Chapter 6 Accounting for a Merchandising

Enterprise
Learning Outcomes
By the end of this lesson, you will be able to:

·         Differentiate revenues earned and expenses incurred by a merchandiser and

servicer

·         Understand the operating cycle for merchandising company

·         Describe the inventory system using periodic method and perpetual method.

·         Determine cost of inventory using the first in- first out method.

·         Account for sales and compute for net sales revenue.

·         Account for purchases and compute for net cost of purchases.

·         Determine cost of sales, gross income and operating income.

·         Prepare the merchandiser's financial statements in accordance with

International Accounting Standards and Philippine Financial Reporting Standards.

Chapter 6 Accounting for a Merchandising Enterprise

Seller Entries under Periodic Inventory Method
Companies using the periodic inventory method make no attempt to determine the
cost of goods sold at the time of each sale. Instead, they calculate the cost of all the
goods sold during the accounting period at the end of the period. We will look at
calculating cost of goods sold a little later.  Key point to remember:  Under the
periodic inventory method, a cost of good sold account is not used to record sales
transactions.

This section explains how to record sales revenues, including the effect of trade
discounts. Then, we explain how to record two deductions from sales revenues—sales
discounts and sales returns and allowances.
Usually sales are for cash or on account. When a sale is for cash, the company credits
the Sales account and debits Cash. For example, it records a 20,000 sale for cash as
follows:

Account Debit Credit

Cash 20,000
    Sales 20,000
To record the sales of merchandise for cash.
When a sale is on account, it credits the Sales account and debits Accounts
Receivable. The following entry records a 20,000 sale on account:

Account Debit Credit

Accounts Receivable 20,000
    Sales 20,000
To record the sales of merchandise on account.   
When a company sells merchandise to a customer, the seller provides credit terms. 
Remember, terms tell a buyer when the invoice is due and if there is a discount
allowed for paying early.  Discounts are not recorded until payment is received since
the seller does not know if the buyer will take the discount at the time of the sale.

Sales returns and allowances

Merchandising companies usually allow customers to return goods that are defective
or unsatisfactory for a variety of reasons, such as wrong color, wrong size, wrong
style, wrong amounts, or inferior quality.  A sales return is merchandise returned by
a buyer.  A sales allowance is a reduction of the price when the customer keeps the
merchandise but is dissatisfied for any of a number of reasons, including inferior
quality, damage, or deterioration in transit.  The account entry is the same whether it
is a sales return or allowance.

Sellers record sales returns and sales allowances in a separate Sales Returns and
Allowances account. The Sales Returns and Allowances account is a contra revenue
account (to Sales) that records the selling price of merchandise returned by buyers or
reductions in selling prices granted.

Following are two examples illustrating the recording of sales returns in the Sales
Returns and Allowances account:
·         Assume that a customer returns 300 of goods sold on account. If payment has
not yet been received, the required entry is:

Account Debit Credit

Sales Returns and Allowances 300
    Accounts Receivable 300
To record a sales return from a customer.   
·         Assume that the customer has already paid the account and the seller gives the
customer a cash refund. Now, the credit is to Cash rather than to Accounts
Receivable. If the customer has taken a 2% discount when paying the account, the
company would return to the customer the sales price less the sales discount amount.
For example, if a customer returns goods that sold for 300, on which a 2% discount
was taken, the following entry would be made:

Account Debit Credit

Sales Returns and Allowances 300
    Cash (300 – 6) 294
    Sales Discount  (300 x 2%) 6
To record a sales return from a customer who had taken a  
discount and was sent a cash refund.  
The debit to the Sales Returns and Allowances account is for the full selling price of
the purchase. The 6 credit reduces the balance of the Sales Discounts account and
the balance is the cash refund.

Next, we illustrate the recording of a sales allowance in the Sales Returns and
Allowances account. Assume that a company grants a 400 allowance to a customer
for damage resulting from improperly packed merchandise. If the customer has not
yet paid the account, the required entry would be:

Account Debit Credit

Sales Returns and Allowances 400
    Accounts Receivable 400
To record a sales allowance granted for damaged merchandise.
If the customer has already paid the account, the credit is to Cash instead of
Accounts Receivable. If the customer took a 2% discount when paying the account,
the company would refund only the net amount 392. Sales Discounts would be
credited for 8. The entry would be:

Account Debit Credit

Sales Returns and Allowances 400
    Cash (400 – 8) 392
    Sales Discount (400 x 2%) 8
To record a sales allowance when a customer has paid and   
taken a 2% discount.  
 

Receiving Payment from Customers

Remember, the credit terms (or terms) provides information to the buyer about
when the invoice is due and if there is a discount allowed for paying the invoice
early.  The discount is not recorded until payment is received because the seller does
not know if a buyer will take the discount or not.  Discounts are recorded in a contra-
revenue account called Sales Discounts.  We will be reducing the amount owed by
the customer (accounts receivable) and increasing sales discounts (if any) and cash.

For example, we receive payment of the 20,000 and the customer took a 2%
discount.  The entry to record this transaction would be:

Account Debit Credit

Sales Discounts (20,000 x 2%) 400
Cash (20,000 – 400) 19,600
     Accounts Receivable 20,000 If th
To record customer payment with 2% discount.   e

customer had returned merchandise for 300 before paying the invoice, the entry to
record this transaction with a 2% discount would be:

Account Debit Credit

Sales Discounts (19,700 x 2%) 394
Cash (19,700 – 394) 19,306
       Accounts Receivable (20,000 – 300) 19,700
To record customer payment with 2% discount and return.   
If the customer had a 400 allowance but paid the invoice after the discount period,
the entry to record the transaction (less the allowance) would be:

Account Debit Credit

Cash (20,000 – 400) 19,600
     Accounts Receivable (20,000 – 400) 19,600
To record customer payment less allowance and no discount.   
Cost of Goods Sold

Remember, companies using the periodic inventory method make no attempt to

determine the cost of goods sold at the time of each sale. Instead, they calculate the
cost of all the goods sold during the accounting period at the end of the period. To
determine the cost of goods sold, a company must know:

·         Beginning inventory (cost of goods on hand at the beginning of the period).

·         Net cost of purchases during the period.

·         Ending inventory (cost of unsold goods at the end of the period).

Inventory is a permanent account meaning the balance rolls over from period to
period.  The ending inventory balance of on period is the beginning inventory of the
next period.

The net cost of purchases is calculated as Purchases + Transportation In – Purchase

Discounts – Purchases Returns and Allowances.

Ending inventory is based on a physical count of inventory on hand before issuing

financial statements.  Taking a physical inventory consists of counting physical units
of each type of merchandise on hand. To calculate inventory cost, they multiply the
number of each kind of merchandise by its unit cost. Then, they combine the total
costs of the various kinds of merchandise to provide the total ending inventory cost.
When taking a physical inventory, company personnel must be careful to count all
goods owned, regardless of where they are located, and include them in the
inventory.
The company would show this information as follows:

An adjusting entry would be made at year end to record the cost of goods sold
expense and reduce inventory so the balance in inventory matches the physical
count.  The entry for the example above would be:

Account Debit Credit

Cost of goods sold 154,000
       Merchandise Inventory 154,000
To record cost of goods sold during period.   

Summary

Under the periodic inventory method, the seller will use the following accounts:

Sales Discounts and Sales Returns and Allowances are contra-revenue accounts. 
Remember, we do not record sales transactions using either merchandise inventory
or cost of goods sold expense account under the periodic inventory method.  Instead,
cost of goods sold is calculated at the end of the period and recorded in an adjusting
journal entry.

Merchandising Business
In Chapter 1 we introduced the three main types of businesses, merchandising,
service and manufacturing. Merchandising companies purchase goods that are ready
for sale and then sell them to customers. Merchandising companies include auto
dealerships, clothing stores, and supermarkets, all of which earn revenue by selling
goods to customers.

In a merchandising sales transaction, the seller sells a product and transfers the legal
ownership (title) of the goods to the buyer.  A business document called an invoice (a
sales invoice for the seller and a purchase invoice for the buyer) becomes the basis for
recording the sale.

An invoice is a document prepared by the seller of merchandise and sent to the

buyer. The invoice contains the details of a sale, such as the number of units sold,
unit price, total price billed, terms of sale, and manner of shipment.

Do you see a due date on the invoice?  What about who pays for shipping?  This is all
detailed in the terms.  You see two types of terms:

·         Payment Terms:  tells you when an invoice is due and if a discount is offered for
early payment
·         Shipping Terms:  tells you who is responsible for paying for shipping and when
the title of the goods passes to the buyer

Payment Terms
In some industries, credit terms include a cash discount of 1% to 3% to encourage
early payment of an amount due. A cash discount is a deduction from the invoice
price that can be taken only if the invoice is paid within a specified time. Sellers call a
cash discount a sales discount and buyers call it a purchase discount. Companies
often state payment terms as follows:

•1/10, n/30—means a buyer who pays within 10 days following the invoice date may
deduct a discount of 1% of the invoice price. If payment is not made within the
discount period, the entire invoice price is due 30 days from the invoice date.

•3/EOM, n/60—means a buyer who pays by the end of the month of purchase may
deduct a 3% discount from the invoice price. If payment is not made within the
discount period, the entire invoice price is due 60 days from the invoice date.

•2/10/EOM, n/60—means a buyer who pays by the 10th of the month following the
month of purchase may deduct a 2% discount from the invoice price. If payment is
not made within the discount period, the entire invoice price is due 60 days from the
invoice date.

•Net 30 —means the entire invoice price is due 30 days from the invoice date without
a discount.

Sellers cannot record the sales discount before they receive the payment since they
do not know when the buyer will pay the invoice. A cash discount taken by the buyer
reduces the cash that the seller actually collects from the sale of the goods, so the
seller must indicate this fact in its accounting records.

Companies base discounts on the invoice price of goods. If merchandise is later

returned, the returned amount must be deducted from the invoice price before
calculating discounts. For example, the invoice price of goods purchased was 30,000
and the company returned 2,000 of the goods, the seller calculates the 2% discount
on 28,000 (30,000 original – 2,000 return).
Shipping Terms
Shipping terms are used to show who is responsible for paying for shipping and when
the title of the goods passes from seller to buyer. To understand how to account for
transportation costs, you must know the meaning of the following terms:

·         FOB shipping point means “free on board at shipping point”. The buyer

incurs all transportation costs after the merchandise has been loaded on a railroad
car or truck at the point of shipment. Thus, the buyer is responsible for ultimately
paying the freight charges.

·         FOB destination means “free on board at destination”. The seller ships the

goods to their destination without charge to the buyer. Thus, the seller is ultimately
responsible for paying the freight charges.

We will look at how these items factor into journal entries for merchandising
companies in the next sections.

Merchandise inventory is the cost of goods on hand and available for sale at any
given time.   Merchandise inventory (also called Inventory) is a current asset with a
normal debit balance meaning a debit will increase and a credit will decrease.

To determine the cost of goods sold in any accounting period, management needs
inventory information. Management must know:

·         its cost of goods on hand at the start of the period (beginning inventory)

·         the net cost of purchases during the period

·         and the cost of goods on hand at the close of the period (ending inventory).

Since the ending inventory of the one period is the beginning inventory for the next
period, management already knows the cost of the beginning inventory. Companies
record purchases, purchase discounts, purchase returns and allowances, and
transportation-in throughout the period. Therefore, management needs to determine
only the cost of the ending inventory at the end of the period in order to calculate
cost of goods sold.

Cost of goods sold is the inventory cost to the seller of the goods sold to customers. 
Cost of Goods Sold is an EXPENSE item with a normal debit balance (debit to
increase and credit to decrease). Even though we do not see the word Expense this in
fact is an expense item found on the Income Statement as a reduction to Revenue.  

Accountants must have accurate merchandise inventory figures to calculate cost of

goods sold. Accountants use two basic methods for determining the amount of
merchandise inventory—perpetual inventory procedure and periodic inventory
procedure.

When discussing inventory, we need to clarify whether we are referring to the

physical goods on hand or the Merchandise Inventory account, which is the financial
representation of the physical goods on hand. The difference between perpetual and
periodic inventory procedures is the frequency with which the Merchandise
Inventory account is updated to reflect what is physically on hand.

Under perpetual inventory procedure, the Merchandise Inventory account is

continuously updated to reflect items on hand, and under the periodic method we
wait until the END to count everything.

Perpetual inventory procedure:

Companies use perpetual inventory procedure in a variety of business settings.
Historically, companies that sold merchandise with a high individual unit value, such
as automobiles, furniture, and appliances, used perpetual inventory procedure.
Today, computerized cash registers, scanners, and accounting software programs
automatically keep track of inflows and outflows of each inventory item.
Computerization makes it economical for many retail stores to use perpetual
inventory procedure even for goods of low unit value, such as groceries.

Under perpetual inventory procedure, the Merchandise Inventory account provides

close control by showing the cost of the goods that are supposed to be on hand at any
particular time. Companies debit the Merchandise Inventory account for each
purchase and credit it for each sale so that the current balance is shown in the
account at all times. Usually, firms also maintain detailed unit records showing the
quantities of each type of goods that should be on hand. Company personnel also
take a physical inventory by actually counting the units of inventory on hand. Then
they compare this physical count with the records showing the units that should be
on hand.
Periodic inventory procedure:
Merchandising companies selling low unit value merchandise (such as nuts and
bolts, nails, Christmas cards, or pencils) that have not computerized their inventory
systems often find that the extra costs of record-keeping under perpetual inventory
procedure more than outweigh the benefits. These merchandising companies often
use periodic inventory procedure.

Under periodic inventory procedure, companies do not use the Merchandise

Inventory account to record each purchase and sale of merchandise. Instead, a
company corrects the balance in the Merchandise Inventory account as the result of a
physical inventory count at the end of the accounting period. Also, the company
usually does not maintain other records showing the exact number of units that
should be on hand. Although periodic inventory procedure reduces record-keeping,
it also reduces control over inventory items.  Firms assume any items not included in
the physical count of inventory at the end of the period have been sold. Thus, they
mistakenly assume items that have been stolen have been sold and include their cost
in cost of goods sold.

To determine the cost of goods sold, a company must know:

·         Beginning inventory (cost of goods on hand at the beginning of the period).

·         Net cost of purchases during the period (purchases + transportation in –

purchase discounts – purchase returns and allowances)

·         Ending inventory (cost of unsold goods at the end of the period).

To illustrate, Hanlon Food Store had the following unadjusted trial balance amounts:

The unadjusted trial balance amount for inventory represents the ending inventory
from last period. In our first adjusting entry, we will close the purchase related
accounts into inventory to reflect the inventory transactions for this
period.  Remember, to close means to make the balance zero and we do this by
entering an entry opposite from the balance in the trial balance.

Next we can look at recording cost of goods sold.  The beginning inventory is the
unadjusted trial balance amount of 24,000.  The net cost of purchases for the year is
166,000 (calculated as Purchases 167,000 + Transportation In 10,000 – Purchase
discounts 3,000 – Purchase returns and allowances 8,000).  On December 31, the
physical count of merchandise inventory was 31,000, meaning that this amount was
left unsold. We calculate cost of goods sold as follows:

Beg. Inventory 24,000 + Net Purchases 166,000 – Ending inventory count 31,000 =
159,000 cost of goods sold

The second adjusting journal would increase (debit) cost of goods sold and decrease
(credit) inventory for the calculated amount of cost of goods sold and would look
like:

Next we would post these adjusting journal entries.  We will look at the how the
merchandise inventory account changes based on these transactions.  The physical
inventory count of 31,000 should match the reported ending inventory balance. 
Notice how the ending inventory balance equals physical inventory of 31,000
(unadjusted balance 24,000 + net purchases 166,000 – cost of goods sold 159,000).

Summary
The perpetual inventory method has ONE additional adjusting entry at the end of the
period.  This entry compares the physical count of inventory to the inventory balance
on the unadjusted trial balance and adjusts for any difference.  The difference is
recorded into cost of goods sold and inventory.

The periodic inventory methods has TWO additional adjusting entries at the end of
the period.  The first entry closes the purchase accounts (purchases, transportation
in, purchase discounts, and purchase returns and allowances) into inventory by
increasing inventory.  The second entry records cost of goods sold for the period
calculated as beginning inventory (unadjusted trial balance amount) + net purchases
– ending inventory (physical inventory account) from the inventory account.

A merchandising company uses the same 4 financial statements we learned before: 

Income statement, statement of retained earnings, balance sheet, and statement of
cash flows.  The balance sheet used is the classified balance sheet.  The income
statement for a merchandiser is expanded to include groupings and subheadings
necessary to make it easier for investors to read and understand.  We will look at the
income statement only as the other statements have been discussed previously.
Multi-Step (or Classified) Income Statement
In preceding chapters, we illustrated the income statement with only two categories
—revenues and expenses. In contrast, a multi-step income statement divides both
revenues and expenses into operating and non-operating (other) items. The
statement also separates operating expenses into selling and administrative expenses.
A multi-step income statement is also called a classified income statement.
The multi-step income statement shows important relationships that help in
analyzing how well the company is performing. For example, by deducting cost of
goods sold from operating revenues, you can determine by what amount sales
revenues exceed the cost of items being sold. If this margin, called gross margin, is
lower than desired, a company may need to increase its selling prices and/or decrease
its cost of goods sold. The classified income statement subdivides operating expenses
into selling and administrative expenses. Thus, statement users can see how much
expense is incurred in selling the product and how much in administering the
business. Statement users can also make comparisons with other years’ data for the
same business and with other businesses. Non-operating revenues and expenses
appear at the bottom of the income statement because they are less significant in
assessing the profitability of the business.

Management chooses which income statement to present a company’s financial data.

This choice may be based either on how their competitors present their data or on
the costs associated with assembling the data.

The major headings of the classified multi-step income statement are explained

below:

·         Net Sales are the revenues generated by the major activities of the business—
usually the sale of products or services or both less any sales discounts and sales
returns and allowances.

·         Cost of goods sold is the major expense in merchandising companies and

represents what the seller paid for the inventory it has sold.

·         Gross margin or gross profit is the net sales – cost of goods sold and
represents the amount we charge customers above what we paid for the items.  This
is also referred to as a company’s markup.

·         Operating expenses for a merchandising company are those expenses, other

than cost of goods sold, incurred in the normal business functions of a company.
Usually, operating expenses are either selling expenses or administrative
expenses. Selling expenses are expenses a company incurs in selling and marketing
efforts. Examples include salaries and commissions of salespersons, expenses for
salespersons’ travel, delivery, advertising, rent (or depreciation, if owned) and
utilities on a sales building, sales supplies used, and depreciation on delivery trucks
used in sales. Administrative expenses are expenses a company incurs in the
overall management of a business. Examples include administrative salaries, rent (or
depreciation, if owned) and utilities on an administrative building, insurance
expense, administrative supplies used, and depreciation on office equipment.
·         Income from Operations is Gross profit (or margin) – operating expenses and
represents the amount of income directly earned by business operations.

·         Other revenues and expenses are revenues and expenses not related to the
sale of products or services regularly offered for sale by a business.   This typically
includes interest earned (interest revenue) and interest owed (interest expense).

·         Net Income is the income earned after other revenues are added and other
expenses are subtracted.

Look at these selected accounts from Hanlon’s adjusted trial balance:

We can prepare Hanlon’s Multi-step Income statement as:

The multi-step income statement shows important relationships that help in
analyzing how well the company is performing. For example, by deducting cost of
goods sold from operating revenues, you can determine by what amount sales
revenues exceed the cost of items being sold. If this margin, called gross margin, is
lower than desired, a company may need to increase its selling prices and/or decrease
its cost of goods sold. The classified income statement subdivides operating expenses
into selling and administrative expenses. Thus, statement users can see how much
expense is incurred in selling the product and how much in administering the
business. Statement users can also make comparisons with other years’ data for the
same business and with other businesses. Non-operating revenues and expenses
appear at the bottom of the income statement because they are less significant in
assessing the profitability of the business.

Management chooses which income statement to present a company’s financial data.

This choice may be based either on how their competitors present their data or on
the costs associated with assembling the data.

The major headings of the classified multi-step income statement are explained

below:
·         Net Sales are the revenues generated by the major activities of the business—
usually the sale of products or services or both less any sales discounts and sales
returns and allowances.

·         Cost of goods sold is the major expense in merchandising companies and

represents what the seller paid for the inventory it has sold.

·         Gross margin or gross profit is the net sales – cost of goods sold and
represents the amount we charge customers above what we paid for the items.  This
is also referred to as a company’s markup.

·         Operating expenses for a merchandising company are those expenses, other

than cost of goods sold, incurred in the normal business functions of a company.
Usually, operating expenses are either selling expenses or administrative
expenses. Selling expenses are expenses a company incurs in selling and marketing
efforts. Examples include salaries and commissions of salespersons, expenses for
salespersons’ travel, delivery, advertising, rent (or depreciation, if owned) and
utilities on a sales building, sales supplies used, and depreciation on delivery trucks
used in sales. Administrative expenses are expenses a company incurs in the
overall management of a business. Examples include administrative salaries, rent (or
depreciation, if owned) and utilities on an administrative building, insurance
expense, administrative supplies used, and depreciation on office equipment.

·         Income from Operations is Gross profit (or margin) – operating expenses and
represents the amount of income directly earned by business operations.

·         Other revenues and expenses are revenues and expenses not related to the
sale of products or services regularly offered for sale by a business.   This typically
includes interest earned (interest revenue) and interest owed (interest expense).

·         Net Income is the income earned after other revenues are added and other
expenses are subtracted.

Look at these selected accounts from Hanlon’s adjusted trial balance:

We can prepare Hanlon’s Multi-step Income statement as:

To illustrate a cost of goods sold statement, Hanlon Food Store had the following
unadjusted trial balance amounts:
Remember, the merchandise inventory on the unadjusted trial balance is the
beginning balance (or ending balance from the previous period.  A physical count of
inventory on December 31 showed inventory of 31,000 unsold.  The Cost of Goods
Sold Statement would appear as:

Other financial statements

After the income statement is complete, we would use the net income to calculate
ending retained earnings on the statement of retained earnings.  We would use
ending retained earnings in preparing the balance sheet.  Finally, we would prepare
the statement of cash flows.  These financial statements are prepared the same way
under either the perpetual or periodic inventory methods.

Summary
To summarize the important relationships in the income statement of a
merchandising firm in equation form:

·         Net sales = Sales revenue – Sales discounts – Sales returns and allowances.

·         Gross margin = Net sales – Cost of goods sold.

·         Total Operating Expenses = Selling expenses + Administrative expenses.

·         Income from operations = Gross margin – Operating (selling and

administrative) expenses.

·         Total other revenues (expenses) = Other Revenues – Other Expenses

·         Net income = Income from operations + Other revenues – Other expenses.

Each of these relationships is important because of the way it relates to an overall
measure of business profitability. For example, a company may produce a high gross
margin on sales. However, because of large sales commissions and delivery expenses,
the owner may realize only a very small amount of the gross margin as profit.

Journalizing Closing Entries for a Merchandising Enterprise

At this point in the accounting cycle, we have prepared the financial statements. 
Now we do the last part, the closing entries.  The videos in the adjusting entry
section gave you a preview into this process but we will discuss it in more detail.

The closing entries will be a review as the process for closing does not change for a
merchandising company.  Do you remember why we do closing entries?  They are the
journal entry version of the statement of retained earnings to ensure the balance we
report on the statement of retained earnings and the balance sheet matches the
ending balance of retained earnings in our general ledger.  Closing entries also set the
balances of all temporary accounts (revenues, expenses, dividends) to zero for the
next period.

If the process is the same, why do we need to review it?  We have many new accounts
learned for a merchandiser and we want to see how they fit into the closing process. 
The new accounts remaining for a merchandiser after adjusting entries are:

Revenue accounts typically have normal credit balances (credit to increase, debit to
decrease) but Sales Discounts and Sales Returns and Allowances are contra-accounts
because they are revenue accounts but have normal debit balances (debit to increase,
credit to decrease).  Expenses have normal debit balances.

The four basic steps in the closing process are modified slightly:

·         Closing the revenue accounts with credit balances—transferring the credit

balances in the revenue accounts to a clearing account called Income Summary.

·         Closing the expense accounts and contra-revenue accounts—transferring

the debit balances in the expense accounts and contra-revenue accounts to a clearing
account called Income Summary.

·         Closing the Income Summary account—transferring the balance of the

Income Summary account to the Retained Earnings account (this should always
equal net income or loss from the income statement).

·         Closing the Dividends account—transferring the debit balance of the

Dividends account to the Retained Earnings account.

 To illustrate, let’s look at the adjusted trial balance from Hanlon from the previous
section:

*Contra-accounts

We will prepare the closing entries for Hanlon.  Remember to close means to make
the balance zero.  To do this, we will do the opposite of the balance in the adjusted
trial balance in a journal entry and use Income Summary to balance the entry.
1.  Close the revenue accounts with credit balances.  We have 2 revenue accounts
with a credit balance, Sales Revenue (or Sales) and Interest Revenue.

Account Debit Credit

Sales Revenue 275,000
Interest Revenue 150
  Income Summary 275,150
To close revenue accounts with credit balances.
2.  Close contra-revenue accounts and expense accounts with debit balances. 
We will close sales discounts, sales returns and allowances, cost of goods sold, and all
other operating and non-operating expenses.

3.  Close income summary into retained earnings.  We will take the difference
between income summary in step 1 275,150 and subtract the income summary
balance in step 2 268,050 to get the adjustment amount of 7,100.  This should always
match net income calculated on the income statement.

Account   Debit    Credit 

Income Summary (275,150 – 268,050) 7,100
    Retained Earnings 7,100
To close net income into retained earnings.  
4.  Close the debit balance of dividends into retained earnings.  Remember,
dividends are earnings of the company given back to the owner and will reduce
retained earnings.  Retained earnings is an equity account and is decreased with a
debit.  Dividends is a contra-account because it is an equity account but has a normal
debit balance.  Do not use the retained earnings balance in this entry!
Account Debit Credit
Retained Earnings 8,000
    Dividends 8,000
To close dividends into retained earnings.   
To check our work, the Statement of Retained Earnings would look like this:

When we post the closing entries to the general ledger, the revenues, expenses and
dividends accounts are all zero.  The retained earnings ledger card would look like:

The final step in the merchandising accounting cycle would be to prepare a post-
closing trial balance.  The post-closing trial balance will contain assets, liabilities,
common stock and the new ending balance calculated for retained earnings.

Inventory Methods for Ending Inventory and Cost of Goods Sold

Cost of goods sold and Inventory

Remember, cost of goods sold is the cost to the seller of the goods sold to
customers. Cost of Goods Sold is an EXPENSE item. Even though we do not see the
word Expense this in fact is an expense item found on the Income Statement as
a reduction to Revenue. For a merchandising company, the cost of goods sold can be
relatively large. All merchandising companies have a quantity of goods on hand
called merchandise inventory to sell to customers. Merchandise inventory (or
inventory) is the quantity of goods available for sale at any given time.

You will now learn how to calculate the Cost of Goods Sold using 4 different
methods.
The 4 methods of Cost of Goods Sold you will learn are:

·         FIFO (First in, First out) – this means you will use the OLDEST inventory first
to fill orders. This also means the oldest costs will appear in Cost of Goods Sold (since
this is an Expense account this also means oldest costs will appear in the Income
Statement). The most recent costs are shown in the Inventory asset account balances
and are provided on the Balance Sheet. This is an advantage because you are now
reporting Inventory at the current cost which better reflects what it would cost to
replace inventory if that would become necessary due to a disaster. FIFO shows the
actual flow of goods…typically you will sell the oldest inventory before the newest
inventory.

·         LIFO (Last in, First out) – this means you will use the MOST RECENT
inventory first to fill orders. Cost of goods sold will reflect the current or most recent
costs and are a better representation of matching since you are matching revenue will
current costs of the inventory. The Balance Sheet will show inventory at the oldest
inventory costs and may not represent current market value.

·         Weighted Average (also called Average Cost) – this method is best used
when the prices change from purchase to purchase and you want consistency. The
weighted average method smooths out price changes so you have a steady stream of
cost instead of sharp increases and decreases. You will calculate a new Average Cost
after each Purchase (Sales will not change the average cost).

·         Specific Identification – clearly,

this will be your favorite method…it is the
easiest to calculate in our examples
because it specifically tells you which
purchases inventory comes from. This is
most often used for high priced inventory
– think car sales for example. When a car
dealership purchases a blue BMW
convertible for $20,000 and later sells it
for $60,000…they will want to show the exact cost of the BMW it sold as opposed to
the cost of another car. So, specific identification exactly matches the costs of the
inventory with the revenue it creates.

Okay, enough theory – how do these calculations work exactly? There are a couple of
ways you can do them – there is an Inventory Record or a shortcut calculation. You
will see both because they are both beneficial. Most computer systems will show you
the Inventory Record form so you need to understand how to read it. However, it can
be time consuming and not practical for homework and test situations so you learn
the alternative method as well. We will be using the perpetual inventory system
in these examples which constantly updates the inventory account balance to
reflect inventory on hand.

When calculating the Cost of Goods Sold for a sale, you must IGNORE the selling
price. The selling price has NOTHING to do with the cost. We are trying to
determine how much the items we sold originally COST us – that is the purpose
behind cost of goods sold. Next thing to remember, you can only use items that
occurred BEFORE the sale (meaning, you cannot use a purchase from August 28
when calculating cost of goods sold on August 14 – why? It hasn’t happened yet). We
will pick inventory from the different purchases and use the purchase price to
calculate the cost of goods sold.

FIFO (First in, First Out)

Under the FIFO method, we will use the oldest inventory at the time of the sale first.
You must calculate Cost of Goods Sold for each sale individually.

Using the inventory record format, the transactions from the video would look like
this under the FIFO method:

Total cost of goods sold for the month would be 7,200 (4,000 + 3,200). Since total
Sales would the same as we calculated above Jan 8 Sales ( 300 units x 30) 9,000 + Jan
11 Sales (250 units x 40) 10,000 or 19,000. The gross profit (or margin) would be 11,800
(19,000 Sales – 7,200 cost of goods sold). The journal entries for these transactions
would be would be the same as show above the only thing changing would be the
AMOUNT of cost of goods sold used in the Jan 8 and Jan 15 entries.

Weighted Average (or Average Cost)

The Weighted Average method strives to smooth out price changes during the
period. To do this, we will calculate an average cost of inventory at the end of the
month under the periodic method (perpetual method calculates average cost of
inventory after each purchase). Sales of inventory will not affect the average cost of
inventory. It does NOT matter which purchase the inventory comes from when using
the average cost method. Instead, we will use the average cost calculated to
determine cost of goods sold for any sales transactions. Average Cost is calculated by
taking the TOTAL COST of INVENTORY / TOTAL INVENTORY QUANITY.

The Inventory Record for this information in the video would be:

**Jan 15 and 16 off a little from the information in the video due to rounding of the
average cost.

Total cost of goods sold for January would be 7,017.50 (3600 + 3,417.50). Since total
Sales would the same as we calculated before 19,000. The gross profit (or margin)
would be 11,982.50 (19,000 Sales – 7017.50 cost of goods sold). The journal entries for
these transactions would be would be the same as show above the only thing
changing would be the AMOUNT of cost of goods sold used in the Jan 8 and Jan 15
entries.

Specific Identification

Finally, the last method – we are saving the easiest one for last. Specific identification
will tell you exactly which purchase to use when determining cost.

Easy, huh? No guess work, no hard thinking – just take the information given and
calculate based on the purchase prices given. Let’s look at another example:
·         On May 9, you sold 180 units consisting of 80 units from beginning inventory
and 100 units from the May 6 purchase.

·         May 30 sold 300 units consisting of 200 units from the May 6 purchase and 100
units from the May 25 purchase

Using an Inventory Record, cost of goods sold would look like this:

The total cost of goods sold for May would be 233,800 (59,000 + 174,800).

Methods Under a Periodic Inventory System

The good news for you is the inventory valuation methods under FIFO, LIFO,
weighted average (or average cost), and specific identification are calculated basically
the same under the periodic and perpetual inventory systems! The bad news is the
periodic method does do things just a little differently.

·         Perpetual inventory: Calculates cost of good sold for each sales and records a
journal entry for cost of goods sold with each sales transaction.
·         Periodic inventory: Follows the same basic principle but it calculates ONE cost
of goods sold amount at the end of the month for all items based on the beginning
inventory + all purchases and does not record cost of goods sold with each sales
transaction.

The data we have been working with from the videos in the previous section is:

FIFO Method

Under the FIFO Method, we use the oldest inventory first and work our way forward
until the sales are complete. Under the periodic inventory, cost of goods sold is
assigned at the end of the period only and not with each sales transaction. There
were a total of 550 units sold (remember, price doesn’t have anything to do with cost)
and we will assign cost as follows:
The journal entries under the periodic inventory method using FIFO would be (see
how cost of good sold is recorded once at the end of the period, in this case end of
the month):

LIFO Method

Under the LIFO Method, cost of goods sold is calculated using the most recent
inventory first and then working our way backwards until the sales order has been
filled.

The journal entries under FIFO would be the same but the entry to cost of goods sold
and merchandise inventory done on January 31 and would be:

Jan 31 Cost of goods sold 9,950

Merchandise Inventory 9,950

Weighted Average (or Average Cost)

Watch this video from Note Pirate to understand the periodic inventory method
using average cost:

Using the information from the video, average cost was calculated as total value of
beginning inventory and purchase 13,700 /900 total units in beginning inventory and
purchased to get 15.22. This average cost can then be applied to the 550 units in sales
during January and would be calculated as 550 units x 15.22 with the following journal
entry (all other entries presented under FIFO would be the same):

Jan 31 Cost of goods sold 8,371

Merchandise Inventory 8,371

Specific Identification

Since the specific identification method, identifies exactly which cost the purchase
comes from it does not change under perpetual or periodic. The only thing that
changes is the timing of the entry. Under the perpetual method, cost of goods sold is
calculated and recorded with every sale. Under the periodic inventory method, cost
of goods sold is calculated at the end of the period only and recorded in one entry.

Impacts of Inventory Errors on Financial Statements

Importance of proper inventory valuation
A merchandising company can prepare accurate income statements, statements of
retained earnings, and balance sheets only if its inventory is correctly valued. On the
income statement, the cost of inventory sold is recorded as cost of goods sold. Since
the cost of goods sold figure affects the company’s net income, it also affects the
balance of retained earnings on the statement of retained earnings. On the balance
sheet, incorrect inventory amounts affect both the reported ending inventory and
retained earnings. Inventories appear on the balance sheet under the heading
“Current Assets”, which reports current assets in a descending order of liquidity.
Because inventories are consumed or converted into cash within a year or one
operating cycle, whichever is longer, inventories usually follow cash and receivables
on the balance sheet.

Recall that in each accounting period, the appropriate expenses must be matched
with the revenues of that period to determine the net income. Applied to inventory,
matching involves determining (1) how much of the cost of goods available for sale
during the period should be deducted from current revenues and (2) how much
should be allocated to goods on hand and thus carried forward as an asset
(merchandise inventory) in the balance sheet to be matched against future revenues. 
Net income for an accounting period depends directly on the valuation of ending
inventory. This relationship involves three items:

·         First, a merchandising company must be sure that it has properly valued its
ending inventory. If the ending inventory is overstated, cost of goods sold is
understated, resulting in an overstatement of gross margin and net income. Also,
overstatement of ending inventory causes current assets, total assets, and retained
earnings to be overstated. Thus, any change in the calculation of ending inventory is
reflected, dollar for dollar (ignoring any income tax effects), in net income, current
assets, total assets, and retained earnings.

·         Second, when a company misstates its ending inventory in the current year, the
company carries forward that misstatement into the next year. This misstatement
occurs because the ending inventory amount of the current year is the beginning
inventory amount for the next year.

·         Third, an error in one period’s ending inventory automatically causes an error

in net income in the opposite direction in the next period. After two years, however,
the error washes out, and assets and retained earnings are properly stated.

Thus, in contrast to an overstated ending inventory, resulting in an overstatement of

net income, an overstated beginning inventory results in an understatement of net
income. If the beginning inventory is overstated, then cost of goods available for sale
and cost of goods sold also are overstated. Consequently, gross margin and net
income are understated. Note, however, that when net income in the second year is
closed to retained earnings, the retained earnings account is stated at its proper
amount. The overstatement of net income in the first year is offset by the
understatement of net income in the second year. For the two years combined the
net income is correct. At the end of the second year, the balance sheet contains the
correct amounts for both inventory and retained earnings. Exhibit 3 summarizes the
effects of errors of inventory valuation: