Chapter Four

Accounting for
Merchandising
Businesses

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,

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Inventory
 Inventory is tangible property that is
held for resale or will be used in
producing goods or services.
 Inventory is reported on the balance
sheet as an asset.
 Types of inventory:
 Merchandise inventory
 Raw materials inventory
 Work in process inventory
manufacturer
 Finished goods inventory

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,

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Inventory Cost
The cost principle requires
that inventory be recorded
for the price paid or the
consideration given up.
What type of transaction is
the purchase of inventory?

Asset Exchange if cash paid.

Asset Source if “on account”.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,

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Inventory Cost
 The amount recorded for inventory
should include:
 Invoice price (minus purchase
discounts), transportation-in costs (also
called “freight-in”), inspection costs, and
preparation costs.
 The company should accumulate
costs of purchases until raw materials
are ready for use or until merchandise
is ready for shipment to customers.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,
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Income Statement Change

Because of Cost of Goods Sold, the format for the
Income Statement is modified:

Net Sales 7,500

Less: Cost of goods sold
-3,000
Gross Profit Margin 4,500

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,

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Product Costs Versus Selling

and Administrative Costs
Selling &
Product
Admin.
Costs Costs

Costs that are not

included in
Costs that are
inventory. They
included in
are sometimes
inventory.
called period
costs.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,
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Cost of Goods Sold

 Cost of goods sold is calculated as the
number of units sold during the period
multiplied by their unit costs.
 Cost of goods sold is a major expense
item for most non-service businesses.
 The measurement of cost of goods sold is
an excellent example of the application of
the matching principle Why?
The Cost of Goods Sold EXPENSE is recorded in the period the units
are SOLD (REVENUE is recognized), regardless of when the units are
paid for. So, the EXPENSE is MATCHED against the related REVENUE.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,

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Cost of Goods Sold

Beginning inventory
Add: Purchases (net)
Cost of Goods Available for Sale
Deduct: Ending inventory
Cost of goods sold

Cost of Goods Available for Sale expresses

the total cost of what has been available for
sale throughout a given time period.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,

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Allocation of Inventory Cost
Between Asset and Expense
Accounts
Inventory Cost of
Beginning
Purchased Goods
Inventory + =
During the Available
Balance
Period for Sale

Merchandise
Inventory
Cost of Goods (Balance Sheet)
Available for Sale
Cost of Goods Sold
(Income Statement)
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,5-9
5- 10

Purchase $4,000 of Office Supplies

Date Account Title Debit Credit
Jan. 6 Supplies 4,000
Cash 4,000

Post from General Journal to the General Ledger

Supplies Cash
4,000 4,000

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,

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$1,000 of Supplies left over at the end of the month

Date Account Title Debit Credit
Jan. 30 Supplies Expense 3,000
Supplies 3,000
Record use of $3,000 of Supplies
Post from General Journal to the General Ledger
Supplies Expense Supplies
3,000 3,000

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,

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Purchase 1,000 units of Inventory for $4,000

Date Account Title Debit Credit
Jan. 6 Inventory 4,000
Cash 4,000
Purchase 1,000 units @ $4.00 each
Post from General Journal to the General Ledger
Inventory Cash
4,000 4,000

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,

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$1,000 of Inventory left over at the end of the month

Date Account Title Debit Credit
Jan. 30 Cost of Goods Sold 3,000
Inventory 3,000
Record sale of 750 units of Inventory
Post from General Journal to the General Ledger
Cost of Goods Sold Inventory
3,000 3,000

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,

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$3,000 of Inventory was sold for $7,500 Cash

Date Account Title Debit Credit
Jan. 30 Cash 7,500
Revenue 7,500
Record sale of Inventory @ $10 each
Post from General Journal to the General Ledger
Cash Sales Revenue
7,500 7,500

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,

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Cash Discounts
A deduction from the invoice price
granted to induce early payment of
the amount due.

Terms
Discount Period Credit Period
Time
Full amount Full amount due
Due less discount

Purchase or Sale
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,
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Terms of Sales & Purchases

Discount Terms: 2/10, n/30 (for example)
 2% discount if balance paid in ten days,
remainder to be paid within 30 days of
sale
 tells when and how much must be paid
 There is a high interest cost of not taking
purchase discounts when offered.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,

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Cash Discounts

2/10, n/30
Percentage # of Days Otherwise, # of Days
of Discount Discount Is the Full when Full
Available Amount Is Amount Is
Due Due

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,

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Terms of Sales & Purchases

 F. O. B. (Free On Board) shipping
point or F.O.B. destination
 tells who pays for the shipping and
when ownership “title” passes from
the seller to the buyer.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,

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FOB Shipping and

FOB Destination
 FOB Shipping Point:
Buyer pays the shipping costs
because ownership “title”
transfers to buyer at the point
the shipment starts on its
journey.
 FOB Destination:
Seller pays shipping costs
because title does not transfer
to the buyer until the goods
reach their destination (the
buyer’s place of business).
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,
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Who Pays for FOB?

Shipping Point

De
Supplier Su stina
pp tio
lie
rp n–
Destination
ays

Sh
i
Bu pping
s in
ess Pt –
pay Shipping Point
s
Business
De
Bu stin
sin ati Destination
e s on
sp –
Sh ay
s
Cu ippi
sto ng
me Pt
rp –
ay
s Customer

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,

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1. Purchased 1000 units for $4 each

on account.(Terms: 2/10, n/30)
Asset Source
Transaction

BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW

ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Accounts Com. Retain. Rev./ Exp./ Net OA,IA,FA
Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain - Loss = Inc. $ amt
1 4,000 = 4,000 =

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,

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1. Journalize & Post the purchase.

BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW

ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Accounts Com. Retain. Rev./ Exp./ Net OA,IA,FA
Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain - Loss = Inc. $ amt
1 4,000 = 4,000 =

GENERAL JOURNAL
Date Account Titles Debit Credit
1 Inventory 4000
Accounts Payable 4000
to record 1000 units purchased for $4 ea. on credit
GENERAL LEDGER ("T" - Accounts)
Assets = Liabilities + Equity
Cash Accounts Receiv. Accounts Payable Common Stock Retained Earnings
bb 5000 bb 4000 1000 bb 6000 bb 2000 bb
4000 (1) Sales Returns Sales Revenue

Inventory Cost of Gds Sold Transportation Out

(1) 4000

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,

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2. Paid a trucking company $500

to deliver the purchased units
to our warehouse.
Freight charges paid to get inventory to our place of
business (called TRANSPORTATION IN) is part of the
cost of the purchase. It is added to the Inventory account,
thus increasing the asset value. It is NOT “expensed”.
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Accounts Com. Retain. Rev./ Exp./ Net OA,IA,FA
Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain - Loss = Inc. $ amt
2 (500) 500 = = (500) OA

Asset Exchange
Transaction
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,
 2. Journalize & Post the transportation cost
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BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW

ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Accounts Com. Retain. Rev./ Exp./ Net OA,IA,FA
Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain - Loss = Inc. $ amt
2 (500) 500 = = (500) OA
GENERAL JOURNAL
Date Account Titles Debit Credit
2 Inventory 500
Cash 500
to record $500 Transportation In cost
GENERAL LEDGER ("T" - Accounts)
Assets = Liabilities + Equity
Cash Accounts Receiv. Accounts Payable Common Stock Retained Earnings
bb 5000 500 (2) bb 4000 1000 bb 6000 bb 2000 bb
4000 (1) Sales Returns Sales Revenue

Inventory Cost of Gds Sold Transportation Out

(1) 4000
(2) 500

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,

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3. Sold 620 units on account for $6

each. (Terms 1/10, n/30)
3a. Record the Sales Revenue and
related Receivable.

$6 sales price x 620 units = $3720

BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Accounts Com. Retain. Rev./ Exp./ Net OA,IA,FA
Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain - Loss = Inc. $ amt
3a 3,720 = 3,720 3,720 = 3,720
Asset Source
Transaction
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,
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3a. Journalize and Post the sale.

BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Accounts Com. Retain. Rev./ Exp./ Net OA,IA,FA
Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain - Loss = Inc. $ amt
3a 3,720 = 3,720 3,720 = 3,720

GENERAL JOURNAL
Date Account Titles Debit Credit
3a Accounts Receivable 3720
Sales Revenue 3720
to record 620 units sold @ $6 ea.
GENERAL LEDGER ("T" - Accounts)
Assets = Liabilities + Equity
Cash Accounts Receiv. Accounts Payable Common Stock Retained Earnings
bb 5000 500 (2) bb 4000 1000 bb 6000 bb 2000 bb
(3a)3720 4000 (1) Sales Returns Sales Revenue
3720 (3a)

Inventory Cost of Gds Sold Transportation Out

(1) 4000
(2) 500

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,

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3b. Record the Cost of the Goods Sold

and their removal from inventory.
What is the cost of each item in inventory?
$4.00 invoice price + $0.50 transportation
= $4.50 per unit
$500 transport / 1000 units

620 units sold x $4.50 cost each = $2790

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,

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3b. Record the Cost of the Goods Sold

and their removal from inventory.

620 units sold x $4.50 cost each = $2790

Cost of goods sold
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Accounts Com. Retain. Rev./ Exp./ Net OA,IA,FA
Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain - Loss = Inc. $ amt
3b (2,790) = (2,790) 2,790 = (2,790)

Asset Use
Transaction

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,

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3b. Journalize and Post the cost of the sale.

BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Accounts Com. Retain. Rev./ Exp./ Net OA,IA,FA
Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain - Loss = Inc. $ amt
3b (2,790) = 2,790 = (2,790)
GENERAL JOURNAL
Date Account Titles Debit Credit
3b Cost of Goods Sold 2790
Inventory 2790
to record the $4.50 cost of 620 units sold
GENERAL LEDGER ("T" - Accounts)
Assets = Liabilities + Equity
Cash Accounts Receiv. Accounts Payable Common Stock Retained Earnings
bb 5000 500 (2) bb 4000 1000 bb 6000 bb 2000 bb
(3a)3720 4000 (1) Sales Returns Sales Revenue
3720 (3a)

Inventory Cost of Gds Sold Transportation Out

(1) 4000 (3b) 2790 (3b) 2790
(2) 500

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4. The customer in Transaction #3A

returned 20 units for credit.
4a. Remove the previously recorded Sales
Revenue and related Account Receivable.
A separate “Sales
$6 sales price x 20 units = Return” contra-revenue
$120 account may be used.
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Accounts Com. Retain. Rev./ Exp./ Net OA,IA,FA
Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain- Loss = Inc. $ amt
4a (120) = (120) (120) = (120)
Asset Use
Transaction
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,
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4a. Journalize and Post the sales return.

BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Accounts Com. Retain. Rev./ Exp./ Net OA,IA,FA
Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain - Loss = Inc. $ amt
4a (120) = (120) = (120)

GENERAL JOURNAL
Date Account Titles Debit Credit
4a Sales Returns (a contra-revenue) 120
Accounts Receivable 120
record 20 units returned by customer @ $6 ea.
GENERAL LEDGER ("T" - Accounts)
Assets = Liabilities + Equity
Cash Accounts Receiv. Accounts Payable Common Stock Retained Earnings
bb 5000 500 (2) bb 4000 120 (4a) 1000 bb 6000 bb 2000 bb
(3a)3720 4000 (1) Sales Returns Sales Revenue
(4a) 120 3720 (3a)

Inventory Cost of Gds Sold Transportation Out

(1) 4000 2790 (3b) (3b)2790
(2) 500

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,

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4b. Put the cost of the 20 returned units back into

inventory and out of Cost of Goods Sold.
(Recall, the units were “costed out” of
inventory and charged to Cost of Goods
Sold at $4.50 each in Tr. #3b.)
Reduction in “Cost
$4.50 x 20 units = $90 of Goods Sold”.

BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW

ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Accounts Com. Retain. Rev./ Exp./ Net OA,IA,FA
Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain - Loss = Inc. $ amt
4b 90 = 90 (90) = 90

Asset Source
McGraw-Hill/Irwin Transaction © The McGraw-Hill Companies, Inc.,
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4b. Journalize and Post the return to inventory.

BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Accounts Com. Retain. Rev./ Exp./ Net OA,IA,FA
Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain - Loss = Inc. $ amt
4b 90 = 90 (90) = 90

GENERAL JOURNAL
Date Account Titles Debit Credit
4b Inventory 90
Cost of Goods Sold 90
record 20 units returned to inventory @ $4.50 ea.
GENERAL LEDGER ("T" - Accounts)
Assets = Liabilities + Equity
Cash Accounts Receiv. Accounts Payable Common Stock Retained Earnings
bb 5000 500 (2) bb 4000 120 (4a) 1000 bb 6000 bb 2000 bb
(3a)3720 4000 (1) Sales Returns Sales Revenue
(4a) 120 3720 (3a)

Inventory Cost of Gds Sold Transportation Out

(1) 4000 2790 (3b) (3b)2790 90 (4b)
(2) 500
(4b) 90

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5a. The Transaction #3a customer paid

within the ten day discount period.
Record the Sales Discount. (1/10, n/30)
Original Account Receivable (Transaction 3a) $3,720
Less: Sales Return (Transaction 4a) 120
Amount owed by customer before discount 3,600
x 1% sales discount 1%
Sales Discount $ 36
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Accounts Com. Retain. Rev./ Exp./ Net OA,IA,FA
Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain - Loss = Inc. $ amt
3a 3,720 = 3,720 3,720 = 3,720
4a (120) = (120) (120) = (120)
5a (36) = (36) (36) = (36)
Asset Source
McGraw-Hill/Irwin Transaction © The McGraw-Hill Companies, Inc.,
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5a. Journalize and Post the 1% Sales Discount.

ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Accounts Com. Retain. Rev./ Exp./ Net OA,IA,FA
Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain - Loss = Inc. $ amt
5a (36) = (36) (36) = (36)
GENERAL JOURNAL
Date Account Titles Debit Credit
5a Sales Revenue (or Sales Discount) 36
Accounts Receivable 36
to record 1% discount on Trans. #3a credit sale
GENERAL LEDGER ("T" - Accounts)
Assets = Liabilities + Equity
Cash Accounts Receiv. Accounts Payable Common Stock Retained Earnings
bb 5000 500 (2) bb 4000 120 (4a) 1000 bb 6000 bb 2000 bb
(3a)3720 36 (5a) 4000 (1) Sales Returns Sales Revenue
(4a) 120 (5a) 36 3720 (3a)

Inventory Cost of Gds Sold Transportation Out

(1) 4000 2790 (3b) (3b)2790 90 (4b)
(2) 500
(4b) 90

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5b. The Transaction #3a customer paid

within the ten day discount period.
Record the cash collection.
Original Account Receivable (Transaction 3a) $3,720
Less: Sales Return (Transaction 4a) (120)
Less: Sales Discount (Transaction 5a) (36)
Cash receipt that will satisfy the account $3,564
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Accounts Com. Retain. Rev./ Exp./ Net OA,IA,FA
Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain - Loss = Inc. $ amt
3a 3,720 = 3,720 3,720 = 3,720
4a (120) = (120) (120) = (120)
5a (36) = (36) (36) = (36)
5b 3,564 (3,564) = = 3,564 OA

Asset Exchange
McGraw-Hill/Irwin Transaction © The McGraw-Hill Companies, Inc.,
5- 37

5b. Journalize and Post the cash collection.

BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Accounts Com. Retain. Rev./ Exp./ Net OA,IA,FA
Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain - Loss = Inc. $ amt
5b 3,564 (3,564) = = 3,465 OA
GENERAL JOURNAL
Date Account Titles Debit Credit
5b Cash 3564
Accounts Receivable 3564
Collect from Tr. 3 customer (less return and disc.)
GENERAL LEDGER ("T" - Accounts)
Assets = Liabilities + Equity
Cash Accounts Receiv. Accounts Payable Common Stock Retained Earnings
bb 5000 500 (2) bb 4000 120 (4a) 1000 bb 6000 bb 2000 bb
(5b) 3564 (3a)3720 36 (5a) 4000 (1) Sales Returns Sales Revenue
3564 (5b) (4a) 120 (5a) 36 3720 (3a)

Inventory Cost of Gds Sold Transportation Out

(1) 4000 2790 (3b) (3b)2790 90 (4b)
(2) 500
(4b) 90

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6. Returned 50 units to our supplier who

granted us credit for the cost of the items
but not for any transportation costs.
Supplier cost was $4.00 per unit x 50 = $200. Transportation cost
recorded when units were purchased was $0.50 per unit x 50 = $25.
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Accounts Com. Retain. Rev./ Exp./ Net OA,IA,FA
Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain - Loss = Inc. $ amt
6 (225) = (200) (25) 25 = (25)

Technically, this LOSS should be reported in the operating expense

section of the income statement. However, this loss is usually NOT
MATERIAL, so most companies record it as an increase in the
COST OF GOODS SOLD expense account.
That’s what we’ll do here.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,
5- 39
6. Returned 50 units to our supplier who granted us credit for the
cost of the items but not for any transportation costs.
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Accounts Com. Retain. Rev./ Exp./ Net OA,IA,FA
Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain - Loss = Inc. $ amt
6 (225) = (200) (25) 25 = (25)
GENERAL JOURNAL
Date Account Titles Debit Credit
6 Accounts Payable 200
Cost of Goods Sold (or "Inventory Loss") 25
Inventory 225
Adjustment for inventory returned to our supplier.
GENERAL LEDGER ("T" - Accounts)
Assets = Liabilities + Equity
Cash Accounts Receiv. Accounts Payable Common Stock Retained Earnings
bb 5000 500 (2) bb 4000 120 (4a) (6) 200 1000 bb 6000 bb 2000 bb
(5b) 3564 (3a)3720 36 (5a) 4000 (1) Sales Returns Sales Revenue
3564 (5b) (4a) 120 (5a) 36 3720 (3a)

Inventory Cost of Gds Sold Transportation Out

(1) 4000 2790 (3b) (3b)2790 90 (4b)
(2) 500 225 (6) (6) 25
(4b) 90

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7. A physical inventory count shows 340 units

on-hand, indicating 10 units have been lost.
Units in Beginning Inventory 0
+ Units Purchased this period (1000- 50 purchase returns) 950
= Units Available for Sale 950
- Units Sold (620 – 20 sales returns) (600)
= Units that should be in ending inventory 350
- Actual ending inventory from count (340)
= Units missing 10
x $4.50 cost per unit $45.00

BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW

ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Accounts Com. Retain. Rev./ Exp./ Net OA,IA,FA
Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain - Loss = Inc. $ amt
7 (45) = (45) 45 = (45)

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,

5- 41

7. A physical inventory count shows 340 units

on-hand, indicating 10 units have been lost.
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Accounts Com. Retain. Rev./ Exp./ Net OA,IA,FA
Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain - Loss = Inc. $ amt
7 (45) = (45) 45 = (45)

Technically, this LOSS should be reported in the operating expense

section of the income statement. However, this loss is usually NOT
MATERIAL, so most companies record it as an increase in the COST
OF GOODS SOLD expense account.

That’s what we’ll do here.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,

5- 42
7. A physical inventory count shows 340 units
on-hand, indicating 10 units have been lost.
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Accounts Com. Retain. Rev./ Exp./ Net OA,IA,FA
Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain - Loss = Inc. $ amt
7 (45) = (45) 45 = (45)
GENERAL JOURNAL
Date Account Titles Debit Credit
7 Cost of Goods Sold (or "Inventory Loss") 45
Inventory 45
Adjustment for missing inventory
GENERAL LEDGER ("T" - Accounts)
Assets = Liabilities + Equity
Cash Accounts Receiv. Accounts Payable Common Stock Retained Earnings
bb 5000 500 (2) bb 4000 120 (4a) (6) 200 1000 bb 6000 bb 2000 bb
(5b) 3564 (3a)3720 36 (5a) 4000 (1) Sales Returns Sales Revenue
3564 (5b) (4a) 120 (5a) 36 3720 (3a)

Inventory Cost of Gds Sold Transportation Out

(1) 4000 2790 (3b) (3b)2790 90 (4b)
(2) 500 225 (6) (6) 25
(4b) 90 45 (7) (7) 45

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.,

 8a. Paid within discount period, so record the
5- 43

2% discount on the $4000 Tran. #1 purchase

less $200 Tran. #6 return.

Purchase (Transaction #1) $4000 This reduces
Less Purchase Return (Trans. #6) 200 the cost of the
Amount owed 3800 inventory and
the amount we
X discount % 2%
owe the
Amount of Purchase Discount $ 76 supplier.
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Accounts Com. Retain. Rev./ Exp./ Net OA,IA,FA
Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain - Loss = Inc. $ amt
8a (76) = (76) =

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8a. Paid within discount period, so record the discount

on the $4000 Tr. #1 purchase less $200 Tr. #6 return.
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Accounts Com. Retain. Rev./ Exp./ Net OA,IA,FA
Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain - Loss = Inc. $ amt
8a (76) = (76) =
GENERAL JOURNAL
Date Account Titles Debit Credit
8a Accounts Payable 76
Inventory 76
2% discount taken on $3,800 purchase less return
GENERAL LEDGER ("T" - Accounts)
Assets = Liabilities + Equity
Cash Accounts Receiv. Accounts Payable Common Stock Retained Earnings
bb 5000 500 (2) bb 4000 120 (4a) (6) 200 1000 bb 6000 bb 2000 bb
(5b) 3564 (3a)3720 36 (5a) (8a) 76 4000 (1) Sales Returns Sales Revenue
3564 (5b) (4a) 120 (5a) 36 3720 (3a)
Inventory
(1) 4000 2790 (3b) Cost of Gds Sold Transportation Out
(2) 500 225 (6) (3b)2790 90 (4b)
(4b) 90 45 (7) (6) 25
76 (8a) (7) 45

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8b. Paid the remaining balance on the

Transaction #1 inventory purchase.
$4000 purchase (Trans. #1)
- 200 purchase return (Trans. #6)
- 76 purchase discount (Trans. #8a)
$3724 remainder to pay supplier

BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW

ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Accounts Com. Retain. Rev./ Exp./ Net OA,IA,FA
Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain - Loss = Inc. $ amt
8b (3,724) = (3,724) = (3,724) OA

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8b. Paid the remaining balance on the Transaction #1

inventory purchase. ($4000-200-76=$3724 to pay)
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Accounts Com. Retain. Rev./ Exp./ Net OA,IA,FA
Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain - Loss = Inc. $ amt
8b (3,724) = (3,724) = (3,724) OA
GENERAL JOURNAL
Date Account Titles Debit Credit
8b Accounts Payable 3724
Cash 3724
Paid balance due to supplier after return and discount.
GENERAL LEDGER ("T" - Accounts)
Assets = Liabilities + Equity
Cash Accounts Receiv. Accounts Payable Common Stock Retained Earnings
bb 5000 500 (2) bb 4000 120 (4a) (6) 200 1000 bb 6000 bb 2000 bb
(5b) 3564 3724 (8b) (3a)3720 36 (5a) (8a) 76 4000 (1) Sales Returns Sales Revenue
3564 (5b) (8b) 3724 (4a) 120 (5a) 36 3720 (3a)
Inventory
(1) 4000 2790 (3b) Cost of Gds Sold Transportation Out
(2) 500 225 (6) (3b)2790 90 (4b)
(4b) 90 45 (7) (6) 25
76 (8a) (7) 45

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9. The Sale recorded in Transaction #3a was

made with terms of F.O.B. destination.
Record payment of the $340 shipping cost.
Transportation charges on PURCHASES are added to the cost of
the asset, INVENTORY. (Transportation IN)

Transportation charges to ship products TO CUSTOMERS are

reported as operating expenses on the income statement. The
appropriate account title is TRANSPORTATION OUT (or
FREIGHT OUT or SHIPPING EXPENSE).
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Accounts Com. Retain. Rev./ Exp./ Net OA,IA,FA
Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain - Loss = Inc. $ amt
9 (340) = (340) 340 = (340) (340) OA

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9. The Sale recorded in Transaction #3a was made with terms of

F.O.B. destination. Record payment of the $340 shipping cost.
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Accounts Com. Retain. Rev./ Exp./ Net OA,IA,FA
Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain - Loss = Inc. $ amt
9 (340) = (340) 340 = (340) (340) OA
GENERAL JOURNAL
Date Account Titles Debit Credit
9 Transportation Out (or Shipping Exp.) 340
Cash 340
Paid $340 cost to ship to customer.
GENERAL LEDGER ("T" - Accounts)
Assets = Liabilities + Equity
Cash Accounts Receiv. Accounts Payable Common Stock Retained Earnings
bb 5000 500 (2) bb 4000 120 (4a) (6) 200 1000 bb 6000 bb 2000 bb
(5b) 3564 3724 (8b) (3a)3720 36 (5a) (8a) 76 4000 (1) Sales Returns Sales Revenue
340 (9) 3564 (5b) (8b) 3724 (4a) 120 (5a) 36 3720 (3a)
Inventory
(1) 4000 2790 (3b) Cost of Gds Sold Transportation Out
(2) 500 225 (6) (3b)2790 90 (4b) (9) 340
(4b) 90 45 (7) (6) 25
76 (8a) (7) 45

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Clock Company
Ending Balances of LEDGER Accounts
GENERAL LEDGER ("T" - Accounts)
Assets = Liabilities + Equity
Cash Accounts Receiv. Accounts Payable Common Stock Retained Earnings
bb 5000 500 (2) bb 4000 120 (4a) (6) 200 1000 bb 6000 bb 2000 bb
(5b) 3564 3724 (8b) (3a)3720 36 (5a) (8a) 76 4000 (1) Sales Returns Sales Revenue
340 (9) 3564 (5b) (8b) 3724 (4a) 120 (5a) 36 3720 (3a)
eb 4000 eb 4000 1000 eb 3684 eb

Inventory Cost of Gds Sold Transportation Out

(1) 4000 2790 (3b) (3b)2790 90 (4b) (9) 340
(2) 500 225 (6) (6) 25
(4b) 90 45 (7) (7) 45
76 (8a) eb 2770
eb 1454

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Timing is EVERYTHING...
 Recognize revenue when “earned”
 earned when an exchange (seller to buyer) occurs
 Three levels of the matching principle
 Product costs (e.g., inventory costs): assets until
produce revenue
 direct cause & effect relationship between
revenue and expense
 Period costs: systematic & rational allocation
 e.g., depreciation costs
 Period costs: recognize as expense as incurred
 e.g., advertising costs

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Perpetual Inventory Systems

 The inventory account is continuously updated for the
following events:
 Purchases
 Purchase Discounts Taken
 Purchase Returns & Allowances
 Sales (remove from inventory the COST of the units sold)
 Sales Returns (add to inventory the COST of units returned)

The necessary detailed record-keeping required by the perpetual

system has become much easier with current computer
technology.
 A physical count of the inventory is still required at the
end of the accounting period to assure accurate
inventory records in case of errors or theft.

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Perpetual Inventory Systems

 Cost of Goods Sold . . .

 Contains the cost of units that have
been sold to customers.
 Is a temporary account.
(It will be closed out at
the end of the period.)
 Is an expense account.

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Let’s look at another Inventory system.

Periodic Inventory System

Separate Accounts Used
When using the Periodic system, inventory
transactions are not recorded directly in the
INVENTORY account. Instead, separate
accounts are used for
PURCHASES
PURCHASE RETURNS & ALLOWANCES
PURCHASE DISCOUNTS
TRANSPORTATION IN

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Periodic Inventory Systems

 Because entries are not made to the
inventory account during the accounting
period, the amount of inventory is not known
until the end of the period when the inventory
count is done.
 The PERIODIC system is being used
less and less due to advancements
in technology that make the extra
record keeping of the perpetual
system easy and inexpensive.
 Periodic inventory systems require more
closing entries at the end of the period.
(Purchases, Purchase Returns and Allowances,
Purchase Discounts, and Transportation In are
all separate TEMPORARY accounts that must
be closed out at the end of the©period.)
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Periodic Inventory System

Purchases and Purchase Returns and Allowances
 Purchases is an account that
holds the current period’s
inventory purchases (a debit
balance) and is used in the Bar codes/scanners
calculation of Cost of Goods
Sold on the Income Statement.
 The Purchase Returns and
Allowances account also is
used to calculate Cost of Goods
Sold on the income statement.
It is a deduction from the cost of
purchases in a periodic
inventory system.
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Periodic Inventory System

Purchase Discounts

When using the Periodic system

Purchase Discounts are recorded
in a separate account. This helps
managers keep track of the
company’s performance in taking
advantage of discounts.

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Periodic Inventory Systems

 The ending inventory is determined at the
end of the period by taking a physical count
of the goods remaining on hand.
 Cost of goods sold is calculated at the end
of the accounting period by subtracting the
ending inventory (determined from the
physical count) from the Cost of Goods
Available for Sale.
Beginning Inventory $ 400 +
Purchases, net 2000
= Goods Available for Sale 2400
- Ending Inv. (from count) 500
= Cost of Goods Sold $1900
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Gross Margin Percentage

This measure indicates how much
of each sales dollar is left after deducting the
cost of goods sold to cover expenses and
provide a profit.

Gross Margin
Net Sales
Other things being equal, the
company with the higher gross
margin percentage is pricing its
products higher.
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Ratios: Gross Margin

Percentage
 Gross margin %:

 Gross margin as a percent of

sales

 Net sales – CGS gross margin

=
Net sales net sales

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Ratios: Gross Margin

Percentage
Net sales – CGS = $1,000 – 400
Net sales $1,000

= $600___ = 60% or $.60

$1,000

This tells us that each dollar of sales

contributes 60 cents to the
Gross Margin.

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Return on Sales
Net income expressed as a percentage of
sales provides insight as to how much of
each sales dollar is left as net income
after all expenses are paid.

Net Income
Net Sales
Other things being equal, the company
with the higher return on sales
percentage is doing a better job of
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Ratios: Return on sales

 Return on sales =

Net income
Net sales

Revenues - expenses
Net sales

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Ratios: Return on sales

 Return on sales =
Net income =
Net sales

$500___ = 50% or $.50

$1,000

Each dollar of sales is

generating 50 cents
of Net Income

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Income Statement Formats

Single Step - Multi-step -
with details with details

Single Step - Multi-step -

condensed condensed

Let’s look at
examples…..
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Income Statement Formats

Multi-step with details Multi-step: condensed

Net Sales 100 Net Sales 100

Less: Cost of goods sold 60 Less: Cost of goods Sold 60
Gross Profit Margin 40
Operating Expenses: Gross Profit Margin 40
Selling: Operating Expenses:
Sales Salaries 8 Selling Expenses 10
Advertising 2 Administrative Exp. 11
Total Selling 10
Administrative: Total Operating Exp. 21
Admin. Salaries 3 Operating Income 19
Building Rent 8 Non-Operating Rev. (Exp.)
Total Adm. Exp. 11 Interest Expense (1)
Total Operating Exp. 21
Operating Income 19 Income before tax 18
Non-Operating Rev. (Exp.) Income Tax expense 3
Interest Expense (1) Net Income 15
Income before tax 18
Income Tax expense 3
Net Income 15
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Income Statement Formats

The multi-step INCOME Statement format classifies interest as a
NON-operating item. But, interest is still an OPERATING ACTIVITY
onMulti-step
the CASHFLOWwithStatement.
details Multi-step: condensed

Net Sales 100 Net Sales 100

Less: Cost of goods sold 60 Less: Cost of goods Sold 60
Gross Profit Margin 40
Operating Expenses: Gross Profit Margin 40
Selling: Operating Expenses:
Sales Salaries 8 Selling Expenses 10
Advertising 2 Administrative Exp. 11
Total Selling 10
Administrative: Total Operating Exp. 21
Admin. Salaries 3 Operating Income 19
Building Rent 8 Non-Operating Rev. (Exp.)
Total Adm. Exp. 11 Interest Expense (1)
Total Operating Exp. 21
Operating Income 19 Income before tax 18
Non-Operating Rev. (Exp.) Income Tax expense 3
Interest Expense (1) Net Income 15
Income before tax 18
Income Tax expense 3
Net Income 15
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Income Statement Formats

Single-step with details Single-step: condensed

Net Sales 100 Net Sales 100

Less Expenses: Less Expenses:
Cost of goods sold 60 Cost of goods sold 60
Sales Salaries 8 Selling 10
Advertising 2 Administrative 11
Admin. Salaries 3 Interest Expense 1
Building Rent 8 Income Tax Expense 3
Interest Expense 1 Total Expenses 85
Income Tax Expense 3 Net Income 15
Total Expenses 85
Net Income 15

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Income Statement Formats

Single-step with details Single-step: condensed

A common modification of the single-step method is to

have the income tax expense separated out.
Net Sales 100 Net Sales 100
Less Operating Exp. Less Expenses:
Cost of goods sold 60 Cost of goods sold 60
Sales Salaries 8 Selling 10
Advertising 2 Administrative 11
Admin. Salaries 3 Total Oper. Exp. 81
Building Rent 8 Income before taxes 19
Interest Expense 1 Income Tax Expense 4
Total Oper. Exp. 82 Net Income 15
Income before taxes 18
Income Tax Expense 3
Net Income 15
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Common-size Income
Statement
 Each item on the
income statement is
expressed as a % of
%
that year’s Net Sales. Net Sales 100.0
- Cost 60.0
=G.P 40.0
Comparisons are made to:
Budget
Previous year(s)
Competitors

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Comparative Common-size
Income Statements
2013 % of N.Sales
2012 % of N.Sales

Net Sales $3,000 $2,000

100.0 100.0
Cost of Goods Sold 2,000 66.7 1,200 60.0
Gross Profit 1,000 33.3 800 40.0
Operating Expenses:
Selling Expenses 600 20.0 400 20.0
Administrative Exp. 700 23.3 300 15.0
Total Oper. Exp. 1,300 43.3 700 35.0
Net Income ($300) (10.0) $100 5.0
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Income Statement
Trend Analysis
Trend Analysis shows both Dollar and %
changes from one year to the next year for
each item on the income statement.
Example:
From 2012 to 2013 Net Sales increased
from $2,000 to $3,000. So……
Net Sales increased $1,000 which is a 50%
increase over 2012 Net Sales.
($1,000 incr./$2,000 Net Sales of 2012 = 50%)
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Income Statement
Trend Analysis
2013 2012 $ inc.(dec.) % inc.(dec)
Net Sales $3,000 $2,000 $1,000 50.0
Cost of Goods Sold 2,000 1,200 800 66.7
Gross Profit 1,000 800 200 25.0
Operating Expenses:
Selling Expenses 600 400 200 50.0
Administrative Exp. 700 300 400 133.3
Total Oper. Exp. 1,300 700 600 85.7
Net Income ($300) $100 ($400) (400.0)
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How about analyzing the

Balance Sheet?
The same techniques are used to analyze the
Balance Sheet.
Common-size Analysis:
Use the TOTAL ASSETS amount as the 100%
figure. So, …….. Express each Balance Sheet item
as a % of Total Assets.
Trend Analysis:
Same approach as used on the income statement.
1. Calculate the $ change for each bal. sheet item.
2. Express the $ change as a % of the previous
year’s (or base year’s) amount.
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End of Chapter 4
Remember,
Your objectives are to understand
what you are doing and to be able to
analyze the financial information.
Memorization without understanding
is meaningless!

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