Chapter 5 1
1. A Service Company versus a Merchandising Company
1.1 Measuring Income
1.1.1 Service company: service revenue e.g. Schools, Banking, Painting, Travel
Merchandising Company: the primary source of revenues is the sale of
merchandise. (Sales revenue, or sales) e.g. clothing stores
1.1.2 Unlike a service company, expenses for a merchandising company are divided
into two categories:
A) Cost of goods sold - total cost of merchandise sold during the period.
COGS = Beginning Inventory + COG Purchased – COG on hand
(This gives the current amount in stock or the ending inventory).
B) Operating expenses - expenses incurred in the process of earning sales
1.1.5 Gross profit = sales revenue - cost of goods sold.
1.1.6 Operating and non-operating expenses are deducted from gross profit to
determine net income (or loss).
1.2 Operating Cycle: average time it takes to go from cash to cash in producing
revenues. The operating cycle of a merchandising company is longer than that of a
service company. The purchase of merchandise and its eventual sale lengthens the
1.3. Inventory Systems
A)Perpetual Inventory System (large items e.g. sale of computers, TV. etc.)
Accounting records continuously (perpetually) show the inventory that should
be on hand and the cost of goods sold, at any time.
Used for high unit cost, low volume turnover goods, or where computer
systems (e.g., scanners) enable continuous record updating.
When an item of inventory is sold, its cost is transferred from the Merchandise
Inventory asset account to the Cost of Goods Sold expense account.
Under a perpetual inventory system, records are kept of the quantity and cost
of each item as it is bought, held in inventory, and sold.
Merchandise availability, maintaining optimum inventory levels, avoiding
running out of stock.
A periodic physical count determines the accuracy of the recorded amounts
and adjustment for any losses.
B)Periodic Inventory System (Small Items e.g. pencils, candy, nails)
Determines the ending inventory and calculates the cost of goods sold at the
end of each period.
Used for low unit cost, high volume turnover goods.Chapter 5 2
A physical inventory count is done to determine the quantity and cost of goods
on hand at the end of the accounting period.
This amount is deducted from the goods available for sale to determine the
cost of goods sold.
2 Explain and Record Merchandise Costs Under a Perpetual Inventory System
2.1 Cost of Goods Purchased
2.1.1 Purchases of inventory should be supported by business documents. Larger
companies use a purchase order to place an order with a supplier. A
purchase invoice documents the actual quantities and prices for the goods
purchased. It is a copy of the sales invoice prepared by the vendor.
2.1.2 Purchases of merchandise for resale are debited to Merchandise Inventory.
Purchases of items not for resale are debited to other accounts, such as
Supplies, or Equipment.
Dr. Merchandize Inventory
2.2 Subsidiary Inventory Records
The Merchandise Inventory account in the general ledger is a control account for all
the subsidiary or individual inventory accounts. At all times the balance in the
Merchandise Inventory account is equal to the total of all the individual inventory
2.3 Freight Costs
Any freight paid by the purchaser is part of the cost of the merchandise purchased.
The Merchandise Inventory account is increased for freight costs paid by the buyer
to transport goods to the buyer’s place of business.
2.3.1 FOB (free on board) shipping point means the goods are placed free on
board the carrier by the seller. The seller is responsible up to the shipping
point so the buyer must pay the freight costs from there on.
2.3.2 FOB (free on board) destination means the goods are placed free on board
to the buyer’s place of business, and the seller is responsible for the freight
costs all the way until the inventory reaches its destination.
2.4 Purchase Returns and Allowances
A purchaser may be dissatisfied with the merchandise received (due to damage,
wrong order/colour/size etc), and return them to the vendor for a refund or credit. In
other cases, the purchaser may agree to keep the items if the seller grants an
allowance or deduction from the price. The Merchandise Inventory account is creditedChapter 5 3
for the purchase return or purchase allowance.
Dr. Cash or AP
Cr. Purchase Return and Allowances
(To record cash refunded)
2.5 Purchase Discounts
Purchase discounts are offered to customers for early payment of the balance due.
For example, credit terms of 2/10, n/30 enables the customer to deduct 2% from the
invoice total if the bill is fully paid within 10 days, or pay the full amount within 30 days.
Dr. A/P 500
Cr. Cash 490
Cr. Pur. Disc. 10
(Paid invoice in 10 days so discount is received)
Note that both accounts are contra accounts since they reduce the Purchase account.
3. Sales Revenue Entries under a Perpetual Inventory System
3.1 Sales revenues are recognized when earned—typically when goods are transferred
from the seller to the buyer. (Debit: Cost of Goods Sold, Credit: Merchandise Inventory)
* Cost of Goods Sold: cost of merchandise sold during the period at all times
* Merchandise Inventory: cost of merchandise on hand at all times
3.2 Sales taxes are collected on behalf of the federal and provincial governments, and
must be remitted to them periodically. Sales taxes collected are liabilities not revenues.
Examples of sales taxes in Canada are GST, PST and HST.
3.3 When a customer returns goods to the seller for credit, it is called a sales return.
(Decreasing Cost of Goods Sold and increasing the Merchandise Inventory account,
assuming the merchandise is in good condition and resalable) When the customer
chooses to keep the merchandise and is granted an allowance from the selling price, it
is called a sales allowance. Sales returns and sales allowances are combined into
one account, Sales Returns and Allowances, for accounting purposes.
3.4 Distinguish between quantity and sales discounts.
• Quantity (or volume) Discount: price reduction when a specified quantity is sold. Not
recorded separately. Debit Merchandise Inventory account for the purchase price
of the merchandise, net of any quantity discounts.
• Sales discount: occurs when the terms of credit include an offer of a cash discount
for prompt payment of the balance due.
3.6 Sales Returns and Allowances (and Sales Discounts, if any): contra revenue accounts
to Sales and have normal debit balances.
3.7 Freight costs incurred by the seller on outgoing merchandise are an operatingChapter 5 4
expense to the seller, and are debited to Freight Out, or Delivery Expense.
4. Completing the Accounting Cycle for a Merchandising Company
4.1 Adjusting entries
4.1.1 A merchandising company has the same types of adjusting entries as a
service company. But a merchandising company using a perpetual inventory
system may require an additional adjusting entry to make the recorded
inventory agree with the actual inventory on hand. A physical inventory count is
taken at the end of the accounting period. The actual inventory on hand may
differ from the recorded inventory due to errors, theft, or damage. The entry to
record inventory shortages is as follows:
Cost of Goods Sold cost
Merchandise Inventory cost
4.2 Closing entries
4.2.1 The closing entries are the same as those made for a service company.
Closing an account reduces its balance to zero. All temporary accounts are