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MERCHANDISINGACTIVITIES

Chapter

6

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The operating cycle of a business is the time it takesthe business to start with cash, purchase inventory,

sell the inventory, and finally collect the cash from

customers.

The operating cycle of a business that sells inventory

on credit is typically longer than that of a business

that sells only on a cash basis. This additional time isdue to time between when the customer buys the

inventory and the time the customer pays off the

account receivable.

Operating Cycle of a MerchandisingCompany

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Operating Cycle of a MerchandisingCompany

2. Sale of merchandiseon account

Cash

InventoryAccounts

Receivable

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Comparing Merchandising Activities withManufacturing Activities

Merchandising

Company

Purchaseinventory inready-to-sell

condition.

Manufacturing

Company

Manufactureinventory and

have a longer andmore complex

operating cycle.

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Retailers and Wholesalers

Retailers sellmerchandise directly

to the public.

Wholesalers buymerchandise from

several differentmanufacturers and

then sell thismerchandise to

several retailers.

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The income statements of merchandising companieswill have an additional expense item called Cost of

Goods Sold. The Cost of Goods Sold account

represents the cost of the merchandise sold during the

period to help earn revenue.

Cost of Goods Sold is presented as a separate expense

item on the income statement. Net Sales minus Cost ofGoods Sold equals Gross Profit. Gross Profit is the

amount left, after subtracting the cost of the inventory

sold, to cover all other expenses and a profit .

Income Statement of a MerchandisingCompany

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Income Statement of a MerchandisingCompany

Computer Barn

Condensed Income Statement

For the Year Ended December 31, 2005

Revenue from sales 900,000$Less: Cost of goods sold 540,000

Gross profit 360,000$

Less: Expenses 270,000

Net income 90,000$

Cost ofgoods soldrepresents

the expenseof goodsthat are

sold tocustomers.

Gross profit is a useful means of measuring

the profitability of sales transactions.

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6-8

Accounting Systems Requirements forMerchandising Companies

General Ledger

Accounts Receivable

Date Debit Credit Balance2001

June 1 10,000 10,000

15 3,000 7,000

Although general ledger accounts provideuseful information, they do not provide

much of the detailed information needed inthe daily business operations.

Who

owes usmoney?

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Accounting Systems Requirements forMerchandising Companies

Subsidiary Ledger

Heather Jacobs

Date Debit Credit Balance

2001

June 1 7,000 7,00015 2,000 5,000

General LedgerAccounts Receivable

Date Debit Credit Balance

2001

June 1 10,000 10,000

15 3,000 7,000Subsidiary LedgerJake Sparks

Date Debit Credit Balance

2001

June 1 3,000 3,000

15 1,000 2,000

Control AccountSubsidiary Ledgers

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Two Approaches Used in Accounting forMerchandise Transactions

Perpetual

InventorySystem

Periodic

InventorySystem

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Two Approaches Used in Accounting forMerchandise Transactions

In the past, both systems were in widespread use.

Today, however, the growing use of computerized accounting systems has

made the perpetual approach very easy and cost-effective to implement.

Thus, the periodic approach is used primarily by very small businesses with

manual accounting systems.

Before we examine perpetual and periodic inventory systems, it is important

to realize that accounting for inventory is similar to accounting for the

prepaid expenses we discussed in chapter 4 (for example, office supplies,

unexpired insurance policies, prepaid rent, etc.).

As inventory is purchased, it is initially reported as an asset in the balance

sheet.

As it is sold to customers, this asset is converted to an expense, specifically,

the cost of goods sold.

Both perpetual and periodic inventory systems account for the flow of

inventory costs from the balance sheet to the income statement.

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Perpetual Inventory Systems

The inventory account is continuouslyupdated to reflect items on hand.

Lets look

at someentries!

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Perpetual Inventory Systems

On September 5, Worley Co. purchased 100laser lights for resale for $30 per unit from

Electronic City on account.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Sept. 5 Inventory 3,000

Accounts Payable (Electronic City) 3,000

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Perpetual Inventory Systems

On September 10, Worley Co. sold 10 laserlights for $50 per unit on account to ABC

Radios.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Sept. 10 Accounts Receivable (ABC Radios) 500Sales 500

10 Cost of Goods Sold 300

Inventory 300

10 $30 = $300

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Perpetual Inventory Systems

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Sept. 10 Accounts Receivable (ABC Radios) 500Sales 500

10 Cost of Goods Sold 300

Inventory 300Cost

Retail

On September 10, Worley Co. sold 10 laserlights for $50 per unit on account to ABC

Radios.

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Perpetual Inventory Systems

On September 15, Worley Co. paid ElectronicCity $3,000 for the September 5 purchase.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Sept. 15 Accounts Payable (Electronic City) 3,000

Cash 3,000

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Perpetual Inventory Systems

On September 22, Worley Co. received $500from ABC Radios as payment in full for their

purchase on September 10.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Sept. 22 Cash 500

Accounts Receivable (ABC Radios) 500

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Taking a Physical Inventory

In order to ensurethe accuracy oftheir perpetual

records, mostbusinesses take acomplete physical

count of themerchandise on

hand at least once

a year.

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Taking a Physical Inventory

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Dec. 31 Cost of Goods Sold 2,000

Inventory 2,000

Reasonable amounts of inventory shrinkage are viewed asa normal cost of doing business. Examples include

breakage, spoilage and theft.

On December 31, Worley Co. counts its inventory.An inventory shortage of $2,000 is discovered.

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Closing Entries in a Perpetual InventorySystem

Close Revenue accounts(including Sales) toIncome Summary.

Close Expense accounts(including Cost ofGoods Sold) to IncomeSummary.

Close Income Summaryaccount to RetainedEarnings.

Close Dividends to

Retained Earnings.

The closingentries are the

same!

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Next is theperiodic

inventorysystem!

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Periodic Inventory Systems

No effort is made to keep up-to-date records ofeither inventory or cost of goods sold.

Only on a periodic basis are these two

accounts updated.

Lets look

at someentries!

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Periodic Inventory Systems

On September 5, Worley Co. purchased 100laser lights for resale for $30 per unit from

Electronic City on account.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Sept. 5 Purchases 3,000

Accounts Payable (Electronic City) 3,000

Notice that no entry ismade to Inventory.

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Periodic Inventory Systems On September 10, Worley Co. sold 10 laser lights for $50 per unit on account

to ABC Radios. Under the periodic inventory system, a sale of inventory requiresonly one entry: a debit to Accounts Receivable and a credit to Sales for the retail

amount of the sale, which in this case is five hundred dollars.

The cost entry that we made under the perpetual inventory system is not required

because the periodic system does not attempt to keep the inventory and cost of goodsold accounts up to date.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Sept. 10 Accounts Receivable (ABC Radios) 500

Sales 500

Retail

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Periodic Inventory Systems

On September 15, Worley Co. paid Electronic City$3,000 for the September 5 purchase. This entry is

the same as under the perpetual inventory system.

Worley Company would debit Accounts Payable and

credit Cash for three thousand dollars.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Sept. 15 Accounts Payable (Electronic City) 3,000

Cash 3,000

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Periodic Inventory Systems

On September 22, Worley Co. received $500 from ABCRadios as payment in full for their purchase onSeptember 10. This entry is also the same as under theperpetual inventory system. Worley Company would debit

Cash and credit Accounts Receivable for five hundred dollars.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Sept. 22 Cash 500

Accounts Receivable (ABC Radios) 500

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6-27Computing Cost of Goods Sold.Because the periodic system does not maintain a cost of good sold

account, at the end of the period, cost of goods sold must be calculated.

The accounting records of PartySupply show the following:

Inventory, Jan. 1, 2005 $ 14,000

Purchases (during 2005) 130,000

At December 31, 2005, Party

Supply counted the merchandiseon hand at $12,000.

Calculate Party Supplys cost of goods sold

for 2005.

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Computing Cost of Goods Sold

Inventory (beginning of the year) 14,000$

Add: Purchases 130,000

Cost of goods available for sale 144,000Less: Inventory (end of year) 12,000

Cost of goods sold 132,000$

Cost of Goods Sold can becalculated as follows:

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Creating a Cost of Goods Sold Account

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Dec. 31 Cost of Goods Sold 144,000

Inventory (beginning of year) 14,000

Purchases 130,000

Now, Party Supply must create the Cost of Goods Soldaccount. This is accomplished by zeroing out the balances in therelated accounts that have a debit balance, namely the beginning

inventory balance and the Purchases account.

So, we credit the Purchases account for its balance and we credit

the Inventory account for its beginning balance. This part of the

entry creates a zero balance in each of these accounts. The related

debit is for the total to the Cost of Goods Sold account.

Now, we still have one more entry to make to finish this process.

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Creating a Cost of Goods Sold Account

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Dec. 31 Inventory (end of year) 12,000

Cost of Goods Sold 12,000

Now, Party Supply must record the endinginventory amount.The second entry records the physical count in the Inventory

account and adjusts the balance in the Cost of Goods Sold

account.

After this entry, the Inventory account balance reflects the

ending inventory amount and the Cost of Goods Soldbalance reflects the calculated cost of goods sold amount.

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Completing the Closing Process

Close Revenue accounts(including Sales) toIncome Summary.

Close Expense accounts(including Cost ofGoods Sold) to IncomeSummary.

Close Income Summaryaccount to RetainedEarnings.

Close Dividends to

Retained Earnings.

The closingentries are the

same!

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Selecting an Inventory System

Factors Suggesting aPerpetual Inventory System

Factors Suggesting aPeriodic Inventory System

Large company with

professional management.

Small company, run by

owner.

Management and employees

wanting information about

items in inventory and the

quantities of specificproducts that are selling.

Accounting records of

inventories and specific

product sales not needed in

daily operations; suchinformation developed

primarily for use in annual

income tax returns.

Items in inventory with a high

per-unit cost.

Inventory with many different

kinds of low-cost items.

Low volume of sales

transactions or a

computerized accounting

system.

High volume of sales

transactions and a manual

accounting system.

Merchandise stored at

multiple locations or in

warehouses separate from

sales sites.

Lack of full-time accounting

personnel.

All merchandise stored at the

sales site.

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Credit Terms and Cash Discounts

2/10, n/30

Read as: Two ten, net thirty

When manufacturers and wholesalers sell their products onaccount, the credit terms are stated in the invoice.Cash discounts are provided to customers as a incentive for them to

pay early. The credit period is the normal period of time the company

allows for customers to extend their account receivable, typically 30 or

60 days.

The discount period is a much shorter period of time, typically 10 or 15

days. If payment is received during the discount period, a discount may

be taken. If payment is made after the discount period expires, then the

full payment is due on or before the end of the credit period.

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Credit Terms and Cash Discounts

2/10, n/30Percentageof Discount

# of DaysDiscount IsAvailable

Otherwise,the Full

Amount IsDue

# of Dayswhen FullAmount Is

Due

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Many companies plan to take advantage of cashdiscounts offered so they go ahead and record their

purchases net of the discount. Since they typically

take the discount, this process simplifies future

entries. If a cash discount is not taken in the future,

then a purchase discounts lost account is used.

Lets see how these entries work.

Recording Purchases at Net Cost

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Recording Purchases at Net Cost

Purchases arerecorded at their

net amounts.

PurchaseDiscounts Lost

are recordedwhen paymentis made outside

the discount

period.

NetMethod

6 37

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Recording Purchases at Net Cost

On July 6, Play Clothes purchased $4,000 ofmerchandise on credit with terms of

2/10, n/30 from Kids Clothes.

Prepare the journal entry for Play Clothes.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

6 38

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Recording Purchases at Net Cost

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

July 6 Inventory 3,920

Accounts Payable (Kid's Clothes) 3,920

$4,000 98% = $3,920

On July 6, Play Clothes purchased $4,000 ofmerchandise on credit with terms of

2/10, n/30 from Kids Clothes.

Prepare the journal entry for Play Clothes.

6 39

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Recording Purchases at Net Cost

On July 15, Play Clothes pays the full amountdue to Kids Clothes.

Prepare the journal entry for Play Clothes.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

6 40

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Recording Purchases at Net Cost

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

July 15 Accounts Payable (Kid's Clothes) 3,920

Cash 3,920

On July 15, Play Clothes pays the full amountdue to Kids Clothes.

Prepare the journal entry for Play Clothes.

6 41

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Recording Purchases at Net Cost

Now, assume that Play Clothes waited until July20 to pay the amount due in full to Kids

Clothes.

Prepare the journal entry for Play Clothes.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

6 42

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Recording Purchases at Net Cost

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

July 20 Accounts Payable (Kid's Clothes) 3,920

Purchase Discounts Lost 80

Cash 4,000

Nonoperating Expense

Now, assume that Play Clothes waited until July20 to pay the amount due in full to Kids

Clothes.

Prepare the journal entry for Play Clothes.

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R di P h t G I i

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Recording Purchases at Gross InvoicePrice

Purchases arerecorded at theirgross amounts.

Purchasediscounts taken

are recordedwhen paymentis made insidethe discount

period.

GrossMethod

6-44

R di P h t G I i

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Recording Purchases at Gross InvoicePrice

On July 6, Play Clothes purchased $4,000 ofmerchandise on credit with terms of

2/10, n/30 from Kids Clothes.

Prepare the journal entry for Play Clothes.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

6-45

R di P h t G I i

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Recording Purchases at Gross InvoicePrice

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

July 6 Inventory 4,000

Accounts Payable (Kid's Clothes) 4,000

On July 6, Play Clothes purchased $4,000 ofmerchandise on credit with terms of

2/10, n/30 from Kids Clothes.

Prepare the journal entry for Play Clothes.

6-46

R di P h t G I i

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Recording Purchases at Gross InvoicePrice

On July 15, Play Clothes pays the full amountdue to Kids Clothes.

Prepare the journal entry for Play Clothes.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

6-47

R di P h t G I i

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Recording Purchases at Gross InvoicePrice

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

July 15 Accounts Payable (Kid's Clothes) 4,000

Cash 3,920

Purchase Discounts Taken 80

Reduces Cost ofGoods Sold

$4,000 98% = $3,920

On July 15, Play Clothes pays the full amountdue to Kids Clothes.

Prepare the journal entry for Play Clothes.

6-48

R di P h t G I i

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Recording Purchases at Gross InvoicePrice

Now, assume that Play Clothes waited until July20 to pay the full amount due to Kids Clothes.

Prepare the journal entry for Play Clothes.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

6-49

Recording Purchases at Gross Invoice

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Recording Purchases at Gross InvoicePrice

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

July 20 Accounts Payable (Kid's Clothes) 4,000

Cash 4,000

Now, assume that Play Clothes waited until July20 to pay the full amount due to Kids Clothes.

Prepare the journal entry for Play Clothes.

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Returns of Unsatisfactory Merchandise

On August 5, Play Clothes returned $500 ofunsatisfactory merchandise purchased from Kids

Clothes on credit terms of 2/10, n/30. Thepurchase was originally recorded at net cost.

Prepare the journal entry for Play Clothes.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

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Returns of Unsatisfactory Merchandise

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Aug. 5 Accounts Payable (Kid's Clothes) 490

Inventory 490

$500 98% = $490

On August 5, Play Clothes returned $500 ofunsatisfactory merchandise purchased from Kids

Clothes on credit terms of 2/10, n/30. Thepurchase was originally recorded at net cost.

Prepare the journal entry for Play Clothes.

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Transportation Costs on Purchases

Transportation costs related to theacquisition of assets are part of the

cost of the assetbeing acquired.

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Now, lets talk

about sales!

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Transactions Relating to Sales

Computer Barn

Partial Income Statement

For the Year Ended December 31, 2005

Revenue

Sales 912,000$

Less: Sales returns and allowances 8,000$

Sales discounts 4,000 12,000

Net sales 900,000$

Credit terms and merchandise returnsaffect the amount of revenue earned by

the seller.

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Sales

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Aug. 2 Accounts Receivable (Play Clothes) 2,000

Sales 2,000

On August 2, Kids Clothes sold $2,000 of merchandise toPlay Clothes on credit terms 2/10, n/30. Kids Clothes

originally paid $1,000 for the merchandise.

Because Kids Clothes uses a perpetual inventory system,

they must make two entries.

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Sales

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Aug. 2 Cost of Goods Sold 1,000

Inventory 1,000

On August 2, Kids Clothes sold $2,000 of merchandise toPlay Clothes on credit terms 2/10, n/30. Kids Clothes

originally paid $1,000 for the merchandise.

Because Kids Clothes uses a perpetual inventory system,

they must make two entries.

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Sales Returns and Allowances

On August 5, Play Clothes returned $500 of unsatisfactorymerchandise to Kids Clothes from the August 2 sale.

Kids Clothes cost for this merchandise was $250.

Because Kids Clothes uses a perpetual inventory system,

they must make two entries.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Aug. 5 Sales Returns and Allowances 500

Accounts Receivable (Play Clothes) 500

Contra-revenue

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On August 5, Play Clothes returned $500 of unsatisfactorymerchandise to Kids Clothes from the August 2 sale.

Kids Clothes cost for this merchandise was $250.

Because Kids Clothes uses a perpetual inventory system,

they must make two entries.

Sales Returns and Allowances

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Aug. 5 Inventory 250

Cost of Goods Sold 250

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Sales

On July 6, Kids Clothes sold $4,000 of merchandise to PlayClothes on credit with terms of 2/10, n/30. The

merchandise originally cost Kids Clothes $2,000.

Because Kids Clothes uses a perpetual inventory system,

they must make two entries.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

July 6 Accounts Receivable (Play Clothes) 4,000

Sales 4,000

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Sales

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

July 6 Cost of Goods Sold 2,000

Inventory 2,000

On July 6, Kids Clothes sold $4,000 of merchandise to PlayClothes on credit with terms of 2/10, n/30. The

merchandise originally cost Kids Clothes $2,000.

Because Kids Clothes uses a perpetual inventory system,

they must make two entries.

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Sales Discounts

On July 15, Kids Clothes receives the fullamount due from Play Clothes from the July 6

sale.

Prepare the journal entry for Kids Clothes.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

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Sales Discounts

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

July 15 Cash 3,920

Sales Discounts 80

Accounts Receivable (Play Clothes) 4,000

$4,000 98% = $3,920Contra-revenue

On July 15, Kids Clothes receives the fullamount due from Play Clothes from the July 6

sale.

Prepare the journal entry for Kids Clothes.

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Sales Discounts

Now, assume that it wasnt until July 20 thatKids Clothes received the full amount due

from Play Clothes from the July 6 sale.

Prepare the journal entry for Kids Clothes.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

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Sales Discounts

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

July 20 Cash 4,000

Accounts Receivable (Play Clothes) 4,000

Now, assume that it wasnt until July 20 thatKids Clothes received the full amount due

from Play Clothes from the July 6 sale.

Prepare the journal entry for Kids Clothes.

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Delivery Expenses

Delivery costs incurred by sellers are debited to Delivery

Expense, an operating expense.When sellers incur transportation costs, or delivery expense, it is debited

to an operating expense account called Delivery Expense. This is

considered a cost of doing business and is treated as a regular operating

expense of the business.

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Accounting for Sales Taxes

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Cash 1,070

Sales Tax Payable 70

Sales 1,000

Businesses collect sales tax at the point of sale.

Then, they remit the tax to the appropriategovernmental agency at times specified by law.

$1,000 sale 7% tax = $70 sales tax

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Modifying an Accounting System

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Most businesses use special journals rather than a general

journal to record routine transactions that occur frequently.When companies use special journals, similar entries are recorded

together. Companies may have several special journals such as a Cash

Receipts Journal, Cash Payments Journal, Sales Journal, and several

others. When using special journals, the General Journal is used only

for a few entries that do not fit in a special journal.

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Financial Analysis

Net SalesGrossProfit

Margins

Trends over time

Comparable store sales Sales per square foot ofselling space

Gross profit Net sales

Overall gross profitmargin

Gross profit margins bydepartment and

products

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End of Chapter 6