Before we illustrate how a merchandising company accounts for the transactions in its operating cycle, let us consider the basic types of information which the company’s accounting system should develop. The company needs accounting information that will (1) meet its financial reporting requirements (2) serve the needs of company personnel in conducting daily business operations, and (3) meet any special reporting requirements such as information required by income tax authorities.
To meet its financial reporting requirement, a merchandising company must measure and record its revenue from sales transactions and also the cost of goods sold. (Other types of revenue and expenses must also be recorded, but this is done in the same manner as in a service type business.) In addition, the accounting system must provide a complete record of the company’s assets and liabilities.
The information appearing in financial statements is highly summarized. For example the amount shown as accounts receivable in a balance sheet represents the total accounts receivable at the balance sheet date. Managers and other Company employees need much more detailed accounting information that provided in financial statements. In billing customers for example the company billing clerks need to know the account receivables from amount receivable from each credit Customer. In addition, the accounting system must provide the billing clerks with the dates and amounts of all charges and payments affecting each customer's account.
Businesses which are organized as corporations must file corporate income tax returns. In many respects, the information needed for income tax purposes parallels that used in the financial statements.
Let us now see how the accounting system of a merchandising company meets the company’s needs for financial information.
General Ledger Accounts
These general ledger accounts are used in preparing financial statements and other accounting reports which summarize the financial position of a business and the results of operations. Although general ledger accounts provide a useful overview of a company’s financial activities, they do not provide much of he detailed information needed by managers and other company employees in daily operations. This detailed information is found in accounting records, called subsidiary ledgers.
A subsidiary ledger shows separately the individual items which comprise the balance of a general ledger account. For example, an accounts receivable subsidiary ledger (or customers ledger) contains a separate account for each credit customer. If the company has 500 credit customers, there will be 500 separate accounts in the accounts receivables subsidiary ledger. The balance of these 500 subsidiary ledger account add up to the balance in the accounts receivable account in the general ledger.
An accounts receivable subsidiary ledger includes all of the information needed to bill specific customers, including the amounts due, the dates and amounts of credit sales and past payments, the dates that payments are due, and the customers billing addresses. In fact, each subsidiary account provides a complete history other credit transactions between the company and a particular credit customer.
Most businesses maintain several different subsidiary. ledgers, each providing details about the composition of a different general ledger account. A general ledger account which summarizes the content of a subsidiary ledger is called a controlling account (or control account).
For convenience, the word subsidiary often is omitted in describing a T subsidiary ledger. Thus, an accounts. receivable subsidiary ledger be called the accounts receivable ledger (or customers Ledger).
Subsidiary Ledgers Needed for Merchandising Transactions
In addition to a subsidiary for accounts receivables, every merchandising company also maintains a an account payable subsidiary ledger, showing the amount owned to each creditors. Most merchandising companies also maintain an inventory subsidiary ledger, with a separate account for each type of merchandising that the company sells. Thus, the inventory ledger of large department store contains thousands of accounts. Each of these accounts costs of all units purchased, sold, and currently "in inventory".
Subsidiary ledgers are intended to meet the information needs of the company’s managers and employees. These accounting records are not used in the preparation of financial statements, nor are they usually made available to persons outside of the business organization.
Posting to Subsidiary Ledger Accounts
Any entry which affects the balance of a subsidiary ledger account also affects the balance of the related controlling account. Thus, entries affecting subsidiary ledger accounts must be posted twice—once to the subsidiary ledger account and once to the controlling account in the general ledger.
To illustrate, assume that on July 12 Hillside Company collects a $1,000 account receivable from L. Brown, a credit customer. This transaction is illustrated below in the form of a general journal entry:
Assume that in the general ledger the account number for the Cash account is 101 and the account number of the Accounts Receivable controlling account is120. Hillside also maintains an accounts receivable subsidiary ledger, in which customers accounts are arranged alphabetically. We will assume that the company has only one bank account and does not maintain a subsidiary ledger for cash.
Our original journal entry is repeated below, along with the appropriate posting references included in the LP (Ledgers Page) column:
The account numbers 101 and 120 entered in this column indicate that the entry has been posted to. both the Cash, account and the Accounts Receivable controlling account in the. general ledger. The check mark (P) indicates that the credit portion of the entry also has been posted to the account for L. Brown in the accounts receivable subsidiary ledger.
Reconciling Subsidiary Ledgers with the Controlling Account
As previously mentioned, the balance in a general ledger controlling account should be equal to the sum of the balances of all of the accounts in the related subsidiary ledger. Periodically, accountants reconcile a subsidiary of the controlling account- that is, they determine that the sum of the subsidiary account balances does, in fact, equal that of the controlling account.
Reconciling a subsidiary ledger is an internal control procedure that may bring to light certain types of errors. For example, this procedure should detect a failure to post a transaction to the subsidiary ledger or a mechanical error in computing an account balance. Unfortunately, it does not provide assurance that all transactions were posted to the correct account within the subsidiary ledger. If a debit or credit entry is posted to the wrong account in the subsidiary ledger, the subsidiary ledger and controlling account will remain “in balance.” These types of posting errors are difficult to detect and are one reason why individuals and businesses that purchase merchandise on account should review carefully the monthly billings which they receive from their suppliers.
Subsidiary Ledgers in Computer-Based Systems
At first, it may seem that maintaining subsidiary ledgers with hundreds or thousands of separate accounts would involve a great deal of work. However, business organizations that are large enough to require large subsidiary ledgers use computer-based accounting systems. In a computer-based accounting system., subsidiary ledger accounts and general ledger accounts all are posted automatically as transactions are recorded. In addition, the computer automatically reconciles the subsidiary ledgers with the controlling accounts. Thus, no significant effort is required of accounting personnel to maintain subsidiary ledgers in a computer-based system.
Two Approaches Widely Used in Accounting tor Merchandising Transactions
1 - Perpetual Inventory Systems
In a Perpetual inventory system merchandising transactions are recorded as they occur. The system draws its name from the fact that the accounting records are kept Perpetually up-to-date. Purchases of merchandise are recorded by debiting an asset account entitled Inventory when merchandise is sold, two entries are necessary: one to recognize the revenue earned and the second to recognize the related cost of goods sold. This second entry also reduces the balance of the Inventory account to reflect the sale of Some of the company’s inventory.
A perpetual inventory system usually includes an inventory subsidiary ledger. This ledger provides company personnel with up to-date information about every type of product that the company sells, including the cost and the number of units purchased, sold, and currently on hand.
To illustrate the perpetual inventory system, we will follow specific items of merchandise through the operating cycle of Computer Barn, a retail store. The transactions comprising this illustration are as follows:
Purchased 10 Regent CX-2 1 computer monitors on account from Okawa Wholesale Company. The monitors cost $600 each, for a total of $6,000; payment is due in 30 days.
Sold 2 monitors on account to RJ Travel Agency at a retail sales price of $1,000 each, for a total, of $2,000. Payment is due in 30 days.
Oct. 1 Paid the $6,000 account payable to Okawa Wholesale Company.
Oct. 7 Collected the $2,000 account receivable from RJ Travel Agency.
In addition to a general ledger, Computer Barn maintains separate subsidiary ledgers for accounts receivable, inventory, and accounts payable.
Purchases of Merchandise
Purchases of inventory are recorded at cost, Thus, Computer Barn records its purchase of the 10 computer monitors on September 1 as follows:
The data contained in this entry is posted to the general ledger and also to the subsidiary ledgers. First, the entry is posted to the Inventory and Accounts Payable controlling accounts in the general ledger. The debit to inventory also is posted to the Regent CX-21 Monitors account in the inventory subsidiary ledger.3 The quantity of monitors purchased (10) and the per-unit cost ($600) also are recorded in this subsidiary ledger account.
The credit to Accounts Payable also is posted to the account for Okawa Wholesale Company in Computer Barn’s accounts payable subsidiary ledger.
Sales of Merchandise
The revenue earned in a sales transaction is equal to the sales price of the merchandise and is credited to a revenue account entitled Sales. Except in rare circumstances, sales revenue is considered “realized” when the merchandise is delivered to the customer, even if the sale is made on account. Therefore, Computer Barn will recognize the revenue from the sale to RJ Travel Agency on September 7, as shown below:
The matching principle requires that revenue be matched (offset) with all of the costs and expenses incurred in producing that revenue. Therefore, a second journal entry is required at the date of sale to record the cost of goods sold.
Notice that this second entry is based upon the cost of the merchandise to Computer Barn, not upon its retail sales price. The per-unit cost of the Regent monitors ($600) was determined from the inventory subsidiary ledger.
Both of the journal entries relating to this sales transaction are posted to Computer Barn’s general ledger. In addition, the $2,000 debit to Accounts Receivable (first entry) is posted to the account for RJ Travel Agency in the accounts receivable ledger. The credit to Inventory (second entry) also is posted to the Regent CX-21 Monitors account in the inventory subsidiary ledger.
Payment of Accounts Payable to Suppliers:
The payment to Okawa Wholes sale Company on October 1 is recorded as follows:
Both portions of this entry are posted to the general edger. In addition, payment of the account payable is entered in the Okawa Wholesale Company account in the Computer Barn’s accounts payable subsidiary ledger.
Collection of Accounts Receivable from Customers
On October 7, collection of the account receivable from RJ Travel Agency is recorded as follows:
Both portions of this entry are posted to the general ledger; the credit to Account’s Receivable also is posted to the RJ Travel Agency account in the accounts receivable ledger.
Collection of the cash from RJ Travel Agency completes Computer Barn’s operating cycle with respect to these two units of merchandise.
The Inventory Subsidiary Ledger
An inventory subsidiary ledger includes a separate account (or “inventory card”) for each type of product in the company’s inventory. Computer Barn’s subsidiary inventory record for Regent monitors is illustrated below:
When Regent CX-21 monitors are purchased, the quantity, unit cost, and total cost are entered in this subsidiary ledger account. When any of these monitors are sold, the number of units, unit cost, and total cost of the. units sold also are recorded in this subsidiary ledger account. After each purchase or sales transaction, the “Balance” columns are updated to share the quantity, unit cost, and total cost of the monitors still on hand.
An inventory ledger provides useful information to a variety of company personnel. A few examples of the company personnel who utilize this information on a daily basis are listed below:
Sales managers use the inventory ledger at a glance which products are selling quickly and which are not.
Accounting personnel use these records to determine the unit costs of merchandise sold.
Sales personnel use this subsidiary ledger to determine the quantities of specific products currently on hand and the physical location of this merchandise.
Employees responsibility for ordering merchandising refer to the inventory ledger to determine when specific products should be reordered, the quantities to order, and the names of major suppliers.
When a physical inventory is taken, management uses the inventory ledger to determine on a product by product basis whether inventory shrinkage has been reasonable or excessive.
Taking a Physical Inventory
The basic characteristic of the perpetual inventory system is that the Inventory account is continuously updated for all purchases and sales of merchandise. Over time, however, normal inventory shrinkage usually causes some discrepancies between the quantities of merchandise shown in the inventory records and the quantities actually on hand. Inventory shrinkage refers to unrecorded inventory resulting from such factors as breakage, spoilage, employee theft, and shoplifting.
In order to ensure the accuracy of their perpetual inventory records most businesses take a complete physical count of the merchandise on hand at least once a year. This procedure is called 'taking a physical inventory' and it usually is performed near the end of the year.
Once the quantity of merchandise on hand has been determined by a physical count, the per-unit costs in the inventory ledger accounts are used to determine the total cost of the inventory. The Inventory controlling account and also the accounts in the inventory subsidiary ledger then are adjusted to the quantities and dollar amounts indicated by the physical inventory.
To illustrate assume that at year-end the Inventory controlling account and inventory Subsidiary ledger of Computer Barn both show an inventory with a cost of $72,200. A physical count however, reveals that some of the merchandise on the accounting records is missing; the items a total cost of $70,000. Computer Barn would make the following adjusting entry to correct its inventory controlling account:
Computer Barn also will adjust the appropriate accounts in its inventory subsidiary ledger to reflect the quantities indicated by the physical count. Reasonable amounts of inventory shrinkage are viewed as a normal cost of doing business and simply are debited to the Cost of Goods Sold account, as illustrated above.
Closing Entries in a Perpetual Inventory System
Revenue and expense accounts are closed at the end of each accounting period: A merchandising business with a perpetual inventory system makes closing entries which parallel those of a service-type business. The Sales account is a revenue account and is closed into the Income Summary along with other revenue accounts. The Coat of Goods Sold account is closed into the Income Summary in the same manner as the other expense accounts.
Periodic Inventory Systems
The alternative to the perpetual inventory system is called the periodic inventory system. In a periodic inventory system, no effort is made either to update the Inventory account or to record the cost of goods sold as transactions occur throughout the year. Rather, the accounting records are updated only periodically- usually at year-end.
The fact that the accounting records are not updated until year-end explains why this system is not satisfactory for a business which makes use of accounting information throughout the year. However, periodic: system is easy and inexpensive to operate and may meet the needs of a very small business.
A traditional periodic system operates as follows. When merchandise is purchased, its cost is debited to an account entitled Purchases, rather than to the Inventory account. When merchandise is sold, an entry is made to recognize the sales revenue earned, but no entry is made to record the cost of goods sold.
The foundation of the periodic inventory system is the taking of a complete physical inventory at year-end. This year-end count determines the amount of inventory to appear in. the balance sheet and also is used, as the basis for’ computing the cost of goods sold.
In this example, the business had merchandise costing $12,000 on hand at the beginning of the year. During the year, it purchased additional merchandise at a cost of $140,000. Therefore, merchandise with a total cost of $152,000 was available for sale during the year. At year-end, merchandise with a cost of $8,000 remains on hand. Thus, merchandise which had cost $144,000 is no longer on hand, and is presumed to have been sold.
Three amounts are used in computing the cost of goods sold: (1) the inventory at the beginning of the year, (2) purchases made during the year, and 3) the inventory at the end of the year. The amounts of inventory on
hand at the beginning and end of each year are determined by taking a complete physical inventory at year-end. (Only one physical inventory is taken each year; the ending inventory of one year represents the beginning
inventory of the following year.) The cost of all merchandise purchased during the year is indicated by the year-end balance in the Purchases account.
In a periodic inventory system, the closing entries are somewhat more complex than in a perpetual inventory system.
Comparison of Perpetual and Periodic Inventory Systems
Both the perpetual and periodic inventory systems produce the same results in annual financial statements. Throughout the year, however, the perpetual inventory system provides a company with a great deal of useful information which simply is not available in a periodic system.
A perpetual inventory system provides up-to-date information, about the quantity and cost of the inventory on hand and also about the cost of goods sold. This enables the company to prepare monthly or quarterly financial statements directly from the accounting records. In a periodic system, however, the amounts of inventory on hand and the cost of goods sold are not known until a physical inventory is taken at year-end. If interim financial statements are prepared, the amounts of inventory on hand and the cost of goods sold can only be estimated.
Also, a perpetual inventory system usually includes an inventory subsidiary ledger, showing for each type of product, the cost and quantities of units purchased sold, and currently on hand. A periodic system does not provide management with an inventory subsidiary ledger.
If a perpetual inventory system provides so much more useful information, why would any company use a periodic system? The periodic system has only one advantage: it is not necessary to record the cost of goods sold as sales transactions occur. Prior to the invention of electronic point of sale terminals, businesses which sold many different products had no choice but to use periodic inventory systems. A supermarket, for example, may sell between 5,000 and 10,000 different items per hour. Imagine the difficulty of determining and recording the cost of each item sold if the accounting records were maintained by hand. With modern point-of-sale terminals, however, even supermarkets are now able to use perpetual inventory systems.
In summary, technology has made the periodic inventory system all but obsolete. All large merchandising companies and manufacturing firms use perpetual inventory systems for every significant component of their inventory. Periodic systems are used only by some small businesses with manual accounting systems and by some larger companies to account for relatively minor components of their total inventory. When a periodic system is in use, it usually is modified along the lines described below.