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Chapter 5

Chapter 5 notes


Department
Financial Accounting
Course Code
MGAB01H3
Professor
G.Quan Fun
Chapter
5

Page:
of 4
Chapter 5 Merchandising Operations Notes
Merchandising Operations
x operating cycle : the time required to go from cash to cash in producing revenues
x sales revenue : the main source of revenue in a merchandising company
x cost of goods sold : the total cost of merchandise sold during the period; in a perpetual inventory system, it is calculated and
recorded for each sale; in a periodic inventory system, it is calculated at the end of the accounting period by deducting ending
inventory from the cost of goods available for sale
x gross profit : sales revenue less cost of goods sold
x operating expenses : expenses incurred in the process of earning sales revenue; they are deducted from gross profit to arrive at
earnings from operations
Inventory Systems
Perpetual Inventory System
x perpetual inventory system : a detailed inventory system in which the quantity and cost of each inventory item is maintained;
the records continuously show the inventory that should be on hand and the cost of the items sold
x when inventory items are purchased, the purchased item is recorded by debiting (increasing) the Merchandise Inventory account
x when merchandise inventory is later sold, the COGS is obtained from the inventory records
x this cost is transferred from the account Merchandise Inventory (an asset) to the account Cost of Goods Sold (an expense)
Periodic Inventory System
x periodic inventory system : an inventory system in which detailed records are not maintained and the ending inventory and cost
of goods sold are determined only at the end of the accounting period
x to determine the cost of goods sold under a periodic inventory system, the following steps are necessary:
x cost of goods available for sale : the sum of beginning inventory and the cost of goods purchased
Recording Purchases of Merchandise
x cash purchases should be supported by a cash register receipt indicating the items purchased and amounts paid
x cash purchases are recorded by an increase (debit) in Merchandise Inventory and a decrease (credit) in Cash
x credit purchases should be supported by a purchase invoice that indicates the total purchase price and other relevant information
x original copy of invoice goes to buyer to be used as purchase invoice, and copy is kept by seller to be used as sales invoice
x the buyer would record an increase (debit) in Merchandise Inventory and an increase (credit) in Accounts Payable
Sales Tax
x sales tax are collected by most merchandising and service companies on the goods they sell and the services they provide
x when merchandising companies purchase goods for resale, they pay GST on the cost of the goods, however, because companies
can get back any GST they pay on purchases (by offsetting it against the GST they collect from customers), this cost is not part
of the cost of the merchandise
x PST, on the other hand, is never paid by a merchandiser on goods it purchases for resale—it is paid only by the final consumer
x sales taxes add much complexity to the accounting process, and not all companies and their goods and services are taxable
Freight Costs
x invoice should indicate whether seller or the buyer must pay the cost of transporting the goods to the buyer’s place of business
x freight terms state who pays the freight charges and who is responsible for the risk of damage to the merchandise during transit
x FOB (free on board) shipping point : freight terms indicating that the seller is responsible for the goods only until they reach
their shipping point (normally the seller’s place of business); the buyer will pay for the shipping costs of the goods from the
shipping point until they arrive at their destination
x FOB (free on board) destination : freight terms indicating that the seller will pay for the shipping costs of the goods until they
arrive at their destination (normally the buyer’s place of business)
Purchase Returns and Allowances
x purchase returns and allowances : a return of goods for cash or credit, or a deduction granted by the seller on the selling price
of unsatisfactory merchandise; when the result is a decrease in the cost of goods purchased
Discounts
x quantity discount : a price reduction that reduces the invoice price and is given to the buyer for volume purchases
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x purchase discount : a price reduction, based on the invoice price less any returns and allowances, claimed by a buyer for early
payment of a credit purchase
x quantity discounts are not recorded or accounted for separately, but purchase discounts are
Summary of Purchase Transactions
x net purchases : purchases less purchase returns and allowances and purchase discounts
x cost of goods purchased : the sum of net purchases and freight in
Recording Sales of Merchandise
x two entries are made for each sale in a perpetual inventory system—the first entry records the sales revenue and the second entry
records the cost of the merchandise sold: COGS is increased by a debit and Merchandise Inventory is decreased by a credit for
the cost of the goods
x as a result, at all times Merchandise Inventory will show the amount of inventory that should be on hand
Sales Taxes
x when a company collects sales taxes from selling a product or service, these sales taxes are not recorded as revenue
x sales taxes is collected for federal and provincial governments, and must be periodically remitted to these collecting authorities
x sales taxes that are collected from selling a product or service are recorded as a liability until they are paid to the government
Freight Costs
x if the term is FOB destination, the seller assumes the responsibility for getting the goods to their intended destination
x freight costs incurred by the seller on outgoing merchandise are an operating expense to the seller
x these costs are debits to the account Freight Out or Delivery Expense
x when freight charges are paid by seller, seller will usually set higher invoice price for goods to cover cost of shipping
Sales Returns and Allowances
x sales returns and allowances : a return of goods or reduction in price of unsatisfactory merchandise
x when customers (buyers) return goods, or are given price reductions, the seller will either return cash to the buyer, or reduce the
buyer’s accounts receivable if the goods were originally purchased on credit
x contra revenue account : an account that is offset against (reduces) a revenue account on the statement of earnings
Discounts
x sales discount : a price reduction that is based on the invoice less any returns and allowances and is given by a seller for early
payment of a credit sale
x Sales Discount is a contra revenue account to sales; its normal balance is a debit
x this account is used, instead of debiting Sales, to show the amount of cash discounts taken by customers
Summary of Sales Transactions
x gross sales : total sales before deducting any sales returns and allowances and sales discounts
x net sales : gross sales less sales returns and allowances and sales discounts
Summary of Merchandising Entries
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Statement of Earnings Presentation
Single Step Statement of Earnings
x single – step statement of earnings : a statement of earnings that shows only one step (revenue less expenses) in determining
net earnings (or net loss); income tax expense is usually disclosed separately from the other expenses
x there are two main reasons for using the single – step form: (1) a company does not realize any type of profit or earnings until
total revenues exceed total expenses, so it makes sense to divide the statement into these categories; and (2) the single – step
form is simple and easy to read
Multiple – Step Statement of Earnings
x multiple – step statement of earnings : a statement of earnings that shows several steps to determine net earnings or net loss
x the multiple – step statement of earnings shows five main steps:
1. Net sales: sales returns and allowances and sales discounts are subtracted from gross sales to determine net sales
2. Gross profit: cost of goods sold is subtracted from net sales to determine gross profit
3. Earnings from operations: operating expenses are deducted from gross profit to determine earnings from operations
4. Non – operating activities: the results of activities that are not related to operations are added (as other revenue) or
subtracted (as other expenses) to determine earnings from income tax
5. Net earnings: income tax expense is subtracted from earnings before income tax to determine net earnings (loss)
Earnings from Operations
x earnings from operations : results of company’s normal operating activities; calculated as gross profit less operating expenses
x sometimes operating expenses are subdivided into selling expenses (associated with making sales, including advertising
expenses as well as the expenses of completing the sale, such as delivery and shipping expenses) and administrative expenses
(related to general operating activities such as management, accounting, and legal matters)
Non – Operating Activities
x non – operating activities : other revenues and expenses that are unrelated to the company’s main operations
x examples of other revenues include interest, rental (if the company’s main activity is not rentals), and investment
x examples of other expenses include interest expense
Evaluating Profitability
Gross Profit Margin
x gross profit margin : gross profit expressed as a percentage of sales; it is calculated by dividing gross profit by net sales
x represents the merchandising profit of a company
x as operating expenses have not been deducted from gross profit, it is not a measure of the overall profit of a company
Profit Margin
x profit margin : net earnings expressed as a percentage of net sales; it is calculated by dividing net earnings by net sales
x gross profit margin indicates how much higher the selling price is than the COGS, while profit margin indicates how well the
selling price covers all expenses (including COGS)
x a company can improve its profit margin by increasing its gross profit margin or by controlling its operating expenses (and non-
operating expenses), or by doing both
x both the gross profit margin and profit margin are profitability measures that vary according to the specific industry
x businesses with a high turnover of inventory, such as food stores, generally experience lower gross profit and profit margins
x low-turnover businesses, such as computer services, have higher gross profit and profit margins
Appendix 5A – Periodic Inventory System
x in the periodic inventory system, revenues from the sale of merchandise are recorded when sales are made, in the same way as a
perpetual inventory system; however, on the date of the sale, the cost of the merchandise sold is not recorded, instead, a physical
inventory count is done at the end of the period to determine the cost of the merchandise on hand (the ending inventory)
Recording Purchase of Merchandise
x purchases is a temporary expense account on the statement of earnings; its normal balance is a debit
Freight Costs
x Freight In is a temporary expense account whose normal balance is a debit, it is part of the cost of goods purchased
x in accordance with the cost principle, the cost of goods purchased should include any freight charges incurred in bringing the
goods to the buyer, as a result, freight in is added to net purchases to determine the cost of goods purchased
Purchase Returns and Allowances
x is a temporary account whose normal balance is credit, it is a contra expense account whose balance is subtracted from Purchases
Purchase Discounts
x Purchase Discounts is a temporary account whose normal balance is a credit, it is a contra expense account
Recording Sales of Merchandise
x in a periodic inventory system, there is only one journal entry made at the time of the sale (the entry to record the sales revenue)
x the cost of the sale is not recorded, instead the COGS is determined by calculation at the end of the period
Freight Costs
x freight costs incurred by the seller on outgoing merchandise are an operating expense to the seller
x under both systems, these costs are debited to the Freight Out or Delivery Expense account
Calculating Cost of Goods Sold
x to calculate the COGS in a periodic inventory, three steps are required:
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