Financial Accounting: An Integrated Statements Approach, 2nd Edition

Chapter 5 Accounting for Merchandise Operations 237

Exhibit 6. Since no dividends payable appears on the balance sheets, cash dividends of

$18,000 must have been paid during the year. In addition, notes payable decreased

by $5,000 during the year. Thus, cash must have been used in paying off $5,000 of

the notes. As a result, cash of $23,000 was used for financing activities, as shown in

Exhibit 8.

Distinguish the activities and financial statements of
a service business from those of a merchandise busi-
ness.The revenue activities of a service enterprise involve
providing services to customers. In contrast, the revenue ac-
tivities of a merchandising business involve the buying and
selling of merchandise.

Describe and illustrate the financial statements of a
merchandising business. The multiple-step income
statement of a merchandiser reports sales, sales returns and
allowances, sales discounts, and net sales. The cost of the
merchandise sold is subtracted from net sales to determine
the gross profit. The cost of merchandise sold is determined
by using either the periodic or perpetual method. Operating
income is determined by subtracting operating expenses
from gross profit. Operating expenses are normally classified
as selling or administrative expenses. Net income is deter-
mined by subtracting income taxes and other expense and
adding other income. The income statement may also be re-
ported in a single-step form. The retained earnings statement
and the statement of cash flows are similar to those for a ser-
vice business. The balance sheet reports merchandise inven-
tory at the end of the period as a current asset.

Describe the accounting for the sale of merchandise.
Sales of merchandise for cash or on account are
recorded by crediting Sales. The cost of merchandise sold
and the reduction in merchandise inventory are also
recorded for the sale. For sales of merchandise on account,
the credit terms may allow sales discounts for early pay-
ment. Such discounts are recorded by the seller as a debit to
Sales Discounts. Sales discounts are reported as a deduction
from the amount initially recorded in Sales. Likewise, when
merchandise is returned or a price adjustment is granted,
the seller debits Sales Returns and Allowances. For sales on
account, a subsidiary ledger is maintained for individual
customer accounts receivable.
Under the perpetual inventory system, the cost of mer-
chandise sold and the reduction of merchandise inventory
on hand are recorded at the time of sale. In this way, the
merchandise inventory account indicates the amount of mer-
chandise on hand at all times. Likewise, any returned mer-
chandise is recorded in the merchandise inventory account,
with a related reduction in the cost of merchandise sold.

Describe the accounting for the purchase of merchan-

dise.Purchases of merchandise for cash or on account

are recorded by debiting Merchandise Inventory. For pur-

chases of merchandise on account, the credit terms may al-

low cash discounts for early payment. Such purchases

discounts are viewed as a reduction in the cost of the mer-

chandise purchased. When merchandise is returned or a

price adjustment is granted, the buyer credits Merchandise

Inventory.

Describe the accounting for transportation costs and

sales taxes. When merchandise is shipped FOB ship-

ping point, the buyer pays the transportation costs and deb-

its Merchandise Inventory. When merchandise is shipped

FOB destination, the seller pays the transportation costs and

debits Transportation Out or Delivery Expense. If the seller

prepays transportation costs as a convenience to the buyer,

the seller debits Accounts Receivable for the costs.

The liability for sales tax is incurred when the sale is

made and recorded by the seller as a credit to the sales taxes

payable account. When the amount of the sales tax is paid

to the taxing unit, Sales Taxes Payable is debited and Cash

is credited.

Illustrate the dual nature of merchandising transac-

tions.Each merchandising transaction affects a buyer

and a seller. The illustration in this chapter shows how the

same transactions would be recorded by both.

Describe the accounting for merchandise shrinkage.

The physical inventory taken at the end of the account-

ing period may differ from the amount of inventory shown

in the inventory records. The difference, called inventory

shrinkage, requires an adjusting entry debiting Cost of

Merchandise Sold and crediting Merchandise Inventory.

After this entry has been recorded, the adjusted

Merchandise Inventory (book inventory) in the accounting

records agrees with the actual physical inventory at the end

of the period.

Describe and illustrate the effects of inventory mis-

statements on the financial statements. Any errors in

the physical inventory count at the end of the accounting

period affect the income statement and balance sheet. If the

physical inventory is misstated, the amount of inventory

shrinkage is misstated and the cost of merchandise sold will

be misstated after the inventory shrinkage adjustment is

recorded. Because net income is closed to Retained

Earnings at the end of the accounting period, the retained

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SUMMARY OF LEARNING GOALS

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