Basic Financial Accounting and Reporting

1. Chapter 5: Accounting for Merchandising Operations

2. Introduction

Merchandising is one of the largest and most influential industries in the country. It is likely that a number
of you will work for a merchandiser. Therefore, understanding the financial statements of merchandising
companies is important. In this chapter, you will learn the basics about reporting merchandising
transactions. In addition, you will learn how to prepare and analyze a commonly used form of the income
statement—the multiple-step income statement. The content and organization of the chapter are as
follows.

3. Learning Outcome

a. Identify the differences between service and merchandising companies.

b. Explain the recording of purchases under a perpetual inventory system.
c. Explain the recording of sales revenues under a perpetual inventory system.
d. Explain the steps in the accounting cycle for a merchandising company.
e. Distinguish between a multiple-step and a single-step income statement.
f. Explain the computation and importance of gross profit.
g. Explain the recording of purchases and sales of inventory under a periodic inventory system.

4. Learning Content

a. Merchandising Operations

Wal-Mart, SaveMore, and Mercury Drug are called merchandising companies because they buy and
sell merchandise rather than perform services as their primary source of revenue. Merchandising
companies that purchase and sell directly to consumers are called retailers. Merchandising
companies that sell to retailers are known as wholesalers.

The primary source of revenues for merchandising companies is the sale of merchandise, often
referred to simply as sales revenue or sales. A merchandising company has two categories of
expenses:
1. cost of goods sold and
2. operating expenses

Cost of goods sold is the total cost of merchandise sold during the period. This expense is directly
related to the revenue recognized from the sale of goods.

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The illustration below shows the income measurement process for a merchandising company. The
items in the two blue boxes are unique to a merchandising company; they are not used by a service
company.

Income measurement process for a merchandising company

Operating Cycles

The operating cycle of a merchandising company ordinarily is longer than that of a service company.
The purchase of merchandise inventory and its eventual sale lengthen the cycle. The illustration below
contrasts the operating cycles of service and merchandising companies. Note that the added asset
account for a merchandising company is the Inventory account. Companies report inventory as a
current asset on the balance sheet.

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Flow of Costs

The flow of costs for a merchandising company is as follows: Beginning inventory plus the cost of
goods purchased is the cost of goods available for sale. As goods are sold, they are assigned to cost
of goods sold. Those goods that are not sold by the end of the accounting period represent ending
inventory. The illustration below describes these relationships.

Companies use one of two systems to account for inventory:

1. a perpetual inventory system or
2. a periodic inventory system.

1. PERPETUAL SYSTEM.

In a perpetual inventory system, companies keep detailed records of the cost of each inventory
purchase and sale. These records continuously—perpetually—show the inventory that should
be on hand for every item.

• For example, a Ford dealership has separate inventory records for each automobile, truck,
and van on its lot and showroom floor.
• Similarly, a Kroger grocery store uses bar codes and optical scanners to keep a daily running
record of every box of cereal and every jar of jelly that it buys and sells.

Under a perpetual inventory system, a company determines the cost of goods sold each time a
sale occurs.

2. PERIODIC SYSTEM.

In a periodic inventory system, companies do not keep detailed inventory records of the goods
on hand throughout the period.

Instead, they determine the cost of goods sold only at the end of the accounting period—that is,
periodically. At that point, the company takes a physical inventory count to determine the cost of
goods on hand.

To determine the cost of goods sold under a periodic inventory system, the following steps are
necessary:
1. Determine the cost of goods on hand at the beginning of the accounting period.
2. Add to it the cost of goods purchased.
3. Subtract the cost of goods on hand at the end of the accounting period.

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 The illustration below graphically compares the sequence of activities and the timing of the cost
of goods sold computation under the two inventory systems.

Comparing perpetual and periodic inventory systems

ADDITIONAL CONSIDERATIONS

Companies that sell merchandise with high unit values, such as automobiles, furniture, and major
home appliances, have traditionally used perpetual systems. The growing use of computers and
electronic scanners has enabled many more companies to install perpetual inventory systems. The
perpetual inventory system is so named because the accounting records continuously—perpetually—
show the quantity and cost of the inventory that should be on hand at any time.

A perpetual inventory system provides better control over inventories than a periodic system. Since
the inventory records show the quantities that should be on hand, the company can count the goods
at any time to see whether the amount of goods actually on hand agrees with the inventory records.
If shortages are uncovered, the company can investigate immediately. Although a perpetual inventory
system requires additional clerical work and additional cost to maintain the subsidiary records, a
computerized system can minimize this cost.

Some businesses find it either unnecessary or uneconomical to invest in a computerized perpetual

inventory system. Many small merchandising businesses, in particular, find that a perpetual inventory
system costs more than it is worth. Managers of these businesses can control their merchandise and
manage day-to-day operations using a periodic inventory system.

Because the perpetual inventory system is growing in popularity and use, we illustrate it in this
chapter.

b. Recording Purchases of Merchandise

Companies purchase inventory using cash or credit (on account). They normally record purchases
when they receive the goods from the seller. Business documents provide written evidence of the
transaction. A cash register receipt, for example, indicates the items purchased and amounts paid for
each cash purchase. Companies record cash purchases by an increase in Inventory and a decrease
in Cash.

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A purchase invoice should support each credit purchase. This invoice indicates the total purchase
price and other relevant information. However, the purchaser does not prepare a separate purchase
invoice. Instead, the purchaser uses as a purchase invoice a copy of the sales invoice sent by the
seller.

In the illustration below, for example, Sauk Stereo (the buyer) uses as a purchase invoice the sales
invoice prepared by PW Audio Supply, Inc. (the seller).

Sauk Stereo makes the following journal entry to record its purchase from PW Audio Supply. The
entry increases (debits) Inventory and increases (credits) Accounts Payable.

Under the perpetual inventory system, companies record purchases of merchandise for sale in the
Inventory account. Thus, Wal-Mart would increase (debit) Inventory for clothing, sporting goods, and
anything else purchased for resale to customers.

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Not all purchases are debited to Inventory, however:

Companies record purchases of assets acquired for use and not for resale, such as supplies,
equipment, and similar items, as increases to specific asset accounts rather than to Inventory. For
example, to record the purchase of materials used to make shelf signs or for cash register receipt
paper, Wal-Mart would increase Supplies.

Freight Costs

The sales agreement should indicate who—the seller or the buyer—is to pay for transporting the
goods to the buyer’s place of business. When a common carrier such as a railroad, trucking company,
or airline transports the goods, the carrier prepares a freight bill in accord with the sales agreement.

Freight terms are expressed as either FOB shipping point or FOB destination. The letters FOB mean
free on board.
• FOB shipping point means that the seller places the goods free on board the carrier, and the
buyer pays the freight costs.
• FOB destination means that the seller places the goods free on board to the buyer’s place of
business, and the seller pays the freight.

For example, the sales invoice in the previous page indicates FOB shipping point. Thus, the buyer
(Sauk Stereo) pays the freight charges. The illustration below shows these shipping term:

• FREIGHT COSTS INCURRED BY THE BUYER. When the buyer incurs the transportation costs,
these costs are considered part of the cost of purchasing inventory. Therefore, the buyer
debits (increases) the account Inventory. For example, if upon delivery of the goods on May 6,
Sauk Stereo (the buyer) pays Acme Freight Company P150 for freight charges, the entry on Sauk
Stereo’s books is:

Thus, any freight costs incurred by the buyer are part of the cost of merchandise purchased. The
reason: Inventory cost should include any freight charges necessary to deliver the goods to the
buyer.

• FREIGHT COSTS INCURRED BY THE SELLER. In contrast, freight costs incurred by the
seller on outgoing merchandise are an operating expense to the seller. These costs increase
an expense account titled Freight-out or Delivery Expense. If the freight terms on the invoice had
required PW Audio Supply (the seller) to pay the freight charges, the entry by PW Audio Supply
would be (refer to the next page):

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 When the seller pays the freight charges, it will usually establish a higher invoice price for the
goods to cover the shipping expense.

When merchandise is shipped by a common carrier—a trucking entity or an airline—the carrier

prepares a freight bill in accordance with the instructions of the party making the shipping
arrangements. The freight bill designates which party shoulders the costs, and whether the
shipment is freight prepaid or freight collect:

• In freight prepaid, the seller pays the transportation costs before shipping the goods sold;
• In freight collect, the freight entity collects from the buyer.

NOTE: Payment by either party will not dictate who should ultimately shoulder the costs.

Normally, the party bearing the freight cost pays the carrier. Thus, goods are typically shipped
freight collect when the terms are FOB shipping point; and freight prepaid when the terms are
FOB destination.

Sometimes, as a matter of convenience, the firm not bearing the freight cost pays the carrier.
When this situation occurs, the seller and buyer simply adjust the amount of the payment for the
merchandise. The illustration below shows which party—the buyer or the seller— shoulders the
transportation costs and pays the shipper for various freight terms:

Who Shoulders the

Transportation Who Pays the
Freight Terms Costs? Shipper?
FOB Destination, Freight Prepaid Seller Seller
FOB Shipping Point, Freight Collect Buyer Buyer
FOB Destination, Freight Collect Seller Buyer
FOB Shipping Point, Freight Prepaid Buyer Seller

Purchase Returns and Allowances

A purchaser may be dissatisfied with the merchandise received because the goods are damaged or
defective, of inferior quality, or do not meet the purchaser’s specifications. In such cases, the
purchaser may return the goods to the seller for credit if the sale was made on credit, or for a
cash refund if the purchase was for cash. This transaction is known as a purchase return.
Alternatively, the purchaser may choose to keep the merchandise if the seller is willing to grant an
allowance (deduction) from the purchase price. This transaction is known as a purchase allowance.

Assume that on May 8 Sauk Stereo returned goods costing P300 to PW Audio Supply. The following
entry by Sauk Stereo for the returned merchandise decreases (debits) Accounts Payable and
decreases (credits) Inventory.

Because Sauk Stereo increased Inventory when the goods were received, Inventory is decreased
when Sauk Stereo returns the goods (or when it is granted an allowance).

Suppose instead that Sauk Stereo chose to keep the goods after being granted a P50 allowance
(reduction in price). It would reduce (debit) Accounts Payable and reduce (credit) Inventory for P50.
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Purchase Discounts

The credit terms of a purchase on account may permit the buyer to claim a cash discount for prompt
payment. The buyer calls this cash discount a purchase discount. This incentive offers advantages
to both parties: The purchaser saves money, and the seller shortens the operating cycle by more
quickly converting the accounts receivable into cash.

Credit terms specify the amount of the cash discount and time period in which it is offered. They also
indicate the time period in which the purchaser is expected to pay the full invoice price.

In the sales invoice in the illustration on page 5, credit terms are 2/10, n/30, which is read “two-ten,
net thirty.”

This means that the buyer may take a 2% cash discount on the invoice price less (“net of”) any returns
or allowances, if payment is made within 10 days of the invoice date (the discount period). Otherwise,
the invoice price, less any returns or allowances, is due 30 days from the invoice date.

Alternatively, the discount period may extend to a specified number of days following the month in
which the sale occurs. For example, 1/10 EOM (end of month) means that a 1% discount is available
if the invoice is paid within the first 10 days of the next month.

When the seller elects not to offer a cash discount for prompt payment, credit terms will specify only
the maximum time period for paying the balance due. For example, the invoice may state the time
period as n/30, n/60, or n/10 EOM. This means, respectively, that the buyer must pay the net amount
in 30 days, 60 days, or within the first 10 days of the next month.

When the buyer pays an invoice within the discount period, the amount of the discount decreases
Inventory. Why? Because companies record inventory at cost and, by paying within the discount
period, the merchandiser has reduced that cost.

To illustrate, assume Sauk Stereo pays the balance due of P3,500 (gross invoice price of P3,800 less
purchase returns and allowances of P300) on May 14, the last day of the discount period. The cash
discount is P70 (P3,500 X 2%), and Sauk Stereo pays P3,430 (P3,500 -- P70). The entry Sauk Stereo
makes to record its May 14 payment decreases (debits) Accounts Payable by the amount of the gross
invoice price, reduces (credits) Inventory by the P70 discount, and reduces (credits) Cash by the net
amount owed.

If Sauk Stereo failed to take the discount, and instead made full payment of P3,500 on June 3, it
would debit Accounts Payable and credit Cash for P3,500 each.

A merchandising company usually should take all available discounts. Passing up the discount may
be viewed as paying interest for use of the money. For example, passing up the discount offered by
PW Audio Supply would be comparable to Sauk Stereo paying an interest rate of 2% for the use of
P3,500 for 20 days. This is the equivalent of an annual interest rate of approximately 36.5% (2% X
365/20). Obviously, it would be better for Sauk Stereo to borrow at prevailing bank interest rates of
6% to 10% than to lose the discount.

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 Summary of Purchasing Transactions

The following T account (with transaction descriptions in blue) provides a summary of the effect of the
previous transactions on Inventory. Sauk Stereo originally purchased P3,800 worth of inventory for
resale. It then returned P300 of goods. It paid P150 in freight charges, and finally, it received a P70
discount off the balance owed because it paid within the discount period. This results in a balance in
Inventory of P3,580.

c. Recording Sales of Merchandise

Companies record sales revenues, like service revenues, when earned, in compliance with the
revenue recognition principle. Typically, companies earn sales revenues when the goods transfer
from the seller to the buyer. At this point, the sales transaction is complete and the sales price
established.

Sales may be made on credit or for cash. A business document should support every sales
transaction, to provide written evidence of the sale.
• Cash register tapes provide evidence of cash sales.
• A sales invoice provides support for a credit sale.

The original copy of the invoice goes to the customer, and the seller keeps a copy for use in recording
the sale. The invoice shows the date of sale, customer name, total sales price, and other relevant
information.

The seller makes two entries for each sale:

1. The first entry records the sale:
The seller increases (debits) Cash (or Accounts Receivable, if a credit sale), and also increases
(credits) Sales Revenue.

2. The second entry records the cost of the merchandise sold:

The seller increases (debits) Cost of Goods Sold, and also decrease (credits) Inventory for the
cost of those goods.

As a result, the Inventory account will show at all times the amount of inventory that should be on
hand.

To illustrate a credit sales transaction, PW Audio Supply records its May 4 sale of P3,800 to Sauk
Stereo (see the illustration on page 5) as follows (assume the merchandise cost PW Audio Supply
P2,400).

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Sales Returns and Allowances

We now look at the “flipside” of purchase returns and allowances, which the seller records as sales
returns and allowances. These are transactions where the seller either accepts goods back from
the buyer (a return) or grants a reduction in the purchase price (an allowance) so the buyer will keep
the goods.

PW Audio Supply’s entries to record credit for returned goods involve:

1. an increase (debit) in Sales Returns and Allowances (a contra account to Sales Revenue) and a
decrease (credit) in Accounts Receivable at the P300 selling price, and
2. an increase (debit) in Inventory (assume a P140 cost) and a decrease (credit) in Cost of Goods
Sold, as shown below (assuming that the goods were not defective).

If Sauk Stereo returns goods because they are damaged or defective, then PW Audio Supply’s entry
to Inventory and Cost of Goods Sold should be for the fair value of the returned goods, rather than
their cost. For example, if the returned goods were defective and had a fair value of P50, PW Audio
Supply would debit Inventory for P50, and would credit Cost of Goods Sold for P50.

What happens if the goods are not returned but the seller grants the buyer an allowance by reducing
the purchase price? In this case, the seller debits Sales Returns and Allowances and credits Accounts
Receivable for the amount of the allowance.

Sales Returns and Allowances is a contra-revenue account to Sales Revenue. The normal balance
of Sales Returns and Allowances is a debit. Companies use a contra account, instead of debiting
Sales Revenue, to disclose in the accounts and in the income statement the amount of sales returns
and allowances. Disclosure of this information is important to management:

Excessive returns and allowances may suggest problems—inferior merchandise, inefficiencies in

filling orders, errors in billing customers, or delivery or shipment mistakes.

Moreover, a decrease (debit) recorded directly to Sales Revenue would obscure the relative
importance of sales returns and allowances as a percentage of sales. It also could distort comparisons
between total sales in different accounting periods.

Sales Discounts

As mentioned in our discussion of purchase transactions, the seller may offer the customer a cash
discount—called by the seller a sales discount—for the prompt payment of the balance due. Like a
purchase discount, a sales discount is based on the invoice price less returns and allowances, if any.
The seller increases (debits) the Sales Discounts account for discounts that are taken.

For example, PW Audio Supply makes the following entry (refer to the next page) to record the cash
receipt on May 14 from Sauk Stereo within the discount period.

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 Like Sales Returns and Allowances, Sales Discounts is a contra-revenue account to Sales
Revenue. Its normal balance is a debit. PW Audio Supply uses this account, instead of debiting Sales
Revenue, to disclose the amount of cash discounts taken by customers. If Sauk Stereo does not take
the discount, PW Audio Supply increases (debits) Cash for P3,500 and decreases (credits) Accounts
Receivable for the same amount at the date of collection.

The following T accounts summarize the three sales-related transactions and show their combined
effect on net sales.

d. Completing the Accounting Cycle

Up to this point, we have illustrated the basic entries for transactions relating to purchases and sales
in a perpetual inventory system. Now we consider the remaining steps in the accounting cycle for a
merchandising company. Each of the required steps described in Chapter 4 for service companies
apply to merchandising companies.

Adjusting Entries

A merchandising company generally has the same types of adjusting entries as a service company.
However, a merchandiser using a perpetual system will require one additional adjustment to make
the records agree with the actual inventory on hand. Here’s why:

At the end of each period, for control purposes, a merchandising company that uses a perpetual
system will take a physical count of its goods on hand. The company’s unadjusted balance in
Inventory usually does not agree with the actual amount of inventory on hand. The perpetual inventory
records may be incorrect due to recording errors, theft, or waste. Thus, the company needs to adjust
the perpetual records to make the recorded inventory amount agree with the inventory on hand. This
involves adjusting Inventory and Cost of Goods Sold.

For example, suppose that PW Audio Supply has an unadjusted balance of P40,500 in Inventory.
Through a physical count, PW Audio Supply determines that its actual merchandise inventory at year-
end is P40,000. The company would make an adjusting entry as follows.

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Closing Entries

A merchandising company, like a service company, closes to Income Summary all accounts that
affect net income. In journalizing, the company credits all temporary accounts with debit balances,
and debits all temporary accounts with credit balances, as shown below for PW Audio Supply. Note
that PW Audio Supply closes Cost of Goods Sold to Income Summary.

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 Summary of Merchandising Entries. The illustration below summarizes the entries for the
merchandising accounts using a perpetual inventory system.

e. Forms of Financial Statements

Merchandising companies widely use the classified balance sheet introduced in Chapter 4 and one
of two forms for the income statement. This section explains the use of these financial statements by
merchandisers.

Multiple-Step Income Statement

The multiple-step income statement is so named because it shows several steps in determining
net income. Two of these steps relate to the company’s principal operating activities. A multiple-step
statement also distinguishes between operating and nonoperating activities. Finally, the statement
also highlights intermediate components of income and shows subgroupings of expenses.

• INCOME STATEMENT PRESENTATION OF SALES. The multiple-step income statement

begins by presenting sales revenue. It then deducts contra-revenue accounts—sales returns and
allowances, and sales discounts— to arrive at net sales. The illustration on the next page
presents the sales revenues section for PW Audio Supply, using assumed data.

This presentation discloses the key data about the company’s principal revenue-producing
activities.

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• [f] GROSS PROFIT. From the (first) illustration on page 2, you learned that companies deduct
cost of goods sold from sales revenue in order to determine gross profit. For this computation,
companies use net sales (which takes into consideration Sales Returns and Allowances and Sales
Discounts) as the amount of sales revenue. On the basis of the sales data in the above illustration
(net sales of P460,000) and cost of goods sold under the perpetual inventory system (assume
P316,000), PW Audio Supply’s gross profit is P144,000, computed as follows.

We also can express a company’s gross profit as a percentage, called the gross profit rate. To
do so, we divide the amount of gross profit by net sales. For PW Audio Supply, the gross profit
rate is 31.3%, computed as follows.

Gross profit represents the merchandising profit of a company. It is not a measure of the overall
profitability, because operating expenses are not yet deducted. But managers and other interested
parties closely watch the amount and trend of gross profit. They compare current gross profit with
amounts reported in past periods. They also compare the company’s gross profit rate with rates
of competitors and with industry averages. Such comparisons provide information about the
effectiveness of a company’s purchasing function and the soundness of its pricing policies.

• OPERATING EXPENSES AND NET INCOME. Operating expenses are the next component in
measuring net income for a merchandising company. They are the expenses incurred in the
process of earning sales revenue. These expenses are similar in merchandising and service
companies. At PW Audio Supply, operating expenses were P114,000. The company determines
its net income by subtracting operating expenses from gross profit. Thus, net income is P30,000,
as shown below.

The net income amount is the so-called “bottom line” of a company’s income statement.

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• NONOPERATING ACTIVITIES. Nonoperating activities consist of various revenues and
expenses and gains and losses that are unrelated to the company’s main line of operations.

When nonoperating items are included, the label “Income from operations” (or “Operating
income”) precedes them. This label clearly identifies the results of the company’s normal
operations, an amount determined by subtracting cost of goods sold and operating expenses from
net sales.

The results of nonoperating activities are shown in the categories “Other revenues and gains”
and “Other expenses and losses.” The illustration below lists examples of each.

Merchandising companies report the nonoperating activities in the income statement immediately
after the company’s operating activities. The illustration on the next page shows these sections
for PW Audio Supply, Inc., using assumed data.

The distinction between operating and nonoperating activities is crucial to many external users of
financial data. These users view operating income as sustainable and many nonoperating
activities as nonrecurring. Therefore, when forecasting next year’s income, analysts put the most
weight on this year’s operating income, and less weight on this year’s nonoperating activities.

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 PW Audio Supply, Inc.
Income Statement
For the Year Ended December 31, 2020

Single-Step Income Statement

Another income statement format is the single-step income statement. The statement is so named
because only one step—subtracting total expenses from total revenues—is required in determining
net income.

In a single-step statement, all data are classified into two categories:

(1) revenues, which include both operating revenues and other revenues and gains; and
(2) expenses, which include cost of goods sold, operating expenses, and other expenses and losses.

The illustration on the next page shows a single-step statement for PW Audio Supply.

There are two primary reasons for using the single-step format:
1. A company does not realize any type of profit or income until total revenues exceed total
expenses, so it makes sense to divide the statement into these two categories.
2. The format is simpler and easier to read.

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 PW Audio Supply, Inc.
Income Statement
For the Year Ended December 31, 2020

Classified Balance Sheet

In the balance sheet, merchandising companies report inventory as a current asset immediately below
accounts receivable. Companies generally list current asset items in the order of their closeness to
cash (liquidity). Inventory is less close to cash than accounts receivable because the goods must first
be sold and then collection made from the customer. The illustration below presents the assets section
of a classified balance sheet for PW Audio Supply.

PW Audio Supply, Inc.

Balance Sheet (Partial)
December 31, 2020

g. Appendix: Periodic Inventory System

In the chapter, we focused on the characteristics of the perpetual inventory system. In this appendix,
we discuss and illustrate the periodic inventory system. One key difference between the two
systems is the point at which the company computes cost of goods sold. For a visual reminder of this
difference, refer back to the illustration on page 4.

Determining Cost of Goods Sold Under a Periodic System

Determining cost of goods sold is different when a periodic inventory system is used rather than a
perpetual system. As you have seen, a company using a perpetual system makes an entry to record
cost of goods sold and to reduce inventory each time a sale is made.

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A company using a periodic system does not determine cost of goods sold until the end of the
period. At the end of the period the company performs a count to determine the ending balance of
inventory. It then calculates cost of goods sold by subtracting ending inventory from the goods
available for sale. Goods available for sale is the sum of beginning inventory plus purchases.

Basic formula for cost of goods sold using the periodic system

Another difference between the two approaches is that the perpetual system directly adjusts the
Inventory account for any transaction that affects inventory (such as freight costs, returns, and
discounts). The periodic system does not do this. Instead, it creates different accounts for purchases,
freight costs, returns, and discounts.

These various accounts are shown in the illustration below, which presents the calculation of cost of
goods sold for PW Audio Supply using the periodic approach.

PW Audio Supply, Inc.

Cost of Goods Sold
For the Year Ended December 31, 2020

The use of the periodic inventory system does not affect the form of presentation in the balance sheet.
As under the perpetual system, a company reports inventory in the current assets section.

Recording Merchandise Transactions

In a periodic inventory system, companies record revenues from the sale of merchandise when
sales are made, just as in a perpetual system.
Unlike the perpetual system, however, companies do not attempt on the date of sale to record the
cost of the merchandise sold. Instead, they take a physical inventory count at the end of the period
to determine
1. the cost of the merchandise then on hand and
2. the cost of the goods sold during the period.

And, under a periodic system, companies record purchases of merchandise in the Purchases
account rather than the Inventory account. Also, in a periodic system, purchase returns and
allowances, purchase discounts, and freight costs on purchases are recorded in separate accounts.

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To illustrate the recording of merchandise transactions under a periodic inventory system, we will use
purchase/sale transactions between PW Audio Supply, Inc. and Sauk Stereo, as illustrated for the
perpetual inventory system in this chapter.

Recording Purchases of Merchandise

On the basis of the sales invoice (see page 5) and receipt of the merchandise ordered from PW Audio
Supply, Sauk Stereo records the P3,800 purchase as follows.

Purchases is a temporary account whose normal balance is a debit.

• FREIGHT COSTS. When the purchaser directly incurs the freight costs, it debits the account
Freight-in (or Transportation-in). For example, if Sauk Stereo pays Acme Freight Company P150
for freight charges on its purchase from PW Audio Supply on May 6, the entry on Sauk Stereo’s
books is:

Like Purchases, Freight-in is a temporary account whose normal balance is a debit. Freight-in is
part of cost of goods purchased. The reason is that cost of goods purchased should include
any freight charges necessary to bring the goods to the purchaser. Freight costs are not subject
to a purchase discount. Purchase discounts apply only to the invoice cost of the merchandise.

• PURCHASE RETURNS AND ALLOWANCES. Sauk Stereo returns P300 of goods to PW Audio
Supply and prepares the following entry to recognize the return.

Purchase Returns and Allowances is a temporary account whose normal balance is a credit.

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

Purchase Discounts is a temporary account whose normal balance is a credit.

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Recording Sales of Merchandise

The seller, PW Audio Supply, records the sale of P3,800 of merchandise to Sauk Stereo on May 4
(sales invoice No. 731, on page 5) as follows.

• SALES RETURNS AND ALLOWANCES. To record the returned goods received from Sauk
Stereo on May 8, PW Audio Supply records the P300 sales return as follows.

• SALES DISCOUNTS. On May 14, PW Audio Supply receives payment of P3,430 on account from
Sauk Stereo. PW Audio Supply honors the 2% cash discount and records the payment of Sauk
Stereo’s account receivable in full as follows.

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COMPARISON OF ENTRIES—PERPETUAL VS. PERIODIC

The illustration below summarizes the periodic inventory entries and compares them to the perpetual-
system entries from the chapter. Entries that differ in the two systems are shown in color.

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5. Teaching and Learning Activities

Activity 1 Compute missing amounts in determining net income.

Presented below are the components in Wales Company’s income statement.

Instruction: Determine the missing amounts.

Activity 2 Identify worksheet columns for selected accounts

Presented below is the format of the worksheet presented in the chapter.

Instruction: Indicate where the following items will appear on the worksheet: (a) Cash, (b) Merchandise
Inventory, (c) Sales, (d) Cost of goods sold.

Example: Cash: Trial balance debit column; Adjusted trial balance debit column; and Balance sheet debit
column.

Activity 3 Purchase Transactions.

On September 5, De La Cruz Company buys merchandise on account from Junot Dantes Company. The
selling price of the goods is P1,500, and the cost to Dantes Company was P800. On September 8, De
La Cruz returns defective goods with a selling price of P200.

Instruction: Record the transactions on the books of De La Cruz Company.

Activity 4 Sales Transactions.

On September 5, De La Cruz Company buys merchandise on account from Junot Dantes Company. The
selling price of the goods is P1,500, and the cost to Dantes Company was P800. On September 8, De
La Cruz returns defective goods with a selling price of P200 and a fair value of P30.

Instruction: Record the transactions on the books of Junot Dantes Company.

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 Activity 5 Financial Statement Classifications.
You are presented with the following list of accounts from the adjusted trial balance for merchandiser
Gapan Company.

Accounts Payable Interest Payable

Accounts Receivable Inventory
Accumulated Depreciation—Buildings Land
Accumulated Depreciation—Equipment Notes Payable (due in 3 years)
Advertising Expense Owner’s Capital (beginning balance)
Buildings Owner’s Drawings
Cash Property Taxes Payable
Depreciation Expense Salaries and Wages Expense
Equipment Salaries and Wages Payable
Freight-out Sales Returns and Allowances
Gain on Disposal of Plant Assets Sales Revenue
Insurance Expense Utilities Expense
Interest Expense

Required: Indicate in which financial statement and under what classification each of the following would
be reported.

Activity 6 Comprehensive
The adjusted trial balance columns of Francia Company’s worksheet for the year ended December 31,
2020, are as follows.

Debit Credit
Cash P 14,500 Accumulated Depreciation––
Accounts Receivable 11,100 Equipment P 18,000
Inventory 29,000 Notes Payable 25,000
Prepaid Insurance 2,500 Accounts Payable 10,600
Equipment 95,000 Owner’s Capital 81,000
Owner’s Drawings 12,000 Sales Revenue 536,800
Sales Returns and Allowances 6,700 Interest Revenue 2,500
Sales Discounts 5,000 P 673,900
Cost of Goods Sold 363,400
Freight-out 7,600
Advertising Expense 12,000
Salaries and Wages Expense 56,000
Utilities Expense 18,000
Rent Expense 24,000
Depreciation Expense 9,000
Insurance Expense 4,500
Interest Expense 3,600
P 673,900

Prepare a multiple-step income statement for Francia Company

6. Self-Assessment

Problem 1 Trade and Cash Discount Calculations.

On June 1, 2019, Elias Balmes Jr. Forest Products sold merchandise with a P120,000 list price.

Trade Discount Credit Terms Date Paid

a. 30% 2/10, n/30 June 8
b. 40% 1/10, n/30 June 15
c. - 2/10, n/30 June 11
d. 20% 1/15, n/30 June 14
e. 40% n/30 June 28
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For each of the sales terms, determine the following:
1. the amount recorded as a sale.
2. the amount of cash received.

Problem 2 Cash Discount and Remittance Calculations.

For each of the following Maria de la Costa Retailers purchases, assume that credit terms are 2/10, n/30
and that any. credit memorandum was issued and known before Maria de la Costa Retailers made the
payments.

Prepaid Freight Credit

Purchases Shipping Terms (by seller) Memo
a. P12,000 FOB shipping point P1,000 P3,000
b. 24,000 FOB destination 2,400 2,000
c. 28,000 FOB shipping point - 4,000
d. 40,000 FOB shipping point 3,000 -

1. Determine the cash discount available.

2. Determine the cash remitted if the payment is made within the discount period.

Problem 3 Point of Recognition.

Edgardo Alvarez Car Repairs Shop purchases a large amount of auto parts for its business. The following
table summarizes selected transaction data:

Order Date Shipped Date Received Amount

A June 26 July 5 P30,000
B July 10 July 15 75,000
C July 16 July 22 40,000
D July 23 July 30 60,000
E July 27 Aug. 1 75,000
F Aug. 3 Aug. 7 50,000

Determine the July total purchases under each of the following assumptions:
1. The entity recognizes purchases when orders are shipped.
2. The entity recognizes purchases when orders are received.

Problem 4 Determining the Missing Elements of the Income Statement.

The partial income statements of five different companies are as follows:

1 2 3 4 5
Net Sales a d 250,000 290,000 400,000
Merchandise Inventory, 1/1/2019 b 50,000 70,000 j 120,000
Net Cost of Purchases 80,000 e g 160,000 390,000
Goods Available for Sale 110,000 160,000 h k m
Merch. Inventory, 1/31/2019 40,000 f 30,000 70,000 n
Cost of Goods Sold c 140,000 230,000 l 380,000
Gross Profit 50,000 40,000 i 160,000 o

Required: Replace the lettered blanks with the appropriate amounts.

Problem 5 General questions about merchandisers.

Mr. Wayco has prepared the following list of statements about service companies and merchandisers.
1. _____ Measuring net income for a merchandiser is conceptually the same as for a service company.
2. _____ For a merchandiser, sales less operating expenses is called gross profit.
3. _____ For a merchandiser, the primary source of revenues is the sale of inventory.
4. _____ Sales salaries is an example of an operating expense.
5. _____ The operating cycle of a merchandiser is the same as that of a service company.

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6. _____ In a perpetual inventory system, no detailed inventory records of goods on hand are
maintained.
7. _____ In a periodic inventory system, the cost of goods sold is determined only at the end of the
accounting period.
8. _____ A periodic inventory system provides better control over inventories than a perpetual system.

Instructions: Identify each statement as true or false. If false, indicate how to correct the statement.

Problem 6 Journalize perpetual inventory entries.

On September 1, Honesto Office Supply had an inventory of 30 calculators at a cost of P18 each. The
company uses a perpetual inventory system. During September, the following transactions occurred.
Sept. 6 Purchased 80 calculators at P20 each from DeVito Co. for cash.
9 Paid freight of P80 on calculators purchased from DeVito Co.
10 Returned 2 calculators to DeVito Co. for P42 credit (including freight) because they did not
meet specifications.
12 Sold 26 calculators costing P21 (including freight) for P31 each to Mega Book Store, terms
n/30.
14 Granted credit of P31 to Mega Book Store for the return of one calculator that was not ordered.
20 Sold 30 calculators costing P21 for P31 each to Barbara’s Card Shop, terms n/30.

Instructions: Journalize the September transactions.

Problem 7 Compute various income statement items.

On January 1, 2020, Raya Reyes Corporation had merchandise inventory of P50,000. At December 31,
2020, Raya Reyes had the following account balances.

At December 31, 2020, Raya Reyes determines that its ending inventory is P60,000.

Instructions
a. Compute Raya Reyes’s 2020 gross profit.
b. Compute Raya Reyes’s 2020 operating expenses if net income is P130,000 and there are no
nonoperating activities.

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Problem 8 Prepare a worksheet.
The trial balance columns of the worksheet for Verde Company at June 30, 2020, are as follows.

VERDE COMPANY
Worksheet
For the Month Ended June 30, 2020

Other data: Operating expenses incurred on account, but not yet recorded, total P1,500.

Instructions: Enter the trial balance on a worksheet and complete the worksheet.

Problem 9 Journalize, post, and prepare a partial income statement.

Oliveros Distributing Company completed the following merchandising transactions in the month of April.
At the beginning of April, the ledger of Oliveros showed Cash of P9,000 and M. Oliveros, Capital of
P9,000.

Apr. 2 Purchased merchandise on account from Damian Supply Co. P6,900, terms 1/10, n/30.
4 Sold merchandise on account P5,500, FOB destination, terms 1/10, n/30. The cost of the
merchandise sold was P4,100.
5 Paid P240 freight on April 4 sale.
6 Received credit from Damian Supply Co. for merchandise returned P500.
11 Paid Damian Supply Co. in full, less discount.
13 Received collections in full, less discounts, from customers billed on April 4.
14 Purchased merchandise for cash P3,800.
16 Received refund from supplier for returned goods on cash purchase of April 14, P500.
18 Purchased merchandise from Skywalker Distributors P4,500, FOB shipping point, terms 2/10,
n/30.
20 Paid freight on April 18 purchase P100.
23 Sold merchandise for cash P6,400. The merchandise sold had a cost of P5,120.
26 Purchased merchandise for cash P2,300.
27 Paid Skywalker Distributors in full, less discount.
29 Made refunds to cash customers for defective merchandise P90. The returned merchandise
had a scrap value of P30.
30 Sold merchandise on account P3,700, terms n/30. The cost of the merchandise sold was
P2,800.

Oliveros Company’s chart of accounts includes the following: No. 101 Cash, No. 112 Accounts
Receivable, No. 120 Merchandise Inventory, No. 201 Accounts Payable, No. 301 M. Oliveros, Capital,
No. 401 Sales, No. 412 Sales Returns and Allowances, No. 414 Sales Discounts, No. 505 Cost of Goods
Sold, and No. 644 Freight-out.

Instructions
a. Journalize the transactions using a perpetual inventory system.
b. Enter the beginning cash and capital balances, and post the transactions using “T-Account”.
c. Prepare the income statement through gross profit for the month of April 2020.

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 Problem 10 Calculate missing amounts and assess profitability.
Cristina Montano operates a retail clothing operation. She purchases all merchandise inventory on credit
and uses a periodic inventory system. The accounts payable account is used for recording inventory
purchases only; all other current liabilities are accrued in separate accounts. You are provided with the
following selected information for the fiscal years 2017, 2018, 2019, and 2020.

2017 2018 2019 2020

Instructions
a. Calculate cost of goods sold for each of the 2018, 2019, and 2020 fiscal years.
b. Calculate the gross profit for each of the 2018, 2019, and 2020 fiscal years.
c. Calculate the ending balance of accounts payable for each of the 2018, 2019, and 2020 fiscal years.
d. Sales declined in fiscal 2020. Does that mean that profitability, as measured by the gross profit rate,
necessarily also declined? Explain, calculating the gross profit rate for each fiscal year to help support
your answer. (Round to one decimal place.)

7. References

Ballada, W. et al 2019. Basic Financial Accounting and Reporting. DomDane Publishers

Millan, Z. 2019. Intermediate Accounting. Bandolin Enterprises

Weygandt, J. et al 2019. Accounting Principles 13E. John Wiley & Sons, Inc.

ISUE__ __ Syl ___

Revision: 02
Effectivity: August 1, 2020
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