6.5 Financial Analysis and Interpretation: Asset Turnover

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Obj. 5

Asset turnover, sometimes called the ratio of sales to assets, measures how effectively a business is using its assets to generate sales. A high ratio indicates an effective use of assets.

The asset turnover is computed as follows:

Asset Turnover=SalesAverage Total Assets

To illustrate, the following data (in millions) were taken from recent annual reports of Dollar Tree, Inc.:

 

The asset turnover for each year is as follows:

 

Dollar Tree’s asset turnover declined from 2.84 in Year 1 to 2.71 in Year 2. Thus, Dollar Tree’s utilization of its assets to generate sales declined slightly in Year 2.

Using the asset turnover for comparisons to competitors and with industry averages could also be beneficial in interpreting Dollar Tree’s use of its assets. For example, the following data (in millions) were taken from recent annual reports of Dollar General Corporation:

 

Dollar General’s asset turnover for Year 2 is as follows:

 

Comparing Dollar General’s Year 2 asset turnover of 1.71 to Dollar Tree’s Year 2 ratio of 2.71 implies that Dollar Tree is using its assets more efficiently than is Dollar General.

Example Exercise 6-8

Asset Turnover

Obj. 5

Financial statement data for the years ending December 31, 2019 and 2018, for Gilbert Company follow:

 

Follow My Example 6-8

1. Determine the asset turnover for 2019 and 2018.

Answer

2. Does the change in the asset turnover from 2018 to 2019 indicate a favorable or an unfavorable trend?

Answer

The change from 1.25 to 1.50 indicates a favorable trend in using assets to generate sales.

Practice Exercises: PE 6-8A, PE 6-8B

 

6-1Nature of Merchandising Businesses

Obj. 1

The activities of a service business differ from those of a merchandising business. These differences are reflected in the operating cycles of a service and merchandising business as well as in their financial statements.

6-1aOperating Cycle

The operating cycle is the process by which a company spends cash, generates revenues, and receives cash either at the time the revenues are generated or later by collecting an account receivable. The operating cycle of a service and merchandising business differs in that a merchandising business must purchase merchandise for sale to customers. The operating cycle for a merchandise business is shown in Exhibit 1.

Exhibit 1The Operating Cycle for a Merchandising Business

 

The time in days to complete an operating cycle differs significantly among merchandise businesses. Grocery stores normally have short operating cycles because of the nature of their merchandise. For example, many grocery items, such as milk, must be sold within their expiration dates of a week or two. In contrast, jewelry stores often carry expensive items that are displayed months before being sold to customers.

6-1bFinancial Statements

The differences between service and merchandising businesses are also reflected in their financial statements. For example, these differences are illustrated in the following condensed income statements:

 

Link to Dollar Tree

In a recent income statement, Dollar Tree reported the following (in billions):

 

On its balance sheet, it reported merchandise inventory of $1.0 billion.

The revenue activities of a service business involve providing services to customers. On the income statement for a service business, the revenues from services are reported as fees earned. The operating expenses incurred in providing the services are subtracted from the fees earned to arrive at operating income.

In contrast, the revenue activities of a merchandising business involve the buying and selling of merchandise. A merchandising 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. This expense is called the cost of merchandise sold. The cost of merchandise sold is subtracted from sales to arrive at gross profit. This amount is called gross profit because it is the profit before deducting operating expenses.

Merchandise on hand (not sold) at the end of an accounting period is called merchandise inventory. Merchandise inventory is reported as a current asset on the balance sheet.

Business Connection

Comcast versus Lowe’s

Comcast Corporation is a service business that offers cable communications, broadcast television (NBC television), filmed entertainment (Universal Pictures), and theme parks (Universal Parks) to its customers. Lowe’s Companies is a large home improvement retailer. The differences in the operations of a service and merchandising business are illustrated in their recent income statements, as follows:

 

 

As a merchandising company, Lowe’s subtracts cost of merchandise sold from sales to disclose gross profit. As a service company, Comcast shows neither cost of merchandise sold nor a gross profit line. Rather, service expenses are subtracted from revenue straight to operating income.

Example Exercise 6-1

Gross Profit

Obj. 1

1. During the current year, merchandise is sold for $250,000 cash and for $975,000 on account. The cost of the merchandise sold is $735,000. What is the amount of the gross profit?

Follow My Example 6-1

Answer

The gross profit is .

Practice Exercises: PE 6-1A, PE 6-1B

6-2Merchandising Transactions

Obj. 2

This section illustrates merchandise transactions for NetSolutions after it becomes a retailer of computer hardware and software. During 2018, Chris Clark implemented the second phase of NetSolutions’ business plan. In doing so, Chris notified clients that beginning July 1, 2019, NetSolutions would no longer offer consulting services. Instead, it would become a merchandising business.

NetSolutions’ business strategy is to offer personalized service to individuals and small businesses that are upgrading or purchasing new computer systems. NetSolutions’ personal service includes a no-obligation, on-site assessment of the customer’s computer needs. By providing personalized service and follow-up, Chris believes that NetSolutions can compete effectively against such retailers as Best Buy, Office Depot, and Dell.

6-2aChart of Accounts for a Merchandising Business

NetSolutions merchandise transactions are recorded in the accounts, using the rules of debit and credit that are described and illustrated in Chapter 2. However, since merchandising transactions differ from those of a service business, NetSolutions adopted the new chart of accounts shown in Exhibit 2.

Exhibit 2Chart of Accounts for NetSolutions as a Merchandising Business

 

The accounts related to merchandising transactions are highlighted in pink in Exhibit 2. The nature of these accounts will be described and illustrated as the related merchandising transactions are discussed.

As shown in Exhibit 2, NetSolutions’ chart of accounts now consists of three-digit account numbers. The first digit indicates the major financial statement classification (1 for assets, 2 for liabilities, etc.). The second digit indicates the subclassification (e.g., 11 for current assets and 12 for noncurrent assets). The third digit identifies the specific account (e.g., 110 for Cash and 123 for Store Equipment).

Most merchandising companies use accounting systems with computerized reports that are similar to special journals and subsidiary ledgers illustrated in Chapter 5. For example, a merchandise accounting system typically produces sales and inventory reports. However, for the sake of simplicity, the transactions in this chapter will be illustrated using a two-column general journal.

6-2bPurchases Transactions

Link to Dollar Tree

Dollar Tree uses point-of-sale computerized software to plan purchases and track inventory. This system automatically reorders key items based on sales and inventory levels.

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. 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 merchandise on hand at the end of the period and the cost of merchandise sold during the period.

Most merchandise companies use computerized perpetual inventory systems. Such systems use bar codes or radio frequency identification codes embedded in a product. An optical scanner or radio frequency identification device is then used to read the product codes and track inventory on hand and sold.

Because computerized perpetual inventory systems are widely used, this chapter illustrates merchandise transactions using a perpetual inventory system. The periodic system is described and illustrated in an appendix at the end of this chapter.

Under the perpetual inventory system, cash purchases of $2,510 of merchandise are recorded as follows:

 

Purchases of $9,250 of merchandise on account are recorded as follows:

 

The terms of purchases on account are normally indicated on the invoice or bill that the seller sends the buyer. An example of an invoice sent to NetSolutions by Alpha Technologies is shown in Exhibit 3.

Exhibit 3Invoice

 

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.

If payment is due within a stated number of days after the invoice date, such as 30 days, the terms are net 30 days. These terms may be written as n/30.  If payment is due by the end of the month in which the sale was made, the terms are written as n/eom.

Purchases Discounts

To encourage the buyer to pay before the end of the credit period, the seller may offer a discount. For example, a seller may offer a 2% discount if the buyer pays within 10 days of the invoice date. If the buyer does not take the discount, the total invoice amount is due within 30 days. These terms are expressed as 2/10, n/30 and are read as “2% discount if paid within 10 days, net amount due within 30 days.” The credit terms of 2/10, n/30 are summarized in Exhibit 4, using the invoice in Exhibit 3.

Exhibit 4Credit Terms

 

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. Even if the buyer has to borrow to pay within a discount period, it is normally to the buyer’s advantage to do so. For this reason, accounting systems are normally designed so that all available discounts are taken.

To illustrate, the invoice shown in Exhibit 3 is used. The last day of the discount period is January 15 (invoice date of January 5 plus 10 days). Assume that in order to pay the invoice on January 15, NetSolutions borrows $2,940, which is $3,000 less the discount of . If an annual interest rate of 6% and a 360-day year is also assumed, the interest on the loan of $2,940 for the remaining 20 days of the credit period is .

The net savings to NetSolutions of taking the discount is $50.20, computed as follows:

 

The savings can also be seen by comparing the interest rate on the money saved by taking the discount and the interest rate on the money borrowed to take the discount. The interest rate on the money saved in the prior example is estimated by converting 2% for 20 days to a yearly rate, as follows:

NetSolutions borrowed $2,940 at 6% to take the discount. If NetSolutions does not take the discount, it pays an estimated interest rate of 36% for using the $2,940 for the remaining 20 days of the credit period. Thus, buyers should normally take all available purchase discounts.

Since buyers normally take all purchases discounts, Merchandise Inventory is debited for the net purchase price under the perpetual inventory system. That is, the buyer debits Merchandise Inventory for the amount of the invoice less the discount.

To illustrate, NetSolutions would record the Alpha Technologies invoice and its payment as follows:

 

If the invoice is not paid within the discount period, the full amount of the invoice would be due and the discount lost would be debited to Merchandise Inventory. For example, assuming that NetSolutions paid Alpha Technologies on February 4, the payment would be recorded by NetSolutions as follows:

 

Purchases Returns and Allowances

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 to notify the seller of reasons for the return (purchase return) or to request a price reduction (purchase allowance).

A debit memorandum, often called a debit memo, is shown in Exhibit 5. A debit memo informs the seller of the amount the buyer proposes to debit to the account payable due the seller. It also states the reasons for the return or the request for the price allowance.

Exhibit 5Debit Memo

 

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 Merchandise Inventory.

To illustrate, NetSolutions records the return of the merchandise indicated in the debit memo in Exhibit 5 as follows:

 

Before paying an invoice, a buyer may return merchandise 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.

To illustrate, assume the following data concerning a purchase of merchandise by NetSolutions on May 2:

May 2.		Purchased $5,000 of merchandise on account from Delta Data Link, terms 2/10, n/30.
4.		Returned $1,000 of the merchandise purchased on May 2.
12.		Paid for the purchase of May 2 less the return and discount.

NetSolutions would record these transactions as follows:

 

Example Exercise 6-2

Purchases Transactions

Obj. 2

Rofles Company purchased merchandise on account from a supplier for $11,500, terms 2/10, n/30. Rofles Company returned $2,500 of the merchandise and received full credit.

Follow My Example 6-2

1. If Rofles Company pays the invoice within the discount period, what is the amount of cash required for the payment?

Answer

$8,820. Purchase of  less the return of .

2. Under a perpetual inventory system, what account is credited by Rofles Company to record the return?

Answer

Merchandise Inventory

Practice Exercises: PE 6-2A, PE 6-2B

6-2cSales Transactions

Revenue from merchandise sales is usually recorded as Sales. Sometimes a business may use the title Sales of Merchandise.

Cash Sales

A business may sell merchandise for cash. Cash sales are normally entered on a cash register and recorded in the accounts. To illustrate, assume that on March 3, NetSolutions sells merchandise for $1,800. These cash sales are recorded as follows:

 

Using the perpetual inventory system, the cost of merchandise sold and the decrease in merchandise inventory are also recorded. In this way, the merchandise inventory account indicates the amount of merchandise on hand (not sold).

To illustrate, assume that the cost of merchandise sold on March 3 is $1,200. The entry to record the cost of merchandise sold and the decrease in the merchandise inventory is as follows:

 

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.

Link to Dollar Tree

Dollar Tree normally receives cash from credit card sales within three business days and thus records credit card sales as cash sales.

If customers use MasterCards to pay for their purchases, the sales would be recorded exactly as shown in the first March 3 entry illustrated in this section. Any processing fees charged by the clearinghouse or issuing bank are periodically recorded as an expense. This expense is normally reported on the income statement as an administrative expense. To illustrate, assume that NetSolutions paid credit card processing fees of $4,150 on March 31. These fees would be recorded as follows:

 

Sales on Account

Link to Dollar Tree

Dollar Tree only accepts cash, checks, credit cards, and debit cards from its customers.

A business may sell merchandise on account. The seller records such sales as a debit to Accounts Receivable and a credit to Sales. An example of an entry for a NetSolutions sale on account of $6,000 to Jones Consulting follows. The cost of merchandise sold was $3,500.

 

Customer Discounts

Link to Dollar Tree

Because Dollar Tree does not sell merchandise to customers on account, but only accepts cash, checks, credit cards, and debit cards, it did not report any accounts receivable on a recent balance sheet.

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 common discount, called a sales discount, encourages customers to pay their invoice early. For example, a seller may offer credit terms of 2/10, n/30, which provides a 2% sales discount if the invoice is paid within 10 days. If not paid within 10 days, the total invoice amount is due within 30 days.

To illustrate the accounting for sales discounts, assume that NetSolutions sold $18,000 of merchandise to Digital Technologies on March 10 with credit terms 2/10, n/30. The cost of merchandise sold was $10,800. The March 10 sale would be recorded as follows:

 

The sale to Digital Technologies is recorded by NetSolutions as $17,640, which is the invoice amount of $18,000 less the sales discount of .

The payment by Digital Technologies on March 19 is recorded as follows:

 

If Digital Technologies did not pay within the discount period, NetSolutions would receive $18,000 and Sales would be credited for the amount of the discount. For example, assuming that Digital Technologies paid NetSolutions on April 9, the payment would be recorded by NetSolutions as follows:

 

Cash Refunds and Allowances

A buyer may receive merchandise that is defective, has been damaged during shipment, or does not meet the buyer’s expectations. In these cases, the seller may pay the buyer a cash refund or grant a customer allowance that reduces the account receivable owed on the original selling price.

If the buyer is paid a refund, the seller debits Customer Refunds Payable and credits Cash. For example, assume that on March 4, NetSolutions pays Jones & Hunt a refund of $400 for merchandise that was damaged in shipment. Jones & Hunt has agreed to keep the merchandise and make any necessary repairs. Netsolutions would record the payment of the refund as follows:

 

Customer refunds payable is a liability account for estimated refunds and allowances that will be paid or granted customers in the future. It is recorded at the end of the accounting period as part of the adjusting process. The adjusting entry for customer refunds payable is illustrated later in this chapter.

In some cases, a customer who is due a refund has an outstanding account receivable balance. Instead of paying a cash refund, the seller may grant the customer an allowance against the customer’s account receivable. 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.

To illustrate, assume that NetSolutions granted Blake & Sons a customer allowance of $900 against its outstanding accounts receivable. NetSolutions notifies Blake & Sons of the allowance by issuing the credit memo shown in Exhibit 6.

Exhibit 6Credit Memo

 

Link to Dollar Tree

Dollar Tree does not offer refunds, and all sales are final.

The credit memo indicates that NetSolutions intends to reduce Blake & Sons’ accounts receivable for $900 due to merchandise damaged in shipment. NetSolutions would record the granting of the customer allowance as follows:

 

Customer Returns

In the preceding example, Blake & Sons did not return merchandise. When customers return merchandise for a cash refund or allowance, an additional entry must be made. This additional entry debits Merchandise Inventory and credits Estimated Returns Inventory for the seller’s original cost of the returned merchandise.

To illustrate, assume that on January 15 Bormann Enterprises returned merchandise with a selling price of $3,000 for a cash refund. The merchandise originally cost NetSolutions $2,100. NetSolutions would record the cash refund and the return with the following two entries:

 

The first entry records the cash refund payment of $3,000. The second entry records the receipt of the $2,100 of returned merchandise by debiting Merchandise Inventory and crediting Estimated Returns Inventory.

Estimated returns inventory is a current asset that is reported on the balance sheet after Merchandise 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. The adjusting entry for estimated returns inventory is illustrated later in this chapter.

If Bormann Enterprises had an outstanding accounts receivable balance on January 15, NetSolutions could have issued a $3,000 credit memo to Bormann Enterprises. In this case, NetSolutions would have credited Accounts Receivable—Bormann Enterprises instead of Cash.

Link to Dollar Tree

Although all sales are final, with the original receipt, Dollar Tree will “exchange” any unopened item.

The journal entries to record customer refunds, allowances, and returns are summarized in Exhibit 7.

Exhibit 7Journal Entries to Record Customer Refunds, Allowances, and Returns

 

Example Exercise 6-3

Sales Transactions

Obj. 2

Journalize the following merchandise transactions:

Follow My Example 6-3

1. Sold merchandise on account to Smith Inc., $7,500, with terms 2/10, n/30. The cost of the merchandise sold was $5,625.

Answer

2. Received payment for the sale in (a) less the discount.

Answer

3. Issued a credit memo to Wilson Company for returned merchandise that was sold for $4,000, terms n/30. The cost of the merchandise returned was $2,275.

Answer

Practice Exercises: PE 6-3A, PE 6-3B

Integrity, Objectivity, and Ethics in Business

The Case of the Fraudulent Price Tags

One of the challenges for a retailer is policing its sales return policy. There are many ways in which customers can unethically or illegally abuse such policies. In one case, a couple was accused of attaching Marshalls‘ store price tags to cheaper merchandise bought or obtained elsewhere. The couple then returned the cheaper goods and received the substantially higher refund amount. Company security officials discovered the fraud and had the couple arrested after they had allegedly bilked the company for more than $1 million.

6-2dFreight

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.

Note

The buyer bears the freight costs if the shipping terms are FOB shipping point.

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 Merchandise Inventory.

To illustrate, assume that on June 10, NetSolutions purchased merchandise as follows:

June 10.		Purchased merchandise from Magna Data, $900, terms FOB shipping point.
10.		Paid freight of $50 on June 10 purchase from Magna Data.

NetSolutions would record these two transactions as follows:

 

Note

The seller bears the freight costs if the shipping terms are FOB destination.

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.

To illustrate, assume that NetSolutions sells merchandise as follows:

June 15.		Sold merchandise to Kranz Company on account, $700, terms FOB destination. The cost of the merchandise sold is $480.
15.		NetSolutions pays freight of $40 on the sale of June 15.

NetSolutions records the sale, the cost of the sale, and the freight cost as follows:

 

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 Merchandise Inventory for the total amount of the invoice, including the freight. Any discount terms would not apply to the prepaid freight.

To illustrate, assume that NetSolutions sells merchandise as follows:

June 20.

Sold merchandise to Planter Company on account, $800, terms FOB shipping point. NetSolutions paid freight of $45, which was added to the invoice. The cost of the merchandise sold is $360.

NetSolutions records the sale, the cost of the sale, and the freight as follows:

 

Shipping terms, the passage of title (control), and whether the buyer or seller is to pay the freight costs are summarized in Exhibit 8.

Exhibit 8Freight Terms

 

Example Exercise 6-4

Freight Terms

Obj. 2

1. Determine the amount to be paid in full settlement of each of the two invoices, (a) and (b), assuming that credit for returns and allowances was received prior to payment and that all invoices were paid within the discount period.

 

Follow My Example 6-4

Answer

1. $3,863. Purchase of  less return of  plus $200 of shipping.
2. $2,450. Purchase of  less return of .

Practice Exercises: PE 6-4A, PE 6-4B

6-2eSummary: Recording Merchandise Inventory Transactions

Recording merchandise inventory transactions under the perpetual inventory system has been described and illustrated in the preceding sections. These transactions involved purchases, purchases returns and allowances, freight, cost of merchandise sold (from sales), and customer returns. Exhibit 9 summarizes how these transactions are recorded in T account form.

Exhibit 9Recording Merchandise Inventory Transactions

 

6-2fDual Nature of Merchandise Transactions

Each merchandising transaction affects a buyer and a seller. In Exhibit 10, a series of merchandise transactions are presented. For each transaction, the journal entry that should be recorded by both the seller (Scully Company) and the buyer (Burton Company) is shown.

Exhibit 10Illustration of Merchandise Inventory Transactions for Seller and Buyer

 

Example Exercise 6-5

Transactions for Buyer and Seller

Obj. 2

1. Sievert Co. sold merchandise to Bray Co. on account, $11,500, terms 2/15, n/30. The cost of the merchandise sold is $6,900. Journalize the entries for Sievert Co. and Bray Co. for the sale, purchase, and payment of amount due. Assume that all discounts are taken.

Follow My Example 6-5

Answer

Practice Exercises: PE 6-5A, PE 6-5B

6-2gSales Taxes and Trade Discounts

Sales of merchandise often involve sales taxes. Also, the seller may offer buyers trade discounts.

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. For example, the seller would record a sale of $100 on account to Lemon Co., subject to a tax of 6%, as follows:

 

On a regular basis, the seller pays to the taxing authority (state) the amount of the sales tax collected. The seller records such a payment of $2,900 as follows:

 

Business Connection

Sales Taxes

While there is no federal sales tax, most states have enacted statewide sales taxes. In addition, many states allow counties and cities to collect a “local option” sales tax. Delaware, Montana, New Hampshire, and Oregon have no state or local sales taxes. Tennessee (9.45%), Washington (8.8%), and Louisiana (8.75%) have the highest average combined rates (including state and local option taxes). Several towns in Tuscaloosa County, Alabama, have the highest combined rates in the United States of 11%, while Chicago, Illinois, has the highest combined city rate of 10.25%.

What about companies that sell merchandise over the Internet? The general rule is that if the company ships merchandise to a customer in a state where the company does not have a physical location, no sales tax is due. For example, a customer in Montana who purchases merchandise online from a New York retailer (which has no physical location in Montana) does not have to pay sales tax to either Montana or New York.

Source: The Sales Tax Clearinghouse at www.thestc.com/FAQ.stm.

Trade Discounts

Wholesalers are companies that sell merchandise to other businesses rather than to the public. Many wholesalers publish or upload sales catalogs online. However, wholesalers often offer special discounts to government agencies or businesses that order large quantities. Such discounts are called trade discounts.

Sellers and buyers do not normally record the list prices of merchandise and trade discounts in their accounts. For example, assume that an item has a list price of $1,000 and a 40% trade discount. The seller records the sale of the item at $600 [$1,000 less the trade discount of . Likewise, the buyer records the purchase at $600.

6-3The Adjusting Process

Obj. 3

Thus far, the chart of accounts and the recording of transactions for a merchandising business (NetSolutions) have been described and illustrated. Next, the adjusting process for a merchandising business is described and illustrated. This discussion focuses on the following adjusting entries that differ from those of a service business:

• Inventory Shrinkage
• Customer Returns and Allowances

6-3aAdjusting Entry for Inventory Shrinkage

Under the perpetual inventory system, the merchandise 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 Merchandise Inventory. This difference is called a inventory shrinkage or inventory shortage.

To illustrate, NetSolutions‘ inventory is as follows on December 31, 2020:

 

At the end of the accounting period, inventory shrinkage is recorded by the following adjusting entry:

 

After the preceding entry is recorded, the balance of Merchandise Inventory agrees with the physical inventory on hand at the end of the period. Since inventory shrinkage cannot be totally eliminated, it is considered a normal cost of operations. If, however, the amount of the shrinkage is unusually large, it may be disclosed separately on the income statement. In such cases, the shrinkage may be recorded in a separate account, such as Loss from Inventory Shrinkage.

Example Exercise 6-6

Inventory Shrinkage

Obj. 3

1. Pulmonary Company’s perpetual inventory records indicate that $382,800 of merchandise should be on hand on March 31, 2019. The physical inventory indicates that $371,250 of merchandise is actually on hand. Journalize the adjusting entry for the inventory shrinkage for Pulmonary Company for the year ended March 31, 2019. Assume that the inventory shrinkage is a normal amount.

Follow My Example 6-6

Answer

Practice Exercises: PE 6-6A, PE 6-6B

Integrity, Objectivity, and Ethics in Business

The Cost of Employee Theft

One survey reported that the 24 largest U.S. retail store chains have lost more than $6 billion to shoplifting and employee theft. The stores apprehended over 1 million shoplifters and dishonest employees and recovered more than $161 million from these thieves. Approximately 1 out of every 36 employees was apprehended for theft from his or her employer. Each dishonest employee stole approximately 6 times the amount stolen by shoplifters ($665.77 versus $113.30).

Source: Jack L. Hayes International, 24th Annual Retail Theft Survey, 2012.

6-3bAdjusting 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:

1. 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.
2. 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 merchandise sold.

To illustrate, assume the following for NetSolutions on December 31, 2020, before any adjustments:

 

On December 31, 2020, NetSolutions makes the following two adjusting entries:

 

The first adjusting entry reduces 2020 sales by the amount of estimated refunds that may occur in 2021. Since 1% of sales are expected to be refunded, Sales is debited for . In addition, a liability is recorded for $7,154 by crediting Customer Refunds Payable for the estimated customer refunds in 2021.

The second adjusting entry debits the asset Estimated Returns Inventory and reduces Cost of Merchandise Sold for the cost of merchandise that is expected to be returned in 2021 of $5,000. Estimated Returns Inventory is debited rather than Merchandise Inventory because the type of merchandise returned will not be known until the returns actually occur.

After the adjusting entries are posted to the ledger, Estimated Returns Inventory will have an adjusted balance of , and Customer Refunds Payable will have a balance of . Estimated returns inventory of $5,300 is reported on the balance sheet in Exhibit 14 as a current asset following Merchandise Inventory. Customer refunds payable of $7,954 is reported in Exhibit 14 as a current liability following Accounts Payable. The adjusting entries ensure that the current period sales are matched with the related cost of merchandise sold on the income statement.

Example Exercise 6-7

Customer Allowances and Returns

Obj. 3

Assume the following data for Bighorn Inc. before its year-end adjustments:

 

Journalize the adjusting entries for the following:

Follow My Example 6-7

1. Estimated customer refunds and allowances

Answer

2. Estimated customer returns

Answer

Practice Exercises: PE 6-7A, PE 6-7B

6-4Financial Statements for a Merchandising Business

Obj. 4

Although merchandising transactions affect the balance sheet in reporting inventory, they primarily affect the income statement. An income statement for a merchandising business is normally prepared using either a multiple-step or single-step format.

6-4aMultiple-Step Income Statement

The 2020 income statement for NetSolutions is shown in Exhibit 11. This form of income statement, called a multiple-step income statement, contains several sections, subsections, and subtotals.

Exhibit 11Multiple-Step Income Statement

 

Sales

The total amount of sales to customers for cash and on account is reported in this section. NetSolutions reported sales of $708,255 for the year ended December 31, 2020.

Cost of Merchandise Sold

As shown in Exhibit 11, NetSolutions reported cost of merchandise sold of $520,305 during 2020. This amount is the cost of merchandise sold to customers. Cost of merchandise sold may also be reported as cost of goods sold or cost of sales.

Gross Profit

The excess of sales over cost of merchandise sold is gross profit. As shown in Exhibit 11, NetSolutions reported gross profit of $187,950 in 2020.

Link to Dollar Tree

Dollar Tree reports its income using the multiple-step income statement format.

Income from Operations

Income from operations, sometimes called operating income, is determined by subtracting operating expenses from gross profit. Operating expenses are normally classified as either selling expenses or administrative expenses.

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, and advertising.

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, and office supplies used.

See Appendix B for more information.

Each selling and administrative expense may be reported separately as shown in Exhibit 11. However, many companies report selling, administrative, and operating expenses as single line items, as follows for NetSolutions:

 

Other Revenue and Expense

Other revenue 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 revenue include revenue from interest, rent, and gains resulting from the sale of fixed assets. Other expense is an expense that cannot be traced directly to the normal operations of the business. Examples of other expenses include interest expense and losses from disposing of fixed assets.

Other revenue and other expense are offset against each other on the income statement. If the total of other revenue exceeds the total of other expense, the difference is added to income from operations to determine net income. If the reverse is true, the difference is subtracted from income from operations. The other revenue and expense items of NetSolutions are reported as follows and in Exhibit 11:

 

6-4bSingle-Step Income Statement

An alternate form of income statement is the single-step income statement. As shown in Exhibit 12, the income statement for NetSolutions deducts the total of all expenses in one step from the total of all revenues.

Exhibit 12Single-Step Income Statement

 

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.

6-4cStatement of Owner’s Equity

The statement of owner’s equity for NetSolutions is shown in Exhibit 13. This statement is prepared in the same manner as for a service business.

Exhibit 13Statement of Owner’s Equity for Merchandising Business

 

6-4dBalance Sheet

The balance sheet for NetSolutions is shown in Exhibit 14. In Exhibit 14, merchandise inventory of $62,150 and estimated returns inventory of $5,300 are reported as current assets and the current portion of the note payable of $5,000 is reported as a current liability.

Exhibit 14Balance Sheet for Merchandising Business

 

6-4eThe Closing Process

The closing entries for a merchandising business are similar to those for a service business. The two closing entries for a merchandising business are as follows:

1. Debit each revenue account for its balance, credit each expense account for its balance, and credit owner’s capital account for net income. Debit the owner’s capital account for a net loss. Cost of merchandise sold is a temporary account and is closed like an expense account.
2. Debit the owner’s capital account for the balance of the drawing account and credit the drawing account.

The two closing entries for NetSolutions are as follows:

 

After the closing entries are posted to the accounts, a post-closing trial balance is prepared. The only accounts that should appear on the post-closing trial balance are the asset, contra asset, liability, and owner’s capital 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.

Chapter Review

6-6aAppendix

The Periodic Inventory System

Throughout this chapter, the perpetual inventory system was used to record purchases and sales of merchandise. Not all merchandise businesses, however, use the perpetual inventory system. For example, small merchandise 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. For these reasons, a business may elect to use the periodic inventory system.

Under the periodic inventory system, purchases are normally recorded at their invoice amount. If the invoice is paid within the discount period, the discount is recorded in a separate account called Purchases Discounts. Likewise, purchases returns are recorded in a separate account called Purchases Returns and Allowances.

Chart of Accounts Under the Periodic Inventory System

The chart of accounts for NetSolutions under a periodic inventory system is shown in Exhibit 15. The accounts used to record transactions under the periodic inventory system are highlighted in Exhibit 15.

Exhibit 15Chart of Accounts Under the Periodic Inventory System

 

Recording Merchandise Transactions Under the Periodic Inventory System

Using the periodic inventory system, purchases of inventory are not recorded in the merchandise 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 merchandise 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 merchandise inventory on hand is taken. This physical count is used to determine the cost of merchandise sold, as will be illustrated later.

The use of purchases, purchases discounts, purchases returns and allowances, and freight in accounts are described in this section.

Purchases

Purchases of inventory are recorded in a purchases account rather than in the merchandise inventory account. Purchases is debited for the invoice amount of a purchase.

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.

Purchases Returns and Allowances

Purchases returns and allowances are recorded in a similar manner as purchases discounts. 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.

Freight In

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

The preceding periodic inventory accounts and their effect on the cost of merchandise purchased are summarized as follows:

Account	Entry to Increase	Normal Balance	Effect on Cost of Merchandise Purchased
Purchases	Debit	Debit	Increases
Purchases Discounts	Credit	Credit	Decreases
Purchases Returns and Allowances	Credit	Credit	Decreases
Freight In	Debit	Debit	Increases

Exhibit 16 illustrates the recording of merchandise transactions using the periodic system.

Exhibit 16Transactions Using the Periodic Inventory System

 

Adjusting Process Under the Periodic Inventory System

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.

Under the perpetual inventory system, the ending inventory physical count is compared to the balance of Merchandise Inventory. The difference is the amount of inventory shrinkage. The inventory shrinkage is then recorded as a debit to Cost of Merchandise Sold and a credit to Merchandise Inventory.

Under the periodic inventory system, the merchandise 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 merchandise sold as shown in Exhibit 17. This is a major disadvantage of the periodic inventory system. That is, inventory shrinkage is not separately determined.

Exhibit 17Determining Cost of Merchandise Sold Using Periodic Inventory

 

Like the perpetual inventory system, the periodic system records the same adjusting entry debiting Sales and crediting Customer Refunds Payable for estimated customer refunds and allowances of $7,154. No entry, however, is made for estimated returns inventory. Instead, cost of merchandise sold is reduced by the cost of the estimated returns inventory for the current year. The estimated cost of the returns for NetSolutions‘ 2020 sales is $5,000. This amount is subtracted from the cost of merchandise sold before estimated returns of $525,305 to yield cost of merchandise sold of $520,305 shown in Exhibit 17.

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 merchandise sold may be reported as shown in Exhibit 17.

Closing Entries Under the Periodic Inventory System

In the periodic inventory system, the purchases, purchases discounts, purchases returns and allowances, and freight in accounts are closed to Chris Clark, Capital. In addition, the merchandise 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.

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

1. 1. Debit Merchandise Inventory for its end-of-period balance based on the physical inventory.
   2. Debit Estimated Returns Inventory for the cost of the future estimated returns of the current period’s sales.
   3. Debit each revenue account and the following temporary periodic inventory accounts for their balances.
      • Purchases Discounts
      • Purchases Returns and Allowances
   4. Credit Merchandise Inventory for its balance as of the beginning of the period.
   5. Credit each expense account and the following temporary periodic inventory accounts for their balances.
      • Purchases
      • Freight In
   6. Credit the owner’s capital account (Chris Clark, Capital) for the net income. Debit the owner’s capital account for a net loss.
2. Debit the owner’s capital account (Chris Clark, Capital) and credit the owner’s drawing account (Chris Clark, Drawing) for its balance.

The two closing entries for NetSolutions under the periodic inventory system are shown in Exhibit 18.

Exhibit 18Closing Entries: Periodic Method

 

In the first closing entry, Merchandise Inventory is debited for $62,150. This is the ending physical inventory count on December 31, 2020. In addition, the cost of the estimated merchandise returns from 2020 sales is debited to Estimated Returns Inventory for $5,000. Merchandise Inventory is credited for its January 1, 2020, balance of $59,700. In this way, the closing entries reflect the effects of the beginning and ending inventory in determining the cost of merchandise sold, as shown in Exhibit 17. After the closing entries are posted, Merchandise Inventory will have a balance of $62,150 and Estimated Returns Inventory will have a balance of $5,300, which are the amounts reported on the December 31, 2020, balance sheet.

In Exhibit 18, the periodic inventory accounts are highlighted. Under the perpetual inventory system, the highlighted periodic inventory accounts are replaced with the cost of merchandise sold account.