Service Company vs. Merchandising Company - Online Tutor, Practice Problems & Exam Prep

Service companies provide intangible services, earning revenue when the service is performed, regardless of cash received. In contrast, merchandising companies sell physical goods, recognizing revenue upon delivery to the customer. They make two journal entries: one for sales revenue and another for the cost of goods sold (COGS), which reflects the expense of the inventory sold. This matching principle ensures that expenses are aligned with revenues, maintaining the accounting equation's balance.

Service Company

Alright. So let's discuss the difference between a service company and a merchandising company. A service company, well, they provide services to their customers, right? They're going to provide services, and when we talk about a service company, there's no physical good. So there's no actual tangible thing that's being handed to the customer, they're providing a service to the customer. Examples of service-type companies include a tutoring company like when we did our clutch tutoring example, they were providing a service. House cleaning, shipping, lawyers, right? In all of these situations, there's no physical tangible good being transferred to the customer. You're performing some sort of service for the customer, and that is how we're going to discuss our revenue here.

So when we talk about revenue for a service company, we have to remember, first and foremost, our revenue recognition principle, and this revenue recognition principle is true for all companies. So let's see how it relates to a service company. Remember that revenue is recognized when the company fulfills its end of the bargain, right? That's when we're going to make the journal entry to say hey, we made revenue when we do our end of the bargain. It has nothing to do with the cash being received. So a service company is going to earn its revenue when it performs the service, right? When it does whatever it's going to do for the customer, that's when it earns revenue. When the tutoring session is complete, the revenue is earned; when you clean the house, the revenue is earned; when you finish shipping the supplies; when you handle the case for the client, if you're a lawyer. In all these cases, you earn the revenue once you perform the service. It has nothing to do with the cash.

So let's look at this example. Squeaky Cleaners cleaned Squirt's shirts at a price of $20, right? So Squeaky Cleaners is going to make a journal entry when they clean the shirts, right? They finish cleaning the shirts regardless of whether or not they've been paid by Squirt, they're going to make this journal entry, right? So let's assume that Squirt did pay them; well, let's assume that they did it on account, right? Squirt hasn't even paid them yet because the money doesn't matter, but they cleaned the shirt so they earned the revenue. So the journal entry, well since it's on account, they didn't receive cash, they received an IOU, an accounts receivable. So our debit in this entry is going to be for accounts receivable and it's going to be in that amount of $20. So that's our debit, right? We're increasing accounts receivable by $20, and we're going to credit our revenue. In this case, let's say service revenue because it's a service we provided, we'll call it service revenue. It could be sales revenue or just revenue, it doesn't really matter, I'm just trying to be a little more transparent here. So we credit the revenue $20 that increases our revenue by $20. Revenues go up with the credit.

So how does this affect our balance sheet? Well, our accounts receivable, right? The accounts receivable owe anything to and this revenue is increasing our equity in the company. The revenue over here, so we see we're still balanced, right? The assets went up by $20, the equity went up by $20, so the equation stays balanced, right? Pretty simple. This is a simple example. So what I want to do now is I want to take this over to a merchandising company and let's see what the difference is there, alright? Let's do that in the next video.

Merchandising Company

Alright. So let's continue here with the merchandising company. Different from a service company, a merchandising company provides a physical product to the customer. When we talk about a merchandising company, I want to be specific that we're talking about companies that resell; they are resellers. They don't have a factory where they produce a product and then sell it to the customer. Instead, they go to a supplier, and perhaps for a t-shirt company, they buy the t-shirts from the supplier and then sell them to the customer at a higher price. That's the merchandising company model there. There are tons of merchandising companies – any clothing store, grocery store, shops like Walmart – all these types of stores are merchandising companies, selling goods to the customer.

Let's see what happens when we take a revenue entry in a merchandising company. A merchandising company earns its revenue basically when it delivers the goods to the customer. Whenever we hand the goods over to the customer, as we fulfill our end of the bargain, we earn the revenue. In most cases, they are standing right in front of us, and we are literally just handing them the goods.

Let's look at this example. Things on Shelves (TOS) company sells things. Mandy walks in and buys a thing for $15; the thing costs TOS $5. When dealing with the merchandising company, we generally need to make two entries when we take revenue. There is one entry where we earn the revenue for selling something, but then there is going to be a second entry for the cost of earning that revenue.

Let's see these two entries in action. For the first entry, the journal entry for revenue: Mandy walks in and buys a thing for $15. This is us providing our goods to the customer, the reason we are in business. The cash is debited by $15, and the sales revenue is credited by $15.

Now, let's look at the other side, the cost to the company. We want to match the expense of what it cost the company to the revenue. The thing sold to Mandy cost TOS $5. When TOS purchased the things they were going to sell, they would have debited the total value into inventory. At the time of the sale, we must credit our inventory by $5, decreasing it as the thing sold to Mandy is no longer in our warehouse. Concurrently, we debit the Cost of Goods Sold (COGS) account by $5, an expense account that tracks the actual cost of the product selling to customers.

These two entries I've made – the entry for revenue and the entry for cost of goods sold – are standard in a merchandising company; expect to make two entries like this whenever there is a revenue transaction.

By the end of this transaction, our cash has gone up by $15, and our inventory went down by $5, reflecting a net increase in our assets of $10. Concurrently, our equity increased by the revenue of $15 and decreased by the COGS expense of $5. As a result, our equation stays balanced: our assets went up by $10, and our equity went up by $10, maintaining balance.

That's about it for the merchandising company. Take a look at the service company and notice the difference in the journal entries: we made an extra journal entry for the cost of goods sold in the merchandising company. Alright, cool. Let's pause here and move on to the next video.

Here’s what students ask on this topic:

What is the main difference between a service company and a merchandising company?

The main difference between a service company and a merchandising company lies in what they offer to their customers. A service company provides intangible services, such as tutoring, house cleaning, or legal advice. They earn revenue when the service is performed, regardless of when cash is received. In contrast, a merchandising company sells physical goods, like clothing or groceries. They recognize revenue upon delivering the goods to the customer. Additionally, merchandising companies make two journal entries for each sale: one for sales revenue and another for the cost of goods sold (COGS), which reflects the expense of the inventory sold.

How do service companies recognize revenue?

Service companies recognize revenue when they fulfill their end of the bargain by performing the service, regardless of when cash is received. This follows the revenue recognition principle, which states that revenue is recognized when the service is completed. For example, a tutoring company earns revenue once the tutoring session is finished, even if the payment is received later. The journal entry would debit accounts receivable and credit service revenue, reflecting the earned revenue and the amount owed by the customer.

What are the journal entries for a merchandising company when a sale is made?

When a merchandising company makes a sale, it records two journal entries. The first entry is for the sales revenue: debit cash (or accounts receivable) and credit sales revenue. The second entry is for the cost of goods sold (COGS): debit COGS and credit inventory. This second entry reflects the expense of the inventory sold, ensuring that expenses are matched with revenues. For example, if a company sells an item for $15 that cost $5, the entries would be: (1) debit cash $15, credit sales revenue $15; (2) debit COGS $5, credit inventory $5.

Why do merchandising companies make two journal entries for each sale?

Merchandising companies make two journal entries for each sale to adhere to the matching principle, which ensures that expenses are aligned with revenues. The first entry records the sales revenue, debiting cash (or accounts receivable) and crediting sales revenue. The second entry records the cost of goods sold (COGS), debiting COGS and crediting inventory. This second entry reflects the expense of the inventory sold, providing a clear picture of the company's profitability by matching the cost of the sold goods with the revenue generated from the sale.

How does the revenue recognition principle apply to service companies?

The revenue recognition principle for service companies states that revenue is recognized when the service is performed, not when cash is received. This means that a service company earns revenue once it completes the service for the customer. For example, a house cleaning service recognizes revenue when the cleaning is done, regardless of whether the customer has paid. The journal entry would debit accounts receivable and credit service revenue, reflecting the earned revenue and the amount owed by the customer.