Although there are many ways in which retail businesses operate, most of them share a few common characteristics:
As is always the case, the general ledger accounts should reflect the nature of the business being carried on. Establishing these accounts requires a consideration of the following questions:
Example - Setting Up Accounts
Jo-Jo’s operates four convenience stores in a large city in Manitoba. The store sells a small number of grocery items, snack foods, confections, tobacco products, newspapers and magazines. Jo-Jo’s collects GST on most items it sells (other than some groceries) and PST on a similar variety of items. Jo-Jo’s sets up its accounts using the following structure. Each store is assigned a suffix which follows its accounts: 001 is the main store, 002 is the store in the north end, 003 is the store in the south end and store 004 is the store in the west end. Inventory accounts are set up for snack foods, confections, basic groceries (those that are zero-rated for GST purposes), other (non zero-rated) groceries, publications, tobacco products and miscellaneous sales. A selection of accounts from the trial balance would look like this: This only is required for balance sheet accounts as the accounting software is set up for departments using “Classes” which allocate the income statement amounts.
The structure of the accounts in the example given above should be fairly obvious. Using a uniform system for codifying the accounts (“6” always means “tobacco”) makes it easier to accumulate and analyze information. With this type of establishment, software that has a departmental feature should be used. All income statement amounts should be allocated to the correct location when posting.
Most computerized accounting systems provide a great deal of flexibility in setting up, summarizing, and manipulating general ledger accounts in this manner.
There is a caution, however, that the experienced bookkeeper will always keep in mind: the more detail there is in the accounts, the more work there is in ensuring that data is entered accurately. The greater the number of accounts involved, the more likely it is that errors will be made.
Accounts should therefore only be set up to accumulate information to the level of detail that management requires.
Example - More Detail than is Needed
When the accounting systems for Jo-Jo’s was set up, it was decided to track separately the sales of bread, margarine, butter, milk, fruit and fruit juices. Separate accounts were set up for each. As Jo-Jo’s does not have a bar code scanning system, the sales clerks are required to punch the correct key on the cash register when they enter a sale in order that it is classified correctly. Given the high turnover and the relatively low level of expertise the sales staff has, inaccurate information is the norm. Management does not use this sales information in any event. Because these goods are perishable, sales, inventory and re-ordering are monitored personally by the store managers.
There is no doubt that the single most important bookkeeping function for most retailers relates to accounting for inventory.
A retailer is concerned with:
There are two basic ways in which an inventory system can be established: a perpetual inventory system and a periodic inventory system. There are several ways in which inventory can be valued.
In a perpetual inventory system, the accounting records purport to reflect at all times a current record of the quantity of each item of inventory that is in stock and its value. Thus, a perpetual system tracks both quantities and value in real time, as it were.
In a periodic system, no attempt is made to track inventory quantities or values on a day-to-day basis. Rather, inventory quantities are determined by physically counting stock periodically and valuing that physical count.
Comparison - Perpetual and Periodic Inventories
When the accounting systems for Jo-Jo’s was set up, it was decided to track separately the sales of bread, margarine, butter, milk, fruit and fruit juices. Separate accounts were set up for each. As Jo-Jo’s does not have a bar code scanning system, the sales clerks are required to punch the correct key on the cash register when they enter a sale in order that it is classified correctly. Given the high turnover and the relatively low level of expertise the sales staff has, inaccurate information is the norm. Management does not use this sales information in any event. Because these goods are perishable, sales, inventory and re-ordering are monitored personally by the store managers. PerpetualPeriodicInventory quantities Always available in the general ledgerOnly available when a count has taken placeInventory values Always available in the general ledgerOnly available when a count has been pricedCost of sales Accurate as goods are sold Only quantified accurately once a count has taken place and has been priced
It will be obvious that a perpetual system gives much more timely and, at least in theory, accurate information. Why would anyone not use a perpetual inventory system?
There is a great deal more effort required to create and maintain a perpetual inventory system than to maintain a periodic system. In a perpetual system, every transaction that can affect inventory – a purchase, a sale, shrinkage due to theft, spoilage or waste, a return – must be accounted for and recorded to the level of detail reflected in the general ledger.
In a periodic system far less effort is required to account for day-to-day transactions, as only aggregate values are accounted for until the accounts are ‘trued-up’ with a physical count.
Recording Inventory Transactions
Purchase - perpetual Dr: Inventory - charged to specific item/categoryXXX Cr: Cash/payable XXX Purchase - periodic Dr: Purchases – generally not segregated by itemXXX Cr: Cash/payable XXX Sale - perpetual Dr: Cash/accounts receivableYYY Dr: Cost of sales – charged to specific item/categoryXXX Cr: Inventory – charged to specific item/category XXXCr: Sales YYY Sale - periodic Dr: Cash/accounts receivableYYY Cr: Sales YYY Inventory Count - perpetual Dr: Cost of sales – charged to a specific item/categoryXXX Cr: Inventory – charged to a specific item/category XXX Inventory Count - periodic Dr: Cost of sales – generally not segregated by itemXXX Cr: Inventory – generally not segregated by item XXX
It will be noted that even where a perpetual inventory system is used, inventory must be counted from time to time. Even the best inventory system in the world will not reflect accurately the entire inventory that is in stock.
You’ve no doubt had the experience of going to a retail outlet looking for a particular item where the clerk keys your request into the cash register/computer and says, “Yes, we have that. Just let me check in the back.” The checking is a reflection that although the perpetual inventory system records that the goods are available for sale, the clerk knows from experience that what the computer says and what is really in the back are not always the same thing!
When a perpetual inventory system is used, a periodic physical count is needed to ensure that the accounting system has accurate information. Unlike a periodic system, where the entire inventory is typically counted at one time, a perpetual system is usually subject to a cycle count.
In a cycle count, only certain categories of inventory are counted at any given time. Generally, high value or high turnover items are counted more frequently – perhaps monthly – and goods that are less valuable or which do not turn over rapidly may only be counted annually.
Most retailers today use a perpetual inventory system. Modern computerized accounting systems have made it relatively easy to keep track of inventory by specific item. Bar coding, in particular, greatly facilitates the recording of a sale and the almost unerring removal of goods from inventory – automatically and without any intelligent input from the person recording the sale.
Where the goods involved are relatively easy to count or where sales transactions are not frequent, it may still make sense to use a periodic inventory system. A long-established business, which might best be served by a perpetual inventory system, may be unwilling to make the required investment in systems, processes and time to change.
No matter what system is used for recording inventory quantities, inventory must be valued whenever a financial statement is to be prepared. The accurate valuation of inventory – knowing both how many units are in inventory and how much each is worth – is essential to the determination of income.
For financial statement purposes, according to IAS 2 and ASPE section 3031, the inventory must now be valued at the lower of cost and net realisable value.
Canadian income tax rules state that the inventory evaluation used must be consistent with current Canadian GAAP. Therefore the only method available is the lower of cost and net realisable value. Furthermore, the income tax system imposes limits on how a business can determine the cost of its inventory.
Valuing inventory at the lower of cost or fair market value generally gives the most conservative measure of inventory and, accordingly, income and this method is by far the most commonly encountered.
Cost can be defined in many, many ways but for income tax purposes only three methods are generally accepted:
Although accounting theory recognizes a fourth method for determining cost – the last-in, first-out method – this method cannot be used for income tax purposes and very few businesses ever use it.
Software generally uses the average cost method for items that are not individually itemized within the inventory, such as automobiles by VIN’s. For these individually items, the specific cost method is used.
When dealing with inventory, fair market value means either replacement cost or net realizable value. The former is a measure of what it would cost to replace an item of inventory, including all related costs in getting the inventory into stock – freight, duties, sales taxes (if any), stocking fees, etc. Net realizable value measures the net amount that would be realized on a sale of the property, after taking into account all costs of the sale – shipping, sales commissions, etc.
If goods are being sold at a profit (so net realizable value is greater than cost) and costs are increasing (so replacement cost is also greater than cost), fair market value, no matter how determined, will normally be greater than cost. For this reason, businesses typically do not choose to value inventory at fair market value. Such a valuation simply accelerates the recognition of income and the payment of taxes.
There is another method of valuing inventory which is peculiar to the retail industry and which is acceptable for income tax purposes – the retail method.
The retail method provides an estimate of the cost of inventory by discounting the retail value of the inventory by the average margin realized on the sale of such goods during a period. This is done as follows:
At first blush it may appear that the retail method is more difficult to apply than keeping track of actual cost, but the retail method can be useful where a retailer has many individual categories of inventory, each of which has a relatively low value, but where margins tend to be similar. Margins can be measured either on sales (the ‘sales margin’) or on cost (the ‘markup’).
Example - Margins
Goods that are purchased for $600 are sold for $1,000. The sales margin is 40% - $400 margin/$1,000 sales price. The markup is 67% - $400 markup/$600 cost.
Note – the CRA accepts the retail method as a reasonable measure of cost.
Computerized accounting systems may include utilities which make it easier for a bookkeeper to apply the lower of cost or market rule, but whether such a system is used or not, the process the bookkeeper goes through is similar.
Step 1 Obtain a listing of inventory to be valued. In a perpetual system this will simply be a print out of the inventory listing, usually showing a description, quantities and cost, however cost is determined in the accounting system. In a periodic system, the starting point will be the physical inventory listing from the most recent count.
Step 2 For each item or category of inventory, determine a unit fair market value. If replacement cost is being used, this will be a unit purchase price plus any related costs involved in getting the item into stock. If net realizable value is being used, this will be the estimated sales price less any costs involved in making the sale.
Step 3 Where fair market value is lower than cost, revalue those items/categories of inventory at the lower value.
Step 4 Adjust the total carrying value of inventory to reflect the lower valuation.
Our Accounting News article “Sales Taxes in Canada” contains a detailed discussion of the GST/HST and the various provincial sales taxes. There are a few issues that are of particular concern to retailers.
The federal GST applies to most goods and services except those that are zero-rated (which are actually taxed at 0%) and those that are exempt. There are very few goods that are exempt, so most retailers are simply faced with determining whether the goods that are being sold are zero-rated or taxed at the regular GST rates of 5% or 15% NB, NL, Nova Scotia and PEI (13% ON).
Most computerized accounting systems allow a tax code to be associated with a particular customer or inventory item so that tax is applied automatically when the goods or services are sold.
The provincial retail sales taxes generally apply only to goods sold in a retail sale. Most retailers who sell into provinces that have such a tax must register and collect PST on their sales.
A status Indian who lives on a reserve is exempt from paying tax on property on a reserve, by virtue of the Indian Act.
Administratively, the various taxing agencies accept that an off-reserve sale to a status Indian will be exempt from sales tax so long as the retailer makes a notation of the purchaser’s name and takes a copy of the purchaser’s treaty card and, for GST, the goods are delivered to the reserve by the vendor, or the vendor’s agent. There are exceptions to this GST rule when the reserve is in a remote location.
A retailer may offer discounts to certain customers and/or may be able to claim discounts from suppliers. For example, in some industries it is not unusual for a supplier to offer a so-called ‘prompt payment discount’ which provides a discount to a purchaser if payment is made within a specified period of time. A volume discount may be offered, which permits a price discount if a certain level of sales or purchase activity is met.
Example - Prompt Payment Discount
Jo-Jo’s has a supplier whose invoices contain the following caption:• "2%/10, net 30" This means the full invoice price is due within 30 days but that the supplier will permit a 2% discount on the purchase price if payment is made within 10 days.
Although a discount taken (or given) could simply be accounted for by recording only the net value of the transaction, it is usually a good idea to record the discount separately in the general ledger. Recording the discount separately allows management to assess the value or cost of discounts. Where a retailer has a policy of taking all discounts offered, it may make more sense to record discounts not taken.
Note that a prompt payment discount does not affect the amount of GST/HST that applies to the transaction, which remains based on the original invoice amount, not the amount after the discount. The same principle applies, generally, to provincial sales taxes.
Recording Inventory Transactions
Jo-Jo has a supplier who offers 2%/10, net 30 terms. Jo-Jo receives an invoice for $10,600 (ignoring taxes) and makes payment in sufficient time to claim the discount. If the discount is not recorded separately, the entry is: Dr: Purchases10,388 Cr: Cash 10,388 If the discount is recorded separately: Dr: Purchases10,600 Cr: Purchase discounts taken (cost of sales contra a/c) 212Cr: Cash 10,388 If the policy is to claim all discounts and the payment is too late to claim the discount, the entry is: Dr: Purchases10,388 Dr: Purchase discounts lost (cost of sales a/c)212 Cr: Cash 10,600
Similar principles would apply to discounts given to customers.
The way in which a chart of accounts is set up for a retailer will vary with the nature of the goods sold and how the business operates – in particular, the level of detail to be reported.
Inventory can be recorded and managed either through a perpetual inventory system or a periodic system.
Inventory is typically valued either at cost or at the lower of cost and fair market value. Both ‘cost’ and ‘fair market value’ have specific meanings.
Most retailers have to collect and account for sales taxes.
We can assist you with advice and reporting as it relates to your Retail business issues such as setting up the proper accounts and the handling of inventory in Canada. Here at Green Quarter Consulting - Accounting and Bookkeeping Services for Small Businesses in White Rock South Surrey, Vancouver, Langley and Surrey BC, we assist Small Business Owners with analyzing transactions, sources of income and your tax risks and how they relate to your business strategy. Learn more about our Greenstamp CFO Services here.