CHAPTER 5
Merchandising Operations and the Accounting Cycle
Chapter Overview
Chapter 5 first compares a service business with a merchandising business and then discusses the purchase and sale of
merchandise inventory and explains how to complete the accounting cycle for a merchandising company. Following an
illustration of the operating cycle, both the periodic and perpetual inventory systems are defined; however, only the
perpetual inventory system is emphasized. Students learn to make journal entries based on the purchase invoice. Purchase
discounts, purchase returns and allowances, and transportation costs are discussed. The terms FOB destination and FOB
shipping point are explained. The chapter then illustrates the journal entries for cash and credit sales, cost of goods sold,
sales discounts, and sales returns and allowances. Gross profit is explained. A mid-chapter summary problem asks
students to prepare journal entries, post transactions to Inventory and Cost of Goods Sold, and decide whether borrowing
funds to take advantage of a discount is wise.
The second part of the chapter begins with a discussion of the adjusting and closing process in a merchandising
business. Students add an inventory adjustment to the adjusting entries previously learned. The work sheet for a
merchandising business is illustrated and the similarities and differences between this work sheet and a service business’s
work sheet are highlighted. Adjusting and closing entries for a merchandiser are journalized and posted. Preparation of
the financial statements is discussed, emphasizing the classifications on the income statement. The multi-step and singlestep income statement formats are compared. The gross profit percentage and the inventory turnover and ways to use
these ratios in decision making complete the chapter. Decision Guidelines help students answer some key questions about
a merchandiser’s financial statements, and an Excel Application problem reinforces concepts learned in the chapter. A
summary problem reviews the work sheet, adjusting and closing entries, financial statements, and inventory turnover. An
appendix to the chapter covers accounting for merchandise in a periodic system, journal entries for the periodic system,
and the work sheet.
Learning Objectives
After studying Chapter 5, your students should be able to:
1.
Account for the purchase of inventory
2.
Account for the sale of inventory
3.
Use sales and gross profit to evaluate a company
4.
Adjust and close the accounts of a merchandising business
5.
Prepare a merchandiser’s financial statements
6.
Use gross profit percentage and inventory turnover to evaluate a business
Chapter Outline
What Are Merchandising Operations?
A.
A merchandising business earns its revenue by selling products called inventory. Merchandising companies
have these different accounts on their financial statements:
1.
Balance sheet—Merchandise Inventory, or simply, Inventory, is reported as an asset.
2.
Income statement—Revenue is reported as Sales revenue, or simply Sales. The cost of the products
sold is reported as an expense, Cost of goods sold.
3.
Exhibit 5-1 shows how a service entity differs from a merchandiser.
B.
The operating cycle is the length of time that is required for a business to purchase inventory, sell the inventory,
and collect the cash from the sale so that the cycle can begin again. Exhibit 5-2 illustrates the operating cycle of a
merchandising business.
C.
Companies use two different inventory systems to account for inventory.
1.
The periodic system is used by businesses that sell relatively inexpensive goods and/or cannot afford a
computerized inventory system. Under the periodic system, inventory is counted at regular intervals, but
the level of inventory between inventory counts is not maintained. This system is becoming less popular
as more businesses keep their inventory records on computers.
2.
The perpetual system maintains a running count of the amount of inventory on hand. Inventory must
still be counted at least once a year and. This system is often combined with an integrated inventory
system. The remainder of the chapter is based on this method.
Objective 1: Account for the purchase of inventory
A.
The cycle of a merchandising entity begins with the purchase of inventory..
1.
A purchase invoice (illustrated in Exhibit 5-3) is the supplier’s request for payment from the purchaser.
The purchase of inventory on account is recorded as follows:
Inventory
Accounts Payable
2.
XX
XX
(↑ assets)
(↑ liabilities)
A purchase discount is granted by the seller for early payment of an invoice.
a.
An invoice contains terms of payment that specify how much the discount is and when the
invoice must be paid.
b.
The terms 3/15 n/30 indicate to the purchaser that a 3% discount is offered if the invoice is paid
within 15 days, or the full (net) amount of the invoice is due in 30 days.
c.
The discount is recorded if the payment is made within the discount period.
Accounts Payable
Inventory (discount)
Cash
XX
XX
XX
d.
If the discount is not taken, the entry to record the payment of the full (net) amount is:
Accounts Payable
Cash
3.
XX
XX
(↓ liabilities)
(↓ assets)
The purchase agreement specifies FOB terms to indicate who pays the transportation costs on
purchased merchandise. Exhibit 5-4 summarizes these terms.
a.
FOB shipping point indicates that the buyer bears the shipping costs. Title passes to the buyer
upon shipment of the goods. This method is more common than FOB destination.
b.
FOB destination indicates that the seller bears the shipping costs. Title passes to the buyer when
the goods reach their destination.
c.
Transportation costs, often called freight in, are added to the cost of the inventory and are not
subject to the purchase discount.
Inventory
Cash
d.
5.
XX
Merchandise returned to the seller and allowances granted to the purchaser for damaged goods reduce
the amount that will be paid to the supplier and reduce the cost of inventory. Returns and allowances are
recorded as follows:
Accounts Payable
Inventory
4.
XX
XX
XX
Freight Out (Delivery Expense) on inventory sold is not added to the inventory but is considered
an operating expense.
The total cost of the inventory can be summarized as follows:
Purchase of inventory
Purchase discounts
Purchase returns/allowances
Freight-in
Debit Inventory
Credit Inventory
Credit Inventory
Debit Inventory
Increases inventory
Decreases inventory
Decreases inventory
Increases inventory
Objective 2: Account for the sale of inventory
A.
The sale of inventory may be for cash or on account.
1.
A sale requires two entries.
a.
The entry to record the sale:
Cash (or Accounts Receivable) XX
Sales Revenue
b.
XX
The entry to update the inventory and record the cost of the goods sold:
Cost of Goods Sold
Inventory
XX
XX
2.
The seller records the cash receipt on account as follows:
Cash
XX
Accounts Receivable
B.
XX
Merchandise returned by customers and allowances granted to customers are recorded in the contra account, Sales
Returns and Allowances. Discounts are not taken on returned merchandise.
1.
Both returns and allowances require this first entry:
Sales Returns and Allowances XX
Accounts Receivable (or Cash) XX
2.
Only when merchandise is returned is this second entry needed:
Inventory
Cost of Goods Sold
C.
XX
XX
A sales discount is a cash incentive granted to the customer to encourage prompt payment. Sales discounts are
recorded in the contra account, Sales Discounts, when the account receivable is collected.
Cash
Sales Discounts
Accounts Receivable
D.
XX
XX
XX
Net sales is computed as follows:
=
Sales revenue
Sales discounts
Sales returns and allowances
Net sales revenue
Credit balance
Debit balance
Debit balance
Not a separate account
Objective 3: Use sales and gross profit to evaluate a company
A.
Sales revenue, cost of goods sold, and gross profit are used to evaluate a business’s profitability.
B.
The gross profit or gross margin is calculated as follows:
Sales revenue – Cost of goods sold (or Cost of sales) = Gross profit (or Gross margin)
Objective 4: Adjust and close the accounts of a merchandising business
A.
One additional adjusting entry is required to adjust the ledger balance of Inventory to the physical count. Any
difference between the physical count and the ledger balance is adjusted through Cost of Goods Sold and
Inventory.
1.
To reduce Inventory to its physical count:
Cost of Goods Sold
Inventory
2.
XX
XX
Or, to increase Inventory to its physical count:
Inventory
Cost of Goods Sold
XX
XX
B.
The work sheet is similar to the one presented in Chapter 4. Exhibit 5-5 is an illustration of a work sheet for a
merchandising business.
1.
Inventory, Sales returns and allowances, and Sales discounts, and Cost of goods sold are new additions to
the Trial Balance columns.
2.
The adjustments in the Adjustments column are prepared as in Chapter 4 with the addition of the
inventory adjustment.
3.
The adjusted trial balance columns are omitted in this chapter.
4.
Unlike the Income Statement columns in Chapter 4, the credit column does not equal total revenue and
the debit column does not equal total expenses. The difference between the debit and credit column
totals still equals net income or loss.
5.
The only new item in the Balance Sheet columns is Inventory.
C.
Both adjusting entries and closing entries may be prepared from the work sheet. (See Exhibit 5-6 for the adjusting
and closing entries of Austin Sound.)
D.
The closing entries in this chapter are prepared as in Chapter 4 with the addition of some new accounts—Sales
Discounts, Sales Returns and Allowances, and Cost of Goods Sold.
1.
Debit all income statement accounts with a credit balance. Credit Income Summary for the total.
2.
Credit all income statement accounts with a debit balance. Debit Income Summary for the total.
3.
If Income Summary has a credit balance (net income), debit Income Summary to close it and credit
Retained Earnings. If Income Summary has a debit balance (net loss), credit Income Summary to close it
and debit Retained Earnings.
4.
Credit Withdrawals to close it and debit Capital.
Objective 5: Prepare a merchandiser’s financial statements
A.
The income statement for a merchandising concern shows classification of income statement accounts in the
following order (as illustrated in Exhibit 5-7):
1.
Net sales revenue
2.
Cost of goods sold
3.
Gross profit
4.
Operating expenses that may be further divided into:
a.
Selling expenses—expenses related to selling, such as commissions and advertising.
b.
General expenses—expenses that are office-related, such as office salaries and office supplies
expense.
5.
Income from operations, or operating income, equals gross profit less operating expenses.
6.
Other revenues and expenses are revenues and expenses outside the main operations of the business,
such as interest expense, interest revenue, gains and losses on the sale of assets.
7.
Net income equals income from operations plus other revenues and minus other expenses.
B.
The statement of owner’s equity is the same as in Chapter 4.
C.
The balance sheet is similar to the one in Chapter 4 except for the addition of Inventory, a current asset.
D.
Two formats of the income statement are the multi-step and the single-step.
1.
The income statement presented thus far in the chapter is a multi-step income statement, which presents
gross profit and income from operations—two key measures of operating performance.
2.
The advantage of a single-step format is that it groups all revenues together and then deducts all expenses
together. Exhibit 5-8 illustrates the single-step income statement.
Objective 6: Use gross profit percentage and inventory turnover to evaluate a business
A.
The gross profit percentage expresses the relationship of an entity’s gross profit to its sales.
1.
The gross profit percentage is important to retail businesses. A change in the gross profit percentage may
be an indication that the business must take corrective action.
2.
Exhibit 5-9 illustrates the gross profit per dollar of sales for three companies. The computation is:
Gross profit percentage =
B.
Gross margin
The rate of inventory turnover indicates how rapidly inventory is sold.
Net Sales Revenue
1.
A business desires to sell its inventory as quickly as possible.
2.
Exhibit 5-10 illustrates the rate of inventory turnover for Amazon.com. The computation is:
Inventory turnover = Cost of goods sold
Average inventory
Average inventory =
C.
(Beginning inventory + Ending inventory)  2
Decision Guidelines summarize some key decisions of a merchandising business.
CHAPTER 5 APPENDIX
Accounting for Merchandise Inventory in a Periodic System
Appendix Overview
Accounting for the purchase and sale of inventory using a periodic system is illustrated. The appendix uses the same
examples used in the chapter but adapts those examples to the periodic system. Accounting for purchase returns and
allowances and transportation costs is illustrated. Under the periodic system, cost of goods sold is not an account and
therefore the computation of cost of goods sold is emphasized. A detailed income statement through gross profit is
presented.
The appendix then discusses the adjusting and closing process for a merchandising business. The end of the
period procedures begin with the preparation of the work sheet. The adjusting and closing process is then discussed. The
inventory account is updated during the closing entries. The financial statements are presented.
Appendix Learning Objectives
After studying the appendix to Chapter 5, your students should be able to:
A1.
Account for the purchase and sale of inventory
A2.
Compute cost of goods sold
A3.
Adjust and close the accounts of a merchandising business
A4.
Prepare a merchandiser’s financial statements
Appendix Outline
Appendix Objective 1: Account for the purchase and sale of inventory
A.
The periodic system is used by businesses that can not justify the expense of using a perpetual system. The
inventory account is not updated when inventory is sold.
1.
An account called Purchases is used to accumulate the cost of all merchandise purchased. Exhibit 5A-1
illustrates an invoice from which the purchase is recorded.
2.
The entry to record the purchase of merchandise is:
Purchases
Accounts Payable (or Cash)
3.
XX
XX
Payment of the account within the discount period results in the following entry:
Accounts Payable
Cash
Purchase Discounts
XX
XX
XX
4.
Merchandise that is returned or allowances granted for damaged merchandise are recorded in the contra
account, Purchase Returns and Allowances.
Accounts Payable
XX
Purchase Returns and Allowances
5.
Net purchases is the remainder after subtracting the contra accounts from Purchases.
=
6.
Purchases (debit balance)
Purchases discounts (credit balance)
Purchase returns and allowances (credit balance)
Net purchases
The costs of transporting the merchandise from the seller to the buyer are debited to an account called
Freight In. Freight charges increase the cost of purchasing inventory.
Freight In
Cash
7.
XX
XX
XX
Recording sales in a periodic system requires only one entry to record the sale.
Accounts Receivable or Cash
Sales Revenue
XX
XX
Appendix Objective 2: Compute cost of goods sold
A.
Cost of Goods Sold must be computed in a periodic system. It is not a ledger account. Exhibit 5A-2 illustrates
the computation of cost of goods sold. A detailed income statement through gross profit is illustrated in Exhibit
5A-3.
B.
The computation for cost of goods sold is:
Beginning inventory
+ Net purchases
+ Freight in
= Cost of goods available for sale
- Ending inventory
= Cost of goods sold
Purchases of inventory
- Purchase discounts
- Purchase returns and allowances
= Net purchases
Appendix Objective 3: Adjust and close the accounts of a merchandising business
A.
The end of the period procedures begin with preparation of the work sheet. Exhibit 5A-4 is a trial balance with
accounts that will be used to illustrate the adjusting and closing entries.
B.
The work sheet is similar to the one studied in Chapter 4. Exhibit 5A-5 illustrates a work sheet.
1.
Sales returns and allowances, Sales discounts, Inventory, Purchases, Purchase returns and allowances,
Purchase discounts, and Freight in are new additions to the trial balance columns.
2.
The adjustment columns are the same as in Chapter 4.
3.
The adjusted trial balance columns are omitted.
4.
Unlike the income statement columns in Chapter 4, the credit column does not equal total revenue, and
the debit column does not equal total expenses.
5.
C.
a.
The difference between the debit and credit column totals still equals net income or loss.
b.
Beginning inventory is extended to the debit column and ending inventory is entered in the credit
column.
c.
The beginning and ending inventories cannot be extended in the same way as the other accounts
on the work sheet.
The only new item in the balance sheet columns is Inventory.
Adjusting and closing entries are prepared from the work sheet as illustrated in exhibit 5A-6. The closing entries
under the periodic system are similar to those studied in Chapter 4.
1. The first closing entry closes all revenue accounts into Income Summary.
2.
The second closing entry closes the beginning balance of Inventory, along with Purchases and Freight In,
into Cost of Goods Sold.
3.
The third closing entry establishes the ending balance of Inventory and closes the balance of Purchases
Discounts, and Purchase Returns and Allowances into Cost of Goods Sold. The balances of Inventory
and Cost of Goods Sold are now correct.
4.
The fourth closing entry closes Sales Returns and Allowances, Sales Discounts, and Cost of Goods Sold
into Income Summary.
5.
The fifth closing entry closes Income Summary into Retained Earnings as in Chapter 4.
6.
The sixth closing entry closes Dividends into Retained Earnings as in Chapter 4.
Appendix Objective 4: Prepare a merchandiser’s financial statements
A.
The financial statements are prepared after the work sheet is completed. Exhibit 5A-6 illustrates the financial
statements.
B.
The income statement for a merchandising concern shows classification of income statement accounts in the
following order:
1.
Net sales revenue
2.
Cost of goods sold
3.
Gross profit
4.
Operating expenses that may be further divided into:
a.
Selling expenses are expense related to selling, such as commissions and advertising.
b.
General expenses are expenses that are office-related, such as office salaries and office supplies
expense.
5.
Income from operations, or operating income, equals gross profit less operating expenses.
6.
Other revenue and expenses are revenues and expenses outside the main operations of the business,
such as interest expense, interest revenue, gains and losses on the sale of assets.
7.
Net income equals income from operations plus other revenues and minus other expenses.
C.
The statement of owner’s equity is the same as in Chapter 4.
D.
The balance sheet is similar to the one in Chapter 4 except for the addition of Inventory.
E.
After the financial statements are prepared, the adjusting entries can be journalized and posted from the work
sheet. Exhibit 5A-7 shows the adjusting and closing entries.