Accounting MEMO (Writing Assignment)

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Financial & Managerial Accounting

Fifteenth Edition

Chapter 5

Accounting for Retail Businesses

Nature of Retail Businesses

The activities of a service business differ from those of a retail business.

These differences are reflected in the operating cycles of a service and retail business as well as in their financial statements.

Operating Cycle (1 of 2)

The operating cycle is the process by which a company spends cash, generates revenues, and receives cash from customers.

The operating cycle of a service and retail business differs in that a retail business must purchase merchandise for sale to customers.

Operating Cycle (2 of 2)

The time in days to complete an operating cycle differs significantly among retail businesses.

For example, many grocery items, such as milk, have a short operating cycle and must be sold within their expiration dates of a week or two.

In contrast, jewelry stores often carry expensive items that are often displayed months before being sold to customers.

Financial Statements (1 of 3)

The time in days to complete an operating cycle differs significantly among retail businesses.

For example, many grocery items, such as milk, have a short operating cycle and must be sold within their expiration dates of a week or two.

In contrast, jewelry stores often carry expensive items that are often displayed months before being sold to customers.

Financial Statements (2 of 3)

In contrast, the revenue activities of a retail business involve the buying and selling of merchandise.

A retail business first purchases merchandise to sell to its customers.

When this merchandise is sold, the revenue is reported as sales, and its cost is recognized as an expense called cost of goods sold or cost of merchandise sold.

The cost of goods sold is subtracted from sales to arrive at gross profit, which is the profit before deducting operating expenses.

The operating expenses are subtracted from gross profit to arrive at operating income.

Financial Statements (3 of 3)

Merchandise on hand (not sold) at the end of an accounting period is called inventory or merchandise inventory.

Inventory is reported as a current asset on the balance sheet.

Chart of Accounts for Retail Business

Merchandise transactions are recorded in the accounts, using the rules of debit and credit.

Subsidiary Ledgers (1 of 5)

A separate account for each customer and creditor could be added to the ledger. However, as the number of customers and creditors increases, the ledger will become large and awkward to use.

A large number of individual accounts with a common characteristic can be grouped together in a separate ledger, called a subsidiary ledger.

The primary ledger, which contains all of the balance sheet and income statement accounts, is then called the general ledger.

Subsidiary Ledgers (2 of 5)

Each subsidiary ledger is represented in the general ledger by a summarizing account, called a controlling account.

The sum of the balances of the accounts in the subsidiary ledger must equal the balance of the related controlling account.

Subsidiary Ledgers (3 of 5)

Following are the common subsidiary ledgers:

Accounts receivable subsidiary ledger

The accounts receivable subsidiary ledger, or customers ledger, lists the individual customer accounts in alphabetical order.

The controlling account in the general ledger is Accounts Receivable.

Accounts payable subsidiary ledger

The accounts payable subsidiary ledger, or creditors ledger, lists individual creditor accounts in alphabetical order.

Subsidiary Ledgers (4 of 5)

The controlling account in the general ledger is Accounts Payable.

Inventory subsidiary ledger

The inventory subsidiary ledger, or inventory ledger, lists individual inventory by item (bar code) number.

The controlling account in the general ledger is Inventory.

Subsidiary Ledgers (5 of 5)

Most retail companies use computerized accounting systems that record similar transactions in separate journals called special journals. These journals generate purchase, sales, and inventory reports.

Purchases Transactions (1 of 4)

There are two systems for accounting for merchandise transactions: perpetual and periodic.

In a perpetual inventory system, each purchase and sale of merchandise is recorded in the inventory account and related subsidiary ledger.

In this way, the amount of merchandise available for sale and the amount sold are continuously (perpetually) updated in the inventory records.

Purchases Transactions (2 of 4)

In a periodic inventory system, the inventory does not show the amount of merchandise available for sale and the amount sold.

Instead, a listing of inventory on hand, called a physical inventory, is prepared at the end of the accounting period.

This physical inventory is used to determine the cost of inventory on hand at the end of the period and the cost of goods sold during the period.

Purchases Transactions (3 of 4)

The terms of purchases on account are normally indicated on the invoice or bill that the seller sends the buyer.

Purchases Transactions (4 of 4)

The terms for when payments for merchandise are to be made are called the credit terms.

If payment is required on delivery, the terms are cash or net cash.

Otherwise, the buyer is allowed an amount of time, known as the credit period, in which to pay.

The credit period usually begins with the date of the sale as shown on the invoice.

Purchases Discounts

To encourage the buyer to pay before the end of the credit period, the seller may offer a discount.

Discounts taken by the buyer for early payment of an invoice are called purchases discounts.

Purchases discounts taken by a buyer reduce the cost of the merchandise purchased.

Purchases Returns and Allowances (1 of 3)

A buyer may request an allowance for merchandise that is returned (purchases return) or a price allowance (purchases allowance) for damaged or defective merchandise. From a buyer’s perspective, such returns and allowances are called purchases returns and allowances.

In both cases, the buyer normally sends the seller a debit memorandum, often called a debit memo, to notify the seller of reasons for the return (purchase return) or to request a price reduction (purchase allowance).

A debit memo also informs the seller of the amount the buyer proposes to debit to the account payable due the seller and states the reasons for the return or the request for the price allowance.

Purchases Returns and Allowances (2 of 3)

The buyer may use the debit memo as the basis for recording the return or allowance or wait for approval from the seller (creditor).

In either case, the buyer debits Accounts Payable and credits Inventory.

Purchases Returns and Allowances (3 of 3)

Before paying an invoice, a buyer may return inventory or be granted a price allowance for an invoice with a purchase discount.

In this case, the amount of the return is recorded at its invoice amount less the discount.

Sales Transactions

Revenue from merchandise sales is usually recorded as Sales.

Sometimes a business may use the title Sales of Merchandise.

Cash Sales (1 of 3)

Using the perpetual inventory system, the cost of goods sold and the decrease in inventory are also recorded.

In this way, the inventory account indicates the amount of inventory on hand (not sold).

Cash Sales (2 of 3)

Sales may be made to customers using credit cards such as MasterCard or VISA.

Such sales are recorded as cash sales.

This is because these sales are normally processed by a clearinghouse that contacts the bank that issued the card. The issuing bank then electronically transfers cash directly to the retailer’s bank account. Thus, the retailer normally receives cash within a few days of making the credit card sale.

Cash Sales (3 of 3)

Sales may be made to customers using credit cards such as MasterCard or VISA.

Such sales are recorded as cash sales.

Customer Discounts

A seller may grant customers a variety of discounts, called customer discounts, as incentives to encourage customers to act in a way benefiting the seller.

For example, a seller may offer customer discounts to encourage customers to purchase in volume or order early.

A sales discount encourages customers to pay their invoice early.

Cash Refunds and Allowances (1 of 2)

A buyer may receive merchandise that is defective, is damaged during shipment, or does not meet the buyer’s expectations.

If the customer has already paid for the merchandise, the seller may pay the buyer a cash refund.

If the customer purchased the merchandise on account, the seller may grant a customer allowance that reduces the accounts receivable owed on the original selling price.

When this is done, the seller sends the buyer a credit memorandum, or credit memo, indicating its intent to credit the customer’s account receivable.

Cash Refunds and Allowances (2 of 2)

Customer refunds payable is a liability account for estimated refunds that will be paid to customers in the future.

It is recorded at the end of the accounting period as part of the adjusting process.

Customer Returns

Estimated returns inventory is a current asset account that is reported on the balance sheet after Inventory.

It represents an estimate of merchandise that will be returned by customers.

It is recorded at the end of the accounting period as part of the adjusting process.

Freight (1 of 4)

Purchases and sales of merchandise often involve freight.

The terms of a sale indicate when ownership (title and control) of the merchandise passes from the seller to the buyer.

This point determines whether the buyer or the seller pays the freight costs.

Freight (2 of 4)

The ownership of the merchandise may pass to the buyer when the seller delivers the merchandise to the freight carrier.

In this case, the terms are said to be FOB (free on board) shipping point.

This term means that the buyer pays the freight costs from the shipping point to the final destination.

Such costs are part of the buyer’s total cost of purchasing inventory and are added to the cost of the inventory by debiting Inventory.

Freight (3 of 4)

The ownership of the merchandise may pass to the buyer when the buyer receives the merchandise.

In this case, the terms are said to be FOB (free on board) destination.

This term means that the seller pays the freight costs from the shipping point to the buyer’s final destination.

When the seller pays the delivery charges, the seller debits Delivery Expense or Freight Out.

Delivery Expense is reported on the seller’s income statement as a selling expense.

Freight (4 of 4)

The seller may prepay the freight, even though the terms are FOB shipping point. The seller will then add the freight to the invoice.

The buyer debits Inventory for the total amount of the invoice, including the freight.

Any discount terms would not apply to the prepaid freight.

Dual Nature of Merchandise Transactions

Each merchandising transaction affects a buyer and a seller.

Illustration of Inventory Transactions for Seller and Buyer (1 of 2)

Illustration of Inventory Transactions for Seller and Buyer (2 of 2)

Sales Taxes

Almost all states levy a tax on sales of merchandise.

The liability for the sales tax is incurred when the sale is made.

At the time of a cash sale, the seller collects the sales tax.

When a sale is made on account, the seller charges the tax to the buyer by debiting Accounts Receivable.

The seller credits the sales account for the amount of the sale and credits the tax to Sales Tax Payable.

Trade Discounts (1 of 2)

Wholesalers are companies that sell merchandise to other businesses rather than to the public, called B2B transactions.

Many wholesalers publish or upload sales catalogs online.

Wholesalers often offer special discounts off list prices to government agencies or businesses that order large quantities.

Such discounts are called trade discounts.

Trade Discounts (2 of 2)

Sellers and buyers do not normally record the list prices of merchandise and trade discounts in their accounts.

Adjusting Entry for Inventory Shrinkage

Under the perpetual inventory system, the inventory account is continually updated for purchase and sales transactions.

As a result, the balance of the inventory account is the amount of merchandise available for sale at that point in time.

However, retailers normally experience some loss of inventory due to shoplifting, employee theft, or errors.

Thus, the physical inventory on hand at the end of the accounting period is usually less than the balance of Inventory.

This difference is called inventory shrinkage or inventory shortage.

Adjusting Entries for Customer Refunds, Allowances, and Returns

Sellers are required to estimate returns and allowances at the end of an accounting period and prepare two adjusting entries:

The first adjusting entry reduces the sales account and creates a customer refund liability account for the estimated refunds and allowances that will be granted to customers in the future.

The second adjusting entry creates an estimated returns inventory account for the cost of merchandise that is expected to be returned and reduces Cost of Goods Sold.

Adjusted Trial Balance

After the adjusting entries are posted to the ledger, an adjusted trial balance is prepared.

Financial Statements for a Retail Business

Although merchandising transactions affect the balance sheet in reporting inventory, they primarily affect the income statement.

An income statement for a retail business is normally prepared using either a multiple-step format or a single-step format.

Multiple-Step Income Statement

The multiple-step income statement contains several sections, subsections, and subtotals, including the following:

Sales

Cost of Goods Sold

Gross Profit

Operating Income

Other Revenue and Expense

Multiple-Step Income Statement—Sales

The total amount of sales to customers for cash and on account is reported in this section.

Multiple-Step Income Statement— Cost of Goods Sold

The amount of cost of goods sold to customers is reported in this section.

Cost of goods sold may also be reported as cost of merchandise sold or cost of sales.

Multiple-Step Income Statement—Gross Profit

The excess of sales over cost of goods sold is gross profit.

Multiple-Step Income Statement—Operating Income (1 of 3)

Operating income, sometimes called income from operations, is determined by subtracting operating expenses from gross profit.

Operating expenses are normally classified as either selling expenses or administrative expenses.

Multiple-Step Income Statement—Operating Income (2 of 3)

Selling expenses are incurred directly in the selling of merchandise.

Examples of selling expenses include

sales salaries

store supplies used

depreciation of store equipment

delivery expense

advertising

Multiple-Step Income Statement—Operating Income (3 of 3)

Administrative expenses, sometimes called general expenses, are incurred in the administration or general operations of the business.

Examples of administrative expenses include

office salaries

depreciation of office equipment

office supplies used

Multiple-Step Income Statement— Other Revenue and Expense (1 of 3)

Other income and expense items are not related to the primary operations of the business.

Other revenue is revenue from sources other than the primary operating activity of a business.

Examples of other income include

income from interest

rent

gains resulting from the sale of fixed assets

Multiple-Step Income Statement— Other Revenue and Expense (2 of 3)

Other expense is an expense that cannot be traced directly to the normal operations of the business.

Examples of other expenses include

interest expense

losses from disposing of fixed assets

Multiple-Step Income Statement— Other Revenue and Expense (3 of 3)

Other income and other expense are offset against each other on the income statement.

If the total of other income exceeds the total of other expense, the difference is added to income from operations to determine net income.

If the total of other expense exceeds the total of other income, the difference is subtracted from income from operations to determine net income.

Single-Step Income Statement

An alternative form of income statement is the single-step income statement.

The single-step form deducts the total of all expenses in one step from the total of all revenues.

The single-step form emphasizes total revenues and total expenses in determining net income.

A criticism of the single-step form is that gross profit and income from operations are not reported.

The Closing Process (1 of 2)

The two closing entries for a retail business are as follows:

Debit each revenue account with for its balance, credit each expense account for its balance, and credit the retained earnings account for net income. Debit the retained earnings account for a net loss. Cost of Goods Sold is a temporary account and is closed like an expense account.

Debit the retained earnings account for the balance of the dividends account and credit the dividends account.

The Closing Process (2 of 2)

After the closing entries are posted to the accounts, a post-closing trial balance is prepared.

The only accounts that appear on the post-closing trial balance are the asset, contra asset, liability, and stockholders’ equity accounts with balances.

These are the same accounts that appear on the end-of-period balance sheet.

If the two totals of the trial balance columns are not equal, an error has occurred that must be found and corrected.

Analysis for Decision Making: Asset Turnover Ratio

The asset turnover ratio measures how effectively a business is using its assets to generate sales.

A high ratio indicates an effective use of assets.

The asset turnover ratio is computed as follows:

Appendix 1: Gross Method of Recording Sales Discounts—Transactions

Under the gross method, a sales invoice with credit terms granting a discount for early payment is recorded at the gross amount of the invoice.

The customer pays within the discount period, Cash is debited for the amount received, the discount is recorded as a debit to Sales, and Accounts Receivable is credited for the invoice amount.

Adjusting Entry (1 of 2)

Since GAAP requires that revenue (sales) be recorded in the amount most likely to be received, the gross method requires an adjusting entry at the end of the accounting period.

The adjusting entry reduces Sales for the estimated sales discounts related to the current period’s sales that are expected to be taken in the next period.

Adjusting Entry (2 of 2)

Allowance for Sales Discounts is a contra asset account similar to the contra asset account Accumulated Depreciation.

Just as Accumulated Depreciation is a contra account to a fixed asset account, Allowance for Sales Discounts is a contra account to Accounts Receivable.

Subsequent Period

Customers with outstanding accounts receivable balances at the year end will pay their balances in a subsequent year. If a customer pays within the discount period, Allowance for Sales Discounts is debited instead of Sales.

Comparison with the Net Method

Both the gross method and the net method are acceptable under GAAP. However, the gross method is more complex in that it requires an adjusting entry and a contra asset account.

Gross Method and Net Method Journal Entries

Appendix 2: The Periodic Inventory System (1 of 2)

Small retail businesses, such as a local hardware store, may use a manual accounting system.

A manual perpetual inventory system is time consuming and costly to maintain.

In this case, the periodic inventory system may be used.

Appendix 2: The Periodic Inventory System (2 of 2)

Under the periodic inventory system, purchases are normally recorded at their invoice amount as a debit to Purchases.

If the invoice is paid within the discount period, the discount is recorded as a credit in a separate account called Purchases Discounts.

Likewise, purchases returns are recorded as a credit in a separate account called Purchases Returns and Allowances.

Appendix 2: Recording Merchandise Transactions Under the Periodic Inventory System

Using the periodic inventory system, purchases of inventory are not recorded in the inventory account.

Instead, purchases, purchases discounts, and purchases returns and allowances accounts are used.

In addition, the sales of merchandise are not recorded in the inventory account.

Thus, there is no detailed record of the amount of inventory on hand at any given time.

At the end of the period, a physical count of inventory on hand is taken.

This physical count is used to determine the cost of goods sold.

Appendix 2: Recording Merchandise Transactions Under the Periodic Inventory System—Purchases

Purchases of inventory are recorded in a purchases account rather than in the inventory account.

Purchases is debited for the invoice amount of a purchase.

Appendix 2: Recording Merchandise Transactions Under the Periodic Inventory System—Purchases Discounts

Purchases discounts are normally recorded in a separate purchases discounts account.

The balance of the purchases discounts account is reported as a deduction from Purchases for the period.

Thus, Purchases Discounts is a contra (or offsetting) account to Purchases.

Appendix 2: Recording Merchandise Transactions Under the Periodic Inventory System—Purchases Returns and Allowances

A separate purchases returns and allowances account is used to record returns and allowances.

Purchases returns and allowances are reported as a deduction from Purchases for the period.

Thus, Purchases Returns and Allowances is a contra (or offsetting) account to Purchases.

Appendix 2: Recording Merchandise Transactions Under the Periodic Inventory System—Freight In

Under the periodic inventory system, freight paid when purchasing merchandise FOB shipping point is debited to Freight In, Transportation In, or a similar account.

Transactions Using the Periodic Inventory System

Appendix 2: Adjusting Process Under the Periodic Inventory System (1 of 2)

The adjusting process is the same under the periodic and perpetual inventory systems except for the inventory shrinkage adjustment and customer refunds and allowances.

The ending inventory is determined by a physical count under both systems.

Appendix 2: Adjusting Process Under the Periodic Inventory System (2 of 2)

Under the perpetual inventory system, the ending inventory physical count is compared to the balance of Inventory.

The difference is the amount of inventory shrinkage.

The inventory shrinkage is then recorded as a debit to Cost of Goods Sold and a credit to Inventory.

Under the periodic inventory system, the inventory account is not kept up to date for purchases and sales.

As a result, the inventory shrinkage cannot be directly determined.

Instead, any inventory shrinkage is included indirectly in the computation of the cost of goods sold.

Appendix 2: Financial Statements Under the Periodic Inventory System

The financial statements are similar under the perpetual and periodic inventory systems.

When the multiple-step format of income statement is used, the cost of goods sold may be reported.

Appendix 2: Closing Entries Under the Periodic Inventory System (1 of 3)

The closing entries differ in the periodic inventory system in that there is no cost of goods sold account to close.

Instead, the purchases, purchases discounts, purchases returns and allowances, and freight in accounts are closed.

In addition, the inventory account is adjusted to the end-of-period physical inventory count during the closing process.

The estimated returns inventory account is also adjusted for the estimated returns from the current period’s sales.

Appendix 2: Closing Entries Under the Periodic Inventory System (2 of 3)

The two closing entries under the periodic inventory system are as follows:

Entry one includes the following elements:

Debit Inventory for its end-of-period balance based on the physical inventory.

Debit Estimated Returns Inventory for the cost of the future estimated returns of the current period’s sales.

Debit each revenue account and the following temporary periodic inventory accounts for their balances: Purchases Discounts and Purchases Returns and Allowances.

Appendix 2: Closing Entries Under the Periodic Inventory System (3 of 3)

Credit Inventory for its balance as of the beginning of the period.

Credit each expense account and the following temporary periodic inventory accounts for their balances: Purchases and Freight In accounts for their balances.

Credit the retained earnings account for the net income or debit the retained earnings account for a net loss.

Debit the retained earnings account and credit the dividends account for its balance.

Assets

Total

Average

Sales

Ratio

Turnover

Asset