Prepared by

Coby Harmon
University of California, Santa Barbara
5-1 Westmont College
 5 Accounting for
Merchandising Operations
Learning Objectives
Describe merchandising operations and inventory
1 systems.

2 Record purchases under a perpetual inventory system.

3 Record sales under a perpetual inventory system.

Apply the steps in the accounting cycle to a

4 merchandising company.

Compare a multiple-step with a single-step income

5 statement.
5-2
LEARNING Describe merchandising operations and
OBJECTIVE 1
inventory systems.

Merchandising Companies
Buy and Sell Goods
Retailer

Wholesaler Consumer

The primary source of revenues is referred to as

sales revenue or sales.
5-3 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

Cost of Equals 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.

5-4 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

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

Companies use either a perpetual inventory system or a periodic

inventory system to account for inventory.
5-6 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.

5-7 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

5-8 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.

5-9 LO 1
5-10 LO 1
 Merchandising Operations and Inventory
DO IT! 1 Systems

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

shorter than that of a merchandising company. True

3. Sales revenue less cost of goods sold equals gross

True
profit.

4. Ending inventory plus the cost of goods purchased

equals cost of goods available for sale.
False

5-11 LO 1
LEARNING Record purchases under a perpetual
OBJECTIVE 2
inventory system.

◆ Made using cash or

credit (on 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 150

Cash 150
5-15 LO 2
 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

Cash 3,430
Inventory 70

(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! 2 Purchase Transactions

On September 5, De La Hoya Company buys merchandise on

account from Junot Diaz Company. The selling price of the
goods is $1,500, and the cost to Diaz Company was $800. On
September 8, De La Hoya returns defective goods with a
selling price of $200. Record the transactions on the books of
De La Hoya Company.

Sept. 5 Inventory 1,500

Accounts Payable 1,500
Sept. 8 Accounts Payable 200
Inventory 200

5-25 LO 2
LEARNING Record sales under a perpetual
OBJECTIVE 3
inventory system.

◆ Made using cash or credit (on account).

Illustration 5-6

◆ 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.
5-26
 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
5-29 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.

5-30 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

5-31 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

5-32 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.

5-33 LO 3
5-34 LO 3
 Sales Discount

◆ Offered to customers to promote prompt payment of

the balance due.

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

5-35 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%]

5-36 LO 3
 DO IT! 3 Sales Transactions

On September 5, De La Hoya Company buys merchandise on

account from Junot Diaz Company. The selling price of the
goods is $1,500, and the cost to Diaz Company was $800. On
September 8, De La Hoya returns defective goods with a
selling price of $200 and a fair value of $30. Record the
transactions on the books of Junot Diaz Company.

Sept. 5 Accounts Receivable 1,500

Sales Revenue 1,500
Sept. 5 Cost of Goods Sold 800
Inventory 800

5-37 LO 3
 DO IT! 3 Sales Transactions

On September 5, De La Hoya Company buys merchandise on

account from Junot Diaz Company. The selling price of the
goods is $1,500, and the cost to Diaz Company was $800. On
September 8, De La Hoya returns defective goods with a
selling price of $200 and a fair value of $30. Record the
transactions on the books of Junot Diaz Company.

Sept. 8 Sales Returns and Allowances 200

Accounts Receivable 200
Sept. 8 Inventory 30
Cost of Goods Sold 30

5-38 LO 3
LEARNING Apply the steps in the accounting cycle
OBJECTIVE 4
to a merchandising company.

Adjusting Entries
◆ 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.

5-39 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

5-40 LO 4
 Closing Entries

5-41 LO 4
 Closing Entries

5-42 LO 4
 DO IT! 4 Closing Entries

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

5-43 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
Salaries and Wages Expense 22,000
5-44 LO 4
LEARNING Compare a multiple-step with a single-
OBJECTIVE 5
step income statement.

Multiple-Step Income Statement

◆ Shows several steps in determining net income.

◆ Two steps relate to principal operating activities.

◆ Distinguishes between operating and non-operating

activities.

5-45 LO 5
 Multiple-
Step

Key Items:
◆ Net sales

Illustration 5-14
5-46
LO 5
 Multiple-
Step

Key Items:
◆ Net sales

◆ Gross profit

Illustration 5-14
5-47
LO 5
 Multiple-
Step

Key Items:
◆ Net sales

◆ Gross profit

◆ Operating
expenses

Illustration 5-14
5-48
LO 5
 Multiple-
Step

Key Items:
◆ Net sales

◆ Gross profit

◆ Operating
expenses

◆ Nonoperating
activities

Illustration 5-14
5-49
LO 5
 Multiple-
Step

Key Items:
◆ Net sales

◆ Gross profit

◆ Operating
expenses

◆ Nonoperating
activities

Illustration 5-13
Illustration 5-14

5-50
 Multiple-
Step

Key Items:
◆ Net sales

◆ Gross profit

◆ Operating
expenses

◆ Nonoperating
activities

◆ Net income

Illustration 5-14
5-51
LO 5
 Multiple-Step Income Statement

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

5-52 LO 5
5-53 LO 5
 Single-Step Income Statement

◆ Subtract total expenses from total revenues

◆ Two reasons for using the single-step format:

1. Company does not realize any profit until total

revenues exceed total expenses.

2. Format is simpler and easier to read.

5-54 LO 5
 Single-Step Income Statement
Illustration 5-15

5-55 LO 5
 Comprehensive Income Statement
Illustration 5-16

5-56 LO 5
 Classified Balance Sheet
Illustration 5-17

5-57 LO 5
 DO IT! 5 Multiple-Step Income Statement

The following information is available for Art Center Corp. for the
year ended December 31, 2019.

Other revenues and gains $ 8,000

Sales revenue 462,000
Other expenses and losses 3,000
Operating expenses 187,000
Cost of goods sold 147,000
Sales discounts 20,000

Other comprehensive income 10,000 Prepare a multiple-step

income statement and comprehensive income statement for Art
Center Corp.

5-58 LO 5
5-59
 Evaluating Profitability

Gross Profit Rate

May be expressed as a percentage by dividing the amount
of gross profit by net sales.

A decline in the gross profit rate might have several causes.

► Selling products with a lower “markup.”

► Increased competition may result in a lower selling price.

► Company forced to pay higher prices to its suppliers without

being able to pass these costs on to its customers.

5-60 LO 6 Explain the factors affecting profitability.

 Evaluating Profitability

Gross Profit Rate

Illustration 5-15

Why does REI’s gross profit rate differ so much from that of
Dick’s Sporting Goods and the industry average?

5-61 LO 6 Explain the factors affecting profitability.

 Evaluating Profitability

Profit Margin Ratio

Measures the percentage of each dollar of sales that results
in net income.

How do the gross profit rate and profit margin ratio differ?

► Gross profit rate - measures the margin by which selling

price exceeds cost of goods sold.

► Profit margin ratio - measures the extent by which selling

price covers all expenses (including cost of goods sold).

5-62 LO 6 Explain the factors affecting profitability.

 Evaluating Profitability

Profit Margin Ratio

Illustration 5-17

How does REI compare to its competitors? Its profit margin was lower
than Dick’s in 2010 and was less than the industry average. Thus, its
profit margin does not suggest exceptional profitability.

5-63 LO 6 Explain the factors affecting profitability.

 Evaluating Profitability

Earnings have high quality if they provide a

full and transparent depiction of how a
company performed.

► A measure significantly less than 1 suggests that a company

may be using more aggressive accounting techniques in order to
accelerate income recognition.
► A measure significantly greater than 1 suggests that a
company is using conservative accounting techniques which
cause it to delay the recognition of income.

5-64 LO 7 Identify a quality of earnings indicator.

LEARNING APPENDIX 5A: Prepare a worksheet for
OBJECTIVE 6
a merchandising company.

Using a Worksheet
As indicated in Chapter 4, 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, Inc. (excluding nonoperating items). The unique
accounts for a merchandiser using a perpetual inventory
system are in red.

5-65 LO 6
 Illustration 5A-1

5-66 LO 6
LEARNING APPENDIX 5B: Record purchases and
OBJECTIVE 7
sales under a periodic inventory system.

Determining Cost of Goods Sold Under a

Periodic 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.

5-67 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

5-68 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.

5-69 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

5-70 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

5-71 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

5-72 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

5-73 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.

5-74 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

5-75 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

5-76 LO 7
 Recording Purchases of Merchandise

COMPARISON OF ENTRIES
Illustration 5B-3

5-77 LO 7
 Recording Sales of Merchandise

COMPARISON OF ENTRIES
Illustration 5B-3

5-78 LO 7
Illustration 5B-5
Worksheet for
merchandising
company—periodic
inventory system

5-79 LO 7
LEARNING Compare the accounting for merchandising
OBJECTIVE 8 under GAAP and IFRS.

Key Points
Similarities
◆ Under both GAAP and IFRS, a company can choose to use either a
perpetual or a periodic inventory system.
◆ The definition of inventories is basically the same under GAAP and
IFRS.
◆ As indicated above, the basic accounting entries for merchandising
are the same under both GAAP and IFRS.

5-80 LO 8
 Key Points
Similarities
◆ For example, IFRS requires that 2 years of income statement
information be presented, whereas GAAP requires 3 years.
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 either by 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.
5-81 LO 8
 Key Points
Differences
◆ 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.
◆ 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 result in more transactions affecting equity
(other comprehensive income) but not net income.

5-82 LO 8
 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 statement analysts.
5-83 LO 8
 IFRS Self-Test Questions
Which of the following would not be included in the definition of
inventory under IFRS?

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.

5-84 LO 8
 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) Salaries expense.

c) Interest expense.

d) Manufacturing expense.

5-85 LO 8
 IFRS Self-Test Questions
Which of the following would not be a line item of a company
reporting costs by function?

a) Administration.

b) Manufacturing.

c) Utilities expense.

d) Distribution.

5-86 LO 8
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5-87