Chapter 6

Merchandising
Activities

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Operating Cycle: Diagram

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Income Statement Comparison: Service
Company vs. Merchandising Company

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Merchandising Income Statement: Example

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Inventory Cost Flow
When inventory is initially purchased, it is
recorded on the balance sheet as an asset.
When the inventory is sold, it is moved to the
income statement as a cost of goods sold.

KEY POINT
This process facilitates the matching principle as the cost of the
merchandise is matched against the sales revenue in the accounting
period in which the sale occurs.

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The Flow of Inventory Costs

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Two Approaches for Merchandise
Inventories
1. Perpetual inventory system
o Due to advances in technology including
computerized accounting systems, this
approach has become easy and cost-
effective.
o Most companies use the perpetual system.
2. Periodic inventory system
o Primarily used by very small businesses with
manual accounting systems.

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Perpetual Inventory System
Transactions are recorded immediately as they
occur; records are kept “perpetually” up-to-date.
When merchandise is sold, two journal entries
are necessary:
1. Recognize revenue earned based on the sales
price of the merchandise.
2. Recognize the cost of goods sold and relieve
the inventory account.

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 Illustration of Merchandise Transactions
for Computer City
Purchased 10 Regent 21-inch computer monitors
on account from Okawa Wholesale Co. The
monitors cost $600 each, for a total of $6,000;
payment is due in 30 days.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Sept. 1 Inventory 6,000
Accounts Payable (Okawa Wholesale Co.) 6,000

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 Illustration: Sept. 7

On September 7, Computer City sold two

computer monitors for $1,000 per unit on
account to RJ Travel Agency.

Retail
2 ´ $1,000
GENERAL JOURNAL= $2,000
P
Date Account Titles and Explanation R Debit Credit
Sept. 10 Accounts Receivable (RJ Travel Agency) 2,000
Sales 2,000
2 ´ $600 = $1,200
10 Cost of Goods Sold 1,200
Inventory Cost 1,200
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Illustration: Oct. 1
On October 1, Computer City paid Okawa
Wholesale Co. $6,000 for the
September 1 purchase.

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Illustration: Oct. 7

On October 7, Computer City collected the $2,000

account receivable from RJ Travel Agency for
their purchase on September 7.

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Taking a Physical Inventory
In order to ensure the accuracy of their perpetual records, most
businesses take a complete physical count of the merchandise
on hand at least once a year.

Reasonable amounts of inventory shrinkage are viewed as a

normal cost of doing business.
Examples include breakage, spoilage, and theft.
On December 31, Computer City counts its inventory.
An inventory shortage of $2,200 is discovered.
GENERAL JOURNAL
P
Date Account Titles and Explanation R Debit Credit
Dec. 31 Cost of Goods Sold 2,200
Inventory 2,200

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Periodic Inventory System
The periodic inventory system
o Alternative to a perpetual inventory system.
o No effort is made to keep up-to-date records of
either the inventory or the cost of goods sold.
o Instead, these amounts are determined only
periodically—usually at the end of each year.

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Procedures Under the Periodic System
When merchandise is purchased, its cost is
debited to an account entitled Purchases, rather
than to the Inventory account.
When merchandise is sold, an entry is made to
recognize the sales revenue, but no entry is
made to record the cost of goods sold or to
reduce the balance of the Inventory account.
As the inventory records are not updated as
transactions occur, there is no inventory
subsidiary ledger.

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Foundation of the Periodic System

KEY POINT
The foundation of the periodic inventory system is the taking of a
complete physical inventory at year-end. This physical count
determines the amount of inventory appearing in the balance sheet.
The cost of goods sold for the entire year then is determined by a
short computation.

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Illustration: Periodic Inventory System
On January 6, Wagner Office Products
purchased merchandise amounting to $2,000
on account from Ink Jet Solutions.

Notice that no entry is

made to Inventory.

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Computing Cost of Goods Sold
The accounting records of Wagner Office
Products show the following:
Inventory, Jan. 1 $ 14,000
Purchases (during year) 130,000
Inventory, Dec. 31 12,000

Inventory (beginning of the year) $ 14,000

Add: Purchases 130,000
Cost of goods available for sale 144,000
Less: Inventory (end of year) 12,000
Cost of goods sold $132,000
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Creating a Cost of Goods Sold Account

Wagner must create the Cost of Goods Sold

GENERALaccount.
JOURNAL
P
Date Account Titles and Explanation R Debit Credit
Dec. 31 Cost of Goods Sold 144,000
Inventory (beginning of year) 14,000
Purchases 130,000

Wagner must record the ending inventory

amount.

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Creating a COGS Account for the
Closing Process

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Selecting an Inventory System

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Learning Objective Summary LO6-2
LO6-2: Understand the components of a merchandising
company’s income statement. In a merchandising company’s
income statement, sales (or net sales) represent the total revenue
generated by selling merchandise to its customers. As items are
sold from inventory, their costs are transferred from the balance
sheet to the income statement, where they appear as the cost of
goods sold. The cost of goods sold is subtracted from sales to
determine the company’s gross profit. Other expenses (such as
wages, advertising, utilities, and depreciation) are subtracted from
gross profit in the determination of net income. Only if a
company’s gross profit exceeds the sum of its other expenses will
it be profitable.

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Learning Objective Summary LO6-3
LO6-3: Account for purchases and sales of merchandise in a
perpetual inventory system. In a perpetual inventory system,
purchases of merchandise are recorded by debiting the Inventory
account. Two entries are required to record each sale: one to
recognize sales revenue and the second to record the cost of goods
sold. This second entry consists of a debit to Cost of Goods Sold
and a credit to Inventory.

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Learning Objective Summary LO6-4
LO6-4: Explain how a periodic inventory system operates. In a
periodic system, up-to-date records are not maintained for inventory
or the cost of goods sold. Thus less recordkeeping is required than
in a perpetual system.
The beginning and ending inventories are determined by taking a
complete physical count at each year-end. Purchases are recorded in
a Purchases account, and no entries are made to record the cost of
individual sales transactions. Instead, the cost of goods sold is
determined at year-end by a computation.
The amounts of inventory and the cost of goods sold are recorded in
the accounting records during the year-end closing procedures.

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Learning Objective Summary LO6-5
LO6-5: Discuss the factors to be considered in selecting an
inventory system. In general terms, a perpetual system should be
used when (1) management and employees need timely information
about inventory levels and product sales, and (2) the company has
the resources to develop this information at a reasonable cost. A
periodic system should be used when the usefulness of current
information about inventories does not justify the cost of
maintaining a perpetual system.
Perpetual systems are most widely used in companies with
computerized accounting systems and in businesses that sell high-
cost merchandise. Periodic systems are most often used in small
businesses that have manual accounting systems and that sell many
types of low-cost merchandise.

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End of Chapter 6

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