General Comments for Chapter 3
Accounting for Merchandising Businesses
Chapter 3 introduces accounting for inventory transactions using the perpetual method. In
today’s high-technology environment, the perpetual system has become the predominant method
of accounting for inventories. Because the periodic method is still used by some companies, it is
included in the chapter appendix, though in less depth.
With the perpetual method, purchases and related transactions (purchase returns and
allowances, purchase discounts, and transportation-in) are recorded in the inventory account.
Likewise, sales returns and allowances and sales discounts are recorded directly in the Sales
account. The balance in the Sales account is therefore the amount of net sales, which is the first
item reported on the income statement. This presentation is consistent with the way sales are
reported in real-world financial statements.
The text explains only the net method of accounting for cash discounts. The net method is
easier to understand and theoretically superior. Indeed, GAAP requires “purchase discounts lost”
to be reported as interest in the financial statements if the amount is material. When the gross
method is used, “purchase discounts lost” is misclassified as a product cost that is first placed in
the inventory account and later recognized as cost of goods sold expense.
This chapter introduces the multistep income statement; earlier chapters used the single step
income statement. Within this context, direct your students’ attention toward the reporting of
interest. As you are aware, interest is classified as a nonoperating item on a multistep income
statement and as an operating activities item on the statement of cash flows. This inconsistency
provides an opportunity to discuss how accounting standards are developed. If you have not yet
talked about the role of the Financial Accounting Standards Board, this is a good time to do so.
Students should learn that accounting standards evolve through a participative process influenced
by changes in society. While we may strive for perfection, we are not likely to attain it. Good
accounting requires the ability to adapt and to exercise judgment. It is not a discipline of hard
facts and natural laws, but a living social science.
Detailed Outline of a Lesson Plan for Chapter 3
I. Define merchandise inventory as goods purchased for resale to customers, then
distinguish product costs from selling and administrative costs. Explain that product
costs are first accumulated in inventory accounts and then expensed when the products
are sold, regardless of when the costs were initially incurred. In contrast, selling and
administrative costs are usually, though not always, expensed in the period in which they
are incurred. The most common exception is the cost of long-term assets. While the cost
of obtaining a long-term asset may be incurred in a single accounting period, expense
recognition occurs over multiple periods. Because selling and administrative costs are
usually matched with the period in which they are incurred, they are frequently called
period costs.
II. Sketch adjacent income statements on the chalkboard to contrast service businesses
and merchandising businesses. Explain that merchandising companies have the same
types of expenses as service companies (salaries, utilities, advertising, depreciation), but
unlike service companies, merchandising companies also have cost of goods sold.
Introduce the multistep income statement by showing the subtotal for gross margin (net
sales minus cost of goods sold) before subtracting period expenses. Initially, avoid more
advanced topics such as accounting for returns, allowances, discounts, and freight.
Introduce these topics after the students understand the basic events illustrated in
Demonstration Problem 3-1.
III. Work Demonstration Problem 3-1. We suggest you write each transaction on the
board one step at a time. Allow students time to record each event in the financial
statements model. Show them the answer before moving on to the next transaction. The
problem, solution, and work papers are available if you desire to duplicate them for your
students.
The requirements call only for preparing an income statement and a balance sheet.
The statement of changes in stockholders’ equity and the statement of cash flows are not
required. Instead of requiring a full set of formal statements each time you or students
work a problem, require only the relevant ones. In this problem the income statement is
required because it appears in a new format (multistep). Likewise, students need to see
the reporting of inventory on the balance sheet. It is meaningful for students to prepare
these two statements in addition to showing financial statement effects in the statements
model.
Use the statements model to demonstrate the cash flow effects. Emphasize that
although the company paid $4,500 cash for inventory, only $3,500 of that cost was
charged to cost of goods sold. The remaining amount of product cost ($1,000) is reported
as inventory on the balance sheet. This illustration demonstrates that product costs are
expensed in the period in which inventory is sold regardless of when cash for it is paid.
IV. Demonstration Problem 3-2 provides a platform for explaining such advanced
topics as returns, allowances, cash discounts, and freight costs. Work the problem in
steps, explaining each topic as it arises in the problem. Event No. 2 introduces cash
discount terms. Explain the meaning of 2/10, n/30. Event No. 3 involves freight costs.
At this point you should explain FOB shipping point and FOB destination. The event
invites you to introduce the general topic of freight costs, going beyond the specific
freight transaction described in the problem. Draw pictures! Put rectangles on the board
representing the merchandising company, a supplier, and a customer. Draw trucks
traveling between the companies. Explain to your students that we are viewing all
inventory transactions from the merchandising company’s point of view. Help students
see that transactions between the merchandising company and its suppliers are purchases,
though from the supplier’s point of view they are sales. In this way your lecture flows
from the problem. Use Event No. 4 to introduce purchase returns and allowances. Using
this approach, you will explain sales and purchase returns and allowances, cash
discounts, and freight costs by the time you have finished Demonstration Problem 3-2.
V. Explain that failure to pay for purchases within the discount period results in
interest costs. Refer to the payment LDS made in Event No. 5 of Demonstration
Problem 3-2. If LDS had paid after the discount period expired, it would have owed the
supplier $50,000 (list price of $54,000 purchase – list price of $4,000 purchase return),
not $49,000. The $1,000 difference represents interest expense and the payment would
have been recorded as follows:
2014
Cash
+
Acct.
Rec.
+
Inv.
=
Acct.
Pay.
+
Com.
Stock
+
Ret. Ear.
(5) Pay Acct. Payable
(50,000)
(49,000)
(1,000)
VI. If you plan to include the appendix material, use Demonstration Problem 3-3 to
introduce the periodic inventory method. This problem uses the same transactions as
Demonstration Problem 3-2, illustrating that either of two different accounting methods
can be used to record the same data. Prepare a schedule of cost of goods sold. Compare
the amount of cost of goods sold in the schedule with the amount of cost of goods sold
determined using the perpetual method. Ask your students to prepare a set of financial
statements using the periodic method. Chances are few of them will realize that the
statements resulting from the periodic method are identical to the statements resulting
from the perpetual method. We usually let them finish the income statement before
stopping them. Preparing at least one comparative statement demonstrates that the two
methods are alternative approaches to the same end.
VII. Discuss accounting for lost, damaged, or stolen merchandise. Illustrate by asking
your students to return to Demonstration Problem 3-2. Suppose a physical count
establishes that only $9,000 of inventory is actually on hand at the end of the accounting
period. Recall that the balance in the inventory account at the end of the period was
$10,800. Have students explain how the $1,800 loss would affect the financial
statements by recording the event in a statements model like shown below. The
“Balances” row displays the amounts in various categories after recording all of the
Demonstration Problem 3-2 transactions. Expenses are shown as one single total
($39,200 + $1,200 + $9,600 = $50,000). These balances agree with the financial
statements solution for Demonstration Problem 3-2. The row labeled “Inv. Loss”
demonstrates the effects of the inventory loss on the financial statements. The “Totals”
row displays the balances after recognizing the inventory loss.
Assets
=
Claims
Rev.
−
Exp.
=
Net Inc.
Cash Flow
Cash
+
Accts.
Rec.
+
Inv.
=
Com.
Stk.
+
Ret. Ear.
Balances
48,700
+
13,860
+
10,800
=
60,000
+
13,360
63,360
–
50,000
=
13,360
48,700 NC
Inv. Loss
-0-
+
-0-
+
(1,800)
=
-0-
+
(1,800)
-0-
–
1,800
=
(1,800)
-0-
Totals
48,700
+
13,860
+
9,000
=
60,000
+
11,560
63,360
–
51,800
=
11,560
48,700 NC
VIII. Time considerations and homework assignments. Allot two to three hours of class
time for Chapter 3. Exercise 3-2 contrasts merchandising companies with service
companies; Exercises 3-3 through 3-5 require students to demonstrate the effect of
inventory transactions on the financial statements. Exercise 3-15 involves preparation of
single step and multistep income statements. Exercise 3-12 shows the interest costs of
failure to pay for purchases within the discount period. Problems 3-25 and 3-26 provide
a comprehensive follow-up of Demonstration Problem 3-2. Problem 3-28 focuses on
preparing financial statements using the periodic method.
IX. Enrichment. By now you are familiar with the types of cases included at the end of each
chapter. You probably have a preference consistent with your personal objectives. We
leave to your judgment the most appropriate form of enrichment. You may choose to use
the study guide, computer tutorials, or other supplements that accompany the text.
Demonstration Problems for Chapter 3
Demonstration Problem 3-1: Inventory Purchase/Sale, Perpetual
Method
The following events pertain to Jefferson Hardware Store. Jefferson uses the perpetual inventory
method.
1. Jefferson Hardware was started on January 1, 2014 when it acquired $5,000 cash by issuing
common stock.
2. The store paid $4,500 cash to purchase inventory.
3. Jefferson sold for $6,000 cash inventory that cost $3,500.
4. During 2014, the store paid $2,000 cash for operating expenses.
Required
Record the events in a financial statements model. Then prepare an income statement and a
balance sheet.
Demonstration Problem 3-2: Perpetual Inventory Transactions
Lisa’s Dress Shop (LDS) experienced the following events in 2014, its first year of operations.
The dress shop uses the perpetual inventory method.
1. LDS was started when it issued common stock for $60,000 cash.
2. LDS purchased on account inventory with a list price of $54,000. Payment terms were 2/10,
n/30. LDS records inventory transactions net of discounts.
3. The freight terms for the merchandise delivered in Event No. 2 were FOB shipping point.
LDS paid the freight cost of $1,000 in cash.
4. An inspection revealed that merchandise with a list price of $4,000 purchased in Event No.
2 was defective. LDS returned this merchandise to the supplier for credit.
5. LDS paid within the discount period for the inventory purchased in Event No. 2.
6. LDS sold inventory on account. LDS offers customers payment terms of 1/15, n/30. The list
price for the sale was $68,000. The net cost of the inventory sold was $42,140.
7. Customers returned some goods LDS had sold in Event No. 6. The goods had been sold for
a net price of $3,960 and had a net cost of $2,940.
8. LDS paid in cash freight cost of $1,200 for goods delivered to customers FOB destination.
9. LDS collected cash from customers who paid off accounts receivable with a list price of
$50,000 within the 15-day discount period.
10. LDS paid $9,600 in cash for other operating expenses.
Required
Record the events under an accounting equation, and prepare an income statement, a balance
sheet, and a statement of cash flows.
Demonstration Problem 3-3: Periodic Inventory Transactions
Assume Lisa’s Dress Shop (LDS) uses the periodic rather than the perpetual inventory method.
LDS determined by physical count there was $10,800 of inventory on hand at the end of 2014.
Required
Determine account balances using information in Demonstration Problem 3-2, but assuming use
of the periodic inventory method. Then prepare a schedule of cost of goods sold, an income
statement, a balance sheet, and a statement of cash flows based on the periodic method.
SOLUTIONS TO
DEMONSTRATION PROBLEMS
Demonstration Problem 3-1: Solution
Assets
=
Liab.
+
Equity
Rev.
−
Exp.
=
Net Inc.
Cash Flow
No.
Cash
+
Inven.
=
Liab.
+
C. Stk.
+
Ret. Ear.
Beg. Bal.
-0-
+
-0-
=
-0-
+
-0-
+
-0-
-0-
–
-0-
=
-0-
-0-
1
5,000
+
-0-
=
-0-
+
5,000
+
-0-
-0-
–
-0-
=
-0-
5,000 FA
2
(4,500)
+
4,500
=
-0-
+
-0-
+
-0-
-0-
–
-0-
=
-0-
(4,500) OA
3(a)
6,000
+
-0-
=
-0-
+
-0-
+
6,000
6,000
–
-0-
=
6,000
6,000 OA
3(b)
-0-
+
(3,500)
=
-0-
+
-0-
+
(3,500)
-0-
–
3,500
=
(3,500)
-0-
4
(2,000)
+
-0-
=
-0-
+
-0-
+
(2,000)
-0-
–
2,000
=
(2,000)
(2,000) OA
Totals
4,500
+
1,000
=
-0-
+
5,000
+
500
6,000
–
5,500
=
500
4,500 NC
Jefferson Hardware Store
Financial Statements
Income Statement
For the Year Ended December 31,
2014
Sales
$6,000
Cost of Goods Sold (Product Cost)
(3,500)
Gross Margin
$2,500
Operating Expenses (Period Cost)
(2,000)
Net Income
$ 500
Balance Sheet as of December 31
Assets
Cash
$4,500
Inventory
1,000
Total Assets
$5,500
Stockholders’ Equity
Common Stock
$5,000
Retained Earnings
500
Total Stockholders’ Equity
$5,500
Demonstration Problem 3-2: Solution, Accounting Equation
2014
Cash
+
Acct.
Rec.
+
Inv.
=
Acct.
Pay.
+
Com.
Stock
+
Ret. Ear.
Beginning Balances
$ -0-
$ -0-
$ -0-
$ -0-
$ -0-
$ -0-
(1) Common Stock Issue
60,000
60,000
(2) Inventory Purchase
52,920
52,920
(3) Transportation-in
(1,000)
1,000
(4) Purchase Return
(3,920)
(3,920)
(5) Pay Acct. Payable
(49,000)
(49,000)
(6a) Sale of Inventory
67,320
67,320
(6b) Cost of Goods Sold
(42,140)
(42,140)
(7a) Sales Return
(3,960)
(3,960)
(7b) Cost of Goods Sold
2,940
2,940
(8) Transportation-out
(1,200)
(1,200)
(9) Collect Acct. Rec.
49,500
(49,500)
(10) Other Oper. Exp.
(9,600)
(9,600)
−−−−−
−−−−−
−−−−−
−−−−−
−−−−−
−−−−−
Ending Balances
$48,700
$13,860
$10,800
$ -0-
$60,000
$13,360
════
════
═════
════
═════
═════
Demonstration Problem 3-2: Solution, Financial Statements
Lisa’s Dress Shop
Financial Statements
Income Statement
For the Year Ended December 31,
2014
Net Sales
$63,360
Cost of Goods Sold (Product Cost)
(39,200)
Gross Margin
$24,160
Transportation-out (Period Cost)
(1,200)
Other Operating Expenses (Period Cost)
(9,600)
Net Income
$13,360
Balance Sheet at December 31
Assets
Cash
$48,700
Accounts Receivable
13,860
Inventory
10,800
Total Assets
$73,360
Stockholders’ Equity
Common Stock
$60,000
Retained Earnings
13,360
Total Stockholders’ Equity
$73,360
Statement of Cash Flows
Net Cash Flow from Operating Activities1
$(11,300)
Net Cash Flow from Investing Activities
-0-
Net Cash Flow from Financing Activities
60,000
Net Change in Cash
$48,700
Beginning Cash Balance
-0-
Ending Cash Balance
$48,700
1Net cash flow from operating activities: $49,500 inflow from revenue less outflows of $1,000
Demonstration Problem 3-3: Solution
Account Balances – Lisa’s Dress Shop – Determine account balances by showing
increases and decreases
Cash +60,000 – 1,000 – 49,000 -1,200 + 49,500 – 9,600 = 48,700
Accounts Receivable +67,320 – 3,960 – 49,500 = 13,860
Accounts Payable +52,920 – 3,920 – 49,000 = 0
Common Stock +60,000 = 60,000
Sales Revenue +67,320 = 67,320
Sales Returns and Allowances +3,960 = 3,960
Purchases +52,920 = 52,920
Purchase Returns and Allowances + 3,920 = 3,920
Transportation-in +1,000 = 1,000
Other Operating Expenses +9,600 = 9,600
Transportation-out +1,200 = 1,200
Lisa’s Dress Shop
Schedule of Cost of Goods Sold
Beginning Inventory
$ -0-
Purchases
52,920
Purchase Returns and Allowances
(3,920)
Transportation-in
1,000
Cost of Goods Available for Sale
$50,000
Ending Inventory
(10,800)
Cost of Goods Sold
$39,200
The financial statements are the same as those prepared for Demonstration Problem 3-2.
The periodic inventory method is an alternative accounting approach that produces the same
end result.
WORK PAPERS FOR
DEMONSTRATION PROBLEMS
Demonstration Problem 3-1: Work Paper
Assets
=
Liab.
+
Equity
Rev.
−
Exp.
=
Net Inc.
Cash Flow
No.
Cash
+
Inven.
=
Liab.
+
C. Stk.
+
Ret. Ear.
Beg. Bal.
-0-
+
-0-
=
-0-
+
-0-
+
-0-
-0-
–
-0-
=
-0-
-0-
1
+
=
+
+
–
=
2
+
=
+
+
–
=
3(a)
+
=
+
+
–
=
3(b)
+
=
+
+
–
=
4
+
=
+
+
–
=
Totals
4,500
+
1,000
=
-0-
+
5,000
+
500
6,000
–
5,500
=
500
4,500 NC
Jefferson Hardware Store
Financial Statements
Income Statement
For the Year Ended December 31,
2014
Sales
Cost of Goods Sold (Product Cost)
Gross Margin
Operating Expenses (Period Cost)
Net Income
$ 500
Balance Sheet as of December 31
Assets
Cash
Inventory
Total Assets
Stockholders’ Equity
Common Stock
$5,000
Retained Earnings
Total Stockholders’ Equity
$5,500
Demonstration Problem 3-2: Work Paper, Accounting Equation
2014
Cash
+
Acct.
Rec.
+
Inv.
=
Acct.
Pay.
+
Com.
Stock
+
Ret. Ear.
Beginning Balances
$ -0-
$ -0-
$ -0-
$ -0-
$ -0-
$ -0-
(1) Common Stock Issue
(2) Inventory Purchase
(3) Transportation-in
(4) Purchase Return
(5) Pay Acct. Payable
(6a) Sale of Inventory
(6b) Cost of Goods Sold
(7a) Sales Return
(7b) Cost of Goods Sold
(8) Transportation-out
(9) Collect Acct. Rec.
(10) Other Oper. Exp.
−−−−−
−−−−−
−−−−−
−−−−−
−−−−−
−−−−−
Ending Balances
$48,700
$13,860
$10,800
$ -0-
$60,000
$13,360
════
════
═════
════
═════
═════
Demonstration Problem 3-2: Work Paper, Financial Statements
Lisa’s Dress Shop
Financial Statements
Income Statement
For the Year Ended December 31,
2014
Net Sales
Cost of Goods Sold (Product Cost)
Gross Margin
$24,160
Transportation-out (Period Cost)
Other Operating Expenses (Period Cost)
Net Income
$13,360
Balance Sheet at December 31
Assets
Cash
Accounts Receivable
Inventory
Total Assets
Stockholders’ Equity
Common Stock
$60,000
Retained Earnings
Total Stockholders’ Equity
$73,360
Statement of Cash Flows
Net Cash Flow from Operating Activities1
Net Cash Flow from Investing Activities
Net Cash Flow from Financing Activities
Net Change in Cash
$48,700
Beginning Cash Balance
Ending Cash Balance
1The net cash flow from operating activities consists of an inflow from revenue less outflows
for transportation-in, payments of accounts payable, transportation-out, and other operating
expenses.
Demonstration Problem 3-3: Work Paper
Account Balances – Lisa’s Dress Shop – Determine account balances by
showing increases and decreases
Cash
Accounts Receivable
Accounts Payable
Common Stock
Sales Revenue
Sales Returns and Allowances
Purchases
Purchase Returns and Allowances
Transportation-in
Other Operating Expenses
Transportation-out
Lisa’s Dress Shop
Schedule of Cost of Goods Sold
Beginning Inventory
$ -0-
Purchases
Purchase Returns and Allowances
Transportation-in
Cost of Goods Available for Sale
Ending Inventory
Cost of Goods Sold
$39,200
The financial statements are the same as those prepared for Demonstration Problem 3-2.
The periodic inventory method is an alternative accounting approach that produces the
same end result as the perpetual inventory method.