CHAPTER 3

Accounting cycl

e for merchandising business

Characteristics of merchandising business

The primary differences between a service business and a merchandising business relate to revenue
activities. Service business involve in service provision to generate revenues while merchandising
business involve in buying and selling of merchandise inventory to generate revenue. A business that
earns its revenue through buying and selling goods and services to its customers is merchandising
business.

Merchandise inventories: are goods that are held to be sold to customers in the normal course of
business activities (products that a company owns and intends to sell in its normal operations of
business). They are reported as a current asset on the balance sheet.

The main difference between in the accounting system of service business and merchandising business
lies on the reporting of income statement.

Income statement

Service business Merchandising business

Fees earned……………………... xx Sales……………………………………xx
Less operating expense…………... xx less cost of goods sold……………….xx
Net income/net loss……………… xxx Gross profit……………………………xx
Less operating expense………………..xx
Net income/ loss………………………..xxx

3.2 Accounting for purchases of merchandises

Purchase of merchandise is usually identified in the ledger as “purchase”. Thus a merchandising business
can accumulate in the purchase account the cost of all merchandise purchased for resale during the
accounting period. Acquisition of inventories can be made for cash or on account

When purchases are made for cash the When purchases are made on credit the
transaction could be recorded as transaction can be recorded as

Purchases………….xx Purchases……………….xx

Cash………………xx Account payable………….xx

Example during June 2, ABC trading company purchased $30,000 of merchandise from XYZ Company
paying $20,000 cash and the remaining on account. Record transaction
Purchases………….…………30000

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 Cash……………………….……….20000
Account payable……………………10000

Purchase discount

 Purchase discount refers to the cash discount given by the seller and taken by the buyer for early
payment of an invoice. It is the means of encouraging buyers for their early payment of their credits.
 Credit terms: the terms when payments for merchandise are to be made agreed up on by the buyer
and seller are called credit terms. It is the arrangements agreed up on by the buyer and seller as to
when payments for merchandises are to be made. If the payment is made on delivery (when
merchandises are immediately delivered) the term is “cash” or “net cash”. Otherwise, the buyer is
allowed a certain amount of time known as the credit period, in which to pay.
 Credit period: when goods are sold on account, the period of time given for payment to the buyer
or the time allowed for the buyer to pay the amount. Credit period usually begins with date of sales.
As means of encouraging payment before the end of credit period, the seller may offer a discount for
early payment of cash. Examples of credit terms 2/10, 1/15, n/30, n/eom
 “2/10, n/30”- the credit period is 30 days if you pay or return within 10 days you will get
2% discount unless and otherwise you must have to pay within 30 days starting from date
of sales.
 1/15, n/eom means if you pay the total amount with 15 days i.e within the discount
period, you will get 1% discount unless and otherwise you must have to pay by the end
of the month.
Purchase discount (contra or offsetti

ng account of purchase) decreases purchase account and has credit normal balance. From above example,
if ABC trading pays the balance on June 12, and if the agreement was 2/10, n/30 the purchase discount
could be computed and recorded as follows.

June, 12 /Account payable…………..10000

Cash…………………………………….9800
Purchase discount………………………..200
(Purchase discount = 10000*2%)
If ABC trading company fails to take discount and full payment will be made on July 2

July, 2/ Account payable……………………...10000

Cash……….…………………………….…..10000
Purchase return and allowance

The merchandises that were bought may be returned to the seller due to Wrong size, damage, under
quality, defectiveness... etc. When merchandise is returned (purchases returns) or a price adjustment
(price allowance) is requested, the buyer usually communicates with the seller in writing. Purchase
returns and allowance is price reduction or price adjustment on merchandise purchased due to various
reasons mentioned so far. It is contra (offsetting) account of purchase. There are two documents assuring
purchase returns and allowance.

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  Debit memorandum: prepared by the buyer (debtor) and sent to the seller giving the details about
the reason and amount of the return.
 Credit memorandum: prepared by the seller (creditor) and sent to the buyer as acknowledgement
or the seller confirms the return or allowance.
Example, XYZ trading company returned merchandise amounting $1000 from the purchase of
June 2 .The entry is
Cash (Account payable)…………………..1000
Purchase return and allowance……….1000

Record the following transactions

June 3, ABC Company purchased merchandise amounting $20,000 for cash from XZY Company.
Purchase…………………………..20,000
Cash ……………………..…………20,000
June 6, purchased merchandise worth of $10,000 with terms of 2/10, n/eom from XYZ company on account
Purchase…………………………..10000
Account payable…………..……….10000
June 16, paid amount due to XYZ co. in settlement of merchandise purchased June 6
Account payable…………………………..10000
Cash ……………..……………………….9800
Purchase discount (2%* 10000)…………200

Illustration

Record the following transactions in journal entry for “L” company

July 1, purchased merchandise on account terms of 2/10, n/eom $20,000

July 5, returned 20 % of merchandise by writing a debit memorandum on June purchase

June 8, purchased merchandise for cash $10,000

July 11 paid the amount due.

Solution

June 1/ purchase ………..20000

Account payable……..20000

June 5/ Account payable ………..4000

Purchase return and allowance…..4000

June 8/ purchase ………...10000

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 Cash…………………....10000

June 11/ Account payable ………..16,000

Cash …………………………...15,680

Purchase discount ($16000*2%)… 320

3.3 Accounting for sales of merchandises

Merchandise sales are usually identified in the ledger as “sales”. When merchandise is sold for cash it
could be recorded by debiting cash and crediting sales. Example, merchandise business sold merchandise
costing $1500 for cash
Cash………1500
Sales………………….1500
When merchandise is sold on credit it could be recorded by debiting account receivable and crediting sales.
Account receivable……………….xx
Sales ……………………………xx

Sales discount: the discount taken by the buyer for early payment of an invoice. It is recorded by debiting
sales discount and considered to be a reduction in the amount initially recorded as sales. It is viewed as
contra (offsetting against) account to sales. Example, “HO” merchandising enterprise sold merchandise
on account $500 on January1, terms of 2/10, n/30
Account receivable……………500
Sales......................………………500
What will be the journal entry if the seller received the invoice within the discount period?
Cash…………………………..490
Sales discount (500*2%)………10
Account receivable…………….500
For the buyer
Purchase…………………..500
Account payable…………….500
If the buyer remits the amount within the invoice period
Account payable………………..500
Cash………………………………..490
Purchase discount…………………..10

Sales return and allowance - is receiving of goods that have been already sold or reduction of price from
the original cost due it’s under quality or wrong size. The effect of sales return or allowance is reduction
in sales revenue and a reduction in cash or account receivable. Example, a seller issued a credit
memorandum for $200 to customer on account for merchandise returned.

Sales return and allowance ………………….200

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 Account receivable…………………………….200
Record the following transaction for both cases
June 10, XYZ company sold merchandise for Rossi company on account $900 terms 2/10, n/30
June 12, XYZ Company received $100 of merchandise returned from Rossi co.
June 20, XYZ Company received the amount of invoice.

Prepare journal entry for XYZ (seller) and Rossi (buyer) company

XYZ (seller) company Rossi (buyer) company

June 10/ Account receivable……….900 June10/ purchase……….900

Sale………………..…….….900 Account payable.……....900

June 12/ sales return and allowance……100 June 12/ Account payable…..100

Account receivable……………..100 purchase return &allowance…..100

June 20/ cash………….……………784 June 20/ A/p……..800

Sales discount (900-100*2%)……16 purchase discount……......16

Account receivable (900-100)………….800 cash (800*2% =16)……..784

Trade discount, transportation cost and sales taxes

Trade discount: a reduction in list price or the discount given for those businesses that orders goods in
large quantities. Whole sellers are businesses that sell merchandise to other businesses rather than to

general public. Whole sellers may offer special discount to certain classes of buyers, such as government
agencies.

Sellers and buyers do not normally record the list price of merchandise and related discounts in their
accounts (list price and related discount is not recorded neither by the buyer nor by the seller). Example,
an item has a list price of $1000 and a 40% trade discount. The seller records the sale of the item at
$600($1000-400) and the buyer also records the purchase at $600.

Buyer seller
Purchase……….600 Account receivable/cash……..600
Account payable/cash….600 sales………………………..600
“H” trading company purchase merchandise having a list price of $10,000, such as to 20% a trade
discount in cash. Required calculate

A, the amount of trade discount and invoice price

B, record the transaction as the buyer and seller

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 $10000X20%=$2000 trade discount
Invoice price=list price- trade discount=$10,000-2000=$8,000
Buyer seller
Purchase…………8000 cash………..8000

Cash………………..8000 sales……………..8000

Transportation costs: depend on the terms of agreement between the buyer and seller. The terms of
agreement between the buyer and seller include provisions concerning

 When the owner ship (possession or title) of merchandise passes to the buyer
 Which party to bear the cost of delivering (transportation cost) merchandise to the buyer
There are two types of agreement or terms

A) FOB shipping point: It means that the seller places the merchandise “free on board” at the shipping
point and the buyer is responsible costs beyond that point and the ownership is transferred at the place
of the seller when goods are loaded to the transportation system. In this agreement transportation cost
is covered by the buyer and this cost is considered as part of purchasing cost of merchandise and
added to buyers cost. The buyer is responsible for any risks after merchandises are loaded to the
transportation. It can be recorded for buyer as
Freight in……………xx
Cash /Account payable………xx
B) FOB destination: it means that the seller places the merchandise “free on board” to its destination by
paying the delivery cost. The seller pays transportation cost and record by debiting an account called
transportation out or delivery expense (selling expense). Ownership or title is transferred at the place
of the buyer when transportation system is completed or when merchandises are received by the
buyer. For the seller TC is considered as selling expense and recorded as
Transportation out (delivery expense)……..xx no entry to the buyer
Cash ……………..………xx
Illustration: the following transactions were completed during July between Durban Company (seller) and
Bell corp. (buyer)
July 8/ Durban co. sold merchandise on account $10,000 terms of FOB destination 1/15, n/eom
July 8/ Durban Company Paid transportation cost of $300 for delivery sold
July 11/ Bell corp. returned merchandise purchased on account on July 8 from Durban co. $4000
July 23/ Bell corp. Paid Durban co. for purchase of July 8, less discount and return of July 11.
Prepare journal entry for Durban co. and Bell Corporation
Durban company (seller) Bell Corporation (buyer)
July 8/ Account receivable………10000 July 8/ purchase………10000
Sales…………………………….10000 Account payable……………10000
July 8/ transportation out…………..300 no entry
Cash……………………………300
July 11/ sales return and allowance…..4000 July 11/ Account payable….4000

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 Account receivable……………4000 purchase return and allowance….4000

July 23/ cash…………………..5940 July 23/ Account payable....6000

Sales discount…………………60 cash………….……………….5, 940

Account receivable…………………..6000 purchase discount……………… 60

If the seller covers the transportation cost on behalf of the buyer even though the term is FOB shipping
point, the seller records transportation cost as

Account receivable….xx
Cash………………..xx
Example, July 23 ABC company sold merchandise on account to XYZ company $8000 terms FOB
shipping point, n/neom
July 24/ ABC co. paid transportation charges of $3000 on behalf of XYZ company merchandise
purchased on July, 23
July 25/ returned merchandise total $4000
July 31/ XYZ paid to ABC co. for purchase of July23
Solution
ABC co (seller) XYZ co (buyer)
July 23/ account receivable…….8000 July 23/ purchase …….8000
Sales…………………………8000 Account payable…….8000
July 24/ Account receivable…..3000 July 24/ transportation in…..3000
Cash………3000 Account payable………. 3000
July 25/ sales return and allowance….4000 July 25/account payable……….4000
Account receivable………….….4000 purchase return &allowance…….…4000
July 31/ cash……………4000 July 31/ Account payable...4000
Account receivable……….4000 cash…………….4000

Sales taxes: are taxes levied or imposed on sales of merchandise by the government to be collected by the
seller from the buyer. The liability for the sales tax is ordinarily incurred at the time the sale is made,
regardless of the term of sale. At the time of cash sales the seller collects the sales tax. Example, “N”
business center made a sale of merchandise for birr $4000 on cash to “S” company, subject to a sales tax
of 15%. The transaction could be recorded as
Cash…………………4600
Sales………………………………….4000
Sales tax payable (4000*15%)………….600
When the seller pays to the government, the transaction could be recorded as
Sales tax payable……………………600
Cash…………………….600

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 3.4 Merchandise transactions using perpetual and periodic inventory systems
There are two main systems for accounting for merchandise held for sales (systems of accounting for
merchandise):

 Periodic inventory systems

 Perpetual inventory systems
Periodic inventory systems: In this system, only revenues from sales are recorded when sales are made
but, no attempt is made on the sales date to record the cost of merchandise sold. Periodic inventory
systems do not show the amount of inventory available for sale or sold during the period. It is only detail
listing of merchandise on hand (physical inventory) at the end of accounting period. This physical
counting of merchandise at the end of the period is used to determine

 The cost of merchandise sold during the period

 The cost of merchandise on hand at the end of the period
In periodic inventory system purchases of inventory are recorded in the purchase account, while in
perpetual inventory system purchases of merchandise is recorded in merchandise inventory account. In
this system also transportation cost paid when purchasing of merchandise is FOB shipping point
transportation in or fright in is debited but under perpetual inventory system, merchandise inventory
account is debited. Note: revenues from sales are recorded in the same manner in both systems.

Perpetual inventory system: in this system, each purchase and sale of merchandise is recorded in the
merchandise inventory account. As a result, the amount of merchandise available for sale and the amount
sold are continuously (perpetually) disclosed in the inventory records. Under perpetual system both sales
revenue and the cost of merchandise sold are recorded on the date of sales when each item of merchandise
is sold. In this inventory system, purchase return and allowance are not used rather merchandise inventory
is recorded at their costs.

Accounting for purchases in perpetual inventory system

Cash purchase or purchase on account is recorded as

Merchandise inventory…………..xxx

Cash / Account payable………….xxx

If there is purchase discount or purchase return and allowance the transaction could be recorded as
Account payable (Cash)……………xxx

Merchandise inventory………………………..xxx

Accounting for sales in perpetual inventory system

Sales for cash

Example: on January 3 “X” sold merchandise for cash of $1800 and the cost of merchandise sold was
$1200

Jan 3/ cash ………....1800

Sale………….1800

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Jan 3/ cost of merchandise sold …….1200

Merchandise inventory………………………1200

Sales on account sales discount

Account receivable……………xxx cash………….xx

Sales………………………..xxx sales discount…xx

Cost of merchandise sold……….xxx Account receivable……xxx

Merchandise inventory……….xxx
Sales return and allowance if the buyer pays transportation cost
Sales return and allowance ……xxx FOB shipping point
Account receivable………….xxx merchandise inventory……..xxx
Cost of merchandise sold……..xxx Account payable (cash)……..xxx
Merchandise inventory……….xxx

Cost of merchandise sold

For merchandising enterprises that uses the periodic system, the cost of merchandise sold during the
period is reported in a separate section in the income statement. Merchandise business using this
inventory system reports the cost of merchandise sold, the beginning and ending inventories in the
income statement in the following manner
Cost of merchandise sold=
Beginning inventory……………………………………………………...........xxx
Purchases…………………………………………. xx
Less purchase discount and allowance……………xx
Net purchases…………………………………………………xxx
Add: Freight in …………………………………………….......xx
Cost of merchandise purchased…………………………………………………xxx
Merchandise available for sale…………………………………………………..xxx
Less merchandise inventory on hand at the
End of the period (Ending inventory)……………………………………………xxx
Cost of merchandise sold………………………………………………………..xxxx
Or CGS=BI+ Cost of merchandise purchased- EI=BI +CMP–EI
Cost of merchandise purchased= net purchase + transportation in

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CGAFS= BI + CMP
CGAFS= Cost of goods available for sale
CGAFS-EI=CGS

Note - Purchase returns & allowances and purchase discounts are deducted from the total purchases to
yield the net purchases.
- Transportation costs are added to the net purchases to yield cost of merchandise purchased.
- The beginning inventory id added to the cost of merchandise purchase to yield the merchandise
available for sale
- Ending inventory is subtracted from merchandise available for sale to yield cost of merchandise sold.

Example: Given the following information for ABC Company;

Beginning inventory…….. ……. $60,000 Purchase discount………………$3560

Purchase ………………………...$500,000 Freight in ………………………..$10,440

Purchase return and allowance…..$15000 Ending inventory………………. $75,000

Sales………………………………$653,200

A. Determine the net purchase

B. Determine the cost of merchandise purchased
C. Cost of merchandise available for sale
D. Cost of goods sold
E. Gross profit
Purchase – (Purchase discount +purchase return and allowance&) =$500,000-(3560+15000)

 Net purchase=$481440
 Cost of merchandise purchased=NP+TC $481440+10,440= $491,880
 CMP+CBI=CGAFS =$491,880+60,000=$551,880
 CGS=CGAFS-CEI =$551,880-75000=$476,880
 Gross profit=sale-CGS =$653,200-476,880=$176,320
Example: Assume that at the end of year 2003 physical count made by Guna trading company reveals
merchandise of $20,000 remains on hand. Assume also again during the following year (2004) Guna
trading company purchases additional worth of $120,000, received credit for purchase returns and
allowance $3,500, takes purchase discount of $1500 and pays transportation cost of $7,500. And the
physical count at the end of the period shows an inventory of $35,000. Note the ending inventory of
previous period (2003) becomes the beginning inventory of this period. Determine the cost of goods sold.
Beginning inventory (2004) …………………………………………..........$20000
Purchases ……………………………………...........$120000
Less purchase returns & allowance………$3500
Purchase discount…………….……………1500…….. (5000)
Add: Freight in…………………………………………..7500
Cost of goods purchased……………………………………………………...122500

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Cost of goods available for sale…………………………………………..…..142500
Less ending inventory (December, 2004)………………………………..……..35000
Cost of goods sold……………………………………………………………..$107,500

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