Chapter 6
Accounting for Merchandising Operations
Learning Objectives
1. Dene merchandising accounting, and dierentiate perpetual from periodic inventory
systems.
2. Describe the features of multistep and single-step classied income statements.
3. Describe the terms of sale related to merchandising transactions.
4. Prepare an income statement, and record merchandising transactions under the
perpetual inventory system.
5. Prepare an income statement, and record merchandising transactions under the periodic
inventory system.
6. Explain the role of the operating cycle and foreign business transactions in evaluating
the liquidity of a merchandising company.
Section 1: Concepts
Concepts
Faithful representation
Classication
Lecture Outline
0. A service business provides a service (e.g., a dry cleaner, an accountant, or a car
wash), whereas a merchandising business sells goods (e.g., a department, drug, or
grocery store).
II0. Merchandise inventory is an important component on the operating cycle
III. Two basic inventory systems are used.
A. Perpetual inventory system
B. Periodic inventory system
Summary
While a service business earns income by providing a service for a fee, a merchandising
business, such as a wholesaler or retailer, buys goods and resells them. Merchandise
inventory is an important component on the operating cycle, which is the cycle of buying
and holding merchandise until it is sold and then collecting payment for the sales. Although
the two types of businesses use the same basic accounting method, the process is more
complex for the merchandiser.
A management decision regarding inventory is the choice of inventory system. There are
two basic systems of accounting for the items in the merchandising inventory: the perpetual
inventory system and the periodic inventory system.
The perpetual inventory system is used when management wants to always have a
current inventory balance. Under this system, inventory records are continuously updated,
providing management with up-to-date information regarding inventory levels, which is
important for both inventory control and customer service. The Merchandise Inventory
account is increased for the cost of goods purchased and decreased for the cost of goods
sold. The Cost of Goods Sold account is increased at the time of each sale.
A merchandiser can determine the quantity and the cost of the inventory not sold or the
goods on hand by using the periodic inventory system. While simpler and less costly to
maintain, the periodic inventory system does not provide management with continuously
updated current inventory balances. Under the periodic inventory system, a physical
inventory (manual count of inventory on hand) is taken periodically, usually at the end of
the accounting period. No detailed records of inventory on hand are kept during the
accounting period—the inventory gure is accurate only on the balance sheet date.
It is important to note that the perpetual inventory system does not eliminate the need for a
physical count of inventory, which still must be done periodically to verify the accuracy of
the perpetual records.
Small merchandisers, both retailers and wholesalers, use periodic inventory systems
because they can actually observe their inventory or can control inventory by recording
information on cards or computers, thus requiring minimal clerical work. For larger
businesses, however, the lack of detailed records can result in lost sales or high operating
costs.
Teaching Strategy
Ask students to give examples of service businesses and merchandising businesses.
Contrast the perpetual and periodic inventory systems. Exercise 1A will help students
understand the major concepts presented in this section.
This section of the chapter also introduces students to inventory maintenance. Ask students
if anyone has been involved in taking a physical inventory. Ask what type of merchandise
they counted. Examples of types of businesses that may use the dierent inventory systems
are helpful. Give examples of merchandise that a business owns that is not located on the
premises and vice versa.
Explain why a physical inventory must be taken in a perpetual system. Explain how bar
coding is used in a perpetual system. Point out that many retailers keep perpetual inventory
records in quantities only and use the periodic system for costs and for accounting purposes.
Show how inventory losses are identied in a perpetual inventory system and why it is not
possible to do this in a periodic system. Mention some ways in which companies try to
prevent and detect inventory losses. This discussion will provide a lead-in to a discussion of
management’s responsibilities with respect to internal control.
Case 1 addresses the conceptual issues in this section.
Section 2: Accounting Applications
Accounting Applications
Prepare a multistep income statement
Prepare a single-step income statement
Record inventory transactions under the perpetual method
Record inventory transactions under the periodic method
Lecture Outline
I0. The multistep income statement arrives at net income through a series of steps, or
subtotals, including gross margin and income from operations.
0. Net sales
0. Cost of goods sold
0. Gross margin
0. Operating expenses
0. Income from operations
0. Other revenues and expenses
G. Net income
0. The single-step income statement arrives at net income in a single step. The single-step
form is a simple deduction of all costs and expenses from all revenues.
III0. Trade discounts are reductions from the list price and are not recorded in the accounts.
V0. Sales discounts are oered by the seller for prompt payment.
0. 2/10, n/30 means that the buyer can take a 2 percent discount by paying within 10
days of the invoice date or can pay the full amount within 30 days.
B0. Purchases discounts apply to the buyer.
V0. Transportation costs
A. FOB shipping point means that title to the goods transfers at origin and freight
charges are paid by the buyer.
B0. FOB destination means that title to the goods transfers at destination and freight
charges are paid by the seller.
C0. Freight-in is the transportation cost paid by the buyer and added to cost of goods
sold.
D0. Delivery expense, or freight-out, is the transportation cost paid by the seller and is
an operating expense.
VI0. Terms of debit and credit card sales
A. Debit cards deduct directly from a person’s bank account, whereas a credit card
allows for payment later.
B. In credit card transactions, the credit card company takes a discount of 2 to 6
percent of the credit card sales, which is recorded as a selling expense by the
merchandiser.
0. With the perpetual inventory system, inventory records are updated with every
purchase and every sale.
A. Cost of goods sold on the income statement comes from the balance in the Cost of
Goods Sold account.
B. Purchases of merchandise
1. Journalize a purchase of merchandise on account
20. Journalize a return of merchandise purchased
0 3. Journalize a payment on account
C. Sales of merchandise
10. Journalize a sale of merchandise on account with two entries
20. Journalize a return of merchandise sold with two entries
30. Journalize collection from a customer on account
VIII0. With the periodic inventory system, inventory records are updated only at the end of
the period, when a physical count is taken.
A. Merchandising income statement must show detailed computations to arrive at
cost of goods sold
10. Beginning inventory is the merchandise on hand at the beginning of the
period.
20. Ending inventory is the merchandise on hand at the end of the period. The
ending inventory of one period becomes the beginning inventory of the next
period.
30. Net purchases equals total purchases less purchases returns and allowances
and purchases discounts.
40. Net cost of purchases equals net purchases plus freight-in.
50. Cost of goods available for sale is the cost of merchandise available for sale
during the period. It equals beginning inventory plus net cost of purchases.
60. Cost of goods sold is the cost to the merchandiser of the goods sold that
period. It equals cost of goods available for sale less ending inventory.
C0. Purchases of merchandise
1. Journalize a purchase of merchandise on account
20. Journalize a return of merchandise purchased
30. Journalize a payment on account
D0. Sales of merchandise
1. Journalize a sale of merchandise on account with one entry
20. Journalize a return of merchandise sold with one entry
30. Journalize collection from a customer on account
Summary
In the income statements presented thus far, expenses have been deducted from revenue in
a single step to arrive at net income. In the single-step income statement, the revenues
section lists all revenues, including other income, and the costs and expenses section lists
all expenses, including other expenses. Many companies, however, use a form of income
statement that is more detailed, containing several subtractions and subtotals:
Net Sales
– Cost of Goods Sold
= Gross Margin
– Operating Expenses
= Income from Operations
± Other Revenues and Expenses
= Net Income
A multistep income statement goes through a series of steps, or subtotals, to arrive at
net income. It is used by a merchandising company, which buys and sells products, and a
manufacturing company, which makes and sells products. Four major parts of the
merchandising or manufacturing company’s multistep income statement are net sales, cost
of goods sold, gross margin, and operating expenses.
Net sales are the gross proceeds from sales of merchandise (gross sales) less sales returns
and allowances and any discounts allowed. Gross sales are the total sales for cash and on
credit that occur during an accounting period. Sales returns and allowances are cash
refunds, credits on account, and discounts from selling prices made to customers who have
received defective products or products that are otherwise unsatisfactory. Cost of goods
sold, also called cost of sales, is the amount a merchandiser paid for the merchandise it sold
during an accounting period or the cost to a manufacturer of making the products it sold
during an accounting period. Gross margin, or gross prot, is the dierence between net
sales and the cost of goods sold. Operating expenses are expenses other than cost of
goods sold that are incurred in running a business. They are often grouped into the
categories of selling expenses and general and administrative expenses.
Income from operations, or operating income, is the gross margin minus operating
expenses and represents the income from a company’s normal, or main, business. Other
revenues and expenses on a multistep income statement include revenues and expenses
not related to business operations, such as those from dividends and interest on stocks,
bonds, and savings accounts. Net income is what remains of the gross margin after
operating expenses are deducted, and other revenues and expenses are added or deducted.
Terms of sale are negotiated by the buyer and seller and cover not only the selling price but
also the credit period, delivery charges, return policy, and so on. As a matter of
convenience, manufacturers and wholesalers frequently quote prices of merchandise based
on a discount from the list or catalogue price (called a trade discount). Trade discounts are
never recorded in the accounting records.
Sellers sometimes oer a sales discount for timely payment, which is intended to accelerate
cash receipts, thereby improving liquidity. Terms of 2/10, n/30, for example, mean that a 2
percent discount will be given if payment is made within 10 days of the invoice date; otherwise,
the full amount is due within 30 days. It is almost always advantageous for the buyer to pay
within the discount period because of the high eective annual rate implied in the terms. For
example, terms of 1/10, n/30 represents an eective annual rate of 18 percent (1 percent for
20 days is equal to 18 percent for 365 days). Similarly, purchases discounts are discounts
that buyers take for paying early.
Freight charges are borne by the buyer or seller of the goods, depending upon the terms
specied. FOB shipping point means that title to the goods passes from seller to buyer at
the origin and the buyer pays freight charges. FOB destination means that title to the
goods passes from seller to buyer at the destination and the seller pays the freight charges.
Freight-in is the transportation cost paid by the buyer and is added to cost of goods sold.
Delivery expenses, or freight-out, are transportation costs paid by the seller and are
considered operating expenses.
Companies that allow customers to use national debit or credit cards (such as MasterCard or
Visa) must follow special accounting procedures. The credit card company reimburses the
merchant for the sale, less a service charge. The credit card company levies this service
charge because it is responsible for establishing credit and collecting money from the
customer. Assuming that the merchant deposits its credit card sales invoices into a special
bank account for immediate credit, it would debit the Cash and Credit Card Discount
Expense accounts and credit the Sales account.
Under the perpetual inventory system, the cost of goods sold and merchandise inventory are
updated whenever a purchase, sale, or other inventory transaction takes place. In addition,
freight-in is usually included in cost of goods sold.
Transactions are recorded under the perpetual inventory system as follows:
0. A purchase of merchandise on credit is debited to the Merchandise Inventory
account and credited to the Accounts Payable account.
0. Transportation costs for goods received are debited to the Freight-In account and
credited to either the Accounts Payable or Cash account.
0. A purchase return to the supplier (for credit) is debited to the Accounts Payable
account and credited to the Merchandise Inventory account.
0. A payment on account is debited to the Accounts Payable account and credited to
the Cash account.
0. Sales of merchandise on credit are debited to the Accounts Receivable account
and credited to the Sales account. However, an additional entry must be made,
debiting the Cost of Goods Sold account and crediting the Merchandise Inventory
account.
0. The payment of delivery costs for goods sold is recorded as a debit to the Delivery
Expense account and a credit to either the Accounts Payable or Cash accounts.
0. Returns of merchandise by customers are debited to the Sales Returns and
Allowances account (a contra-revenue account) and credited to the Accounts
Receivable account. The Sales Returns and Allowances account is debited instead
of the Sales account to provide management with data about dissatised
customers. Under the perpetual inventory system, a second entry is needed to
transfer the cost of the returned goods from the Cost of Goods Sold account to the
Merchandise Inventory account.
0. Receipts from customers on account are debited to the Cash account and credited
to the Accounts Receivable account.
The following journal entries are introduced in this section for the perpetual inventory system:
Merchandise Inventory XX (purchase price)
Accounts Payable XX (amount due)
Purchased merchandise on credit
Accounts Payable XX (amount returned)
Merchandise Inventory XX (amount returned)
Returned merchandise from purchase
Accounts Payable XX (amount owed)
Cash XX (amount paid)
Made payment on account
Accounts Receivable XX (amount to be received)
Sales XX (sales price)
Sold merchandise on credit
Merchandise Inventory XX (cost of goods sold)
Cost of Goods Sold XX (cost of goods sold)
Transferred cost of merchandise inventory
sold to Cost of Goods Sold
Sales Returns and Allowances XX (price of goods returned)
Accounts Receivable XX (amount credited to account)
Accepted return of merchandise
Merchandise Inventory XX (cost of units sold)
Cost of Goods Sold XX (cost of units sold)
Transferred cost of merchandise returned
to Merchandise Inventory
Cash XX (amount received)
Accounts Receivable XX (amount settled)
Received payment on account
The choice of an inventory system aects the way cost of goods sold is calculated for the
income statement. The income statement for a merchandising business that uses the
periodic inventory system will show the computation for cost of goods sold, including
beginning and ending inventory, freight-in, and net purchases. (The cost of goods sold = the
cost of goods available for sale – ending inventory.) The cost of goods available for sale
is the sum of the beginning inventory and the net cost of purchases during the year. The
ending inventory in one period becomes the beginning inventory of the next period. The net
cost of purchases includes purchases reduced by any discounts and returns and
allowances (net purchases), plus freight charges paid.
Transactions are recorded under the periodic inventory system as follows:0
0. All purchases of merchandise on account are debited to the Purchases account
and credited to the Accounts Payable account. The purpose of the Purchases
account is to accumulate the cost of merchandise purchased for resale during the
period.
0. Transportation costs for goods purchased are debited to the Freight-In account and
credited to either the Accounts Payable or Cash accounts.
0. A purchase return to the supplier (for credit) is debited to the Accounts Payable
account and credited to the Purchases Returns and Allowances account. The
latter appears as a contra account to Purchases on the income statement.
0. A payment on account is debited to the Accounts Payable account and credited to
the Cash account.
0. Cash sales of merchandise are debited to the Cash account and credited to the
Sales account. When a credit sale is made, Accounts Receivable is debited and
Sales is credited. Generally, a sale is recorded when the goods are delivered and
title passes to the customer, regardless of when payment is made.
0. The payment of delivery costs for goods sold is recorded as a debit to the Delivery
Expense account and a credit to either the Accounts Payable or Cash accounts.
0. Returns of merchandise by customers (for credit) are debited to the Sales Returns
and Allowances account and credited to the Accounts Receivable account.
0. Receipts from customers on account are debited to the Cash account and credited
to the Accounts Receivable account.
The following journal entries are introduced in this section for the periodic inventory system:
Purchases XX (purchase price)
Accounts Payable XX (amount due)
Purchases on credit
Accounts Payable XX (amount returned)
Purchases Returns and Allowances XX (amount returned)
Returned merchandise from purchase
Accounts Payable XX (amount owed)
Cash XX (amount paid)
Made payment on account
Accounts Receivable XX (amount to be received)
Sales XX (sales price)
Sold merchandise on credit
Sales Returns and Allowances XX (price of goods returned)
Accounts Receivable XX (amount credited to account)
Accepted return of merchandise
Cash XX (amount received)
Accounts Receivable XX (amount settled)
Received payment on account
Relevant Examples and Exhibits
Exhibit 1 A Comparison of the Components of Multistep Income Statements for
Service and Merchandising or Manufacturing Companies
Exhibit 2 Multistep Income Statement for Davila Company
Exhibit 3 Single-Step Income Statement for Davila Company
Exhibit 4 Income Statement Under the Perpetual Inventory System
Exhibit 5 Recording Purchase Transactions Under the Perpetual Inventory System
Exhibit 6 Recording Sales Transactions Under the Perpetual Inventory System
Exhibit 7 Income Statement Under the Periodic Inventory System
Exhibit 8 The Components of Cost of Goods Sold
Exhibit 9 Recording Purchase Transactions Under the Periodic Inventory System
Exhibit 10 Recording Sales Transactions Under the Periodic Inventory System
Exhibit 11 Merchandising Income Statement Groups Accounts in Useful Categories