• Gross profit: sales less cost of goods sold
• Income from operations: gross profit less operating expenses
• Income before income tax: income from operations plus non-
operating revenues less non-operating expenses
• Net Income: income before income tax less income tax expense
Single-Step Statement of Income
Multiple-Step Statement of Income
Statement of Comprehensive Income (1 of 2)

• Presents items that are not included in determining net

income, but included in a broader measure referred to as
comprehensive income
• Examples:
o Certain gains and losses on foreign currency translation
o Unrealized gains and losses on certain types of investments
Statement of Comprehensive Income (2 of 2)
Evaluating Profitability: Gross Profit Margin

• Measures the gross profit expressed as a percentage of

sales
Gross profit
Gross profit margin =
Sales

Higher is generally better

Evaluating Profitability: Profit Margin

• Measures the percentage of each dollar of sales that

results in profit
Profit
Profit margin =
Sales

Higher is generally better

Reviewing IFRS and ASPE
Key Standard International Financial Reporting Accounting Standards for Private Enterprises (ASPE)
Differences Standards (IFRS)
Revenue recognition Uses the contract-based approach, which uses Uses the earnings-based approach, which enables
a five-step model for determining when a revenue to be recognized when the goods or services
company has satisfied a performance have been provided, the amount is measurable, and
obligation and can recognize revenue. collection is reasonably assured.
Accounting for sales These are considered to be variable The full amount of the selling price is normally
discounts consideration. The transaction price is reduced recognized at the time of sale. When sales discounts are
by the expected sales discounts. taken by customers, a contra revenue account is used to
account for them.
Accounting for sales These are considered to be variable The full amount of the selling price is normally
returns and consideration. The transaction price is reduced recognized at the time of sale. When sales returns and
allowances by the expected sales returns and allowances. allowances are granted, a contra revenue account is used
A refund liability is established for these to account for them.
amounts.
Statement of income Expenses must be classified by nature or by Expenses can be classified in any manner the company
function. finds useful.
Statement of A statement that presents the sum of net There is no requirement to revalue any assets or
comprehensive income and other comprehensive income. liabilities to fair value at the end of each reporting period.
income Unrealized gains and losses that are not As a result, there are no unrealized gains and losses and,
included in net income are included in therefore, no other comprehensive income and no need
comprehensive income. for this statement.