Sales Discounts

A sales discount is an incentive the seller offers in exchange for prompt payment on
credit sales. Sales discounts are recorded in another centrarevenue account, enabling
management to monitor the effectiveness of the company's discount policy. Invoices
generally include credit terms, which specify when the customer must pay and define
the sales discount if one is available. For example, the credit terms on the invoice below
are 2/10, n/30, which is read twoten, net thirty.





The terms 2/10, n/30 mean the customer may take a two percent discount on the
outstanding balance (original invoice amount less any returns and allowances) if
payment occurs within ten days of the invoice date. If the customer chooses not to take
the discount, the outstanding balance is due within thirty days. An abbreviation that
sometimes appears in the credit terms section of an invoice isEOM, which stands
for end of month. The terms n/15 EOM indicate that the outstanding balance is due
fifteen days after the end of the month in which the invoice is dated.
If Music World returns merchandise worth $100 after receiving a $1,000 order, they still
owe Music Suppliers, Inc., $900. Assuming the credit terms are 2/10, n/30 and Music
World pays the invoice within ten days, the payment equals $882, an amount
calculated by subtracting $18 (2% of $900) from the outstanding balance. To record
this payment from Music World, Music Suppliers, Inc., makes a compound journal entry
that increases (debits) cash for $882, increases (debits) sales discounts for $18, and
decreases (credits) accounts receivable for $900.



Net Sales
Net sales is calculated by subtracting sales returns and allowances and sales discounts
from sales. Suppose Music Suppliers, Inc., sells merchandise worth $116,500 during
June and, in conjunction with these sales, handles $9,300 in returns and allowances
and $1,200 in sales discounts. The company's net sales for June equal $106,000.

Music Suppliers, Inc. Calculation of Net Sales For the Month Ended June 30,
20X3
Sales

$116,500
Less: Sales Returns and Allowances $9,300

Sales Discounts
1,200 10,500
Net Sales

$106,000
Cliff's Notes
Inventory Systems
There are two systems to account for inventory: the perpetual system and the periodic
system. With the perpetual system, the inventory account is updated after every
inventory purchase or sale. Before computers became widely available, only companies
that sold a relatively small number of highpriced items used this system. Under
the periodic system, a careful evaluation of inventory occurs only at the end of each
accounting period. At that time, each product available for sale is counted and
multiplied by its per unit cost, and the total of all such calculations equals the value of
inventory.

Cliff's Notes
I love watching TV court shows, and would enjoy them more if I understood some of the legal jargon,
like ex post facto. What does that mean?
Which U.S. presidents also served in the House of Representatives?
More Study Help
Recording Purchases
Under the periodic system, a temporary expense account named merchandise
purchases, or simply purchases, is used to record the purchase of goods intended for
resale. The source documents used to journalize merchandise purchases include the
seller's invoice, the company's purchase order, and a receiving report that verifies the
accuracy of the inventory quantities. When Music World receives a shipment of
merchandise worth $1,000 on account from Music Suppliers, Inc., Music World
increases (debits) the purchases account for $1,000 and increases (credits) accounts
payable for $1,000.





For reference purposes, the journal entry's description usually includes the invoice
number.
When a seller pays to ship merchandise to a purchaser, the seller records the cost as a
delivery expense, which is considered an operating expense and, more specifically, a
selling expense. When a purchaser pays the shipping fees, the purchaser considers the
fees to be part of the cost of the merchandise. Instead of recording such fees directly in
the purchases account, however, they are recorded in a separate expense account
named freightin or transportationin, which provides management with a way to
monitor these shipping costs.
If Music World pays a shipping company $30 for delivering the merchandise from Music
Suppliers, Inc., Music World increases (debits) freightin for $30 and decreases (credits)
cash for $30.



Freight terms, which indicate whether the purchaser or seller pays the shipping fees,
are often specified with the abbreviations FOB shipping point or FOB
destination. FOB means free on board. FOB shipping point means the purchaser pays
the shipping fees and gains title to the merchandise at the shipping point (the seller's
place of business). FOB destination means the seller pays the shipping fees and
maintains title until the merchandise reaches its destination (the purchaser's place of
business).
More Study Help
Returns and Allowances
When a purchaser receives defective, damaged, or otherwise undesirable merchandise,
the purchaser prepares a debit memorandum that identifies the items in question and
the cost of those items. The purchaser uses the debit memorandum to inform the seller
about the return and to prepare a journal entry that decreases (debits) accounts
payable and increases (credits) an account namedpurchases returns and allowances,
which is a contraexpense account. Contraexpense accounts normally have credit
balances. On the income statement, the purchases returns and allowances account is
subtracted from purchases.

If Music World discovers $100 worth of defective merchandise in the shipment from
Music Suppliers, Inc., Music World prepares a debit memorandum, returns the
merchandise, and makes a journal entry that decreases (debits) accounts payable for
$100 and that increases (credits) purchases returns and allowances for $100.



For reference purposes, the journal entry's description may include the debit
memorandum number and the seller's invoice number.
Accounting Inventory
Although the accounting cycle and the basic accounting principles are the same for
companies that sell merchandise and companies that provide services, merchandising
companies use several accounts that service companies do not use. The balance sheet
includes an additional current asset called merchandise inventory, or simply inventory,
which records the cost of merchandise held for resale. On balance sheets, the inventory
account usually appears just below accounts receivable because inventory is less liquid
than accounts receivable.

Music World Partial Balance Sheet June 30, 20X3
ASSETS

Current Assets

Cash $10,000
Accounts Receivable 2,000
Inventory 37,000
Supplies 1,000
Prepaid Insurance
2,000
Total Current Assets $52,000
Merchandising companies also have several specific income statement accounts
designed to provide detailed information about revenues and expenses associated with
salable merchandise.
Purchases Discounts
Companies that take advantage of sales discounts usually record them in an account
named purchases discounts, which is another contraexpense account that is subtracted
from purchases on the income statement. If Music Suppliers, Inc., offers the terms
2/10, n/30 and Music World pays the invoice's outstanding balance of $900 within ten
days, Music World takes an $18 discount. To record this payment to Music Suppliers,
Inc., Music World makes a compound journal entry that decreases (debits) accounts
payable for $900, decreases (credits) cash for $882, and increases (credits) purchases
discounts for $18.




Recording Sales
Sales invoices are source documents that provide a record for each sale. For control
purposes, sales invoices should be sequentially prenumbered to help the accounting
department determine the disposition of every invoice. Sales revenuesequal the
selling price of all products that are sold. In accordance with the revenue recognition
principle, sales revenue is recognized when a customer receives title to the
merchandise, regardless of when the money changes hands. If a customer purchases
merchandise at a sales counter and takes possession of the goods immediately, the
sales invoice or cash register receipt is the only source document needed to record the
sale. However, if merchandise is shipped to the customer, a delivery record or shipping
document is matched with the invoice to prove that the merchandise has been shipped
to the customer.

Suppose a company named Music Suppliers, Inc., sells merchandise worth $1,000 on
account to a retail store named Music World. Music Suppliers, Inc., records the sale
with the journal entry below.



For reference purposes, the journal entry's description often includes the invoice
number.
Net Purchases and Goods Purchased
Net purchases is found by subtracting the credit balances in the purchases returns
and allowances and purchases discounts accounts from the debit balance in the
purchases account The cost of goods purchased equals net purchases plus the
freightin account's debit balance.






Sales Returns and Allowances
Although sales returns and sales allowances are technically two distinct types of
transactions, they are generally recorded in the same account. Sales returns occur
when customers return defective, damaged, or otherwise undesirable products to the
seller. Sales allowances occur when customers agree to keep such merchandise in
return for a reduction in the selling price.

If Music World returns merchandise worth $100, Music Suppliers, Inc., prepares
a credit memorandum to account for the return. This credit memorandum becomes
the source document for a journal entry that increases (debits) the sales returns and
allowances account and decreases (credits) accounts receivable.



A $100 allowance requires the same entry.
In the sales revenue section of an income statement, the sales returns and allowances
account is subtracted from sales because these accounts have the opposite effect on
net income. Therefore, sales returns and allowances is considered a contrarevenue
account, which normally has a debit balance. Recording sales returns and allowances
in a separate contrarevenue account allows management to monitor returns and
allowances as a percentage of overall sales. High return levels may indicate the
presence of serious but correctable problems. For example, improved packaging might
minimize damage during shipment, new suppliers might reduce the amount of defective
merchandise, or better methods for recording and packaging orders might eliminate or
reduce incorrect merchandise shipments. The first step in identifying such problems is
to carefully monitor sales returns and allowances in a separate, contrarevenue
account.
The Cost of Goods Available and Sold
The cost of goods available for sale equals the beginning value of inventory plus the
cost of goods purchased. The cost of goods sold equals the cost of goods available for
sale less the ending value of inventory.






Gross Profit
Gross profit, which is also called gross margin, represents the company's profit from
selling merchandise before deducting operating expenses such as salaries, rent, and
delivery expenses. Gross profit equals net sales minus the cost of goods sold.




The statement of owner's equity and the statement of cash flows are the same for
merchandising and service companies. Except for the inventory account, the balance
sheet is also the same. But a merchandising company's income statement includes
categories that service enterprises do not use. A singlestep income statement for a
merchandising company lists net sales under revenues and the cost of goods sold under
expenses.

Music World Income Statement For the Year Ended June 30,20X3
Revenues

Net Sales

$1,172,000
Interest Income

7,500
Gain on Sale of Equipment
1,500
Total Revenues

1,181,000
Expenses

Cost of Goods Sold $596,600

Selling Expenses 177,000

General and Administrative Expenses 152,900

Interest Expense
18,000
Total Expenses
944,500
Net Income
$ 236.500
Although the singlestep format is easier to read than the multiplestep format, most
companies produce a multiplestep income statement, which clearly identifies each step
in the calculation of net income or net loss.
Music World Income Statement For the Year Ended June 30,20X3
Sales

$1,240,000
Less: Sates Returns and Allowances

$65,000

Sales Discounts
3,000 68,000
Net Sates

1,172,000
Cost of Goods Sold

Inventory, July 1,20X2

37,000

Purchases

$610,000

Less: Purchases Returns and Allowances $9,000

Purchases Discounts
8,000 17,000
Net Purchases

593,000

Add: Freight-In

5,600

Cost of Goods Purchased

598,600

Cost of Goods Available for Sate

635,600

Less: Inventory, June 30,20X3
39,000
Cost of Goods Sold
596,600
Gross Profit

575,400
Operating Expenses

Selling Expenses

Sales Salaries Expense

120,000

Sales Commission Expense

21,000

Delivery Expense

15,000

Store Rent Expense

12,000

Depredation Expense-Store Equipment
9,000
Total Selling Expenses

177,000

General and Administrative Expenses

Office Salaries Expense

140,000

Insurance Expense

6,000

Depredation Expense-Office Equipment

5,000

Office Rent Expense

1,200

Office Supplies Expense
700
Total General and Administrative
Expenses
152,900
Total Operating Expenses
329,900
Operating Income

245,500
Other Income/(Expense), Net

Interest Income

7,500

Gain on Sate of Equipment

1,500

Interest Expense

(18,000)

Other Income/(Expense), Net
(9,000)
Net Income
$236,500

Key Topics to Know

Note: The same example transactions are presented for Purchase Transactions and
Sales Transactions to highlight the differences between cost and selling price.

Purchase Transactions

When companies purchase goods they intend to sell to customers, the transaction is
recorded in the Merchandise Inventory account, a current asset. Inventory is recorded
at cost, which includes the price paid for the goods plus all necessary costs of getting
the inventory to the companys place of business and ready to sell. The rules of FOB
determine whether freight costs are included in the cost of inventory.

Example 1: $800 of inventory is purchased for cash, FOB shipping point. In a separate
transaction, the purchaser pays $100 of shipping charges to the shipping company,
which are added to the cost of the inventory. Therefore the total cost of the inventory
purchased is $800 purchase price + $100 shipping charges:

Merchandise Inventory 800
Cash 800

Merchandise Inventory 100
Cash 100

$200 of merchandise purchased is returned prior to payment:

Cash 200
Merchandise Inventory 200

Example 2: $800 of inventory is purchased on account, FOB shipping point. The seller
pays $100 to the shipping company on behalf of the buyer, which is added to the sellers
invoice. The credit terms offered by the seller are 2/10, n/30. Therefore the total cost
of the inventory purchased is $800 purchase price + $100 shipping charges:

Merchandise Inventory 900
A/P 900

$200 of merchandise purchased is returned prior to payment.

A/P 200
Merchandise Inventory 200 Revised Fall 2012
Page 6 of 25

When the invoice is paid within the discount period
$800 purchase - $200 return = $600 merchandise * 2% = $12 discount
$700 owed ($600 + $100 shipping) - $12 discount = $688 paid
A/P 700
Cash 688
Merchandise Inventory 12

Example 3: $800 of inventory is purchased on account, FOB destination. In a separate
transaction, the seller pays $100 of shipping charges to the shipping company. The
buyer records only the cost of the merchandise. The credit terms offered by the seller
are 2/10, n/30. Therefore the total cost of the inventory purchased is $800 purchase
price.

Merchandise Inventory 800
A/P 800

$200 of merchandise purchased is returned prior to payment.

A/P 200
Merchandise Inventory 200

When the invoice is paid within the discount period assuming credit terms of 2/10, n/30:
$800 purchase - $200 return = $600 merchandise * 2% = $12 discount
$600 owed - $12 discount = $588 paid

A/P 500
Cash 490
Merchandise Inventory 10

Practice Problem #1
Journalize the following purchase related transactions:

a. Jingle Co. purchased $4,000 worth of merchandise on account, terms 2/10, n/30,
FOB shipping point. Prepaid transportation charges of $200 were added to the
invoice.
b. Returned $500 of merchandise purchased in (a).
c. Paid on account for purchases in (a), less return (b) and discount.
Revised Fall 2012
Page 7 of 25

Sales Transactions
When companies sell merchandise inventory, the transaction requires two journal
entries: the first entry records the revenue from the sale at the selling price and the
second entry decreases the inventory account and records the expense of the sale at
cost.

Revenue (sales) is recorded at the time the transaction occurs, regardless of whether
payment is received from the buyer. Revenue is always greater the cost of the goods
being sold.

Inventory is decreased for the cost of the inventory sold, which includes the price paid
for the goods plus all necessary costs of getting the inventory to the companys place of
business and ready to sell as noted above.

The rules of FOB determine whether freight costs are recorded as transportation out, a
selling expense.

The seller would record the examples in Purchase Transactions above as follows. Note
that the seller had a gross margin ratio of 20%.

Example 1: Inventory is sold for $800 cash (FOB shipping point. In a separate
transaction, the purchaser pays $100 of shipping charges to the shipping company.
The total cost of the inventory when purchased was $640 (800 ( 20% * 800)):

Cash 800
Sales 800
Cost of Goods Sold 640
Merchandise Inventory 640

$200 of merchandise purchased is returned by the customer prior to payment:

Sales returns and Allowances 200
Cash 200
Merchandise Inventory 160
Cost of Goods Sold 160

Example 2: $800 of inventory is sold on account, FOB shipping point. The seller pays
$100 to the shipping company on behalf of the buyer, which is added to the sellers
invoice. The credit terms offered by the seller are 2/10, n/30. Therefore the total
account receivable is $900 selling price + $100 shipping charges. The total cost of the
inventory when purchased was $640 (800 (20% * 800)):
A/R 900
Sales 800
Cash 100
Cost of Goods Sold 640
Merchandise Inventory 640

$200 of merchandise purchased is returned prior to payment.

Sales Returns and Allowances 200
A/R 200
Merchandise Inventory 160
Cost of Goods Sold 160

When the invoice is paid within the discount period
$800 purchase - $200 return = $600 merchandise * 2% = $12 discount
$700 owed ($600 + $100 shipping) - $12 discount = $688 paid

Cash 688
Sales Discounts 12
A/R 700

Example 3: $800 of inventory is sold on account, FOB shipping point. In a separate
transaction, the seller pays $100 to the shipping company. Therefore the total account
receivable is $800 selling price. The total cost of the inventory when purchased was
$640 (800 20% * 800):

A/R 800
Sales 800
Cost of Goods Sold 640
Merchandise Inventory 640

Transportation Out 100
Cash 100

$200 of merchandise purchased is returned prior to payment.

Sales Returns and Allowances 200
A/R 200
Merchandise Inventory 160
Cost of Goods Sold 160

When the invoice is paid within the discount period
$800 purchase - $200 return = $600 merchandise * 2% = $12 discount
$600 owed - $12 discount = $588 paid

Cash 588
Sales Discounts 12
A/R 600

Practice Problem #2
Journalize the following sales related transactions.

a) Sold merchandise on account to Jangle Co., $5,000, terms FOB
Shipping Point, 2/10, n/30. The cost of the merchandise sold
was $3,000. Paid transportation charges of $200, which were
added to the invoice.
b) Sold merchandise on account to Comet Co., $10,000, terms
FOB Destination, 1/10, n/30. The cost of the merchandise was
$6,000.
c) Paid transportation charges of $400 for delivery of merchandise
sold to Comet Co.
d) Issued credit memorandum for $2,000 to Comet Co. for
merchandise returned from sale in (b). The cost of the
merchandise was $1,200.
e) Received amount due from Jangle Co. within the discount
period.
f) Received amount due, less return and discount from Comet Co.
g) Sold merchandise on account to Jangle Co., $5,000, terms FOB
Shipping Point, 2/10, n/30. The cost of the merchandise sold
was $3,000. Paid transportation charges of $200, which were
added to the invoice.
h) Sold merchandise on account to Comet Co., $10,000, terms
FOB Destination, 1/10, n/30. The cost of the merchandise was
$6,000.
i) Paid transportation charges of $400 for delivery of merchandise
sold to Comet Co.
j) Issued credit memorandum for $2,000 to Comet Co. for
merchandise returned from sale in (b). The cost of the
merchandise was $1,200.
k) Received amount due from Jangle Co. within the discount
period.
l) Received amount due, less return and discount from Comet Co.
Practice Problem #2
a) Accounts Receivable/Jangle 5,200
Sales 5,000
Cash 200
Cost of Merchandise Sold 3,000
Merchandise Inventory 3,000

b) Accounts Receivable/Comet 10,000
Sales 10,000
Cost of Merchandise Sold 6,000
Merchandise Inventory 6,000

c) Transportation Out 400
Cash 400

d) Sales Returns & Allowances 2,000
Accounts Receivable/Comet 2,000
Merchandise Inventory 1,200
Cost of Merchandise Sold 1,200

e) Cash 5,100
Sales Discounts 100
Accounts Receivable/Jangle 5,200
$5,000 sale * 2% = $100 discount
$5,200 owed ($5,000 + $200 shipping)
- $100 discount = $5,100 received


Cash 7,920
Sales Discounts 80
Accounts Receivable/Comet 8,000
$10,000 sale - $2,000 return = $8,000 owed
$8,000 * 1% = $80 discount
$8,000 owed - $80 discount = $7,920 received
Inventory Shrinkage

When a company takes a physical count of its inventory, should it reasonably expect to
find all of the inventory items present and accounted for? Unfortunately, this is not
always the case. Inventory could have been stolen (e.g. shoplifting) or damaged,
disposed of and not reported as such (e.g. the inventory fell off the shelf in the
warehouse, was damaged by the fall and was disposed of by the cleaning crew).
Although companies try to protect their inventory through proper internal controls,
inventory losses or shrinkage still occur. Under the matching principle, these losses are
recorded as expenses in the period in which they occur to match them against the
revenue earned. Although the text suggests that they should be recorded as cost of
goods sold, in practice they may be recorded in a separate inventory shrinkage expense
account reported within cost of goods sold.

Example: The balance in the Merchandise Inventory account in the general ledger was
$300,000 before adjustment. A Physical Inventory was taken and the value of the
merchandise on hand was $294,000.

Adjusting entry required:

Cost of Merchandise Sold 6,000
Merchandise Inventory 6,000


Multi-Step Income Statement

The Multi-Step Income statement provides a substantial amount of additional significant
information to the user of the financial statements. It also incorporates revenues and
expenses unique to the merchandising company versus a service provider.

Key changes compared to the single-step income statement include:
-to-Net Sales to account for contra-revenue accounts

merchandise sold that is available to cover operating expenses

to provide an additional level detail

being in business

related to the companys reason for being in business Revised Fall 2012
Page 11 of 25

and expenses and Net Income. It is excluded in this illustration and in the
textbook for simplicity.

Gross Sales $500,000
- Sales Returns & allow. $5,000
- Sales Discounts 3,000 8,000
Net Sales 492,000
Cost of Merchandise Sold 294,000
Gross Profit 198,000
Operating Expenses:
Selling Expenses 50,000
Admin Expense 45,000
Total Operating Expenses 95,000
Income from Operations 103,000
Other Income:
Interest Revenue 1,000
Other Expenses:
Interest Expense 700 300
Net Income $102,700

Practice Problem #3
Using the format for the multi-step income statement, compute the following:
a. Calculate Net Sales and Gross Profit if, Sales are $375,000, Sales Returns and
Allowances are $32,000, Sales Discounts are $12,000 and Cost of Merchandise
Sold is $255,000.
b. Calculate Sales Returns and Allowances and Cost of Merchandise Sold if,
Sales are $750,000, Sales Discounts are $9,000, Net Sales are $736,000 and
Gross Profit is $310,000.
c. Calculate Sales and Net Sales if, Sales Returns and Allowances are $25,000,
Sales Discounts are $15,000, Cost of Merchandise Sold is $620,000 and Gross
Profit is $185,000.
Practice Problem #3

a) Sales $375,000
- Sales Returns & Allowances (32,000)
- Sales Discounts (12,000)
Net Sales 331,000
-Cost of Merchandise Sold (255,000)
Gross Profit $76,000

b) Sales $750,000 750,000 x 9,000 = 736,000
- Sales Returns &
Allowances x 741,000 x = 736,000
- Sales Discounts (9,000) x = 5,000
Net Sales 736,000 736,000 y = 310,000
- Cost of
Merchandise Sold y y = 426,000
Gross Profit $310,000

c) Sales X x 25,000 15,000 = y
- Sales Returns &
Allowances (25,000)
- Sales Discounts (15,000) y 620,000 = 185,000
Net Sales Y y = 805,000
- Cost of
Merchandise Sold (620,000) x = 845,000
Gross Profit 185,00
Page 12 of 25

Practice Problem #4
Journalize the following related transactions.

a) Purchased mdse on account from Blitzen Co., list price $20,000,
trade discount 25%, terms FOB shipping point, 2/10, n/30, with
prepaid transportation costs of $650 added to the invoice.
b) Purchased merchandise on account from Cupid Co., $8,000, terms
FOB destination, 1/10, n/30.
c) Sold merchandise on account to Donner Co., $9,800, terms 2/10,
n/30. The cost of the merchandise sold was $5,800.
d) Returned $2,000 of merchandise purchased from Cupid Co. (b)
e) Paid Blitzen Co. on account for purchase in (a) less discount.
f) Received merchandise returned by Donner Co. from sale in (c),
$1,800. The cost of the merchandise returned was $1,080.
g) Paid Cupid Co. on account for purchase in (b) less return (d) and
discount.
h) Received cash on account from Donner Co. for sale in (c) less
return (f) and discount.
i) Perpetual inventory records indicate that $85,000 of merchandise
should be on hand. The physical inventory indicates that $81,350
Practice Problem #4

a. Merchandise Inventory 15,650
Accounts Payable/Blitzen 15,650
(20,000 * 25%) = $5,000 discount
(20,000 5,000 + 650 shipping)

b. Merchandise Inventory 8,000
Accounts Payable/Cupid 8,000

c. Accounts Receivable/Donner 9,800
Sales 9,800
Cost of Merchandise Sold 5,800
Merchandise Inventory 5,800

d. Accounts Payable/Cupid 2,000
Merchandise Inventory 2,000

e. Accounts Payable/Blitzen 15,650
Cash 15,350
Merchandise Inventory 300
(15,000 mdse * 2% = $300 disc.)

f. Sales Returns & Allowances 1,800
A/R Donner 1,800
Merchandise Inventory 1,080
Cost of Merchandise Sold 1,080

g. Accounts Payable/Cupid 6,000
Cash 5,940
Merchandise Inventory 60
(8,000 2,000 return = 6,000 bal.)
(6,000 * 1% = $60 discount)

h. Cash 7,840
Sales Discount 160
A/R Donner 8,000
(8,000 * 2% = $160 discount)
(9,800 1,800 return = 8,000 bal.)

i. Cost of Merchandise Sold 3,650
Merchandise Inventory 3,650
(85,000 81,350 = 3,650)
oSOLUTIONS TO PRACTICE PROBLEMS

Practice Problem #1

a) Merchandise Inventory 4,200
A/P 4,200

b) A/P 500
Merchandise Inventory 500

c) A/P 3,700
Cash 3,630
Merchandise Inventory 70f merchandise is on hand
Cost of goods available for sale, cost of goods sold (COGS), gross margin, inventory; selling and
administrative expenses; multi-step income statement and single-step income statement.
1. Definition of inventory
We have talked about businesses that provide services. However, there are other types of businesses
and one of them is a merchandising company. Merchandising companies create a supply of goods that
are delivered to customers. This supply is called inventory:
Inventory is a current asset on a company's balance sheet. Inventory includes goods for resale, raw
materials, spare parts, etc.
Inventory usually includes goods that are being made (in the process of being produced) and goods that
are finished and ready for sale.
Merchandise inventory is goods that are held for resale by a merchandising company.
Inventory for resale is accounted for in the Merchandise Inventory account. This is an asset account
shown in the assets section of the balance sheet.
2. Inventory costs. Product and period costs
All costs related to acquiring goods and making them ready for sale are accumulated in the Merchandise
Inventory account. Such costs are associated with products and often called product costs:
Product costs are costs required to produce inventory and make it ready for sale. Such costs are directly
associated with the inventory production.
Product costs are expensed in the period when inventory is sold regardless of when the inventory was
purchased or produced by a company.
There are a few types of expenditures that cannot be directly traced to a specific product. Such costs
include (but are not limited to) advertising, administrative salaries, insurance, etc. Such costs are
called selling and administrative expenses:
Selling and administrative expenses are expenses of selling and administrative nature that are not
directly traceable to a specific product. Examples are advertising, administrative salaries and insurance,
among others.
Because selling and administrative expenditures are expensed in the period in which they are incurred,
they are labeled period costs:
Period costs are costs associated with a specific period and not a specific product. Period costs include
selling and administrative expenses.
3. Cost of goods available for sale and cost of goods sold
The total inventory cost for a given accounting period is calculated by adding the beginning inventory
account balance to the amount of inventory acquired during the period. The result of adding these two
numbers is called a cost of goods available for sale:
Cost of goods available for sale is the cost of goods acquired during a period plus the cost of goods on
hand at the beginning of the period. This cost represents all inventories available for sale during the
period.
The cost of goods available for sale is allocated between the Merchandise Inventory account and an
expense account called Cost of Goods Sold. At a period end, inventory that was not sold during the
period is shown as an asset on the balance sheet (Merchandise Inventory) and inventory that was sold is
shown as an expense on the income statement (Cost of Goods Sold).
Cost of goods sold (COGS) is the difference between the cost of goods available for sale and the cost
of goods on hand at a period end. This cost represents the cost of goods sold by the company during the
period.
Gross margin is the difference between the sales revenue (i.e., revenue generated from sales) and the
cost of goods sold. Gross margin shows what profit the company made after the cost of goods sold, but
before any other expenses (selling and administrative, etc.).
Operating income is the difference between the gross margin and selling and administrative expenses.
Sales
Less: Cost of Goods Sold
Gross Margin
Less: Selling and Administrative Expenses
Operating Income
4. Perpetual and periodic inventory systems
There are two inventory accounting systems - perpetual and periodic:
Perpetual inventory system means that the Inventory account is adjusted perpetually. The Inventory
account is affected each time inventory is sold or purchased.
Periodic inventory system only adjusts the Inventory account at the end of an accounting period.
Purchases and sales do not affect the Inventory account during the accounting period, but do affect at the
period end.
Although both systems have different approaches to inventory accounting, they are to provide the same
results. The cost of goods sold amount and the sales amount should be the same regardless which
system a company applies.
5. First illustration of accounting for inventory (period 1)
In our example, we will follow the rules of the perpetual inventory system. Under the perpetual inventory
system sales and purchases of inventory are recorded directly to the Merchandise Inventory account
when they take place. The accounting events below refer to a bookstore business called Dav's Books that
was opened in 20X6:
1. The owner contributed $3,000 of inventory and $9,000 cash to the business.
2. $4,000 cash was paid to purchase additional inventory.
3. $200 cash was paid for the inventory transportation (see Event No. 2) from the vendor to the
bookstore.
4. Inventory that cost $2,000 was sold for $5,500 cash.
5. Transportation expenses of $300 to deliver the sold goods (see Event No. 4) were incurred and
paid with cash.
6. $400 of selling expenses were incurred and paid with cash.
5.1. Analysis of capital contribution transaction
Event No. 1: The owner made a combined capital contribution that consisted of cash and inventory. Cash
($9,000), Inventory ($3,000), and Contributed Capital (totally, $12,000) increase. This is an asset source
transaction:
Illustration 1: Effect of capital contribution
Event
No.
Balance Sheet Income Statement
Cash
Flows
Cash + Inv. =
Cont.
Cap.
+
Ret.
Earn.
Rev. - Exp. =
Net
Inc.
Beg. $ 0 + $ 0 = $ 0 + $ 0 $ 0 - $ 0 = $ 0
1 9,000 + 3,000 = 12,000 + n/a n/a - n/a = n/a 9,000 FA
End. 9,000 + 3,000 = 12,000 + 0 0 - 0 = 0
5.2. Analysis of inventory acquisition transaction
Event No. 2: The Merchandise Inventory account increased when the $4,000 inventory purchase was
made. Inventory increased and cash decreased. This is an asset exchange transaction:
Illustration 2: Effect of inventory acquisition
Event
No.
Balance Sheet Income Statement
Cash Flows
Cash + Inv. =
Cont.
Cap.
+
Ret.
Earn.
Rev. - Exp. =
Net
Inc.
Beg. 9,000 + 3,000 = 12,000 + 0 0 - 0 = 0
2 (4,000) + 4,000 = n/a + n/a n/a - n/a = n/a (4,000) OA
End. 5,000 + 7,000 = 12,000 + 0 0 - 0 = 0
5.3. Analysis of transportation-in costs
Event No. 3: Recall that all expenses incurred to deliver goods and make them ready for sale are treated
as part of inventory costs and recorded in the Merchandise Inventory account. So, the transportation
costs related to the delivery of inventory from the vendor to the bookstore are recorded in
the Merchandise Inventoryaccount. This transportation expense is called transportation-in:
Transportation-in expenditures are costs incurred to deliver inventory from a vendor (supplier) to a
company. Transportation-in costs are treated as part of the inventory costs (product costs).
The transaction acts to increase merchandise inventory and to decrease cash. This is an asset exchange
transaction:
Illustration 3: Effect of transportation-in costs
Event Balance Sheet Income Statement Cash Flows
No.
Cash + Inv. =
Cont.
Cap.
+
Ret.
Earn.
Rev. - Exp. =
Net
Inc.
Beg. 5,000 + 7,000 = 12,000 + 0 0 - 0 = 0
3 (200) + 200 = n/a + n/a n/a - n/a = n/a (200) OA
End. 4,800 + 7,200 = 12,000 + 0 0 - 0 = 0
5.4. Analysis of inventory sale transaction
Event No. 4: This event is composed of two parts. The first one (4a in the table below) is the recognition
of sales revenue. Cash and Retained Earnings increase by $5,500. Transaction 4a is an asset source
transaction. The second part (4b) is designed to record the cost of goods sold. Remember that goods are
only expensed at the point of sale (under the perpetual system). Accordingly, $2,000 should be removed
from the Merchandise Inventory account and placed to the expense account called Cost of Goods Sold.
Transaction 4b is an asset use transaction.
Illustration 4: Effects of inventory sale
Event
No.
Balance Sheet Income Statement
Cash Flows
Cash + Inv. =
Cont.
Cap.
+
Ret.
Earn.
Rev. - Exp. =
Net
Inc.
Beg. 4,800 + 7,200 = 12,000 + 0 0 - 0 = 0
4a 5,500 + n/a = n/a + 5,500 5,500 - n/a = 5,500 5,500 OA
4b n/a + (2,000) = n/a + (2,000) n/a - (2,000) = (2,000)
End. 10,300 + 5,200 = 12,000 + 3,500 5,500 - (2,000) = 3,500
5.5. Analysis of transportation-out expenses
Event No. 5: The cash expenditure made by the bookstore to deliver goods to the customer is
calledtransportation-out:
Transportation-out expenditures are expenses incurred to deliver products from a company to a
customer. Transportation-out expenditures are treated as period costs and expensed in the period of
incurrence.
The company records transportation-out expenditures as an operating expense. This is an asset use
transaction:
Illustration 5: Effect of transportation-out expenses
Event
No.
Balance Sheet Income Statement
Cash
Flows
Cash + Inv. =
Cont.
Cap.
+
Ret.
Earn.
Rev. - Exp. =
Net
Inc.
Beg. 10,300 + 5,200 = 12,000 + 3,500 5,500 - (2,000) = 3,500
5 (300) + n/a = n/a + (300) n/a - (300) = (300) (300) OA
End. 10,000 + 5,200 = 12,000 + 3,200 5,500 - (2,300) = 3,200
5.6. Analysis of selling expenses transaction
Event No. 6: The $400 cash payment for selling expense has the same effect as operating expenses do.
Cash and Retained Earnings decrease. This is an asset use transaction:
Illustration 6: Effect of selling expenses
Event
No.
Balance Sheet Income Statement
Cash
Flows
Cash + Inv. =
Cont.
Cap.
+
Ret.
Earn.
Rev. - Exp. =
Net
Inc.
Beg. 10,000 + 5,200 = 12,000 + 3,200 5,500 - (2,300) = 3,200
6 (400) + n/a = n/a + (400) n/a - (400) = (400) (400) OA
End. 9,600 + 5,200 = 12,000 + 2,800 5,500 - (2,700) = 2,800
. Comparison of the periodic and perpetual inventory systems
The periodic inventory system is known to be used more frequently than the perpetual one. The reason is
simple. It is easier to make a few period-end adjusting entries than to adjust accounting records every
time a sale or purchase is made (for example, grocery store sales are very frequent). Under the periodic
system the cost of goods sold is determined at the end of the period. Purchases or sales of inventory do
not affect the inventory account during the period. When goods are purchased, the cost is recorded in the
Purchases (Inventory Purchases) account. When goods are sold, a reduction in the Inventory account
does not take place. Transportation-out expenditures, purchase returns, and allowances are recorded in
separate accounts. The cost of goods sold is calculated by subtracting the amount of ending inventory
from the total cost of goods available for sale (see the table below). The ending inventory is determined
by performing a period end physical count.
The schedule of cost of goods sold helps in performing these computations:
Illustration 13: Schedule of cost of goods sold
Beginning Inventory
Plus: Purchases
Plus: Transportation-in
Less: Purchase Returns and Allowances
Less: Purchase Discounts
Cost of Goods Available for Sale
Less: Ending Inventory
Cost of Goods Sold
However, there is one weak point about the periodic system which relates to lost, damaged, or stolen
merchandise. Because the periodic system determines the cost of goods sold and the ending inventory at
the end of the period, it is impossible, during the period, to figure out whether there were any goods
stolen, damaged, or lost. It is rather difficult even at the period end because all goods not available at
hand are considered sold.
At the same time, it is quite easy to figure out damaged, lost, or stolen goods if a company employs
the perpetual system. A simple comparison of the physically counted merchandise on hand at the end of
the period and the book balance of the Merchandise Inventory account will do the job. If there is a
difference between the two, then some goods were damaged, stolen, or lost. In such a case an adjusting
entry is needed to record the goods not available any more. The adjusting entry acts to decrease assets
and equity. The equity is decreased by increasing an expense account called Inventory Loss (or
sometimes directly increasing the Cost of Goods Sold account). The assets are decreased by reducing
the Inventory account.
For example, let us assume a company applies the perpetual inventory system and has the book balance
of the Merchandise Inventory account of $1,500. The physical count at the end of the period showed that
only $1,300 of goods was on hand. The inventory loss of $200 ($1,500 - $1,300) should be recorded as
follows:
Illustration 14: Effect of recording inventory loss in the horizontal model
Assets = Liabilities + Equity Rev. - Exp. = Net Inc. Cash Flow
(200) = n/a + (200) n/a - (200) = (200) n/a
The entry in the general journal looks like this:
Illustration 15: Journal entry to record the inventory loss
Event No Account titles Debit Credit
1 Inventory Loss (Cost of Goods Sold) 200
Inventory 200
Perpetual vs. Periodic Inventory System
Journal Entries
A. The Sale and Purchase of Products
Perpetual inventory systems show all changes in inventory in
the "Inventory" account. Purchase accounts are not used in
a perpetual inventory system.
Periodic inventory systems keep the inventory balance at the
same value that it was at the beginning of the year. At year
end, the inventory balance is adjusted to a physical count.
To account for inventory purchases in a periodic inventory
system, an account called "Purchases" is used rather than
debiting "Inventory".
Example: (Unit cost is held constant to avoid the necessity of a using
a cost flow assumption)

Beginning inventory 100 units @ $6 = $ 600
Purchases 900 units @ $6 = $5,400
Sales 600 units @ $12 = $7,200
Ending inventory 400 units @ $6 = $2,400


Perpetual Inventory System | Periodic Inventory System
----------------------------------------------------------------------
1. Beginning inventory 100 units at $600
----------------------------------------------------------------------
Inventory account shows | Inventory account shows
$600 in inventory. | $600 in inventory.
----------------------------------------------------------------------
2. Purchase of 900 units at $6 per unit
----------------------------------------------------------------------
Inventory 5,400 | Purchases 5,400
Acc. Payable 5,400| Acc. Payable 5,400
----------------------------------------------------------------------
3. Sale of 600 units at a selling price of $12 per unit
----------------------------------------------------------------------
Acc. Receivable 7,200 | Acc. Receivable 7,200
Sales 7,200| Sales 7,200
|
Cost of Goods Sold 3,600 | No entry
Inventory 3,600|
----------------------------------------------------------------------
4. End-of-period entry for inventory adjustment
----------------------------------------------------------------------
No entry needed. | Inventory 1,800
The ending balance of inventory | Cost of Goods Sold 3,600
shows $2,400. | Purchases 5,400
----------------------------------------------------------------------
Note: The periodic inventory adjustment in transaction 4 adjusts
inventory to the physical count, closes out any purchase
accounts,
and runs any difference through cost of goods sold.

B. Cost of Goods Sold in a Periodic Inventory System
Perpetual inventory systems record cost of goods sold and
keep inventory at its current balance throughout the year.
Therefore, there is no need to do a year-end inventory
adjustment unless the perpetual records disagree with the
inventory count. In addition, a separate cost of goods sold
calculation is unnecessary since cost of goods sold is
recorded whenever inventory is sold.
The inventory account in a periodic inventory system keeps
its beginning balance until the end of period adjustment to
the physical inventory count. Therefore, a separate cost of
goods sold calculation is necessary. The following calculation
shows the calculation for the preceding example.
Beginning Inventory 600
Net Purchases 5,400
-------
Goods Available for Sale 6,000
Ending Inventory 2,400
-------
Cost of Goods Sold 3,600
=======
C. Purchase Returns and Allowances and Purchase
Discounts
"Purchases" has a normal debit balance since it replaces the
debit to "Inventory". It has two contra accounts known as
"Purchase Discounts" (Purch. Disc.) and "Purchase Returns
and Allowances" (Purch. R&A) that reduce it to determine
"Net Purchases". The balance of these two contra accounts
is a credit because "Purchases" is a debit. Remember that
contra accounts always have a normal balance that is
opposite to what they are contra to. Purchase-type accounts
are temporary accounts (i.e., they are closed at year end)
and only appear in a periodic inventory system. They simply
serve to replace the corresponding inventory portion of an
entry that exists in a perpetual inventory system. The
following entries illustrate purchase returns and discounts in
perpetual and periodic inventory systems:

Perpetual Inventory System | Periodic Inventory System
-----------------------------------------------------------------------
1. Ace Company returned $600 of damaged merchandise and received a
price reduction allowance of $100 on the portion of the merchandise
they retained.
-----------------------------------------------------------------------
Acc. Payable 700 | Acc. Payable 700
Inventory 700 | Purch. R&A 700
-----------------------------------------------------------------------
2. In a previous transaction, Ace purchased merchandise on account at
a cost of $1,000. The credit terms were 2/10, n/30. Ace paid for
the merchandise within the discount period.
-----------------------------------------------------------------------
Acc. Payable 1,000 | Acc. Payable 1,000
Inventory 20 | Purch. Disc. 20
Cash 980 | Cash 980
-----------------------------------------------------------------------

D. Sales Returns and Allowances and Sales Discounts
Sales has two contra accounts known as "Sales Discounts"
(Sales Disc.) and "Sales Returns and Allowances" (Sales
R&A) that reduce it. The normal balance for these two
contra accounts is a debit. Sales and its contra accounts may
appear with either a perpetual or periodic inventory system.
The following entries illustrate the accounts in perpetual and
periodic inventory systems. The entries assume the gross
method.

Perpetual Inventory System | Periodic Inventory System
-----------------------------------------------------------------------
1. Sam Company received $600 of damaged merchandise from their
customer
Ace. They also gave Ace a $100 allowance for some of the damaged
merchandise that Ace retained. The original cost of the
merchandise
returned to Sam was $400.
-----------------------------------------------------------------------
Sales R&A 700 | Sales R&A 700
Acc. Receivable 700 | Acc. Receivable 700
|
Inventory 400 | No entry
Cost of Goods Sold 400 |
-----------------------------------------------------------------------
2. Sam received a customer payment for a prior sale on account of
$1,000
subject to credit terms of 2/10, n/30. The customer made payment
within the discount period.
-----------------------------------------------------------------------
Cash 980 | Cash 980
Sales Disc. 20 | Sales Disc. 20
Acc. Receivable 1,000| Acc. Receivable 1,000
-----------------------------------------------------------------------
Sales on the income statement should be shown net of its
contra accounts. For example, if a company has $980,000 in
sales, $3,400 in sales returns and allowances, and $2,200 in
sales discounts; net sales would be $974,400.
. The FIFO Method
The FIFO method considers the oldest goods sold first. The
ending inventory consists of the newer purchases. During times
of rising prices, FIFO will result in a higher ending inventory
value and a lower cost of goods sold (i.e., in comparision to
LIFO).
B. The LIFO Method
The LIFO method considers the most recent purchases as being
sold first. The ending inventory consists of the older purchases.
During times of rising prices, LIFO will result in a lower ending
inventory and a higher cost of goods sold (i.e., in comparison to
FIFO)
C. Computing Cost of Goods Sold in a Periodic Inventory
System
The calculations can be broken down into three basic parts:(1)
determine goods available for sale, (2) determine the value of
ending inventory, and (3) determining cost of goods sold.


Example:

Beginning Inventory, Jan. 1
10 units @ $20 per unit

Purchases:
Jan 10 8 units @ $21 per unit
Jan 30 10 units @ $22 per unit

Sales:
Jan 4 7 units
Jan 22 4 units
Jan 28 2 units


Step 1: Determine Goods Available for Sale

Units Cost
Total
----- ----- --
---
Beginning Inventory 10 x $20 =
$200
Jan 10 Purchases 8 x $21 =
$168
Jan 30 Purchases 10 x $22 =
$220
----- --
---
Goods available for sale 28
$588
=====
=====

Step 2: Determine Ending Inventory (28 units available - 13
units sold = 15)

A. FIFO

Units Cost
Total
----- ----- --
---
10 x $22 =
$220
5 x $21 =
$105
----- --
---
15
$325
=====
=====
A. LIFO

Units Cost
Total
----- ----- --
---
10 x $20 =
$200
5 x $21 =
$105
----- --
---
15
$305
=====
=====

Step 3: Determine Cost of Goods Sold

FIFO LIFO
------ -----
-
Goods Available for Sale $588 $588
Less Ending Inventory 325 305
------ -----
-
Cost of Goods Sold $263 $283
======
======