Chap 006 Notes

6-1
Chapter
MERCHANDISING ACTIVITIES
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2005
Operating Cycle of a Merchandising Company
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The operating cycle of a business is the time it takes

the business to start with cash, purchase inventory, sell the inventory, and finally collect the cash from customers.
The operating cycle of a business that sells inventory

on credit is typically longer than that of a business that sells only on a cash basis. This additional time is due to time between when the customer buys the inventory and the time the customer pays off the account receivable.
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Operating Cycle of a Merchandising Company
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Cash
Accounts Receivable
Inventory
2. Sale of merchandise on account
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Comparing Merchandising Activities with Manufacturing Activities

Purchase inventory in ready-to-sell condition.
Manufacture inventory and have a longer and more complex operating cycle.
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McGraw-Hill/Irwin
Merchandising Company
Manufacturing Company
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Retailers and Wholesalers
Wholesalers buy merchandise from several different manufacturers and then sell this merchandise to several retailers.
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Retailers sell merchandise directly to the public. The McGraw-Hill Companies, Inc., 2005
Income Statement of a Merchandising Company

The income statements of merchandising companies
will have an additional expense item called Cost of Goods Sold. The Cost of Goods Sold account represents the cost of the merchandise sold during the period to help earn revenue.
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Cost of Goods Sold is presented as a separate expense

item on the income statement. Net Sales minus Cost of Goods Sold equals Gross Profit. Gross Profit is the amount left, after subtracting the cost of the inventory sold, to cover all other expenses and a profit .
McGraw-Hill/Irwin
Income Statement of a Merchandising Company

Computer Barn Condensed Income Statement For the Year Ended December 31, 2005 Revenue from sales $ 900,000 Less: Cost of goods sold 540,000 Gross profit $ 360,000 Less: Expenses 270,000 Net income $ 90,000
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Cost of goods sold represents the expense of goods that are sold to customers.
McGraw-Hill/Irwin
Gross profit is a useful means of measuring the profitability of sales transactions.Companies, Inc., 2005 The McGraw-Hill
Accounting Systems Requirements for Merchandising Companies

Although general ledger accounts provide useful information, they do not provide much of the detailed information needed in the daily business operations.
General Ledger Accounts Receivable Debit Credit Balance 10,000 3,000 10,000 7,000
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Date 2001 June 1 15

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Who owes us money?
Accounting Systems Requirements for Merchandising Companies

Control Account Subsidiary Ledgers
Subsidiary Ledger Jake Sparks Debit Credit 3,000
Date 2001 June 1 15
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General Ledger Accounts Receivable Debit Credit Balance 10,000 3,000 10,000 7,000
Date 2001 June 1 15
Balance 3,000 2,000
Date 2001 June 1 7,000 McGraw-Hill/Irwin 15
1,000 Subsidiary Ledger Heather Jacobs Debit Credit Balance
2,000
7,000 5,000
Two Approaches Used in Accounting for Merchandise Transactions
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Perpetual Inventory System
Periodic Inventory System
McGraw-Hill/Irwin
Two Approaches Used in Accounting for Merchandise Transactions
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In the past, both systems were in widespread use. Today, however, the growing use of computerized accounting systems has
made the perpetual approach very easy and cost-effective to implement. Thus, the periodic approach is used primarily by very small businesses with manual accounting systems. Before we examine perpetual and periodic inventory systems, it is important to realize that accounting for inventory is similar to accounting for the prepaid expenses we discussed in chapter 4 (for example, office supplies, unexpired insurance policies, prepaid rent, etc.). As inventory is purchased, it is initially reported as an asset in the balance sheet. As it is sold to customers, this asset is converted to an expense, specifically, the cost of goods sold. Both perpetual and periodic inventory systems account for the flow of inventory costs from the balance sheet to the income statement.
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Perpetual Inventory Systems

The inventory account is continuously updated to reflect items on hand.
Lets look at some entries!

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On September 5, Worley Co. purchased 100 laser lights for resale for $30 per unit from Electronic City on account.
GENERAL JOURNAL
Date Account Titles and Explanation Accounts Payable (Electronic City) Debit 3,000 3,000 Credit
Sept. 5 Inventory
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On September 10, Worley Co. sold 10 laser lights for $50 per unit on account to ABC Radios.
GENERAL JOURNAL
Date Account Titles and Explanation Sales 10 Cost of Goods Sold
McGraw-Hill/Irwin
10 $30 = $300
Debit 500 500 300
Credit
Sept. 10 Accounts Receivable (ABC Radios)
Inventory
300
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On September 10, Worley Co. sold 10 laser lights for $50 per unit on account to ABC Radios.
GENERAL JOURNAL
Date Account Titles and Explanation Sales 10 Cost of Goods Sold
McGraw-Hill/Irwin
Retail
Debit 500 500 300 Credit
Inventory
Cost
300
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On September 15, Worley Co. paid Electronic City $3,000 for the September 5 purchase.
GENERAL JOURNAL
Date Account Titles and Explanation Cash Debit 3,000 3,000 Credit
Sept. 15 Accounts Payable (Electronic City)
McGraw-Hill/Irwin
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On September 22, Worley Co. received $500 from ABC Radios as payment in full for their purchase on September 10.
GENERAL JOURNAL
Date Account Titles and Explanation Accounts Receivable (ABC Radios) Debit 500 500 Credit
Sept. 22 Cash
McGraw-Hill/Irwin
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Taking a Physical Inventory

In order to ensure the accuracy of their perpetual records, most businesses take a complete physical count of the merchandise on hand at least once a year.
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Taking a Physical Inventory

Reasonable amounts of inventory shrinkage are viewed as a normal cost of doing business. Examples include breakage, spoilage and theft.
On December 31, Worley Co. counts its inventory. An inventory shortage of $2,000 is discovered.
GENERAL JOURNAL
Date Account Titles and Explanation Inventory
McGraw-Hill/Irwin
Debit 2,000
Credit 2,000
Dec. 31 Cost of Goods Sold
Closing Entries in a Perpetual Inventory System

Close Revenue accounts
(including Sales) to Income Summary. The closing entries are the same!
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Close Expense accounts

(including Cost of Goods Sold) to Income Summary.
Close Income Summary

account to Retained Earnings.
Close Dividends to
McGraw-Hill/Irwin
Retained Earnings.
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Next is the periodic inventory system!
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Periodic Inventory Systems

No effort is made to keep up-to-date records of either inventory or cost of goods sold. Only on a periodic basis are these two accounts updated.
Lets look at some entries!

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On September 5, Worley Co. purchased 100 laser lights for resale for $30 per unit from Electronic City on account.
Notice that no entry is made to Inventory. GENERAL JOURNAL
Date Account Titles and Explanation Accounts Payable (Electronic City) Debit 3,000 3,000 Credit Sept. 5 Purchases
McGraw-Hill/Irwin
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On September 10, Worley Co. sold 10 laser lights for $50 per unit on account to ABC Radios. Under the periodic inventory system, a sale of inventory requires only one entry: a debit to Accounts Receivable and a credit to Sales for the retail amount of the sale, which in this case is five hundred dollars. The cost entry that we made under the perpetual inventory system is not required because the periodic system does not attempt to keep the inventory and cost of good sold accounts up to date.
GENERAL JOURNAL
Date Account Titles and Explanation Sales Debit
Retail
Credit 500
500
McGraw-Hill/Irwin
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On September 15, Worley Co. paid Electronic City $3,000 for the September 5 purchase. This entry is the same as under the perpetual inventory system. Worley Company would debit Accounts Payable and credit Cash for three thousand dollars.
GENERAL JOURNAL
Date Account Titles and Explanation Cash Debit 3,000 3,000 Credit
Sept. 15 Accounts Payable (Electronic City)
McGraw-Hill/Irwin
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On September 22, Worley Co. received $500 from ABC
Radios as payment in full for their purchase on September 10. This entry is also the same as under the perpetual inventory system. Worley Company would debit Cash and credit Accounts Receivable for five hundred dollars.
GENERAL JOURNAL
Date Account Titles and Explanation Accounts Receivable (ABC Radios) Debit 500 500 Credit
Sept. 22 Cash
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Computing Cost of Goods Sold.

Because the periodic system does not maintain a cost of good sold account, at the end of the period, cost of goods sold must be calculated.
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The accounting records of Party Supply show the following:

Inventory, Jan. 1, 2005 $ 14,000
Purchases (during 2005) 130,000

At December 31, 2005, Party Supply counted the merchandise on hand at $12,000. Calculate Party Supplys cost of goods sold for 2005. The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin
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Computing Cost of Goods Sold
Cost of Goods Sold can be calculated as follows:

Inventory (beginning of the year) Add: Purchases Cost of goods available for sale Less: Inventory (end of year) Cost of goods sold
McGraw-Hill/Irwin
$ 14,000 130,000 144,000 12,000 $ 132,000
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Creating a Cost of Goods Sold Account

Now, Party Supply must create the Cost of Goods Sold account. This is accomplished by zeroing out the balances in the related accounts that have a debit balance, namely the beginning inventory balance and the Purchases account. So, we credit the Purchases account for its balance and we credit the Inventory account for its beginning balance. This part of the entry creates a zero balance in each of these accounts. The related debit is for the total to the Cost of Goods Sold account. Now, we still have one more entry to make to finish this process.
GENERAL JOURNAL
Date Account Titles and Explanation Inventory (beginning of year) Purchases
McGraw-Hill/Irwin
Debit 144,000
Credit 14,000 130,000
Dec. 31 Cost of Goods Sold
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Creating a Cost of Goods Sold Account

Now, Party Supply must record the ending inventory amount. The second entry records the physical count in the Inventory account and adjusts the balance in the Cost of Goods Sold account. After this entry, the Inventory account balance reflects the ending inventory amount and the Cost of Goods Sold balance reflects the calculated cost of goods sold amount.
GENERAL JOURNAL
Date Account Titles and Explanation Cost of Goods Sold
McGraw-Hill/Irwin
Debit 12,000
Credit 12,000
Dec. 31 Inventory (end of year)
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Completing the Closing Process

Close Revenue accounts
(including Sales) to Income Summary. The closing entries are the same!
Close Expense accounts

(including Cost of Goods Sold) to Income Summary.
Close Income Summary

account to Retained Earnings.
Close Dividends to
McGraw-Hill/Irwin
Retained Earnings.
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Selecting an Inventory System

Factors Suggesting a Perpetual Inventory System Large company with professional management. Management and employees wanting information about items in inventory and the quantities of specific products that are selling. Factors Suggesting a Periodic Inventory System Small company, run by owner. Accounting records of inventories and specific product sales not needed in daily operations; such information developed primarily for use in annual income tax returns. Inventory with many different kinds of low-cost items. High volume of sales transactions and a manual accounting system. Lack of full-time accounting personnel.
Items in inventory with a high per-unit cost. Low volume of sales transactions or a computerized accounting system. Merchandise stored at multiple locations or in warehouses separate from sales sites.
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All merchandise stored at the sales site.
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Credit Terms and Cash Discounts

When manufacturers and wholesalers sell their products on account, the credit terms are stated in the invoice. Cash discounts are provided to customers as a incentive for them to pay early. The credit period is the normal period of time the company allows for customers to extend their account receivable, typically 30 or 60 days. The discount period is a much shorter period of time, typically 10 or 15 days. If payment is received during the discount period, a discount may be taken. If payment is made after the discount period expires, then the full payment is due on or before the end of the credit period.
2/10, n/30
Read as: Two ten, net thirty
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Credit Terms and Cash Discounts
2/10, n/30
Percentage of Discount # of Days Discount Is Available Otherwise, the Full Amount Is Due # of Days when Full Amount Is Due
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Recording Purchases at Net Cost
Many companies plan to take advantage of cash

discounts offered so they go ahead and record their purchases net of the discount. Since they typically take the discount, this process simplifies future entries. If a cash discount is not taken in the future, then a purchase discounts lost account is used.
Lets see how these entries work.
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Purchases are recorded at their net amounts.
Net Method
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Purchase Discounts Lost are recorded when payment is made outside the discount period. Companies, Inc., 2005 The McGraw-Hill
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On July 6, Play Clothes purchased $4,000 of merchandise on credit with terms of 2/10, n/30 from Kids Clothes. Prepare the journal entry for Play Clothes.
GENERAL JOURNAL
Date Account Titles and Explanation Debit Credit
McGraw-Hill/Irwin
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GENERAL JOURNAL
Date Account Titles and Explanation Accounts Payable (Kid's Clothes)
McGraw-Hill/Irwin
Debit 3,920
Credit 3,920
July 6 Inventory
$4,000 98% = $3,920
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On July 15, Play Clothes pays the full amount due to Kids Clothes. Prepare the journal entry for Play Clothes.
GENERAL JOURNAL
McGraw-Hill/Irwin
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GENERAL JOURNAL
Date Account Titles and Explanation Cash
McGraw-Hill/Irwin
Debit 3,920
Credit 3,920
July 15 Accounts Payable (Kid's Clothes)
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Now, assume that Play Clothes waited until July 20 to pay the amount due in full to Kids Clothes. Prepare the journal entry for Play Clothes.
GENERAL JOURNAL
McGraw-Hill/Irwin
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Now, assume that Play Clothes waited until July 20 to pay the amount due in full to Kids Clothes. Prepare the journal entry for Play Clothes.
GENERAL JOURNAL Nonoperating Expense
Date Account Titles and Explanation Purchase Discounts Lost Cash
McGraw-Hill/Irwin
Debit 3,920 80
Credit
4,000
Recording Purchases at Gross Invoice Price

Purchases are recorded at their gross amounts.
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Gross Method
McGraw-Hill/Irwin
Purchase discounts taken are recorded when payment is made inside the discount period. Companies, Inc., 2005 The McGraw-Hill

GENERAL JOURNAL
Date Account Titles and Explanation Debit
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Credit
McGraw-Hill/Irwin

GENERAL JOURNAL
Date Account Titles and Explanation Accounts Payable (Kid's Clothes)
McGraw-Hill/Irwin
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Debit 4,000
Credit 4,000
July 6 Inventory

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GENERAL JOURNAL
McGraw-Hill/Irwin

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Reduces Cost of $4,000 98% = $3,920 GENERAL JOURNAL Goods Sold

Date Account Titles and Explanation Cash Purchase Discounts Taken
McGraw-Hill/Irwin
Debit 4,000
Credit 3,920 80
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Now, assume that Play Clothes waited until July 20 to pay the full amount due to Kids Clothes. Prepare the journal entry for Play Clothes.
GENERAL JOURNAL
McGraw-Hill/Irwin
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Now, assume that Play Clothes waited until July 20 to pay the full amount due to Kids Clothes. Prepare the journal entry for Play Clothes.
GENERAL JOURNAL
Date Account Titles and Explanation Cash
McGraw-Hill/Irwin
Debit 4,000
Credit 4,000
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Returns of Unsatisfactory Merchandise

On August 5, Play Clothes returned $500 of unsatisfactory merchandise purchased from Kids Clothes on credit terms of 2/10, n/30. The purchase was originally recorded at net cost. Prepare the journal entry for Play Clothes.
GENERAL JOURNAL
McGraw-Hill/Irwin
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Returns of Unsatisfactory Merchandise

On August 5, Play Clothes returned $500 of unsatisfactory merchandise purchased from Kids Clothes on credit terms of 2/10, n/30. The purchase was originally recorded at net cost. Prepare the journal entry for Play Clothes.
GENERAL JOURNAL
McGraw-Hill/Irwin
Debit 490
Credit 490
Aug. 5 Accounts Payable (Kid's Clothes)
$500 98% = $490
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Transportation Costs on Purchases Transportation costs related to the acquisition of assets are part of the cost of the asset being acquired.
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Now, lets talk about sales!
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Transactions Relating to Sales

Computer Barn Partial Income Statement For the Year Ended December 31, 2005 Revenue Sales Less: Sales returns and allowances $ Sales discounts Net sales $ 912,000 8,000 4,000 12,000 $ 900,000
Credit terms and merchandise returns affect the amount of revenue earned by the seller.
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Sales
On August 2, Kids Clothes sold $2,000 of merchandise to Play Clothes on credit terms 2/10, n/30. Kids Clothes originally paid $1,000 for the merchandise. Because Kids Clothes uses a perpetual inventory system, they must make two entries.
GENERAL JOURNAL
Date Account Titles and Explanation Sales
McGraw-Hill/Irwin
Debit 2,000
Credit 2,000
Aug. 2 Accounts Receivable (Play Clothes)
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Sales
On August 2, Kids Clothes sold $2,000 of merchandise to Play Clothes on credit terms 2/10, n/30. Kids Clothes originally paid $1,000 for the merchandise. Because Kids Clothes uses a perpetual inventory system, they must make two entries.
GENERAL JOURNAL
McGraw-Hill/Irwin
Debit 1,000
Credit 1,000
Aug. 2 Cost of Goods Sold
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Sales Returns and Allowances

On August 5, Play Clothes returned $500 of unsatisfactory merchandise to Kids Clothes from the August 2 sale. Kids Clothes cost for this merchandise was $250. Because Kids Clothes uses a perpetual inventory system, they must make two entries.
GENERAL JOURNAL
Date Account Titles and Explanation
Contra-revenue
Debit 500 500
Credit
Aug. 5 Sales Returns and Allowances Accounts Receivable (Play Clothes)

McGraw-Hill/Irwin
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Sales Returns and Allowances

On August 5, Play Clothes returned $500 of unsatisfactory merchandise to Kids Clothes from the August 2 sale. Kids Clothes cost for this merchandise was $250. Because Kids Clothes uses a perpetual inventory system, they must make two entries.
GENERAL JOURNAL
Date Account Titles and Explanation Cost of Goods Sold
McGraw-Hill/Irwin
Debit 250
Credit 250
Aug. 5 Inventory
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Sales
On July 6, Kids Clothes sold $4,000 of merchandise to Play Clothes on credit with terms of 2/10, n/30. The merchandise originally cost Kids Clothes $2,000. Because Kids Clothes uses a perpetual inventory system, they must make two entries.
GENERAL JOURNAL
Date Account Titles and Explanation Sales
McGraw-Hill/Irwin
Debit 4,000
Credit 4,000
July 6 Accounts Receivable (Play Clothes)
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Sales
On July 6, Kids Clothes sold $4,000 of merchandise to Play Clothes on credit with terms of 2/10, n/30. The merchandise originally cost Kids Clothes $2,000. Because Kids Clothes uses a perpetual inventory system, they must make two entries.
GENERAL JOURNAL
McGraw-Hill/Irwin
Debit 2,000
Credit 2,000
July 6 Cost of Goods Sold
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Sales Discounts
On July 15, Kids Clothes receives the full amount due from Play Clothes from the July 6 sale. Prepare the journal entry for Kids Clothes.
GENERAL JOURNAL
McGraw-Hill/Irwin
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Sales Discounts
On July 15, Kids Clothes receives the full amount due from Play Clothes from the July 6 sale. Prepare the journal entry for Kids Clothes.
Contra-revenue
Date
GENERAL JOURNAL
$4,000 98% = $3,920

Debit 3,920 80 4,000
Account Titles and Explanation Sales Discounts Accounts Receivable (Play Clothes)
Credit
July 15 Cash
McGraw-Hill/Irwin
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Sales Discounts
Now, assume that it wasnt until July 20 that Kids Clothes received the full amount due from Play Clothes from the July 6 sale. Prepare the journal entry for Kids Clothes.
GENERAL JOURNAL
McGraw-Hill/Irwin
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Sales Discounts
Now, assume that it wasnt until July 20 that Kids Clothes received the full amount due from Play Clothes from the July 6 sale. Prepare the journal entry for Kids Clothes.
GENERAL JOURNAL
Date Account Titles and Explanation Accounts Receivable (Play Clothes)
McGraw-Hill/Irwin
Debit 4,000
Credit 4,000
July 20 Cash
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Delivery Expenses
Delivery costs incurred by sellers are debited to Delivery Expense, an operating expense. When sellers incur transportation costs, or delivery expense, it is debited to an operating expense account called Delivery Expense. This is considered a cost of doing business and is treated as a regular operating expense of the business.
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Accounting for Sales Taxes

Businesses collect sales tax at the point of sale. Then, they remit the tax to the appropriate governmental agency at times specified by law. $1,000 sale 7% tax = $70 sales tax
Debit 1,070 70 1,000
GENERAL JOURNAL
Date
Account Titles and Explanation Cash Sales Tax Payable Sales
Credit
McGraw-Hill/Irwin
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Modifying an Accounting System

Most businesses use special journals rather than a general journal to record routine transactions that occur frequently. When companies use special journals, similar entries are recorded together. Companies may have several special journals such as a Cash Receipts Journal, Cash Payments Journal, Sales Journal, and several others. When using special journals, the General Journal is used only for a few entries that do not fit in a special journal.
GENERAL JOURNAL
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Financial Analysis
Gross Profit Margins
Gross profit Net sales
Net Sales
Trends over time
Comparable store sales

Sales per square foot of selling space
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Overall gross profit margin

Gross profit margins by department and products McGraw-Hill Companies, Inc., 2005 The
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End of Chapter 6
McGraw-Hill/Irwin

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6-1

The McGraw-Hill Companies, Inc., 2005

Operating Cycle of a Merchandising Company

The operating cycle of a business is the time it takes

The operating cycle of a business that sells inventory

Operating Cycle of a Merchandising Company

The McGraw-Hill Companies, Inc., 2005

Comparing Merchandising Activities with Manufacturing Activities

Retailers and Wholesalers

Income Statement of a Merchandising Company

Cost of Goods Sold is presented as a separate expense

Income Statement of a Merchandising Company

Accounting Systems Requirements for Merchandising Companies

Date 2001 June 1 15

Who owes us money?

The McGraw-Hill Companies, Inc., 2005

Accounting Systems Requirements for Merchandising Companies

Date 2001 June 1 15

Balance 3,000 2,000

Date 2001 June 1 7,000 McGraw-Hill/Irwin 15

1,000 Subsidiary Ledger Heather Jacobs Debit Credit Balance

The McGraw-Hill Companies, Inc., 2005

Two Approaches Used in Accounting for Merchandise Transactions

Perpetual Inventory System

Periodic Inventory System

The McGraw-Hill Companies, Inc., 2005

Two Approaches Used in Accounting for Merchandise Transactions

Perpetual Inventory Systems

Lets look at some entries!

Perpetual Inventory Systems

The McGraw-Hill Companies, Inc., 2005

Perpetual Inventory Systems

Sept. 10 Accounts Receivable (ABC Radios)

Perpetual Inventory Systems

Sept. 10 Accounts Receivable (ABC Radios)

The McGraw-Hill Companies, Inc., 2005

Perpetual Inventory Systems

Sept. 15 Accounts Payable (Electronic City)

The McGraw-Hill Companies, Inc., 2005

Perpetual Inventory Systems

The McGraw-Hill Companies, Inc., 2005

Taking a Physical Inventory

Taking a Physical Inventory

Dec. 31 Cost of Goods Sold

The McGraw-Hill Companies, Inc., 2005

Closing Entries in a Perpetual Inventory System

Close Expense accounts

Close Income Summary

The McGraw-Hill Companies, Inc., 2005

Next is the periodic inventory system!

The McGraw-Hill Companies, Inc., 2005

Periodic Inventory Systems

Lets look at some entries!

Periodic Inventory Systems

The McGraw-Hill Companies, Inc., 2005

Periodic Inventory Systems

Sept. 10 Accounts Receivable (ABC Radios)

The McGraw-Hill Companies, Inc., 2005

Periodic Inventory Systems

Sept. 15 Accounts Payable (Electronic City)

The McGraw-Hill Companies, Inc., 2005

Periodic Inventory Systems

The McGraw-Hill Companies, Inc., 2005