Financial Accounting

Module 7: Merchandising Operations

Module Learning Outcomes

Describe the accounting and reporting of purchases and sales of

merchandise

7.1: Identify issues unique to merchandising companies

7.2: Accounting for inventory under the periodic method
7.3: Accounting for inventory under the perpetual method
Merchandising Business
Learning Outcomes: Merchandising Business

7.1: Identify issues unique to merchandising companies

7.1.1: Compare and contrast merchandising enterprises and service
providers
7.1.2: Define merchandise inventory
7.1.3: Describe cost of goods sold in relation to the matching principles
7.1.4: Define gross profit and gross profit percentage
Merchandisers versus Service Enterprises

• Merchandising businesses,
unlike service businesses
have inventory. Inventory is
goods for sale during the
ordinary course of business.
• Manufacturing business have
inventory as well: raw
materials, work-in-process
and finished goods.
Inventory

• On a used car lot, cars are the

inventory. Clothing is the inventory in a
clothing store. For a real estate
developer, inventory is homes waiting
to be sold. On the car lot, the sales
building would not be inventory, even if
the owner of the lot decided to sell it for
some reason (say it’s a small building
that could be moved, or the owner is
selling the entire business).
• In addition, if the owner had a company
car used only for business, that car
would be an asset, not inventory. Only
items held for sale during the ordinary
course of business are considered
inventory.
Cost of Goods Sold

• Under accrual basis accounting, we recognize revenue as it is earned and

expenses as they are incurred in order to match those expenses with the
revenue. It means when we buy inventory, and it is sitting on the lot,
lying on the shelf, or hanging on a rack, it is not an expense.
• Inventory is not recorded as an expense when we buy it from the
wholesaler or distributor. It is an asset: something we own that will
produce future revenue.
• Under the matching principle, we record the expense when we recognize
the revenue from the sale of inventory.

Cost of Goods Sold = Beginning Inventory + Purchases - Ending Inventory

Gross Profit

Gross profit (or Gross Margin) is a calculation:

Sales Revenue − Cost of Goods Sold = Gross Profit

Gross Profit Percentage is also an easy calculation:

Gross Profit / Sales Revenue

Practice Question 1

The Warm Tootsies company sells socks in bulk. This year the company had
a total in sales of $350,000, with the cost of goods sold being $225,000 and
the company’s operating expenses at $50,000. What is the gross profit and
the gross profit percentage for the company?

A. $125,000 gross profit : 36% gross profit percentage

B. $75,000 gross profit : 21% gross profit percentage
C. $175,000 gross profit : 50% gross profit percentage
D. $300,000 gross profit : 86% gross profit percentage
Periodic Inventory System
Learning Outcomes: Periodic Inventory System

7.2: Accounting for inventory under the periodic method

7.2.1: Compare and contrast periodic and perpetual inventory systems
7.2.2: Record Purchases under a periodic system
7.2.3: Record purchase returns and allowances and purchase discounts
under a periodic system
7.2.4: Record sales of inventory under a periodic system
7.2.5: Compute cost of goods sold under a periodic system and create
journal entries
Periodic Inventory System Compared to
Perpetual
In a periodic system, the inventory In a perpetual system, the inventory
account: account:
• Has only the ending balance from the • Is debited whenever there is a
previous accounting year. purchase of goods (there is no
• Excludes the cost of purchases, Purchases account).
purchases returns and allowances, • Is credited for the cost of the items
etc. sold (and the account Cost of Goods
• Must be adjusted at the end of the Sold is debited).
accounting year in order to report the • Has a continuously or perpetually
costs actually in inventory. changing balance because of the
• Requires a physical inventory at least above entries.
once per year and estimates within • Requires a physical inventory to
the year. correct any errors in the Inventory
• The periodic inventory system account.
requires a calculation to determine • The cost of goods sold is readily
the cost of goods sold. available in the account Cost of Goods
Sold.
Purchases under a Periodic System

• Companies using periodic

inventory don’t update the
Merchandise Inventory account
when purchases or sales are
made. Instead, the company
posts purchases of inventory to
an expense account called
Purchases.
• The Purchases account is usually
grouped with the income
statement expense accounts in
the chart of accounts.
Purchase Adjustments under a Periodic System

Formula for purchase returns, allowances, and discounts under a Periodic

System:

Beginning inventory + (Purchases, net of returns and allowances, and

purchase discounts) + freight in − Ending inventory = Cost of goods sold
Periodic Method vs. Perpetual Method
Comparative chart of accounts for Cost of Goods Sold (also called Cost of Sales)
Account Periodic Method Perpetual Method
purchases, purchase discounts,
returns and allowances, and freight
only one entry made at the end of the
Merchandise Inventory in are all posted here, and every
period
time a sale is made, this account is
updated.

all the other accounts listed below are

every time a sale is made, this
closed to this one at the end of the period
Cost of Goods Sold account is updated (with a debit
including the adjustment to Merchandise
entry)
inventory

purchases of inventory are posted here as a

Purchases not used
debit

Purchase Discounts (Contra purchase discounts are posted here as a

not used
Account) credit

Purchase Returns and purchase returns and allowances are posted

not used
Allowances (Contra Account) here as a credit

shipping on inventory purchases are posted

Freight in not used
here as a debit
Sales under a Periodic System

Gross Method

JOURNAL
Post.
Date Description Debit Credit
Ref.
20–
20,700.0
Dec 19 Accounts Receivable
0
Dec 19 Shipping Billed to Customers 700.00
20,000.0
Dec 19 Sales Revenue
0
Dec 19 To record sale of XPX-101 to Geyer inv. 1258
Sales under a Periodic System (cont.)

Net Method
• Under the net method, sales would be recorded net of the discount and if
a customer pays after the discount period expires, the extra revenue is
posted to an account called “Sales Discounts Forfeited” or something
similar.
Cost of Goods Sold: Periodic System
Geyer Co.
Income Statement (partial)
For the year ended December 31, 20XX
$2,548,95
Sales Revenue, net
9

Cost of goods sold

Merchandise inventory, January 1, 20XX $457,897

Purchases 1,532,444

Less purchase discounts 20,222

Less returns and allowances 56,000

Purchases, net 1,456,222

Plus Freight in 66,231

Goods available for sale $1,980,350

Less merchandise inventory, December 31,

238,687
20XX

Cost of goods sold 1,741,663

Gross profit $807,296

Gross profit % 31.67%

Perpetual Inventory System
Learning Outcomes: Perpetual Inventory System

7.3: Accounting for inventory under the perpetual method

7.3.1: Record Purchases under a perpetual system
7.3.2: Record sales of inventory under a perpetual system
7.3.3: Illustrate how inventory counts are used as an internal control under
a perpetual system
Perpetual and Periodic Inventory Systems
Purchases under a Perpetual System

JOURNAL Page 101

Post.
Date Description Debit Credit
Ref.
20XX
20,700.0
Dec 19 Merchandise Inventory
0
20,700.0
Accounts Payable
0
To record purchase of XPS-101 from Bryan Whls
200 count
Purchases under a Perpetual System (cont.)
Sales under a Perpetual System
Gross Method

Periodic Method Perpetual Method

Sales Revenue—gross sales are posted here as a credit Sales Revenue—gross sales are posted here as a credit

Sales Discounts (Contra Account)—sales discounts are posted here as Sales Discounts (Contra Account)—sales discounts are posted here as
a debit a debit

Sales Returns and Allowances (Contra Account)—sales returns and Sales Returns and Allowances (Contra Account)—sales returns and
allowances are posted here as a debit allowances are posted here as a debit

Net Method

Periodic Method Perpetual Method

Sales Revenue—net sales are posted here as a credit Sales Revenue—net sales are posted here as a credit

Sales Discounts Forfeited—sales discounts not claimed by the Sales Discounts Forfeited—sales discounts not claimed by the
customer are posted here as a credit customer are posted here as a credit

Sales Returns and Allowances (Contra Account)—sales returns and Sales Returns and Allowances (Contra Account)—sales returns and
allowances are posted here as a debit allowances are posted here as a debit
Internal Controls over Inventory

• One of the main internal controls over inventory when using the
perpetual system is the physical count. Unlike periodic inventory, where
we count at the very end of the accounting period in order to calculate
COGS, under perpetual inventory we constantly take test counts. We
don’t count everything all at once though. In January, we count one class
of items or category, and then another in February, and so on, or at
random times, unannounced.
• Under the perpetual inventory system, when the actual physical counts
don’t agree with the accounting records, we have to make an adjustment
to the accounting records. It’s usually not “swelling,” which means there
is more inventory on hand than in the records. It’s usually “shrinkage.”
Let’s say the actual physical count revealed there were only 63 MMM 333
in stock. We would probably post the shrinkage to COGS.
Practice Question 2

Trevor started a small corner convenience store last year and was successful
enough to expand into a larger space this year. With more space, he has
more products to offer and is switching over to a perpetual inventory system
and hired you to set it up. While setting up the system, you need to map the
purchases of the convenience store products such as toiletries and candy
bars to be sold to which account?

A. Purchases account
B. Sales account
C. Supplies account
D. Merchandise Inventory account
Quick Review
• What are the differences between merchandising enterprises and service providers?
• What is the definition of merchandise inventory?
• What is cost of goods sold in relation to the matching principles?
• What is the definition of gross profit and gross profit percentage?
• Compare and contrast periodic and perpetual inventory systems.
• How are Purchases recorded under a periodic system?
• How are purchase returns and allowances and purchase discounts recorded under a
periodic system?
• How are sales of inventory under a periodic system recorded?
• What is the cost of goods sold under a periodic system and how are the journal
entries created?
• How are Purchases recorded under a perpetual system?
• When and how is sales of inventory recorded under a perpetual system?
• Describe how inventory counts are used as an internal control under a perpetual
system.