Chapter 5 Lecture & Study Notes

Study Objective 1 - Identify the Differences Between a Service Enterprise and a

Merchandising Company.
In a merchandising company, the primary source of revenues is the sale of merchandise,
referred to as sales revenue or sales.
Unlike expenses for a service company, expenses for a merchandising company are
divided into two categories:
Cost of goods sold - the total cost of merchandise sold during the period.
Operating expenses - selling and administrative expenses.
Study Tip

Know examples of service companies and merchandising companies in the local area.
Consider flower shops, hair salons, banks, service stations, funeral homes, etc. The yellow
pages of the phone book can be a good resource.
The operating cycle of a merchandising company ordinarily is longer than that of a service
company.
The purchase of inventory and its eventual sale lengthen the cycle.
Steps in the operating cycles for a service company and a merchandising company:
Service Company
Perform Services
Bill Customers (Accounts
Receivable)
Collect Cash from Accounts
Receivable

Merchandising Company
Buy Inventory (Cash or Accounts
Payable)
Sell Inventory
Bill Customers (Accounts
Receivable)
Collect Cash from Accounts
Receivable

Merchandising companies use one of two systems to account for inventory

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Perpetual
Detailed records of the cost of each inventory purchase and sale are maintained
and the records continuously show the inventory that should be on hand for every
item.
Under a perpetual system, a company determines the cost of goods sold each
time a sale occurs.
For control purposes, companies take a physical inventory count to verify the
accuracy of the inventory records.

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Periodic
Detailed records of the goods on hand are not kept throughout the period.
A physical inventory is taken at the end of the accounting periods to determine
cost of goods on hand as well as cost of goods sold.
Study Tip

Even with sophisticated computer systems, scanners, and software, not all companies use a
perpetual system to keep up with inventory costs. Some companies will use a perpetual
system to keep up with inventory quantities and a periodic system to keep up with costs.

Study Objective 2 - Explain the Recording of Purchases under a Perpetual Inventory

System.
The purchase of inventory for resale is normally recorded by the merchandiser when the goods
are received from the seller.
Every purchase should be supported by business documents that provide written
evidence of the transaction.
Every cash purchase should be supported by a canceled check or a cash register
receipt indicating the items purchased and the amounts paid.
Each credit purchase should be supported by a purchase invoice, which indicates the
total purchase price and other relevant information.
Cash purchases are recorded by an increase in Inventory and a decrease in Cash.
Credit purchases are recorded by an increase in Inventory and an increase in Accounts
Payable. For example, the entry to record the May 4 purchases merchandise inventory by
Sauk Stereo from PW Audio Supply, 2/10, n/30 (as shown in the text) is:
May 4

Inventory..................................................................
Accounts Payable...........................................

3,800
3,800

Freight costs are the cost of transporting the goods to the buyers place of business. If
the freight costs are to be paid by the buyer, the costs are considered part of the cost of
purchasing inventory. In this instance, Inventory is increased and Cash is decreased.

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For example, if upon delivery of goods on May 6, Sauk Stereo (the buyer pays Haul-It
Freight Company $150 for freight charges, the entry on Sauks books is:
May 6

Inventory...............................................................
Cash...............................................................
(To record payment of freight on
goods purchased)

150
150

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Freight costs incurred by the seller on outgoing merchandise are an operating expense
to the seller and labeled freight-out or Delivery Expense. Freight-out is recorded by
increasing Freight-out and decreasing Cash.
For example, if the freight terms require that the seller pay $150 freight charges, the
entry would be:
Freight-out...........................................................................
Cash.........................................................................
(To record payment of freight on
goods sold)

150
150

Goods that are damaged, defective, of inferior quality, or do not meet purchaser
specifications may be returned to the seller for credit if the sale was made on credit, or
for a cash refund if the purchase was for cash. The transaction described is a purchase
return and is recorded by decreasing Accounts Payable and decreasing Inventory.
Alternatively, the purchaser may choose to keep the goods that are damaged, defective,
or of inferior quality provided the seller will grant a discount referred to as a purchase
allowance.
The credit terms of a purchase on account may allow the buyer to claim a discount if
prompt payment is made. A common credit term is 2/10, n/30, which means a 2 percent
purchase discount may be taken if the invoice is paid within 10 days of the invoice
date. Net amount of the invoice is due within 30 days. When payment is made within the
discount period, the amount of Inventory decreases. The entry to record a payment
would require the purchaser to decrease Accounts Payable, Decrease Cash, and
decrease Inventory.
For example, assume Sauk Stereo pays the balance due of $3,500 on May 14, the last
day of the discount period, and takes the $70 discount. The credit terms are 2/10, n/30.
May 14 Accounts Payable..................................................
Cash...............................................................
Inventory.........................................................

3,500
3,430
70

If Sauk Stereo failed to take the discount and instead made full payment of $3,500 on
June 3, Sauk would debit Accounts Payable and credit Cash for $3,500.
June 3 Accounts Payable..................................................
Cash...............................................................

3,500
3,500

Passing up the discount may be viewed as paying interest for use of the money.
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Study Tip

Not all purchases constitute purchases of Inventory. Rather, a purchase of a cash register to
be used in a clothing business would not be a purchase of merchandise for resale. However,
if Dixie Cash Register purchased a cash register for resale the transaction would be
considered a purchase of Inventory.

Study Tip

Give examples of purchases on account that would not be considered inventory and give the
proper accounting treatment for each. Some possible responses are included in the following
chart.
Item purchased
Supplies

Buildings, Equipment,
Furniture, Computers,
Autos (currently used in
business operations)
Land
Assets acquired for
future use

Accounting treatment
Record as a current asset. Make an adjusting entry on
the last day of the accounting period to record supplies
expense for the amount that was used during the
accounting period.
Record as property, plant, and equipment. Record
depreciation expense.

Record as a property, plant, and equipment. No

depreciation is recorded.
Record as long-term investments.

Study Objective 3 - Explain the Recording of Sales Revenues under a Perpetual

Inventory System.
Sales revenues are recorded when earned, in accordance with the revenue recognition
principle. Typically this occurs when goods are transferred from the seller to the buyer.
Sales may be made on credit or for cash.
Each sales transaction should be supported by a business document that provides written
evidence of the sale.

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Cash register tapes provide evidence of cash sales.

A sales invoice provides written evidence of a credit sale.

Cash sales are recorded by increasing Cash and increasing Sales.

Credit sales are recorded by increasing Accounts Receivable and increasing Sales
Revenue. For example, the journal entry that PW. Audio Supply records on May 4 for the
sale to Sauk Stereo is (the merchandise cost to PW is $2,400), terms 2/10, n/30:
May 4

Accounts Receivable ............................................

Sales Revenue...............................................

3,800

Cost of Goods Sold...............................................

Inventory.........................................................

2,400

3,800

2,400

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 For internal decision-making purposes, merchandising companies may use more than one
sales account.
Study Tip

Know why the following journal entry is not appropriate for this transaction:
May 4

Accounts Receivable.............................................
Inventory.........................................................
Sales Revenue...............................................

3,800

2,400
1,400

Sales Returns and Allowances, a contra revenue account to Sales, may be used to
record credit for returned goods.
Two entries are required to record the credit for Sales Returns and Allowances.
The first entry is an increase in Sales Returns and Allowances and a decrease in
Accounts Receivable.
The second entry is an increase in Inventory and a decrease in Cost of Goods Sold.
For example, the entry that PW Audio Supply records for a return from a customer on
May 8 for which the selling price was $300 and the merchandise cost to PW was $140 is:
May 8

Sales Returns and Allowances.............................

Accounts Receivable......................................

300

Inventory...............................................................
Cost of Goods Sold........................................

140

300

140

The seller may offer the customer a sales discount for the prompt payment of the balance
due.
Like a purchase discount, a sales discount, which is based on the invoice price less any
returns and allowances, is recorded by increasing cash for the amount received from the
customer, decreasing Accounts Receivable for the amount owed by the customer, and
increasing Sales Discounts by the amount of the discount.
For example, the entry recorded by PW Audio Supply to show the cash receipt on May 14
from Sauk Stereo within the discount period is:
May 14

Cash......................................................................
Sales Discounts....................................................

3,430
70
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Accounts Receivable......................................
(To record collection within 2/10,n/30
discount period from Sauk Stereo)

3,500

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 Like Sales Returns and Allowances, Sales Discounts is a contra revenue account to
Sales Revenue.
Study Tip

Know the importance of having the net sales figure as well as the amounts in the contra
asset accountssales returns and allowances and sales discounts.
A Sales Returns and Allowances account is used rather than decreasing sales revenue
directly because the company will want to know about the amount of merchandise being
returned. Likewise, a Sales Discounts account is used in order disclose the amount of cash
discounts taken by customers. Both the Sales Returns and Allowances account and the
Sales Discounts accounts are contra revenue accounts to the Sales Revenue account.
Because they are contra revenue accounts, they will have normal debit balances.

Study Objective 4 - Distinguish Between a Single-Step and a Multiple-Step Income

Statement.
There are two forms of income statements used by companies:
Single-step income statement - one step is required in determining net incomesubtract
total expenses from total revenues.
Revenuesincludes both operating revenues and nonoperating revenues and gains.
Expensesincludes cost of goods sold, operating expenses, as well as nonoperating
expenses and losses.
Multiple-step income statement
Highlights the components of net income.
Includes gross profit (which is net sales less cost of goods sold).
Distinguishes between operating and nonoperating activities.
Sales revenuesThe income statement for a merchandising concern typically presents
gross sales revenues for the period and deducts the contra revenue accounts (sales
returns and allowances and sales discounts) to arrive at net sales.
Cost of goods sold is the cost of the merchandise sold during the period.
Gross profit (also called gross margin)is calculated by deducting cost of goods sold
from net sales. Gross profit is the merchandising profit of the company. It is not a
measure of the overall profit of a company.

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Study Tip

For a merchandising company the cost of goods sold is an expense and, traditionally, the
largest expense item the company will have.
Gross profit or gross margin is the amount a merchandising company has left after it pays for
the merchandise it sold.

Operating expenses - are subtracted from gross profit in order to determine income
from operations
Operating expenses include Selling expensesall of the expenses associated with selling the merchandise
from the solicitation of the sale until the product is in the hands of the buyer.
Administrative expensesgeneral expenses relating to general operating
activities, human resources, accounting, clerical, security, etc.
Nonoperating activitiesunrelated to the companys primary line of operations.
Nonoperating items are preceded by Income from operations in the income
statement.
Other revenues and gainsInterest, dividend, rent revenue, and gain from sale of
property.
Other expenses and lossesInterest expense; casualty losses; loss from sale or
abandonment of property, plant, and equipment; and loss from strikes by employees
and suppliers

Study Tip

Would you rather have a single-step or multiple-step income if they were a manager or a
potential investor. Why?
In trying to predict future earnings, which is the more relevant figure - net income or operating
income?

Study Objective 5 - Determine Cost of Goods Sold under a Periodic Inventory

System.

To determine cost of goods sold:

Beginning Inventory (amount of ending inventory for the previous period)

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Add: Cost of Goods Purchased, which includes:

Purchases
Less: Purchase Returns and Allowances
Purchase Discounts
Add: Freight-in
This results in Cost of Goods Available for Sale (total amount that could have
been sold during the accounting period)
Subtract: Ending Inventory (determined by a physical count on the last day of the
accounting period)
This results in Cost of Goods Sold (subtract this amount from Net Sales to arrive
at Gross Profit)

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Study Objective 6 - Explain the Factors Affecting Profitability.

Gross profit rate, calculated by dividing the amount of gross profit by net sales, is generally
considered to be more informative than the gross profit amount because it expresses a more
meaningful (qualitative) relationship between gross profit and net sales.
Study Tip

Consider the following problem:

Smith Company has had gross profit percentages of 20 22% for the past 5 years. The
current gross profit percentage is 14%.
What are some possible causes of this change in gross profit percentage?
What should the management of Smith Company do?
Suggest ways in which a company can improve its gross profit percentage.
Profit margin ratio, calculated by dividing net income by net sales, measures the percentage
of each dollar of sales that results in net income.
The profit margin ratio measures the extent by which selling price covers all expenses
(including cost of goods sold) and the gross profit rate measures the margin by which selling
price exceeds cost of goods sold.
A company can improve its profit margin ratio by either increasing its gross profit rate and/or by
controlling its operating expenses and other costs.
A decline in a companys gross profit may be due to initiatives to sell products with lower
markups, increased competition forcing lower selling prices, or higher prices paid to suppliers
that cannot be passed along to customers.
Study Tip

Know ways in which a company can either improve its profit margin ratio or control its
operating expenses.
Consider the following questions: What types of business are more likely to have high profit
margins? What types of business are more likely to have lower profit margins?

Study Objective 7 Identify a Quality of Earnings Indicator.

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Earnings have high quality if they provide a full and transparent presentation of how a
company performed.
The quality of earnings ratio
Is an indicator of the quality of earnings
Is calculated as net cash provided by operating activities divided by net income.
Interpreting the quality of earnings ratio:
Measures greater than 1 suggest the company is employing more conservative
accounting techniques.
Measures significantly below 1 may suggest that a company is using more
aggressive accounting techniques which accelerate income recognition.

Study Objective 8 (Appendix) Explain the Recording of Purchases and Sales of

Inventory Under a Periodic Inventory System.

A key difference between the perpetual inventory system and the periodic inventory
system is the point at which the company computes cost of goods sold.

Periodic systems require a physical inventory count at the end of the period to
determine: (1) the cost of merchandise then on hand and (2) the cost of the goods
sold during the period.

To record purchases under the periodic system, entries are required for (a) cash and
credit purchases, (b) purchase returns and allowances, (c) purchase discounts and
(d) freight costs.
To record sales under the periodic system, entries are required for (a) cash and credit
sales, (b) sales returns and allowances, and (c) sales discounts.

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