CHAPTER 5

Merchandising Operations
Milestones
Chapter 4
Accrual Accounting Concepts
• Explain the accrual basis of
accounting and the reasons
for adjusting entries.
• Prepare adjusting entries for
prepayments and accruals.
• Prepare adjusted trial
balance
• Prepare closing entries and
a post-closing trial balance.
Chapter 5
Merchandising Operations
• Identify the differences
between service and
merchandising companies.
• Prepare entries for
purchases and sales under
perpetual inventory system.
• Prepare single-step and
multi-step income
statement.
• Calculate the gross profit
margin and profit margin.
Chapter 6
Reporting and analyzing
inventory
• Describe the steps in
determining inventory
quantities
• Apply the cost formulas
using specific identification
• Explain the effects on the
financial statements of
choosing each of the
inventory cost formulas
• Identify the effects of
inventory errors on financial
statements.
• Demonstrate the
presentation and analysis of
inventory.
• Apply FIFO and average cost
formulas under periodic
inventory system
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LEARNING OBJECTIVES
By the end of this lecture, learners will be able to:

• Identify the differences between service and merchandising companies.

• Prepare entries for purchases and sales of inventory under a perpetual inventory system.
Differences between
service and merchandising
companies

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Comparison of Accounting Cycles
• Accounting cycle is the same
Comparison of Operating Cycles
• The operating cycle is the time it takes to go from cash-to-cash in producing revenues
• The operating cycle is usually longer for a merchandising company than it is for a service company
• The steps for each type of company can be seen below

(Start) (Start)

6
Comparison of Income Measurement
• Measuring
  profit for a merchandising company is basically the same as for a service
company

• Revenues of service companies are termed as service revenues and of merchandise

companies are termed as sales revenues.

• Unlike expenses for a service company, expenses for a merchandising company are
divided into two categories: cost of goods sold and operating expenses
• Cost of goods sold is the total cost of the merchandise that was sold during the period
• Operating expenses are expenses that are incurred in the process of earning revenue

7
Income Measurement of Merchandising Operations

• The figure on right details the income measurement

process for a merchandising company
• The two items in the blue boxes are unique to a
merchandising company as a service company does not
use them
Or Gross Margin
• Income measurement of merchandising company involves
three costs
1. Cost of good sold
2. Operating expenses
3. Income tax expenses

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Benefit of Division of Expenses
• It gives reader information to assess that revenues cover both the cost of goods sold and
other costs (salaries, rents, and utilities).

Revenues

Cost of Goods Sold Operating

Expenses

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Summary of Differences between Service and
Merchandising Companies
Service Companies
• Same accounting cycle as of
merchandising companies
• Shorter operating cycle
• Sales of service companies are known
as service revenues
• Many operating expenses of service
companies are the same as for
merchandising companies
• Income measurement does not
include “cost of goods sold” and
“gross profit”.
Merchandising Companies
• Same accounting cycle as of service
companies
• Longer operating cycle as
merchandising involves inventory
• Sales of merchandise is referred to as
sales revenue
• Operating expenses are similar (e.g.
salaries, insurance, utilities, and
depreciation).
• “Cost of goods sold” and “gross profit”
are unique to merchandising
company.
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 The operating cycle of a merchandising
company is ordinarily shorter than that of
Comparison a service company.
Question # 1 • True
• False

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 The operating cycle of a service company
is shorter because service companies
A. Offer purchase discount
B. Have more employees
Comparison C. Do not have inventory
Question # 2 D. Are smaller in size

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 Manufacturer Wholesaler Retailer

Classification of inventory of
manufacturing company Characteristics of merchandise Inventory
1) Raw material 1) The company owns them.
2) Work in process 2) They are ready for sale.
3) Finished goods
Income Measurement of Merchandising Operations

• Let’s take a closer look at the income measure process for a merchandising company and
where the information is derived from
Nolan's Corporation
Income Statement
For the year ended December 31, 2018
Revenues
Sales 480,000 Sales
Cost of Goods Sold
Gross Profit
316,000
164,000
COGS
Operating Expenses Gross Profit
Salaries 45,000
Rent 19,000
Utilities 17,000
Advertising 16,000
Depreciation 8,000 105,000
Income Before Tax 59,000
Income Tax Expense (25%) 14,750
Net Income (Loss) 44,250
15
Income Measurement of Merchandising Operations

• Let’s take a closer look at the income measure process for a merchandising company and
where the information is derived from
Nolan's Corporation
Income Statement
For the year ended December 31, 2018
Revenues
Sales 480,000 Sales
Cost of Goods Sold
Gross Profit
316,000
164,000
COGS
Operating Expenses Gross Profit
Salaries 45,000
Rent 19,000
Utilities 17,000
Advertising 16,000 This is the amount (price x quantity) that
Depreciation 8,000 105,000 Nolan’s Corp received from their customers
Income Before Tax 59,000
Income Tax Expense (25%) 14,750
Net Income (Loss) 44,250
16
Income Measurement of Merchandising Operations

• Let’s take a closer look at the income measure process for a merchandising company and
where the information is derived from
Nolan's Corporation
Income Statement
For the year ended December 31, 2018
Revenues
Sales 480,000 Sales
Cost of Goods Sold
Gross Profit
316,000
164,000
COGS
Operating Expenses Gross Profit
Salaries 45,000
Rent 19,000
Utilities 17,000
Advertising 16,000 This is the amount (price x quantity) that
Depreciation 8,000 105,000 Nolan’s Corp paid to purchase merchandise
Income Before Tax 59,000 from manufacturer (or wholesaler).
Income Tax Expense (25%) 14,750 Customers are unaware of this price
Net Income (Loss) 44,250
17
Income Measurement of Merchandising Operations

• Let’s take a closer look at the income measure process for a merchandising company and
where the information is derived from
Nolan's Corporation
Income Statement
For the year ended December 31, 2018
Revenues
Sales 480,000 Sales
Cost of Goods Sold
Gross Profit
316,000
164,000
COGS
Operating Expenses Gross Profit
Salaries 45,000
Rent 19,000
Utilities 17,000
Advertising 16,000 This is the difference between amount
Depreciation 8,000 105,000 received from customers and amount paid
Income Before Tax 59,000 to purchase merchandise.
Income Tax Expense (25%) 14,750
Net Income (Loss) 44,250
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Inventory System of Merchandising Companies
• A merchandising company keeps track of its inventory to determine what is available for
sale (inventory) and what has been sold (cost of goods sold)
• The flow of costs for a merchandising company is as follows:

Beginning Inventory
+ Purchases
Cost of Goods Available for + =
Sale

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Inventory System of Merchandising Companies
• A merchandising company keeps track of its inventory to determine what is available for
sale (inventory) and what has been sold (cost of goods sold)
• The flow of costs for a merchandising company is as follows:

Cost of Goods Available for Sale

- Cost of goods sold
Ending Inventory - =

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Problem 1
BestBuy Co. has reported the following iPhone balances
Cost of Goods Sold 53
Purchases 29
Beginning Inventory 102
• What would you record as cost of goods available for sale?
• What would you record as ending inventory?

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Problem 2
BestBuy Co. has reported the following Note 9 balances
Cost of Goods Sold 65
Purchases 37
Cost of Goods Available for Sale 93

1. What would you record as beginning inventory?

2. What would you record as ending inventory?

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Types of Inventory Systems
• Inventory systems tracks inventory and provide detailed information about sales and cost of goods
sold.
• The choice of inventory system depends on the information needs of internal and external users.

• Types of Inventory Systems

• Perpetual System
• This system continuously (perpetually) maintains detailed records of each item purchased and sold.
• Cost of goods sold and the reduction in inventory are recorded each time a sale occurs
• Physical counts are done to ensure physical inventory levels match those in the system.
• Periodic System
• Detailed records of Inventory and Cost of Goods Sold balances are not kept
• Cost of goods sold = Goods Available for Sale - Ending inventory (difference is assumed to be sold)
• Only updated by physical inventory count at the end of the accounting period

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Which of the two inventory systems is more
informative?

Perpetual inventory system is more informative and prevalent, hence we limit our discussion
to perpetual inventory system.

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 How do companies decide which inventory system to use?

Companies compare the cost of the detailed record keeping that is required for a
perpetual inventory system with the benefits of having the additional information
about, and control over, their inventory.

Discussion Question 26
Journal Entries for Purchases

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Purchase of Merchandise
• Inventory purchases can be made for cash or credit (on account).
• Buyer normally records purchases when the goods are received.
• Sale/Purchase documentation serves as the evidence of the transaction. These evidences
may include
• Invoices, purchase orders, receiving documents, and receipts

• Different documents serve different purposes

• Purchase order documents the types, quantities, and agreed prices for goods
• Receiving reports document the types and quantities shipped/received.
• Purchase order and receiving reports are reconciled to ensure that
• The goods that were ordered were received
• Received goods are in appropriate condition
• The price being charged is as agreed.
Inventory Defined
Inventory is the merchandise purchased for the purpose of selling to customers
Inventory purchases are recorded in the Inventory account

• Inventory Account is an asset account

• This means that inventory has a normal debit balance
• This also means that journal entry records debit to increase inventory

• Includes all costs to get merchandise to place of business and ready for resale
• Includes freight and applicable taxes
• Less: purchase returns, allowances, discounts

• Inventory should not be confused with other assets such as supplies or equipment.
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 Sauk
PW Technologies
Communications
(Manufacturer)
(Wholesaler)
Example of Inventory Purchases
PW Technologies, Inc. (the seller) sells $3,800 equipment to Sauk Communications Ltd. (the buyer) on
account on May 2

What is the journal entry by Sauk Communications

Sauk Communications
Inventory
Debit (Increase) Credit (Decrease)
(Purchase) 2-May 3,800

3,800

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Freight Terms
Ownership of the goods passes

• When the goods are received by the buyer • When the goods are shipped
(i.e. @ the destination point) (i.e. @ the shipping point)
• Seller is responsible for the freight, risk, and • Buyer is responsible for the freight, risk, and
loss of goods. loss of goods.
• Freight is part of the cost of merchandise
purchased.
DR Inventory
CR Cash

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Exercise 5-1

Recording the Purchase of Merchandise – Perpetual - Example

J.Crew currently has an inventory balance of $15,000. On the last day of the August, they
made a purchase on account from their manufacturer with the following details:

What would J.Crew show

Product: 80 pains of jeans
Cost: $64 per pair
Freight: $5 per product
Terms: FOB Destination
Time: Two weeks shipping
as the ending balance in
their inventory account
for the month of August?
In September when J.Crew
received the product,
how would they record
this transaction?
Exercise 5-1 (Different Freight Terms)

Recording the Purchase of Merchandise – Perpetual - Example

J.Crew currently has an inventory balance of $15,000. On the last day of the August, they
made a purchase on account from their manufacturer with the following details:

What would J.Crew show

Product: 80 pains of jeans
Cost: $64 per pair
Freight: $5 per product
Terms: FOB Shipping Point
Time: Two weeks shipping
as the ending balance in
their inventory account
for the month of August?
In September when J.Crew
received the product,
how would they record
this transaction?
Tips to remember these terms
In FOB Shipping Point

Freight costs Fall On Buyer from Shipping point

In FOB Destination

Freight costs Fall On Buyer from Destination (i.e. free delivery)

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Example of Freight Costs Paid by Buyer
PW Technologies (the seller) sold equipment to Sauk Communications (the buyer) on May 2.
Terms of deliver were FOB shipping point. Upon delivery of the goods on May 4, Sauk
Communications pays CanTruck Ltd. (shipping company) $150 for freight charges.

What is the journal entry for Sauk Communications

Sauk Communications
Inventory
Debit (Increase) Credit (Decrease)
(Purchase) 2-May 3,800
(Freight) 4-May 150

3,950
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Discussion Question
What will be the journal entry to record freight costs on the buyer’s books if terms of sale
were FOB destination?

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Returns and Allowances
Buyer can be dissatisfied with goods if goods are damaged, defective, inferior, or unfit for
use.

Purchase return: Merchandise may be returned by the buyer to the seller for a cash refund
or credit
Purchase allowance: Merchandise may be kept by the buyer, if the seller is willing to give an
allowance (deduction) from the purchase price

In both cases, the result is a decrease to the cost of goods purchased via CR Inventory

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Example of Returns by Buyer
Sauk Communications (the buyer) returned goods costing $300 to PW Technologies (the
seller) on May 8. Because these goods were originally sold on account, Sauk
Communications received a credit (rather than cash) from PW Technologies for the return of
this merchandise.

What is the Journal entry by Sauk Communications for the returned merchandise

Sauk Communications
Inventory
Debit (Increase) Credit (Decrease)
(Purchase) 2-May 3,800 8-May 300 (Purchase Return)
(Freight) 4-May 150

3,650
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Discounts
Discounts are divided into to types:

• Quantity Discount are received by buyer when based on the volume or amount of goods
purchased.
• Quantity discounts are not recorded or accounted for separately

• Purchase Discount are received when buyer pays the seller before the due date (applies
to on account purchases).
• Such discounts are offered by sellers to quickly convert account receivable into cash (shorten
seller’s operating cycle).
• Purchase discounts are applied to the value of merchandise purchased, not to the freight costs.
• A credit entry in “inventory” account is used to journalize purchase discount.
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Terms of Purchase Discount
Inventory
Debit (Increase) Credit (Decrease)
Purchases Purchase Returns
Freight-in Purchase Discounts

Displayed as: 2/10, n/30

2/10 means that IF the n/30 means that
invoice is paid within 10 the invoice is
days, buyer is entitled to a due in full within
2% discount. 30 days

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Example of Purchase Discount
The terms of May 2 sale by PW Technologies (seller) specified that the credit terms were 2/10, n/30,
which is read “two-ten, net thirty.” Sauk Communications (the buyer) pays the balance due of $3,500
on May 12, the last day of the discount period.

Sauk Communications
Calculate the amount of discount? Inventory
Debit (Increase) Credit (Decrease)
(Purchase) 2-May 3,800 8-May 300 (Purchase Return)
(Freight) 4-May 150

3,650
Calculate the amount of cash paid after applying discount?

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Journalize Purchase Discount
The terms of May 2 sale by PW Technologies (seller) specified that the credit terms were 2/10, n/30,
which is read “two-ten, net thirty.” Sauk Communications (the buyer) pays the balance due of $3,500
on May 12, the last day of the discount period.
• Discount amount = 70 (3500x2%)
• Cash paid after applying discount = 3430 (3500 – 70)

What is the journal entry by Souk Communications?

Sauk Communications
Inventory
Debit (Increase) Credit (Decrease)
(Purchase) 2-May 3,800 8-May 300 (Purchase Return)
(Freight) 4-May 150 12-May 70 (Purchase Discount)

3,580 43
Summary of Recording Inventory Purchases
[Perpetual System]

Sauk Communications
Inventory
Debit (Increase) Credit (Decrease)
(Purchase) 2-May 3,800 8-May 300 (Purchase Return)
(Freight) 4-May 150 12-May 70 (Purchase Discount)

3,580

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Solution 1
BestBuy Co. has reported the following iPhone balances
Cost of Goods Sold 53
Purchases 29
Beginning Inventory 102
• What would you record as cost of goods available for sale?
• What would you record as ending inventory?

45
Solution 2
BestBuy Co. has reported the following Note 9 balances
Cost of Goods Sold 65
Purchases 37
Cost of Goods Available for Sale 93

1. What would you record as beginning inventory?

2. What would you record as ending inventory?

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Exercise 5-1 Solution
What would J.Crew show as the ending balance in their inventory account for the month
of August?
Because the terms of purchase are FOB Destination, the inventory values will not change
until the product is received in August.

In September when J.Crew received the product, how would they record this transaction?
80 (pairs) x 64 (cost/pair) = 5120 (Cost of Goods)
DR: Inventory 5,120
CR: Accounts Payable 5,120

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Exercise 5-1 Solution (Different Freight Terms)

What would J.Crew show as the ending balance in their inventory account for the month of August?

Inventory Beginning 15,000

Purchases 5,120
Freight (80 x 5) 400
Inventory Ending 20,520

In September when J.Crew received the product, how would they record this transaction?
Because the terms of purchase were FOB Shipping, the inventory values will not change as the entry was already made
in August.