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4-1
Chapter 4
Accounting for Merchandising Businesses
General Comments for Chapter 4
Chapter 4 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 in many cir-
cumstances, it is included in the chapter appendix, though in less depth.
With the perpetual method, purchases and related transactions (purchase returns and allow-
ances, purchase discounts, and transportation-in) are recorded in the Inventory account.
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 re-
ported in real-world financial statements. We challenge you to find a published annual report
that displays the amount of sales discounts or sales returns and allowances in the income
statement. You may want to tell your students that companies can maintain separate ac-
counts for these items if management desires to capture this information for decision-making
purposes. Regardless, these accounts are netted against gross sales before the information is
reported in financial statements.
Recall that the primary objective of the textbook is to teach students how accounting events
affect financial statements. Students do not need to learn both the gross and net methods of
accounting for cash discounts to understand how those discounts affect financial statements.
A disadvantage of traditional textbooks is information overload. The textbook addresses this
problem by reducing the number of alternative recording procedures it presents to students.
In this chapter, the text explanation of cash discounts is limited to the gross method. If stu-
dents learn in accounting principles how discounts affect financial statements, they can easily
learn the net method when they take intermediate accounting.
This chapter introduces the multistep income statement. Direct special attention toward the
reporting of interest. 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 incon-
sistency provides an opportunity to discuss how accounting standards are developed. If you
have not explained 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 democratic pro-
cess influenced by changes in society. Effective accounting requires adaptation and judg-
ment. It is governed not by natural laws, but by the needs of information users.
4-2
Using Horizontal Financial Statements Models
By now your students should understand a direct approach to explaining how accounting
events affect financial statements. You should use the horizontal financial statements model
whenever it serves your purposes. You may want to use a condensed version of the model.
For example, students should be familiar enough with financial statements to no longer need
statement labels in the model. Also, you may prefer to show net income effects in a single
column. An abbreviated statements model is shown below.
Assets
=
Liabilities
+
Equity
Net Income
Cash Flow
Alter the model as needed to make the points you are teaching. The model’s explanatory
power comes from recording individual events directly into financial statements that are vis-
ually adjacent to one another. So long as these features are retained, the model can be ex-
pressed in various levels of detail. It is a teaching tool. It is not a formal financial statement
presentation. You therefore have considerable latitude with the format of statements models.
You can use the horizontal financial statements model in conjunction with T-accounts.
Show the effects of events on statements before you show how the entries are recorded in T-
accounts or vice versa. Again, you should select the approach that best meets your teaching
objectives. Some instructors use the model extensively. Others use it sparingly. The text
supports whatever approach you find the most effective.
Detailed Outline of a Lesson Plan for Chapter 4
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 peri-
od in which they are incurred. Since 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 board to contrast service businesses
and merchandising businesses. Explain that merchandising companies have the
same types of expenses as service companies (salaries, utilities, advertising), but un-
like service companies, merchandising companies also have cost of goods sold. In-
troduce 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 illustrat-
ed in Demonstration Problem 4-1.
4-3
III. Work Demonstration Problem 4-1. This problem is so simple; you can write each
transaction on the board one step at a time. Allow students time to record each event
in the horizontal financial statements model. Show them the answer before moving
on to the next transaction. The problem, solution, and workpapers are available if
you desire to duplicate them for your students. Depending on how much you wish to
emphasize recording procedures, you may have your students record the transactions
in general journal format and then post the information into T-accounts.
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. By this point, students should be familiar enough with statement prepa-
ration that continual reinforcement is no longer necessary. The effects of events on
statements are easily reinforced through the horizontal financial statements model.
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 re-
quired because it appears in a new format (multistep). Students should also see how
inventory is reported on the balance sheet.
Use the horizontal financial 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 4-2 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
horizontally across the board representing a supplier, the merchandising company,
and a customer. Draw trucks traveling between the companies. Explain to your stu-
dents that we are viewing all inventory transactions from the merchandising compa-
ny’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 explanation flows from the problem. Use Event No.
4 to introduce purchase returns and allowances. With this approach, you will explain
sales and purchase returns and allowances, cash discounts, and freight costs by the
time you have finished Demonstration Problem 4-2.
V. Explain that failing to pay for purchases within the discount period increases the
actual cost of the inventory. Refer to the payment LDS made in Event No. 5 of
Demonstration Problem 4-2. If LDS had paid after the discount period expired, it
4-4
would have owed the supplier $50,000 (list price of $54,000 purchase – list price of
$4,000 purchase return), not $49,000. The payment would have been recorded as fol-
lows:
Cash
+
Accts.
Receiv.
+
Inventory
=
Accts.
Payable
+
Com.
Stock
+
Ret. Earn.
(5) Pay Acct. Payable
(50,000)
(50,000)
VI. If you plan to include the appendix material, use Demonstration Problem 4-3 to
introduce the periodic inventory method. This problem uses the same transactions
as Demonstration Problem 4-2, 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. You may limit your dis-
cussion to this comparison, or you may go further by requiring your students to pre-
pare journal entries using the periodic 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 4-2. Suppose a physical count
establishes that only $9,000 of inventory is actually on hand at the end of the account-
ing 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 columns after recording all of the
Demonstration Problem 4-2 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 4-2. The row labeled “Inv. Loss”
demonstrates the effects of the inventory loss on the financial statements. The “To-
tals” row displays the balances after recognizing the inventory loss.
Assets
=
Claims
Rev.
–
Exp.
=
Net Inc.
Cash Flow
Cash
+
Accts.
Rec.
+
Inv.
=
Com.
Stk.
+
Ret.
Earn.
Balances
48,700
+
14,000
+
10,800
=
60,000
+
13,500
63,500
–
50,000
=
13,500
48,700 NC
Inv. Loss
0
+
0
+
(1,800)
=
0
+
(1,800)
0
–
1,800
=
(1,800)
0
Totals
48,700
+
14,000
+
9,000
=
60,000
+
11,700
63,500
–
51,800
=
11,700
48,700 NC
4-5
VIII. Time considerations and homework assignments. Allot approximately two hours
of class time for Chapter 4. Exercises 4-1A or B and 4-2A or B reinforce the con-
cepts in Demonstration Problem 4-1. Exercises 4-10A and B show the effects of pur-
chase returns and cash discounts. Exercises 4-15A and B contrast single and multi-
step income statements. Problems 4-27A and B provide comprehensive follow-up of
Demonstration Problem 4-2, including a write-down for lost inventory. Problems 4-
28A and B focus 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 objec-
tives. We leave to your judgment the most appropriate form of enrichment. You may
also choose to use the study guide, computer tutorials, or other supplements that ac-
company the text.
4-6
Demonstration Problem 4-1 - Inventory Purchase/Sale, Perpetual
Method
The following events pertain to Jefferson Hardware Store. Jefferson uses the perpetual in-
ventory method.
1. Jefferson Hardware was started on January 1, 2015 when it acquired $5,000 cash by is-
suing 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 2015, the store paid $2,000 cash for operating expenses.
Required
Record the events using the horizontal financial statements model. Prepare a formal income
statement and a balance sheet.
4-7
Demonstration Problem 4-2 - Perpetual Inventory Transactions
Lisa’s Dress Supply (LDS), a garment wholesaler, experienced the following events in 2015,
its first year of operations. LDS 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 at the gross amount.
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 its supplier for credit.
5. LDS paid within the discount period for the inventory purchased in Event No. 2.
6. LDS sold inventory to various retail store customers on account. LDS offers customers
payment terms of 1/15, n/30. The list price for the sales was $68,000. The 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 list price of $4,000 and had a cost of $2,940.
8. LDS paid in cash freight cost of $1,200 for goods delivered to customers FOB destina-
tion.
9. LDS collected cash from customers who paid their balances of LDS accounts receivable
having 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 4-3 - Periodic Inventory Transactions
(Appendix)
Assume Lisa’s Dress Supply 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
2015.
Required
Record the events in Demonstration Problem 4-2 in general journal form. Include an adjust-
ing entry to summarize cost of goods sold, and then prepare closing entries. Prepare a sched-
ule of cost of goods sold. Prepare an income statement, a balance sheet, and a statement of
cash flows assuming that LDS uses the periodic inventory method.
4-8
Demonstration Problem 4-1 Solution
Assets
=
Liab.
+
Equity
Rev.
–
Exp.
=
Net Inc.
Cash Flow
No.
Cash
+
Inven.
=
Liab.
+
Com. Stk.
+
Ret. Earn.
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,
2015
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
4-9
Demonstration Problem 4-2 Solution
Worksheet Edmonds
FFAC9e Ch 4 IM.xlsx
Demonstration Problem 4-2 Solution Financial Statements
Lisa’s Dress Supply
Financial Statements
Income Statement
For the Year Ended December 31,
2015
Net sales
$63,500
Cost of goods sold (product cost)
(39,200)
Gross margin
24,300
Transportation-out (period cost)
(1,200)
Other operating expenses (period cost)
(9,600)
Net income
$13,500
Balance Sheet at December 31
Assets
Cash
$48,700
Accounts receivable
14,000
Inventory
10,800
Total assets
$73,500
Stockholders’ equity
Common stock
$60,000
Retained earnings
13,500
Total stockholders’ equity
$73,500
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 for transportation-in, $49,000 for payments of accounts payable, $1,200 for trans-
4-10
portation-out, and $9,600 for other operating expenses [$49,500 Ä $1,000 – $49,000 –
$1,200 – $9,600 = ($11,300)].
Copyright © McGraw-Hill Education. Permission required for reproduction or display.
4-11
Demonstration Problem 4-3 Solution
Date
Account Titles
Debit
Credit
Event No.
1
Cash
60,000
Common Stock
60,000
Event No.
2
Purchases
54,000
Accounts Payable
54,000
Event No.
3
Transportation-in
1,000
Cash
1,000
Event No.
4
Accounts Payable
4,000
Purchase Returns and Allowances
4,000
Event No.
5a
Accounts Payable
1,000
Purchase Discounts
1,000
Event No.
5b
Accounts Payable
49,000
Cash
49,000
Event No.
6
Accounts Receivable
68,000
Sales
68,000
Event No.
7
Sales Returns and Allowances
4,000
Accounts Receivable
4,000
Event No.
8
Transportation-out
1,200
Cash
1,200
Event No.
9a
Sales Discounts
500
Accounts Receivable
500
Event No.
9b
Cash
49,500
Accounts Receivable
49,500
Event No.
10
Other Operating Expenses
9,600
Cash
9,600
Adjusting
Cost of Goods Sold
39,200
Inventory
10,800
Purchase Returns and Allowances
4,000
Purchase Discounts
1,000
Purchases
54,000
Transportation-in
1,000
Closing
Sales
68,000
Sales Returns and Allowances
4,000
Sales Discounts
500
Cost of Goods Sold
39,200
Transportation-out
1,200
Other Operating Expenses
9,600
Retained Earnings
13,500
