Introduction :

In Chapters 1-4, all text examples were ones involving service businesses. In
this lesson, we examine the accounting for merchandising operations -- those
that sell products. An example of a merchandising Income Statement appears
in Illustration 5-11 on page 198. You’ll note that in addition to the operating
expenses, there is something called Cost of Goods Sold. Cost of Goods Sold
is the cost of the inventory that was sold, and is often the major cost of a
merchandising company. The cost of inventory that was not sold would
appear as the balance of the inventory account on the Balance Sheet.

Learning Objectives

A productive approach to Chapter 5 is as follows:

1. Learn the account names, locations, and how the journal entries work;
2. Get a fundamental understanding of the Income Statement;

3. Study the closing entries for a merchandising company;

4. Consider how the Accounting system measures both costs and

revenues in support of the Income Statement, and the Inventory
balance on the Balance Sheet.

Merchandising Accounts and Journal Entries

There are two general methodologies for merchandising accounting:

1. The periodic inventory system;

2. The perpetual inventory system.
Chapter 5 concentrates on the perpetual system. The "perpetual" refers to the
fact that every purchase of inventory is debited to the Inventory account;
likewise, every sale of inventory is credited to the Inventory account.
Therefore, unless there has been a theft or unrecorded loss of some units of
inventory, the Inventory account should reflect the current cost of inventory
on hand.

Accounts Used in the Perpetual Inventory Method

In the perpetual inventory system, you'll find a new account in the assets
section (Merchandise Inventory) and several new accounts in owner's equity
that are used for recording sales, subtractions from sales, and cost of goods
sold.

Journal Entries for the Perpetual Inventory Method

As suggested above, the Perpetual method makes use of the Inventory

account when Inventory is purchased sold. Here is a summary of the typical
journal entries:

1. When inventory is purchased, a debit is made to the Inventory account

and a credit made to Cash or Accounts Payable. Inventory is a current
asset.

Example: Jones purchases $5,000 of Inventory on account, with terms

of 2/10, n/30. The journal entry would be:
2. If merchandise is returned to a supplier, a debit is made to Accounts
Payable or Cash, and a credit is made to the Inventory account.

Example: Jones returns $500 of goods to the supplier because they

were defective. The entry is:

3. When a sale of merchandise occurs, there are two entries. The first
entry is a debit to Accounts Receivable and a credit to Sales. The
second entry is a debit to Cost of Goods Sold and a credit to the
Inventory account. The Cost of Goods Sold is considered a type of
expense account, and this second entry transfers the inventory cost out
of the asset section and into Cost of Goods Sold. Remember that the
selling amount should be higher than the cost of the goods, since we
are in business to make a profit.
 Example: Jones sells $1,000 of Inventory for a price of $1,300, on
account, with terms of 2/10, n/30:

4. Depending upon prevailing interest rates, merchandisers may offer a

discount if their customer pays early. Such discounts are expressed
something like this: "2/10, n/30", which means that if the customer
pays within 10 days, the customer can deduct 2% of the amount of
their invoice. Suppose Jones pays off the supplier for the inventory
purchased in transaction 1 above. Keep in mind that he originally
purchased $5,000 of inventory, but that he immediately returned $500
to the supplier. He currently owes $4500. If he pays within 10 days, he
can deduct 2% of the invoice amount. Two percent of $4500 is $90,
and he can satisfy the invoice by paying $4410. Here is the journal
entry:
 Notice that, by paying early, we can reduce the cost of inventory by
$90.
5. Similarly, we can offer terms to our customers. Looking back at
transaction 3, if Jones offers terms of 2/10, n/30 on a sale of $1300,
the customer can deduct $26, and Jones will receive a check for $1274
to satisfy the bill:

6. If freight charges are paid on incoming merchandise, such charges are

just added to the inventory cost. For example, if freight of $80 is paid
for delivery of inventory to us, the entry is:

Freight charges are considered an additional cost of inventory from

the buyer's point of view. Note that from the seller's point of view,
freight charges are considered a selling expense (Freight Out).
7. If a customer returns goods to us, such goods are considered a Sales
Return. For example, if a customer returns goods for which $100 was
paid, the following entry would be made:
 Note: if the goods that are returned to us are unsaleable due to
damage or malfunction, no further entry is necessary. However, if the
returned items can be resold, they must be put back in the Inventory
account (at our cost), as follows:

You might think of this situation as an "unsale" of the goods; both the
Sale is reversed (by the debit to Sales Returns and Allowances) and
the cost of the sold inventory is moved from Cost of Goods Sold back
into the Inventory account. A convenient summary of these
merchandising transactions appears on page 194 in Illustration 5-5.

The Merchandising Income Statement

As mentioned earlier, the Merchandising Income Statement is illustrated on

page 198 in Illustration 5-11. The general format of this statement is as
follows:
This is the format for a multiple step income statement. There are two main
calculations (the steps), as follows:

1. Net Sales - Cost of Goods Sold = Gross Profit

2. Gross Profit - Expenses = Net Income

For simplicity, I've omitted the Other Revenues and Gains, and the Other
Expenses and Losses.

Your text also illustrates a single step income statement, in which Cost of
Goods Sold is simply presented as an ordinary expense. This form of
statement appears on page 199 in Illustration 5-12.

Closing Entries for Merchandising

Going back to the T-accounts for the Perpetual Inventory method, the
closing entries would be journalized as follows:

Sales XXX
Income Summary XXX
Income
XXX
Summary
Sales Discounts XXX
Sales Ret. & All. XXX
Cost of Goods
XXX
Sold
All Expenses... XXX

Income
XXX
Summary
Capital XXX

Capital XXX
Drawing XXX

An example of the closing entries appears on pages 193-194.

Hints and Check Figures for Chapter 5

Q5 Cost of Goods Sold is determined at the moment of sale.

Q15 Tricky question: Gross Profit is $39,000
Q16 Operating Expenses = $330,000
BE5-3a. Seller's viewpoint. Debit Accounts Receivable $800,000, credit
Sales $800,000; then debit COGS $620,000 and credit Merchandise
Inventory $620,000.
BE5-4a.. Buyer's viewpoint. Deebit Merchandise Inventory for $800,000
and credit Accounts Payable for $800,000.
P5-2A c. Net Sales = $12,650; Cost of Goods Sold = $8,800; Gross Profit =
$3,850. Check your journal entries here.

Consider the situation in which a person invests money for retirement. How
much would you hope to earn in a bank account, mutual fund, or in the stock
market? Would 6% be satisfactory to you? Turning to the nature of
merchandising businesses, what sort of return do you think they make?
There are a couple of interesting measures that you might consider:

1. Gross Profit Percentage = Gross Profit divided by Net Sales

2. Net Income as a Percent of Net Sales = Net Income divided by Net Sales

Choose two merchandising companies and then go to their web sites or home pages, and
see if you can locate the income statement. Calculate the Gross Profit Percentage and the
Net Income as a Percent of Net Sales. On the home page, look for something like "About
Us", "Investor Relations" or "Annual Reports." You might even be able to find enough
detail in the "Financial Highlights" section.

Two other items: unlike your textbook, most companies do not calculate the gross profit
in the income statement, so grab your calculator before logging in. Also, you may find
that Cost of Goods Sold is called "Cost of Sales" and may be combined with other costs.
This is ok; just make an approximate calculation. Here are some possibilities for your
search:

i) Perpetual Inventory System

A perpetual inventory system, as the name suggests, gives a continuous

record of the amount of inventory on hand. A perpetual inventory system
adds up all the merchandise purchases in the Inventory account, and
removes them from this account when an item is sold, and transfers it to
Cost of Goods sold. Therefore, a merchandise piece sits as Inventory on the
balance sheet of Costco when it is not sold. However as soon as it is sold, it
is moved from the Inventory account to Cost of goods sold, an expense item
on the Income statement. The advantage of using a perpetual inventory
system is that at any given point in time, we can see the amount of
merchandise inventory on hand without doing any calculations. The
perpetual inventory system has become popular due to advancements in
computer technology that continually post inventory transactions and keep
an updated account. Doing this on paper or by hand using human
accountants is impossible, especially for a large company such as Costco
Wholesale. Perpetual inventory systems therefore provide more timely
information to investors, are currently widely used across all businesses and
will be the focus of our tutorials here.

ii) Periodic Inventory System

A periodic inventory system, as the name suggests, provides a periodic

balance of the inventory account only at the end of an accounting period
such as March 31st, 2009 which is the end of first quarter for most large
corporations. Periodic inventory system does not update the inventory
account after every transaction. The cost of new purchases of merchandise is
recorded in a temporary expense account known as Purchases. When
merchandise is sold, revenue is recorded but the cost of the merchandise sold
is not yet recorded as cost. When financial statements are prepared at the end
of the year, the company takes a physical inventory count of its entire
warehouse(s). Each item on this physical inventory count is assigned a cost,
and total inventories are tabulated.
Periodic inventory systems were largely used by large hardware, drug &
department stores that sold large quantities of low-value items such as
shampoo, soap, toothpaste, etc. Without today’s Point of Sale (POS)
scanners, computers and cameras, it was not feasible enough for accounting
systems to track such small items.

Accounting for Merchandise Purchases – Perpetual Inventory System

i) Purchase of Inventory

Any purchase of merchandise is debited to the Merchandise Inventory

account and creates an accounts payable liability or cash payment entry.
Consider Binti Kiziwi Corp. records a purchase of $1,500 Sony camera on
credit on September 14th, 2009.

September 14th, 2009

Debit Credit
Account Name
Dr. Merchandise Inventory $1,500
Cr. Accounts Payable $1,500
Entry to record purchase of merchandise inventory on credit

ii) Purchase Returns & Allowances

Purchase returns are merchandise received by a buyer but returned to the

supplier due to reasons such as incorrect size, color, defective merchandise,
etc. This triggers a purchase return and a purchase allowance entry is made
to reduce the cost of merchandise purchased. For example, consider the
camera bought from Sony was defective but still able to be sold. Here are the
set of journal entries made to record the initial purchase of the camera, and
the defective return.

September 14th, 2009

Debit Credit
Account Name
Dr. Merchandise Inventory $1,500
Cr. Accounts Payable $1,500
Entry to record purchase of merchandise inventory on credit

Assume on October 9th, 2009, the defective camera is returned to Sony. The
journal entry made to record this is:

October 9th, 2009

Debit Credit
Account Name
Dr. Accounts Payable $400
Cr. Merchandise Inventory $400
Purchase allowance on inventory bought September 14th, 2009 due to defectiveness.

If this merchandise was bought for cash, then the journal entry will look
like:

October 9th, 2009

Debit Credit
Account Name
Dr. Cash $400
Cr. Merchandise Inventory $400
Cash refund on inventory bought September 14th, 2009 due to defectiveness

iii) Purchase Discounts

Merchandise that is bought on credit requires a clear statement of expected
amounts & dates of future payments as well as terms of credit. Credit terms
are a listing of the amounts & timing of payments between a buyer and a
seller, and the discount percent if the payment is made within a certain time
period. The equation for setting up the terms is: n/10 = EOM. The EOM
means “end of month” and most invoices are due for payment in 30 days,
thus making the EOM 30 days. The “n” in this case means the discount
percent if the payment is made within 10 days. Thus, the following equation
means
2.5/10 = 30 days -> 2.5% discount if invoice is paid within 10 days,
otherwise the invoice is due in 30 days.

A seller offering a cash discount when the credit period is long is

encouraging the buyer to make prompt payment. The buyer thus views this
as a purchase discount. In the eyes of the seller, this is a sales discount. To
illustrate these concepts, let’s do a journal entry. Consider Binti Kiziwi Corp.
records a purchase of $1,500 Sony camera on credit on September 14th,
2009, for terms of 2/10 n30 days.

September 14th, 2009

Debit Credit
Account Name
Dr. Merchandise Inventory $1,500
Cr. Accounts Payable $1,500
To record purchase of merchandise inventory on credit

Now consider that Binti Kiziwi Corp. takes advantage of this discount
offering, and pays the invoice by September 20th, 2009. Here is the journal
entry we record in our books:
September 20th, 2009
Debit Credit
Account Name
Dr. Accounts Payable $1,500
Cr. Cash ($1,500 x 98%) $1,470
Cr. Merchandise Inventory ($1,500 x 2%) $30
To record payment of invoice of Sony camera purchased on credit with 2/10 n30 terms on
September 14th, 2009.

Accounting for Merchandising Operations

Merchandising- buying and selling products rather than services

Merchandisers have additional items on balance sheet and income statement

Balance Sheet- inventory (asset)

Income Statement- sales revenue/sales, cost of goods sold (expense)

Operating Cycle of Merchandising Business

1. Company purchases inventory from vendor

2. Sells inventory to customer
3. Collects cash from customers

Two kinds of inventory accounting systems:

- Periodic System- used for inexpensive goods, updated through

inventory counting

- Perpetual System- up to date computerized record

Units purchased and their costs

Units sold, sales and cost amounts

Quantity on hand and its cost

Purchasing Inventory

Inventory is asset (debit)

Accounts Payable is credit

Purchase discounts

3/15, Net 30 Days or 3/15, n/30

- Deducts 3% from total bill if paid within 15 days, or else total

balance due in 30 days

Eom- end of month

Paying Inventory

Accounts payable debit

Cash credit

If paid in discount frame the discounted value is under inventory

Purchase Return- returning merchandise that is defective, damaged,

unusable

Purchase Allowances- granted to purchaser as an incentive to keep goods

that are not “as ordered”

Returning inventory
Accounts payable is debited

Inventory is credited

Transportation Costs

FOB- Free on Board- is specified in purchase agreement to determine

when title to good transfers to the purchaser and who pays for the freight

FOB Shipping Point- buyer takes ownership to the goods at the shipping
point.

FOB Destination- buyer takes ownership of the goods at the destination

point

Freight in- transportation cost to ship goods into a warehouse

Freight out- transportation cost to ship goods out to customer

Freight In

- Discounts not on shipping cost. Shipping cost can be added to

inventory

Freight out

Operating expense- expenses that occur in the entity’s major line of

business

Delivery expense debit

Cash credit

Inventory – purchase allowance/returns – purchase discounts +freight in =

inventory(net cost)
Sale of Inventory

Sales Revenue (sales)- amount a business earns selling merchandise

Cost of goods sold (COGS) is the cost of inventory that has been sold

Cost of Sales (COS) – also known as cost of goods sold

Sales return- customer returning product asking for refund of credit

Sales Allowance

Sales Discount- discount amount would be collected

Freight Out- May have to pay delivery expense to ship goods to customer

Cash Sale

Cash debit

Sales revenue credit

Cost of goods sold debit

Inventory credit

Sales returns

Sales returns and allowances debit

Accounts receivable credit

Inventory debit

Cost of goods sold credit

Sales Allowances

Returns and allowances debit

Accounts receivable credit

Net Sales Revenue, Cost of Goods Sold, Gross Profit

Net sales – cost of goods sold = profit, Gross Profit, Gross Margin

Adjusting and Closing Accounts of a Merchandiser

Adjusting for Inventory’s Actual Count

Shrink reduces actual inventory

Yearly inventory found that total inventory is 300 dollars less

Cost of goods sold is debited 300

Inventory is credited 300