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Part 1. Special Issues for Merchants

1. The Merchandising Operation - Sales

The discussion and illustrations in the earlier chapters were all based on businesses that generate their revenues by providing services (like law firms, lawn services, architects, etc.). Service businesses are a large component of an advanced economy. However, we also spend a lot of time in the stores or on the internet, buying the things we want or need. Such businesses are generally referred to as "merchants," and their business models are generally based upon purchasing inventory and reselling it at a higher price to customers.

Therefore, this chapter shifts focus from the service business to the merchandising business. Measuring income and reporting it on the income statement involves unique considerations. The most obvious issue is the computation and presentation of an amount called "gross profit." Gross profit is the difference between sales and cost of goods sold, and is reported on the income statement as an intermediate amount. Observe the income statement for Chair Depot below. The gross profit number indicates that the company is selling merchandise for more than cost ($200,000 in sales was generated from goods that cost $120,000 to buy). Of course, the company also incurred other operating expenses; advertising, salaries, and rent. Nevertheless, the gross profit was sufficient to easily cover those costs and leave a tidy profit to boot. The presentation of the gross profit information is very important for users of the financial statements to get a clear picture of operating success. Obviously, if the gross profit rate is small, the business might have trouble making a profit, even if sales improved. Quite the reverse is true if the gross profit rate is strong; improved sales can markedly improve the bottom-line net income (especially if operating expenses like rent, etc., don't change with increases in sales)! It is easy to see why separating the gross profit number from the other income statement components is an important part of reporting for the merchandising operation.

CHAIR DEPOT Income Statement For the Year Ending December 31, 20X3

Sales

$200,000

Cost of goods sold

120,000

Gross profit

$ 80,000

Expenses

Advertising

$ 6,000

Salaries

9,000

Rent

5,000

20,000

Net income

1.1. Sales

The Sales account is a revenue account used strictly for sales of merchandise. Sales are initially recorded via one of the following entries, depending on whether the sale is for cash or on account:

Cash sale:

1-5-X5

Cash

4,000

Sales

4,000

Sold merchandise for cash

Sale on account:

1-5-X5

Accounts Receivable

4,000

Sales

4,000

Sold merchandise on account

1.2. Sales Returns and Allowances

Occasionally, a customer returns merchandise. When that occurs, the following entry should be made:

1-9-X5

Sales Returns and Allowances

1,000

Accounts Receivable

1,000

Customer returned merchandise previously purchased on account

Sales Returns and Allowances

Notice that the above entry included a debit to Sales returns and allowances (rather than canceling the sale). The Sales returns and allowances account is a contra-revenue account that is deducted from sales; sales less sales returns and allowances is sometimes called "net sales." This approach is deemed superior because it allows interested parties to easily track the level of sales returns in relation to overall sales. Importantly, this presentation reveals information about the relative level of returns and provides a measure of customer satisfaction or dissatisfaction. Sales returns (on account) are typically documented by the creation of an instrument known as a credit memorandum. The credit memorandum indicates that a customer's account receivable balance has been credited (reduced), and that payment for the returned goods is not expected. If the preceding transaction involved a cash refund, the only difference in the entry would involve a credit to cash instead of accounts receivable. The calculation of net sales would be unaffected.

Note that use of the word "allowances" in the account title "Sales Returns and Allowances." What is the difference between a return and an allowance? Perhaps a customer's reason for wishing to return an item is because of a minor defect; they may be willing to keep the item if the price is slightly reduced. The merchant may give them an allowance (e.g., a reduction in the price they previously agreed to) to induce them not to return the item. The entry to record an allowance would be identical to that above for the agreed amount of the price reduction, and the customer would keep the inventory item. (Of course, one could use a separate account for returns and another for allowances if they wished to track information about each of these elements.)

 
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