6.8: Summary

6.1 Compare and Contrast Merchandising versus Service Activities and Transactions

• Service companies sell intangible services and do not have inventory. Their operating cycle begins with cash-on-hand, providing service to customers, and collecting customer payments.
• Merchandising companies resell goods to consumers. Their operating cycle begins with cash-on-hand, purchasing inventory, selling merchandise, and collecting customer payments.
• A purchase discount is an incentive for a retailer to pay their account early. Credit terms establish the percentage discount, and Merchandise Inventory decreases if the discount is taken.
• A retailer receives a full or partial refund for returning or keeping defective merchandise. This can reduce the value of the Merchandise Inventory account.
• A customer receives an incentive for paying on their account early. Sales Discounts is a contra revenue account that will reduce Sales at the end of a period.
• A customer receives a refund for returning or keeping defective merchandise. Sales returns and allowances is a contra revenue account that will reduce Sales at the end of a period.

6.2 Compare and Contrast Perpetual versus Periodic Inventory Systems

• A perpetual inventory system inventory updates purchase and sales records constantly, particularly impacting Merchandise Inventory and Cost of Goods Sold.
• A periodic inventory system only records updates to inventory and costs of sales at scheduled times throughout the year, not constantly. Merchandise Inventory and Cost of Goods Sold are updated at the end of a period.
• Cost of goods sold (COGS) includes all elements of cost related to the sale of merchandise. The formula to determine COGS if one is using the periodic inventory system, is Beginning Inventory + Net Purchases – Ending Inventory.
• The perpetual inventory system keeps real-time data and the information is more robust. However, it is costly and time consuming, and physical counts of inventory are scarce.
• With the periodic inventory system, there are more frequent inventory counts and reduced chances for shrinkage and damaged merchandise. However, the periodic system makes it difficult for businesses to keep track of inventory costs and to make present decisions about their business.

6.3 Analyze and Record Transactions for Merchandise Purchases Using the Perpetual Inventory System

• A retailer can pay with cash or on credit. If paying with cash, Cash decreases. If paying on credit instead of cash, Accounts Payable increases.
• If a company pays for merchandise within the discount window, they debit Accounts Payable, credit Merchandise Inventory, and credit Cash. If they pay outside the discount window, the company debits Accounts Payable and credits Cash.
• If a company returns merchandise before remitting payment, they would debit Accounts Payable and credit Merchandise Inventory. If the company returns merchandise after remitting payment, they would debit Cash and credit Merchandise Inventory.
• If a company obtains an allowance for damaged merchandise before remitting payment, they would debit Accounts Payable and credit Merchandise Inventory. If the company obtains an allowance for damaged merchandise after remitting payment, they would debit Cash and credit Merchandise Inventory.

6.4 Analyze and Record Transactions for the Sale of Merchandise Using the Perpetual Inventory System

• A customer can pay with cash or on credit. If paying on credit instead of cash, Accounts Receivable increases rather than Cash; Sales increases in both instances. A company must also record the cost of sale entry, where Merchandise Inventory decreases and COGS increases.
• If a customer pays for merchandise within the discount window, the company would debit Cash and Sales Discounts while crediting Accounts Receivable. If the customer pays outside the discount window, the company debits Cash and credits Accounts Receivable only.
• If a customer returns merchandise before remitting payment, the company would debit Sales Returns and Allowances and credit Accounts Receivable or Cash. The company may return the merchandise to their inventory by debiting Merchandise Inventory and crediting COGS.
• If a customer obtains an allowance for damaged merchandise before remitting payment, the company would debit Sales Returns and Allowances and credit Accounts Receivable or Cash. The company does not have to consider the merchandise condition because the customer keeps the merchandise in this instance.

6.5 Discuss and Record Transactions Applying the Two Commonly Used Freight-In Methods

• Establishing ownership of inventory is important because it helps determine who is responsible for shipping charges, goods in transit, and transfer points. Ownership also determines reporting requirements for the buyer and seller. The buyer is responsible for the merchandise, and the cost of shipping, insurance, purchase price, taxes, and fees are held in inventory in its Merchandise Inventory account. The buyer would record an increase (debit) to Merchandise Inventory and either a decrease to Cash or an increase to Accounts Payable (credit) depending on payment method.
• FOB Shipping Point means the buyer should record the merchandise as inventory when it leaves the seller’s location. FOB destination means the seller should continue to carry the merchandise in inventory until it reaches the buyer’s location. This becomes really important at year-end when each party is trying to determine their actual balance sheet inventory accounts.
• FOB Destination means the seller is responsible for the merchandise, and the cost of shipping is expensed immediately in the period as a delivery expense. The seller would record an increase (debit) to Delivery Expense, and a decrease to Cash (credit).
• In FOB Destination, the seller is responsible for the shipping charges and like expenses. The point of transfer is when the merchandise reaches the buyer’s place of business, and the seller owns the inventory in transit.
• In FOB Shipping Point, the buyer is responsible for the shipping charges and like expenses. The point of transfer is when the merchandise leaves the seller’s place of business, and the buyer owns the inventory in transit.

6.6 Describe and Prepare Multi-Step and Simple Income Statements for Merchandising Companies

• Multi-step income statements provide greater detail than simple income statements. The format differentiates sales costs from operating expenses and separates other revenue and expenses from operational activities. This statement is best used internally by managers to make pricing and cost reduction decisions.
• Simple income statements are not as detailed as multi-step income statements and combine all revenues and all expenses into general categories. There is no differentiation between operational and non-operational activities. Therefore, this statement is sometimes used as a summary for external users to view general company information.
• The gross profit margin ratio can show a company if they have a significant enough margin after sales revenue and cost data are computed to cover operational costs and profit goals. If a company is not meeting their target for this ratio, they may consider increasing prices or decreasing costs.

6.7 Appendix: Analyze and Record Transactions for Merchandise Purchases and Sales Using the Periodic Inventory System

• A retailer can pay with cash or credit. Unlike in the perpetual inventory system, purchases of inventory in the periodic inventory system will debit Purchases rather than Merchandise Inventory.
• If a company pays for merchandise within the discount window, it debits Accounts Payable, credits Purchase Discounts, and credits Cash. If they pay outside the discount window, the company debits Accounts Payable and credits Cash.
• If a company returns merchandise before remitting payment, they would debit Accounts Payable and credit Purchase Returns and Allowances. If the company returns merchandise after remitting payment, they would debit Cash and credit Purchase Returns and Allowances.
• If a company obtains an allowance for damaged merchandise before remitting payment, they would debit Accounts Payable and credit Purchase Returns and Allowances. If the company obtains an allowance for damaged merchandise after remitting payment, they would debit Cash and credit Purchase Returns and Allowances.
• A customer can pay with cash or on credit. Unlike a perpetual inventory system, when recording a sale under a periodic system, there is no cost entry.
• If a customer pays for merchandise within the discount window, the company would debit Cash and Sales Discounts and credit Accounts Receivable. If the customer pays outside the discount window, the company debits Cash and credits Accounts Receivable only.
• If a customer returns merchandise before remitting payment, the company would debit Sales Returns and Allowances and credit Accounts Receivable or Cash.
• If a customer obtains an allowance for damaged merchandise before remitting payment, the company would debit Sales Returns and Allowances and credit Accounts Receivable or Cash.

Note: All of the following assessments assume a periodic inventory system unless otherwise noted.

Key Terms

cash discount

provides a discount on the final price after purchase, if a retailer pays within a discount window, typically stated in days

cost of goods sold (COGS)

expense account that houses all costs associated with getting a product ready for sale

FOB destination point

transportation terms whereby the seller transfers ownership and financial responsibility at the time of delivery

FOB shipping point

transportation terms whereby the seller transfers ownership and financial responsibility at the time of shipment

freight-in

buyer is responsible for when receiving shipment from a seller

freight-out

seller is responsible for when shipping to a buyer

goods in transit

time in which the merchandise is being transported from the seller to the buyer

gross margin

amount available after deducting cost of goods sold from net sales, to cover operating expenses and profit

gross profit margin ratio

proportion of margin a company attains, above their cost of goods sold to cover operating expenses and profit, calculated by subtracting cost of goods sold from total net revenue to arrive at gross profit and then taking gross profit divided by total net revenues

gross purchases

original amount of the purchase without factoring in reductions for purchase discounts, returns, or allowances

gross sales

original amount of the sale without factoring in reductions for sales discounts, returns, or allowances

income from operations

gross margin less deductions for operating expenses

merchandising company

resells finished goods produced by a manufacturer (supplier) to customers

net income

when revenues and gains are greater than expenses and losses

net purchases

outcome of purchase discounts, returns, and allowances deducted from gross purchases

net sales

outcome of sales discounts, returns, and allowances deducted from gross sales

operating cycle

amount of time it takes a company to use its cash to provide a product or service and collect payment from the customer

operating expenses

daily operational costs not associated with the direct selling of products or services

other revenue and expenses

revenues and expenses not associated with daily operations, or the sale of goods and services

ownership of inventory

which party owns the inventory at a particular point in time, the buyer or the seller

periodic inventory system

updates and records the inventory account at certain, scheduled times at the end of an operating cycle

perpetual inventory system

system that automatically updates and records the inventory account every time a sale or purchase of inventory occurs

physical inventory count

manual stock check of inventory to make sure what is recorded on the books matches what is actually in the warehouse and on the sales floor

point of transfer

when the responsibility for the inventory transfers from the seller to the buyer

purchase discounts

provide an incentive for the retailer to pay early on their accounts, by issuing a reduced rate on their final purchase cost; the discount reduces the value of merchandise inventory

purchase returns and allowances

retailer receives a partial or full refund from the manufacturer for defective merchandise

sales discounts

reduction in the selling price offered to customers who pay their account within the discount period; the actual account is a contra revenue account that reduces sales

sales returns and allowances

contra revenue account with a normal debit balance that reduces the gross sales figure at the end of the period; the customer returns merchandise with a sales return, and keeps the merchandise with a sales allowance

service company

provides intangible services to customers, and does not have inventory

trade discount

reduction to the advertised manufacturer’s price during negotiation of a final purchase price