CHAPTER 5: MERCHANDISING OPERATIONS

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1 CHAPTER 5: MERCHANDISING OPERATIONS CHAPTER SYNOPSIS Chapter 5 first compares a service business with a merchandising business and then discusses the purchase and sale of merchandise inventory. The chapter then explains how to complete the accounting cycle for a merchandising company. Following an illustration of the operating cycle, both the periodic and perpetual inventory systems are defined; however, only the perpetual inventory system is emphasized. Students learn to make journal entries based on the purchase invoice. Purchase discounts, purchase returns and allowances, and transportation costs are discussed. The terms FOB destination and FOB shipping point are explained. The chapter then illustrates the journal entries for cash and credit sales, cost of goods sold, sales discounts, and sales returns and allowances. Gross profit is explained. The second part of the chapter begins with a discussion of the adjusting and closing process in a merchandising business. Students add an inventory adjustment to the adjusting entries previously learned. Closing entries for a merchandiser are journalized and posted. Preparation of the financial statements is discussed, emphasizing the classifications on the income statement. The multi-step and single-step income statement formats are compared. The gross profit percentage and the inventory turnover and ways to use these ratios in decision making complete the chapter. Decision guidelines help students answer some key questions about a merchandiser s financial statements. A summary problem reviews closing entries, financial statements, and inventory turnover. The work sheet for a merchandising business is illustrated and the similarities and differences between this work sheet and a service business s work sheet are highlighted. The computation of cost of goods sold in a periodic inventory system is discussed and illustrated. CHAPTER OBJECTIVES After reading this chapter, students should be able to: Describe and illustrate merchandising operations and the two types of inventory systems Account for the purchase of inventory using a perpetual system Account for the sale of inventory using a perpetual system Adjust and close the accounts of a merchandising business Prepare a merchandiser s financial statements Use gross profit percentage and inventory turnover to evaluate a business Page 1

2 ISSUES FOR REVIEW AND DISCUSSION 1. Credit terms of 2/10 n/30 mean that the purchaser may deduct 2 percent if the invoice is paid within 10 days, with the full amount due in 30 days if the early payment option is NOT exercised. 2. Freight in is an addition to the inventory account if the company uses the perpetual inventory method. 3. The accounting cycle for a merchandising company begins with the purchase of inventory. 4. Inventory is the most important asset for a merchandiser. 5. Owners and managers generally strive to sell inventory quickly. 6. The perpetual inventory system keeps a running record of inventory and cost of goods sold. 7. Describe a perpetual inventory system and a periodic inventory system. What are the important differences in these two types of inventory systems? A perpetual inventory system keeps a running record of inventory and cost of goods sold. This inventory system is integrated with accounts receivable and sales. Computers help to keep up-to the minute records to show the current inventory at any time. The system keeps track of inventory as it is both bought and sold, constantly updating the inventory account to current levels. This system offers management more control over inventory but requires a tremendous amount of record keeping. The sale of inventory requires not just one, but two entries, to record a transaction. One entry records the sales price of an item in revenue, while the other entry record the cost of the item in cost of goods sold. A periodic inventory system does NOT keep a continuous record of inventory on hand. At the end of the period, a physical count must be taken of inventory on hand to determine the cost of the items sold during the period. This type of system is used for relatively inexpensive goods. It does NOT offer as much control over inventory, but is much easier to account for on a daily basis. Page 2

3 8. A company uses the perpetual inventory method. Which of the following entries would be made to record a purchase of inventory on account? The accounting entry would be a debit to Inventory and a credit to Accounts payable. 9. A company uses the perpetual inventory method. Which of the following entries would be made to record a $1,200 purchase of inventory on account? The accounting entry would be a $1,200 debit to Inventory and a $1,200 credit to Accounts payable. 10. Journalize the following transactions (using the periodic inventory method): July 5 Purchased merchandise on account for $4,300 July 8 Paid freight charge on merchandise purchased on July 3 $230 Purchases 4,300 Accounts payable 4300 Freight in 230 Cash Journalize the following transactions (using the perpetual inventory method): July 5 Purchased merchandise on account for $4,300 July 8 Paid freight charge on merchandise purchased on July 3 $230 Inventory 4,300 Accounts payable 4,300 Inventory 230 Cash Compute the discount and the amount of payment for an invoice of $5600, 4/10, n30 paid on the 7th day x.04 = $224; pay = $5,376 Page 3

4 13. Create the journal entry for the purchase and payment of an invoice of $2200, 3/10, n15 if paid on the 17th day (using the perpetual inventory method). Inventory 2200 Accounts 2200 payable Accounts 2200 payable Cash 2200 Page 4

5 CHAPTER 6: MERCHANDISE INVENTORY CHAPTER SYNOPSIS Chapter 6 examines the accounting for merchandise inventory. The perpetual inventory record is explained. Four different costing methods specific unit cost, average cost, FIFO cost, and LIFO cost are explained. Students learn how to determine the quantity and cost of inventories and cost of goods sold for FIFO, LIFO, and average costing by using the perpetual inventory record and how to create the related journal entries. The inventory methods are compared and the advantages and disadvantages of each are detailed. A mid-chapter summary problem allows students to practice preparing three perpetual inventory records, preparing journal entries using FIFO, LIFO, and average cost, and computing gross profit for each method. The accounting principles and concepts that affect inventory the consistency principle, the disclosure principle, the materiality concept, and accounting conservatism are explained. The lower-of-cost-or-market rule is defined, followed by an illustration of the effects of inventory errors. The process of estimating the value of ending inventory by the gross profit method is explained. Ethical issues in inventory accounting are emphasized. The chapter then illustrates how to estimate inventory using the gross profit method. The Decision guidelines provide guidance for inventory management. The chapter concludes with a summary problem that has students prepare three income statements using FIFO, LIFO, and average cost. CHAPTER OBJECTIVES After reading this chapter, students should be able to: Define accounting principles related to inventory Define inventory costing methods Account for perpetual inventory by the three most common costing methods Compare the effects of the three most common costing methods Apply the lower-of-cost-or-market rule to inventory Measure the effects of inventory errors Estimate ending inventory by the gross profit method ISSUES FOR REVIEW AND DISCUSSION 1. Effects of inventory on the financial statements: Balance Sheet: current asset Income Statement: Cost of goods sold Page 5

6 Gross profit and net income 2. Accounting concepts and principles related to inventory: The consistency principle The disclosure principle The materiality concept Conservatism 3. Inventory Costing Methods: Specific unit cost (a.k.a. specific identification) - Uses specific cost of each unit of inventory First-In, First-Out (FIFO) - Cost of goods sold is based on oldest purchases - Inventory is based on most recent purchases Last-In, First-Out (LIFO) - Cost of goods sold is based on most recent purchases - Inventory is based on oldest costs of the period Average-cost - Cost of goods sold and inventory are based on the new weighted-average cost calculated after each purchase 4. Comparison of inventory methods in a period of rising prices: FIFO highest inventory, lowest cost of goods sold, highest gross profit, and net income LIFO lowest inventory, highest cost of goods sold, lowest gross profit, and net income - Lowest income taxes The opposite would be true in a period of decreasing prices - FIFO lowest inventory, highest cost of goods sold, lowest gross profit and net income - LIFO highest inventory, lowest cost of goods sold, highest gross profit and net income 5. The perpetual inventory system requires the use of a perpetual record. The perpetual record keeps track of purchases, cost of goods sold, and inventory on hand. Revenue is not recorded on the perpetual record. 6. The lower-of-cost-or-market (LCM) rule follows the conservatism principle. Inventory is recorded at whichever is lower the historical cost of the inventory, or Page 6

7 the market value (i.e., current replacement cost) of the inventory. 7. An error in inventory (i.e., understatement or overstatement) affects inventory, cost of goods sold, gross profit, and net income for two accounting periods. The error carries over to the second period but has the opposite effect on each item in the second period. The third period s financial statements would be correct. 8. The gross profit method can be used to estimate the value of ending inventory. Beginning inventory + net purchases = cost of goods available for sale cost of goods sold* = ending inventory *Cost of goods sold = Sales gross profit 9. Ending inventory can only be determined through a physical count for the periodic system. FIFO, LIFO, and average cost can be used to determine the value of ending inventory. 10. Samson Company had the following balances and transactions during Beginning inventory 10 units at $70 March 10 sold 8 units for $100 June 10 purchased 20 units at $80 October 30 sold 15 units for $100 What would the company's inventory amount be on the December 31, 2009 balance sheet if the perpetual First-in, First-out costing method is used? (Answers are rounded to the nearest dollar.) $ Metro Computer Company had the following balances and transactions during Beginning inventory 100 units at $75 March 10 sold 50 units for $200 June 10 purchased 200 units at $80 October 30 sold 150 units for $220 What would the company's inventory amount be on the December 31, 2009 balance sheet if the perpetual Last-in, First-out costing method is used? Page 7

8 (Answers are rounded to the nearest dollar.) $7,750 Page 8

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