Chapter 5

Question 1

What is gross profit and how is it calculated?

Answer 1

Sales

Less: Cost of Goods Sold

Equals: Gross Profit

Question 2

How is a merchandiser different from a service company?

Answer 2

A merchandising company, or merchandiser, differs in several basic ways from a company that provides services. First, a merchandiser purchases and then sells goods whereas a service company sells services. For example, a car dealership is a merchandiser that sells cars while an airline is a service company that sells air travel. Because merchandising involves the purchase and then the resale of goods, an expense called cost of goods sold results. Cost of goods sold is the cost of the actual goods sold.

A service company does not have an expense called cost of goods sold since it does not sell goods. Because a merchandiser has cost of goods sold expense and a service business does not, the income statement for a merchandiser includes different details. A merchandising income statement highlights cost of goods sold by showing the difference between sales revenue and cost of goods sold called gross profit or gross margin.

Another difference between a service company and a merchandiser relates to the balance sheet. A merchandiser purchases goods for resale. Goods held for resale by a merchandiser are called merchandise inventory and are reported as an asset on the balance sheet. A service company would not normally have merchandise inventory.

Question 3

What is a perpetual inventory system?

Answer 3

In a perpetual inventory system, the merchandise inventory account and cost

of goods sold account are updated immediately when transactions occur. In a perpetual system, as merchandise inventory is purchased, it is debited to the merchandise inventory account.

As inventory is sold to customers, the cost of the inventory sold is removed from the merchandise inventory account and debited to the cost of goods sold account. A perpetual system means that account balances are known on a real-time basis.

Question 4

How is the purchase of merchandise inventory on credit recorded in a perpetual system?

Answer 4

When merchandise inventory is purchased, the cost is recorded in a Merchandise Inventory general ledger account. An account payable results when the merchandise inventory is acquired but
will not be paid in cash until a later date. For example, recall the vehicle purchased on account by Excel for $3,000. The journal entry and general ledger T-account effects would be as follows.

Merchandise Inventory . . . . . . . . . . . . . . . . . 3,000
Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . .3,000
To record the purchase of merchandise inventory on account.

Question 5

How is a purchase return recorded in a perpetual system?

Answer 5

Assume that the vehicle purchased by Excel turned out to be the wrong colour. The supplier was contacted and agreed to reduce the price by $300 to $2,700. This is an example of a purchase returns and allowances adjustment. The amount of the allowance, or reduction, is recorded as a credit to the Merchandise Inventory account, as follows:

Accounts Payable . . . 300
>> Merchandise Inventory . . . . .300
To record purchase allowance; incorrect colour.

Question 6

How is the sale of merchandise inventory on credit recorded in a perpetual system?

Answer 6

Accounts Receivable . . . . . . . . . . . . . . . . . . . 4,000
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

To record the sale of merchandise on account.

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . 2,798
Merchandise Inventory . . . . . . . . . . . . . . . . . . .2,798
To record the cost of the sale

Question 7

How is a sales return that is restored to inventory recorded versus a sales return that is not restored to inventory (assuming a perpetual inventory system)?

Question 8

What is a sales discount and how is it recorded in a perpetual inventory system?

Answer 8

To record discounts:

Sales Discounts . . . . . . . . . . . . . . . . . . . . . . . . XX
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . XX
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . .XX

Question 9

Why does merchandise inventory need to be adjusted at the end of the accounting period and how is this done in a perpetual inventory system?

Question 10

What types of transactions affect merchandise inventory in a perpetual inventory system?

Answer 10

Purchase of MI

Shipping Costs

Sales Return

Question 11

How are the closing entries for a merchandiser using a perpetual inventory system different than for a service company?

Answer 11

The process of recording closing entries for service companies was illustrated in Chapter 3. The closing procedure for merchandising companies is the same as for service companies — all income statement accounts are transferred to the Income Summary account, the Income Summary is closed to Retained Earnings, and Dividends are closed to Retained Earnings.

When preparing closing entries for a merchandiser, the income statement accounts unique for merchandisers need to be considered — Sales, Sales Discounts, Sales Returns and Allowances, and Cost of Goods Sold. Sales is a revenue account so has a normal credit balance. To close Sales, it must be debited with a corresponding credit to the income summary. Sales Discounts and Sales Returns and Allowances are both contra revenue accounts so each has a normal debit balance.

Cost of Goods Sold has a normal debit balance because it is an expense. To close these debit balance accounts, a credit is required with a corresponding debit to the income summary.

Question 12

When reporting expenses on an income statement, how is the function of an expense reported versus the nature of an expense?

Question 13

On a classified multiple-step income statement, what is reported under the heading ‘Other revenues and expenses’ and why?

Question 14

What is the periodic inventory system?

Question 15

How is cost of goods sold calculated under the periodic inventory system?

Question 16

Because merchandising involves the purchase and then the resale of goods, an expense called ______________ results

Answer 16

Because merchandising involves the purchase and then the resale of goods, an expense called cost of goods sold results.

Question 17

A merchandising income statement highlights cost of goods sold by showing the difference between sales revenue and cost of goods sold called _______________

Answer 17

A merchandising income statement highlights cost of goods sold by showing the difference between sales revenue and cost of goods sold called gross profit or gross margin.

Question 18

Merchandising Income Statement

Answer 18

Merchandising Company

Sales

Less: Cost of Goods Sold

Equals: Gross Profit

Less: Expenses

Equals: Net Income

Question 19

In a _______________ the merchandise inventory account and cost
of goods sold account are updated immediately when transactons occur.

Answer 19

In a perpetual inventory system, the merchandise inventory account and cost
of goods sold account are updated immediately when transactons occur.

Question 20

When merchandise inventory is purchased, the cost is recorded in a Merchandise Inventory general ledger account. An account payable results when the merchandise inventory is acquired but will not be paid in cash until a later date.

For example, recall the vehicle purchased on account by Excel for $3,000. The journal entry and general ledger T-account effects would be as follows.

Answer 20

Merch Inventory . . . . . 3,000

>>> Accounts Payable . . . . . . 3,000

To record the purchase of merchandise inventory on account.

Question 21

Assume that the vehicle purchased by Excel turned out to be the wrong colour. The supplier was contacted and agreed to reduce the price by $300 to $2,700. This is an example of________________

Answer 21

Assume that the vehicle purchased by Excel turned out to be the wrong colour. The supplier was contacted and agreed to reduce the price by $300 to $2,700. This is an example of a purchase returns and allowances adjustment.

Question 22

**Purchase Returns and Allowances (Perpetual)

Assume that the vehicle purchased by Excel turned out to be the wrong colour. The supplier was contacted and agreed to reduce the price by $300 to $2,700. This is an example of a purchase returns and allowances adjustment. The amount of the allowance, or reduction, is recorded as a credit to the Merchandise Inventory account, as follows:**

Answer 22

Accounts Payable . . . . 300

>>> Merch Inventory . . . . . 300

To record purchase allowance; incorrect colour.

Question 23

Purchase Discounts (Perpetual) Purchase discounts affect the purchase price of merchandise if payment is made within a time period specified in the supplier’s invoice. For example, if the terms on the $3,000 invoice for one vehicle received by Excel indicates “1/15, n45”, this means that the $3,000 must be paid within 45 days (‘n’ = net).

However, if cash payment is made by Excel within 15 days, the purchase price will be reduced by 1%. Assuming the amount is paid within 15 days, the supplier’s terms entitle Excel to deduct $27 [($3,000 - $300) = $2,700 x 1% = $27].

Answer 23

Purchase Discounts (Perpetual) Purchase discounts affect the purchase price of merchandise if payment is made within a time period specified in the supplier’s invoice. For example, if the terms on the $3,000 invoice for one vehicle received by Excel indicates “1/15, n45”, this means that the $3,000 must be paid within 45 days (‘n’ = net).

However, if cash payment is made by Excel within 15 days, the purchase price will be reduced by 1%. Assuming the amount is paid within 15 days, the supplier’s terms entitle Excel to deduct $27 [($3,000 - $300) = $2,700 x 1% = $27].

Question 24

For example, if the terms on the $3,000 invoice for one vehicle received by Excel indicates “1/15, n45”, this means that the $3,000 must be paid within 45 days (‘n’ = net). However, if cash payment is made by Excel within 15 days, the purchase price will be reduced by 1%.

Assuming the amount is paid within 15 days, the supplier’s terms entitle Excel to deduct $27 [($3,000 - $300) = $2,700 x 1% = $27]. The payment to the supplier would be recorded as:

Answer 24

**Accounts Payable . . . . .2,700
>>>Merch Inventory . . . 27
>>>Cash . . . . . . . . . . . . 2,673

To record payment on account within the discount period.**

Question 25

The cost of the vehicle in Excel’s inventory records is now $2,673 ($3,000 – 300 – 27). If payment is made after the discount period, $2,700 of cash is paid and the entry would be:

Answer 25

Accounts Payable . .. . . 2,700
>>>Cash . . . .2,700
To record payment of account; no purchase discount applied.

Question 26

Trade discounts are similar to purchase discounts. A supplier advertises a list price which is the normal selling price of its goods to merchandisers. Trade discounts are given by suppliers to merchandisers that buy a large quantity of goods. For instance, assume a supplier offers a 10% trade discount on purchases of 1,000 units or more where the list price is $1/unit. If Beta Merchandiser Corp. buys 1,000 units on account, the entry in Beta’s records would be:

Answer 26

**Merch Inv . . . 900
>>>Accnts Payable . . . . 900

To record purchase on account; 10% trade
discount ($1,000 – 10% = $900).**

Question 27

Transportation
Costs to transport goods from the supplier to the seller must also be considered when recording the cost of merchandise inventory. The shipping terms on the invoice identify the point at which
ownership of the inventory transfers from the supplier to the purchaser.

When the terms are FOB shipping point, ownership transfers at the ‘shipping point’ so the purchaser is responsible for
transportation costs. FOB destination indicates that ownership transfers at the ‘destination point’ so the seller is responsible for transportation costs. FOB is the abbreviation for “free on board.”

Answer 27

Transportation
Costs to transport goods from the supplier to the seller must also be considered when recording the cost of merchandise inventory. The shipping terms on the invoice identify the point at which
ownership of the inventory transfers from the supplier to the purchaser.

When the terms are FOB shipping point, ownership transfers at the ‘shipping point’ so the purchaser is responsible for
transportation costs. FOB destination indicates that ownership transfers at the ‘destination point’ so the seller is responsible for transportation costs. FOB is the abbreviation for “free on board.”

Question 28

Assume that Excel’s supplier sells with terms of FOB shipping point indicating that transportation costs are Excel’s responsibility. If the cost of shipping is $125 and this amount was paid in cash to
the truck driver at time of delivery, the entry would be:

Answer 28

Merch Inv . . . . 125
>>>Cash . . . . . . . . 125
To record shipping costs on inventory purchase

Question 29

The cost of the vehicle in the Excel Merchandise Inventory account is now $2,798 (calculated as $3,000 original cost - $300 allowance - $27 discount + $125 shipping).

It is important to note that later when Excel sells vehicles to customers, its transportation costs to deliver goods to customers
are recorded as delivery expenses and do not affect the Merchandise Inventory account. In other words, delivery expenses TO customers are a SELLING cost for the seller (Excel) and are to be expensed.

The next second describes how the sale of merchandise is recorded as well as the related costs of items sold.

Answer 29

The cost of the vehicle in the Excel Merchandise Inventory account is now $2,798 (calculated as $3,000 original cost - $300 allowance - $27 discount + $125 shipping).

It is important to note that later when Excel sells vehicles to customers, its transportation costs to deliver goods to customers
are recorded as delivery expenses and do not affect the Merchandise Inventory account. In other words, delivery expenses TO customers are a SELLING cost for the seller (Excel) and are to be expensed.

The next second describes how the sale of merchandise is recorded as well as the related costs of items sold.

Question 30

Assume the vehicle purchased by Excel is sold for $4,000 on account. Recall that the cost of this vehicle in the Excel Merchandise Inventory account is $2,798, as shown below.

The entries to record the sale of the merchandise inventory are:

Answer 30

Accounts Receive . . . 4,000
>>>Sales . . . . . 4,000

To record the sale of merchandise on account.

_________________

Cost of Goods Sold . . . . . 2,798

>>>Merch Inventory . . . . 2,798

To record the cost of the sale

Question 31

When merchandise inventory that has been sold is returned to the merchandiser by the customer, a sales return and allowance is recorded. For example, assume some damage occurs to the merchandise inventory sold by Excel while it is being delivered to the customer. Excel gives the customer a sales allowance by agreeing to reduce the amount owing by $100. The entry is:

Answer 31

Sales Returns and Allow . . . 100
>>>Accounts Receivable . . . .100

To record allowance for damage to merchandise inventory during delivery.

Question 32

Accounts receivable is credited because the original sale was made on account and has not yet been paid. The amount owing from the customer is reduced to $3,900. If the $3,900 had already been paid, a credit would be made to Cash and $100 refunded to the customer. The Sales Returns and Allowances account is a contra revenue account and is therefore deducted from Sales when preparing the income statement.

Answer 32

Accounts receivable is credited because the original sale was made on account and has not yet been paid. The amount owing from the customer is reduced to $3,900. If the $3,900 had already been paid, a credit would be made to Cash and $100 refunded to the customer. The Sales Returns and Allowances account is a contra revenue account and is therefore deducted from Sales when preparing the income statement.

Question 33

If goods are returned by a customer, a sales return occurs. The related sales and cost of goods sold recorded on the income statement are reversed and the goods are returned to inventory. For example, assume Max Corporation sells a plastic container for $3 that it purchased for $1. The dual entry at the time of sale would be:

Accounts Receivable . . . . . . . . . . . . . . . . . . . 3
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
To record sale on credit.

Cost of Goods Sold . . 1
>>>Merchandise Inventory . . .1
To record the cost of the sale.

If the customer returns the container and the merchandise is restored to inventory, the dual journal entry would be:

Sales Returns and Allow . . . 3
>>>Accounts Receivable . . . 3
To record sales return.

Merchandise Inventory . . . . . . . . . . . . . . . . . 1
Cost of Goods Sold . . . . . . . . . . . . . . . . . . 1
To record sales return being restored to inventory.

The use of a contra account to record sales returns and allowances permits management to track the amount of returned and damaged items.

Answer 33

If goods are returned by a customer, a sales return occurs. The related sales and cost of goods sold recorded on the income statement are reversed and the goods are returned to inventory. For example, assume Max Corporation sells a plastic container for $3 that it purchased for $1. The dual entry at the time of sale would be:

Accounts Receive . . . 3
>>> Sales . . . 3
To record sale on credit.

Cost of Goods Sold . . . 1
>>>Merch Inv . . .1
To record the cost of the sale.

If the customer returns the container and the merchandise is restored to inventory, the dual journal entry would be:

Sales Returns and Allow .. . . . . 3
>>>Accounts Receivable . . . . . 3

To record sales return.

Merch Inv .. . . 1
>>>Cost of Goods Sold . . . 1
To record sales return being restored to inventory.

The use of a contra account to record sales returns and allowances permits management to track the amount of returned and damaged items.

Question 34

Another contra revenue account, Sales Discounts, records reductions in sales amounts when a customer pays within a certain time period. For example, assume Excel Cars Corporation offers sales terms of “2/10, n30.” This means that the amount owed must be paid by the customer within 30 days (‘n’ = net); however, if the customer chooses to pay within 10 days, a 2% discount may be deducted from the amount owing.

Answer 34

Another contra revenue account, Sales Discounts, records reductions in sales amounts when a customer pays within a certain time period. For example, assume Excel Cars Corporation offers sales terms of “2/10, n30.” This means that the amount owed must be paid by the customer within 30 days (‘n’ = net); however, if the customer chooses to pay within 10 days, a 2% discount may be deducted from the amount owing.

Question 35

Consider the sale of the vehicle for $3,900 ($4,000 less the $100 allowance for damage). Payment within 10 days entitles the customer to a $78 discount ($3,900 x 2% = $78). If payment is made within the discount period, Excel receives $3,822 cash ($3,900 - 78) and prepares the following entry:

Answer 35

Consider the sale of the vehicle for $3,900 ($4,000 less the $100 allowance for damage). Payment within 10 days entitles the customer to a $78 discount ($3,900 x 2% = $78). If payment is made within the discount period, Excel receives $3,822 cash ($3,900 - 78) and prepares the following entry:

Cash . . . . . 3,822
>>>Sales Discounts . . . 78
>>>Accounts Receive . . . . . 3,900

To record payment on account and sales discount applied

Question 36

The adjusting entry to record shrinkage is:

Answer 36

Cost of Goods Sold . . XX
>>>>Merch Inventory . . . XX
To adjust for shrinkage.

Question 37

To record the purchase of merchandise inventory from a supplier:

Answer 37

Merch Inv . . XX
>>> Accounts Pay. . . XX

Question 38

To record purchase return and allowances:

Answer 38

Accounts Pay. . . XX
>>> Merch Inv . . . XX

Question 39

To record purchase discounts:

Answer 39

Accounts Pay . . . XX
>>> Merch Inv . . . . . .XX

Question 40

To record shipping costs from supplier to merchandiser:

Answer 40

Merch Inv. . . XX
>>> Accounts Pay . XX

Question 41

To record sale of merchandise inventory and cost of the sale:

Answer 41

Accounts Rec. . . XX
>>> Sales . . . . . . . .XX

AND

Cost of Goods Sold . . XX
>>> Merch Inv . . . . . . . . . .XX

Question 42

To record sales returns restored to inventory:

Answer 42

Sales Returns and Allowances . . XX
>>> Accounts Receivable . . . . . . . . . .XX

AND

Merch Inv. . . . XX
>>> Cost of Goods Sold . . ..XX

Question 43

To record discounts:

Answer 43

Sales Discounts . . . XX
Cash . . . . .XX
>>Accounts Receivable . . . . .XX

Question 44

To record adjustment for shrinkage at the end of the accounting period:

Answer 44

Cost of Goods Sold . . . . XX
>>> Merchandise Inventory . . ..XX

Question 45

Sales is a _______ account so has a normal ______ balance

Answer 45

Sales is a revenue account so has a normal credit balance.

Question 46

To close Sales, it must be _ _ _ _ _ _ _ _ __ _

Answer 46

To close Sales, it must be debited with a corresponding credit to the income summary.

Question 47

Sales Discounts and Sales Returns and Allowances are both _ _ _ _ _ _ _ accounts so each has a normal _ _ _ _ _ _ balance.

Answer 47

Sales Discounts and Sales
Returns and Allowances are both contra revenue accounts so each has a normal debit balance.

Question 48

Cost of Goods Sold has a normal _________ balance because it is an _________.

Answer 48

Cost of Goods Sold has a normal debit balance because it is an expense.

Question 49

Sales Discounts and Sales Returns and Allowances are both contra revenue accounts so each has a normal debit balance.

Cost of Goods Sold has a normal debit balance because it is an expense. To close these debit balance accounts, a credit is required with a corresponding debit to the income summary.

Answer 49

Sales Discounts and Sales Returns and Allowances are both contra revenue accounts so each has a normal debit balance.

Cost of Goods Sold has a normal debit balance because it is an expense. To close these debit balance accounts, a credit is required with a corresponding debit to the income summary.