CHAPTER 6
MERCHANDISING OPERATIONS AND THE
MULTISTEP INCOME STATEMENT
Student Learning Objectives and Related Assignment Materials
Student Learning
Objectives
Mini–
Exercises
Exercises
Coached
Problems
Problems
(Groups
A & B)
Compre-
hensive
Problem
Skills
Develop-
ment
Cases
Continuing
Cases
LO 6-1 Distinguish
between service
and
merchandising
operations.
1
1
3
LO 6-2 Explain the
differences
between periodic
and perpetual
inventory
systems.
2*, 12^,
18^
2, 3*, 4,
5*, 6
1, 2
LO 6-3 Analyze
purchase
transactions under
a perpetual
inventory system.
2*, 3, 4,
5, 6, 7
7, 8, 9,
10, 11
1
A1, B1
1#
LO 6-4 Analyze sales
transactions under
a perpetual
inventory system.
8, 9, 10,
11
11, 12,
13*, 14,
15, 16,
17, 18,
19
2, 3
A2, A3,
B2, B3
1#
1†, 2£
LO 6-5 Prepare and
analyze a
merchandiser’s
multistep income
statement.
7, 12^,
13, 14,
15, 16*,
17, 18^
5, 6, 18,
19, 20*,
21, 22
2, 3, 4
A2, A3,
A4, B2,
B3, B4
1#
1, 2, 3,
4, 5, 6
1†, 2£
LO S-1 Record
inventory
transactions in a
period system.
23
5
A5, B5
* Animated solution included in the PowerPoint Slides.
^ Particularly challenging; requires students to combine multiple concepts in order to advance to the
next level of accounting knowledge.
# Comprehensive Problem 6-1 also covers LO5-4.
† Continuing Case 6–1 builds on the story of Nicole’s Getaway Spa, introduced in earlier chapters. This
case focuses on analyzing transactions and preparing journal entries, and calculating the company’s
gross profit percentage.
Student Learning Objectives and Related Assignment Materials, continued
£ Continuing Case 6-2 builds on the story of Wiki Art Gallery (WAG), an instructional case in Connect.
This case focuses on revenue recognition, the multistep income statement format, and the gross profit
percentage. The case will be extended in future chapters.
Overview
The operating cycle, internal controls, and financial reporting practices of the world’s largest retailer are
investigated in this chapter.
Students learn the central elements of a merchandiser’s operating cycle, the accounting procedures
applied to purchase and sales transactions, and how to prepare and analyze a merchandiser’s income
statement.
Synopsis of Chapter Revisions
• Substantially changed from the fourth edition: removed internal control topics (now in Chapter 5),
relocated journal entries for inventory purchases (previously in Chapter 7) to accompany inventory
sales in this chapter (Chapter 6)
• Updated focus company illustrations (Walmart) and introduced Life Time Fitness to contrast financial
statements of service company with merchandiser (Exhibit 6.2)
• New illustration of cost of goods sold equations to distinguish periodic and perpetual inventory
systems
• Expanded discussion of shrinkage to include book-to-physical adjustment
• New exhibit comparing journal entries for inventory purchase and sale transactions (Exhibit 6.8) in a
perpetual system (periodic system entries are included in the chapter supplement)
• New Spotlight on Financial Reporting discussing the cost of shoplifting at J.C. Penney
• Updated demonstration case featuring Oakley and Sunglass Hut
• Reviewed and updated all end-of-chapter material
PowerPoint Slides
Student Learning Objective
LO 6-1 Distinguish between service and merchandising, operations.
LO 6-2 Explain the differences between periodic and perpetual inventory
systems.
LO 6-3 Analyze purchase transactions under a perpetual inventory system.
LO 6-4 Analyze sales transactions under a perpetual inventory system.
LO 6-5 Prepare and analyze a merchandiser’s multistep income statement.
LO S-1 Record inventory transactions in a period system.
Animated Builds and Animated Solutions
Mini-Exercise 6-2
Mini-Exercise 6-16
Exercise 6-3
Exercise 6-5
Exercise 6-13
Exercise 6-20
Chapter Summary
LO 6-1 Distinguish between service and merchandising operations.
• Service companies sell services rather than physical goods; consequently, their income statements
show costs of services rather than cost of goods sold.
• Merchandise companies sell goods that have been obtained from a supplier. Retail merchandise
companies sell directly to consumers whereas wholesale merchandise companies sell to retail
companies.
LO 6-2 Explain the differences between periodic and perpetual inventory systems.
• Periodic inventory records are updated only when inventory is counted, usually at the end of each
accounting period.
• Perpetual inventory systems promote efficient and effective operations because they provide an
up-to-date record of inventory that should be on hand at any given time. They protect against
undetected theft because this up-to-date record can be compared to a count of the physical quantity
that actually is on hand.
LO 6-3 Analyze purchase transactions under a perpetual inventory system.
• The Inventory account should include costs incurred to get inventory into a condition and location
ready for sale.
• The cost of inventory includes its purchase price and transportation (freight-in) minus cost
reductions for purchase returns and allowances, purchase discounts, and goods sold. Costs to
deliver inventory to customers (freight-out) are a selling expense and are not included in
inventory.
LO 6-4 Analyze sales transactions under a perpetual inventory system.
• In a perpetual inventory system, two entries are made every time inventory is sold: one entry
records the sale (and corresponding debit to Cash or Accounts Receivable) and the other entry
records the Cost of Goods Sold (and corresponding credit to Inventory).
• Sales discounts and sales returns and allowances are reported as contra-revenues, reducing net
sales.
LO 6-5 Prepare and analyze a merchandiser’s multistep income statement.
• One of the key items in a merchandiser’s multistep income statement is gross profit, which is a
subtotal calculated by subtracting cost of goods sold from net sales. The gross profit percentage is
calculated and interpreted as follows.
Accounting Decision Tools
• Gross Profit Percentage = (Net Sales – COGS) ÷ Net Sales × 100
• It tells you the percentage of profit earned on each dollar of sales, after considering the cost of
products sold.
• A higher ratio means that greater profit is available to cover operating and other expenses.
Chapter Outline
Teaching Notes
I. Understand the Business
LO 6–1 Distinguish among service, merchandising, and manufacturing operations.
A. Operating Cycles
1. Operating cycle—A series of activities that a company
undertakes to generate revenues and, ultimately, cash.
Illustrated in Exhibit 6.1
2. Types of companies:
a. Service company––Sells services rather than physical
goods.
b. Merchandising company—Sells goods that have
been obtained from a supplier; includes retailers and
wholesalers.
c. Manufacturing company—Sells goods that it has made
itself.
Covered in managerial and
cost accounting courses
3. Inventory––Assets acquired for resale to customers.
4. Three key differences in the balance sheet and income
statement of a service company and a merchandiser
company:
Illustrated in Exhibit 6.2
a. Merchandisers report inventories as a current asset;
service companies do not.
b. Merchandisers earn revenue from sales; service
companies earn revenue from service.
c. Merchandisers report an expense called Cost of Goods
Sold, which represents the total cost of all goods sold
to customers during the period; service companies do
not incur this expense because they do not sell goods.
5. Some companies operate as both service and
merchandising companies.
LO 6–2 Explain the differences between periodic and perpetual inventory systems.
B. Inventory Systems
1. Particularly important to merchandisers:
a. Inventories—reports the merchandiser’s total cost of
acquiring goods that it has not yet sold,
b. Sales Revenue and Cost of Goods Sold—indicate the
total selling price and cost of all goods that the
merchandiser did sell to customers during the period.
c. Gross profit—represents the profit earned before
taking into account other expenses.
2. Cost of goods sold
a. Goods available for sale––Equals beginning
inventory plus cost of new purchases.
b. Cost of goods sold equals goods available for sale
minus ending inventory.
c. Cost of Goods Sold Equation
Beginning inventory + Purchases – Ending Inventory
= Cost of Goods Sold
or Beginning inventory + Purchases – Cost of Goods
Sold = Ending Inventory
Illustrated in Exhibit 6.3
Chapter Outline
Teaching Notes
C. Periodic Inventory System
1. Periodic inventory system––Inventory records are
updated “periodically” at the end of the accounting
period.
2. Simple to maintain; major drawback is that accurate
records of the inventory on hand and sold are unavailable
during the accounting period.
3. Employees must physically count the inventory, which
they do at the end of the period.
4. Inventory count is used to adjust the balances for
Inventories and Cost of Goods Sold.
D. Perpetual Inventory System
1. Perpetual inventory system––Inventory records are
updated every time an item is bought, sold or returned.
2. As a result, the Inventory and Cost of Goods Sold
accounts are always up to date.
E. Inventory Control
1. A perpetual inventory system’s continuous tracking
allows companies to instantly determine the quantity of
products on the shelves and to evaluate the amount of
time they have spent there.
2. Shrinkage––The cost of inventory lost to theft, fraud,
and error.
a. Can be estimated only when a perpetual inventory
system is in use.
b. Accounted for by recording a “book–to-physical
adjustment” that reduces inventory; shrinkage is an
expense included in Cost of Goods Sold.
The “Spotlight on Ethics”
feature addresses causes of
inventory shrinkages.
3. Even if a perpetual inventory system is in use, the
inventory should still be counted occasionally (at least
yearly) to ensure the accounting records are accurate and
that any shrinkage is detected.
4. Once too costly, computerized inventory systems have
become so cheap that most merchandisers use perpetual
inventory systems.
II. Recording Inventory Purchases
LO 6-3 Analyze purchase transactions under a perpetual inventory system.
LO 6-3 and LO 6-4 assume that all inventory-related
transactions are recorded in the Inventory account; this approach
is generally associated with a perpetual inventory system.
Accounting under a periodic
inventory system is covered
in the Supplement 6A.
A. Inventory Purchases
✓ Supplemental Enrichment
Activity (Activity) #1
1. Most large retailers use perpetual inventory systems that
monitor inventory quantities and automatically issue
purchase orders to replenish inventory.
a. Purchase order instructs supplier to send specified
quantities of particular products at certain dates.
b. No journal entry recoded yet.
Chapter Outline
Teaching Notes
2. Upon receipt, purchases of merchandise inventory are
recorded in the Inventory account (with a debit).
3. Transportation Cost
a. FOB shipping point––A term of sale indicating that
goods are owned by the buyer the moment they leave
the seller’s shipping department.
b. FOB destination––A term of sale indicating that
goods are owned by the seller until they are delivered
to the buyer.
c. If the terms are FOB shipping point, the purchaser
pays for shipping. The additional cost of transporting
the goods (called freight-in) is added to Inventory.
4. Other Costs
a. In general, a purchaser should include in the Inventory
account any costs needed to get the inventory into a
condition and location ready for sale.
b. Costs that are incurred after the inventory has been
made ready for sale, such as freight-out to deliver
goods to customers, are selling expenses.
B. Purchase Returns and Allowances
1. Purchase returns and allowances––A reduction in the
cost of inventory purchases associated with unsatisfactory
goods.
2. When goods purchased arrive in damaged condition or do
not meet specifications, the buyer can either (1) return
them for a full refund or (2) keep them and ask for a cost
reduction (called an allowance).
3. Either way, these purchase returns and allowances are
accounted for by reducing the cost of the inventory and
recording the cash refund or the reduction in the liability
owed to the supplier.
C. Purchase Discount—Cash discount received for prompt
payment of a purchase on account.
1. When merchandise is bought on credit, terms, such as
2/10, n/30 may be specified.
Illustrated in Exhibit 6.4
a. The “2/10” part means that if the purchaser pays by the
10th day of taking ownership of the goods, a 2%
purchase discount can be deducted from the amount
owed.
b. The “n/30” part means that if payment is not made
within the 10-day discount period, the full amount is
due 30 days after ownership transferred.
2. When a purchase discount is offered at the time of
purchase, the purchaser accounts for it in two stages.
a. Initially, the inventory purchase is accounted for at its
full cost because it is not clear whether the company
will take advantage of the discount.
Chapter Outline
Teaching Notes
b. Later, if payment is made within the discount period,
the purchaser reduces the Inventory account by the
amount of the discount because it effectively reduces
the cost of the inventory.
c. The purchase discount is calculated using the net
amount owing to the supplier, after considering
purchase returns and allowances.
D. When the company pays, Accounts Payable is reduced by the
amount owed (with a debit), Cash is reduced by the amount
paid (with a credit), and, because the discount represents a
reduction in the purchase price of the inventory, Inventory is
reduced by the amount of the discount (with a credit).
E. Summary of Inventory Transactions
Summarized in Exhibit 6.5
III. Recording Inventory Sales
LO 6–4 Analyze sales transactions under a perpetual inventory system.
A. Inventory Sales
1. Merchandisers record revenue when they fulfill their
performance obligations by transferring ownership of the
goods to customers; the sales agreement specifies one of
two possible times:
✓ Activity #2
a. FOB shipping point—Sale is recorded when the goods
leave the seller’s shipping department.
Unless otherwise indicated,
assumed in text.
b. FOB destination—Sale is recorded when the goods
reach their destination (customer).
2. Every merchandise sale has two components; each
requires an entry in a perpetual inventory system:
Illustrated in Exhibit 6.6
a. Selling price—Record as increase in Sales Revenue
and increase in either Cash (if a cash sale) or Accounts
Receivable (if a sale on account).
b. Cost—Record a decrease in Inventory and increase in
Cost of Goods Sold, an expense.
Many merchandising
companies use different Sales
and Cost of Goods Sold
accounts for different product
lines
3. Gross profit is not directly recorded in an account by
itself, but instead is a subtotal produced by subtracting the
Cost of Goods Sold from the Sales Revenue.
B. Sales Returns and Allowances
1. Sales returns and allowances––Refunds and price
reductions given to customers after goods have been sold
and found unsatisfactory.
a. The company would make two entries that basically
reverse what this seller recorded above when the item
was initially sold.
b. The Sales Revenue account is not directly reduced;
instead, a contra-revenue account (like Sales Returns
and Allowances) is used.
Contra account allows
management to monitor
amount of returns
2. A sales allowance (without return of goods) is accounted
for in a similar way, except the increase in Inventory and
decrease in Cost of Goods Sold are not recorded.