ch05 Fundamental of Financial Accounting by Edmonds (4th Edition)

Fundamental
Financial
Accounting
Concepts
Fourth Edition
by
Edmonds, McNair, Milam, Olds
PowerPoint® presentation by
J. Lawrence Bergin
5- 2
Chapter 5
Accounting
for
Merchandising
Businesses
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

5- 3
Chapter 5: Accounting for

Merchandising Businesses
In Chapter 5 we will consider the
following questions.
● What is the difference between a
service firm and a merchandising firm?
● How does a firm account for inventory?
● How are financial statements
affected by the purchase and
sale of merchandise inventory? Sale
5- 4
Four Major Types of

Businesses
● Service
■ accountants, attorneys, physicians
● Merchandising
■ Wal-Mart, Safeway, The Gap
● Manufacturing
■ General Motors, 3M, Reynolds
Metals
● Financial
■ Citicorp, Merrill Lynch, American
Express
[Obviously, some businesses provide more than one of the
functions listed above]
5- 5
Four Major Types of

Businesses
Which •Performs at concerts
type of Service business
business •Sells CDs during breaks
is a Merchandiser
musician? •Records and duplicates
Service, Merchandising, own CDs

Manufacturing, Financial?
Manufacturer
5- 6
Net Sales
Sales (sometimes called “Gross Sales”)

Minus: Sales Returns and Allowances
Minus: Sales Discounts (often given to

credit customers who pay the seller quickly)
= Net Sales

5- 7
Cost of Goods Sold

● Cost of goods sold is calculated as the
number of units sold during the period
multiplied by their unit costs.
● Cost of goods sold is a major expense
item for most non-service businesses.
● The measurement of cost of goods sold is
an excellent example of the application of
the matching principle Why?
The Cost of Goods Sold EXPENSE is recorded in the period the units
are SOLD (REVENUE is recognized), regardless of when the units are
paid for. So, the EXPENSE is MATCHED against the related REVENUE.

5- 8
Cost of Goods Sold

What is included in the Beginning inventory
“net” cost of purchases? Add: Purchases (net)
Cost of Goods Available for Sale
Deduct: Ending inventory
Cost of goods sold
Cost of Goods Available for Sale expresses

the total cost of what has been available for
sale throughout a given time period.

5- 9
Cost of Goods Sold

Beginning inventory
Plus: Purchases
Minus: Purchase Returns & Allowances
Minus: Purchase Discounts
Plus: Transportation-in
Purchases, net
= Cost of Goods available for sale
Minus: Ending inventory
= Cost of goods sold
“Cost of Goods Available for Sale” is the total cost of what has
been available for sale throughout a given time period.
5- 10
Income Statement Formats

Single Step - Multi-step -
with details with details
Single Step - Multi-step -

condensed condensed
Let’s look at
examples…..
5- 11

Multi-step with details Multi-step: condensed
Net Sales 100 Net Sales 100

Less: Cost of goods sold 60 Less: Cost of goods Sold 60
Gross Profit Margin 40
Operating Expenses: Gross Profit Margin 40
Selling: Operating Expenses:
Sales Salaries 8 Selling Expenses 10
Advertising 2
Total Selling 10 Administrative Exp. 11
Administrative: Total Operating Exp. 21
Admin. Salaries 3 Operating Income 19
Building Rent 8 Non-Operating Rev. (Exp.)
Total Adm. Exp. 11
Total Operating Exp. 21 Interest Expense (1)
Operating Income 19 Income before tax 18
Non-Operating Rev. (Exp.) Income Tax expense 3
Interest Expense (1) Net Income 15
Income before tax 18
Income Tax expense 3
Net Income 15
5- 12

The multi-step INCOME Statement format classifies interest as a
NON-operating item. But, interest is still an OPERATING ACTIVITY
onMulti-step
the CASHFLOWwithStatement.
details Multi-step: condensed

Less: Cost of goods sold 60 Less: Cost of goods Sold 60
Gross Profit Margin 40
Operating Expenses: Gross Profit Margin 40
Selling: Operating Expenses:
Sales Salaries 8 Selling Expenses 10
Advertising 2
Total Selling 10 Administrative Exp. 11
Administrative: Total Operating Exp. 21
Admin. Salaries 3 Operating Income 19
Building Rent 8 Non-Operating Rev. (Exp.)
Total Adm. Exp. 11
Total Operating Exp. 21 Interest Expense (1)
Operating Income 19 Income before tax 18
Non-Operating Rev. (Exp.) Income Tax expense 3
Interest Expense (1) Net Income 15
Income before tax 18
Income Tax expense 3
Net Income 15
5- 13

Single-step with details Single-step: condensed

Less Expenses: Less Expenses:
Cost of goods sold 60 Cost of goods sold 60
Sales Salaries 8 Selling 10
Advertising 2 Administrative 11
Admin. Salaries 3 Interest Expense 1
Building Rent 8 Income Tax Expense 3
Interest Expense 1 Total Expenses 85
Income Tax Expense 3 Net Income 15
Total Expenses 85
Net Income 15
When using the Condensed form for either multi- or single-step, if
there isn’t enough information to separate the expenses into Selling
& Administrative categories, list their sum as “Operating
Expenses”.
5- 14

Single-step with details Single-step: condensed
A common modification of the single-step method is

to have the income tax expense separated out.
Less Operating Exp. Less Expenses:
Cost of goods sold 60 Cost of goods sold 60
Sales Salaries 8 Selling 10
Advertising 2 Administrative 11
Admin. Salaries 3 Total Oper. Exp. 81
Building Rent 8 Income before taxes 19
Interest Expense 1 Income Tax Expense 4
Total Oper. Exp. 82 Net Income 15
Income before taxes 18
Income Tax Expense 3
Net Income 15
5- 15

The meaning of these three special items are covered in more
Treatment of Special items
advanced courses.
Results of Discontinued Operations, Extraordinary Gains and
Losses, and Cumulative Effect of a Change in Accounting Principle
No matter Sales 100
Less Expenses:
which income Cost of goods sold 60
statement Selling 10
format is used, Administrative 11
these 3 special Total Oper. Exp. 81
Income before taxes 19
items are Income Tax Expense 4
ALWAYS at the Inc. from Continuing Operations 15
bottom of the Discontinued Operation-Disposal Gain 2
Extraordinary Item-Tornado Loss (3)
income Cumulative Effect of a Change
statement. in Accounting Principle 4
Net Income 18
5- 16
Inventory
● Inventory is tangible property that is
held for resale or will be used in
producing goods or services.
● Inventory is reported on the balance
sheet as an asset.
● Types of inventory:
Merchandise inventory
Raw materials inventory
Work in process inventory manufacturer
Finished goods inventory

5- 17
Inventory Cost
The cost principle requires
that inventory be recorded
for the price paid or the
consideration given up.
What type of transaction is
the purchase of inventory?
Asset Exchange if cash paid.

Asset Source if “on account”.

5- 18
Inventory Cost
● The amount recorded for inventory
should include:
■ Invoice price (minus purchase
discounts), transportation-in costs (also
called “freight-in”), inspection costs, and
preparation costs.
● The company should accumulate

costs of purchases until raw
materials are ready for use or until
merchandise is ready for shipment to
customers.
McGraw-Hill/Irwin ©
The McGraw-Hill Companies, Inc., 2003
5- 19
Terms of Sales & Purchases

Discount Terms: 2/10, n/30 (for example)
■ 2% discount if balance paid in ten days,
remainder to be paid within 30 days of
sale
■ tells when and how much must be paid
■ There is a high interest cost of not taking
purchase discounts when offered.
Let’s look at an example.

5- 20
What is the annual interest rate equivalent

of NOT taking a 2/10, n30 discount?
Q. How many “extra” days can ABC Co. keep its money if it gives
up the 2% discount?
A. 20 extra days.
ABC could pay on day 10 and still take the discount.
By not taking the discount ABC can keep the money
from day 11 through day 30, which is 20 more days.
Q. How many 20 day periods are there in a 360 day year?
A. 360/20 = 18 twenty day periods in a year.
Q. What is the approximate ANNUAL interest rate cost of not taking
2% discounts?
A. 2% lost discount for each of 18 twenty day periods = (2%x18) =
36% annual interest rate
CONCLUSION
If you can borrow at less than 36% APR, borrow to take the discount.
5- 21
Terms of Sales & Purchases

● F. O. B. (Free On Board) shipping
point or F.O.B. destination
■ tells who pays for the shipping and
when ownership “title” passes from
the seller to the buyer.

5- 22
FOB Shipping and

FOB Destination
● FOB Shipping Point:
Buyer pays the shipping costs
because ownership “title”
transfers to buyer at the point
the shipment starts on its
journey.
● FOB Destination:
Seller pays shipping costs
because title does not transfer
to the buyer until the goods
reach their destination (the
buyer’s place of business).
5- 23
Timing is EVERYTHING...
● Recognize revenue when “earned”
■ earned when an exchange (seller to buyer) occurs
● Three levels of the matching principle
■ Product costs (e.g., inventory costs): assets until
produce revenue
▲ direct cause & effect relationship between
revenue and expense
■ Period costs: systematic & rational allocation
▲ e.g., depreciation costs
■ Period costs: recognize as expense as incurred
▲ e.g., advertising costs

5- 24
Perpetual Inventory Systems

● The inventory account is continuously updated for the
following events:
■ Purchases
■ Purchase Discounts Taken
■ Purchase Returns & Allowances
■ Sales (remove from inventory the COST of the units sold)
■ Sales Returns (add to inventory the COST of units returned)
The necessary detailed record-keeping required by the perpetual

system has become much easier with current computer
technology.
● A physical count of the inventory is still required at the
end of the accounting period to assure accurate
inventory records in case of errors or theft.
5- 25
Perpetual Inventory Systems
● Cost of Goods Sold . . .

■ Contains the cost of units that have
been sold to customers.
■ Is a temporary account.
(It will be closed out at

the end of the period.)
■ Is an expense account.

5- 26
Transaction Analysis
● The following selected events
occurred during 2004 at Clock
Company which uses the
PERPETUAL INVENTORY SYSTEM.
● For each event:
■ Determine the effect on the financial
statements.
■ Record the event in the journal and
ledger.

5- 27
Transactions
1. Purchased 1000 units for $4 each on account. Terms: 2/10, n/30
2. Paid a trucking company $500 to deliver the purchased units to
our warehouse.
3. Sold 620 units on account for $6 each. (Terms 1/10, n/30)
3A: Record the revenue. 3B: Record cost of goods.
4. The customer in Transaction #3 returned 20 units for credit.
4A: Remove the revenue. 4B: Return the units to inventory.
5. Customer in Trans. #3 paid within the 10 day discount period.
5A: Record the 1% sales discount. 5B: Record the cash collection.
6. Returned 50 units to our supplier who granted us credit for the
cost of the units but not for any transportation costs.
7. A physical inventory count shows 340 units on-hand, indicating 10
units have been lost.
8. Paid for the Trans. #1 purchase within the 10 day discount period.
8A: Record 2% purchase discount. 8B: Record the cash payment.
9. Record payment of the $340 shipping cost to customer in Tran. #3.
(Original sale was based on F.O.B. destination.)
5- 28
1. Purchased 1000 units for $4 each

on account. (Terms: 2/10, n/30)
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW

ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Accounts Com. Retain. Rev./ Exp./ Net OA,IA,FA
Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain - Loss = Inc. $ amt
1 4,000 = 4,000 =

5- 29
1. Journalize & Post the purchase.

1 4,000 = 4,000 =
GENERAL JOURNAL
Date Account Titles Debit Credit
1 Inventory 4000
Accounts Payable 4000
to record 1000 units purchased for $4 ea. on credit
GENERAL LEDGER ("T" - Accounts)
Assets = Liabilities + Equity
Cash Accounts Receiv. Accounts Payable Common Stock Retained Earnings
bb 5000 bb 4000 1000 bb 6000 bb 2000 bb
4000 (1) Sales Returns Sales Revenue
Inventory Cost of Gds Sold Transportation Out

(1) 4000

5- 30
1. Paid a trucking company $500

to deliver the purchased units
to our warehouse.
Freight charges paid to get inventory to our place of
business (called TRANSPORTATION IN) is part of the
cost of the purchase. It is added to the Inventory account,
thus increasing the asset value. It is NOT “expensed”.
2 (500) 500 = = (500) OA

2. Journalize & Post the transportation cost
5- 31

2 (500) 500 = = (500) OA
GENERAL JOURNAL
2 Inventory 500
Cash 500
to record $500 Transportation In cost
bb 5000 500 (2) bb 4000 1000 bb 6000 bb 2000 bb
4000 (1) Sales Returns Sales Revenue

(1) 4000
(2) 500

5- 32
3. Sold 620 units on account for $6

each. (Terms 1/10, n/30)
3a. Record the Sales Revenue and
related Receivable.
$6 sales price x 620 units = $3720

3a 3,720 = 3,720 3,720 = 3,720

5- 33
3a. Journalize and Post the sale.

3a 3,720 = 3,720 3,720 = 3,720
GENERAL JOURNAL
3a Accounts Receivable 3720
Sales Revenue 3720
to record 620 units sold @ $6 ea.
bb 5000 500 (2) bb 4000 1000 bb 6000 bb 2000 bb
(3a)3720 4000 (1) Sales Returns Sales Revenue
3720 (3a)

(1) 4000
(2) 500

5- 34
3b. Record the Cost of the Goods Sold

and their removal from inventory.
What is the cost of each item in inventory?
$4.00 invoice price + $0.50 transportation
= $4.50 per unit
$500 transport / 1000 units
620 units sold x $4.50 cost each = $2790

ASSETS = LIABILITY + STK. EQUITY Cost of goods sold STATEMENT
3b (2,790) = (2,790) 2,790 = (2,790)

5- 35
3b. Journalize and Post the cost of the sale.

3b (2,790) = 2,790 = (2,790)
GENERAL JOURNAL
3b Cost of Goods Sold 2790
Inventory 2790
to record the $4.50 cost of 620 units sold
bb 5000 500 (2) bb 4000 1000 bb 6000 bb 2000 bb
3720 (3a)

(1) 4000 (3b) 2790 (3b) 2790
(2) 500

5- 36
4. The customer in Transaction #3A

returned 20 units for credit.
4a. Remove the previously recorded Sales
Revenue and related Account Receivable.
A separate “Sales
$6 sales price x 20 units = Return” contra-revenue
$120 account may be used.
Cash + Receiv. + Inventory = Payable + Stk. + Earn. Gain- Loss = Inc. $ amt
4a (120) = (120) (120) = (120)

5- 37
4a. Journalize and Post the sales return.

4a (120) = (120) = (120)
GENERAL JOURNAL
4a Sales Returns (a contra-revenue) 120
Accounts Receivable 120
record 20 units returned by customer @ $6 ea.
bb 5000 500 (2) bb 4000 120 (4a) 1000 bb 6000 bb 2000 bb
(4a) 120 3720 (3a)

(1) 4000 2790 (3b) (3b)2790
(2) 500

5- 38
4b. Put the cost of the 20 returned units back into

inventory and out of Cost of Goods Sold.
(Recall, the units were “costed out” of
inventory and charged to Cost of Goods
Sold at $4.50 each in Tr. #3b.)
Reduction in “Cost
$4.50 x 20 units = $90 of Goods Sold”.

4b 90 = 90 (90) = 90

5- 39
4b. Journalize and Post the return to inventory.

4b 90 = 90 (90) = 90
GENERAL JOURNAL
4b Inventory 90
Cost of Goods Sold 90
record 20 units returned to inventory @ $4.50 ea.
bb 5000 500 (2) bb 4000 120 (4a) 1000 bb 6000 bb 2000 bb
(4a) 120 3720 (3a)

(1) 4000 2790 (3b) (3b)2790 90 (4b)
(2) 500
(4b) 90

5- 40
5a. The Transaction #3a customer paid

within the ten day discount period.
Record the Sales Discount. (1/10, n/30)
Original Account Receivable (Transaction 3a) $3,720
Less: Sales Return (Transaction 4a) 120
Amount owed by customer before discount 3,600
x 1% sales discount 1%
Sales Discount $ 36
3a 3,720 = 3,720 3,720 = 3,720
4a (120) = (120) (120) = (120)
5a (36) = (36) (36) = (36)

5- 41
5a. Journalize and Post the 1% Sales Discount.

5a (36) = (36) (36) = (36)
GENERAL JOURNAL
5a Sales Revenue (or Sales Discount) 36
to record 1% discount on Trans. #3a credit sale
bb 5000 500 (2) bb 4000 120 (4a) 1000 bb 6000 bb 2000 bb
(3a)3720 36 (5a) 4000 (1) Sales Returns Sales Revenue
(4a) 120 (5a) 36 3720 (3a)

(1) 4000 2790 (3b) (3b)2790 90 (4b)
(2) 500
(4b) 90

5- 42
5b. The Transaction #3a customer paid

within the ten day discount period.
Record the cash collection.
Original Account Receivable (Transaction 3a) $3,720
Less: Sales Return (Transaction 4a) (120)
Less: Sales Discount (Transaction 5a) (36)
Cash receipt that will satisfy the account $3,564
3a 3,720 = 3,720 3,720 = 3,720
4a (120) = (120) (120) = (120)
5a (36) = (36) (36) = (36)
5b 3,564 (3,564) = = 3,564 OA

5- 43
5b. Journalize and Post the cash collection.

5b 3,564 (3,564) = = 3,465 OA
GENERAL JOURNAL
5b Cash 3564
Collect from Tr. 3 customer (less return and disc.)
bb 5000 500 (2) bb 4000 120 (4a) 1000 bb 6000 bb 2000 bb
(5b) 3564 (3a)3720 36 (5a) 4000 (1) Sales Returns Sales Revenue
3564 (5b) (4a) 120 (5a) 36 3720 (3a)

(1) 4000 2790 (3b) (3b)2790 90 (4b)
(2) 500
(4b) 90

5- 44
1. Returned 50 units to our supplier who

granted us credit for the cost of the items
but not for any transportation costs.
Supplier cost was $4.00 per unit x 50 = $200. Transportation cost
recorded when units were purchased was $0.50 per unit x 50 = $25.
6 (225) = (200) (25) 25 = (25) 200 OA
Technically, this LOSS should be reported in the operating expense

section of the income statement. However, this loss is usually NOT
MATERIAL, so most companies record it as an increase in the
COST OF GOODS SOLD expense account.
That’s what we’ll do here.
5- 45
6. Returned 50 units to our supplier who granted us credit for the
cost of the items but not for any transportation costs.
6 200 (225) = (25) 25 = (25) 200 OA
GENERAL JOURNAL
6 Accounts Payable 200
Cost of Goods Sold (or "Inventory Loss") 25
Inventory 225
Adjustment for inventory returned to our supplier.
bb 5000 500 (2) bb 4000 120 (4a) (6) 200 1000 bb 6000 bb 2000 bb
3564 (5b) (4a) 120 (5a) 36 3720 (3a)

(1) 4000 2790 (3b) (3b)2790 90 (4b)
(2) 500 225 (6) (6) 25
(4b) 90

5- 46
7. A physical inventory count shows 340 units

on-hand, indicating 10 units have been lost.
Units in Beginning Inventory 0
+ Units Purchased this period (1000- 50 purchase returns) 950
= Units Available for Sale 950
- Units Sold (620 – 20 sales returns) (600)
= Units that should be in ending inventory
350
- Actual ending inventory from count (340)
= Units missing 10
x $4.50 cost per unit $45.00
7 (45) = (45) 45 = (45)

5- 47

7 (45) = (45) 45 = (45)
Technically, this LOSS should be reported in the operating expense

section of the income statement. However, this loss is usually NOT
MATERIAL, so most companies record it as an increase in the
COST OF GOODS SOLD expense account.
That’s what we’ll do here.

5- 48
7 (45) = (45) 45 = (45)
GENERAL JOURNAL
7 Cost of Goods Sold (or "Inventory Loss") 45
Inventory 45
Adjustment for missing inventory
bb 5000 500 (2) bb 4000 120 (4a) (6) 200 1000 bb 6000 bb 2000 bb
3564 (5b) (4a) 120 (5a) 36 3720 (3a)

(1) 4000 2790 (3b) (3b)2790 90 (4b)
(2) 500 225 (6) (6) 25
(4b) 90 45 (7) (7) 45

8a. Paid within discount period, so record the
5- 49
2% discount on the $4000 Tran. #1 purchase
less $200 Tran. #6 return.

Purchase (Transaction #1) $4000 This reduces
Less Purchase Return (Trans. #6) 200 the cost of the
inventory and
Amount owed 3800
the amount we
X discount % 2% owe the
Amount of Purchase Discount $ 76 supplier.
8a (76) = (76) =

5- 50
8a. Paid within discount period, so record the discount

on the $4000 Tr. #1 purchase less $200 Tr. #6 return.
8a (76) = (76) =
GENERAL JOURNAL
8a Accounts Payable 76
Inventory 76
2% discount taken on $3,800 purchase less return
bb 5000 500 (2) bb 4000 120 (4a) (6) 200 1000 bb 6000 bb 2000 bb
(5b) 3564 (3a)3720 36 (5a) (8a) 76 4000 (1) Sales Returns Sales Revenue
3564 (5b) (4a) 120 (5a) 36 3720 (3a)
Inventory
(1) 4000 2790 (3b) Cost of Gds Sold Transportation Out
(2) 500 225 (6) (3b)2790 90 (4b)
(4b) 90 45 (7) (6) 25
76 (8a) (7) 45

5- 51
8b. Paid the remaining balance on the

Transaction #1 inventory purchase.
$4000 purchase (Trans. #1)
- 200 purchase return (Trans. #6)
- 76 purchase discount (Trans. #8a)
$3724 remainder to pay supplier

8b (3,724) = (3,724) = (3,724) OA

5- 52
8b. Paid the remaining balance on the Transaction #1

inventory purchase. ($4000-200-76=$3724 to pay)
8b (3,724) = (3,724) = (3,724) OA
GENERAL JOURNAL
8b Accounts Payable 3724
Cash 3724
Paid balance due to supplier after return and discount.
bb 5000 500 (2) bb 4000 120 (4a) (6) 200 1000 bb 6000 bb 2000 bb
(5b) 3564 3724 (8b) (3a)3720 36 (5a) (8a) 76 4000 (1) Sales Returns Sales Revenue
3564 (5b) (8b) 3724 (4a) 120 (5a) 36 3720 (3a)
Inventory
(2) 500 225 (6) (3b)2790 90 (4b)
(4b) 90 45 (7) (6) 25
76 (8a) (7) 45

5- 53
9. The Sale recorded in Transaction #3a was

made with terms of F.O.B. destination.
Record payment of the $340 shipping cost.
Transportation charges on PURCHASES are added to the cost of
the asset, INVENTORY. (Transportation IN)
Transportation charges to ship products TO CUSTOMERS are

reported as operating expenses on the income statement. The
appropriate account title is TRANSPORTATION OUT (or
FREIGHT OUT or SHIPPING EXPENSE).
9 (340) = (340) 340 = (340) (340) OA

5- 54
9. The Sale recorded in Transaction #3a was made with terms of

F.O.B. destination. Record payment of the $340 shipping cost.
9 (340) = (340) 340 = (340) (340) OA
GENERAL JOURNAL
9 Transportation Out (or Shipping Exp.) 340
Cash 340
Paid $340 cost to ship to customer.
bb 5000 500 (2) bb 4000 120 (4a) (6) 200 1000 bb 6000 bb 2000 bb
340 (9) 3564 (5b) (8b) 3724 (4a) 120 (5a) 36 3720 (3a)
Inventory
(2) 500 225 (6) (3b)2790 90 (4b) (9) 340
(4b) 90 45 (7) (6) 25
76 (8a) (7) 45

5- 55
Clock Company
Ending Balances of LEDGER Accounts
bb 5000 500 (2) bb 4000 120 (4a) (6) 200 1000 bb 6000 bb 2000 bb
340 (9) 3564 (5b) (8b) 3724 (4a) 120 (5a) 36 3720 (3a)
eb 4000 eb 4000 1000 eb 3684 eb

(1) 4000 2790 (3b) (3b)2790 90 (4b) (9) 340
(2) 500 225 (6) (6) 25
(4b) 90 45 (7) (7) 45
76 (8a) eb 2770
eb 1454

5- 56
Summary Transactions
using the Perpetual Inventory System
BB 5,000 4,000 = 1,000 6,000 2,000 = 5,000 bal.
1 4,000 = 4,000 =
2 (500) 500 = = (500) OA
3a 3,720 = 3,720 3,720 = 3,720
3b (2,790) = (2,790) 2,790 = (2,790)
4a (120) = (120) (120) = (120)
4b 90 = 90 (90) = 90
5a (36) = (36) (36) = (36)
5b 3,564 (3,564) = = 3,564 OA
6 (225) = (200) (25) 25 = (25)
7 (45) = (45) 45 = (45)
8a (76) = (76) =
8b (3,724) = (3,724) = (3,724) OA
9 (340) = (340) 340 = (340) (340) OA
EB 4,000 + 4,000 + 1,454 = 1,000 + 6,000 + 2,454 3,564 - 3,110 = 454 4,000 bal.

5- 57
Let’s look at another Inventory system.
Periodic Inventory System

Separate Accounts Used
When using the Periodic system, inventory
transactions are not recorded directly in the
INVENTORY account. Instead, separate
accounts are used for
PURCHASES
PURCHASE RETURNS & ALLOWANCES
PURCHASE DISCOUNTS
TRANSPORTATION IN

5- 58
Periodic Inventory Systems

● Because entries are not made to the inventory
account during the accounting period, the
amount of inventory is not known until the end
of the period when the inventory count is done.
● The PERIODIC system is being used Bar codes/scanners
less and less due to advancements
in technology that make the extra
record keeping of the perpetual
system easy and inexpensive.
● Periodic inventory systems require more
closing entries at the end of the period.
(Purchases, Purchase Returns and Allowances,
Purchase Discounts, and Transportation In are
all separate TEMPORARY accounts that must
be closed out at the end of the period.)
5- 59

Purchases and Purchase Returns
and Allowances
● Purchases is an account that holds the
current period’s inventory purchases (a
debit balance) and is used in the
calculation of Cost of Goods Sold on the
Income Statement.
● The Purchase Returns and Allowances
account also is used to calculate Cost of
Goods Sold on the income statement. It
is a deduction from the cost of purchases
in a periodic inventory system.
5- 60

Purchase Discounts
When using the Periodic system

Purchase Discounts are recorded
in a separate account. This helps
managers keep track of the
company’s performance in taking
advantage of discounts.

5- 61
Periodic Inventory Systems

● The ending inventory is determined at the
end of the period by taking a physical count
of the goods remaining on hand.
● Cost of goods sold is calculated at the end
of the accounting period by subtracting the
ending inventory (determined from the
physical count) from the Cost of Goods
Available for Sale.
Beginning Inventory $ 400
+ Purchases, net 2000
= Goods Available for Sale 2400
- Ending Inv. (from count) 500
= Cost of Goods Sold $1900
5- 62
Using a few selected

transactions, let’s look at the
differences between the
journal entries for the
Perpetual and Periodic
Inventory Systems.

5- 63
Selected transactions comparing the

PERPETUAL vs. PERIODIC Inventory Systems
PERPETUAL INVENTORY SYSTEM PERIODIC INVENTORY SYSTEM
Date/Event Accounts Debit Credit Date/Event Accounts Debit Credit
1 Inventory 4000 1 Purchases 4000
Accounts Payable 4000 Accounts Payable 4000
Purchased 1000 units on account Purchased 1000 units on account
2 Inventory 551 2 Transportation In 551

Cash 551 Cash 551
Paid trucking fee on purchases Paid trucking fee on purchases
3 Accounts Payable 200 3 Accounts Payable 200

Inventory 200 Purchase Returns & Allow. 200
Returned 50 units to supplier for credit Returned 50 units to supplier for credit
4A Accounts Payable 76 4A Accounts Payable 76

Inventory 76 Purchase Discounts 76
Purch. Disc. ($4000-200)x2% = $76 Purch. Disc. ($4000-200)x2% = $76
4B Accounts Payable 3724 4B Accounts Payable 3724

Cash 3724 Cash 3724
Paid remaining balance to supplier Paid remaining balance to supplier
Ave. $ = [4000+551-200-76] /950= $4.50 Ave. $ = [4000+551-200-76] /950= $4.50

5- 64
Selected transactions comparing PERPETUAL vs.

PERIODIC Inventory Systems – Cont’d
PERPETUAL INVENTORY SYSTEM PERIODIC INVENTORY SYSTEM
5A Accounts Receivable 3720 5A Accounts Receivable 3720
Sales Revenue 3720 Sales Revenue 3720
Sold 620 units @ $6 on account Sold 620 units @ $6 on account
5B Cost of Goods Sold 2790 5B NO ENTRY. The Cost of Goods Sold and
Inventory 2790 inventory adjustment are made for ALL sales at
Remove 620 units from inv.@ $4.50 the end of the period.
6A Sales (or Sales Returns) 120 6A Sales (or Sales Returns) 120
Accounts Receivable 120 Accounts Receivable 120
Customer returned 20 units sold @ $6 Customer returned 20 units sold @ $6
6B Inventory 90 6B NO ENTRY. The Cost of Goods Sold & Inventory

Cost of Goods Sold 90 accounts were NOT affected when the original
Returned units put into inv. @ $4.50 sale was recorded, so NO reversal needed now.
7 NO YR-END ADJUSTING ENTRY REQUIRED 7 Cost of Goods Sold

The inventory and Cost of Goods Sold account Inventory
are already "up-to-date". Purchase Returns & Allow. 200
Purchase Discounts 76
Use a Yr.-end inventory count to Purchases 4000
Transportation In 551
determine the inventory adjustment. Year-end inventory adjustment
5- 65
Selected
Use the Cost transactions comparing
of Goods Sold schedule to PERPETUAL vs.
calculate the cost of the units that are
“gone”PERIODIC
and ASSUMEDInventory
to have been Systems – Cont’d
sold. CouldPERPETUAL some of the
INVENTORY units actually
SYSTEM PERIODIC INVENTORY SYSTEM
have
6A been lost,
Accounts Receivable stolen, or thrown
3720 away? 6A Accounts Receivable 3720
Sales Revenue 3720 Sales Revenue 3720
Begin. Inventory
Sold 620 units @ $6 on account
$ 0 Sold 620 units @ $6 on account
6B+ Purchase
Cost of Goods Sold $2790
4000 6B NO ENTRY. The Cost of Goods Sold and
- Purchase
Inventory
Returns ( 200) 2790 inventory adjustment are made for ALL sales at
Remove 620 units from inv.@ $4.50 the end of the period.
- Purchase Discounts ( 76)
7A Sales (or Sales Returns)
+ Transportation In 120
551 7A Ending Inventory
Sales (or Sales Returns) $1575
120
Accounts Receivable 120 Accounts Receivable 120
Purchases,
Customer returnednet20 units sold @ $6 4275 Less: Begin. Inv.
Customer returned 20 units sold @ $6
0
Cost of Goods Avail. for Sale 4275 7B Add to Inv. account $1575
7B Inventory 90 NO ENTRY. The Cost of Goods Sold & Inventory
Less:CostEnding
of GoodsInventory
Sold (901575) accounts were NOT affected when the original
Returned units put into inv. @ $4.50 sale was recorded, so NO reversal needed now.
Cost of Goods Sold $2700
8 NO YR-END ADJUSTING ENTRY REQUIRED 8 Cost of Goods Sold 2700
The inventory and Cost of Goods Sold account Inventory 1575
are already "up-to-date". Purchase Returns & Allow. 200
Purchase Discounts 76
A Yr-end count shows 350 units (at a Purchases 4000
Transportation In 551
cost of $4.50 each) still in stock =$1575 Year-end inventory adjustment
5- 66
Accounting and Inventory

Management
The accounting system plays three
roles in inventory management:
● Provides accurate information for financial
statements and tax reports.
● Provides up-to-date information on
inventory quantities and cost.
● Provides information necessary to protect
inventory from theft and misuse.

5- 67
Ratios: Gross Margin

Percentage
● Gross margin %:
■ gross margin as a percent of

sales
■ Net sales – CGS = Gross Margin

Net sales Net Sales

5- 68
Ratios: Return on sales
● Return on sales =
Net income
Net sales
Revenues - expenses
Net sales

5- 69
Common-size Income
Statement
● Each item on the
income statement is
expressed as a % of
%
that year’s Net Sales. Net Sales 100.0
- Cost 60.0
=G.P 40.0
Comparisons are made to:
Budget
Previous year(s)
Competitors

5- 70
Comparative Common-size
Income Statements
2005 % of N.Sales 2004 % of N.Sales
Net Sales $3,000 100.0 $2,000 100.0
Cost of Goods Sold 2,000 1,200
Gross Profit 1,000 800
Operating Expenses:
Selling Expenses 600 400
Administrative Exp. 700 300
Total Oper. Exp. 1,300 700
Net Income ($300) $100
5- 71
Comparative Common-size
Income Statements
Net Sales $3,000 100.0 $2,000 100.0
Cost of Goods Sold 2,000 66.7 1,200 60.0
Gross Profit 1,000 33.3 800 40.0
Operating Expenses:
Selling Expenses 600 20.0 400 20.0
Administrative Exp. 700 23.3 300 15.0
Total Oper. Exp. 1,300 43.3 700 35.0
Net Income ($300) (10.0) $100 5.0
5- 72
Question: Why did the company have a

net loss when sales increased by $1,000?
Net Sales $3,000 100.0 $2,000 100.0
Cost of Goods Sold 2,000 66.7 1,200 60.0
Gross Profit 1,000 33.3 800 40.0
Operating Expenses:
Selling Expenses 600 20.0 400 20.0
Administrative Exp. 700 23.3 300 15.0
Total Oper. Exp. 1,300 43.3 700 35.0
Net Income ($300) (10.0) $100 5.0
5- 73
Income Statement
Trend Analysis
Trend Analysis shows both Dollar and %
changes from one year to the next year for
each item on the income statement.
Example:
From 2004 to 2005 Net Sales increased
from $2,000 to $3,000. So……
Net Sales increased $1,000 which is a 50%
increase over 2004 Net Sales.
($1,000 incr./$2,000 Net Sales of 2004= 50%)
5- 74
Income Statement
Trend Analysis
2005 2004 $ inc.(dec.) % inc.(dec)
Net Sales $3,000 $2,000 $1,000 50.0

Cost of Goods Sold 2,000 1,200 800 66.7
Gross Profit 1,000 800 200 25.0
Operating Expenses:
Selling Expenses 600 400 200 50.0
Administrative Exp. 700 300 400 133.3
Total Oper. Exp. 1,300 700 600 85.7
Net Income ($300) $100 ($400) (400.0)
5- 75
Income Statement
Trend Analysis
2005 2004 $ inc.(dec) % inc.(dec)
Net Sales $3,000 $2,000 $1,000 50.0

Cost of Goods Sold 2,000 1,200
Gross Profit 1,000 800
Operating Expenses:
Selling Expenses 600 400
Administrative Exp. 700 300
Total Oper. Exp. 1,300 700
Net Income ($300) $100
5- 76
How about analyzing the

Balance Sheet?
The same techniques are used to analyze the
Balance Sheet.
Common-size Analysis:
Use the TOTAL ASSETS amount as the 100%
figure. So, …….. Express each Balance Sheet item
as a % of Total Assets.
Trend Analysis:
Same approach as used on the income statement.
1. Calculate the $ change for each bal. sheet item.
2. Express the $ change as a % of the previous
year’s (or base year’s) amount.
5- 77
Chapter 5
Remember,
Your objectives are to understand
what you are doing and to be able to
analyze the financial information.
Memorization without understanding
is meaningless!

5- 78
Chapter 5
The End

ch05 Fundamental of Financial Accounting by Edmonds (4th Edition)

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ch05 Fundamental of Financial Accounting by Edmonds (4th Edition)

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Fundamental

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

Chapter 5: Accounting for

Four Major Types of

Four Major Types of

type of Service business

business •Sells CDs during breaks

musician? •Records and duplicates

Service, Merchandising, own CDs

Sales (sometimes called “Gross Sales”)

Minus: Sales Discounts (often given to

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Cost of Goods Sold

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

Cost of Goods Sold

Cost of Goods Available for Sale expresses

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Cost of Goods Sold

Income Statement Formats

Single Step - Multi-step -

Income Statement Formats

Net Sales 100 Net Sales 100

Income Statement Formats

Net Sales 100 Net Sales 100

Income Statement Formats

Net Sales 100 Net Sales 100

Income Statement Formats

A common modification of the single-step method is

Income Statement Formats

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Asset Exchange if cash paid.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

● The company should accumulate

Terms of Sales & Purchases

Let’s look at an example.

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What is the annual interest rate equivalent

Terms of Sales & Purchases

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FOB Shipping and

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Perpetual Inventory Systems

The necessary detailed record-keeping required by the perpetual

Perpetual Inventory Systems

● Cost of Goods Sold . . .

(It will be closed out at

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

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1. Purchased 1000 units for $4 each

BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW

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BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW

Inventory Cost of Gds Sold Transportation Out

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1. Paid a trucking company $500

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BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW

Inventory Cost of Gds Sold Transportation Out

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3. Sold 620 units on account for $6

$6 sales price x 620 units = $3720

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