Chapter 5
1
Service enterprises
perform services as
their primary source of
revenue.
Merchandising
companies buy
and sell
merchandise.
2
Differences Between a Service Business
and a Merchandising Company
 In a merchandising company, the primary source of
revenues is the sale of merchandise, referred to as
sales revenue or sales.
 Unlike expenses for a service company, expenses for
a merchandising company are divided into two
categories:
o Cost of goods sold - the total cost of merchandise
sold during the period.
o Operating expenses - selling and administrative
expenses.
Calculating Net Income
Net Income--A measure of the overall
performance of a business entity.
Calculating Net Income
Net Income--A measure of the overall
performance of a business entity.
Service Company
Revenues
- Operating Expenses
Net Income
Calculating Net Income
Net Income--A measure of the overall
performance of a business entity.
Service Company
Product Company
Revenues
- Operating Expenses
Net Income
Revenues
- Cost of Goods Sold
Gross Margin
- Operating Expenses
Net Income
Terms
 Sales revenue or sales = sale of
merchandise
 Cost of goods sold = total cost of
merchandise sold
Operating cycle of any
company is...
the average time it takes to
go from cash to cash in
producing revenues.
TO
Operating cycle of a
merchandising company is...
 Ordinarily longer than that of
a service company;
 Purchase of merchandise and
its sale lengthens the cycle.
Service Company
Receive Cash
Perform Services
Cash
Accounts
Receivable
Merchandising Company
Receive Cash
Cash
Buy Inventory
Sell Inventory
Accounts
Receivable
Merchandise
10
Inventory
Inventory
• The Inventory account is one of the
largest assets for any company.
• The determination of which goods
should be included in inventory at the
end of a period is “Inventory Cutoff.”
• Inventory errors will affect the financial
statements for 2 years.
What Is Charged to
Merchandise Inventory?
 All costs needed to get inventory to a
company and ready to sell
• +Freight-In
• +Special Permits
 Only costs associated with merchandise
purchased for resale - not assets
acquired for use, such as supplies
Transportation Costs
• The cost of inbound transportation is
added to the cost of inventory.
• For the perpetual method, the cost must
be added to the Inventory account to
reflect actual cost of acquiring inventory.
• For the periodic method, a Freight-In
account is used.
Inventory Control Methods
• Perpetual Inventory Method--A system
of accounting in which cost of goods
sold and inventory are adjusted when
the merchandise is purchased or sold.
• Periodic Inventory Method--A system of
accounting in which the cost of goods
sold and inventory are adjusted at the
end of the accounting period.
• First:
Let’s look at the whole process assuming
Perpetual Inventory
Perpetual Inventory
• Transaction records of every sale or
purchase are required to account for
inventory.
• The perpetual method is similar to how
you would account for cash.
• The Inventory account should represent
the amount of inventory on hand at any
time.
Merchandise Purchases
On May 4 the company bought $ 3,800 worth
of merchandise from PW Audio Supply, Inc.
Task: Record the purchase by getting
information from the Purchase Invoice.
The Purchase Invoice is the buyer’s copy
of the sales invoice.
Merchandise Purchases
On May 4 the company bought $ 3,800 worth
of merchandise from PW Audio Supply, Inc.
GENERAL JOURNAL
May 4
Debit
Credit
Merchandise Inventory
3,800
Accounts Payable
3,800
To record goods purchased on account.
Merchandise Purchases
On May 5 the company received an invoice
from a freight company for $ 120 for delivery
of the merchandise from PW Audio
GENERAL JOURNAL
May 5
Debit
Merchandise Inventory
120
Accounts Payable
To record in-coming freight on account.
Credit
120
Purchase Returns
On May 8 the company returned $300 worth
of merchandise to PW Audio Supply, Inc.
GENERAL JOURNAL
Debit
Credit
May 8 Accounts Payable
300
Merchandise Inventory
Record goods returned on account.
300
Purchase Discounts
A purchase discount is a reduction in the
purchase price, usually when payment is
made within a specified period.
Purchase discounts reduce the net cost of
the purchases account.
For perpetual inventory, a purchase
discount reduces inventory by the same
amount.
Purchase Discount Example:
On March 1, the Morris Company purchased
(received) 10 accounting books for $100 each.
The terms of the contract were 2/10, n/30. Write
down the journal entry made Mar. 1 and the entry
made on Mar. 10 for the payment to the supplier.
Purchase Discount Example:
On March 1, the Morris Company purchased
(received) 10 accounting books for $100 each.
The terms of the contract were 2/10, n/30. Write
down the journal entry made Mar. 1 and the entry
made on Mar. 10 for the payment to the supplier.
3/1
Inventory ………….................... 1,000
Accounts Payable ...........…
1,000
Received books from Wiley, purchase
order #M1234 with terms of 2/10, n/30.
Purchase Discount Example:
On March 1, the Morris Company purchased
(received) 10 accounting books for $100 each.
The terms of the contract were 2/10, n/30. Write
down the journal entry made Mar. 1 and the entry
made on Mar. 10 for the payment to the supplier.
3/10 Accounts Payable..................... 1,000
Inventory…………...........…
20
Cash...................................
980
Paid Wiley’s invoice 1234 for purchase
of books with 2% discount.
Purchase Discount Example:
On March 1, the Morris Company purchased
(received) 10 accounting books for $100 each.
The terms of the contract were 2/10, n/30. Write
down the journal entry made for the payment to
the supplier, but assume the payment was Apr 1
4/1
Accounts Payable..................... 1,000
Cash...................................
1000
Paid Wiley’s invoice 1234 for purchase
of books. No discount taken.
Sales Revenues:
 are recorded when earned-revenue
recognition principle
 must be supported by a business documentwritten evidence
 2 entries are made for each sale
 one to record sale
 one to record cost of merchandise sold
26
Sales Revenue Example:
On March 1, the Morris Company sold
merchandise for $5,000 with terms of 2/10, n/30.
The cost to Morris was $2,900.
3/1
3/1
Accounts Receivable.......... 5,000
Sales………….............…
Record sale to Acme Inc.
5,000
Cost of Goods Sold............ 2,900
Merchandise Inventory..
Record Cost of Goods
2,900
Sales Revenue Example:
Cash
Accounts
Receivable
Merchandise
Inventory
Mar 1 5,000
Sales
5,000 Mar 1
Sales Returns &
Allowances
2,900 Mar 1
Cost of Goods
Sold
Mar 1 2,900
Periodic Inventory
• Inventory levels on the general ledger
are not affected by purchases or sales.
• Might be used in a juice bar or a small
clothing store.
• The Inventory and Cost of Goods Sold
accounts are only correct at the end of
the fiscal period, when a physical
inventory is taken.
Cost of Goods Sold -Periodic
Method
A running account of changes in inventory is not
maintained.
Separate accounts are used to record
–
–
–
–
Purchases
Freight in,
Purchase returns
Discounts
Cost of goods sold is calculated at end of period.
Periodic Inventory
MERCHANDISE
INVENTORY
BEG. BALANCE
$25,000
Periodic Inventory
MERCHANDISE
INVENTORY
$25,000
This account is NOT
changed during the
accounting period
Periodic Inventory
MERCHANDISE
INVENTORY
$25,000
PURCHASES
XXX
Merchandise bought during
the year is debited to
Purchases instead of
Merchandise Inventory
Periodic Inventory
MERCHANDISE
INVENTORY
PURCHASES
$25,000
XXX
SALES
XXX
The COST of merchandise sold is NOT recorded.
The selling price is credited to the Sales account
Sales Revenue Periodic
On March 1, the Morris Company sold
merchandise for $5,000 with terms of 2/10, n/30.
The cost to Morris was $2,900.
3/1
3/1
Accounts Receivable.......... 5,000
Sales………….............…
Record sale to Acme Inc.
5,000
Cost of Goods Sold............ 2,900
Merchandise
Inventory..
Periodic
Record Cost of Goods
2,900
Periodic Inventory
MERCHANDISE
INVENTORY
$25,000
After a year of purchasing
and selling merchandise,
the balance is no
longer accurate!
Periodic Inventory
MERCHANDISE
INVENTORY
$25,000
An adjustment is needed to update the
balance of the Merchandise Inventory
account. That takes a physical count.
Periodic Inventory
The calculation to determine Cost of Goods
Sold using the periodic method is as follows:
Beginning Inventory, Jan 1
+ Purchases for the year
= Cost of goods available for sale
- Ending Inventory, Dec. 31
= Cost of Goods Sold
What Is the Sales Returns and
Allowances Account?
Contra Revenue Account to sales
Used to show how much came back in returns
and allowances
 Excessive returns and allowances suggest:
 inferior merchandise
 inefficiencies in filing orders
 errors in billing customers
 mistakes in delivery or shipment of goods
Sales Returns and Allowances
Flip side of purchase returns and allowance
On buyer’s books
GENERAL JOURNAL
Mar 1 Accounts Payable
Merchandise Inventory
To record goods returned to Sauk.
Debit Credit
300
300
On seller’s books
GENERAL JOURNAL
Mar 1
Mar 1
Debit Credit
Sales Returns and Allowance
300
Accounts Receivable
To record return of goods sold to Sauk Stereo.
300
Merchandise Inventory
170
Cost of Goods Sold
170
To record cost of goods returned from Sauk Stereo.
What Is the Sales Discount
Account?
• Contra Revenue Account to sales
• Used to disclose amount of cash
discounts given to customers
Sales Discounts
Flip side of purchase discounts
On buyer’s books
GENERAL JOURNAL
Debit Credit
May 14 Accounts Payable
Cash
Merchandise Inventory
3,500
3,430
70
To record payment within discount period
On seller’s books
GENERAL JOURNAL
Debit Credit
May 14 Cash
Sales Discounts
Accounts Receivable
3,430
70
To record collection within discount period.
3500
Transportation Costs
LOOK OUT !!!
It’sthe
not part of
For
inventory!
Outbound
freight
Freight Costs-on outgoing
inventory
On May 6 we paid $150 to have merchandise
inventory delivered to the buyer.
Freight-Out
Merchandise
Expense
Inventory
Cash
May 6
150
GENERAL JOURNAL
May 6 Freight-Out Expense
Cash
To record payment of freight on goods sold.
May 6 150
Debit Credit
150
150
Two Forms Of
Income Statements
• Single-step income statement
• Multiple-step income statement
Single-Step Income Statement
One step… subtract total
expenses from total revenues
Revenues $10,000
Expenses
3,000
Net income $ 7,000
PW AUDIO, Inc.
Single-step Income Statement
For the Year Ended December 31, 20xx
Sales
Interest Revenue
Gain on Sale of equipment
Total Revenues
Expenses
Cost of goods sold
Selling expenses
Administrative expenses
Interest expense
Casualty Loss from vandalism
Income tax expense
Total expenses
Net income
$460,000
3,000
600
$463,600
$316,000
76,000
38,000
1,800
200
10,100
442,100
$ 21,500
PW AUDIO SUPPLY, INC.
Multi-step Income Statement
For the Year Ended December 31, 20xx
Sales revenues
Sales
Less: Sales returns and allowance
Sales discounts
Net sales
Cost of goods sold
Gross profit
Operating expenses
Selling expenses:
Store salaries expense
Advertising expense
Depreciation expense
Freight-out
Total selling expenses
Administrative expenses
Salaries expense
Utilities expense
Insurance Expense
Total administrative expenses
Total operating expenses
Income from operations
$ 480,000
$12,000
8,000
20,000
460,000
316,000
$ 144,000
$45,000
16,000
8,000
7,000
$76,000
$19,000
17,000
2,000
38,000
114,000
$ 30,000
PW AUDIO SUPPLY, INC.
Multi-step Income Statement
For the Year Ended December 31, 20xx
Income from operations (continued)
Other revenues and gains
Interest revenue
Gain on sale of equipment
$ 30,000
$ 3,000
600
$ 3,600
Other expenses and losses
Interest expense
Casualty loss from vandalism
$ 1,800
200
2,000
Income before income taxes
Income tax expense
Net income
1,600
31,600
10,100
$21,500
PW AUDIO SUPPLY, INC.
Cost of Goods Sold
For the Year Ended December 31, 2005
Cost of goods sold
Inventory, January 1
Purchases
Less Purchase returns and allowances $10,400
Purchase discounts
6,800
Net purchases
Add: Freight-in
Cost of goods purchased
Cost of goods available for sale
Inventory, December 31
Cost of goods sold
$ 36,000
$325,000
17,200
307,800
12,200
320,000
356,000
40,000
316,000
Gross Profit Rate=
Gross Profit
Net Sales
Company’s gross profit expressed as a
percentage of revenue
Profit Margin Ratio
Measures the percentage of each dollar of
sales that results in net income
Profit Margin Ratio =
Net Income
Net Sales
Higher value suggests favorable
return on each dollar of sales.
Now, that wasn’t so bad! Was it?