Introduction To FinancialAccounting Sarath Fall 2013
Lecture 7: Chapter 5
Merchandizing firms buy and sell goods and make a profit on the difference between the buying
and selling price. Such firms can be wholesalers (sell only to other merchandizing firms) or
retailers (sell to customers).
The operating revenues for a merchandizing firm come from its core operations of buying and
selling merchandize. A secondary source of revenue is from interest from a credit card operation.
The expenses are split into three (1) COGS (2) Operating expenses and (3) Other expenses (See
illustration 5-11, p 212.)
Before discussing the details of accounting for merchandizing operations, we begin with some
basics about accrual accounting. Revenue and expenses are ____ the same as cash in and cash
out. The differences between the sum total of cash flows (carried in the cash account) and the
sum total of all earnings (carried in RE -- note that for conceptual reasons, we are assuming
dividends paid are 0) is accrued on the balance sheet. The basic balance sheet equation:
Assets = Liabilities + Stockholders equity may be rewritten as
Cash + non Cash assets = Liabilities + Contributed Capital + Retained Earnings or as
Cash - Retained Earnings = Liabilities + Contributed Capital - non Cash assets
We shall track this identity for merchandize transactions.
1) Firm Issues Stock for $1,000. 2) Firm purchases $100 of inventory 3) Firm sells inventory on
account for $200. 4) Firm collects Cash of $200
1 Introduction To FinancialAccounting Sarath Fall 2013
Most firms track inventory very closely and have detailed information about goods (Walmart
uses Radio tags on merchandize). However, for financial accounting purposes, the periodic
system is usual. Under the periodic system, the COGS is estimated based on the ending balance
counted at the end of the period (hence the name periodic method). In contrast, under the
perpetual method, the COGS is measured continuously and the end balance is estimated based on
the COGS. Both methods rely on the following equation:
Begin Balance + Purchases - COGS = End Balance.
Begin Balance and purchases are based on journal entries. Under the perpetual method COGS is
based on Journal entries and the End balance is calculated. In contrast, under the periodic
method, COGS is an adjusting entry based on the end inventory.
Measuring Cost of Purchases
The total cost of purchases includes all freight and insurance. Freight charges may be paid by the
buyer (Free on Board Shipping) or by the seller (Free on Board Destination) based on whether
the seller pays nothing to place it on board or the buyer pays nothing to take it off the shipper.
Another issue relates to discounts that are provided for
(a) Bulk purchases or (b) pay on time
Purchase price is usually measured net of discount. You will not be tested on the net method of
treating purchase discounts -- however, you will be expected to know the difference between the
two methods which is:
The net method initially values the purchased goods net of discount and takes a loss if
the discount is not taken whereas the gross method values the purchased goods at full
cost and reduces the cost of inventory if the discount is taken.
Measuring Sales Revenue
Sales Revenue must be adjusted for possible returns and sales discounts. Sales returns is a
contra-revenue account and is debited whenever goods are returned.
Ship 100 items at $10
expect 5 returned
SALES REV 1000
Sales Rev 50
Allowance for Returns 50
Net sales rev=950
2 Introduction To FinancialAccounting Sarath Fall 2013
E5-3. On September 1, Howe Office Supply had an
inventory of 30 calculators at a cost of $18 each.
The company uses a perpetual inventory system.
During September, the following transactions
Purchased 80 calculators at $20 each from DeVito Co. for cash.
Dr Inventory 1600
Paid freight of $80 on calculators purchased from DeVito Co.