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chapter
6
Accounting for
Merchandising Businesses
_____________________________________________
OPENING COMMENTS
Chapter 6 introduces the merchandising form of business. It opens by contrasting the income statements
of service and merchandising businesses. The majority of the chapter is focused on the presentation of
inventory, purchase of inventory and sale of inventory including returns, discounting, and freight charges.
The 26th edition of Accounting focuses on the perpetual inventory method, since computerized
accounting and inventory systems have made it feasible for even small merchandisers to track each
purchase and sale of inventory. The text illustrates how to record transactions related to the purchase and
sale of merchandise under the perpetual inventory system. It also presents a chart of accounts and an
overview of the accounting cycle for a merchandiser using a perpetual inventory system. The chapter then
presents the financial statements for a merchandising business and summarizes the essential differences
between the periodic and perpetual inventory systems.
A summary of the closing process as it differs in a merchandising environment is provided to assist
students in identifying additional income statement accounts to include in the closing process.
A presentation of the ratio of sales to assets that illustrates how effectively a business is using its assets to
generate sales follows and explains its relevance to a company from year to year or as a comparison to its
industry average.
The appendix explains and illustrates the use of the periodic inventory system. It also contains a table that
displays how the same business transaction would be journalized differently between a perpetual and a
periodic inventory system.
After studying the chapter, your students should be able to:
2. Describe and illustrate the accounting for merchandise transactions.
4. Describe the adjusting and closing process for a merchandising business.
5. Describe and illustrate the use of the ratio of sales to assets in evaluating a company’s operating
performance.
KEY TERMS
account form
administrative expenses (general expenses)
cost of merchandise sold
credit memorandum (credit memo)
credit period
credit terms
debit memorandum (debit memo)
FOB (free on board) destination
FOB (free on board) shipping point
gross profit
income from operations (operating income)
inventory shrinkage (inventory shortage)
invoice
merchandise inventory
multiple-step income statement
operating cycle
other expense
other income
periodic inventory system
perpetual inventory system
physical inventory
purchases discounts
purchases returns and allowances
ratio of sales to assets
report form
sales
sales discounts
selling expenses
single-step income statement
trade discounts
STUDENT FAQS
• How do you handle a business that is primarily a service business but has some merchandising
aspects?
Chapter 6 Accounting for Merchandising Businesses 99
• In a merchandising (retail) type businesses, how can you use the periodic inventory method and still
use a computer to monitor with inventory?
• Which method is more current or is more correct so that what is in inventory can be determined at any
given time?
• If you are viewing a chart of accounts, how do you tell if it is for a periodic or perpetual inventory
system?
• What accounts are in the chart of accounts of a periodic inventory system?
• What accounts are in the chart of accounts of a perpetual inventory system?
• Which inventory method will yield the most net income?
• Which inventory method will yield the least net income?
• How can a business have gross profit but end up with a net loss for the year?
• Why not debit the sales account directly for any adjustments?
• Why do you add transportation in and do not deduct delivery expense when determining the cost of
merchandise purchased?
• Why does it matter that we identify other revenues and expenses on the income statement? It doesn’t
impact the overall net income or net loss.
• Why can’t we deduct credit card expense from sales? After all, it reduces the cash we receive from
the sale.
• Why don’t discount terms apply to the total amount we may owe a supplier when the supplier prepays
the freight for us?
• Why do we record the sales tax separately from the sales amount? Wouldn’t it be easier to credit sales
for the total amount (sales and tax) and then debit sales when we remit the sales tax?
• When computing ratio of sales to assets, why is there a choice about which value of assets to use?
Does it matter?
OBJECTIVE 1
Distinguish between the activities and financial statements of service and merchandising
businesses.
SYNOPSIS
The differences between service and merchandising businesses are discussed in this chapter. The first
objective describes the operating cycle process for merchandising businesses in Exhibit 1. The time in
days of this operating cycle differs vastly depending upon the type of merchandise sold. Financial
statements reflect the differences between these types of businesses. The income of a services business is
often reported as fees earned; for a merchandising business, it is reported as sales. Condensed income
statements from a service business (H&R Block) and a retail business (The Home Depot) illustrate how
these statements differ.
100 Chapter 6 Accounting for Merchandising Businesses
Key Terms and Definitions
• Cost of Merchandise Sold - The cost that is reported as an expense when merchandise is sold.
• Gross Profit - Sales minus the cost of merchandise sold.
• Merchandise Inventory - Merchandise on hand (not sold) at the end of an accounting period.
• Operating Cycle - The process by which a company spends cash, generates revenues, and
receives cash either at the time the revenues are generated or later by collecting an accounts
receivable.
• Sales - The total amount charged customers for merchandise sold, including cash sales and sales
on account.
Relevant Example Exercises and Exhibits
• Example Exercise 6-1 Gross Profit
• Exhibit 1 – The Operating Cycle for a Merchandising Business
SUGGESTED APPROACH
The goal of Objective 1 is to introduce the student to the basic skeleton of the income statement for the
merchandiser.
Sales
– Cost of Merchandise Sold
Gross Profit
– Operating Expenses
Net Income
To demonstrate the need for this new format, ask your students the following question: What is the largest
expense incurred by a retail store, such as Target or Old Navy? (Answer: the cost of the merchandise that
is sold to the customer)
Because this cost is the retailer’s major expense, it is shown separately from the operating expenses when
preparing the income statement. The cost of merchandise sold is deducted from sales to get the subtotal
gross profit. This amount is the profit left after “paying for” the merchandise that was sold to the
customer. It must be used to “pay” the retailer’s operating expenses, such as salaries, rent, utilities, and
advertising. It might be beneficial to clarify up front that a merchandising business both buys and sells
merchandise inventory. Make sure the student can put on the buyer’s hat and the seller’s hat and
distinguish between the two activities.
Objective 1 also introduces Merchandise Inventory, explaining that this account is reported as a current
asset on the balance sheet.
Chapter 6 Accounting for Merchandising Businesses 101
OBJECTIVE 2
Describe and illustrate the accounting for merchandise transactions.
SYNOPSIS
NetSolutions becomes a retailer in this chapter and its transactions are illustrated by using a simplified
general journal. Using a perpetual inventory system, the merchandise available for sale and the cost of
goods sold are continuously updated. As computerized inventory is widely used, this method has become
more common. When merchandise is purchased by the retailer, an inventory account is debited and the
credit goes to either Cash or Accounts Payable. The terms laying out how the merchandise is to be paid
for are called credit terms. If payment on delivery is required, the terms are cash or net cash. If the buyer
is permitted an amount of time to pay, it is called the credit period. The credit period usually begins with
the date of the invoice. Terms expressed as 2/10, n/30 means a discount of 2% will be given if the invoice
is paid within 10 days and the net amount is due within 30 days. Exhibit 2 shows a typical invoice with
credit due terms, and Exhibit 3 illustrates how to count days for the credit terms. Discounts taken by the
buyer are called purchase discounts. Under the perpetual inventory system, the buyer debits Merchandise
Inventory and credits Accounts Payable assuming all purchase discounts are taken. In this way,
merchandise inventory shows the net amount paid to the buyer.
If a retailer returns any merchandise, the retailer may request an allowance for merchandise returned.
From the buyer’s perspective, these returns are called purchases returns and allowances. The buyer sends
the seller a debit memo, which shows the seller the amount the buyer is requesting to debit to Accounts
Payable and also the reasons for the request. The buyer then debits Accounts Payable and credits
Merchandise Inventory. If the buyer is granted the allowance prior to paying the invoice, the amount is
deducted before computing any discounts.
Cash sales are recorded as a debit to Cash and a credit to Sales for the amount of the sale. Using the
perpetual inventory system, the decrease in inventory must also be recorded at the same time. Cost of
Goods Sold is debited, and Inventory is credited for the amount the inventory cost the buyer. If a credit
card is used, the transaction is recorded as a cash sale and the credit card processing fee charged the
retailer is paid periodically by the retailer. Credit card companies charge retailers a processing fee, which
when paid is recorded as debit to an expense account and credit to Cash. If the retailer sells on account, an
account receivable is debited, a sale is credited, and the cost of merchandise sold and merchandise
inventory is recorded as above. If the seller is offering the buyer credit terms, it will reduce the amount in
sales. If the product is returned, it will also reduce the amount of sales.
Purchases and sales of merchandise often involve freight costs. FOB (free on board) shipping point means
that ownership of the merchandise passes to the buyer when it is picked up by the freight carrier. This also
means that the buyer will be paying the shipping costs. FOB destination means ownership of the
merchandise does not pass to the buyer until it is physically received. This means that shipping costs are
usually paid by the seller. In the first case, shipping costs are paid by the buyer and debited directly to the
inventory account. When freight costs are paid by the seller, the cost of the freight is debited to an
expense account. These freight terms are summarized in Exhibit 6. Exhibit 7 summarizes how these
transactions are journalized using T accounts.
Another topic that is addressed in the chapter is sales tax. When a retailer sells merchandise to the end
consumer, a liability for sales tax is incurred. The seller collects the taxes at the time of sale. Accounts
receivable is debited for the total amount, Sales is credited for only the price of the merchandise, and an
additional amount is credited to the sales tax payable account. Businesses that sell to other businesses for
102 Chapter 6 Accounting for Merchandising Businesses
resale do not charge sales taxes. These businesses may offer trade discounts to other businesses that are
not offered to consumers. Usually, only the net price is recorded in this type of transaction.
Key Terms and Definitions
• Credit Memorandum (Credit Memo) - A form used by a seller to inform the buyer of the
amount the seller proposes to credit to the account receivable due from the buyer.
• Credit Period -The amount of time the buyer is allowed in which to pay the seller.
• Credit Terms - Terms for payment on account by the buyer to the seller.
• Debit Memorandum (Debit Memo) - A form used by a buyer to inform the seller of the amount
the buyer proposes to debit to the account payable due the seller.
• FOB (Free on Board) Destination - Freight terms in which the seller pays the transportation
costs from the shipping point to the final destination.
• FOB (Free on Board) Shipping Point - Freight terms in which the buyer pays the transportation
costs from the shipping point to the final destination.
• Invoice - The bill that the seller sends to the buyer.
• Periodic Inventory System - The inventory system in which the inventory records do not show
the amount available for sale or sold during the period.
• Perpetual Inventory System - The inventory system in which each purchase and sale of
merchandise is recorded in an inventory account.
• Physical Inventory - A detailed listing of merchandise on hand.
• Purchases Discounts - Discounts taken by the buyer for early payment of an invoice.
• Purchases Returns and Allowances - From the buyer’s perspective, returned merchandise or an
adjustment for defective merchandise.
• Sales Discounts - From the seller’s perspective, discounts that a seller may offer the buyer for
early payment.
• Trade Discounts - Discounts from the list prices in published catalogs or special discounts
offered to certain classes of buyers.
Relevant Example Exercises and Exhibits
• Example Exercise 6-2 Purchases Transactions
• Example Exercise 6-3 Sales Transactions
• Example Exercise 6-4 Freight Terms
• Example Exercise 6-5 Transactions for Buyer and Seller
• Exhibit 2 – Invoice
• Exhibit 3 – Credit Terms
• Exhibit 4 – Debit Memo
• Exhibit 5 – Credit Memo
• Exhibit 6 – Freight Terms
• Exhibit 7 – Recording Merchandise Inventory Transactions
• Exhibit 8 – Illustration of Merchandise Inventory Transactions for Seller and Buyer
• Exhibit 9 – Chart of Accounts for NetSolutions, a Merchandising Business
SUGGESTED APPROACH
This objective demonstrates to the student that merchandising businesses engage in purchasing and
selling of merchandise inventory. First the purchase of inventory is demonstrated using the perpetual
Chapter 6 Accounting for Merchandising Businesses 103
method of accounting for inventory. Note the periodic method is demonstrated in the appendix to the
chapter.
The second part of this objective covers the entries to record sales in a perpetual inventory system. Begin
by stressing that selling merchandise to a customer requires two entries—one to record the sales revenue
and another to remove the item sold from merchandise inventory.
DEMONSTRATION PROBLEM—Entries for Merchandise Purchases
Purchases of merchandise for resale to a customer are recorded in the merchandise inventory account.
Point out that this account is an asset. Therefore, it is debited whenever inventory is increased and
credited whenever inventory is decreased.
TM 6-18 lists purchase-related transactions for S & V Office Supply Company. Read the first transaction
to your students and ask them to journalize it in their notes. After giving them a minute to work, show
them the correct journal entry. Proceed with the other transactions listed on the TM. The correct journal
entries are listed on TM 6-19. Use transaction 5 to explain the concept of a debit memo in regards to
returned merchandise.
The transactions on TM 6-18 do include references to credit terms (for example, 2/10, n/30). Remind
students that all merchandise purchases are recorded at invoice price; discounts are shown as a reduction
to the cost recorded for the inventory only if they are taken. The amount of the discount is credited to the
merchandise inventory account at the time of payment.
DEMONSTRATION PROBLEM—Entries to Record Merchandise Sales
TMs 6-11 and 6-12 present a matrix that explains the new accounts related to sales. Review these
transparencies with your class.
TMs 6-13 and 6-14 list several sales-related transactions for S & V Office Supply Company. One method
to present this material is to give the students examples of the entries to record the sale of inventory items
in lecture format. Another is to allow students to decipher the entries on their own. Try reading the first
transaction to your students and ask them to journalize it in their notes. After giving them a minute to
work, show them the correct journal entry. Proceed with the other transactions listed on the TM. The
correct journal entries are listed on TMs 6-15 and 6-16. Use transaction 4 to demonstrate the use of a
credit memo for acknowledgement of returned merchandise.
The transactions on TM 6-13 do include references to credit terms (for example, 2/10, n/30). You may
want to explain these credit terms before beginning this exercise.
WRITING EXERCISE—Recording Merchandise Sales
To emphasize some of the operational considerations in recording sales, ask your students to write
answers to one or more of the following questions (TM 6-17).
1. Why would a retailer offer customers a discount for timely payment?
2. If you owned a merchandising business, how would you decide which credit cards, if any, to accept?
3. Which of the following credit terms would be more generous to your customers: n/30 or n/eom?
Possible responses: 1) Retailers offer discounts to customers to encourage them to pay early to improve
cash flow. 2) A large expense for merchandisers is credit card fees. These costs would come into the
decision making process. On the other hand, the convenience of consumers using credit cards and those
cards that the majority of buyers carry will also factor into this decision process. 3) The only time the
n/eom is more favorable is when an invoice is issued on the first day of the month in a month that has 31
days.
LECTURE AID—Discounts
For many students, a 2 percent discount doesn’t sound very impressive. They may need a little help
understanding the true financial impact of taking discounts on purchases. The following questions will
stress the savings of taking discounts:
1. What is the net savings from borrowing at a 12 percent interest rate in order to take the discount on a
$10,000 purchase, terms 1/10, n/30? Answer: $34 ($100 – [$9,900 20/360 12%]).
2. What is the interest rate earned on taking a discount with terms 3/15, n/60? Answer: 24 percent (3%
360/45).
LECTURE AID—Transportation Costs on Sales
If merchandise is sold FOB destination, the seller is responsible for paying the shipping cost. The cost is
debited to Freight Out or Delivery Expense. For example, assume goods costing $100 are sold to a
customer on account for $250, terms FOB destination. The freight cost paid to have these goods delivered
is $25. The following entries are needed to record this sale and the transportation costs:
Accounts Receivable………… 250
Sales…………………. 250
Cost of Merchandise Sold…… 100
Merchandise Inventory 100
Delivery Expense………….. 25
Cash…………………. 25
FOB (free on board) terms identify (1) when legal title to goods passes from seller to buyer and (2) who is
responsible for paying transportation costs. TM 6-20 lists the operational implications of FOB terms.
Notice that TM 6-20 points out that the buyer bears the risk of loss during transportation when
merchandise is shipped FOB shipping point. Therefore, the buyer should make sure that the merchandise
is insured against loss during shipment.
Chapter 6 Accounting for Merchandising Businesses 105
A couple of points related to shipping terms usually need special emphasis. First, when merchandise is
shipped FOB shipping point, the seller frequently prepays the transportation costs and adds this amount to
the buyer’s invoice. Second, remind students that transportation costs are not eligible for early payment
discounts. Those discounts apply only to the cost of the merchandise purchased. To test their
understanding of these concepts, ask them to compute the cash to be paid in the following problem (TM
6-21).
Logan Appliances purchased $8,000 of merchandise, 2/10, n/30, FOB shipping point. The seller prepaid
the shipping charges of $200. If Logan pays for this merchandise within the discount period, how much
should Logan remit to the seller? (Answer: $8,040)
DEMONSTRATION PROBLEM—Transportation Costs on Purchases
Ask your students to record the transactions related to the purchase of merchandise and transportation
costs on TM 6-22. The correct entries are listed on TM 6-23.
TEACHING SUGGESTION—Chart of Accounts, Trade Discounts, and Sales
Tax
Chart of Accounts: After explaining the text’s system, it is interesting to point out the variety in charts of
accounts and their numbering systems by providing some real-world examples. Ask students to bring in
copies of charts of accounts for merchandising businesses. Students may have access to charts of accounts
through their job or the job of a relative. There are also several Web sites that provide sample charts of
accounts to various industries. These can be found by searching for “chart of accounts” using an Internet
search engine. Many industry trade organizations will provide these samples on their Web site. As an
alternative, you may want to describe the chart of accounts for a local company with which you are
familiar.
In discussing the chart of accounts for a merchandising firm, the text uses a three-digit account number.
This reflects the growing number of accounts required by the increased complexity of a merchandiser’s
accounting transactions.
Under the three-digit chart of accounts, the first digit represents the account classification (1 for assets, 2
for liabilities, etc.). The second digit represents the sub classification (11 for current assets and 21 for
current liabilities). The third digit identifies the specific account.
Trade Discounts: To introduce trade discounts to your students, you need only to define the term and
give a quick example. A trade discount is a discount off the normal (or list) price of merchandise given to
a certain class of buyers, such as customers buying wholesale, not-for-profits, or governmental agencies,
etc. If merchandise with a list price of $700 is sold to a customer entitled to a 25 percent trade discount,
the selling price is reduced to $525 ($700 25% = $175; $700 – $175 = $525). Remind students that
trade discounts are not shown separately in journal entries. The amount credited to sales (and debited to
cash or accounts receivable) is simply the discounted price.
106 Chapter 6 Accounting for Merchandising Businesses
Sales Tax: Unless your students have lived exclusively in a state that does not charge sales tax, they will
already be familiar with this concept. Remind students that when sales tax is collected by a merchandiser
at the time of a sale, it is recorded in a liability account (sales tax payable); the merchandiser is obligated
to remit the sales tax collected to the appropriate government authority. You may want to refer to the
journal entries related to sales tax in the text.
OBJECTIVE 3
Describe and illustrate the financial statements of a merchandising business.
SYNOPSIS
Merchandising businesses have a few unique items in their financial statements. First, let’s take a look at
the multiple-step income statement shown in Exhibit 10. The first section shows sales. The cost of
merchandise sold is subtracted from sales to calculate gross profit. The operating expense section is
divided in two parts: selling expenses and administrative expenses. The total expenses are subtracted from
gross profit to calculate income from operations, and then there is a small section for other income and
expenses before arriving at net income. Exhibit 11 displays the same information in a single-step income
statement. The statement of owner’s equity for a merchandising business does not differ from the service
business statement shown in previous chapters. The balance sheet may be presented two ways. In the
account form, the asset section is displayed on the left side and the liability and owner’s equity is on the
right. The balance sheet may also be presented in a downward sequence of three sections known as the
report form. The balance sheet for NetSolutions in the report form is in Exhibit 13.
Key Terms and Definitions
• Account Form - The form of balance sheet that resembles the basic format of the accounting
equation, with assets on the left side and Liabilities and Owner’s Equity sections on the right side.
• Administrative Expenses (General Expenses) - Expenses incurred in the administration or
general operations of the business.
• Income from Operations (Operating Income) - Revenues less operating expenses and service
department charges for a profit or an investment center.
• Multiple-Step Income Statement - A form of income statement that contains several sections,
subsections, and subtotals.
• Other Expense - Expenses that cannot be traced directly to operations.
• Other Income - Revenue from sources other than the primary operating activity of a business.
• Report Form - The form of balance sheet with the Liabilities and Owner’s Equity sections
presented below the Assets section.
• Sales - Revenue received for merchandise sold to customers.
• Selling Expenses - Expenses that are incurred directly in the selling of merchandise.
• Single-Step Income Statement - A form of income statement in which the total of all expenses is
deducted from the total of all revenues.
Chapter 6 Accounting for Merchandising Businesses 107
Relevant Example Exercises and Exhibits
• Exhibit 10 – Multiple-Step Income Statement
• Exhibit 11 – Single-Step Income Statement
• Exhibit 12 – Statement of Owner’s Equity for Merchandising Business
• Exhibit 13 – Report Form of Balance Sheet
SUGGESTED APPROACH
This objective introduces the multiple-step income statement. This income statement format contains
various sections, subsections, and subtotals, which increase the length and complexity of the income
statement. Point out that the benefit of this more detailed format is greater flexibility in analyzing a
company’s performance. For example, the gross profit percentage (gross profit divided by sales) is used
to analyze the mark-up above cost charged by retailers.
The trap that many students fall into is blindly attempting to memorize the multiple-step income
statement line by line. Instead, they need to approach it as a series of pieces (sections) that must be fit
together to provide a total picture of a company—similar to fitting together pieces of a jigsaw puzzle.
Note: The format of the multiple-step income statement is significantly different in the area of Cost of
Merchandise Sold when periodic inventory is used than when perpetual inventory is used.
GROUP LEARNING ACTIVITY—Multiple-Step Income Statement
Before digging into the multiple-step income statement, you will need to define the new terms for your
students.
Sales: The total amount charged customers for merchandise sold. (This is a revenue account.)
Cost of Merchandise Sold: The cost to purchase the inventory being sold.
Gross Profit: Proceeds available for selling and administrative expenses.
Selling Expenses: Costs directly incurred in selling the merchandise, such as the cost of advertising or
commissions paid to salespersons.
Administrative Expenses: Costs incurred in the administration or general operations of the business, such
as the cost of office supplies or the salary paid to an accountant.
Income from Operations: Profit earned by the conducting company’s primary business of buying and
selling merchandise.
Other Income: Revenue from sources other than the company’s primary business, such as interest revenue
on a checking account or rent revenue from leasing unused space.
Other Expense: Costs incurred from activities other than the company’s primary business of buying and
selling its product, such as interest expense on business loans.
You may want to demonstrate how intuitive the calculations are on the income statement by asking the
following question:
Assume a retailer sold $100 in merchandise to a customer on account. That customer returned $10 of the
merchandise. The customer also paid for the remaining merchandise early, entitling her to a $5 discount.
What amount of revenue was really earned on the sale? (Answer: $85)
TM 6-2 lists an adjusted trial balance for Gem City Music. Divide students into small groups and ask
them to prepare an income statement for this retailer. A completed income statement is shown on TM 6-3.
GROUP LEARNING ACTIVITY—Statement of Owner’s Equity and Balance
Sheet
This learning objective contrasts the account form of balance sheet (assets on the left-hand side and
sheet from the adjusted trial balance for Gem City Music on TM 6-2. See TMs 6-4 and 6-5 for the
completed financial statements.
OBJECTIVE 4
Describe the adjusting and closing process for a merchandising business.
SYNOPSIS
Closing entries are similar to a service business. Temporary accounts are closed to Income Summary,
Income Summary is closed to the owner’s equity account, and the owner’s drawing account is closed to
Chapter 6 Accounting for Merchandising Businesses 109
the owner’s equity account. After the closing entries and post-closing trial balance are prepared, only
permanent accounts are shown on the post-closing trial balance.
Key Terms and Definitions
• Inventory Shrinkage (Inventory Shortage) - The amount by which the merchandise for sale, as
indicated by the balance of the merchandise inventory account, is larger than the total amount of
merchandise counted during the physical inventory.
Relevant Example Exercises and Exhibits
• Example Exercise 6-6 Inventory Shrinkage
SUGGESTED APPROACH
This objective introduces the adjusting entry for inventory shrinkage. Remind students that merchandisers
also record any of the adjusting entries introduced in Chapter 3 that are applicable (for example, supplies
used, insurance expired, wages owed to employees, fees earned, etc.). It also discusses closing entries;
point out to students that closing entries for a merchandising business are similar to those for a service
business. Discuss the new merchandising accounts that are added as part of the closing process. Cost of
merchandise sold is an all new merchandising account that gets closed along with the already familiar
expense accounts. The revenue account for merchandising business is the Sales account and requires a
debit entry to close the account.
The adjusting process may require Merchandise Inventory to be adjusted for various causes (see text).
Ask students to name a few. Large shortages can exist due to spoilage and shrinkage or maybe theft
(employee, customer, unknown). The related expenses are Cost of Merchandise Sold, and likewise,
Merchandise Inventory has disappeared, so it must be reduced (credited). Large shrinkage/shortages may
be put in a separate expense account, but they still increase Cost of Merchandise Sold. Physical inventory
and book inventory must agree at the end of the period.
LECTURE AID—Adjusting Entry for Inventory Shrinkage
Unfortunately, inventory shrinkage is considered a normal cost of operations for a retailer. Theft of
inventory (shoplifting), damaged inventory, and mistakes in recording inventory can never be totally
eliminated. Therefore, the inventory account must be adjusted prior to preparing financial statements. Any
shrinkage is recorded as an expense.
For example, assume a company’s perpetual inventory records show that there should be $89,500 of
inventory on hand. (Emphasize that the perpetual records show what should be in inventory based on
merchandise purchased and sold during the year.) However, a physical inventory count reveals that only
$87,000 is actually on hand at year end. Ask your students to determine the amount of shrinkage.
(Answer: $2,500)
110 Chapter 6 Accounting for Merchandising Businesses
This shrinkage is recorded as follows:
Cost of Merchandise Sold………. 2,500
Merchandise Inventory….. 2,500
You may want to point out that if the amount of shrinkage is unusually large, it is better to record it in a
separate account, such as Loss from Merchandise Inventory Shrinkage; stress that all companies must do
a physical inventory count at least once per year to verify the information in the perpetual inventory
records.
LECTURE AID—Closing Process for Merchandising Business
The process of closing entries has not changed from Chapter 4; there are simply more accounts to close.
In a perpetual inventory system cost of merchandise sold accounts are closed to Income Summary, along
with the other debit balance accounts shown in the Income Statement column of the end-of-period
spreadsheet (work sheet). The Sales account is the revenue account closed to Income Summary.
GROUP LEARNING ACTIVITY—Closing Entries for a Merchandiser
TM 6-25 reviews the basics of the closing process. Remind students that closing entries can be taken
directly from the Income Statement columns of the end-of-period spreadsheet (work sheet). Also stress
that the balance of the Income Summary account after the first two closing entries must equal the net
income or net loss for the period. After a brief review of these concepts, ask your students to prepare
closing entries for Gem City Music, using the work sheet on Handout 6-1 (TM 6-24). These closing
entries are displayed on TM 6-26.
OBJECTIVE 5
Describe and illustrate the use of the ratio of sales to assets in evaluating a company’s
operating performance.
SYNOPSIS
To measure how effectively a company uses its assets to generate sales, the ratio of sales (Sales/ Average
Total Assets) is computed. This objective gives an example of the ratio and shows the calculation for
average assets to be the average of the assets at the beginning and end of the year.
Key Terms and Definitions
• Ratio of Sales to Assets - Ratio that measures how effectively a company uses its assets,
computed as sales divided by average total assets.
Chapter 6 Accounting for Merchandising Businesses 111
Relevant Example Exercises and Exhibits
• Example Exercise 6-7 Ratio of Sales to Assets
SUGGESTED APPROACH
Explain to students that the assets of a company are “used up” as a normal part of conducting business.
How efficiently a company uses those assets to generate sales is another good indicator of the company’s
operating performance. As the text indicates, the value of the assets used to compute the ratio may be the
total assets at the end of the year, the average between the beginning and the end of the year, or the
average of the monthly assets.
APPENDIX—THE PERIODIC INVENTORY
SYSTEM
SYNOPSIS
The periodic inventory system may be used for businesses that use a manual accounting system. In the
periodic system, the cost of merchandise sold is determined at the end of the period. An example is shown
in Exhibit 14. Additional accounts used in this system are shown in the chart of accounts in Exhibit 15.
Using the periodic system, instead of recording merchandise purchases in the inventory account,
purchases, purchases discounts, purchase returns and allowances, and freight in accounts are used. The
adjusting process is the same under this system with the exception of the adjustment for shrinkage. Since
the inventory account is not kept up to date, shrinkage can be determined only indirectly in the cost of
merchandise sold. The closing process is the same under the periodic system except that the names of the
accounts change. Examples of the closing entries are on page 292 in the text.
Relevant Example Exercises and Exhibits
• Exhibit 14 – Determining Cost of Merchandise Sold Using the Period System
• Exhibit 15 – Chart of Accounts Under the Periodic Inventory System
• Exhibit 16 – Transactions Using the Periodic and Perpetual Inventory Systems
SUGGESTED APPROACH
Chapter 6 assumes the merchandising business uses a perpetual inventory system. Some business may
still use a periodic inventory system, and this appendix points out the differences in the two systems.
Point out Exhibit 14 in the text, and emphasize the difference in accounts and timing of recording Cost of
Merchandise Sold between the periodic and perpetual inventory systems.
Problems 6-8A or 6-8B in the textbook can be used to demonstrate the entries and differences between
the two inventory methods.
112 Chapter 6 Accounting for Merchandising Businesses
LECTURE AID—Calculating Cost of Merchandise Sold Using the Periodic
Inventory System
This objective presents a brief comparison of the perpetual and periodic inventory systems. TMs 6-6
through 6-8 contrast the two inventory systems, show the costs and benefits of a perpetual inventory
system, and offer insight on how businesses choose an inventory system. To illustrate the essence of a
perpetual inventory system, relate it to a checkbook. Maintaining a checkbook register for a bank account
is a type of perpetual inventory system. By tracking increases (deposits) and decreases (withdrawals or
checks written) in the checkbook register, you can keep a running balance of your cash.
A merchandiser who uses the periodic inventory system must compute the Cost of Merchandise Sold
when preparing an income statement. This calculation is based on the amount of inventory purchased and
the amount in inventory at the beginning and the end of the period. The following story will illustrate this
calculation.
Assume that you are a “Twinkies junkie.” Whenever you study, you eat Twinkies. One evening, before a
big accounting test, you go to your cupboard and find that you have only three Twinkies left. You know
that three Twinkies will never get you through the night, so you head off to the grocery to buy another
box. The box contains twelve Twinkies. You then proceed to study and eat, study and eat, and study and
eat. The next morning, you decide to figure out how many Twinkies you ate while studying. You didn’t
count the Twinkies as you ate them, but you know the old box is empty and the new box has only five
Twinkies left. How many Twinkies did you eat? (After waiting for a response, continue the illustration.)
Let’s review your calculation using accounting terminology. You started with a beginning inventory of
three Twinkies. You then purchased twelve Twinkies. This gave you fifteen Twinkies available for
consumption. Since five Twinkies were left in ending inventory, you must have eaten ten.
This is essentially the calculation of Cost of Merchandise Sold under a periodic inventory system:
Merchandise Inventory on hand at the beginning of the year
+ Cost of Merchandise Purchased
Merchandise Available for Sale
– Merchandise Inventory left at the end of the year
Cost of Merchandise Sold
When purchasing merchandise inventory, a business may be required to pay transportation costs to have
the merchandise delivered from the supplier. The purchaser may also receive early payment discounts or
make returns of unwanted merchandise. Therefore, the Cost of Merchandise Purchased must be calculated
as follows:
Purchases
– Purchase Returns and Allowances
– Purchase Discounts
Net Purchases
+ Transportation In
Cost of Merchandise Purchased
TM 6-9 shows these calculations and how they fit together.
TM 6-10 provides a practice problem related to the calculation of Cost of Merchandise Sold in the
periodic system. Ask your students to calculate the Cost of Merchandise Purchased (answer: $975) and
the Cost of Merchandise Sold (answer: $905).
Handout 6-1
A
B
C
D
E
F
G
H
I
J
K
1
Gem City Music
2
End-of-Period Spreadsheet (Work Sheet)
3
For the Year Ended December 31, 20--
4
Unadjusted
Adjusted
Income
Balance
5
Trial Balance
Adjustments
Trial Balance
Statement
Sheet
6
Account Title
Dr.
Cr.
Dr.
Cr.
Dr.
Cr.
Dr.
Cr.
Dr.
Cr.
7
Cash
11,000
11,000
11,000
8
Accounts Receivable
15,800
15,800
15,800
9
Merchandise Inventory
10,400
800
9,600
9,600
10
Office Equipment
23,000
23,000
23,000
11
Acc. Depr.—Office
Equip.
6,400
2,800
9,200
9,200
12
Accounts Payable
16,000
16,000
16,000
28
Type Item Description LO(s) Difficulty Time Est BUSPROG AICPA ACBSP - APC Bloom's EE Excel GL SMH FAI Service Real World Writing Ethics Internet Group
DQ 1 1 Easy 5 min. Analytic Measurement Purpose Remembering
DQ 2 1 Easy 5 min. Analytic Measurement Financial Statements Remembering
DQ 3 3 Easy 5 min. Analytic Measurement Purc Remembering
DQ 4 3 Easy 5 min. Analytic Measurement Receivables Reporting Remembering
DQ 5 3 Easy 5 min. Analytic Measurement Receivables Reporting Remembering
DQ 6 2 Easy 5 min. Analytic Measurement Receivables Reporting Remembering
DQ 7 2 Easy 5 min. Analytic Measurement Inventories Reporting Remembering
DQ 8 2 Easy 5 min. Analytic Measurement Inventories Reporting Applying
DQ 9 2 Easy 5 min. Analytic Measurement Inventories Reporting Applying
DQ 10 2 Easy 5 min. Analytic Measurement Inventories Reporting Applying
PE 1A Gross profit 1 Easy 5 min. Analytic Measurement Inventories Reporting Applying x
PE 1B Gross profit 1 Easy 5 min. Analytic Measurement Inventories Reporting Applying x
PE 2A Sales transactions 2 Easy 5 min. Analytic Measurement Inventories Reporting Applying x
PE 2B Sales transactions 2 Easy 5 min. Analytic Measurement Inventories Reporting Applying x
EX 1 Determining gross profits 1 Easy 5 min. Analytic Measurement Inventories Reporting Applying x x
EX 2 Determining cost of merchandise sold 1 Easy 5 min. Analytic Measurement Inventories Reporting Applying x
EX 3 Purchase-related transactions 2 Easy 10 min. Analytic Measurement Inventories Reporting Applying x
EX 4 Purchase-related transactions 2 Easy 5 min. Analytic Measurement Inventories Reporting Applying
EX 5 Purchase-related transactions 2 Easy 10 min. Analytic Measurement Inventories Reporting Applying
EX 6 Purchase-related transactions 2 Easy 5 min. Analytic Measurement Inventories Reporting Applying x
EX 7 Purchase-related transactions 2 Moderate 15 min. Analytic Measurement Inventories Reporting Applying x
EX 8 Sales-related transactions, including the use of credit cards 2 Easy 20 min. Analytic Measurement Inventories Reporting Applying x
EX 9 Sales returns and allowances 2 Easy 10 min. Analytic Measurement Inventories Reporting Applying x
EX 10 Sales-related transactions 2 Easy 10 min. Analytic Measurement Inventories Reporting Applying x
EX 11 Sales-related transactions 2 Easy 10 min. Analytic Measurement Inventories Reporting Applying
EX 12 Sales-related transactions 2 Easy 10 min. Analytic Measurement Inventories Reporting Applying x
EX 13 Determining amounts to be paid on invoices 2 Moderate 15 min. Analytic Measurement Inventories Reporting Applying x
EX 14 Sales-related transactions 2 Easy 10 min. Analytic Measurement Inventories Reporting Applying x
EX 15 Purchase-related transactions 2 Easy 10 min. Analytic Measurement Inventories Reporting Applying x
EX 16 Chart of accounts 2 Easy 20 min. Analytic Measurement Purpose Remembering
EX 17 Sales tax 2 Easy 10 min. Analytic Measurement Inventories Reporting Applying x
EX 18 Sales tax transactions 2 Easy 10 min. Analytic Measurement Inventories Reporting Applying x
EX 19 Normal balances of merchandise accounts 2 Easy 5 min. Analytic Measurement Inventories Reporting Applying
EX 20 Income statement for merchandiser 3 Easy 5 min. Analytic Measurement Inventories Reporting Applying x
EX 21 Income statement for merchandiser 3 Easy 5 min. Analytic Measurement Inventories Reporting Remembering
EX 22 Determining amounts for items omitted from income statement 3 Moderate 15 min. Analytic Measurement Inventories Reporting Applying x
EX 23 Multiple-step income statement 3 Moderate 30 min. Analytic Measurement Inventories Reporting Applying x x
EX 24 Multiple-step income statement 3 Moderate 15 min. Analytic Measurement Financial Statements Applying
EX 25 Single-step income statement 3 Easy 10 min. Analytic Measurement Financial Statements Applying x
EX 26 Adjusting entry for merchandise inventory shrinkage 4 Easy 5 min. Analytic Measurement Inventories Reporting Applying x
EX 27 Closing the accounts of a merchandiser 4 Easy 5 min. Analytic Measurement Inventories Reporting Applying
EX 28 Closing entries, net income 4 Easy 10 min. Analytic Measurement Inventories Reporting Applying
PR 4A Sales-related transactions and purchase-related transactions for buyer and seller 2 Challenging 2 hours Analytic Measurement Recording Transactions Applying
PR 5A Multiple-step income statement and report form of balance sheet 3 Moderate 1.5 hours Analytic Measurement Financial Statements Applying x x
PR 6A Single-step income statement and account form of balance sheet 3 Moderate 1 hour Analytic Measurement Financial Statements Applying x
PR 7A Purchase-related transactions using periodic inventory system Appendix Moderate 45 min. Analytic Measurement Recording Transactions Applying
PR 8A Sales-related and purchase-related transactions using periodic inventory system Appendix Challenging 1.5 hours Analytic Measurement Recording Transactions Applying
PR 9A Sales-related and purchase-related transactions using periodic inventory system Appendix Challenging 2 hours Analytic Measurement Recording Transactions Applying
PR 10A Periodic inventory accounts, multiple-step income statement, closing entries Appendix Challenging 2 hours Analytic Measurement Inventories Reporting Applying x
PR 1B Purchase-related transactions 2 Moderate 45 min. Analytic Measurement Recording Transactions Applying x
PR 2B Sales-related transactions 2 Moderate 45 min. Analytic Measurement Recording Transactions Applying x x
PR 3B Sales-related transactions and purchase-related transactions 2 Challenging 1.5 hours Analytic Measurement Recording Transactions Applying x x
PR 4B Multiple-step income statement and report form of balance sheet 2 Challenging 2 hours Analytic Measurement Recording Transactions Applying x
PR 5B Multiple-step income statement and report form of balance sheet 3 Moderate 1.5 hours Analytic Measurement Financial Statements Applying x x
PR 6B Single-step income statement and account form of balance sheet 3 Moderate 1 hour Analytic Measurement Financial Statements Applying x
PR 7B Purchase-related transactions using periodic inventory system Appendix Moderate 45 min. Analytic Measurement Recording Transactions Applying
PR 8B Sales-related and purchase-related transactions using periodic inventory system Appendix Challenging 1.5 hours Analytic Measurement Recording Transactions Applying
PR 9B Sales-related and purchase-related transactions using periodic inventory system Appendix Challenging 2 hours Analytic Measurement Recording Transactions Applying
PR 10B Periodic inventory accounts, multiple-step income statement, closing entries Appendix Challenging 2 hours Analytic Measurement Inventories Reporting Applying x
Comprehensive Problem 2 Challenging 3 hours Analytic Measurement Recording Transactions Applying x
CP 1 Ethics and professional conduct in business 2 Easy 5 min. Ethics Measurement Recording Transactions Analyzing x x
CP 2 Purchases discounts and accounts payable 2 Easy 10 min. Analytic Measurement Financial Statement Analysis Analyzing x
CP 3 Determining cost of purchase 2 Moderate 15 min. Analytic Measurement Inventories Reporting Applying x
CP 4 Sales discounts 2 Challenging 30 min. Analytic Measurement Inventories Reporting Applying x
CP 5 Shopping for a television 2 Moderate 30 min. Analytic Measurement Inventories Reporting Analyzing
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