Chapter 5—Accounting for Merchandising Operations

Study Objectives:
1. Identify the differences between a service enterprise and a merchandising
company.
2. Explain the entries for purchases under a perpetual inventory system.
3. Explain the entries for sales revenues under a perpetual inventory system.
4. Explain the steps in the accounting cycle for a merchandising company.
5. Distinguish between a multiple-step and a single-step income statement.
6. Explain the computation and importance of gross profit.
7. Determine cost of goods sold under a periodic system.

I. Merchandising Operations
A. Introduction
1. A merchandising company is an enterprise that buys and
sells goods to earn a profit.
a) Wholesalers sell to retailers such as grocery stores,
drugstores, and restaurants. Examples of retailers would be Wal-
Mart, Safeway, and Toys “R” Us.
b) Retailers sell to consumers and usually are those who
purchase goods in bulk from manufacturers and sell them to retailers,
other wholesalers, schools and other not-for-profit institutions, and, at
times, directly to consumers. For example, retailer Walgreens might
buy goods from wholesaler McKesson HBOC; Office Depot might
buy office supplies from wholesaler United Stationers.
2. Define merchandise (or merchandise inventory)—goods
held for sale to customers in the normal course of business. Note that
this includes only goods held for resale. For example, if a grocery store
decided to sell an old display case, this would not be merchandise because
grocery stores do not normally sell display cases. But a display case would
be merchandise for a furniture store. Merchandise for one firm may be
an asset for another. The merchandise (display cases) for the furniture
store is an asset for the grocery store.
3. A merchandiser’s primary source of revenue is sales
revenue or sales.
4. Expenses for a merchandising company are divided into two
categories:
a) cost of goods sold (COGS)—total cost of merchandise
sold during the period and
b) Operating expenses (OP)—expenses incurred in the
process of earning sales revenue that are deducted from gross
profit in the income statement). Examples are sales salaries and
insurance expense.
5. Gross profit (GP) is equal to Sales Revenue less Cost of
Goods Sold.

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 6. Income measurement process for a merchandiser:
Sales - COGS = Gross Profit - Operating Exp. = Net Income (Loss)

B. Operating Cycles—Operating Cycles for a service company and a

merchandiser:
1. Service Company operating cycle (to go from cash to cash)
involves performing services which may be on account involving
accounts receivable and finally receiving the cash.
2. Merchandising Company operating cycle (cash to cash)
involves:
a) Buy Inventory,
b) Sell Inventory,
c) Obtain Accounts Receivable, and
d) Receive Cash.
C. Inventory Systems—Merchandising entities may use either of the
following inventory systems:
a) Perpetual System—Detailed records of the cost of
each item are maintained, and the cost of each item sold is
determined from records when the sale occurs. For example, a
Ford dealership has separate inventory records for each vehicle on
the lot.
b) Record purchase of Inventory.
c) Record revenue and record cost of goods sold when the
item is sold.
d) At the end of the period, no entry is needed except to
adjust inventory for losses, etc.
2. Periodic System—Cost of goods sold is determined only at
the end of an accounting period. This system involves:
a) Record purchase of Inventory.
b) Record revenue only when the item is sold.
c) At the end of the period, you must compute cost of
goods sold (COGS):
1) Determine the cost of goods on hand at the
beginning of the accounting period (Beginning Inventory = BI),
2) Add it to the cost of goods purchased (COGP),
3) Subtract the cost of goods on hand at the
end of the accounting period (Ending Inventory = EI)
illustrated as follows:
BI + COGP = Cost of goods available for sale - EI = COGS
3. Additional Considerations
a) Perpetual systems have traditionally been used by
companies that sell merchandise with high unit values such as
automobiles, furniture, and major home appliances. But with the

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 use of computers and scanners, many companies now use the
perpetual inventory system.
b) The perpetual inventory system is named because the
accounting records continuously—perpetually—shows the
quantity and cost of the inventory that should be on hand at any
time. The periodic system only periodically updates the cost of
inventory on hand.
c) A perpetual inventory system provides better control
over inventories than a periodic inventory since the records always
show the quantity that should be on hand and then any shortages
from the actual quantity and what the records show can be
investigated immediately.
II. Recording Purchases and Sales of Merchandise under the
Perpetual System
A. PURCHASES OF MERCHANDISE: MERCHANDISE
PURCHASE ENTRIES FOR A MERCHANDISER (PERPETUAL
SYSTEM):
1. When merchandise is purchased for resale to customers, the
account, Merchandise Inventory, is debited for the cost of goods
purchased.
2. Like sales, purchases may be made for cash or on account
(credit).
3. The purchase is normally recorded by the purchaser when
the goods are received from the seller.
a) Each credit purchase should be supported by a
purchase invoice.
b) A purchase invoice received by the buyer is actual a
sales invoice prepared by the seller.
c) Note that only purchases of merchandise are debited to
Merchandise Inventory. Purchases if other assets: supplies,
equipment, and similar items) are debited to their respective
accounts.

B. PURCHASE RETURNS AND ALLOWANCES

1. A purchaser may be dissatisfied with merchandise received
because the goods
a) 1) are damaged or defective,
b) 2) are of inferior quality, or
c) 3) are not in accord with the purchaser’s specifications.
2. The purchaser initiates the request for a reduction of the
balance due through the issuance of a debit memorandum.
3. The debit memorandum is a document issued by a buyer to
inform a seller that the seller’s account has been debited because of
unsatisfactory merchandise.

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 4. A purchase return or a purchase allowance (a deduction from
the purchase price when unsatisfactory goods are kept) is shown by
the entry where Accounts Payable is debited and Merchandise
Inventory is credited to show that the cost of the Merchandise
Inventory is reduced with a return or an allowance.
C. ACCOUNTING FOR FREIGHT COSTS
1. The sales agreement should indicate whether the seller or the
buyer is to pay the cost of transporting the goods to the buyer’s place
of business. FOB SHIPPING POINT AND FOB DESTINATION:
a) FOB Shipping Point
1) Goods placed free on board (FOB) the carrier
by seller.
2) Buyer pays freight costs.
a. Merchandise Inventory is debited if
buyer pays freight.
b. Cash is a credit if the goods come COD,
for example, and paid immediately. Accounts Payable
would be credited if on account.
b) FOB Destination
1) Goods placed free on board (FOB) at buyer’s
business.
2) Seller pays freight costs.
2. Freight-out (or Delivery Expense) is debited if seller pays
freight on outgoing merchandise to a buyer which is an operating
expense to the seller.

D. PURCHASE DISCOUNTS:
1. Credit terms (specify the amount of cash discount and time
period during which a discount is offered) may permit the buyer to
claim a cash discount for the prompt payment of a balance due. If the
credit terms show 2/10, n/30 means a 2% is paid within 10 days (called
the discount period); otherwise the invoice is due in 30 days.
2. The buyer calls this discount a purchase discount.
3. Like a sales discount, a purchase discount is based on the
invoice cost less returns and allowances, if any.
4. A buyer should usually take all available discounts.
a) Refer to the example:
1) If Sauk Stereo takes the discount, it pays $70 less
in cash ($3,500 x 2%).
2) If it forgoes the discount and invests the $3,500
for 20 days at 10% interest, it will earn only $19.06 in interest.
3) The savings obtained by taking the
discount is calculated as follows:
Discount of 2% on $3,500 $70.00

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Interest received on $3,430 (for 20 days @ 10%) (19.06)
Savings by taking the discount $50.94

E. SALES TRANSACTIONS: REVENUE ENTRIES FOR A

MERCHANDISER:
1. Revenues are reported when earned in accordance with the
revenue recognition principle, and in a merchandising company,
revenues are earned when the goods are transferred from seller to
buyer.
2. All sales should be supported by a document such as a cash
register tape (provide evidence of cash sales) or sales invoice.
3. Two entries are made with each sale:
a) The first entry records the sale:
1) Debit—Accounts Receivable (if a credit sale)
or Cash (if a cash sale) which increases assets for the sales
amount.
2) Credit—Sales which increases revenues
b) The second entry records the cost of the
merchandise sold:
1) Debit—Cost of Goods Sold which increases
expenses.
2) Credit—Merchandise Inventory which
decreases assets.
4. The sales account is credited only for sales of good held
for resale. Sales of assets not held for resale (such as equipment,
buildings, land, etc.) are credited directly to the asset account.
F. FREIGHT TERMS: FOB DESTINATION—SELLER PAYS
FREIGHT
1. An entry is made when seller pays the freight to deliver goods
to a customer or buyer.
2. Debit—Freight Out or Delivery Expense and credit—
Cash or Accounts Payable.
G. SALES RETURNS AND ALLOWANCES:
1. Sales Returns result when customers are dissatisfied with
merchandise and are allowed to return the goods to the seller for
credit or a refund.
2. Estimating Sales Returns. Under the new revenue recognition
standard (going into effect after December 15, 2017), companies should
only record sales revenue in the amount they expect to eventually realize.
Therefore, companies must decrease sales by estimated amount of sales
returns to record adjusting entries:
a) Debit Sales revenue and credit Refunds payable

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 b) Debit Estimated Returns inventory and credit Cost of
goods sold.
3. Actual Return of Inventory record the following two entries:
a) Debit Refunds Payable and credit Cash
b) Debit Merchandise Inventory and credit Estimated
Returns Inventory.
4. Sales Allowances result when customers are dissatisfied, and
the seller allows a deduction from the selling price.

H. SALES DISCOUNTS—:
1. A sales discount is the offer of a cash discount to a customer
for the prompt payment of a balance due.
2. Example: If a credit sale has the terms 3/10, n/30, a 3%
discount is allowed if payment is made within 10 days. After 10 days
there is no discount, and the balance is due in 30 days.
3. Under new revenue recognition, sales are recorded at net
amount or the amount of the sale less any sales discounts..
4. Credit terms specify the amount and time period for the cash
discount and length of time in which payment is expected.
III. Completing the Accounting Cycle
A. Adjusting Entries
1. A merchandiser has the same adjusting entries as a service
company.
2. But a merchandiser will have one additional adjustment to
make the records agree with the actual inventory on hand.
a) The perpetual inventory records may be incorrect due
to a variety of causes such as recording errors, theft, or waste.
b) The adjusting entry involves adjusting Merchandise
Inventory and Cost of Goods Sold.
1) An example follows of the adjusting entry to
adjust if book amount is higher than the inventory amount
determined to be on hand.
2) The entry is a debit Cost of Goods Sold and
credit Merchandise Inventory.

B. Closing Entries are completed at the end of the fiscal year are
journalized into the general journal and posted to the general ledger to:
1. Reduce the temporary owner's equity accounts (revenues,
expenses, and drawing) to zero; and
2. To update the balance in the owner's equity capital account
to begin the next fiscal year.
3. Recall from chapter 4 that this is a 4-step process following
the acronym REID (Revenue, Expenses, Income Summary, and
Drawing). Refer to the work sheet on page 221 which is a tool to help
complete the closing entries. A merchandising company also uses the 4-

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 step (4 entries) process for the closing entries but the descriptions of
REID will be expanded to include all the accounts in a particular
column:

a) The first step for the "R" is to close the revenue accounts and
those accounts that act as revenues (meaning they have "credit"
balances on the credit column of the Income Statement columns of
the work sheet) into the Income Summary account.
b) The second step for the "E" is to close the expense accounts and
those accounts that act as expenses (meaning they have "debit"
balances on the debit column of the Income Statement columns of
the work sheet) into the Income Summary account.

c) The third step for the "I" is to close the Income Summary
account. If the Income Summary account has a "credit balance,"
then the company has a NET INCOME or if the balance in the
account is a "debit balance," then the company has a NET LOSS.
The balance in the INCOME SUMMARY account should be
compared with the net income figure on the work sheet or the net
loss figure on the work sheet as they should be the same number if
you properly closed all the revenue and expense accounts.
Compare the "credit" balance of $30,000 in the Income Summary
account below to the $30,000 net income figure on the Work Sheet.

INCOME SUMMARY
Total revenues
Total expenses 450,000 480,000
Balance of Inc. Sum. acct.
Entry to close acct. 30,000 30,000
Final bal. of acct.
Final bal. of acct. ----- -----
a) The fourth step for the "D" is to close the drawing
account by debiting the owner's capital account and crediting the
owner's drawing account. Also the "D" is to close the dividends
account into Retained Earnings account.
IV. Forms of Financial Statements
A. MULTIPLE-STEP INCOME STATEMENT
1. Includes sales revenue, cost of goods sold and gross profit
sections.
a) Net Sales = Sales – Sales returns and allowances and
Sales Discounts.
Note: Freight-out is a selling expense—not a contra account to sales.

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 b) Gross Profit = Net sales – Cost of goods sold. An
example showing the determination of gross profit as
follows:
Net sales 460,000
- Cost of goods sold - 316,000
= Gross profit 144,000
c) Gross profit percentage measure the profitability of each sales
dollar above the cost of goods sold and is calculated by gross profit
/ net sales. Therefore 144,000 / 460,000 = 31.3%.
2. Operating expenses may be subdivided into:
a) Selling Expenses.
b) Administrative Expenses.
3. Additional nonoperating sections may be added for:
a) Nonoperating sections are reported after income from
operations and are classified in two sections.
b) Revenues and expenses resulting from secondary or
auxiliary operations.
1) Other revenues and gains.
2) Other expenses and losses.
c) Gains and losses unrelated to operations. Other
Revenues and Gains in one column and Other Expenses and
Losses in the other column.

4. MULTIPLE-STEP VS. SINGLE-STEP INCOME

STATEMENT showing the formulas for the multiple-step income
statement:
a) Net sales – Cost of goods sold = Gross profit
b) – Operating expenses = Income from operations
c) + Other revenues/gains – Other expenses/losses
= Net income or Net loss.
5. An example for the determination of net
incomefrom gross profit as follows:
Gross profit 144,000
- Total operating expenses - 114,000
= Income from operations 30,000
+ Other revenues and gains + 3,600
- Other expenses and losses - 2,000
= Net income $31,600

B. SINGLE-STEP INCOME STATEMENT

1. All data are classified under two categories:
a) (1) Revenues
b) (2) Expenses

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 2. Only one step is required in determining net income or net
loss—Revenues – Expenses = Net Income.
3. Two primary reasons for using a single step format:
a) (1) A company does not realize any type of profit or
income until total revenues exceed total expenses, so it makes sense
to divide the statement into two categories.
b) (2) The format is simpler and easier to read than the
multiple-step format.

C. CLASSIFIED BALANCE SHEET.

1. Current assets are listed in the order of liquidity.
2. Merchandise Inventory is less liquid than accounts
receivable because the goods must first be sold and then collection
must be made from the customer.
3. Merchandise Inventory is reported as a current asset
immediately below accounts receivable.
V. Determining Cost of Goods Sold Under a Periodic System
A. An important Cost of Goods Sold calculation that is tested backwards and
forwards (but on exam that is sent in so does NOT have to be memorized) on
the certified bookkeeper's (CB) exam):
B. Under the Periodic system, separate accounts are used to record
freight costs, returns, and discounts.
C. Under the Perpetual system all transactions affecting the cost of
merchandise purchased is recorded directly into Merchandise Inventory
account.
D. Also under the Periodic system, a running account of changes in
inventory is not maintained. Therefore, the balance in ending inventory
(done by taking a physical inventory), as well as the cost of goods sold
for the period, is calculated at the end of the period.
E. To memorize the cost of goods sold calculation, it is helpful to first
learn the OUTLINE OF THE COST OF GOODS SOLD SECTION (also
helpful to use acronyms for the words that are used):

1. Beginning inventory (BI)

2. + Cost of goods Purchased (COGP) Gross purchases - Purchase
returns & allowances - Purchase discounts + Freight-in)

3. = Goods available for sale (GAFS)

4. - Ending inventory (EI)

5. = Cost of goods sold (COGS)

Note below the outline of the Cost of goods sold is bolded:

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Cost of goods sold:
Inventory, January 1
$36,000
Purchases
$325,000
Less: Purchases returns and
allowances $10,400
Purchases discounts
6,800 17,200
Net purchases
307,800
Add: Freight in
12,200
Cost of goods purchased
320,000
Cost of goods available for sale
356,000
Inventory, December 31
40,000
Cost of goods sold
316,000

A helpful tip to memorize the COGS calculation is to practice with 4 columns where
you just use the acronyms in the columns as well as the plus and minus signs so you
can visualize where the different numbers go as you move from the beginning of the
year to the end of the year (NOTE that the format moves in a stair-step
arrangement backwards to purchases returns and allowances and then forwards
down to cost of goods sold) (the xxx's represent a number that does not have a word
to describe it):
Cost of goods sold:

BI

P R&A

+ PD - xxx

NP

+ FI

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 +COGP

GAFS

- EI

COGS

VI. Periodic Inventory System

A. Perpetual vs. Periodic Inventory systems comparisons:
1. With both systems, revenues from the sale of merchandise
are recorded when sales are made.
2. But with the periodic system, no attempt is made on the date
of sale to record the cost of the merchandise sold.
3. Under the periodic system, a physical inventory is taken at the
end of the period and this count determines:
a) (1) the cost of merchandise on hand and
b) (2) the cost of goods sold during the period as ending
inventory is part of the cost of goods sold calculation.
4. Under the periodic system, purchases of merchandise are
recorded in a Purchases account rather than a Merchandise
Inventory account.
5. Under the periodic system, it is customary to record the
following in separate accounts:
a) Purchase Returns and Allowances,
b) Purchase Discounts
c) Freight-in

B. Recording Transactions Under a Periodic Inventory System

1. Recording Purchases of Merchandise
a) Purchases—Purchases is a temporary account whose
normal balance is a debit and located under the Expense section of
the accounting equation.
b) Purchase Returns and Allowances—Purchases Returns
and Allowances is a temporary contra expense account with a
normal credit balance.
c) Freight Costs—Freight-in is a temporary account whose
normal balance is a debit balance under the expense section along
with the Purchases account. This account is used with the term
are FOB Shipping Point and a cost paid by the buyer to bring the
goods to the purchaser.
d) Purchase Discounts—Purchases Discounts is a
temporary contra expense account with a normal credit balance.

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 2. Recording Sales of Merchandise
a) Sales—there is just one entry to record the sale. Under
the periodic inventory system is NO second entry to record the
cost of goods sold. Sales is a revenue account with a normal credit
balance.
b) Sales Returns and Allowances—the same entry made
under the perpetual system. Note there is NO second entry to
record the return of the Merchandise Inventory with the cost of
goods sold as done under the perpetual system. Sales Returns and
Allowances is a contra revenue account with a normal debit
balance.
c) Sales Discounts—to record the payment from a
customer within the discount period would be the same entry
under the perpetual system. Sales Discounts is a contra revenue
account with a normal debit balance

VII. Work Sheet for a Merchandiser

A. Introduction—as indicated in Chapter 4, a work sheet is prepared to:
1. To help with the adjusting process;
2. To help with the preparation of the financial statements; and
3. To help with preparing of the closing entries.

B. Trial Balance Columns:

1. Data from the trial balance are obtained from the ledger
balances of PW Audio Supply at December 31.
2. The amount shown for Merchandise Inventory, $40,500, is
the year-end inventory amount which results from the application of a
perpetual inventory system.
3. Note the accounts in red that are the new accounts used for
the merchandising company under the perpetual inventory system.
4. As was covered in chapter 4, a separate trial balance is not
prepared as we use the first two columns of the worksheet for this initial
trial balance (a listing of all ledger accounts to test the equality of debits
and credits).
5. Also recall that the format #2 will include all accounts that will
be needed for the adjusting process are also included in this listing of the
general ledger accounts that are listed in chart of account (general
ledger) order.
6. Remember that the work sheet is started by entering the heading
as shown on page 208 which has the answers to the questions, "who,"
"what," and "when," where the answer to the "when" must be a period
of time as the work sheet's bottom line is to disclose the amount of net
income or net loss for the period.

C. Adjustments Columns

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 1. A merchandising company usually has the same types of
adjustments as a service company
2. Work sheet adjustments (b), (c), and (d) are for insurance,
depreciation, and salaries.
3. Adjustment (a) was required to adjust the perpetual
inventory carrying amount to the actual count.
4. The Adjustments columns like the Trial Balance columns,
must be proved before the work sheet can be continued by adding the
debit and credit columns so see that they balance.
D. Adjusted Trial Balance
1. The adjusted trial balance shows the balance of all accounts
after adjustment at the end of the accounting period.
2. Review and describe how adjustments are carried to the
Adjusted Trial Balance columns:
a) Accounts without adjustments. If an account does not have an
adjustment, simply carry over the Trial Balance figure to the
appropriate Adjusted Trial Balance column.
b) Accounts without balances on the trial balance. If an account
does not have a balance in the Trial Balance columns, but there is an
adjustment, the amount of the adjustment becomes the balance on the
adjusted trial balance.
c) Merchandise Inventory. On the adjusted trial balance, the
Merchandise Inventory account shows the December 31 Inventory
count as adjusted to agree with the physical inventory count.
d) Accounts that had adjustments to their previous balance. When
extending amounts to the adjusted trial balance from the trial balance,
a debit with a debit adjustment has the two debits added together.
Likewise an account with a credit balance on the trial balance is
added to a credit adjustment when extended to the adjusted trial
balance. A debit balance on the trial balance with a credit adjustment
will be subtracted to extend to the adjusted trial balance or a credit
balance with a debit adjustment will be subtracted to extend to the
adjusted trial balance.

E. Income Statement Columns

1. The accounts and balances that affect the income statement
are transferred from the adjusted trial balance columns to the income
statement columns for PW Audio Supply at December 31.
2. All of the amounts in the income statement credit column
should be totaled and compared to the total of the amounts in the
income statement debit column.
F. Balance Sheet Columns
1. The major difference between the balance sheets of a service
company and a merchandising company is inventory.

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 2. For PW Audio Supply, the ending Merchandise Inventory
amount of $40,000 is shown in the balance sheet debit column.
3. The information to prepare the owner’s equity statement is
also found in these columns.
G. Review the determination of net income or loss and completion of
the work sheet. Recall from Chapter 4 that after the amounts are
extended to the income statement and balance sheet columns that
you add the columns down, and rule them. As you can see, a net
income figure appears on the debit column of the income statement
and the credit column of the balance sheet. The reason it shows on
the credit column of the balance sheet is that a net income increases
owner’s capital and owner’s capital increases on the credit side.
Note that owner’s capital is bolded to emphasize why the net income
appears on the credit side of the balance sheet columns. Below is the
work sheet for PW Audio Supply showing format #2: where the
balance sheet accounts are above the bold line and the income
statement below it:
PW Audio Supply
Work Sheet
For the Year Ended December 31, 20--
Account Trial Balance Adjustments Adj. Trial Balance Income Statement Balance Sheet
Titles Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit
Cash 9,500 → → → 9,500 → → → 8,485
AcctsRec. 16,100 → → → 16.100 → → → 300
MerchInv 40,500 → → (a) 500 40,000 → → → 40,000
Prepd Ins. 3,800 → → (b)2000 1,800 → → → 1,800
Str.Equip 80,000 → → → 80,000 → → → 80,000
A/D StrEq 16,000 → (c)8000 → 24,000 → → → 24,000
Accts.Pay. 20,400 → → → 20,400 → → → 20,400
Sal. Pay. 0 → (d)5000 → 5,000 → → → 5,000
RAL, Cap.. 83,000 → → → 83,000 → → → 83,000
RAL, Draw 15,000 → → → 15,000 → → → 15,000
Sales. 480,000 → → → 480,000 → 480,000
Sales R&A 12,000 → → → 12,000 → 12,000
Sales Disc 8,000 → → → 8,000 → 8,000
COGS 315,500 → a) 500 → 316,000 → 316,000
Freight Out 7,000 → → → 7,000 → 800
Adv.Exp. 16,000 → → → 16,000 → 50
AdmSal.xp. 19,000 → → → 19,000 → 1,260
StrSalExp 40,000 → (d)5000 → 45,000 → 45,000
Util.Exp. 17,000 → → → 17,000 → 17,000
Ins.Exp. 0 → (b2000 → 2,000 → 2,000
DepEx. SE 0 → (c)8000 → 8,000 → 8,000
599,400 599,400 15,500 15,500 612,400 612,400 450,000 480,000 162,400 132,400
Net Income → → → → → → 30,000 → → 30,000
480,000 480,000 162,400 162,400

H. Note that in an Excel template, you can use IF functions to

automatically calculate a net income or a net loss depending on whether
revenues are greater than expenses or vice versa. Also you can set an IF
function to automatically writes the words, “Net income” or “Net loss”

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 depending on whether revenues are greater than expenses or vice versa.
Having these formulas in a work sheet along with others can aid the
preparation of a work sheet in just a few minutes and allow for quick
changes to be made.
I. Also spreadsheets can be used to link the financial statements to the
work sheet so that they can be prepared instantly when a work sheet is
prepared.

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