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Chapter 5: Accounting for the Sale of Goods

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    180515
  • Chapter 5: Accounting for the Sale of Goods

     

    To this point, examples of business operations have involved the sale of services. This chapter introduces business operations based on the purchase and resale of goods. For example, Canadian Tire and Walmart each purchase and resell goods — such businesses are known as merchandisers. The accounting transactions for merchandising companies differ from those of service-based businesses. Chapter 5 covers accounting for transactions of sales of goods on credit and related cash collections by merchandising firms, and transactions involving purchases and payments for goods sold in the normal course of business activities.

    Chapter 5 Learning Objectives

    • LO1 – Describe merchandising and explain the financial statement components of sales, cost of goods sold, merchandise inventory, and gross profit; differentiate between the perpetual and periodic inventory systems.

    • LO2 – Analyze and record purchase transactions for a merchandiser.

    • LO3 – Analyze and record sales transactions for a merchandiser.

    • LO4 – Record adjustments to merchandise inventory.

    • LO5 – Explain and prepare a classified multiple-step income statement for a merchandiser.

    • LO6 – Explain the closing process for a merchandiser.

    • LO7 – Explain and identify the entries regarding purchase and sales transactions in a periodic inventory system.

    Concept Self-Check

    Use the following questions as a self-check while working through Chapter 5.

    1. What is gross profit and how is it calculated?

    2. How is a merchandiser different from a service company?

    3. What is a perpetual inventory system?

    4. How is the purchase of merchandise inventory on credit recorded in a perpetual system?

    5. How is a purchase return recorded in a perpetual system?

    6. What does the credit term of "1/15, n30" mean?

    7. How is a purchase discount recorded in a perpetual system?

    8. How is the sale of merchandise inventory on credit recorded in a perpetual system?

    9. How is a sales return that is restored to inventory recorded versus a sales return that is not restored to inventory (assuming a perpetual inventory system)?

    10. What is a sales discount and how is it recorded in a perpetual inventory system?

    11. Why does merchandise inventory need to be adjusted at the end of the accounting period and how is this done in a perpetual inventory system?

    12. What types of transactions affect merchandise inventory in a perpetual inventory system?

    13. How are the closing entries for a merchandiser using a perpetual inventory system different than for a service company?

    14. When reporting expenses on an income statement, how is the function of an expense reported versus the nature of an expense?

    15. On a classified multiple-step income statement, what is reported under the heading 'Other revenues and expenses' and why?

    16. What is the periodic inventory system?

    17. How is cost of goods sold calculated under the periodic inventory system?

    NOTE: The purpose of these questions is to prepare you for the concepts introduced in the chapter. Your goal should be to answer each of these questions as you read through the chapter. If, when you complete the chapter, you are unable to answer one or more the Concept Self-Check questions, go back through the content to find the answer(s). Solutions are not provided to these questions.

    5.1 The Basics of Merchandising

    LO1 – Describe merchandising and explain the financial statement components of sales, cost of goods sold, merchandise inventory, and gross profit; differentiate between the perpetual and periodic inventory systems.

    A merchandising company, or merchandiser, differs in several basic ways from a company that provides services. First, a merchandiser purchases and then sells goods whereas a service company sells services. For example, a car dealership is a merchandiser that sells cars while an airline is a service company that sells air travel. Because merchandising involves the purchase and then the resale of goods, an expense called cost of goods sold results. Cost of goods sold is the cost of the actual goods sold. For example, the cost of goods sold for a car dealership would be the cost of the cars purchased from manufacturers and then resold to customers. A service company does not have an expense called cost of goods sold since it does not sell goods. Because a merchandiser has cost of goods sold expense and a service business does not, the income statement for a merchandiser includes different details. A merchandising income statement highlights cost of goods sold by showing the difference between sales revenue and cost of goods sold called gross profit or gross margin. The basic income statement differences between a service business and a merchandiser are illustrated in Figure 5.1.

    Service Company
     
    Merchandising Company
    Revenues Sales
    Less: Cost of Goods Sold
    Equals: Gross Profit
    Less: Expenses Less: Expenses
    Equals: Net Income Equals: Net Income

    Figure 5.1 Differences Between the Income Statements of Service and Merchandising Companies

    Assume that Excel Cars Corporation decides to go into the business of buying used vehicles from a supplier and reselling these to customers. If Excel purchases a vehicle for $3,000 and then sells it for $4,000, the gross profit would be $1,000, as follows:

    Sales $ 4,000
    Cost of Goods Sold 3,000
     
    Gross Profit
    $ 1,000

    The word "gross" is used by accountants to indicate that other expenses incurred in running the business must still be deducted from this amount before net income is calculated. In other words, gross profit represents the amount of sales revenue that remains to pay expenses after the cost of the goods sold is deducted.

    A gross profit percentage can be calculated to express the relationship of gross profit to sales. The sale of the vehicle that cost $3,000 results in a 25% gross profit percentage ($1,000/4,000). That is, for every $1 of sales, the company has $.25 left to cover other expenses after deducting cost of goods sold. Readers of financial statements use this percentage as a means to evaluate the performance of one company against other companies in the same industry, or in the same company from year to year. Small fluctuations in the gross profit percentage can have significant effects on the financial performance of a company because the amount of sales and cost of goods sold are often very large in comparison to other income statement items.

    Another difference between a service company and a merchandiser relates to the balance sheet. A merchandiser purchases goods for resale. Goods held for resale by a merchandiser are called merchandise inventory and are reported as an asset on the balance sheet. A service company would not normally have merchandise inventory.

    Inventory Systems

    There are two types of ways in which inventory is managed: perpetual inventory system or periodic inventory system. In a perpetual inventory system, the merchandise inventory account and cost of goods sold account are updated immediately when transactions occur. In a perpetual system, as merchandise inventory is purchased, it is debited to the merchandise inventory account. As inventory is sold to customers, the cost of the inventory sold is removed from the merchandise inventory account and debited to the cost of goods sold account. A perpetual system means that account balances are known on a real-time basis. This chapter focuses on the perpetual system.

    Some businesses still use a periodic inventory system in which the purchase of merchandise inventory is debited to a temporary account called Purchases. At the end of the accounting period, inventory is counted (known as a physical count) and the merchandise inventory account is updated and cost of goods sold is calculated. In a periodic inventory system, the real-time balances in merchandise inventory and cost of goods sold are not known. It should be noted that even in a perpetual system a physical count must be performed at the end of the accounting period to record differences between the actual inventory on hand and the account balance. The entry to record this difference is discussed later in this chapter. The periodic system is discussed in greater detail in the appendix to this chapter.

    icon-exploration2.png An exploration is available on the Lyryx system. Log into your Lyryx course to run Using the Information -- Gross Profit Ratio.

    5.2 The Purchase and Payment of Merchandise Inventory (Perpetual)

    LO2 – Analyze and record purchase transactions for a merchandiser.

    As introduced in Chapter 3, a company's operating cycle includes purchases on account or on credit and is highlighted in Figure 5.2.

    img215.png

    Figure 5.2 Purchase and Payment Portion of the Operating Cycle

    Recording the Purchase of Merchandise Inventory (Perpetual)

    When merchandise inventory is purchased, the cost is recorded in a Merchandise Inventory general ledger account. An account payable results when the merchandise inventory is acquired but will not be paid in cash until a later date. For example, recall the vehicle purchased on account by Excel for $3,000. The journal entry and general ledger T-account effects would be as follows.

    img216.png

    In addition to the purchase of merchandise inventory, there are other activities that affect the Merchandise Inventory account. For instance, merchandise may occasionally be returned to a supplier or damaged in transit, or discounts may be earned for prompt cash payment. These transactions result in the reduction of amounts due to the supplier and the costs of inventory. The purchase of merchandise inventory may also involve the payment of transportation and handling costs. These are all costs necessary to prepare inventory for sale, and all such costs are included in the Merchandise Inventory account. These costs are discussed in the following sections.

    Purchase Returns and Allowances (Perpetual)

    Assume that the vehicle purchased by Excel turned out to be the wrong colour. The supplier was contacted and agreed to reduce the price by $300 to $2,700. This is an example of a purchase returns and allowances adjustment. The amount of the allowance, or reduction, is recorded as a credit to the Merchandise Inventory account, as follows:

    img217.png

    Note that the cost of the vehicle has been reduced to $2,700 ($3,000 – 300) as has the amount owing to the supplier. Again, the perpetual inventory system records changes in the Merchandise Inventory account each time a relevant transaction occurs.

    Purchase Discounts (Perpetual)

    Purchase discounts affect the purchase price of merchandise if payment is made within a time period specified in the supplier's invoice. For example, if the terms on the $3,000 invoice for one vehicle received by Excel indicates "1/15, n45", this means that the $3,000 must be paid within 45 days ('n' = net). However, if cash payment is made by Excel within 15 days, the purchase price will be reduced by 1%.

    Assuming the amount is paid within 15 days, the supplier's terms entitle Excel to deduct $27 [($3,000 - $300) = $2,700 x 1% = $27]. The payment to the supplier would be recorded as:

    img218.png

    The cost of the vehicle in Excel's inventory records is now $2,673 ($3,000 – 300 – 27). If payment is made after the discount period, $2,700 of cash is paid and the entry would be:

    img219.png

    Trade discounts are similar to purchase discounts. A supplier advertises a list price which is the normal selling price of its goods to merchandisers. Trade discounts are given by suppliers to merchandisers that buy a large quantity of goods. For instance, assume a supplier offers a 10% trade discount on purchases of 1,000 units or more where the list price is $1/unit. If Beta Merchandiser Corp. buys 1,000 units on account, the entry in Beta's records would be:

    img220.png

    Note that the net amount (list price less trade discount) is recorded.

    Transportation

    Costs to transport goods from the supplier to the seller must also be considered when recording the cost of merchandise inventory. The shipping terms on the invoice identify the point at which ownership of the inventory transfers from the supplier to the purchaser. When the terms are FOB shipping point, ownership transfers at the 'shipping point' so the purchaser is responsible for transportation costs. FOB destination indicates that ownership transfers at the 'destination point' so the seller is responsible for transportation costs. FOB is the abbreviation for "free on board."

    Assume that Excel's supplier sells with terms of FOB shipping point indicating that transportation costs are Excel's responsibility. If the cost of shipping is $125 and this amount was paid in cash to the truck driver at time of delivery, the entry would be:

    img221.png

    The cost of the vehicle in the Excel Merchandise Inventory account is now $2,798 (calculated as $3,000 original cost - $300 allowance - $27 discount + $125 shipping). It is important to note that Excel's transportation costs to deliver goods to customers are recorded as delivery expenses and do not affect the Merchandise Inventory account.

    The next section describes how the sale of merchandise is recorded as well as the related costs of items sold.

    icon-exploration2.png An exploration is available on the Lyryx system. Log into your Lyryx course to run Purchases.

    5.3 Merchandise Inventory: Sales and Collection (Perpetual)

    LO3 – Analyze and record sales transactions for a merchandiser.

    In addition to purchases on account, a merchandising company's operating cycle includes the sale of merchandise inventory on account or on credit as highlighted in Figure 5.3.

    img222.png

    Figure 5.3 Sales and Collection Portion of the Operating Cycle

    There are some slight recording differences when revenue is earned in a merchandising company. These are discussed below.

    Recording the Sale of Merchandise Inventory (Perpetual)

    The sale of merchandise inventory is recorded with two entries:

    1. recording the sale by debiting Cash or Accounts Receivable and crediting Sales, and

    2. recording the cost of the sale by debiting Cost of Goods Sold and crediting Merchandise Inventory.

    Assume the vehicle purchased by Excel is sold for $4,000 on account. Recall that the cost of this vehicle in the Excel Merchandise Inventory account is $2,798, as shown below.

    The entries to record the sale of the merchandise inventory are:

    img223.png
    img224.png

    The first entry records the sales revenue. The second entry is required to reduce the Merchandise Inventory account and transfer the cost of the inventory sold to the Cost of Goods Sold account. The second entry ensures that both the Merchandise Inventory account and Cost of Goods Sold account are up to date.

    Sales Returns and Allowances

    When merchandise inventory that has been sold is returned to the merchandiser by the customer, a sales return and allowance is recorded. For example, assume some damage occurs to the merchandise inventory sold by Excel while it is being delivered to the customer. Excel gives the customer a sales allowance by agreeing to reduce the amount owing by $100. The entry is:

    img225.png

    Accounts receivable is credited because the original sale was made on account and has not yet been paid. The amount owing from the customer is reduced to $3,900. If the $3,900 had already been paid, a credit would be made to Cash and $100 refunded to the customer. The Sales Returns and Allowances account is a contra revenue account and is therefore deducted from Sales when preparing the income statement.

    If goods are returned by a customer, a sales return occurs. The related sales and cost of goods sold recorded on the income statement are reversed and the goods are returned to inventory. For example, assume Max Corporation sells a plastic container for $3 that it purchased for $1. The dual entry at the time of sale would be:

    img226.png
    img227.png

    If the customer returns the container and the merchandise is restored to inventory, the dual journal entry would be:

    img228.png
    img229.png

    The use of a contra account to record sales returns and allowances permits management to track the amount of returned and damaged items.

    Sales Discounts

    Another contra revenue account, Sales Discounts, records reductions in sales amounts when a customer pays within a certain time period. For example, assume Excel Cars Corporation offers sales terms of "2/10, n30." This means that the amount owed must be paid by the customer within 30 days ('n' = net); however, if the customer chooses to pay within 10 days, a 2% discount may be deducted from the amount owing.

    Consider the sale of the vehicle for $3,900 ($4,000 less the $100 allowance for damage). Payment within 10 days entitles the customer to a $78 discount ($3,900 x 2% = $78). If payment is made within the discount period, Excel receives $3,822 cash ($3,900 - 78) and prepares the following entry:

    img230.png

    This entry reduces the accounts receivable amount to zero which is the desired result. If payment is not made within the discount period, the customer pays the full amount owing of $3,900.

    As was the case for Sales Returns and Allowances, the balance in the Sales Discounts account is deducted from Sales on the income statement to arrive at Net Sales. Merchandisers often report only the net sales amount on the income statement. Details from sales returns and allowances, and sales discounts, are often omitted because they are immaterial in amount relative to total sales. However, as already stated, separate general ledger accounts for each of sales returns and allowances, and sales discounts, are useful in helping management identify potential problems that require investigation.

    icon-exploration2.png An exploration is available on the Lyryx system. Log into your Lyryx course to run Gross Profit.

    icon-exploration2.png An exploration is available on the Lyryx system. Log into your Lyryx course to run Sales.

    5.4 Adjustments to Merchandise Inventory (Perpetual)

    LO4 – Record adjustments to merchandise inventory.

    To verify that the actual amount of merchandise inventory on hand is consistent with the balance recorded in the accounting records, a physical inventory count must be performed at the end of the accounting period. When a physical count of inventory is conducted, the costs attached to these inventory items are totalled. This total is compared to the Merchandise Inventory account balance in the general ledger. Any discrepancy is called shrinkage. Theft and deterioration of merchandise inventory are the most common causes of shrinkage.

    The adjusting entry to record shrinkage is:

    img231.png

    Summary of Merchandising Transactions

    As the preceding sections have illustrated, there are a number of entries which are unique to a merchandiser. These are summarized below (assume all transactions were on account):

    (a) To record the purchase of merchandise inventory from a supplier:

    img232.png

    (b) To record purchase return and allowances:

    img233.png

    (c) To record purchase discounts:

    img233.png

    (d) To record shipping costs from supplier to merchandiser:

    img232.png

    (e) To record sale of merchandise inventory and cost of the sale:

    img234.png

    AND

    img235.png

    (f) To record sales returns restored to inventory:

    img236.png

    AND

    img237.png

    (g) To record sales returns and allowances (where returns are not restored to inventory):

    img236.png

    (h) To record discounts:

    img238.png

    (i) To record adjustment for shrinkage at the end of the accounting period:

    img235.png

    The effect of these transactions on each of merchandise inventory and cost of goods sold is depicted below:

    Merchandise Inventory (MI)
     
    Cost of Goods Sold (COGS)
    (a) Purchase of MI (b) Purchase Ret. & Allow. (e) Cost of MI Sold (f) Cost of sales
    returns restored to
    (d) Shipping Costs (c) Purchase Discounts (i) Shrinkage Adjustment inventory
    (f) Sales Return (when (e) Sale of MI
    restored to inventory)
    (i) Shrinkage Adjustment
    Adjusted Balance Reported Adjusted Balance Reported
    on the Balance Sheet on the Income Statement

    icon-exploration2.png An exploration is available on the Lyryx system. Log into your Lyryx course to run Merchandising Adjusting Entry.

    5.5 Merchandising Income Statement

    LO5 – Explain and prepare a classified multiple-step income statement for a merchandiser.

    Businesses are required to show expenses on the income statement based on either the nature or the function of the expense. The nature of an expense is determined by its basic characteristics (what it is). For example, when expenses are listed on the income statement as interest, depreciation, income tax, or wages, this identifies the nature of each expense. In contrast, the function of an expense describes the grouping of expenses based on their purpose (what they relate to). For example, an income statement that shows cost of goods sold, selling expenses, and general and administrative expenses has grouped expenses by their function. When expenses are grouped by function, additional information must be disclosed to show the nature of expenses within each group. The full disclosure principle is the generally accepted accounting principle that requires financial statements to report all relevant information about the operations and financial position of the entity. Information that is relevant but not included in the body of the statements is provided in the notes to the financial statements.

    A merchandising income statement can be prepared in different formats. For this course, only one format will be introduced — the classified multiple-step format. This format is generally used for internal reporting because of the detail it includes. An example of a classified multiple-step income statement is shown below using assumed data for XYZ Inc. for its month ended December 31, 2015.

    XYZ Inc.
    Income Statement
    Month Ended December 31, 2015
    Sales
     
    $100,000
     
    Less: Sales discounts
    $1,000
     
    Sales returns and allowances
    500 1,500
     
    Net sales
    $98,500
    Cost of goods sold 50,000
    Gross profit from sales $48,500
    Operating expenses:
     
    Selling expenses:
     
    Sales salaries expense
    $11,000
     
    Rent expense, selling space
    9,000
     
    Advertising expense
    5,000
     
    Depreciation expense, store equipment
    3,000
     
    Total selling expenses
    $28,000
     
    General and administrative expenses:
     
    Office salaries expense
    $9,000
     
    Rent expense, office space
    3,000
     
    Office supplies expense
    1,500
     
    Depreciation expense, office equipment
    1,000
     
    Insurance expense
    1,000
     
    Total general and administrative expenses
    15,500
     
    Total operating expenses
    43,500
    Income from operations $5,000
     
    Other revenues and expenses:
     
    Rent revenue
    $12,000
     
    Interest expense
    1,500 10,500
    Income before tax $15,500
    Income tax expense 3,000
    Net income $12,500

    Notice that the classified multiple-step income statement shows expenses by both function and nature. The broad categories that show expenses by function include operating expenses, selling expenses, and general and administrative expenses. Within each category, the nature of expenses is disclosed including sales salaries, advertising, depreciation, supplies, and insurance. Notice that Rent Expense has been divided between two groupings because it applies to more than one category or function.

    The normal operating activity for XYZ Inc. is merchandising. Revenues and expenses that are not part of normal operating activities are listed under Other Revenues and Expenses. XYZ Inc. shows Rent Revenue under Other Revenues and Expenses because this type of revenue is not part of its merchandising operations. Interest earned, dividends earned, and gains on the sale of property, plant, and equipment are other examples of revenues not related to merchandising operations. XYZ Inc. deducts Interest Expense under Other Revenues and Expenses. Interest expense does not result from operating activities; it is a financing activity because it is associated with the borrowing of money. Another example of a non-operating expense is losses on the sale of property, plant, and equipment. Income tax expense is a government requirement so it is shown separately. Notice that income tax expense follows the subtotal 'Income before tax'.

    5.6 Closing Entries for a Merchandiser

    LO6 – Explain the closing process for a merchandiser.

    The process of recording closing entries for service companies was illustrated in Chapter 3. The closing procedure for merchandising companies is the same as for service companies — all income statement accounts are transferred to the Income Summary account, the Income Summary is closed to Retained Earnings, and Dividends are closed to Retained Earnings.

    When preparing closing entries for a merchandiser, the income statement accounts unique for merchandisers need to be considered — Sales, Sales Discounts, Sales Returns and Allowances, and Cost of Goods Sold. Sales is a revenue account so has a normal credit balance. To close Sales, it must be debited with a corresponding credit to the income summary. Sales Discounts and Sales Returns and Allowances are both contra revenue accounts so each has a normal debit balance. Cost of Goods Sold has a normal debit balance because it is an expense. To close these debit balance accounts, a credit is required with a corresponding debit to the income summary.

    icon-exploration2.png An exploration is available on the Lyryx system. Log into your Lyryx course to run Closing Entries.

    5.7 Appendix A: The Periodic Inventory System

    LO7 – Explain and identify the entries regarding purchase and sales transactions in a periodic inventory system.

    The perpetual inventory system maintains a continuous, real-time balance in both Merchandise Inventory, a balance sheet account, and Cost of Goods Sold, an income statement account. As a result, the Merchandise inventory general ledger account balance should always equal the value of physical inventory on hand at any point in time. Additionally, the Cost of Goods Sold general ledger account balance should always equal the total cost of merchandise inventory sold for the accounting period. The accounts should perpetually agree; hence the name. An alternate system is considered below, called the periodic inventory system.

    Description of the Periodic Inventory System

    The periodic inventory system does not maintain a constantly-updated merchandise inventory balance. Instead, ending inventory is determined by a physical count and valued at the end of an accounting period. The change in inventory is recorded only periodically. Additionally, a Cost of Goods Sold account is not maintained in a periodic system. Instead, cost of goods sold is calculated at the end of the accounting period.

    When goods are purchased using the periodic inventory system, the cost of merchandise is recorded in a Purchases account in the general ledger, rather than in the Merchandise Inventory account as is done under the perpetual inventory system. The Purchases account is an income statement account that accumulates the cost of merchandise acquired for resale.

    The journal entry, assuming a purchase of merchandise on credit, is:

    img239.png

    Purchase Returns and Allowances (Periodic)

    Under the periodic inventory system, any purchase returns or purchase allowances are accumulated in a separate account called Purchase Returns and Allowances, an income statement account, and recorded as:

    img240.png

    Purchase Returns and Allowances is a contra expense account and the balance is deducted from Purchases when calculating cost of goods sold on the income statement.

    Purchase Discounts (Periodic)

    Another contra expense account, Purchase Discounts, accumulates reductions in the purchase price of merchandise if payment is made within a time period specified in the supplier's invoice and recorded as:

    img241.png

    Transportation (Periodic)

    Under the periodic inventory system, an income statement account called Transportation-in is used to accumulate transportation or freight charges on merchandise purchased for resale. The Transportation-in account is used in calculating the cost of goods sold on the income statement. It is recorded as:

    img242.png

    At the end of the accounting period, cost of goods sold must be calculated which requires that the balance in Merchandise Inventory be determined. To determine the end of the period balance in Merchandise Inventory, a physical count of inventory is performed. The total value of the inventory as identified by the physical count becomes the ending balance in Merchandise Inventory. Cost of goods sold can then be calculated as follows:

    Beginning Balance of Merchandise Inventory XX
    Plus: Net Cost of Goods Purchased* XX
    Less: Ending Balance of Merchandise Inventory XX
    Equals: Cost of Goods Sold XX
    *Net Cost of Goods Purchased is calculated as:
     
    Purchases
    XX
     
    Less: Purchase Returns and Allowances
    XX
     
    Less: Purchase Discounts
    XX
     
    Equals: Net Purchases
    XX
     
    Add: Transportation-In
    XX
     
    Equals: Net Cost of Goods Purchased
    XX

    Closing Entries (Periodic)

    In the perpetual inventory system, the Merchandise Inventory account is continuously updated and is adjusted at the end of the accounting period based on a physical inventory count. In the periodic inventory system, the balance in Merchandise Inventory does not change during the accounting period. As a result, at the end of the accounting period, the balance in Merchandise Inventory in a periodic system is the beginning balance. In order for the Merchandise Inventory account to reflect the ending balance as determined by the physical inventory count, the beginning inventory balance must be removed by crediting Merchandise Inventory, and the ending inventory balance entered by debiting it. This is accomplished as part of the closing process. Closing entries for a merchandiser that uses a periodic inventory system are illustrated below using the adjusted trial balance information for Norva Inc.

    img243.png

    When the closing entries above are posted and a post-closing trial balance prepared as shown below, notice that the Merchandise Inventory account reflects the correct balance based on the physical inventory count.

    Norva Inc.
    Adjusted Trial Balance
    At December 31, 2015
    Debits Credits
    Cash $15,000
    Merchandise inventory 2,000
    Accounts payable $ 5,000
    Common shares 8,000
    Retained earnings 4,000
    Totals $17,000 $17,000

    icon-exploration2.png An exploration is available on the Lyryx system. Log into your Lyryx course to run Journalizing Merchandise Transactions.

    icon-exploration2.png An exploration is available on the Lyryx system. Log into your Lyryx course to run Income Statement and Closing Entries.

    Summary of Chapter 5 Learning Objectives

    LO1 – Describe merchandising and explain the financial statement components of sales, cost of goods sold, merchandise inventory, and gross profit; differentiate between the perpetual and periodic inventory systems.

    Merchandisers buy and resell products. Merchandise inventory, an asset, is purchased from suppliers and resold to customers to generate sales revenue. The cost of the merchandise inventory sold is an expense called cost of goods sold. The profit realized on the sale of merchandise inventory before considering any other expenses is called gross profit. Gross profit may be expressed as a dollar amount or as a percentage. To track merchandise inventory and cost of goods sold in real time, a perpetual inventory system is used; the balance in each of Merchandise Inventory and Cost of Goods Sold is always up-to-date. In a periodic inventory system, a physical count of the inventory must be performed in order to determine the balance in Merchandise Inventory and Cost of Goods Sold.

    LO2 – Analyze and record purchase transactions for a merchandiser.

    In a perpetual inventory system, a merchandiser debits Merchandise Inventory regarding the purchase of merchandise for resale from a supplier. Any purchase returns and allowances or purchase discounts are credited to Merchandise Inventory as they occur to keep the accounts up-to-date.

    LO3 – Analyze and record sales transactions for a merchandiser.

    In a perpetual inventory system, a merchandiser records two entries at the time of sale: one to record the sale and a second to record the cost of the sale. Sales returns that are returned to inventory also require two entries: one to reverse the sale by debiting a sales returns and allowances account and a second to restore the merchandise to inventory by debiting Merchandise Inventory and crediting Cost of Goods Sold. Sales returns not restored to inventory as well as sales allowances are recorded with one entry: debit sales returns and allowances and credit cash or accounts receivable. Sales discounts are recorded when a credit customer submits their payment within the discount period specified.

    LO4 – Record adjustments to merchandise inventory.

    A physical count of merchandise inventory is performed and the total compared to the general ledger balance of Merchandise Inventory. Discrepancies are recorded as an adjusting entry that debits cost of goods sold and credits Merchandise Inventory.

    LO5 – Explain and prepare a classified multiple-step income statement for a merchandiser.

    A classified multiple-step income statement for a merchandiser is for internal use because of the detail provided. Sales, less sales returns and allowances and sales discounts, results in net sales. Net sales less cost of goods sold equals gross profit. Expenses are shown based on both their function and nature. The functional or group headings are: operating expenses, selling expenses, and general and administrative expenses. Within each grouping, the nature of expenses is detailed including: depreciation, salaries, advertising, wages, and insurance. A specific expense can be divided between groupings.

    LO6 – Explain the closing process for a merchandiser.

    The steps in preparing closing entries for a merchandiser are the same as for a service company. The difference is that a merchandiser will need to close income statement accounts unique to merchandising such as: Sales, Sales Returns and Allowances, Sales Discounts, and Cost of Goods Sold.

    LO7 – Explain and identify the entries regarding purchase and sales transactions in a periodic inventory system.

    A periodic inventory system maintains a Merchandise Inventory account but does not have a Cost of Goods Sold account. The Merchandise Inventory account is updated at the end of the accounting period as a result of a physical inventory count. Because a merchandiser using a period system does not use a Merchandise Inventory account to record purchase or sales transactions during the accounting period, it maintains accounts that are different than under a perpetual system, namely, Purchases, Purchase Returns and Allowances, Purchase Discounts, and Transportation-in.

    Discussion Questions

    1. How does the income statement prepared for a company that sells goods differ from that prepared for a service business?

    2. How is gross profit calculated? What relationships do the gross profit and gross profit percentage calculations express? Explain, using an example.

    3. What are some common types of transactions that are recorded in the merchandise Inventory account?

    4. Contrast and explain the sales and collection cycle and the purchase and payment cycle.

    5. What contra accounts are used in conjunction with sales? What are their functions?

    6. (Appendix) Compare the perpetual and periodic inventory systems. What are some advantages of each?

    Exercises

    EXERCISE 5–1 (LO1)

    Consider the following information of Jones Corporation over four years:

    2014 2013 2012 2011
    Sales $10,000 $9,000 $
     
    ?
    $7,000
    Cost of Goods Sold ? 6,840 6,160 ?
    Gross Profit 2,500 ? 1,840 ?
    Gross Profit Percentage ? ? ? 22%

    Required:

    1. Calculate the missing amounts for each year.

    2. What does this information indicate about the company?

    EXERCISE 5–2 (LO2)

    Reber Corp. uses the perpetual inventory system. Its transactions during July 2015 are as follows:

    July 6 Purchased $600 of merchandise on account from Hobson Corporation for terms 1/10,
    net 30.
    9 Returned $200 of defective merchandise.
    15 Paid the amount owing to Hobson.

    Required: Prepare journal entries to record the above transactions for Reber Corp.

    EXERCISE 5–3 (LO2,3,4) Watch Video

    Horne Inc. and Sperling Renovations Ltd. both sell goods and use the perpetual inventory system. Horne Inc. had $3,000 of merchandise inventory at the start of its fiscal year, January 1, 2015. During the 2015, Horne Inc. had the following transactions:

    May 5 Horne sold $4,000 of merchandise on account to Sperling Renovations Ltd., terms 2/10,
    net 30. Cost of merchandise to Horne from its supplier was $2,500.
    7 Sperling returned $500 of merchandise received in error which Horne returned to
    inventory; Horne issued a credit memo. Cost of merchandise to Horne was $300.
    15 Horne received the amount due from Sperling Renovations Ltd.

    A physical count and valuation of Horne's Merchandise Inventory at May 31, the fiscal year-end, showed $700 of goods on hand.

    Required: Prepare journal entries to record the above transactions and adjustment:

    1. In the records of Horne Inc.

    2. In the records of Sperling Renovations Ltd.

    EXERCISE 5–4 (LO2,3) Recording Purchase and Sales Transactions

    Below are transactions for March, 2016 for AngieJ Ltd.:

    March 1 Purchased $25,000 of merchandise on account for terms 2/10, n30.
    March 3 Sold merchandise to a customer for $5,000 for terms 1/10, n30. (Cost $2,600)
    March 4 Customer from March 3 returned $200 of some unsuitable goods which were returned to inventory. (Cost $100)
    March 5 Purchased $15,000 of merchandise from a supplier for cash and arranged for shipping, fob shipping point.
    March 6 Paid $200 for shipping on the March 5 purchase.
    March 7 Contacted the supplier from March 5 regarding $2,000 of merchandise with some minor damages. Supplier agreed to reduce the price and offered an allowance of $500 cash, which was accepted.
    March 8 Sold $25,000 of merchandise for terms 1.5/10, n30. (Cost $13,000). Agreed to pay shipping costs for the goods sold to the customer.
    March 9 Shipped the goods sold on March 8 to customer, fob destination for $500 cash. (Hint: Shipping costs paid to ship merchandise sold to a customer is an operating expense.)
    March 11 Paid for fifty percent of the March 1 purchase to the supplier.
    March 13 Collected the account owing from the customer from March 3.
    March 15 Purchased office supplies on account for $540 for terms 1/10, n30.
    March 18 Ordered merchandise inventory from a supplier totalling $15,000. Goods to be shipped on April 10, fob shipping point.
    March 20 Collected $6,010 cash from an account owing from two months ago. The early payment discount had expired.
    March 25 Paid for the March 15 purchase.
    March 27 Sold $12,500 of merchandise inventory for cash (Cost $5,000).
    March 31 Paid the remaining of the amount owing from the March 1 purchase.

    Required: Prepare the journal entries, if any, for AngieJ Ltd.

    EXERCISE 5–5 (LO2,3) Recording Purchase and Sales Transactions

    Below are the April, 2016 sales for Beautort Corp.

    April 1 Purchased $15,000 of merchandise for cash.
    April 3 Sold merchandise to a customer for $8,000 cash. (Cost $4,600)
    April 5 Purchased $10,000 of merchandise from a supplier for terms 1/10, n30.
    April 7 Returned $2,000 of damaged merchandise inventory from April 5 back to the supplier. Supplier will repair the items and return them to their own inventory.
    April 8 Sold $8,000 of merchandise for terms 2/10, n30. (Cost $4,000). Agreed to pay shipping costs for the goods sold to the customer.
    April 9 Shipped the goods sold on April 8 to customer, fob shipping point for $500 cash. (Hint: Shipping costs paid to ship merchandise sold to a customer is not an inventory cost.)
    April 10 Customer from April 3 returned $1,000 of unsuitable goods which were returned to inventory. (Cost $400). Amount paid was refunded.
    April 10 Agreed to give customer from April 8 sale a sales allowance of $200.
    April 12 Purchased inventory on account for $22,000 for terms 1/10, n30.
    April 15 Paid amount owing for purchases on April 5.
    April 16 Paid $600 for shipping on the April 12 purchase.
    April 18 Collected $5,000 cash, net of discount, for the customer account owing from April 8.
    April 27 Paid for the April 12 purchase.
    April 27 Sold $20,000 of merchandise inventory for cash (Cost $10,000).

    Required: Prepare the journal entries, if any, for Beautort Corp. Round final entry amounts to the nearest whole dollar.

    EXERCISE 5–6 (LO5) Watch Video

    The following information is taken from the records of Smith Corp. for the year ended June 30, 2015:

    Advertising Expense $
     
    1,500
    Commissions Expense 4,000
    Cost of Goods Sold 50,000
    Delivery Expense 500
    Depreciation Expense – Equipment
     
    500
    Insurance Expense 1,000
    Office Salaries Expense 3,000
    Rent Expense – Office 1,000
    Rent Expense – Store 1,500
    Sales Salaries Expense 2,000
    Sales 72,000
    Sales Returns and Allowances 2,000

    Required:

    1. Prepare a classified multi-step income statement for the year ended June 30, 2015. Assume an income tax rate of 20%.

    2. Compute the gross profit percentage, rounding to two decimal places.

    EXERCISE 5–7 (LO4) Calculating Inventory and Cost of Goods Sold

    Below is a table that contains two important calculations that link together to determine net income/(loss):

    Inventory, opening balance $ 10,000 $ 53,000 ? 168,540 50,562
    Plus: purchases 30,000 ? 1,685,400 ? ?
    Total goods available for sale ? 212,000 2,247,200 ? 657,306
    Less: ending inventory 15,000 ? 842,700 556,180 100,000
    Cost of goods sold ? 132,500 ? ? ?
    Sales ? 240,000 1,600,000 900,000 ?
    Less: cost of goods sold ? ? ? ? ?
    Gross profit 30,000 ? ? 276,400 142,694
    Less: operating expenses 12,000 ? 275,000 ? ?
    Net income/(loss) ? 43,900 ? 26,400 (2,306)
    Gross profit/sales (%) ? ? ? ? ?

    Required: Calculate the missing account balances using the relationships between these accounts. Percentage can be rounded to the nearest two decimal places.

    EXERCISE 5–8 (LO6) Watch Video

    Refer to the information in EXERCISE 5–6.

    Required:

    1. Prepare all closing entries. Assume cash dividends totalling $2,000 were declared during the year and recorded as a debit to Dividends Declared and a credit to Cash.

    2. Calculate the June 30, 2015 post-closing balance in Retained Earnings assuming a beginning balance of $18,000.

    EXERCISE 5–9 (LO7 Appendix)

    Consider the information for each of the following four companies.

    A B C D
    Opening Inventory $
     
    ?
    $ 184 $ 112 $
     
    750
    Purchases 1415 ? 840 5,860
    Transportation-In 25 6 15 ?
    Cost of Goods Available for Sale 1,940 534 ? 6,620
    Ending Inventory 340 200 135 ?
    Cost of Goods Sold ? ? ? 5,740

    Required: Calculate the missing amounts.

    EXERCISE 5–10 (LO7 Appendix)

    The following data pertain to Pauling Inc.

    Opening Inventory $
     
    375
    Purchases 2930
    Purchases Discounts 5
    Purchases Returns and Allowances
     
    20
    Transportation-In 105

    Ending inventory amounts to $440.

    Required: Calculate cost of goods sold.

    EXERCISE 5–11 (LO7 Appendix)

    The following information is taken from the records of four different companies in the same industry:

    A B C D
    Sales $300 $150 $
     
    ?
    $
     
    90
    Opening Inventory ? 40 40 12
    Purchases 240 ? ? 63
    Cost of Goods Available for Sale 320 ? 190 ?
    Ending Inventory ? (60) (60) (15)
    Cost of Goods Sold ? 100 130 60
    Gross Profit $100 $
     
    ?
    $
     
    65
    $
     
    ?
    Gross Profit percentage ? ? ? ?

    Required:

    1. Calculate the missing amounts.

    2. Which company seems to be performing best? Why?

    Problems

    PROBLEM 5–1 (LO1,2,3,4)

    Salem Corp. was incorporated on July 2, 2015 to operate a merchandising business. It uses the perpetual inventory system. All its sales are on account with terms: 2/10, n30. Its transactions during July 2015 are as follows:

    July 2 Issued share capital for $5,000 cash.
    2 Purchased $3,500 merchandise on account from Blic Pens Ltd. for terms 2/10, n30.
    2 Sold $2,000 of merchandise on account to Spellman Chair Rentals Inc. (Cost to Salem: $1,200).
    3 Paid Sayer Holdings Corp. $500 for July rent.
    5 Paid Easton Furniture Ltd. $1,000 for equipment.
    8 Collected $200 for a cash sale made today to Ethan Matthews Furniture Ltd. (Cost: $120).
    8 Purchased $2,000 merchandise on account from Shaw Distributors Inc. for terms 2/15, n30.
    9 Received the amount due from Spellman Chair Rentals Inc. for the July 2 sale.
    10 Paid Blic Pens Ltd. for the July 2 purchase.
    10 Purchased $200 of merchandise on account from Peel Products Inc. for terms n30.
    15 Sold $2,000 of merchandise on account to Eagle Products Corp. (Cost: $1,300).
    15 Purchased $1,500 of merchandise on account from Bevan Door Inc. for terms 2/10, n30.
    15 Received a memo from Shaw Distributors Inc. to reduce accounts payable by $100 for defective merchandise included in the July 8 purchase.
    16 Eagle Products Corp. returned $200 of defective merchandise which was scrapped (Cost to Salem: $150).
    20 Sold $3,500 of merchandise on account to Aspen Promotions Ltd. (Cost: $2,700).
    20 Paid Shaw Distributors Inc. for half the purchase made July 8.
    24 Received half the amount due from Eagle Products Corp. in partial payment for the July 15 sale.
    24 Paid Bevan Doors Ltd. for the purchase made July 15.
    26 Sold $600 merchandise on account to Longbeach Sales Ltd. (Cost: $400).
    26 Purchased $800 of merchandise on account from Silverman Co. for terms 2/10, n30.
    31 Paid Speedy Transport Co. $350 for transportation to Salem's warehouse during the month (all purchases are fob shipping point).

    Required:

    1. Prepare journal entries to record the July transactions. Include general ledger account numbers and a brief description.

    2. Calculate the unadjusted ending balance in merchandise inventory.

    3. Assume the merchandise inventory is counted at July 31 and assigned a total cost of $2,400. Prepare the July 31 adjusting entry.

    PROBLEM 5–2 (LO1,5,6)

    The following closing entries were prepared for Whirlybird Products Inc. at December 31, 2015, the end of its fiscal year.

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    Required: Calculate gross profit.

    PROBLEM 5–3 (LO1,5,6)

    The following alphabetized adjusted trial balance has been extracted from the records of Acme Automotive Inc. at December 31, 2015, its third fiscal year-end. All accounts have a normal balance.

    Accounts Payable 9,000
    Accounts Receivable 15,000
    Accumulated Depreciation – Equipment
     
    36,000
    Advertising Expense 14,000
    Bank Loan 14,000
    Cash 2,000
    Commissions Expense 29,000
    Cost of Goods Sold 126,000
    Delivery Expense 14,800
    Depreciation Expense 12,000
    Dividends 11,000
    Equipment 120,000
    Income Taxes Expense 4,200
    Income Taxes Payable 4,200
    Insurance Expense 10,400
    Interest Expense 840
    Merchandise Inventory 26,000
    Office Supplies Expense 3,100
    Rent Expense 32,400
    Rent Revenue 19,200
    Retained Earnings 12,440
    Sales 310,000
    Sales Discounts 1,300
    Sales Returns and Allowances 2,900
    Sales Salaries Expense 26,400
    Share Capital 70,000
    Supplies 3,200
    Telephone Expense 1,800
    Utilities Expense 4,200
    Wages Expense – Office 14,300

    Required:

    1. Prepare a classified multi-step income statement and statement of changes in equity for the year ended December 31, 2015. Assume 40% of the Rent Expense is allocated to general and administrative expenses with the remainder allocated to selling expenses. Additionally, assume that $20,000 of shares were issued during the year ended December 31, 2015.

    2. Prepare closing entries.

    PROBLEM 5–4 (LO1,2,3,4) Challenge Question – Pulling It All Together

    Calculating Purchases, Inventory Shrinkage, Net Sales, Cost Goods Sold, Gross Profit, and Net Income/(Loss)

    The information below is a summary of the merchandise inventory and sales transactions for 2016.

    Total cost of purchases $ 250,000
    Total sales 580,000
    Purchases shipping costs 500
    Merchandise inventory, opening balance 55,000
    Purchase discounts 3,500
    Sales discounts 200
    Total sales returns to inventory 100
    Merchandise inventory, closing GL balance 90,000
    Merchandise inventory, physical inventory count 88,500
    Sales allowances 600
    Operating expenses 250,000
    Sales returns 200
    Purchase returns and allowances 200
    Net purchases ?
    Inventory shrinkage adjustment amount ?
    Cost of goods sold ?
    Net sales ?
    Gross profit ?
    Net income/(loss) ?
    Gross profit ratio ?

    Required: Calculate and fill in the blanks. (Hint: Refer to the merchandising company illustration in Section 5.1 and the T-account summary illustrations for inventory and cost of goods sold at the end of Section 5.4.)

    PROBLEM 5–5 (LO1,2,3,5,6) Preparing a Classified Multiple-step Income Statement and Closing Entries

    Below is the adjusted trial balance presented in alphabetical order for Turret Retail Ltd., for 2016. Their year-end is December 31.

    Turret Retail Ltd.
    Trial Balance
    At December 31, 2016
     
     
    Accounts payable $ 31,250
    Accounts receivable $ 140,000
    Accrued salaries and benefits payable 12,000
    Accumulated depreciation, furniture 4,300
    Cash 21,000
    Cash dividends 10,000
    Cost of goods sold 240,000
    Bank loan payable (long-term) 40,320
    Depreciation expense 3,200
    Copyright 20,000
    Furniture 20,000
    Income tax expense 2,028
    Income taxes payable 8,000
    Insurance expense 5,000
    Interest expense 200
    Interest payable 550
    Land 140,000
    Merchandise inventory 120,000
    Prepaid insurance expense 6,000
    Rent expense 30,240
    Rental income 6,000
    Retained earnings 307,748
    Salaries expense 57,000
    Sales 360,000
    Sales discounts 3,600
    Sales returns and allowances 9,600
    Share capital 20,000
    Shop supplies expense 2,400
    Shop supplies expense 1,000
    Travel expense 2,100
    Unearned revenue 50,500
    Utilities expense 7,300
    $ 840,668 $ 840,668

    Required:

    1. Prepare a classified multiple-step income statement in good form, reporting operating expenses by nature, for the year ended December 31, 2016.

    2. Prepare the closing entries for the year-ended December 31, 2016.

    3. Calculate the gross profit ratio to two decimal places and comment on what this ratio means.

    PROBLEM 5–6 (LO1,2,3,4,5) Challenge Question – Preparing Adjusting Entries and a Classified Multiple-step Income Statement

    Below are the unadjusted accounts balances for Yuba Yabi Enterprises Ltd., for the year ended March 31, 2017. All account balances are normal. Yuba Yabi's business involves selling frozen food to restaurants as well as providing consulting services to assist restaurant businesses with their daily operations.

    Yuba Yabi Enterprises Ltd.
    Unadjusted Trial Balance
    March 31, 2017
     
    Accounts payable 68,750
    Accounts receivable 308,000
    Accrued salaries and benefits payable 26,400
    Accumulated depreciation, furniture 9,460
    Cash 46,200
    Cash dividends 22,000
    Cost of goods sold 528,000
    Advertising expense 9,900
    Bank loan payable (long-term) 88,704
    Depreciation expense 7,040
    Copyright 44,000
    Franchise 66,000
    Furniture 44,000
    Income tax expense -
    Income taxes payable 17,600
    Insurance expense 11,000
    Interest expense 440
    Interest payable 1,210
    Land 308,000
    Merchandise inventory 264,000
    Prepaid insurance expense 13,200
    Prepaid advertising expense 8,800
    Rent expense 66,528
    Rental income 13,200
    Retained earnings 265,364
    Salaries expense 125,400
    Sales 792,000
    Sales discounts 7,920
    Sales returns and allowances 21,120
    Service revenue 495,000
    Share capital 44,000
    Shop supplies 8,360
    Shop supplies expense 2,200
    Travel expense 4,620
    Unearned service revenue 111,100
    Utilities expense 16,060

    Additional information:

    The following are adjusting entries that have not yet been recorded:

    Accrued salaries $12,000
    Accrued interest on the bank loan 5,600
    Inventory shrinkage 7,800
    Prepaid insurance expense 5,000 has expired
    Prepaid advertising expense no change
    Unearned revenue 30,000 has been earned
    Income tax rate 30%

    Required:

    1. Update the affected accounts by the adjustments, if any. Round all adjustments to the nearest whole dollar.

    2. Prepare a classified multiple-step income statement in good form for the year ended March 31, 2017.