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Chapter

MERCHANDISING ACTIVITIES

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Operating Cycle of a Merchandising Company

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The operating cycle of a business is the time it takes


the business to start with cash, purchase inventory, sell the inventory, and finally collect the cash from customers.

The operating cycle of a business that sells inventory


on credit is typically longer than that of a business that sells only on a cash basis. This additional time is due to time between when the customer buys the inventory and the time the customer pays off the account receivable.
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Operating Cycle of a Merchandising Company

6-3

Cash

Accounts Receivable

Inventory
2. Sale of merchandise on account

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Comparing Merchandising Activities with Manufacturing Activities


Purchase inventory in ready-to-sell condition.
Manufacture inventory and have a longer and more complex operating cycle.

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Merchandising Company

Manufacturing Company
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6-5

Retailers and Wholesalers

Wholesalers buy merchandise from several different manufacturers and then sell this merchandise to several retailers.
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Retailers sell merchandise directly to the public. The McGraw-Hill Companies, Inc., 2005

Income Statement of a Merchandising Company


The income statements of merchandising companies
will have an additional expense item called Cost of Goods Sold. The Cost of Goods Sold account represents the cost of the merchandise sold during the period to help earn revenue.

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Cost of Goods Sold is presented as a separate expense


item on the income statement. Net Sales minus Cost of Goods Sold equals Gross Profit. Gross Profit is the amount left, after subtracting the cost of the inventory sold, to cover all other expenses and a profit .
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Income Statement of a Merchandising Company


Computer Barn Condensed Income Statement For the Year Ended December 31, 2005 Revenue from sales $ 900,000 Less: Cost of goods sold 540,000 Gross profit $ 360,000 Less: Expenses 270,000 Net income $ 90,000

6-7

Cost of goods sold represents the expense of goods that are sold to customers.

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Gross profit is a useful means of measuring the profitability of sales transactions.Companies, Inc., 2005 The McGraw-Hill

Accounting Systems Requirements for Merchandising Companies


Although general ledger accounts provide useful information, they do not provide much of the detailed information needed in the daily business operations.
General Ledger Accounts Receivable Debit Credit Balance 10,000 3,000 10,000 7,000

6-8

Date 2001 June 1 15


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Who owes us money?

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Accounting Systems Requirements for Merchandising Companies


Control Account Subsidiary Ledgers
Subsidiary Ledger Jake Sparks Debit Credit 3,000
Date 2001 June 1 15

6-9

General Ledger Accounts Receivable Debit Credit Balance 10,000 3,000 10,000 7,000

Date 2001 June 1 15

Balance 3,000 2,000

Date 2001 June 1 7,000 McGraw-Hill/Irwin 15

1,000 Subsidiary Ledger Heather Jacobs Debit Credit Balance

2,000

7,000 5,000

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Two Approaches Used in Accounting for Merchandise Transactions

6-10

Perpetual Inventory System

Periodic Inventory System

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The McGraw-Hill Companies, Inc., 2005

Two Approaches Used in Accounting for Merchandise Transactions

6-11

In the past, both systems were in widespread use. Today, however, the growing use of computerized accounting systems has
made the perpetual approach very easy and cost-effective to implement. Thus, the periodic approach is used primarily by very small businesses with manual accounting systems. Before we examine perpetual and periodic inventory systems, it is important to realize that accounting for inventory is similar to accounting for the prepaid expenses we discussed in chapter 4 (for example, office supplies, unexpired insurance policies, prepaid rent, etc.). As inventory is purchased, it is initially reported as an asset in the balance sheet. As it is sold to customers, this asset is converted to an expense, specifically, the cost of goods sold. Both perpetual and periodic inventory systems account for the flow of inventory costs from the balance sheet to the income statement.
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6-12

Perpetual Inventory Systems


The inventory account is continuously updated to reflect items on hand.

Lets look at some entries!


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6-13

Perpetual Inventory Systems


On September 5, Worley Co. purchased 100 laser lights for resale for $30 per unit from Electronic City on account.

GENERAL JOURNAL
Date Account Titles and Explanation Accounts Payable (Electronic City) Debit 3,000 3,000 Credit

Sept. 5 Inventory

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6-14

Perpetual Inventory Systems


On September 10, Worley Co. sold 10 laser lights for $50 per unit on account to ABC Radios.
GENERAL JOURNAL
Date Account Titles and Explanation Sales 10 Cost of Goods Sold
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10 $30 = $300
Debit 500 500 300
The McGraw-Hill Companies, Inc., 2005

Credit

Sept. 10 Accounts Receivable (ABC Radios)

Inventory

300

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Perpetual Inventory Systems


On September 10, Worley Co. sold 10 laser lights for $50 per unit on account to ABC Radios.
GENERAL JOURNAL
Date Account Titles and Explanation Sales 10 Cost of Goods Sold
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Retail
Debit 500 500 300 Credit

Sept. 10 Accounts Receivable (ABC Radios)

Inventory

Cost

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300

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Perpetual Inventory Systems


On September 15, Worley Co. paid Electronic City $3,000 for the September 5 purchase.

GENERAL JOURNAL
Date Account Titles and Explanation Cash Debit 3,000 3,000 Credit

Sept. 15 Accounts Payable (Electronic City)

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6-17

Perpetual Inventory Systems


On September 22, Worley Co. received $500 from ABC Radios as payment in full for their purchase on September 10.

GENERAL JOURNAL
Date Account Titles and Explanation Accounts Receivable (ABC Radios) Debit 500 500 Credit

Sept. 22 Cash

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6-18

Taking a Physical Inventory


In order to ensure the accuracy of their perpetual records, most businesses take a complete physical count of the merchandise on hand at least once a year.
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6-19

Taking a Physical Inventory


Reasonable amounts of inventory shrinkage are viewed as a normal cost of doing business. Examples include breakage, spoilage and theft.

On December 31, Worley Co. counts its inventory. An inventory shortage of $2,000 is discovered.
GENERAL JOURNAL
Date Account Titles and Explanation Inventory
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Debit 2,000

Credit 2,000

Dec. 31 Cost of Goods Sold

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Closing Entries in a Perpetual Inventory System


Close Revenue accounts
(including Sales) to Income Summary. The closing entries are the same!

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Close Expense accounts


(including Cost of Goods Sold) to Income Summary.

Close Income Summary


account to Retained Earnings.

Close Dividends to
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Retained Earnings.

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6-21

Next is the periodic inventory system!

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6-22

Periodic Inventory Systems


No effort is made to keep up-to-date records of either inventory or cost of goods sold. Only on a periodic basis are these two accounts updated.

Lets look at some entries!


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6-23

Periodic Inventory Systems


On September 5, Worley Co. purchased 100 laser lights for resale for $30 per unit from Electronic City on account.
Notice that no entry is made to Inventory. GENERAL JOURNAL
Date Account Titles and Explanation Accounts Payable (Electronic City) Debit 3,000 3,000 Credit Sept. 5 Purchases

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6-24

Periodic Inventory Systems

On September 10, Worley Co. sold 10 laser lights for $50 per unit on account to ABC Radios. Under the periodic inventory system, a sale of inventory requires only one entry: a debit to Accounts Receivable and a credit to Sales for the retail amount of the sale, which in this case is five hundred dollars. The cost entry that we made under the perpetual inventory system is not required because the periodic system does not attempt to keep the inventory and cost of good sold accounts up to date.

GENERAL JOURNAL
Date Account Titles and Explanation Sales Debit

Retail
Credit 500

Sept. 10 Accounts Receivable (ABC Radios)

500

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6-25

Periodic Inventory Systems


On September 15, Worley Co. paid Electronic City $3,000 for the September 5 purchase. This entry is the same as under the perpetual inventory system. Worley Company would debit Accounts Payable and credit Cash for three thousand dollars.
GENERAL JOURNAL
Date Account Titles and Explanation Cash Debit 3,000 3,000 Credit

Sept. 15 Accounts Payable (Electronic City)

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6-26

Periodic Inventory Systems


On September 22, Worley Co. received $500 from ABC
Radios as payment in full for their purchase on September 10. This entry is also the same as under the perpetual inventory system. Worley Company would debit Cash and credit Accounts Receivable for five hundred dollars.
GENERAL JOURNAL
Date Account Titles and Explanation Accounts Receivable (ABC Radios) Debit 500 500 Credit

Sept. 22 Cash

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Computing Cost of Goods Sold.


Because the periodic system does not maintain a cost of good sold account, at the end of the period, cost of goods sold must be calculated.

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The accounting records of Party Supply show the following:


Inventory, Jan. 1, 2005 $ 14,000

Purchases (during 2005) 130,000


At December 31, 2005, Party Supply counted the merchandise on hand at $12,000. Calculate Party Supplys cost of goods sold for 2005. The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin

6-28

Computing Cost of Goods Sold

Cost of Goods Sold can be calculated as follows:


Inventory (beginning of the year) Add: Purchases Cost of goods available for sale Less: Inventory (end of year) Cost of goods sold
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$ 14,000 130,000 144,000 12,000 $ 132,000

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6-29

Creating a Cost of Goods Sold Account


Now, Party Supply must create the Cost of Goods Sold account. This is accomplished by zeroing out the balances in the related accounts that have a debit balance, namely the beginning inventory balance and the Purchases account. So, we credit the Purchases account for its balance and we credit the Inventory account for its beginning balance. This part of the entry creates a zero balance in each of these accounts. The related debit is for the total to the Cost of Goods Sold account. Now, we still have one more entry to make to finish this process.

GENERAL JOURNAL
Date Account Titles and Explanation Inventory (beginning of year) Purchases
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Debit 144,000

Credit 14,000 130,000

Dec. 31 Cost of Goods Sold

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6-30

Creating a Cost of Goods Sold Account


Now, Party Supply must record the ending inventory amount. The second entry records the physical count in the Inventory account and adjusts the balance in the Cost of Goods Sold account. After this entry, the Inventory account balance reflects the ending inventory amount and the Cost of Goods Sold balance reflects the calculated cost of goods sold amount.

GENERAL JOURNAL
Date Account Titles and Explanation Cost of Goods Sold
McGraw-Hill/Irwin

Debit 12,000

Credit 12,000

Dec. 31 Inventory (end of year)

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Completing the Closing Process


Close Revenue accounts
(including Sales) to Income Summary. The closing entries are the same!

Close Expense accounts


(including Cost of Goods Sold) to Income Summary.

Close Income Summary


account to Retained Earnings.

Close Dividends to
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Retained Earnings.

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Selecting an Inventory System


Factors Suggesting a Perpetual Inventory System Large company with professional management. Management and employees wanting information about items in inventory and the quantities of specific products that are selling. Factors Suggesting a Periodic Inventory System Small company, run by owner. Accounting records of inventories and specific product sales not needed in daily operations; such information developed primarily for use in annual income tax returns. Inventory with many different kinds of low-cost items. High volume of sales transactions and a manual accounting system. Lack of full-time accounting personnel.

Items in inventory with a high per-unit cost. Low volume of sales transactions or a computerized accounting system. Merchandise stored at multiple locations or in warehouses separate from sales sites.

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All merchandise stored at the sales site.

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6-33

Credit Terms and Cash Discounts


When manufacturers and wholesalers sell their products on account, the credit terms are stated in the invoice. Cash discounts are provided to customers as a incentive for them to pay early. The credit period is the normal period of time the company allows for customers to extend their account receivable, typically 30 or 60 days. The discount period is a much shorter period of time, typically 10 or 15 days. If payment is received during the discount period, a discount may be taken. If payment is made after the discount period expires, then the full payment is due on or before the end of the credit period.

2/10, n/30
Read as: Two ten, net thirty
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6-34

Credit Terms and Cash Discounts

2/10, n/30
Percentage of Discount # of Days Discount Is Available Otherwise, the Full Amount Is Due # of Days when Full Amount Is Due
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6-35

Recording Purchases at Net Cost

Many companies plan to take advantage of cash


discounts offered so they go ahead and record their purchases net of the discount. Since they typically take the discount, this process simplifies future entries. If a cash discount is not taken in the future, then a purchase discounts lost account is used.

Lets see how these entries work.

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6-36

Recording Purchases at Net Cost


Purchases are recorded at their net amounts.

Net Method

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Purchase Discounts Lost are recorded when payment is made outside the discount period. Companies, Inc., 2005 The McGraw-Hill

6-37

Recording Purchases at Net Cost


On July 6, Play Clothes purchased $4,000 of merchandise on credit with terms of 2/10, n/30 from Kids Clothes. Prepare the journal entry for Play Clothes.

GENERAL JOURNAL
Date Account Titles and Explanation Debit Credit

McGraw-Hill/Irwin

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6-38

Recording Purchases at Net Cost


On July 6, Play Clothes purchased $4,000 of merchandise on credit with terms of 2/10, n/30 from Kids Clothes. Prepare the journal entry for Play Clothes.
GENERAL JOURNAL
Date Account Titles and Explanation Accounts Payable (Kid's Clothes)
McGraw-Hill/Irwin

Debit 3,920

Credit 3,920

July 6 Inventory

$4,000 98% = $3,920

The McGraw-Hill Companies, Inc., 2005

6-39

Recording Purchases at Net Cost


On July 15, Play Clothes pays the full amount due to Kids Clothes. Prepare the journal entry for Play Clothes.

GENERAL JOURNAL
Date Account Titles and Explanation Debit Credit

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc., 2005

6-40

Recording Purchases at Net Cost


On July 15, Play Clothes pays the full amount due to Kids Clothes. Prepare the journal entry for Play Clothes.
GENERAL JOURNAL
Date Account Titles and Explanation Cash
McGraw-Hill/Irwin

Debit 3,920

Credit 3,920

July 15 Accounts Payable (Kid's Clothes)

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6-41

Recording Purchases at Net Cost


Now, assume that Play Clothes waited until July 20 to pay the amount due in full to Kids Clothes. Prepare the journal entry for Play Clothes.
GENERAL JOURNAL
Date Account Titles and Explanation Debit Credit

McGraw-Hill/Irwin

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6-42

Recording Purchases at Net Cost


Now, assume that Play Clothes waited until July 20 to pay the amount due in full to Kids Clothes. Prepare the journal entry for Play Clothes.
GENERAL JOURNAL Nonoperating Expense
Date Account Titles and Explanation Purchase Discounts Lost Cash
McGraw-Hill/Irwin

Debit 3,920 80

Credit

July 20 Accounts Payable (Kid's Clothes)

4,000
The McGraw-Hill Companies, Inc., 2005

Recording Purchases at Gross Invoice Price


Purchases are recorded at their gross amounts.

6-43

Gross Method

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Purchase discounts taken are recorded when payment is made inside the discount period. Companies, Inc., 2005 The McGraw-Hill

Recording Purchases at Gross Invoice Price


On July 6, Play Clothes purchased $4,000 of merchandise on credit with terms of 2/10, n/30 from Kids Clothes. Prepare the journal entry for Play Clothes.
GENERAL JOURNAL
Date Account Titles and Explanation Debit

6-44

Credit

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc., 2005

Recording Purchases at Gross Invoice Price


On July 6, Play Clothes purchased $4,000 of merchandise on credit with terms of 2/10, n/30 from Kids Clothes. Prepare the journal entry for Play Clothes.
GENERAL JOURNAL
Date Account Titles and Explanation Accounts Payable (Kid's Clothes)
McGraw-Hill/Irwin

6-45

Debit 4,000

Credit 4,000

July 6 Inventory

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Recording Purchases at Gross Invoice Price


On July 15, Play Clothes pays the full amount due to Kids Clothes. Prepare the journal entry for Play Clothes.

6-46

GENERAL JOURNAL
Date Account Titles and Explanation Debit Credit

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc., 2005

Recording Purchases at Gross Invoice Price


On July 15, Play Clothes pays the full amount due to Kids Clothes. Prepare the journal entry for Play Clothes.

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Reduces Cost of $4,000 98% = $3,920 GENERAL JOURNAL Goods Sold


Date Account Titles and Explanation Cash Purchase Discounts Taken
McGraw-Hill/Irwin

Debit 4,000

Credit 3,920 80

July 15 Accounts Payable (Kid's Clothes)

The McGraw-Hill Companies, Inc., 2005

Recording Purchases at Gross Invoice Price

6-48

Now, assume that Play Clothes waited until July 20 to pay the full amount due to Kids Clothes. Prepare the journal entry for Play Clothes.

GENERAL JOURNAL
Date Account Titles and Explanation Debit Credit

McGraw-Hill/Irwin

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Recording Purchases at Gross Invoice Price

6-49

Now, assume that Play Clothes waited until July 20 to pay the full amount due to Kids Clothes. Prepare the journal entry for Play Clothes.

GENERAL JOURNAL
Date Account Titles and Explanation Cash
McGraw-Hill/Irwin

Debit 4,000

Credit 4,000

July 20 Accounts Payable (Kid's Clothes)

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6-50

Returns of Unsatisfactory Merchandise


On August 5, Play Clothes returned $500 of unsatisfactory merchandise purchased from Kids Clothes on credit terms of 2/10, n/30. The purchase was originally recorded at net cost. Prepare the journal entry for Play Clothes.

GENERAL JOURNAL
Date Account Titles and Explanation Debit Credit

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc., 2005

6-51

Returns of Unsatisfactory Merchandise


On August 5, Play Clothes returned $500 of unsatisfactory merchandise purchased from Kids Clothes on credit terms of 2/10, n/30. The purchase was originally recorded at net cost. Prepare the journal entry for Play Clothes.

GENERAL JOURNAL
Date Account Titles and Explanation Inventory
McGraw-Hill/Irwin

Debit 490

Credit 490

Aug. 5 Accounts Payable (Kid's Clothes)

$500 98% = $490

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6-52

Transportation Costs on Purchases Transportation costs related to the acquisition of assets are part of the cost of the asset being acquired.

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6-53

Now, lets talk about sales!

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Transactions Relating to Sales


Computer Barn Partial Income Statement For the Year Ended December 31, 2005 Revenue Sales Less: Sales returns and allowances $ Sales discounts Net sales $ 912,000 8,000 4,000 12,000 $ 900,000

Credit terms and merchandise returns affect the amount of revenue earned by the seller.
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6-55

Sales
On August 2, Kids Clothes sold $2,000 of merchandise to Play Clothes on credit terms 2/10, n/30. Kids Clothes originally paid $1,000 for the merchandise. Because Kids Clothes uses a perpetual inventory system, they must make two entries.

GENERAL JOURNAL
Date Account Titles and Explanation Sales
McGraw-Hill/Irwin

Debit 2,000

Credit 2,000

Aug. 2 Accounts Receivable (Play Clothes)

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6-56

Sales
On August 2, Kids Clothes sold $2,000 of merchandise to Play Clothes on credit terms 2/10, n/30. Kids Clothes originally paid $1,000 for the merchandise. Because Kids Clothes uses a perpetual inventory system, they must make two entries.

GENERAL JOURNAL
Date Account Titles and Explanation Inventory
McGraw-Hill/Irwin

Debit 1,000

Credit 1,000

Aug. 2 Cost of Goods Sold

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6-57

Sales Returns and Allowances


On August 5, Play Clothes returned $500 of unsatisfactory merchandise to Kids Clothes from the August 2 sale. Kids Clothes cost for this merchandise was $250. Because Kids Clothes uses a perpetual inventory system, they must make two entries.

GENERAL JOURNAL
Date Account Titles and Explanation

Contra-revenue
Debit 500 500
The McGraw-Hill Companies, Inc., 2005

Credit

Aug. 5 Sales Returns and Allowances Accounts Receivable (Play Clothes)


McGraw-Hill/Irwin

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Sales Returns and Allowances


On August 5, Play Clothes returned $500 of unsatisfactory merchandise to Kids Clothes from the August 2 sale. Kids Clothes cost for this merchandise was $250. Because Kids Clothes uses a perpetual inventory system, they must make two entries.

GENERAL JOURNAL
Date Account Titles and Explanation Cost of Goods Sold
McGraw-Hill/Irwin

Debit 250

Credit 250

Aug. 5 Inventory

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6-59

Sales
On July 6, Kids Clothes sold $4,000 of merchandise to Play Clothes on credit with terms of 2/10, n/30. The merchandise originally cost Kids Clothes $2,000. Because Kids Clothes uses a perpetual inventory system, they must make two entries.

GENERAL JOURNAL
Date Account Titles and Explanation Sales
McGraw-Hill/Irwin

Debit 4,000

Credit 4,000

July 6 Accounts Receivable (Play Clothes)

The McGraw-Hill Companies, Inc., 2005

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Sales
On July 6, Kids Clothes sold $4,000 of merchandise to Play Clothes on credit with terms of 2/10, n/30. The merchandise originally cost Kids Clothes $2,000. Because Kids Clothes uses a perpetual inventory system, they must make two entries.

GENERAL JOURNAL
Date Account Titles and Explanation Inventory
McGraw-Hill/Irwin

Debit 2,000

Credit 2,000

July 6 Cost of Goods Sold

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Sales Discounts
On July 15, Kids Clothes receives the full amount due from Play Clothes from the July 6 sale. Prepare the journal entry for Kids Clothes.
GENERAL JOURNAL
Date Account Titles and Explanation Debit Credit

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc., 2005

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Sales Discounts
On July 15, Kids Clothes receives the full amount due from Play Clothes from the July 6 sale. Prepare the journal entry for Kids Clothes.
Contra-revenue
Date

GENERAL JOURNAL

$4,000 98% = $3,920


Debit 3,920 80 4,000
The McGraw-Hill Companies, Inc., 2005

Account Titles and Explanation Sales Discounts Accounts Receivable (Play Clothes)

Credit

July 15 Cash

McGraw-Hill/Irwin

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Sales Discounts
Now, assume that it wasnt until July 20 that Kids Clothes received the full amount due from Play Clothes from the July 6 sale. Prepare the journal entry for Kids Clothes.
GENERAL JOURNAL
Date Account Titles and Explanation Debit Credit

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc., 2005

6-64

Sales Discounts
Now, assume that it wasnt until July 20 that Kids Clothes received the full amount due from Play Clothes from the July 6 sale. Prepare the journal entry for Kids Clothes.
GENERAL JOURNAL
Date Account Titles and Explanation Accounts Receivable (Play Clothes)
McGraw-Hill/Irwin

Debit 4,000

Credit 4,000

July 20 Cash

The McGraw-Hill Companies, Inc., 2005

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Delivery Expenses
Delivery costs incurred by sellers are debited to Delivery Expense, an operating expense. When sellers incur transportation costs, or delivery expense, it is debited to an operating expense account called Delivery Expense. This is considered a cost of doing business and is treated as a regular operating expense of the business.

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Accounting for Sales Taxes


Businesses collect sales tax at the point of sale. Then, they remit the tax to the appropriate governmental agency at times specified by law. $1,000 sale 7% tax = $70 sales tax
Debit 1,070 70 1,000
The McGraw-Hill Companies, Inc., 2005

GENERAL JOURNAL
Date

Account Titles and Explanation Cash Sales Tax Payable Sales

Credit

McGraw-Hill/Irwin

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Modifying an Accounting System


Most businesses use special journals rather than a general journal to record routine transactions that occur frequently. When companies use special journals, similar entries are recorded together. Companies may have several special journals such as a Cash Receipts Journal, Cash Payments Journal, Sales Journal, and several others. When using special journals, the General Journal is used only for a few entries that do not fit in a special journal.

GENERAL JOURNAL
Date Account Titles and Explanation Debit Credit

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Financial Analysis
Gross Profit Margins
Gross profit Net sales

Net Sales

Trends over time

Comparable store sales


Sales per square foot of selling space
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Overall gross profit margin


Gross profit margins by department and products McGraw-Hill Companies, Inc., 2005 The

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End of Chapter 6

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