Accounting Principles

Chapter 05

✓ Inventory is the merchandise that companies buy and sell to customers. The
added Account for a merchandising company is the inventory account.

✓ Merchandising companies have 2 categories of expenses:-

1. Costs of goods , 2. Operating Expenses.
✓ Sales Revenue
– Cost of Goods sold
= Gross Profit
– Operating Expenses
= Net Income

✓ Costs of goods available for sale = Beginning inventory + cost of goods purchased
✓ Costs of goods available for sale = cost of goods sold + Ending inventory

✓ Ending Inventory: Those goods are not sold by the end of the accounting period
represent ending inventory.

✓ Perpetual Inventory System:

• Keep recording detailed of the cost of each inventory and sale.

• Example: Separate inventory records for each Automobiles, Trucks, Vans.
• Determining the cost of goods sold each time a sale occurs.
• Not keep an entry at the end of period .

✓ Periodic System

• Not to keep detailed inventory records.

• Determine the cost of goods sold only at the end of the accounting period.
• Taking a physical inventory count to determine the cost of goods and sales.
✓ INVOICE:- The total purchase price and other relevant information.

Purchased Invoice = Buyer

Sales Invoice= Seller

✓ FOB shipping point :- means that the seller places the goods free on board the
carrier, and the buyer pays the freight costs. [Buyer pays freight costs]

• When the buyer incurs the transportation costs, these costs are considered
part of the cost of purchasing inventory.

• Example:- 1,000/- delivery charge has been paid by the Buyer .

Journal:- Inventory Dr. 1,000/-
Cash Cr. 1000/-

✓ FOB destination:- means that the seller places the goods free on board to the
buyer’s place of business, and the seller pays the freight. [Seller pays freight
costs]

• When the seller pays the freight charges, the seller will usually establish a
higher invoice price for the goods to cover the shipping expense.

• Example:- 1,000/- delivery charge has been paid by the seller .

Journal [Seller perspective] :- Freight- Out Dr. 10,000/-
[It’s an expense for seller]
Cash Cr. 10,000/-

✓ Freight Cost: The sales agreement should indicate who the seller or the buyer
is to pay for transporting the goods to the buyer’s place of business. When a
common carrier such as a railroad, trucking company, or airline transports the
goods, the carrier prepares a freight bill in accordance with the sales agreement
is called Freight Cost. any freight costs incurred by the buyer are part of the cost
of merchandise purchased.
 ✓ Freight costs incurred by the seller on outgoing merchandise are an operating
expense to the seller.

✓ Purchase Discounts: The credit terms of a purchase on account may permit

the buyer to claim a cash discount for prompt payment. Credit terms specify the
amount of the cash discount and time period in which it is offered.

✓ Credit terms are 2/10, n/30, which is read “two-ten, net thirty”
✓ The discount period may extend to a specified number of days following the
month in which the sale occurs.

✓ 1/10 EOM (end of month) means that a 1%

discount is available if the invoice is paid within the first 10 days of the next month.

✓ When the buyer pays an invoice within the discount period, the amount of the
discount decreases Inventory.
• Example:- Mr. John 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. Since the terms are 2/10, n/30.
Solution:- The cash discount is $70 ($3,500 × 2%) and Mr. John pays $3,430 ($3,500 - $70).
Journal:- Accounts Payable Dr. 3,500
Cash Cr. 3,430
Inventory Cr. 70
✓ For internal decision-making purposes, merchandising companies may use more
than one sales revenue account.
✓ Contra Revenue Account :-A contra revenue account is an account that is
offset against a revenue account on the income statement.

• Companies use a contra account, instead of debiting Sales

Revenue, to track separately in the accounts and to report
separately in the income statement the amount of sales returns
and allowances.
• Sales Returns and Allowances & Sales Discounts are a contra
revenue account to Sales Revenue.
 • It is deducted from Sales Revenue on the income statement. It’s
normal balance is Debit.

✓ Any goods returned increase Inventory and reduce Cost of Goods Sold.
✓ Defective or damaged inventory is recorded at fair value (scrap value).

✓ Example:

• DO IT 3! On September 5, Junot Diaz Company sells merchandise on account to

De La Hoya Company. The selling price of the goods is $1,500, and the cost to
Diaz Company was $800. On September 8, De La Hoya returns defective goods
with an initial selling price of $200 and a fair value of $30.Record the
transactions on the books of Junot Diaz Company.

Solution:-
Sept. 5 Accounts Receivable Dr 1,500
Sales Revenue Cr 1,500
(To record credit sale)
Sept. 5 Cost of Goods Sold Dr. 800
Inventory Cr. 800
(To record cost of goods sold)
Sept.8 Sales Returns and Allowances Dr. 200
Accounts Receivable Cr. 200
(To record credit granted for receipt of returned goods)
Sept.8 Inventory Dr. 30
Cost of Goods Sold Cr 30
(To record fair value of goods returned)
✓ Adjusting Entry:- This involves adjusting Inventory and Cost of Goods Sold.

• For example, suppose that PW Audio Supply has an unadjusted balance of $40,500 in
Inventory. Through a physical count, PW Audio Supply determines that its actual
merchandise inventory at December 31 is $40,000. The company would make an
adjusting entry as follows.
✓ Journal:- Dec 31 Cost of Goods Sold Dr. 500
Inventory ($40,500 – $40,000) Cr. 500

✓ Gross Profit ÷ Net Sales = Gross Profit Rate

• Gross profit represents the merchandising profit of a company. It is not a

measure of the overall profitability because operating expenses are not yet
deducted.
• Operating expenses are the next component in measuring net income for a
merchandising company.
• Nonoperating activities consist of various revenues and expenses and gains
and losses that are unrelated to the company’s main line of operations. The
results of nonoperating activities are shown in the categories “Other revenues
and gains” and “Other expenses and losses.”

Other Revenues and Gains

• Interest revenue from notes receivable and marketable securities.
• Dividend revenue from investments in common stock.
• Rent revenue from subleasing a portion of the store.
• Gain from the sale of property, plant, and equipment.

Other Expenses and Losses

• Interest expense on notes and loans payable.
• Casualty losses from recurring causes, such as vandalism and accidents.
• Loss from the sale or abandonment of property, plant, and equipment strikes by
employees and suppliers.
 Determining Cost of Goods Sold Under a Periodic System
Beginning inventory
+ Cost of goods purchased
= Cost of goods available for sale
- Ending inventory
= Cost of goods sold

✓ The periodic system uses separate accounts for purchases, freight costs, returns,
and discounts.

✓ Freight-In is a temporary account whose normal balance is a debit. When the

purchaser directly incurs the freight costs, it debits the account Freight-In. It is
part of cost of goods purchased.

[Note:- If any merchandising company follows Perpetual inventory

system ,they don’t write the cost of purchaser as Freight-in. They use it
as Inventory.]

✓ Example:- Freight costs on purchases 150 Tk .

Perpetual Inventory System Periodic Inventory System

Inventory Dr 150 Freight in Dr 150

Cash Cr 150 Cash Cr. 150

✓ At Periodical Inventory System, there is not need to keep entry of “Cost of Goods Sold”.
 To close the merchandise inventory in a periodic inventory system:

1. The beginning inventory balance is debited to Income Summary and credited to

Inventory.
Inventory [Jan 1] Dr.
Income Statement Cr.
• This Journal debit entry have to be shown on Income Statement at Debit.

2. The ending inventory balance, as determined by the physical count, is debited to

Inventory and credited to Income Summary.

Income Statement Dr.

Inventory [Dec 31] Cr.

• This Journal debit entry have to be shown on Income Statement at Credit

& Inventory [31 Dec] have to be shown on Balance Sheet at Debit.