Purchase Considerations for Merchandising Business

A quick stroll through most any retail store will reveal a substantial investment in inventory. Even if a merchant is selling goods at a healthy profit, financial difficulties can creep up if a large part of the inventory remains unsold for a long period of time. Goods go out of style, become obsolete, and so forth. Therefore, a prudent business manager will pay very close attention to inventory content and level. There are many detailed accounting issues that pertain to inventory, and a separate chapter is devoted exclusively to inventory issues. This chapter's introduction is brief, focusing on elements of measurement that are unique to the merchant's accounting for the basic cost of goods.

Merchandise Acquisition

The first phase of the merchandising cycle occurs when the merchant acquires goods to be stocked for resale to customers. The appropriate accounting for this action requires the recording of the purchase. Now, there are two different techniques for recording the purchase - depending on whether a periodic system or a perpetual system is in use. Generalizing, the periodic inventory system is easier to implement but is less robust than the "real-time" tracking available under a perpetual system. Conversely, the perpetual inventory system involves more "systemization" but is a far superior business management tool. Let's begin with the periodic system; we'll then return to the perpetual system.

Periodic Inventory System

When a purchase occurs and a periodic inventory system is in use, the merchant should record the transaction via the following entry:

The Purchases account is unique to the periodic system. The Purchases account is not an expense or asset, per se. Instead, the account's balance represents total inventory purchased during a period, and this amount must ultimately be apportioned between cost of goods sold on the income statement and inventory on the balance sheet. The apportionment is based upon how much of the purchased goods are resold versus how much remains in ending inventory. Soon, you will see the accounting mechanics of how this occurs. But, for the moment, simply focus on the concepts portrayed by this graphic:

Purchase Returns and Allowances

Recall the earlier discussion of sales returns and allowances. Now, the shoe is on the other foot. Let's see how a purchaser of inventory would handle a return to its vendor/supplier. First, it is a common business practice to contact the supplier before returning goods. Unlike the retail trade, transactions between businesses are not so easily undone. A supplier may require that you first obtain an "RMA" or "Return Merchandise Authorization." This indicates a willingness on the part of the supplier to accept the return. When the merchandise is returned to a supplier a debit memorandum may be prepared to indicate that the purchaser is to debit their Accounts Payable account; the corresponding credit is to Purchases Returns and Allowances:

Purchase returns and allowances are subtracted from purchases to calculate the amount of net purchases for a period. The specific calculation of net purchases will be demonstrated after a few more concepts are introduced.

Cash Discount

Recall the previous discussion of cash discounts (sometimes called purchase discounts from the purchaser's perspective). Discounts are typically very favorable to the purchaser, as they are designed to encourage early payment. While discounts may seem slight, they usually represent a substantial savings and should usually be taken. Consider the calendar on the facing page, assuming a purchase was made on May 1, terms 2/10,n/30. The discount can be taken if payment is made within the "green shaded" days (or potentially one additional day, depending on the specific agreement). The discount cannot be taken during the yellow shaded days (of which there are twenty, as noted). The bill becomes past due during the "red shaded days." What is important to note here is that skipping past the discount period will only achieve a 20-day deferral of the payment. If you consider that you are "earning" a 2% return by paying 20 days early, it is indeed a large savings. Consider that there are more than 18 twenty-day periods in a year (365/20), and, at 2% per twenty-day period, this equates to over a 36% annual interest cost equivalent.

Discount terms vary considerably. Here are some examples:

o 1/15, n/30 ~ 1% if paid within 15 days, net in 30 days

o 1/10, n/eom ~ 1% if paid within 10 days, net end of month

o 5/10, n/60 ~ 1 % if paid within 10 days, net in 60 days

Occasionally, a company may opt to skip a discount. In the case of the half-percent discount example, notice that the net amount is not due until the 60th day. Perhaps the purchaser would conclude that the additional 50 days is worth forgoing the half-percent savings, as the annual interest cost equivalent is only about 3.65% (365/50 = 7.3 "periods" per year ~ times 0.5% per "period"). But, this is the exception rather than the rule. In short, taking the discounts usually makes good economic sense!

A business should set up its accounting system to timely process and take advantage of all reasonable discounts. In a small business setting, this might entail using a hanging-file system where invoices are filed for payment to match the discount dates. A larger company will usually have an automated payment system where checks are scheduled to process concurrent with invoice discount dates. Very large payments, and global payments, are frequently set up as "wire transfers." This method enables the purchaser to retain use of funds (and the ability to generate investment income on those funds) until the very last minute. This is considered to be a good business practice.

However, there is an ethical issue for you to consider. Many vendors will accept a "discounted payment" outside of the discount period. In other words, a purchaser might wait 30, 60, or 90 days and still take the discount! Some vendors are glad to receive the payment and will still grant credit for the discount. Others will return the payment and insist on the full amount due. Is it a good business practice to "bend the terms" of the agreement to take a discount when you know that your supplier will stand for this practice? Is it ethical to "bend the terms" of the agreement? If you discuss this with your classmates, you will find a diversity of opinion.