SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
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Inventory shrinkage refers to the decrease (shrinkage) in inventory resulting from such
factors as theft, breakage, and spoilage. In a company using a perpetual inventory system,
shrinkage is measured and accounted for by taking a physical inventory and adjusting the
accounting records to reflect the actual quantities on hand.
In a perpetual inventory system, ledger accounts for inventory and the cost of goods sold are
kept perpetually up-to-date. The Inventory account is debited whenever goods are purchased.
When sales occur, Cost of Goods Sold is debited and Inventory is credited for the cost of the
merchandise sold. An inventory subsidiary ledger is maintained showing the cost and
quantity of every type of product in the inventory.
The operating cycle of a business is the sequence of transactions by which the company
normally generates its revenue and its cash receipts from customers. In a merchandising
company, this cycle includes: (1) purchasing merchandise; (2) selling merchandise, often on
account; and (3) collecting accounts receivable from customers.
Both wholesalers and retailers are merchandising companies and, therefore, buy their
inventory in a ready-to-sell condition. Wholesalers, however, buy large quantities of
merchandise directly from manufacturers and then sell this merchandise in smaller quantities
to many different retailers. Wholesalers usually operate from a central location and do not
sell directly to the final consumer. Retailers, in contrast, buy from wholesalers and then resell
the merchandise to the final consumer.
General ledger accounts show the total amounts of various assets, liabilities, revenue, and
expenses. While these total amounts are used in financial statements, company personnel
need more detailed information about the items comprising these totals. This detail is
provided in subsidiary ledgers. Subsidiary ledgers are needed to show the amounts
receivable from individual customers, the amounts owed to individual creditors, and the
quantities and costs of the specific products in inventory.
In summary, wholesalers emphasize distribution of the product to the places (retailers) where
it is needed. Retailers specialize in meeting the needs of their local customers.
The cost of goods sold appears in the income statement of any business that sells
merchandise, but not in the income statement of a business that sells only services. The cost
of goods sold represents the original cost to the seller of the merchandise it sells.
Green Bay Company is not necessarily more profitable than New England Company.
Profitability is measured by net income, not by gross profit. For a merchandising company
(or manufacturer) to earn a net income, its gross profit must exceed its expenses (including
nonoperating items). Green Bay’s gross profit exceeds that of New England by $70,000.
However, if Green Bay’s operating expenses (and nonoperating items) exceed those of New
England by more than $70,000, New England is the more profitable company.
Revenue from sales amounts to $1,070,000 (gross profit, $432,000, plus cost of goods sold,
$638,000). Net income is equal to $42,000 (gross profit, $432,000, minus expenses,
$390,000).
© The McGraw-Hill Companies, Inc., 2010
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