Merchandising Business Financial Statements

Merchandise

For service businesses, revenues from services are reported as fees earned on the income statement. The operating expenses are subtracted from the fees earned to obtain the Net Income (or Net Loss). For merchandising businesses, there's more involved.

Revenue activities for merchandising businesses involve the buying and selling of merchandise. Before these businesses can sell to their customers, they have to purchase the items to create inventory. When the merchandise is sold, revenue is reported as sales, while cost is recognized as an expense called Cost of Merchandise Sold. At the end of an accounting period, any merchandise on hand (that has not been sold) is referred to as merchandise inventory. This is reported as an asset on the balance sheet.

First, we will go over the changes to the financial statements from what we've previously discussed. Mostly these changes will affect the income statement. After that, we will look at how the buying and selling of merchandise is recorded, to better understand these changes to the statements.

Multi-Step Income Statement

The Multi-Step Income Statement contains several sections and subsections, as well as subtotals. Some of the sections and subsections are listed below.

Sales is the total amount charged to customers for the merchandise. This includes cash sales, and sales made on account.

Sales returns and allowances represents amounts granted by the seller for damaged or defective merchandise.

Sales discounts are amounts granted by the seller for early payments of items purchased on account. For example: If a buyer purchases $100 of merchandise with the terms 2/10, N30. The N30 means that the buyer has 30 days to pay for the merchandise. However, the 2/10 means that if the buyer pays within ten days, they will receive a 2% discount. So if the buyer pays within the first ten days, they would only have to pay $98. The $2 is recorded as an expense to Sales Discounts and Amounts.

Net sales is the amount after subtracting sales returns and allowances, and sales discounts, from sales. Many companies, rather than reporting sales, sales returns and allowances, and sales discounts, will only list Net Sales on their Income Statements.

Cost of merchandise sold is the cost of the merchandise that is sold to customers. This amount can be reduced by Purchases Discounts, and by Purchases Returns and Allowances. Sales Returns and Allowances and Sales Discounts are all recorded by the seller during the transactions. The buyer records these as Purchases discounts, returns and allowances. These amounts are subtracted from the original cost of the merchandise. When the merchandise is sold, this final cost is recorded as the cost of merchandise sold.

Another way of looking at these costs is as follows. Transportation costs of the merchandise is also calculated into the cost of merchandise sold. The original amount paid for the merchandise minus discounts, returns and allowances is known as net purchases. The transportation costs are called transportation in. The transportation costs are added in to the net purchases to arrive at the cost of merchandise purchased.

Remember with your accounting equation how everything that caused an increase or decrease to assets had to do the same to either liabilities or equity. The same type of relationship is true with merchandise. There is a buyer, and there is a seller. For example, when merchandise is purchased, it is a record of sales to the seller, and a record of purchase to the buyer. A merchandise business will, at one point or another in their business, be both the buyer and the seller. They must buy the merchandise that they will turn around and sell to their customers.

Merchandise available for sale is the beginning merchandise inventory plus any merchandise purchased during the accounting period. Subtracting the ending inventory from the merchandise available for sale will yield the cost of merchandise sold.

There are two systems for determining the cost of merchandise sold and on hand. The first is the periodic system. In this method, the merchandise on hand at the end of the period is determined by taking a physical count of the inventory. Under this system, inventory records do not show the amount available for sale, nor the amount sold during the period. This is the "old school" system of determining merchandise.

The second system is the perpetual system. Under this system of accounting for merchandise inventory, each purchase and sale of merchandise is recorded in the inventory and the cost of merchandise sold accounts. The amount of merchandise available for sale and the amount sold are perpetually disclosed in the inventory records. This is the modern style of determining merchandise.

Gross profit is calculated by taking the cost of merchandise sold and subtracting it from the net sales. Operating income, or income from operations, is determined by taking the gross profit and subtracting operating expenses. Most businesses classify operating expenses as either selling expenses or administrative expenses. Selling expenses are expenses incurred directly in the selling of merchandise. These include sales people's salaries, store supplies used, depreciation of store equipment, delivery expenses and advertising. Administrative expenses are incurred in the administration or general operations of the business. These include office salaries, depreciation of office equipment, and office supplies used. Credit card expenses are generally classified as administrative expenses. Although these two types of expenses may be reported separately, many companies report operating expenses as a single item.

Revenue from sources other than the primary operating activity of a business is classified as other income. In a merchandising business, these would include income from interest, rent and gains from the sale of fixed assets. Expenses that cannot be traced directly to operations are listed as other expenses. These include interest expenses that result from financing activities, and losses incurred in the disposal of fixed assets. These two items are generally listed on the Income Statement as Other income and expenses.

So a Multi-Step Income Statement would look something like this:

Driden Enterprises
Income Statement
For the Year ended December 31, 2008
Revenue from Sales   
  Sales $720185.00 
  Less Sales returns & allowances$6140.00  
     Sales Discounts5790.0011930.00 
    Net sales  $708255.00
Cost of Merchandise Sold  525305.00
Gross profit  $182950.00
Operating Expenses   
  Selling Expenses   
    Sales salaries expense$53430.00  
    Advertising expense10860.00  
    Depr. expense-store equip.3100.00  
    Delivery expense2800.00  
    Misc. selling expense630.00  
     Total selling expenses $70820.00 
  Administrative expenses   
    Office salaries expense$21020.00  
    Rent expense8100.00  
    Depr. expense-office equip.2490.00  
    Insurance expnese1910.00  
    Office supplies expense610.00  
    Misc. admin. expense760.00  
     Total admin expenses 34890.00 
  Total operating expenses  10571.00
Income from operations  $77240.00
Other income and expense   
  Rent revenue $600.00 
  Interest expense (2440.00)(1840.00)
Net Income  $75400.00

Single-Step Income Statement

The single-step income statement is not as detailed as the multiple-step income statement. In this income statement, the total of all expenses are deducted from the total of all revenues in one step. This form emphasizes total revenues and total expenses as the factors that determine net income. With this form, amounts such as gross profit and income from operations are not readily available for analysis.

Retained Earnings Statement

The retained earnings statement for a merchandising company is prepared the same way as discussed in previous articles.

Balance Sheet

As previously mentioned, the balance sheet can be presented in two different forms. The Account form presents the balance sheet with the assets listed on the left. On the right is liabilities, with equity listed under the liabilities. The second form is the report form. This lists everything from the top down. Assets are listed at the top with liabilities under the assets, and then equity under the liabilities. For a merchandising company, note that merchandise inventory at the end of the period is reported as a current asset.

Merchandising Transactions

Now that we've discussed how to record the merchandise on the financial statements, let's go over how merchandising transactions are recorded. We will be using the perpetual system for this discussion, as this is how most companies record their transactions. Later, we'll look at the periodic system so that you have that information.

Merchandising Business Chart of Accounts

As we discussed earlier, every business needs a chart of accounts to represent the different classifications of assets, liabilities and equity. With a merchandising business, there are additional accounts that have to be listed because of merchandise being accounted for. An asset account of Merchandise Inventory must be created. In addition, revenues have to be increased from simply fees earned to indicate sales, sales returns and allowances, and sales discounts. Under costs and expenses, costs of merchandise sold must be added, as well as the costs for delivery expenses. For a service business, having one account for salaries is adequate. For a merchandiser, there is the need to separate the salaries into sales salaries, and office salaries. As you can see, the chart of accounts must be increased from a standard service business.

Sales Transactions

Transactions are recorded in a journal and posted to the accounts using the same accounting rules of debit and credit as mentioned in previous articles. This simple system is often modified to more efficiently record transactions. For example, the ledger can become convoluted when using a separate account for each supplier. For this reason, individual accounts payable to suppliers may be placed in a separate ledger called a subsidiary ledger. Also, individual accounts receivable from customers and individual items of merchandise inventory may be placed in subsidiary ledgers. Each subsidiary ledger is then represented in the primary ledger (the general ledger), by a summarizing account called a controlling account. The balance of the controlling account must equal the sum of the balances of the individual accounts in the subsidiary ledger.

Sales - Cash and On Account: When sales transactions occur, two entries must be recorded. The first is to record the transaction of the sale. For example: An item is sold at the price of $500. If the transaction was a cash sale, then cash would be debited and sales would be credited, each for $500. If the transaction was a sale on account, then accounts receivable would be debited and sales would be credited, each for $500.

The second transaction affects the merchandise inventory. In the above example, $500 was collected from the customer. However, the business did not pay $500 for that inventory. Let's assume that the total cost of the merchandise was $300. Along with the sale transaction above, a merchandise transaction must be recorded. This is done by debiting cost of merchandise sold, and crediting the merchandise inventory. The amount these accounts are debited and credited is $300 as opposed to $500. The reason is that the cost of the merchandise was $300, so the inventory shows $300 of inventory.

Therefore, in each sales transaction, there are two journal entries that must be completed. For the example above, assuming that cash was paid at the time of purchase, then the journal entries would look like this:

Cash  500.00 
   Sales   500.00
Cost of Merch. Sold  300.00 
   Merch. Inventory   300.00

Sales discounts: The terms for when payment for merchandise are to be made are called the credit terms. If payment is not required upon delivery of the merchandise, then the amount of time that the buyer has to pay is called the credit period. The credit period usually begins with the date on the invoice. If the terms are, for example, N30, then payment is due 30 days after the date of the invoice.

As a way to encourage buyers to pay early, the seller may offer a discount. For example, the terms may be 2/10, N30. This means that although payment is not due until the 30th day, if payment is made by the 10th day, there will be a 2% discount. Discounts taken by the buyer for early payment are recorded as sales discounts by the seller. For example: Merchandise of $200 is purchased on account with the terms 2/10, N30. Payment is made on the 8th day in the amount of $196 ($200 minus 2%, or $4). This would be recorded as a credit of the full amount of $200 to Accounts Receivable. The offsetting debits would be recorded as $196 to Cash, and the remaining $4 would be recorded as a debit to the account Sales Discounts.

Sales returns and allowances: Some of the merchandise sold may be returned. In addition, because of defects or other reasons, a seller may reduce the initial price at which the goods were sold. If the return or allowance is for a sale on account, then the seller usually issues a credit memorandum to the buyer.

Sales discounts, returns and allowances reduce sales revenue. They also result in additional shipping and other expenses. The sales returns and allowances are recorded in a contra account to Sales. The seller debits Sales Returns and Allowances. Since the original sale was on account, Accounts Receivable is credited. With the perpetual system, the seller adds the cost of the returned merchandise back to merchandise inventory, which is done through a debit. The seller also credits the account cost of merchandise sold. Basically, it is a reversal of the entries shown in the section above Sales - Cash and On Account.

Purchase Transactions

When a business purchases merchandise, their purchases are recorded with debits to merchandise inventory, and then the offsetting credit either goes to cash or accounts payable (if it's purchased on account).

Purchase discounts: When the buyer pays for merchandise early, they may be offered a discount (this is the sales discount mentioned above under the sales transactions). Using the example above from sales discounts, the buyer makes payment on the 8th day and pays $196 of the $200 of merchandise purchased, with the remaining $4 being the discount. The purchaser would record this payment as a debit to accounts payable for the full amount of $200 to clear accounts payable. The $196 would be credited to cash. The additional $4 would be credited to merchandise inventory, to show that the cost of the inventory was $196 rather than the initial $200.

Purchase returns and allowances: When merchandise is returned or an allowance is requested, the buyer will send a debit memorandum to the seller. The debit memorandum will be used as the basis for recording the return, or will be used by the seller to issue a credit memorandum. In either case, the buyer debits accounts payable and credits merchandise inventory for the amount of the merchandise returned or listed as the allowance.

Basically, purchase transactions are the entries made by the buyer to reflect in their books the same entries (but in reverse) of the seller. The buyer increases their merchandise and decreases their cash (or accounts receivable) when they make the purchase. At the same time, the seller decreases their merchandise and increases their cash (or accounts payable) when they make the sale.

Transportation Costs, Sales Taxes, and Trade Discounts

Transportation: The terms of sale indicate when the buyer takes ownership of the merchandise. This is either when the seller delivers the merchandise to the transportation or delivery company, or when the buyer actually takes possession of the merchandise. When the buyer takes possession determines what type of shipping is being used. The two types of shipping are FOB Shipping Point and FOB Destination. FOB stands for Freight on Board. FOB Shipping Point means that when the merchandise is delivered to the transportation or delivery company, the ownership is transferred to the buyer. This means that if anything happens during the transportation of the merchandise, the buyer is responsible. FOB Destination means that ownership transfers to the buyer when the merchandise is delivered. This means that if anything happens during the transportation of the merchandise, the seller is responsible. The account generally used for transportation is referred to as delivery expense.

Sales Taxes: Almost all states and many other taxing authorities levy a tax on the sale of merchandise. The liability of the sales tax is incurred when the sale is made. If the sale is a cash sale, the seller collects the sales tax from the buyer. If it is a sale on account, then the seller charges the tax to the buyer by debiting accounts receivable while crediting both the sales account for the amount of the sale and the tax amount to Sales Tax Payable. When sales taxes are paid to the taxing authorities, Sales Tax Payable is debited and cash is credited.

Trade Discounts: Some wholesalers publish catalogs for their merchandise. Rather than updating their catalogs every time they change, they often publish price updates. These may involve large discounts from the list prices. In addition, they may offer discounts to certain classes of buyers such as government agencies or businesses that order large quantities. These discounts are called trade discounts.

Sellers and buyers do not normally record the list prices of merchandise and the related trade discounts in their accounts. For example: An item is listed at $100. It sells for $60 (a 40% discount). The seller records the sale of the item as $60, and the buyer records the purchase as $60.

The Adjusting and Closing Entries

Adjusting Entries: With the accounting cycle there are adjusting entries and closing entries. Inventory affects these entries as well. Merchandising business may experience some loss to their inventory through shoplifting, employee theft, errors in recording or counting the inventory, and other irregularities. As a result, the physical inventory may be less at the end of the accounting period than what is shown on the inventory records. This difference is called inventory shrinkage, or inventory shortage.

For example: Inventory records indicate that $10,000 of merchandise should be available for sale. The physical inventory is taken, and indicates there is only $8,000 of merchandise available. The inventory shrinkage is $2,000. The amount is then recorded as an adjusting entry that debits the cost of merchandise sold and credits merchandise inventory for $2,000 each. After this adjusting entry is recorded, the accounting records will agree with the actual physical inventory at the end of the accounting period. This is considered a normal cost of operations as there is no system or safeguard that can totally eliminate it. If it is abnormally large, it may be disclosed separately on the income statement. In these cases it is recorded in a separate account such as Loss From Merchandise Inventory Shrinkage.

Closing Entries: The closing entries of a merchandising business are similar to those for a service business. The first closing entry we discussed with the service business was moving fees earned to Income Summary. The same type of entry is made as the first entry with a merchandising business. However instead of fees earned, the temporary accounts with credit balances will be items such as Sales.

The second entry closes the temporary accounts with debit balances. This includes sales returns and allowances, sales discounts, and cost of merchandise sold. The third entry closes income summary to retained earnings, and the fourth closes dividends to retained earnings, just as with the service business.

Periodic Inventory System

Previously we've been focusing on the perpetual system of accounting. Now, let's take a look at the periodic inventory system. Some small businesses will use the periodic inventory system instead of the perpetual as the perpetual can be more time consuming for them to track each sale.

Using the periodic system, sales are recorded when they are made in the same manner as the perpetual inventory system. However, the recording of the cost of merchandise sold is not done at this time. The cost of merchandise sold is done at the end of the accounting period. From purchases for the period you subtract purchases returns and allowances, and purchase discounts. Then add in the transportation in. This will give you the cost of merchandise purchased. To that add the beginning merchandise inventory, which will give you the merchandise available for sale. From that subtract the merchandise inventory on hand at the end of the accounting period. The final result is the cost of the merchandise sold during the accounting period.

Where the perpetual inventory system used the sales accounts and the purchase accounts in their chart of accounts, the periodic system uses mostly the purchases accounts - Purchases, Purchases Returns and Allowances, and Purchases Discounts. It also uses the Transportation In account.

The adjusting process is the same under the periodic and perpetual inventory systems. The closing entries differ in that there is no cost of merchandise sold account to be closed. Instead, purchases, purchases discounts, purchases returns and allowances, and transportation in accounts are closed to the Income Summary.