Chapter

5-1
 Merchandising Operations
and the Multiple-Step
Income Statement

Chapter
5-2 Financial Accounting, Fifth Edition
 Study
Study Objectives
Objectives

1. Identify the differences between a service company and a

merchandising company.
2. Explain the recording of purchases under a perpetual
inventory system.
3. Explain the recording of sales revenues under a perpetual
inventory system.
4. Distinguish between a single-step and a multiple-step
income statement.
5. Determine cost of goods sold under a periodic system.
6. Explain the factors affecting profitability.
7. Identify a quality of earnings indicator.
Chapter
5-3
 Merchandising
Merchandising Operations
Operations

Recording Recording Income

Merchandising Evaluating
Purchases of Sales of Statement
Operations Profitability
Merchandise Merchandise Presentation

Operating Freight costs Sales returns Sales revenues Gross profit rate
cycles and allowances Gross profit
Purchase Profit margin
Operating expenses
Flow of costs- returns and Sales discounts ratio
Nonoperating
perpetual and allowances activities
periodic Purchase Determining cost of
inventory discounts goods sold-periodic
systems. system
Summary of
purchasing
transactions

Chapter
5-4
 Merchandising
Merchandising Operations
Operations

Merchandising Companies
Buy and Sell Goods

Wholesaler Retailer Consumer

The primary source of revenues is referred to as

sales revenue or sales.
Chapter
5-5 SO 1 Identify the differences between service and merchandising companies.
 Merchandising
Merchandising Operations
Operations

Income Measurement
Not used in a
Sales Less
Service business. Illustration 5-1
Revenue Income measurement process
for a merchandising company

Cost of Equals Gross Less

Goods Sold Profit

Operating Equals Net

Cost of goods sold is the total Income
cost of merchandise sold Expenses
(Loss)
during the period.

Chapter
5-6 SO 1 Identify the differences between service and merchandising companies.
 Merchandising
Merchandising Operations
Operations
Illustration 5-2

Operating
Cycles

The operating cycle

of a merchandising
company ordinarily
is longer than that
of a service
company.

Chapter
5-7 SO 1 Identify the differences between service and merchandising companies.
 Merchandising
Merchandising Operations
Operations

Flow of Costs
Illustration 5-3

Companies use either a perpetual inventory system or a periodic inventory

system to account for inventory.
Chapter
5-8 SO 1 Identify the differences between service and merchandising companies.
 Merchandising
Merchandising Operations
Operations

Flow of Costs
Perpetual System
 Maintain detailed records of the cost of each
inventory purchase and sale.
 Records continuously show inventory that should be
on hand.
 Company determines cost of goods sold each time a
sale occurs.

Chapter
5-9 SO 1 Identify the differences between service and merchandising companies.
 Merchandising
Merchandising Operations
Operations

Flow of Costs
Periodic System
 Do not keep detailed records of the goods on hand.
 Determine cost of goods sold only at end of accounting period.
 Physical inventory count to determine cost of goods on hand.
 Calculation of Cost of Goods Sold:
Beginning inventory

$ 100,000
Add: Purchases, net

800,000
Chapter
5-10
Goods the
SO 1 Identify available for sale
differences between service and merchandising companies.
 Merchandising
Merchandising Operations
Operations

Flow of Costs
Additional Consideration
Perpetual System:
 Traditionally used for merchandise with high unit values.

 Provides better control over inventories.

 Requires additional clerical work and additional cost to

maintain inventory records.

Chapter
5-11 SO 1 Identify the differences between service and merchandising companies.
Chapter
5-12
 Recording
Recording Purchases
Purchases of
of Merchandise
Merchandise

Made using cash or credit (on account).

Illustration 5-5
Normally recorded when
goods are received.
Purchase invoice should
support each credit
purchase.

Chapter
5-13 SO 2 Explain the recording of purchases under a perpetual inventory system.
 Recording
Recording Purchases
Purchases of
of Merchandise
Merchandise
Illustration 5-5

Illustration: Sauk Stereo (the

buyer) uses as a purchase invoice
the sales invoice prepared by PW
Audio Supply, Inc. (the seller).
Prepare the journal entry for
Sauk Stereo for the invoice from
PW Audio Supply.

May 4 Merchandise inventory 3,800

Accounts payable
3,800
Chapter
5-14 SO 2 Explain the recording of purchases under a perpetual inventory system.
 Recording
Recording Purchases
Purchases of
of Merchandise
Merchandise

Freight Costs – Terms of Sale Illustration 5-6

Seller places goods Free On

Board the carrier, and
buyer pays freight costs.

Seller places goods Free On

Board to the buyer’s place
of business, and seller pays
freight costs.

Chapter
5-15
Freight costs incurred by the seller are an operating expense.
 Recording
Recording Purchases
Purchases of
of Merchandise
Merchandise

Illustration: Assume upon delivery of the goods on May 6,

Sauk Stereo pays Haul-It Freight Company $150 for freight
charges, the entry on Sauk Stereo’s books is:
May 6 Merchandise inventory 150
Cash
150
Assume the freight terms on the invoice in Illustration 5-5
had required PW Audio Supply to pay the freight charges, the
entry by PW Audio Supply would have been:
May 4 Freight-out 150
Cash
Chapter 150
5-16 SO 2 Explain the recording of purchases under a perpetual inventory system.
 Recording
Recording Purchases
Purchases of
of Merchandise
Merchandise

Purchase Returns and Allowances

Purchaser may be dissatisfied because goods are
damaged or defective, of inferior quality, or do not
meet specifications.

Purchase Return Purchase Allowance

Return goods for credit May choose to keep the
if the sale was made on merchandise if the seller
credit, or for a cash will grant an allowance
refund if the purchase (deduction) from the
was for cash. purchase price.

Chapter
5-17 SO 2 Explain the recording of purchases under a perpetual inventory system.
 Recording
Recording Purchases
Purchases of
of Merchandise
Merchandise

Question

In a perpetual inventory system, a return of

defective merchandise by a purchaser is recorded by
crediting:
a. Purchases
b. Purchase Returns
c. Purchase Allowance
d. Merchandise Inventory

Chapter
5-18 SO 2 Explain the recording of purchases under a perpetual inventory system.
 Recording
Recording Purchases
Purchases of
of Merchandise
Merchandise

Illustration: Assume that on May 8 Sauk Stereo returned to

PW Audio Supply goods costing $300.

May 8 Accounts payable 300

Merchandise inventory 300

Chapter
5-19 SO 2 Explain the recording of purchases under a perpetual inventory system.
 Recording
Recording Purchases
Purchases of
of Merchandise
Merchandise

Purchase Discounts
Credit terms may permit buyer to claim a cash
discount for prompt payment.
Advantages:
Purchaser saves money.
Seller shortens the operating cycle.

Example: Credit terms of 2/10, n/30, is read “two-ten, net thirty.”

2% cash discount if payment is made within 10 days. Otherwise, net
amount due within 30 days.

Chapter
5-20 SO 2 Explain the recording of purchases under a perpetual inventory system.
 Recording
Recording Purchases
Purchases of
of Merchandise
Merchandise

Purchase Discounts - Terms

2/10, n/30 1/10 EOM n/10 EOM

2% discount if 1% discount if Net amount due

paid within 10 paid within within the first
days, otherwise first 10 days of 10 days of the
net amount due next month. next month.
within 30 days.

Chapter
5-21 SO 2 Explain the recording of purchases under a perpetual inventory system.
 Recording
Recording Purchases
Purchases of
of Merchandise
Merchandise

Illustration: Assume Sauk Stereo pays the balance due of

$3,500 (gross invoice price of $3,800 less purchase returns
and allowances of $300) on May 14, the last day of the
discount period. Prepare the journal entry Sauk makes to
record its May 14 payment.

May 14 Accounts payable 3,500

Merchandise Inventory
70
Cash
3,430
(Discount = $3,500 x 2% = $70)
Chapter
5-22 SO 2 Explain the recording of purchases under a perpetual inventory system.
 Recording
Recording Purchases
Purchases of
of Merchandise
Merchandise

Illustration: If Sauk Stereo failed to take the discount, and

instead made full payment of $3,500 on June 3, the journal
entry would be:

June 3 Accounts payable 3,500

Cash
3,500

Chapter
5-23 SO 2 Explain the recording of purchases under a perpetual inventory system.
 Recording
Recording Purchases
Purchases of
of Merchandise
Merchandise

Purchase Discounts
Should discounts be taken when offered?
Discount of 2% on $3,500 $ 70.00
$3,500 invested at 10% for 20 days 19.18
Savings by taking the discount $ 50.82

Passing up the discount offered equates to paying an

interest rate of 2% on the use of $3,500 for 20 days.
Example: 2% for 20 days = Annual rate of 36.5%
(365/20 = 18.25 twenty-day periods x 2% = 36.5%)
Chapter
5-24 SO 2 Explain the recording of purchases under a perpetual inventory system.
 Recording
Recording Purchases
Purchases of
of Merchandise
Merchandise

Summary of Purchasing Transactions

Illustration Merchandise Inventory

Debit Credit

4th - Purchase $3,500 $300 8th - Return

6th – Freight-in 150 70 14th - Discount

Balance $3,280

Chapter
5-25 SO 2 Explain the recording of purchases under a perpetual inventory system.
 Recording
Recording Sales
Sales of
of Merchandise
Merchandise

Made for cash or credit (on account).

Illustration 5-5

Normally recorded when

earned, usually when
goods transfer from
seller to buyer.
Sales invoice should
support each credit
sale.

Chapter SO 3 Explain the recording of sales revenues

5-26
under a perpetual inventory system.
 Recording
Recording Sales
Sales of
of Merchandise
Merchandise

Two Journal Entries to Record a Sale

#1 Cash or Accounts receivable XXX Selling

Sales XXX Price

#2 Cost of goods sold XXX

Cost
Merchandise inventory XXX

Chapter SO 3 Explain the recording of sales revenues

5-27
under a perpetual inventory system.
 Recording
Recording Sales
Sales of
of Merchandise
Merchandise

Illustration: Assume PW Audio Supply records its May 4 sale

of $3,800 to Sauk Stereo on account (Illustration 5-5) as
follows. Assume the merchandise cost PW Audio Supply
$2,400.

May 4 Accounts receivable 3,800

Sales
3,800
4 Cost of goods sold 2,400
Merchandise inventory
2,400

Chapter SO 3 Explain the recording of sales revenues

5-28
under a perpetual inventory system.
 Recording
Recording Sales
Sales of
of Merchandise
Merchandise

Sales Returns and Allowances

“Flipside” of purchase returns and allowances.
Contra-revenue account (debit).
Sales not reduced (debited) because:
 would obscure importance of sales returns and
allowances as a percentage of sales.
 could distort comparisons between total sales
in different accounting periods.

Chapter SO 3 Explain the recording of sales revenues

5-29
under a perpetual inventory system.
 Recording
Recording Sales
Sales of
of Merchandise
Merchandise

Illustration: Prepare the entry PW Audio Supply would make

to record the credit for returned goods that had a $300
selling price (assume a $140 cost). Assume the goods were not
defective.

May 8 Sales returns and allowances 300

Accounts receivable
300
8 Merchandise inventory 140
Cost of goods sold
140

Chapter SO 3 Explain the recording of sales revenues

5-30
under a perpetual inventory system.
 Recording
Recording Sales
Sales of
of Merchandise
Merchandise

Illustration: Assume the returned goods were defective and

had a scrap value of $50, PW Audio would make the following
entries:

May 8 Sales returns and allowances 300

Accounts receivable
300
8 Merchandise inventory 50
Cost of goods sold
50

Chapter SO 3 Explain the recording of sales revenues

5-31
under a perpetual inventory system.
 Recording
Recording Sales
Sales of
of Merchandise
Merchandise

Review Question
The cost of goods sold is determined and recorded
each time a sale occurs in:
a. periodic inventory system only.
b. a perpetual inventory system only.
c. both a periodic and perpetual inventory system.
d. neither a periodic nor perpetual inventory
system.

Chapter SO 3 Explain the recording of sales revenues

5-32
under a perpetual inventory system.
Chapter
5-33
 Recording
Recording Sales
Sales of
of Merchandise
Merchandise

Sales Discount
Offered to customers to promote prompt payment.
“Flipside” of purchase discount.
Contra-revenue account (debit).

Chapter SO 3 Explain the recording of sales revenues

5-34
under a perpetual inventory system.
 Recording
Recording Sales
Sales of
of Merchandise
Merchandise

Illustration: Assume Sauk Stereo pays the balance due of

$3,500 (gross invoice price of $3,800 less purchase returns
and allowances of $300) on May 14, the last day of the
discount period. Prepare the journal entry PW Audio Supply
makes to record the receipt on May 14.

May 14 Cash 3,430

*
Sales discounts 70
Accounts receivable
3,500

* [($3,800 – $300) X 2%]

Chapter SO 3 Explain the recording of sales revenues
5-35
under a perpetual inventory system.
 Income
Income Statement
Statement Presentation
Presentation

Single-Step Income Statement

Subtract total expenses from total revenues
Two reasons for using the single-step format:
1) Company does not realize any type of profit
until total revenues exceed total expenses.
2) Format is simpler and easier to read.

Chapter
5-36 SO 4 Distinguish between a single-step and a multiple-step income statement.
 Income
Income Statement
Statement Presentation
Presentation
Illustration 5-7
Single-
Step

Chapter
5-37 SO 4 Distinguish between a single-step and a multiple-step income statement.
 Income
Income Statement
Statement Presentation
Presentation

Multiple-Step Income Statement

Considered more useful because it highlights the
components of net income.
Three important line items:
 gross profit,
 income from operations, and
 net income.

Chapter
5-38 SO 4 Distinguish between a single-step and a multiple-step income statement.
 Income
Income Statement
Statement Presentation
Presentation
Illustration 5-8

Multiple-
Step

Key Line
Items

Chapter
5-39 SO 4 Distinguish between a single-step and a multiple-step income statement.
 Income
Income Statement
Statement Presentation
Presentation

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

Chapter
5-40 SO 4 Distinguish between a single-step and a multiple-step income statement.
 Income
Income Statement
Statement Presentation
Presentation

Sales Revenues
Illustration 5-9

Chapter
5-41 SO 4 Distinguish between a single-step and a multiple-step income statement.
 Income
Income Statement
Statement Presentation
Presentation

Gross Profit
Illustration 5-11

Comparisons with past amounts and rates and with those in the industry
indicate the effectiveness of a company’s purchasing and pricing policies.

Chapter
5-42 SO 4 Distinguish between a single-step and a multiple-step income statement.
 Income
Income Statement
Statement Presentation
Presentation
Operating Expenses Illustration 5-11

Chapter
5-43
 Income
Income Statement
Statement Presentation
Presentation

Nonoperating Activities
Various revenues and expenses and gains and losses that
are unrelated to the company’s main line of operations.
Illustration 5-10

Chapter
5-44 SO 4 Distinguish between a single-step and a multiple-step income statement.
 Illustration 5-11

Income
Income
Statement
Statement
Presentation
Presentation

Chapter
5-45
Chapter
5-46
 Income
Income Statement
Statement Presentation
Presentation

Determining Cost of Goods Sold Under a

Periodic System

No running account of changes in inventory.

Ending inventory determined by physical count.
Directly adjust Merchandise Inventory account
for any transaction that affects inventory.

Chapter
5-47 SO 5 Determine cost of goods sold under a periodic system.
 Income
Income Statement
Statement Presentation
Presentation

Determining Cost of Goods Sold Under a

Periodic System
Illustration 5-13
Cost of goods sold for a
merchandiser using a
periodic inventory system

Chapter
5-48 SO 5 Determine cost of goods sold under a periodic system.
 Evaluating
Evaluating Profitability
Profitability

Gross Profit Rate

A company’s gross profit may be expressed as a percentage
by dividing the amount of gross profit by net sales.

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

 The company may have begun to sell products with a lower
“markup.”
 Increased competition may result in a lower selling price.
 Company may be forced to pay higher prices to its suppliers
without being able to pass these costs on to its customers.

Chapter
5-49 SO 6 Explain the factors affecting profitability.
 Evaluating
Evaluating Profitability
Profitability

Gross Profit Rate

Illustration 5-15

Why does Wal-Mart have a lower gross profit rate than

Target and the industry average?
Chapter
5-50 SO 6 Explain the factors affecting profitability.
 Evaluating
Evaluating Profitability
Profitability

Profit Margin Ratio

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

How do the gross profit rate and profit margin ratio

differ?
 Gross profit rate - measures the margin by which selling
price exceeds cost of goods sold.

 Profit margin ratio - measures the extent by which selling

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

Chapter
5-51 SO 6 Explain the factors affecting profitability.
 Evaluating
Evaluating Profitability
Profitability

Profit Margin Ratio Illustration 5-17

How does Wal-Mart compare to its competitors?

Keep in mind that an increasing percentage of Wal-Mart’s sales is
from low-margin groceries.
Chapter
5-52 SO 6 Explain the factors affecting profitability.
Chapter
5-53
 Evaluating
Evaluating Profitability
Profitability
Earnings have high quality if they
provide a full and transparent depiction
of how a company performed.

 In general, a measure significantly less than 1 suggests that a

company may be using more aggressive accounting techniques in
order to accelerate income recognition.
 A measure significantly greater than 1 suggests that a company
is using conservative accounting techniques which cause it to
delay the recognition of income.
Chapter
5-54 SO 7 Identify a quality of earnings indicator.
 Periodic
Periodic Inventory
Inventory System
System

Recording Merchandise Transactions

 Record revenues when sales are made.
 Do not record cost of merchandise sold on the date of sale.
 Physical inventory count at the end of the period to
determine:
1. cost of merchandise on hand and
2. cost of goods sold during the period.
 Record purchases of merchandise in Purchases account.
 Purchase returns and allowances, Purchase discounts, and
Freight costs are recorded in separate accounts.
Chapter SO 8 Explain the recording of purchases and sales of
5-55
inventory under a periodic inventory system.
 Periodic
Periodic Inventory
Inventory System
System

Recording Purchases of Merchandise

Illustration: On the basis of the sales invoice (Illustration 5-5)
and receipt of the merchandise ordered from PW Audio
Supply, Sauk Stereo records the $3,800 purchase as follows.

May 4 Purchases 3,800

Accounts payable
3,800

Chapter SO 8 Explain the recording of purchases and sales of

5-56
inventory under a periodic inventory system.
 Periodic
Periodic Inventory
Inventory System
System

Freight Costs
Illustration: If Sauk pays Haul-It Freight Company $150
for freight charges on its purchase from PW Audio Supply on
May 6, the entry on Sauk’s books is:

May 6 Freight-in (Transportation-in) 150

Cash
150

Chapter SO 8 Explain the recording of purchases and sales of

5-57
inventory under a periodic inventory system.
 Periodic
Periodic Inventory
Inventory System
System

Purchase Returns and Allowances

Illustration: Sauk Stereo returns $300 of goods to PW Audio
Supply and prepares the following entry to recognize the
return.

May 8 Accounts payable 300

Purchase returns and allowances 300

Chapter SO 8 Explain the recording of purchases and sales of

5-58
inventory under a periodic inventory system.
 Periodic
Periodic Inventory
Inventory System
System

Purchase Discounts
Illustration: On May 14 Sauk Stereo pays the balance due on
account to PW Audio Supply, taking the 2% cash discount
allowed by PW Audio for payment within 10 days. Sauk
Stereo records the payment and discount as follows.

May 14 Accounts payable 3,500

Purchase discounts
Cash 70
3,430

Chapter SO 8 Explain the recording of purchases and sales of

5-59
inventory under a periodic inventory system.
 Periodic
Periodic Inventory
Inventory System
System

Recording Sales of Merchandise

Illustration: PW Audio Supply, records the sale of $3,800 of
merchandise to Sauk Stereo on May 4 (sales invoice No. 731,
Illustration 5-5) as follows.

May 4 Accounts receivable 3,800

Sales
3,800
No entry is recorded for cost of goods sold at the time
of the sale under a periodic system.

Chapter SO 8 Explain the recording of purchases and sales of

5-60
inventory under a periodic inventory system.
 Periodic
Periodic Inventory
Inventory System
System

Sales Returns and Allowances

Illustration: To record the returned goods received from
Sauk Stereo on May 8, PW Audio Supply records the $300
sales return as follows.

May 4 Sales returns and allowances 300

Accounts receivable
300

Chapter SO 8 Explain the recording of purchases and sales of

5-61
inventory under a periodic inventory system.
 Periodic
Periodic Inventory
Inventory System
System

Sales Discounts
Illustration: On May 14, PW Audio Supply receives payment of
$3,430 on account from Sauk Stereo. PW Audio honors the 2%
cash discount and records the payment of Sauk’s account
receivable in full as follows.

May 14 Cash 3,430

Sales discounts 70
Accounts receivable
3,500

Chapter SO 8 Explain the recording of purchases and sales of

5-62
inventory under a periodic inventory system.
 Comparison
Comparison of
of Entries—Perpetual
Entries—Perpetual Vs.
Vs. Periodic
Periodic

Chapter SO 8 Explain the recording of purchases and sales of

5-63
inventory under a periodic inventory system.
 Comparison
Comparison of
of Entries—Perpetual
Entries—Perpetual Vs.
Vs. Periodic
Periodic

Chapter SO 8 Explain the recording of purchases and sales of

5-64
inventory under a periodic inventory system.
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Chapter
5-65