5-1

MERCHANDISING
OPERATIONS AND
THE MULTIPLE-STEP
INCOME STATEMENT

Financial Accounting, Seventh Edition

5-2
 Learning Objectives

After studying this chapter, you should be able to:

1. Identify the differences between a service company and a

merchandising company.
2. Explain the recording of purchases under a perpetual inventory
system.
3. Explain the recording of sales revenues under a perpetual inventory
system.
4. Distinguish between a single-step and a multiple-step income
statement.
5. Determine cost of goods sold under a periodic system.
6. Explain the factors affecting profitability.
7. Identify a quality of earnings indicator.
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 Preview of Chapter 5

Financial Accounting
Seventh Edition
Kimmel Weygandt Kieso
5-4
 Merchandising Operations

Merchandising Companies
Buy and Sell Goods
Retailer

Wholesaler Consumer

The primary source of revenues is referred to as

sales revenue or sales.
5-5 LO 1 Identify the differences between service and merchandising companies.
 Merchandising Operations

Income Measurement
Not used in a
Sales Less
Illustration 5-1
Service business.
Revenue Income measurement process for a
merchandising company

Equals
Cost of Gross Less
Goods Sold Profit

Operating Equals Net

Cost of goods sold is the total Income
cost of merchandise sold during Expenses
(Loss)
the period.

5-6 LO 1 Identify the differences between service and merchandising companies.

 Merchandising Operations
Illustration 5-2
Operating
Cycles
The operating
cycle of a
merchandising
company
ordinarily is longer
than that of a
service
company.

5-7 LO 1 Identify the differences between service and merchandising companies.

 Merchandising Operations

Flow of Costs
Illustration 5-3

Companies use either a perpetual inventory system or a periodic inventory

system to account for inventory.

5-8 LO 1 Identify the differences between service and merchandising companies.

 Merchandising Operations

Flow of Costs
Perpetual System
◆ Maintain detailed records of the cost of each inventory
purchase and sale.

◆ Records continuously show inventory that should be on

hand for every item.

◆ Company determines cost of goods sold each time a

sale occurs.

5-9 LO 1 Identify the differences between service and merchandising companies.

 Merchandising Operations

Flow of Costs
Periodic System
◆ Do not keep detailed records of the goods on hand.

◆ Cost of goods sold determined by count at the end of

the accounting period.

◆ Calculation of Cost of Goods Sold:

Beginning inventory $ 100,000
Add: Purchases, net 800,000
Goods available for sale 900,000
Less: Ending inventory 125,000
Cost of goods sold $ 775,000
5-10 LO 1
 Merchandising Operations

Flow of Costs
Advantages of the Perpetual System
◆ Traditionally used for merchandise with high unit values.

◆ Shows the quantity and cost of the inventory that should

be on hand at any time.

◆ Provides better control over inventories than a periodic

system.

5-11 LO 1 Identify the differences between service and merchandising companies.

5-12
 Recording Purchases of Merchandise

◆ Made using cash or credit (on account).

Illustration 5-5

◆ Normally record when

goods are received from
the seller.

◆ Purchase invoice should

support each credit
purchase.

5-13 LO 2 Explain the recording of purchases under a perpetual inventory system.

 Recording Purchases of Merchandise
Illustration 5-5

Illustration: Sauk Stereo (the

buyer) uses as a purchase
invoice the sales invoice
prepared by PW Audio Supply,
Inc. (the seller). Prepare the
journal entry for Sauk Stereo for
the invoice from PW Audio
Supply.

May 4 Inventory 3,800

Accounts payable 3,800

5-14 LO 2 Explain the recording of purchases under a perpetual inventory system.

 Recording Purchases of Merchandise

Freight Costs – Terms of Sale

Illustration 5-6
Shipping terms

Ownership of the goods

passes to the buyer when the
public carrier accepts the
goods from the seller.

Ownership of the goods

remains with the seller until
the goods reach the buyer.

5-15 Freight costs incurred by the seller are an operating expense. LO 2

 Recording Purchases of Merchandise

Illustration: Assume upon delivery of the goods on May 6,

Sauk Stereo pays Public Freight Company $150 for freight
charges, the entry on Sauk Stereo’s books is:

May 6 Inventory 150

Cash 150

Assume the freight terms on the invoice in Illustration 5-5 had

required PW Audio Supply to pay the freight charges, the
entry by PW Audio Supply would have been:

May 4 Freight-out 150

Cash 150
5-16 LO 2 Explain the recording of purchases under a perpetual inventory system.
 Recording Purchases of Merchandise

Purchase Returns and Allowances

Purchaser may be dissatisfied because goods are damaged
or defective, of inferior quality, or do not meet specifications.

Purchase Return Purchase Allowance

Return goods for credit if May choose to keep the
the sale was made on merchandise if the seller
credit, or for a cash refund will grant a reduction of the
if the purchase was for purchase price.
cash.

5-17 LO 2 Explain the recording of purchases under a perpetual inventory system.

 Recording Purchases of Merchandise

Illustration: Assume Sauk Stereo returned goods costing

$300 to PW Audio Supply on May 8.

May 8 Accounts payable 300

Inventory 300

5-18 LO 2 Explain the recording of purchases under a perpetual inventory system.

 Recording Purchases of Merchandise

Review Question
In a perpetual inventory system, a return of defective
merchandise by a purchaser is recorded by crediting:
a. Purchases
b. Purchase Returns
c. Purchase Allowance
d. Inventory

5-19 LO 2 Explain the recording of purchases under a perpetual inventory system.

 Recording Purchases of Merchandise

Purchase Discounts
Credit terms may permit buyer to claim a cash discount
for prompt payment.

Advantages: Example: Credit

terms may read 2/10,
◆ Purchaser saves money. n/30.

◆ Seller shortens the operating cycle by converting the

accounts receivable into cash earlier.

5-20 LO 2 Explain the recording of purchases under a perpetual inventory system.

 Recording Purchases of Merchandise

Purchase Discounts - Terms

2/10, n/30 1/10 EOM n/10 EOM

2% discount if 1% discount if Net amount due

paid within 10 paid within first 10 within the first 10
days, otherwise days of next days of the next
net amount due month. month.
within 30 days.

5-21 LO 2 Explain the recording of purchases under a perpetual inventory system.

 Recording Purchases of Merchandise

Illustration: Assume Sauk Stereo pays the balance due of

$3,500 (gross invoice price of $3,800 less purchase returns
and allowances of $300) on May 14, the last day of the
discount period. Prepare the journal entry Sauk Stereo
makes on May 14 to record the payment.

May 14 Accounts payable 3,500

Inventory 70
Cash 3,430

(Discount = $3,500 x 2% = $70)

5-22 LO 2 Explain the recording of purchases under a perpetual inventory system.

 Recording Purchases of Merchandise

Illustration: If Sauk Stereo failed to take the discount, and

instead made full payment of $3,500 on June 3, the journal
entry would be:

June 3 Accounts payable 3,500

Cash 3,500

5-23 LO 2 Explain the recording of purchases under a perpetual inventory system.

 Recording Purchases of Merchandise

Purchase Discounts
Should discounts be taken when offered?

Discount of 2% on $3,500 $ 70.00

$3,500 invested at 10% for 20 days 19.18
Savings by taking the discount $ 50.82

Example: 2% for 20 days = Annual rate of 36.5%

$3,500 x 36.5% x 20 ÷ 365 = $70

5-24 LO 2 Explain the recording of purchases under a perpetual inventory system.

 Recording Purchases of Merchandise

Summary of Purchasing Transactions

Inventory
Debit Credit

4th - Purchase $3,800 $300 8th - Return

6th – Freight-in 150 70 14th - Discount

Balance $3,580

5-25 LO 2 Explain the recording of purchases under a perpetual inventory system.

 Recording Sales of Merchandise

◆ Made using cash or credit (on account).

Illustration 5-5

◆ Sales revenue, like service

revenue, is recorded when
the performance obligation
is satisfied.

◆ Performance obligation is
satisfied when the goods
are transferred from the
seller to the buyer.

◆ Sales invoice should

support each credit sale.
LO 3 Explain the recording of sales revenues
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under a perpetual inventory system.
 Recording Sales of Merchandise

Journal Entries to Record a Sale

#1 Cash or Accounts receivable XXX Selling

Sales revenue XXX Price

#2 Cost of goods sold XXX

Cost
Inventory XXX

LO 3 Explain the recording of sales revenues

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under a perpetual inventory system.
 Recording Sales of Merchandise

Illustration: PW Audio Supply records the sale of $3,800

on May 4 to Sauk Stereo on account (Illustration 5-5) as
follows (assume the merchandise cost PW Audio Supply
$2,400).

May 4 Accounts receivable 3,800

Sales revenue 3,800

4 Cost of goods sold 2,400

Inventory 2,400

LO 3 Explain the recording of sales revenues

5-28
under a perpetual inventory system.
5-29
 Recording Sales of Merchandise

Sales Returns and Allowances

◆ “Flip side” of purchase returns and allowances.

◆ Contra-revenue account to Sales Revenue (debit).

◆ Sales not reduced (debited) because:

► Would obscure importance of sales returns and

allowances as a percentage of sales.

► Could distort comparisons.

LO 3 Explain the recording of sales revenues

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under a perpetual inventory system.
 Recording Sales of Merchandise

Illustration: Prepare the entry PW Audio Supply would make

to record the credit for returned goods that had a $300 selling
price (assume a $140 cost). Assume the goods were not
defective.

May 8 Sales returns and allowances 300

Accounts receivable 300

8 Inventory 140
Cost of goods sold 140

LO 3 Explain the recording of sales revenues

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under a perpetual inventory system.
 Recording Sales of Merchandise

Illustration: Assume the returned goods were defective

and had a scrap value of $50, PW Audio would make the
following entries:

May 8 Sales returns and allowances 300

Accounts receivable 300

8 Inventory 50
Cost of goods sold 50

LO 3 Explain the recording of sales revenues

5-32
under a perpetual inventory system.
 Recording Sales of Merchandise

Review Question
The cost of goods sold is determined and recorded each
time a sale occurs in:
a. periodic inventory system only.
b. a perpetual inventory system only.
c. both a periodic and perpetual inventory system.
d. neither a periodic nor perpetual inventory system.

LO 3 Explain the recording of sales revenues

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under a perpetual inventory system.
5-34
 Recording Sales of Merchandise

Sales Discount
◆ Offered to customers to promote prompt payment of the
balance due.

◆ Contra-revenue account (debit) to Sales Revenue.

LO 3 Explain the recording of sales revenues

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under a perpetual inventory system.
 Recording Sales of Merchandise

Illustration: Assume Sauk Stereo pays the balance due of

$3,500 (gross invoice price of $3,800 less purchase returns
and allowances of $300) on May 14, the last day of the
discount period. Prepare the journal entry PW Audio Supply
makes to record the receipt on May 14.

May 14 Cash 3,430 *

Sales discounts 70
Accounts receivable 3,500

* [($3,800 – $300) X 2%]

LO 3 Explain the recording of sales revenues

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under a perpetual inventory system.
 Income Statement Presentation

Single-Step Income Statement

◆ Subtract total expenses from total revenues

◆ Two reasons for using the single-step format:

1. Company does not realize any type of profit or

income until total revenues exceed total expenses.

2. Form is simple and easy to read.

5-37 LO 4 Distinguish between a single-step and a multiple-step income statement.

 Single-
Income Statement Presentation Step

Illustration 5-7

5-38 LO 4
 Income Statement Presentation

Multiple-Step Income Statement

◆ Highlights the components of net income.

◆ Three important line items:

1) gross profit,

2) income from operations, and

3) net income.

5-39 LO 4 Distinguish between a single-step and a multiple-step income statement.

 Multiple-
Income Statement Presentation Step

Illustration 5-8

Key
Line
Items

5-40 LO 4
 Multiple- Illustration 5-11

Step

Key Items:
◆ Net sales

5-41 LO 4
 Multiple- Illustration 5-11

Step

Key Items:
◆ Net sales

◆ Gross profit

5-42 LO 4
 Multiple- Illustration 5-11

Step

Key Items:
◆ Net sales

◆ Gross profit

◆ Operating
expenses

5-43 LO 4
 Multiple- Illustration 5-11

Step

Key Items:
◆ Net sales

◆ Gross profit

◆ Operating
expenses

◆ Nonoperating
activities

5-44 LO 4
 Multiple- Illustration 5-11

Step

Key Items:
◆ Net sales

◆ Gross profit

◆ Operating
expenses

◆ Nonoperating
activities

5-45 LO 4
 Multiple- Illustration 5-11

Step

Key Items:
◆ Net sales

◆ Gross profit

◆ Operating
expenses

◆ Nonoperating
activities

◆ Net income

5-46 LO 4
 Income Statement Presentation

Review Question
The multiple-step income statement for a merchandiser
shows each of the following features except:
a. gross profit.
b. cost of goods sold.
c. a sales revenue section.
d. investing activities section.

5-47 LO 4 Distinguish between a single-step and a multiple-step income statement.

5-48
 Income Statement Presentation

Determining Cost of Goods Sold Under a

Periodic System
◆ No running account of changes in inventory.

◆ Ending inventory determined by physical count.

◆ Cost of goods sold not determined until the end of the

period.

5-49 LO 5 Determine cost of goods sold under a periodic system.

 Income Statement Presentation

Determining Cost of Goods Sold Under a

Periodic System
Illustration 5-13

5-50
LO 5
 Aerosmith Company’s accounting records show the following at
the yearend December 31, 2014.
Purchase Discounts $ 3,400 Freight-In 6,100
Purchases 162,500 Beginning Inventory 18,000
Ending Inventory 20,000 Purchase Returns and Allowances 5,200
Assuming that Aerosmith Company uses the periodic system, compute (a) cost of
goods purchased and (b) cost of goods sold.

Solution
Beginning Inventory $ 18,000
Purchases $ 162,500
Purchase Returns and Allowances - 5,200
Purchase Discounts - 3,400
Freight-In + 6,100 160,000 (a)
Goods Available for Sale 178,000
Ending Inventory - 20,000
Cost of Goods Sold $ 158,000 (b)

5-51 LO 5 Determine cost of goods sold under a periodic system.

 Evaluating Profitability

Gross Profit Rate

May be expressed as a percentage by dividing the amount
of gross profit by net sales.

A decline in the gross profit rate might have several causes.

► Selling products with a lower “markup.”

► Increased competition may result in a lower selling price.

► Company forced to pay higher prices to its suppliers without

being able to pass these costs on to its customers.

5-52 LO 6 Explain the factors affecting profitability.

 Evaluating Profitability

Gross Profit Rate

Illustration 5-15

Why does REI’s gross profit rate differ so much from that of
Dick’s Sporting Goods and the industry average?

5-53 LO 6 Explain the factors affecting profitability.

 Evaluating Profitability

Profit Margin Ratio

Measures the percentage of each dollar of sales that results
in net income.

How do the gross profit rate and profit margin ratio differ?

► Gross profit rate - measures the margin by which selling

price exceeds cost of goods sold.

► Profit margin ratio - measures the extent by which selling

price covers all expenses (including cost of goods sold).

5-54 LO 6 Explain the factors affecting profitability.

 Evaluating Profitability

Profit Margin Ratio

Illustration 5-17

How does REI compare to its competitors? Its profit margin was lower
than Dick’s in 2010 and was less than the industry average. Thus, its
profit margin does not suggest exceptional profitability.

5-55 LO 6 Explain the factors affecting profitability.

 Evaluating Profitability

Earnings have high quality if they provide a

full and transparent depiction of how a
company performed.

► A measure significantly less than 1 suggests that a company

may be using more aggressive accounting techniques in order to
accelerate income recognition.
► A measure significantly greater than 1 suggests that a
company is using conservative accounting techniques which
cause it to delay the recognition of income.

5-56 LO 7 Identify a quality of earnings indicator.

 Periodic
Appendix 5A Inventory
System

Recording Merchandise Transactions

◆ Record revenues when sales are made.
◆ Do not record cost of merchandise sold on the date of sale.
◆ Physical inventory count determines:
► Cost of merchandise on hand and
► Cost of merchandise sold during the period.

◆ Record purchases in Purchases account.

◆ Purchase returns and allowances, Purchase discounts, and
Freight costs are recorded in separate accounts.

LO 8 Explain the recording of purchases and sales of

5-57
inventory under a periodic inventory system.
 Periodic
Appendix 5A Inventory
System

Recording Purchases of Merchandise

Illustration: On the basis of the sales invoice (Illustration 5-5)
and receipt of the merchandise ordered from PW Audio Supply,
Sauk Stereo records the $3,800 purchase as follows.

May 4 Purchases 3,800

Accounts payable 3,800

LO 8 Explain the recording of purchases and sales of

5-58
inventory under a periodic inventory system.
 Periodic
Appendix 5A Inventory
System

Freight Costs
Illustration: If Sauk pays Public Freight Company $150
for freight charges on its purchase from PW Audio Supply on
May 6, the entry on Sauk’s books is:

May 6 Freight-in (Transportation-in) 150

Cash 150

LO 8 Explain the recording of purchases and sales of

5-59
inventory under a periodic inventory system.
 Periodic
Appendix 5A Inventory
System

Purchase Returns and Allowances

Illustration: Sauk Stereo returns $300 of goods to PW Audio
Supply and prepares the following entry to recognize the
return.

May 8 Accounts payable 300

Purchase returns and allowances 300

LO 8 Explain the recording of purchases and sales of

5-60
inventory under a periodic inventory system.
 Periodic
Appendix 5A Inventory
System

Purchase Discounts
Illustration: On May 14 Sauk Stereo pays the balance due
on account to PW Audio Supply, taking the 2% cash discount
allowed by PW Audio for payment within 10 days. Sauk
Stereo records the payment and discount as follows.

May 14 Accounts payable 3,500

Purchase discounts 70
Cash 3,430

LO 8 Explain the recording of purchases and sales of

5-61
inventory under a periodic inventory system.
 Periodic
Appendix 5A Inventory
System

Recording Sales of Merchandise

Illustration: PW Audio Supply, records the sale of $3,800 of
merchandise to Sauk Stereo on May 4 (sales invoice No. 731,
Illustration 5-5) as follows.

May 4 Accounts receivable 3,800

Sales revenue 3,800

No entry is recorded for cost of goods sold at the time of the

sale under a periodic system.

LO 8 Explain the recording of purchases and sales of

5-62
inventory under a periodic inventory system.
 Periodic
Appendix 5A Inventory
System

Sales Returns and Allowances

Illustration: To record the returned goods received from Sauk
Stereo on May 8, PW Audio Supply records the $300 sales
return as follows.

May 8 Sales returns and allowances 300

Accounts receivable 300

LO 8 Explain the recording of purchases and sales of

5-63
inventory under a periodic inventory system.
 Periodic
Appendix 5A Inventory
System

Sales Discounts
Illustration: On May 14, PW Audio Supply receives payment
of $3,430 on account from Sauk Stereo. PW Audio honors the
2% cash discount and records the payment of Sauk’s account
receivable in full as follows.

May 14 Cash 3,430

Sales discounts 70
Accounts receivable 3,500

LO 8 Explain the recording of purchases and sales of

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inventory under a periodic inventory system.
 Periodic
Appendix 5A Inventory
System

Comparison of Entries

LO 8 Explain the recording of purchases and sales of

5-65
inventory under a periodic inventory system.
 Periodic
Appendix 5A Inventory
System

Comparison of Entries

LO 8 Explain the recording of purchases and sales of

5-66
inventory under a periodic inventory system.
 Key Points
◆ Under both GAAP and IFRS, a company can choose to use
either a perpetual or a periodic system.

◆ Inventories are defined by IFRS as held-for-sale in the ordinary

course of business, in the process of production for such sale, or
in the form of materials or supplies to be consumed in the
production process or in the providing of services.

5-67 LO 9 Compare the procedures for the merchandising under GAAP and IFRS.
 Key Points
◆ Under GAAP, companies generally classify income statement
items by function. Classification by function leads to
descriptions like administration, distribution, and manufacturing.
Under IFRS, companies must classify expenses by either
nature or function. Classification by nature leads to descriptions
such as the following: salaries, depreciation expense, and
utilities expense. If a company uses the functional-expense
method on the income statement, disclosure by nature is
required in the notes to the financial statements.

5-68 LO 9 Compare the procedures for the merchandising under GAAP and IFRS.
 Key Points
◆ Presentation of the income statement under GAAP follows
either a single-step or multiple-step format. IFRS does not
mention a single-step or multiple-step approach.

◆ Under IFRS, revaluation of land, buildings, and intangible

assets is permitted. The initial gains and losses resulting from
this revaluation are reported as adjustments to equity, often
referred to as other comprehensive income.

◆ IAS 1, “Presentation of Financial Statements,” provides general

guidelines for the reporting of income statement information.

5-69 LO 9 Compare the procedures for the merchandising under GAAP and IFRS.
 Key Points
◆ Similar to GAAP, comprehensive income under IFRS includes
unrealized gains and losses (such as those on certain types of
investment securities) that are not included in the calculation of
net income.

◆ IFRS requires that two years of income statement information

be presented, whereas GAAP requires three years.

5-70 LO 9 Compare the procedures for the merchandising under GAAP and IFRS.
 Looking to the Future
The IASB and FASB are working on a project that would rework the
structure of financial statements. Specifically, this project will
address the issue of how to classify various items in the income
statement. It will adopt major groupings similar to those currently
used by the statement of cash flows (operating, investing, and
financing), so that numbers can be more readily traced across
statements. The new financial statement format was heavily
influenced by suggestions from financial statement analysts.

5-71 LO 9 Compare the procedures for the merchandising under GAAP and IFRS.
 IFRS Practice
Which of the following would not be included in the definition of
inventory under IFRS?

a) Photocopy paper held for sale by an office-supply store.

b) Stereo equipment held for sale by an electronics store.

c) Used office equipment held for sale by the human relations

department of a plastics company.

d) All of the above would meet the definition.

5-72 LO 9 Compare the procedures for the merchandising under GAAP and IFRS.
 IFRS Practice
Which of the following would not be a line item of a company
reporting costs by nature?

a) Depreciation expense.

b) Salaries expense.

c) Interest expense.

d) Manufacturing expense.

5-73 LO 9 Compare the procedures for the merchandising under GAAP and IFRS.
 IFRS Practice
Which of the following would not be a line item of a company
reporting costs by function?

a) Administration.

b) Manufacturing.

c) Utilities expense.

d) Distribution.

5-74 LO 9 Compare the procedures for the merchandising under GAAP and IFRS.
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