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CHAPTER 5
ACCOUNTING FOR MERCHANDISING
OPERATIONS
LEARNING OBJECTIVES
1. DESCRIBE MERCHANDISING OPERATIONS AND
INVENTORY SYSTEMS.
4. APPLY THE STEPS IN THE ACCOUNTING CYCLE TO A
MERCHANDISING COMPANY.
5. COMPARE A MULTIPLE-STEP AND A SINGLE-STEP
INCOME STATEMENT.
CHAPTER REVIEW
Merchandising Operations
1. (L.O. 1) A merchandising company is an enterprise that buys and sells merchandise as their
primary source of revenue. Merchandising companies that purchase and sell directly to
consumers are retailers, and those that sell to retailers are known as wholesalers.
Operating Cycles
6. The operating cycle of a merchandising company is as follows:
Flow of Costs
7. A merchandising company may use either a perpetual or a periodic inventory system in deter-
mining cost of goods sold.
Purchase Transactions
8. (L.O. 2) Under the perpetual inventory system, purchases of merchandise for sale are recorded in
the Inventory account. For a cash purchase, Cash is credited; for a credit purchase, Accounts
Payable is credited.
9. FOB shipping point means that goods are placed free on board the carrier by the seller, and the
10. When the purchaser pays the freight, Inventory is debited and Cash is credited. When the seller
pays the freight, Freight-Out (Delivery Expense) is debited and Cash is credited. This account is
classified as an operating expense by the seller.
11. A purchaser may be dissatisfied with the merchandise received because the goods may be
damaged or defective, of inferior quality, or not in accord with the purchaser’s specifications. The
purchaser may return the merchandise, or choose to keep the merchandise if the supplier is
willing to grant an allowance (deduction) from the purchase price. When merchandise is returned,
Inventory is credited.
Sales Transactions
14. (L.O. 3) In accordance with the revenue recognition principle, companies record sales
revenues when the performance obligation is satisfied. Typically the performance obligation is
satisfied when the goods are transferred from the seller to the buyer.
15. All sales transactions should be supported by a business document. Cash register documents
provide evidence of cash sales; sales invoices provide support for credit sales.
16. A sale on credit is recorded as follows:
Sales Returns and Allowances
17. A sales return results when a customer is dissatisfied with merchandise and is allowed to return
the goods to the seller for credit or for a cash refund. A sales allowance results when a customer
is dissatisfied with merchandise and the seller is willing to grant an allowance (deduction) from the
selling price.
18. To give the customer a sales return or allowance, the seller normally makes the following entry if
the sale was a credit sale (the second entry is made only if the goods are returned):
Sales Returns and Allowances .................................................... XXXX
Accounts Receivable ............................................................ XXXX
Sales Discounts
20. A sales discount is the offer of a cash discount to a customer for the prompt payment of a
balance due. If a credit sale has terms 2/10, n/30, then a 2% discount is taken on the invoice price
(less any returns or allowances) if payment is made within 10 days. If payment is not made within
The Accounting Cycle
22. (L.O. 4) Each of the required steps in the accounting cycle applies to a merchandising company.
Adjusting Entries and Closing Entries
23. A merchandising company generally has the same types of adjusting entries as a service com-
pany but a merchandiser using a perpetual inventory system will require an additional adjustment
Multiple-Step vs. Single-Step Income Statement
24. (L.O. 5) A multiple-step income statement shows several steps in determining net income:
(1) cost of goods sold is subtracted from net sales to determine gross profit and (2) operating
Gross Profit and Operating Expenses
25. Gross profit is net sales less cost of goods sold. The gross profit rate is expressed as a
percentage by dividing the amount of gross profit by net sales. Operating expenses are the third
component in measuring net income for a merchandising company.
Classified Balance Sheet
28. A merchandising company generally has the same type of balance sheet as a service company
except inventory is reported as a current asset.
Using a Worksheet
*29. (L.O. 6) As indicated in Chapter 4, a worksheet enables financial statements to be prepared before
the adjusting entries are journalized and posted. The steps in preparing a worksheet for a
Determining Cost of Goods Sold Under a Periodic System
*30. (L.O. 7) Under a periodic system separate accounts are used to record freight costs, returns,
and discounts. In addition, a running account of changes in inventory is not maintained. Instead, the
balance in ending inventory, as well as cost of goods sold for the period, is calculated at the end
of the period. The determination of cost of goods sold for Tsutsui Co. using a periodic inventory
system, is as follows:
TSUTSUI COMPANY
Cost of Goods Sold
For the Year Ended December 31, 2017
Cost of goods sold
Inventory, January 1 ..................................... $ 28,000
Purchases..................................................... $234,000
*31. To determine the cost of goods sold under a periodic inventory system, three steps are
required: (1) Record purchases of merchandise; (2) Determine the cost of goods purchased; and
(3) Determine the cost of goods on hand at the beginning and end of the accounting period.
Recording Purchases and Sales of Merchandise
*35. In a periodic inventory system revenues from the sale of merchandise are recorded when sales
are made in the same way as in a perpetual system. But, no attempt is made on the date of sale
to record the cost of the merchandise sold. Instead, a physical inventory count is taken at the end
of the period to determine (1) the cost of the merchandise then on hand and
(2) the cost of the goods sold during the period.
LECTURE OUTLINE
A. Merchandising Operations.
1. The primary source of revenues for merchandising companies is the sale
of merchandise, referred to as sales revenue or sales.
2. A merchandising company has two categories of expenses:
INVESTOR INSIGHT
Morrow Snowboards implemented a perpetual inventory system to improve its
control over inventory. It also stated that it would perform a physical inventory
count every quarter until it felt that the perpetual inventory system was reliable.
If a perpetual system keeps track of inventory on a daily basis, why do companies
ever need to do a physical count?
Answer: A perpetual system keeps track of all sales and purchases on a
continuous basis. This provides a constant record of the number of units
B. Recording Purchases and Sales of Merchandise.
1. In a perpetual inventory system, companies keep detailed records of the
cost of each inventory purchase and sale. These records continuously
(perpetually) show the inventory that should be on hand for every item.
2. Under a perpetual inventory system:
a. Companies record purchases of merchandise for sale in the Inventory
account. Companies record purchases of assets acquired for use,
such as supplies and equipment, as increases to specific asset
accounts rather than to Inventory.
b. The company debits the Inventory account for all purchases of
merchandise and freight-in, and credits it for purchase discounts and
purchase returns and allowances. Freight terms are expressed as
either FOB shipping point or FOB destination.
c. A purchaser may return goods to the seller for credit because the
goods are damaged or defective, or of inferior quality. The return of
goods to the seller is known as a purchase return.
(3) In accordance with the revenue recognition principle, companies
record sales revenues when the performance obligation is
satisfied. Typically the performance obligation is satisfied when
goods transfer from the seller to the buyer.
(6) Sales Returns and Allowances is a contra revenue account (offset
against a revenue account) to Sales Revenue. Companies use a
contra account, instead of debiting Sales Revenue, to disclose in
the accounts and in the income statement the amount of sales
returns and allowances.
ACCOUNTING ACROSS THE ORGANIZATION
Costco Wholesale Corp. has always had a generous return policy, but adopted a
new policy requiring that certain electronics be returned within 90 days of their
purchase. The reason for the change was that returned electronics cut an
estimated 8¢ per share off Costco’s earnings per share.
If a company expects significant returns, what are the implications for revenue
recognition?
Answer: If a company expects significant returns, it should make an adjusting
C. Adjusting Entries.
1. A merchandiser using a perpetual system will require one additional adjusting
entry to make the records agree with the actual inventory on hand.
D. Closing Entries.
1. The temporary accounts with credit balances are closed to Income Summary.
2. The temporary accounts with debit balances are closed to Income
Summary.
E. Forms of Income Statements.
Merchandising companies use one of two forms for the income statement:
1. Multiple-step income statement.
2. The multiple-step income statement reports gross profit (net sales less
cost of goods sold).
a. A company’s gross profit can be expressed as a percentage, called
the gross profit rate.
3. Single-step income statement.
a. All data are classified into two categories:
*F. Using a Worksheet.
1. The steps in preparing a worksheet for a merchandising company are
the same as they are for a service company.
2. The Inventory account is extended from the adjusted trial balance
column to the balance sheet debit column.
*G. Determining Cost of Goods Sold Under a Periodic System.
1. Determining cost of goods sold is different under the periodic system
than under the perpetual system.
4. The steps in determining cost of goods sold are:
a. Record the purchases of merchandise.
*H. Periodic Inventory System.
1. Companies record revenues from the sale of merchandise when sales
are made, just as in a perpetual system. But companies do not attempt
on the date of sale to record the cost of the merchandise sold.
A Look at IFRS
The basic accounting entries for merchandising are the same under both GAAP
and IFRS. The income statement is a required statement under both sets of
standards. The basic format is similar although some differences do exist.
KEY POINTS
Following are the key similarities and differences between GAAP and IFRS
related to inventories.
• Under both GAAP and IFRS, a company can choose to use either a
perpetual or periodic system.
• Under GAAP companies generally classify income statement items by
function. Classification by function leads to descriptions like administration,
distribution, and manufacturing. Under IFRS, companies must classify
expenses either by nature or function. Classification by nature leads to
descriptions such as the following: salaries, depreciation expense, and
utilities expense. If a company uses the functional-expense method on the
income statement, disclosure by nature is required in the notes to the
financial statements.
LOOKING TO THE FUTURE
The IASB and FASB are working on a project that would rework the structure of
financial statements. Specifically, this project will address the issue of how to
classify various items in the income statement. A main goal of this new approach
is to provide information that better represents how businesses are run. In
addition, this approach draws attention away from just one number—net income.
It will adopt major groupings similar to those currently used by the statement of
20 MINUTE QUIZ
Circle the correct answer.
True/False
1. Measuring net income for a merchandising company is conceptually the same as for
a service company.
True False
2. The cost of goods sold is determined only at the end of the accounting period under
a perpetual inventory system.
True False
3. Under the perpetual inventory system, the purchase of merchandise is recorded with a debit
to the Purchases account.
True False
4. Sales Discounts is a contra revenue account and has a debit balance.
True False
5. A customer may receive a sales discount for goods that are damaged or defective.
True False
6. In a single-step income statement, gross profit and operating income are shown on the
income statement.
True False
7. In the balance sheet, inventory is reported as a current asset immediately below
accounts receivable.
True False
8. Income from operations is determined by subtracting other expenses and losses from
gross profit.
True False
9. Merchandising companies report nonoperating activities in the income statement imme-
diately after the company’s primary operating activities.
True False
*10. In preparing a worksheet for a merchandising firm, all income statement column debits
represent expenses.
True False
Multiple Choice
1. Sales Discounts
a. is a contra revenue account.
b. has a normal debit balance.
c. appears on the income statement.
d. all of the above.
2. When a company uses the perpetual method of accounting for inventories the
a. Inventory account does not change until the end of the year.
b. Inventory account is debited when inventory is purchased
and Cost of Goods Sold is debited when inventory is sold.
c. sale of inventory requires a credit to Cost of Goods Sold.
d. acquisition of merchandise requires a debit to Purchases.
3. The recording of a sale requires a
a. credit to a sales account and a debit to an asset account.
b. debit to Cash and a credit to Owner’s Capital.
c. debit to a sales account and credit to an asset account.
d. credit to Sales Revenue and a debit to Sales Discounts.
4. Which of the following would not be considered an operating expense?
a. Cost of goods sold
b. Rent expense
c. Freight-out
d. Office expense
5. Which of the following is reported on both a multiple-step and a single-step income statement?
a. Gross profit
b. Income from operations
c. Other revenues and gains
d. Net sales
ANSWERS TO QUIZ
True/False
1. True 6. False
Multiple Choice
1. d.
