Chapter 4

Accounting for Merchandising

Operations

5-1
 PREVIEW OF CHAPTER 4

5-2
 CHAPTER

4 Accounting for
Merchandising Operations
LEARNING OBJECTIVES
After studying this chapter, you should be able to:

1. Identify the differences between service and merchandising companies.

2. Explain the recording of purchases under a perpetual inventory system.
3. Explain the recording of sales revenues under a perpetual inventory
system.
4. Explain the steps in the accounting cycle for a merchandising company.
5. Prepare an income statement for a merchandiser.

5-3
 Merchandising Operations
Learning
Objective 1
Merchandising Companies Identify the
differences between
Buy and Sell Goods service and
merchandising
companies.
Retailer

Wholesaler Consumer

The primary source of revenues is referred to as

sales revenue or sales.
5-4 LO 1
 Merchandising Operations

Income Measurement
Not used in a
Sales Less
Illustration 5-1
Service business.
Revenue Income measurement process for a
merchandising company

Equals
Cost of Gross Less
Goods Sold Profit

Operating Equals Net

Cost of goods sold is the total Income
Expenses
cost of merchandise sold during (Loss)
the period.

5-5 LO 1
 Operating Cycles
Illustration 5-2
The operating
cycle of a
merchandising
company
ordinarily is longer
than that of a
service
company.

Illustration 5-3

5-6 LO 1
 Flow of Costs
Illustration 5-4

Companies use either a perpetual inventory system or a periodic

inventory system to account for inventory.
5-7 LO 1
 Flow of Costs

PERPETUAL SYSTEM
 Maintain detailed records of the cost of each inventory
purchase and sale.
 Records continuously show inventory that should be on
hand for every item.
 Company determines cost of goods sold each time a
sale occurs.

5-8 LO 1
 Flow of Costs

PERIODIC SYSTEM
 Do not keep detailed records of the goods on hand.
 Cost of goods sold determined by count at the end of
the accounting period.
 Calculation of Cost of Goods Sold:
Beginning inventory € 100,000
Add: Purchases, net 800,000
Goods available for sale 900,000
Less: Ending inventory 125,000
Cost of goods sold € 775,000

5-9 LO 1
 Flow of Costs

ADVANTAGES OF THE PERPETUAL SYSTEM

 Traditionally used for merchandise with high unit
values.
 Shows the quantity and cost of the inventory that
should be on hand at any time.
 Provides better control over inventories than a periodic
system.

5-10 LO 1
 > DO IT!

Indicate whether the following statements are true or false.

1. The primary source of revenue for a merchandising

company results from performing services for False
customers.

2. The operating cycle of a service company is usually

True
shorter than that of a merchandising company.

3. Sales revenue less cost of goods sold equals gross

True
profit.

4. Ending inventory plus the cost of goods purchased

False
equals cost of goods available for sale.

5-11 LO 1
 Recording Purchases of Merchandise
Learning Objective 2
Explain the recording of
 Made using cash or credit (on purchases under a perpetual
inventory system.
account).

 Normally record when

goods are received from
the seller.

 Purchase invoice should

support each credit
purchase.

Illustration 5-6
Sales invoice used as purchase
invoice by Sauk Stereo
5-12
 Recording Purchases of Merchandise
Illustration 5-6

Illustration: Sauk Stereo (the

buyer) uses as a purchase
invoice the sales invoice
prepared by PW Audio Supply,
Inc. (the seller). Prepare the
journal entry for Sauk Stereo for
the invoice from PW Audio
Supply.

May 4 Inventory 3,800

Accounts Payable
3,800
5-13 LO 2
 Freight Costs

Ownership of the goods

passes to the buyer when the
public carrier accepts the
goods from the seller.

Ownership of the goods

remains with the seller until
the goods reach the buyer.

Illustration 5-7
Shipping terms
Freight costs incurred by the seller are an
operating expense.
5-14 LO 2
 Freight Costs

Illustration: Assume upon delivery of the goods on May 6, Sauk

Stereo pays Public Freight Company €150 for freight charges,
the entry on Sauk Stereo’s books is:

May 6 Inventory 150

Cash

150
Assume the freight terms on the invoice in Illustration 5-6 had
required PW Audio Supply to pay the freight charges, the entry
by PW Audio Supply would have been:

May 4 Freight-Out (Delivery Expense)150

Cash
5-15 LO 2
150
 Purchase Returns and Allowances

Purchaser may be dissatisfied because goods are damaged

or defective, of inferior quality, or do not meet specifications.

Purchase Return Purchase Allowance

Return goods for credit if the May choose to keep the
sale was made on credit, or merchandise if the seller will
for a cash refund if the grant a reduction from the
purchase was for cash. purchase price.

5-16 LO 2
 Purchase Returns and Allowances

Illustration: Assume Sauk Stereo returned goods costing

€300 to PW Audio Supply on May 8.

May 8 Accounts Payable 300

Inventory 300

5-17 LO 2
 Purchase Returns and Allowances

Question
In a perpetual inventory system, a return of defective
merchandise by a purchaser is recorded by crediting:
a. Purchases
b. Purchase Returns
c. Purchase Allowance
d. Inventory

5-18 LO 2
 Purchase Discounts

Credit terms may permit buyer to claim a cash discount

for prompt payment.
Example: Credit terms
Advantages: may read 2/10, n/30.
 Purchaser saves money.

 Seller shortens the operating cycle by converting the

accounts receivable into cash earlier.

5-19 LO 2
 Purchase Discounts

2/10, n/30 1/10 EOM n/10 EOM

2% discount if 1% discount if Net amount due

paid within 10 paid within first 10 within the first 10
days, otherwise days of next days of the next
net amount due month. month.
within 30 days.

5-20 LO 2
 Purchase Discounts

Illustration: Assume Sauk Stereo pays the balance due of

€3,500 (gross invoice price of €3,800 less purchase returns
and allowances of €300) on May 14, the last day of the
discount period. Prepare the journal entry Sauk Stereo
makes on May 14 to record the payment.

May 14 Accounts Payable 3,500

Inventory 70
Cash 3,430

(Discount = €3,500 x 2% = €70)

5-21 LO 2
 Purchase Discounts

Illustration: If Sauk Stereo failed to take the discount, and

instead made full payment of €3,500 on June 3, the journal
entry would be:

June 3 Accounts Payable 3,500

Cash 3,500

5-22 LO 2
 Purchase Discounts

Should discounts be taken when offered?

Discount of 2% on €3,500 €70.00
€3,500 invested at 10% for 20 days 19.18
Savings by taking the discount €50.82

Example: 2% for 20 days = Annual rate of 36.5%

€3,500 x 36.5% x 20 ÷ 365 = €70

5-23 LO 2
 Summary of Purchasing Transactions

Inventory
Debit Credit

4th - Purchase 3,800 300 8th - Return

6th - Freight-in 150 70 14th - Discount

Balance 3,580

5-24 LO 2
 > DO IT!

On September 5, Zhu Company buys merchandise on account

from Gao Company. The selling price of the goods is ¥15,000,
and the cost to Gao Company was ¥8,000. On September 8,
Zhu returns defective goods with a selling price of ¥2,000.
Record the transactions on the books of Zhu Company.

Sept. 5 Inventory 15,000

Accounts Payable 15,000
Sept. 8 Accounts Payable 2,000
Inventory 2,000

5-25 LO 2
 Recording Sales of Merchandise
Learning Objective 3
Explain the recording of
 Made using cash or credit (on account). sales revenue under a
perpetual inventory system.
 Sales revenue, like service
revenue, is recorded when
the performance obligation
is satisfied.
 Performance obligation is
satisfied when the goods
are transferred from the
seller to the buyer.
 Sales invoice should
support each credit sale.

Illustration 5-6
5-26 LO 3
 Recording Sales of Merchandise

Journal Entries to Record a Sale

#1 Cash or Accounts Receivable XXX Selling

Sales Revenue XXX Price

#2 Cost of Goods Sold XXX

Cost
Inventory XXX

5-27 LO 3
 Recording Sales of Merchandise

Illustration: PW Audio Supply records the sale of €3,800 on

May 4 to Sauk Stereo on account (Illustration 5-6) as follows
(assume the merchandise cost PW Audio Supply €2,400).

May 4 Accounts Receivable 3,800

Sales Revenue 3,800

4 Cost of Goods Sold 2,400

Inventory 2,400

5-28 LO 3
 Sales Returns and Allowances

 “Flip side” of purchase returns and allowances.

 Contra-revenue account to Sales Revenue (debit).

 Sales not reduced (debited) because:

► Would obscure importance of sales returns and
allowances as a percentage of sales.

► Could distort comparisons.

5-29 LO 3
 Sales Returns and Allowances

Illustration: Prepare the entry PW Audio Supply would make

to record the credit for returned goods that had a €300 selling
price (assume a €140 cost). Assume the goods were not
defective.

May 8 Sales Returns and Allowances 300

Accounts Receivable 300

8 Inventory 140
Cost of Goods Sold 140

5-30 LO 3
 Sales Returns and Allowances

Illustration: Assume the returned goods were defective and

had a scrap value of €50, PW Audio would make the following
entries:

May 8 Sales Returns and Allowances 300

Accounts Receivable 300

8 Inventory 50
Cost of Goods Sold 50

5-31 LO 3
 Sales Returns and Allowances

Question
The cost of goods sold is determined and recorded each
time a sale occurs in:
a. periodic inventory system only.
b. a perpetual inventory system only.
c. both a periodic and perpetual inventory system.
d. neither a periodic nor perpetual inventory system.

5-32 LO 3
 Sales Discount

 Offered to customers to promote prompt payment of

the balance due.
 Contra-revenue account (debit) to Sales Revenue.

5-33 LO 3
 Sales Discount

Illustration: Assume Sauk Stereo pays the balance due of

€3,500 (gross invoice price of €3,800 less purchase returns
and allowances of €300) on May 14, the last day of the
discount period. Prepare the journal entry PW Audio Supply
makes to record the receipt on May 14.

May 14 Cash 3,430

Sales Discounts 70 *
Accounts Receivable 3,500

* [(€3,800 – €300) X 2%]

5-34 LO 3
 > DO IT!

On September 5, Zhu Company buys merchandise on account

from Gao Company. The selling price of the goods is ¥15,000,
and the cost to Gao Company was ¥8,000. On September 8,
Zhu returns defective goods with a selling price of ¥2,000 and
the fair value of ¥300. Record the transactions on the books of
Gao Company.

Sept. 5 Accounts Receivable 15,000

Sales Revenue 15,000
Sept. 5 Cost of Goods Sold 8,000
Inventory 8,000

5-35 LO 3
 > DO IT!

On September 5, Zhu Company buys merchandise on account

from Gao Company. The selling price of the goods is ¥15,000,
and the cost to Gao Company was ¥8,000. On September 8,
Zhu returns defective goods with a selling price of ¥2,000 and
the fair value of ¥300. Record the transactions on the books of
Gao Company.

Sept. 8 Sales Returns and Allowances 2,000

Accounts Receivable 2,000
Sept. 8 Inventory 300
Cost of Goods Sold 300

5-36 LO 3
 Recording Sales of Merchandise
Learning Objective 4
Explain the steps in the
Adjusting Entries accounting cycle for a
merchandising company.

 Generally the same as a service company.

 One additional adjustment to make the records agree with
the actual inventory on hand.
 Involves adjusting Inventory and Cost of Goods Sold.

5-37 LO 4
 Adjusting Entries

Illustration: Suppose that PW Audio Supply has an unadjusted

balance of €40,500 in Merchandise Inventory. Through a physical
count, PW Audio determines that its actual merchandise inventory
at year-end is €40,000. The company would make an adjusting
entry as follows.

Cost of Goods Sold 500

Inventory
500

5-38 LO 4
 Closing Entries

5-39 LO 4
 Closing Entries

5-40 LO 4
 > DO IT!

The trial balance of Celine’s Sports Wear Shop at December 31

shows Inventory €25,000, Sales Revenue €162,400, Sales
Returns and Allowances €4,800, Sales Discounts €3,600, Cost
of Goods Sold $110,000, Rent Revenue €6,000, Freight-Out
€1,800, Rent Expense €8,800, and Salaries and Wages
Expense €22,000. Prepare the closing entries for the above
accounts.

Dec. 31 Sales Revenue 162,400

Rent Revenue 6,000
Income Summary 168,400

5-41 LO 4
 The trial balance of Celine’s Sports Wear Shop at December 31
shows Inventory €25,000, Sales Revenue €162,400, Sales
Returns and Allowances €4,800, Sales Discounts €3,600, Cost
of Goods Sold €110,000, Rent Revenue €6,000, Freight-Out
€1,800, Rent Expense €8,800, and Salaries and Wages
Expense €22,000. Prepare the closing entries for the above
accounts.

Dec. 31 Income Summary 151,000

Cost of Goods Sold 110,000
Sales Returns and Allowances
4,800
Sales Discounts 3,600
Freight-Out 1,800
Rent Expense 8,800
5-42 Salaries and Wages Expense LO 4
 Forms of Financial Statements
Learning Objective 5
Prepare an income
Income Statement statement for a
merchandiser.

 Primary source of information for evaluating a company’s

performance.
 Format is designed to differentiate between the various
sources of income and expense.

5-43 LO 5
Income
Statement
The income statement
is a primary source of
information for
evaluating a
company’s
performance.

5-44 Illustration 5-14 LO 5

Income
Statement
Key Items:
 Net sales

5-45 Illustration 5-14 LO 5

Income
Statement
Key Items:
 Net sales
 Gross profit

5-46 Illustration 5-14 LO 5

Income
Statement
Key Items:
 Net sales
 Gross profit

Illustration 5-11
Gross profit rate formula
and computation

5-47 Illustration 5-14 LO 5

Income
Statement
Key Items:
 Net sales
 Gross profit
 Operating
expenses

5-48 Illustration 5-14 LO 5

Income
Statement
Key Items:
 Net sales
 Gross profit
 Operating
expenses
 Other income
and expense

5-49 Illustration 5-14 LO 5

Income
Statement
Key Items:
 Net sales
 Gross profit
 Operating
expenses
 Other income
and expense

5-50 Illustration 5-14 LO 5

Income
Statement
Key Items:
 Net sales
 Gross profit
 Operating
expenses
 Other income and
expense
 Interest expense

5-51 Illustration 5-14 LO 5

Income
Statement
Key Items:
 Net sales
 Gross profit
 Operating
expenses
 Other income and
expense
 Interest expense
 Net income

5-52 Illustration 5-14 LO 5

 Income Statement

Question
The income statement for a merchandiser shows each of
the following features except:
a. gross profit.
b. cost of goods sold.
c. a sales section.
d. investing activities section.

5-53 LO 5
 COMPREHENSIVE INCOME

Includes certain adjustments to pension plan assets, gains and

losses on foreign currency translation, and unrealized gains and
losses on certain types of investments.

Illustration 5-15
Separate statement of net Reported in a combined statement of net income
income and comprehensive
income and comprehensive income, or in a separate
schedule that reports only comprehensive income.
5-54 LO 5
 Inventory Presentation in the Classified
Statement of Financial Position

Illustration 5-16
Assets section of a classified statement of financial position

5-55 LO 5
 > DO IT!
You are presented with the following list of accounts from the adjusted
trial balance for merchandiser Gorman Company. Indicate in which
financial statement and under what classification each of the following
would be reported.
Financial
Account Statement Classification
Accounts payable SFP Current liabilities
Accounts receivable SFP Current assets
Accumulated Depreciation-Buildings SFP Property, plant, and equipment
Accumulated Depreciation-Equipment SFP Property, plant, and equipment
Advertising Expense IS Operating expenses
Buildings SFP Property, plant, and equipment
Cash SFP Current assets
Depreciation Expense IS Operating expenses
Dividends RES Deduction section

5-56 LO 5
 > DO IT!
You are presented with the following list of accounts from the adjusted
trial balance for merchandiser Gorman Company. Indicate in which
financial statement and under what classification each of the following
would be reported.
Financial
Account Statement Classification
Equipment SFP Property, plant, and equipment
Freight-Out IS Operating expenses
Gain on Disposal of Plant Assets IS Other income and expense
Insurance Expense IS Operating expenses
Interest Expense IS Interest expense
Interest Payable SFP Current liabilities
Inventory SFP Current assets
Land SFP Property, plant, and equipment
Notes Payable (due in 3 years) SFP Non-current liabilities

5-57 LO 5
 > DO IT!
You are presented with the following list of accounts from the adjusted
trial balance for merchandiser Gorman Company. Indicate in which
financial statement and under what classification each of the following
would be reported.
Financial
Account Statement Classification
Property Taxes Payable SFP Current liabilities
Salaries and Wages Expense IS Operating expenses
Salaries and Wages Payable SFP Current liabilities
Sales Returns and Allowances IS Sales
Sales Revenue IS Sales
Share Capital—Ordinary SFP Equity
Utilities Expense IS Operating expenses

5-58 LO 5
 Worksheet for a Merchandising
APPENDIX 5A
Company
Learning
Objective 6
Using a Worksheet Prepare a worksheet
for a merchandising
company.
As indicated in Chapter 2, a worksheet enables
companies to prepare financial statements before they
journalize and post adjusting entries. The steps in preparing a
worksheet for a merchandising company are the same as for a
service company. Illustration 5A-1 shows the worksheet for PW
Audio Supply (excluding nonoperating items). The unique
accounts for a merchandiser using a perpetual inventory
system are in red.

5-59 LO 6
 Illustration 5A-1
Worksheet for
merchandising company

5-60 LO 6
 APPENDIX 5B Periodic Inventory System
Learning
Objective 7
Determining Cost of Goods Sold Explain the recording
of purchases and
Under a Periodic System sales of inventory
under a periodic
inventory system.
 No running account of changes in
inventory.
 Ending inventory determined by physical count.
 Cost of goods sold not determined until the end of the
period.

5-61 LO 7
 Determining Cost of Goods Sold
Under a Periodic System Illustration 5B-2
Cost of goods sold for a
merchandiser using a periodic
inventory system

Illustration 5B-2

5-62 LO 7
 Recording Merchandise Transactions

 Record revenues when sales are made.

 Do not record cost of merchandise sold on the date of
sale.
 Physical inventory count determines:
► Cost of merchandise on hand and
► Cost of merchandise sold during the period.
 Record purchases in Purchases account.
 Purchase returns and allowances, Purchase discounts,
and Freight costs are recorded in separate accounts.

5-63 LO 7
 Recording Purchases of Merchandise

Illustration: On the basis of the sales invoice (Illustration 5-6)

and receipt of the merchandise ordered from PW Audio Supply,
Sauk Stereo records the €3,800 purchase as follows.

May 4 Purchases 3,800

Accounts Payable
3,800

5-64 LO 7
 Recording Purchases of Merchandise

FREIGHT COSTS
Illustration: If Sauk pays Public Freight Company €150
for freight charges on its purchase from PW Audio Supply on
May 6, the entry on Sauk’s books is:

May 6 Freight-In (Transportation-In) 150

Cash
150

5-65 LO 7
 Recording Purchases of Merchandise

PURCHASE RETURNS AND ALLOWANCES

Illustration: Sauk Stereo returns €300 of goods to PW Audio
Supply and prepares the following entry to recognize the
return.

May 8 Accounts Payable 300

Purchase Returns and Allowances 300

5-66 LO 7
 Recording Purchases of Merchandise

PURCHASE DISCOUNTS
Illustration: On May 14 Sauk Stereo pays the balance due on
account to PW Audio Supply, taking the 2% cash discount
allowed by PW Audio for payment within 10 days. Sauk
Stereo records the payment and discount as follows.

May 14 Accounts Payable 3,500

Purchase Discounts
70
Cash
3,430

5-67 LO 7
 Recording Sales of Merchandise

Illustration: PW Audio Supply, records the sale of €3,800 of

merchandise to Sauk Stereo on May 4 (sales invoice No. 731,
Illustration 5-6) as follows.

May 4 Accounts Receivable 3,800

Sales Revenue
3,800
No entry is recorded for cost of goods sold at the time of the
sale under a periodic system.

5-68 LO 7
 Recording Sales of Merchandise

SALES RETURNS AND ALLOWANCES

Illustration: To record the returned goods received from Sauk
Stereo on May 8, PW Audio Supply records the €300 sales
return as follows.

May 8 Sales Returns and Allowances 300

Accounts Receivable
300

5-69 LO 7
 Recording Sales of Merchandise

SALES DISCOUNTS
Illustration: On May 14, PW Audio Supply receives payment
of €3,430 on account from Sauk Stereo. PW Audio honors the
2% cash discount and records the payment of Sauk’s account
receivable in full as follows.

May 14 Cash 3,430

Sales Discounts 70
Accounts Receivable 3,500

5-70 LO 7
 Recording Sales of Merchandise

COMPARISON OF ENTRIES

Illustration 5B-3
Comparison of entries for perpetual and periodic inventory systems

5-71 LO 7
 Recording Sales of Merchandise

COMPARISON OF ENTRIES

Illustration 5B-3
Comparison of entries for perpetual and periodic inventory systems

5-72 LO 7
Illustration 5B-5
Worksheet for
merchandising
company—periodic
inventory system

5-73 LO 7
 A Look at U.S. GAAP Learning Objective 8
Compare the accounting
for merchandising under
IFRS and U.S. GAAP.
Key Points
Similarities
 Under both GAAP and IFRS, a company can choose to use either a
perpetual or a periodic system.
 Inventories are defined by IFRS as held-for-sale in the ordinary course of
business, in the process of production for such sale, or in the form of
materials or supplies to be consumed in the production process or in the
performing of services. The definition under GAAP is essentially the same.
 Similar to GAAP, comprehensive income under IFRS includes unrealized
gains and losses (such as those on non-trading securities) that are not
included in the calculation of net income.

5-74 LO 8
 A Look at U.S. GAAP
Key Points
Differences
 Under GAAP, companies generally classify income statement items by
function. Classification by function leads to descriptions like administration,
distribution, and manufacturing. Under IFRS, companies must classify
expenses by either nature or by function. Classification by nature leads to
descriptions such as the following: salaries, depreciation expense, and
utilities expense. If a company uses the functional-expense method on the
income statement, disclosure by nature is required in the notes to the
financial statements.
 Presentation of the income statement under GAAP follows either a single-
step or multiple-step format. IFRS does not mention a single-step or
multiple-step approach.

5-75 LO 8
 A Look at U.S. GAAP
Key Points
Differences
 Under IFRS, revaluation of land, buildings, and intangible assets is
permitted. The initial gains and losses resulting from this revaluation are
reported as adjustments to equity, often referred to as other comprehensive
income. The effect of this difference is that the use of IFRS instead of
GAAP results in more transactions affecting equity (other comprehensive
income) but not net income.
 IFRS requires that two years of income statement information be
presented, whereas GAAP requires three years.

5-76 LO 8
 A Look at U.S. GAAP
Looking to the Future
The IASB and FASB are working on a project that would rework the structure
of financial statements. Specifically, this project will address the issue of how
to classify various items in the income statement. A main goal of this new
approach is to provide information that better represents how businesses are
run. In addition, this approach draws attention away from just one number—
net income. It will adopt major groupings similar to those currently used by the
statement of cash flows (operating, investing, and financing), so that numbers
can be more readily traced across statements. For example, the amount of
income that is generated by operations would be traceable to the assets and
liabilities used to generate the income. Finally, this approach would also
provide detail, beyond that currently seen in most statements (either GAAP or
IFRS), by requiring that line items be presented both by function and by
nature. The new financial statement format was heavily influenced by
suggestions from financial analysts.

5-77 LO 8
 A Look at U.S. GAAP
A Look at IFRS
GAAP Self-Test Questions
Which of the following would not be included in the definition of
inventory under GAAP?

a) Photocopy paper held for sale by an office-supply store.

b) Stereo equipment held for sale by an electronics store.

c) Used office equipment held for sale by the human relations

department of a plastics company.

d) All of the above would meet the definition.

5-78 LO 8
 A Look at U.S. GAAP
A Look at IFRS
IFRS Self-Test Questions
Which of the following would not be a line item of a company
reporting costs by nature?

a) Depreciation expense.

b) Interest expense.

c) Salaries and wages expense.

d) Manufacturing expense.

5-79 LO 8
 A Look at U.S. GAAP
A Look at IFRS
IFRS Self-Test Questions
Which of the following statements is false?
a) GAAP specifically requires use of a multiple-step income
statement.
b) Under GAAP, companies can use either a perpetual or
periodic system.
c) The proposed new format for financial statements was
heavily influenced by the suggestions of financial statement
analysts.
d) The new income statement format will try to de-emphasize
the focus on the “net income” line item.
5-80 LO 8