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CHAPTER 5

Merchandising Operations
and the Multiple-Step Income Statement

ANSWERS TO QUESTIONS
1.

(a) Disagree. The steps in the accounting cycle are the same for both a merchandising company and a
service enterprise.
(b) The measurement of income is conceptually the same. In both types of companies, net
income (or loss) results from the matching of expenses with revenues.

2.

The components of revenues and expenses differ as follows:


Merchandising
Revenues
Expenses

3.

4.

Sales
Cost of Goods Sold and Operating

Service
Fees, Rents, etc.
Operating (only)

Under a periodic inventory system the company does not keep track of how many units are on hand.
Instead it takes a physical count at the end of the period to determine ending inventory and cost of
goods sold. Under a perpetual system the company adjusts its inventory account each time it
purchases or sells inventory. Thus it always has a record of its available inventory. Having knowledge
of inventory balances helps a company avoid lost sales due to stock-outs as well as carrying too
much inventory on hand (which results in additional storage and handling costs). The purchasing
department can make better decisions with the aid of perpetual inventory records.
(a) The income measurement process is as follows:
Sales
Revenue

Less

Cost of
Goods
Sold

Equals

Gross
Profit

Less

Operating
Expenses

Equals

Net
Income

(b) Income measurement in a merchandising company differs from a service company as follows:
(a) sales are the primary source of revenue and (b) expenses are divided into two main
categories: cost of goods sold and operating expenses.
5.

6.

Sales revenue............................................................................................................
Cost of goods sold.....................................................................................................
Gross profit.................................................................................................................

$100,000
65,000
$35,000

Agree. In accordance with the revenue recognition principle, sales revenues are generally considered to be earned when the goods are transferred from the seller to the buyer; that is, when the
exchange transaction occurs. The earning of revenue is not dependent on the collection of credit
sales.

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5-1

7.

(a) The primary source documents are (1) cash salescash register tapes and (2) credit sales sales
invoice.
(b) The entries are:
Debit
Cash sales

5-2

Cash.....................................................................
Sales.............................................................

XX

Cost of Goods Sold...............................................


Merchandise Inventory..................................

XX

Credit
XX

XX

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Questions Chapter 5 (Continued)

Credit sales

8.

9.

July 19

Accounts Receivable............................................
Sales.............................................................

XX

Cost of Goods Sold...............................................


Merchandise Inventory..................................

XX

Cash ($800 $16)...........................................................................


Sales Discount ($800 X 2%)...........................................................
Accounts Receivable ($900 $100).......................................

XX

XX
784
16

800

The practice of shipping more goods than were ordered in order to meet sales goals and get rid of
extra inventory is referred to as channel stuffing. Shipping unwanted goods to customers is generally
considered unethical behavior. In addition, if proper accounting is applied, in most cases it wont
achieve the desired result of increasing sales. If it is expected that the unwanted goods will be shipped
back to the seller, then they should not be treated as sales in the first place.

10.

In most industries returns are not significant, and they are therefore accounted for as they occur.
When returns are expected to be significant, the company should make an adjusting entry at the end
of the period to estimate the amount of returns that will result from the periods sales, so that
revenues will not be overstated during the period.

11.

July 24

12.

Gross profit.......................................................................................................
Less: Net income.............................................................................................
Operating expenses.........................................................................................

13.

Its current terms of 1/10, n/30 means that customers get a 1% discount if they pay within 10 days,
otherwise they have to pay the full amount within 30 days. If they switch to 2/10, n/45 customers
would get a 2% discount for paying within 10 days, otherwise they have to pay the full amount in 45
days. By offering 2%, more of Allisons customers would likely pay within the 10 day period.
Management would have to determine whether it is worth the additional cost to be paid quicker. Also,
by extending the full payment period from 30 to 45 days, Allison would end up receiving its money
even later from its slow payers.

14.

The gain on the sale of the plant represents a one-time gain. That is, it wont be recurring next year.
If you eliminate the effect of this one-time gain, then the companys income actually declined by $5
million relative to the prior year. When predicting future earnings investors frequently place little
weight on non-recurring events such as this.

15.

There are three distinguishing features in the income statement of a merchandising company:
(1) a sales revenues section, (2) a cost of goods sold section, and (3) gross profit.

16.

The normal operating cycle for a merchandising company is likely to be longer than for a service
company because inventory must first be purchased and sold, and then the receivables must be
collected.

Accounts Payable ($1,900 $200).................................................


Merchandise Inventory ($1,700 X 2%)....................................
Cash ($1,700 $34)................................................................

1,700

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34
1,666
$560,000
260,000
$300,000

5-3

Questions Chapter 5 (Continued)


17. Tootsie Roll uses the term gross margin. It breaks down gross margin into two components, product
gross margin and rental and royalty gross margin. Total gross profit declined by $19,888,000.
18. Of the merchandising accounts, only Merchandise Inventory will appear in the post-closing trial
balance.
19. Businesses most likely to use a perpetual inventory system would include automobile dealerships,
equipment supply companies, and other companies selling products having a high unit-value. With
automation, perpetual systems are becoming increasingly cost-effective.
20.
Accounts
Purchase Returns and Allowances
Purchase Discounts
Freight-in

(a)
Added/Deducted
Deducted
Deducted
Added

(b)
Normal Balance
Credit
Credit
Debit

21. (a) X = Purchase returns and allowances and


Y = Purchase discounts, or vice versa.
(b) X = Freight-in.
(c) X = Cost of goods purchased.
(d) X = Ending merchandise inventory.
22. Profitability is affected by gross profit (as measured by the gross profit rate) and by managements
ability to control operating expenses, as measured by the profit margin ratio.
23. Factors affecting a companys gross profit rate include selling products with a higher (or lower)
markup, increased competition that results in lower selling prices, and price increases or decreases
from suppliers.
24. Gross profit represents the amount by which sales exceeds cost of goods sold. In order for the
company to be profitable, gross profit must exceed the companys operating expenses. Before the
selling price is cut, the company should do a careful analysis estimating what its gross profit and
operating expenses would be if more units were sold at a lower selling price. In addition, a big
concern is what the likely reaction of competitors will be. If competitors also cut their price, then
volume will not increase, and the companys net income will be lower.
25. Benny Kat should calculate the companys quality of earnings ratio. This is calculated by dividing net
cash provided by operating activities by net income. A measure significantly below 1 would suggest
that the company might be using aggressive accounting techniques to recognize income early.
*26. July 24

5-4

Accounts Payable ($1,900 $200)...................................


Purchase Discounts ($1,700 X 2%).........................
Cash ($1,700 $34)................................................

1,700
34
1,666

Copyright 2009 John Wiley & Sons, Inc.Kimmel, Financial Accounting, 5/e, Solutions Manual(For Instructor Use Only)

SOLUTIONS TO BRIEF EXERCISES


BRIEF EXERCISE 5-1
(a)
(b)
(c)
(d)
(e)
(f)

Sales = $181,500 ($71,900 + $109,600).


Cost of goods sold = $41,200 ($71,200 $30,000).
Gross profit = $38,000 ($108,000 $70,000).
Operating expenses = $19,200 ($30,000 $10,800).
Operating expenses = $8,500 ($38,000 (from c) $29,500).
Net income = $63,400 ($109,600 $46,200).

BRIEF EXERCISE 5-2


Prior Company
Merchandise Inventory.......................................
Accounts Payable........................................

900

Wood Company
Accounts Receivable..........................................
Sales.............................................................

900

Cost of Goods Sold.............................................


Merchandise Inventory...............................

900

900
630
630

BRIEF EXERCISE 5-3


(a) Accounts Receivable..........................................
Sales..............................................................

800,000

Cost of Goods Sold.............................................


Merchandise Inventory................................

540,000

(b) Sales Returns and Allowances..........................


Accounts Receivable...................................

110,000

Merchandise Inventory.......................................
Cost of Goods Sold.....................................
(c) Cash ($690,000 $13,800)..................................
Sales Discounts ($690,000 X 2%).......................
Accounts Receivable
($800,000 $110,000)...............................

800,000
540,000
110,000
75,000

75,000

676,200
13,800
690,000

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5-5

BRIEF EXERCISE 5-4


(a) Merchandise Inventory.......................................
Accounts Payable........................................

800,000

(b) Accounts Payable................................................


Merchandise Inventory................................

110,000

(c) Accounts Payable ($800,000 $110,000)..........


Merchandise Inventory
($690,000 X 2%)........................................
Cash ($690,000 $13,800)...........................

690,000

800,000

110,000

13,800
676,200

BRIEF EXERCISE 5-5


CARPENTER COMPANY
Income Statement (Partial)
For the Month Ended October 31, 2010
Sales revenues
Sales ($300,000 + $150,000)................................
Less: Sales returns and allowances.................
Sales discounts........................................
Net sales...............................................................

$450,000
$22,000
5,000

27,000
$423,000

BRIEF EXERCISE 5-6


As the name suggests, numerous steps are required in determining net
income in a multiple-step statement.
Item

Section

Gain on sale of equipment


Cost of goods sold
Depreciation expense
Sales returns and allowances

Other revenues and gains


Cost of goods sold
Operating expenses
Sales revenues

5-6

Copyright 2009 John Wiley & Sons, Inc.Kimmel, Financial Accounting, 5/e, Solutions Manual(For Instructor Use Only)

BRIEF EXERCISE 5-7


Beginning inventory....................................................
Add: Purchases.........................................................
Cost of goods available for sale................................
Less: Ending inventory..............................................
Cost of goods sold......................................................

$ 70,000
380,000
450,000
50,000
$400,000

BRIEF EXERCISE 5-8


Purchases....................................................................
Less: Purchase returns and allowances................
Purchase discounts........................................
Net purchases..............................................................

$404,000
$11,000
7,000

Net purchases..............................................................
Add: Freight-in.............................................................
Cost of goods purchased...........................................

18,000
$386,000
$386,000
16,000
$402,000

BRIEF EXERCISE 5-9


Net sales.......................................................................
Beginning inventory....................................................
Add: Cost of goods purchased*................................
Cost of goods available for sale................................
Ending inventory.........................................................
Cost of goods sold......................................................
Gross profit..................................................................

$620,000
$ 60,000
402,000
462,000
90,000
372,000
$248,000

*Information taken from Brief Exercise 5-8.

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5-7

BRIEF EXERCISE 5-10


(a) Profit margin ratio = $37,500 $250,000 = .15
The profit margin ratio measures the extent by which
covers all expenses. In this case 85% of sales revenues
enses (cost of goods sold, operating expenses, and other
15% of revenues as net income. Or, for every dollar of
company earns $0.15 in net income.

selling price
cover all expcosts) leaving
net sales, the

(b) Gross profit rate = ($250,000 $150,000) $250,000 = .40


The gross profit rate measures the margin by which selling price exceeds
cost of goods sold. In this case, 40% of sales revenues remain (after
deducting cost of goods sold) to cover all other expenses and produce
net income.

BRIEF EXERCISE 5-11


(a) Profit margin ratio = $70,000 $800,000 = .088
The profit margin ratio measures the extent by which selling price
covers all expenses. In this case, 91.2% of sales revenues cover all
expenses (cost of goods sold and operating expenses) leaving 8.8% of
revenues as net income.
(b) Gross profit rate = ($800,000 $520,000) $800,000 = .35
The gross profit rate measures the margin by which selling price exceeds
cost of goods sold. In this case, 35% of sales revenues remain (after
deducting cost of goods sold) to cover operating expenses and produce net
income.

5-8

Copyright 2009 John Wiley & Sons, Inc.Kimmel, Financial Accounting, 5/e, Solutions Manual(For Instructor Use Only)

BRIEF EXERCISE 5-12


The quality of earnings ratio is calculated by dividing net cash provided by
operating activities by net income. For Watson Corporation this would be
$221,200 $352,000 = .63. This is significantly less than 1, which
suggests that the company may be using aggressive accounting
techniques in order to recognize income early. The factors that are causing
net income to differ from net cash provided by operating activities should
be examined.

*BRIEF EXERCISE 5-13


(a) Purchases.............................................................
Accounts Payable....................................

800,000

(b) Accounts Payable................................................


Purchase Returns and Allowances........

110,000

(c) Accounts Payable ($800,000 $110,000)..........


Purchase Discounts ($690,000 X 2%)....
Cash ($690,000 $13,800).......................

690,000

800,000

110,000

13,800
676,200

SOLUTIONS TO DO IT! REVIEW EXERCISES

DO IT! 5-1
Oct. 5

Oct. 8

Merchandise Inventory...............................................
Accounts Payable...............................................
(To record goods purchased on account)

5,000

Accounts Payable........................................................
Merchandise Inventory.......................................
(To record return of defective goods)

700

5,000

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700

5-9

DO IT! 5-2
Oct. 5

Oct. 8

Accounts Receivable..................................................
Sales.....................................................................
(To record credit sales)

5,000

Cost of Goods Sold.....................................................


Merchandise Inventory.......................................
(To record cost of goods sold on account)

3,000

Sales Returns and Allowances..................................


Accounts Receivable..........................................
(To record credit granted for receipt of
returned goods)

700

Merchandise Inventory...............................................
Cost of Goods Sold............................................
(To record scrap value of goods returned)

250

5,000

3,000

700

250

DO IT! 5-3
JUNEAU CORP.
Income Statement
For the Year Ended December 31, 2010
Net sales...............................................................
Cost of goods sold..............................................
Gross profit..........................................................
Operating expenses............................................
Income from operations......................................
Other revenues and gains..................................
Other expenses and losses................................
Income before income taxes..............................
Income tax expense............................................
Net income...........................................................

5-10

$552,000
156,000
396,000
186,000
210,000
$12,700
2,300

10,400
220,400
66,120
$154,280

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DO IT! 5-4
(a) Cost of goods purchased:
Purchases Purchase returns Purchase discounts + Freight-in
$162,500 $3,200 $5,700 + $8,400 = $162,000
(b) Cost of goods sold:
Beginning inventory + Cost of goods purchased Ending inventory
$31,720 + $162,000 $27,950 = $165,770

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5-11

SOLUTIONS TO EXERCISES
EXERCISE 5-1
(a) (1) Dec. 3

Accounts Receivable....................
Sales.......................................

500,000

Cost of Goods Sold.......................


Merchandise Inventory.........

320,000

500,000

320,000
28,000

(2) Dec. 8

Sales Returns and Allowances....


Accounts Receivable............

(3) Dec. 13

Cash ($472,000 $4,720)..............


Sales Discounts
[($500,000 $28,000) X 1%]......
Accounts Receivable
($500,000 $28,000)..........

467,280

(b) Cash.........................................................................
Accounts Receivable
($500,000 $28,000)....................................

472,000

28,000

4,720
472,000

472,000

EXERCISE 5-3
(a) (1) April 5

(2) April 6

(3) April 7

(4) April 8

(5) April 15

5-12

Merchandise Inventory.....................
Accounts Payable.....................

25,000

Merchandise Inventory.....................
Cash............................................

900

Equipment..........................................
Accounts Payable.....................

30,000

Accounts Payable.............................
Merchandise Inventory.............

3,600

Accounts Payable
($25,000 $3,600)..........................
Merchandise Inventory

25,000

900

30,000

3,600

21,400

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[($25,000 $3,600) X 2%]......


Cash ($21,400 $428)...............
(b) May 4Accounts Payable ($25,000 $3,600)............
Cash.....................................................

428
20,972
21,400
21,400

EXERCISE 5-6
(a)

YATES COMPANY
Income Statement
For the Month Ended January 31, 2010
Sales revenues
Sales..............................................................
Less: Sales returns and
allowances........................................
Sales discounts................................
Net sales.......................................................
Cost of goods sold..............................................
Gross profit..........................................................
Operating expenses
Salary expense.............................................
Rent expense................................................
Insurance expense......................................
Freight-out....................................................
Total operating expenses....................
Income before income taxes..............................
Income tax expense............................................
Net income...........................................................

(b) Profit margin ratio =

Gross profit rate =

$370,000
$17,000
8,000

25,000
345,000
212,000
133,000

62,000
32,000
12,000
7,000
113,000
20,000
5,000
$ 15,000

$15,000
= 4.3%
$345,000

$133,000
= 38.6%
$345,000

EXERCISE 5-7

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5-13

(a) Iwig Company

5-14

Sales........................................................................................
*Sales returns ($90,000 $84,000).........................................
Net sales..................................................................................

$ 90,000)
(6,000)
$ 84,000)

Net sales..................................................................................
Cost of goods sold.................................................................
*Gross profit.............................................................................

$ 84,000)
(56,700)
$ 27,300)

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EXERCISE 5-7 (Continued)


Gross profit.............................................................................
Operating expenses...............................................................
*Net income..............................................................................

$ 27,300)
(14,580)
$ 12,720)

Pratt Company
*Sales ($100,000 + $5,000)......................................................
Sales returns...........................................................................
Net sales..................................................................................

$105,000)
(5,000)
$100,000)

Net sales..................................................................................
*Cost of goods sold ($100,000 $40,000).............................
Gross profit.............................................................................

$100,000)
(60,000)
$ 40,000)

Gross profit.............................................................................
*Operating expenses ($40,000 $18,000).............................
Net income..............................................................................

$ 40,000)
(22,000)
$18,000)

*Indicates missing amount


(b)

Iwig

Pratt

Profit margin ratio

$12,720 $84,000 = .15

$18,000 $100,000 = .18

Gross profit rate

$27,300 $84,000 = .33

$40,000 $100,000 = .40

(c) Pratt has a higher profit margin ratio than Iwig. Each dollar of sales by
Pratt results in 18 cents of net income compared to only 15 cents for Iwig.
Pratt also has a higher gross profit rate. For each dollar of Pratts sales
revenue, 60 cents is required to cover cost of goods sold leaving 40 cents
to cover other expenses and produce net income. Iwigs gross profit of .33
indicates that only 33 cents of each sales dollar is available to cover other
expenses and produce net income.

Copyright 2009 John Wiley & Sons, Inc.Kimmel, Financial Accounting, 5/e, Solutions Manual(For Instructor Use Only)

5-15

EXERCISE 5-10
Inventory, September 1, 2009....................................
Purchases....................................................................
Less: Purchase returns and allowances.................
Net purchases..............................................................
Add: Freight-in.........................................................
Cost of goods purchased...........................................
Cost of goods available for sale................................
Inventory, August 31, 2010.........................................
Cost of goods sold..............................................

$ 19,200
$154,000
5,000
149,000
8,000
157,000
176,200
22,000
$154,200

EXERCISE 5-11
(a) $1,440 ($1,500 $60)
(b) $1,570 (1,440 + $130)
(c) $1,510 ($1,820 $310)

(g) $7,700
(h) $640
(i) $9,050

(d) $40
(e) $190
(f) $120

(j)
(k)
(I)

($1,080 $1,040)
($1,230 $1,040)
($1,350 $1,230)

($290 + $7,410)
($8,050 $7,410)
($1,000 + $8,050)

$5,000 ($49,530 $44,530 from (I))


$1,300 ($43,590 $42,290)
$44,530 ($42,290 + $2,240)

SOLUTIONS TO PROBLEMS
PROBLEM 5-1A

(a)
General Journal
Date
May 1
2

Account Titles
Debit
Merchandise Inventory...................................... 8,000
Accounts Payable.......................................
Accounts Receivable......................................... 4,400
Sales.............................................................

Credit
8,000
4,400

Cost of Goods Sold............................................ 3,300


5-16

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Merchandise Inventory...............................

3,300
200

Accounts Payable...............................................
Merchandise Inventory...............................

Cash ($4,400 $132).......................................... 4,268


Sales Discounts ($4,400 X 3%).......................... 132
Accounts Receivable..................................

4,400

Accounts Payable ($8,000 $200).................... 7,800


Merchandise Inventory
($7,800 X 2%)...........................................
Cash.............................................................

156
7,644

Supplies............................................................... 900
Cash.............................................................

900

Merchandise Inventory...................................... 2,700


Cash.............................................................

2,700

10

11
12

230

15

Cash.....................................................................
Merchandise Inventory...............................

17

Merchandise Inventory...................................... 2,500


Accounts Payable.......................................

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200

230
2,500

5-17

PROBLEM 5-1A (Continued)


General Journal
Date
May 19

24

Account Titles
Debit
Merchandise Inventory...................................... 250
Cash.............................................................
Cash.....................................................................
Sales.............................................................

27

29

31

5-18

Merchandise Inventory......................................
Accounts Payable.......................................

250

5,400
5,400

Cost of Goods Sold............................................ 4,020


Merchandise Inventory...............................
25

Credit

4,020

800
800

Accounts Payable............................................... 2,500


Merchandise Inventory
($2,500 X 2%)...........................................
Cash.............................................................

50
2,450

Sales Returns and Allowances......................... 124


Cash.............................................................

124

Merchandise Inventory...................................... 90
Cost of Goods Sold....................................

90

Accounts Receivable......................................... 1,280


Sales.............................................................

1,280

Cost of Goods Sold............................................ 830


Merchandise Inventory...............................

830

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PROBLEM 5-1A (Continued)


(b)
Cash
5/1 Bal. 8,000 5/10
5/9
4,268 5/11
5/15
230 5/12
5/24
5,400 5/19
5/27
5/29
5/31 Bal. 3,830

7,644
900
2,700
250
2,450
124

Accounts Receivable
5/2
4,400 5/9
4,400
5/31
1,280
5/31 Bal. 1,280
Merchandise Inventory
5/1
8,000 5/2
3,300
5/12
2,700 5/5
200
5/17
2,500 5/10
156
5/19
250 5/15
230
5/25
800 5/24
4,020
5/29
90 5/27
50
5/31
830
5/31 Bal. 5,554

Common Stock
5/1 Bal. 8,000
5/31 Bal. 8,000
Sales
5/2
5/24
5/31
5/31 Bal.

4,400
5,400
1,280
11,080

Sales Returns and Allowances


5/29
124
5/31 Bal. 124
Sales Discounts
5/9
132
5/31 Bal. 132
Cost of Goods Sold
5/2
3,300 5/29
90
5/24
4,020
5/31
830
5/31 Bal. 8,060

Supplies
5/11
900
5/31 Bal. 900

5/5
5/10
5/27

Accounts Payable
200 5/1
8,000
7,800 5/17
2,500
2,500 5/25
800
5/31 Bal.
800

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5-19

5-20

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PROBLEM 5-1A (Continued)


(c)

STEIN HARDWARE STORE


Income Statement (Partial)
For the Month Ended May 31, 2010
Sales revenues
Sales.....................................................................
Less: Sales returns and allowances.................
Sales discounts........................................
Net sales...............................................................
Cost of goods sold......................................................
Gross profit..................................................................

$11,080
$124
132

256
10,824
8,060
$ 2,764

(d) Profit margin ratio:($2,764 $1,400) $10,824 = .13


Gross profit rate:$2,764 $10,824 = .26

Copyright 2009 John Wiley & Sons, Inc.Kimmel, Financial Accounting, 5/e, Solutions Manual(For Instructor Use Only)

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