CHAPTER THREE

ACCOUNTING CYCLE FOR A MERCHANDISING ENTERPRISE

.1 Characteristics of Merchandise Business
Merchandise enterprise is a business organization that purchases and resells goods to customers.
It engaged in the activities of purchasing merchandises from manufacturer and reselling them to
customers.
 Merchandise enterprise purchases goods at a certain cost and sells them at a certain price.
When this merchandise is sold, the revenue is reported as sales, and its cost is recognized
as an expense called the cost of merchandise sold.
 The cost of merchandise sold is subtracted from sales to arrive at gross profit. This
amount is called gross profit because it is the profit before deducting operating expenses.
 Merchandise on hand (not sold) at the end of an accounting period is called merchandise
inventory. Merchandise inventory is reported as a current asset on the balance sheet.
.2 Accounting for Purchase of Merchandises
 Purchase can be made for cash or on account. Purchase are normally recorded when the
goods are received from the supplier.

 Every purchase should be supported by business documents that provide a written evidence
of the transaction.

 Cash purchase supported by canceled checks or cash register receipts indicating the items
purchased and amounts paid. A credit purchase is supported by an invoice that indicate the
item purchased and the total price.

1. Periodic Inventory System

E.g. (1) Assume that on Jan 3 Martha super market purchases merchandise of birr 10,000 for
cash from Yihun Company. The journal entry for the purchase is recorded under periodic
inventory system as follows:
Jan 3 Purchase 10,000
Cash 10,000
E.g. (2) assume that Tirsit Trading house purchases 8,000 exercise books from Girma Trading
enterprises for birr 40,000 on credit. The journal entry recorded by Tirsit is as follows:
Purchase 40,000
Account payable 40,000
If the liability is to be paid after a month for the above transaction, the journal entry will be:
Account payable 40,000
Cash 40,000
Illustration: Assume the following transactions for Sofumer stationary shop;
January 2, 2012: Purchased merchandise of Br 10,000 for cash
January 4, 2012: Purchase merchandise of Br 4,000 on account
January 8, 2012: Made another purchase of merchandise costing Br 4,300 of which Br 3,500 in
cash and the remaining on credit.
January 10, 2012: Purchase office supplies of Br 2,000 that used for business operation for an
agreement to pay in the near future. Required: Pass the necessary journal entries for Sofumer
Stationary shop.
 Purchases Discounts

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 Cash discount
The buyer and seller of merchandise made an agreement regarding to when payment shall be
made. That is if cash paid immediately at the time of sale, it is a cash term / net cash term.
Otherwise, the buyer allowed a certain period of time for payment.
Example: For credit terms;
1. Net 30 days (n/30): the payment will be due within 30 days because the buyer given 30
days credit period to pay.
2. Net end of the month (n/EOM): the payment will be paid by the end of the month in which
the sale was made
3. (10/EOM): the payment will be paid 10 days after the end of the month.
However, as a means of encouraging payment before the end of the credit period, the sellers may
offer a cash discount for the early payment of cash. That is making certain percent deductions
from the invoice, if it is paid within a specified time. For example: if an invoice for 10,000
provides for terms 1/10, n/30, the customer has two alternatives; either to pay 9, 900 in 10 days
or pay 10,000 in 30 days.
Purchase Discounts: is a contra purchase account that is an account reduces purchase balance.
Then, for the purpose of providing information regarding the total amount of discount taken
during the period, it is recorded in a separate account called purchase discount account.
Generally, discount has an advantage for both the buyer and seller. For the buyer discount is a
cost reduction, for the seller it is early conversion of receivables to cash and reduction of the risk
of uncollectibility of the credit of sales.
Example: The following transactions are for Seifu merchandising Company
December 3: Purchased merchandise costing Br 40,000 on account and a credit term was 2/15,
n/30.
Dec 3 Purchase 40,000
Accounts payable 40,000
December 18: Paid its liability for December 3 purchase on account.
Dec 18 Accounts Payable 40,000
Cash 39,200
Purchase Discount 800
 Purchase Return and Allowance
When the merchandising enterprise get the purchased merchandise are defective,
unsatisfactory/inferior quality or wrong specification, it may return the goods to the
supplier(seller) for reduction of liability, if purchase was made on account or for cash refund, if
purchase was made initially on cash. This transaction is called purchase returns. Whereas, the
merchandising enterprise may choose to keep the purchased merchandise and request (ask) price
reduction, price adjustment for those defective goods. This transaction is a purchase allowance.
The buyer initiates request for reduction of amount payable or cash refund by issuing a debit
memorandum
Example: Assume the following transactions are for Rauda merchandising company;
January 2: Purchased merchandise of Br 8,000 on account
January 2 Purchase 8,000
Accounts payable 8,000
January 4: Out of the merchandise purchased on January 2, having a value of Br 400 was
defective and returned to sellers.
January 4 Accounts payable 400
Purchase return and allowance 400

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The other concept when a buyer returns merchandise or has been granted an allowance prior to
the payment of the invoice, the amount of the debit memorandum / purchase return and
allowance / is deducted from the invoice amount before the purchase discount is computed.
Illustration: The following transactions were for Siham merchandising company;
On December 10: Acquired merchandises of Br 20,000 on account under terms 2/10, n/45
On December 15: Out of goods purchased on December 10, merchandise having a value of Br
800 was wrong specification and returned to the seller.
On December 20: Paid for purchases made on December 10.
Required: Prepare the necessary journal entries.
2. Perpetual Inventory System
Perpetual Inventory System is a system in which each purchase and sales of merchandise is
recorded in an inventory account. Under a perpetual inventory system, inventory shrinkage, lost
or stolen goods are more readily determined because the total record for a period should be
compared to the physical count at the end of the period. To illustrate the purchases of
merchandise under the perpetual inventory system consider on January 3, ABC Co.
purchase merchandise for cash from XYZ Co. Br. 2,510. This transaction recorded by ABC
Co. as follows
2007 Jan 3 Merchandise Inventory 2510
Cash 2510
On January 4, ABC Co. purchase merchandise on account from Thomas Co. for Br. 2,510. This
transaction recorded by ABC Co. as follows
2007 Jan 4 Merchandise Inventory 9,250
Accounts Payable- Thomas Co. 9,250

 Purchase Discount
To illustrate, assume that Feruza Technologies issues an invoice for Br. 3,000 to ABC Co., dated
March 12, with terms 2/10, n/30. The last day of the discount period in which the Br. 60 discount
can be taken is March 22. Assume that in order to pay the invoice on March 22, ABC Co.
borrows the money for the remaining 20 days of the credit period. If an annual interest rate of
6% and a 360-day year is assumed, the interest on the loan of Br. 2,940 (Br. 3,000 - Br. 60) is Br.
9.80 (Br. 2,940 X 6% X 20/360). The net savings to ABC Co. is Br. 50.20, computed as follows:

Discount of 2% on Br. 3,000 Br. 60.00

Interest for 20 days at rate of 6% on Br. 2,940 -9.80
Savings from borrowing Br. 50.20
The savings can also be seen by comparing the interest rate on the money saved by taking the
discount and the interest rate on the money borrowed to take the discount. For ABC Co., the
interest rate on the money saved in this example is estimated by converting 2% for 20 days to a
yearly rate, as follows:
2% X 360 days = 2% X 18= 36%
20 days
If ABC Co. Borrows the money to take the discount, it pays interest of 6%. If ABC Co. does
not take the discount, it pays estimated interest of 36% for using the Br. 60 for an additional 20
days. Under the perpetual inventory system, the buyer initially debits the merchandise inventory
account for the amount of the invoice. When paying the invoice, the buyer credits the
merchandise inventory account for the amount of the discount. In this way, the merchandise
inventory shows the net cost to the buyer. For example, ABC Co. would record the Feruza
Technologies invoice and its payment at the end of the discount period as follows:
Mar. 12 Merchandise Inventory 3,000

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 Accounts Payable–– Feruza Technologies 3,000
22 Accounts Payable–– Feruza Technologies 3,000
Cash 2,940
Merchandise Inventory 60
If ABC Co. does not take the discount because it does not pay the invoice until April 11, it would
record the payment as follows:
April 11 Accounts Payable–– Feruza Technologies 3,000
Cash 3,000
 Purchase Return and Allowance
If the buyer returns merchandise to the seller, it must credit to Merchandise Inventory under
perpetual inventory systems.
Example on March 7 ABC Co. received the delivery from Alen Systems and determined that Br.
900 of the items were not the merchandise ordered.
March 7.Accounts Payable- Alen Systems 900
Merchandise Inventory 900
When a buyer returns merchandise or has been granted an allowance prior to paying the invoice,
the amount of the debit memorandum is deducted from the invoice amount. The amount is
deducted before the purchase discount is computed. For example, assume that on May 2, ABC
Co. purchases Br. 5,000 of merchandise from Nigus Data Link, subject to terms 2/10, n/30. On
May 4, ABC Co. returns Br. 3,000 of the merchandise, and on May 12, ABC Co. pays the
original invoice less the return. ABC Co. would record these transactions as follows:
May 2. Merchandise Inventory 5,000
Accounts Payable—Nigus Data Link 5,000
( Purchased merchandise).
May 4. Accounts Payable—Nigus Data Link 3,000
Merchandise Inventory 3,000
Returned portion of merchandise purchased.
May 12. Accounts Payable—Nigus Data Link 2,000
Cash 1,960
Merchandise Inventory 40
Paid invoice [(Br. 5,000 - Br. 3,000) X 2% = Br. 40;
Br. 2,000 - Br. 40 = Br. 1,960].
3.3. Accounting for sales of merchandise
Merchandise firm is the one that purchases and resells goods. That is a given merchandise firm is
a buyer as well as a seller. When it purchases goods, it is a buyer and when it resells the
purchased goods to customers, it is a seller. Sale of merchandise is the principal source of
revenue for a merchandising firm. Hence, the sale of merchandise during an accounting period
credited to the sales revenue account. Sales (sales revenue) recorded when goods are transferred
from the seller to the buyer. In other words, for the buyer to record it as purchases and for the
seller to record it as sales, the ownership right on the goods should pass from seller to buyer.
Sales can be made on cash basis or on credit basis. Sales of merchandise on cash recorded as a
debit to cash and credit to sales account, while sales made on account recorded as debit to
account receivable and credit to sales account.
1. Periodic Inventory System
The recording of sales under periodic inventory system is illustrated in the following examples.
Ex1. On October 4, Henok Merchandise Company sold merchandise for Br 30,000 on cash to
Nati Merchandise Company. Henok records this transaction as follows;
Oct. 4 Cash 30,000
Sales 30,000

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Ex2. On October 10 Alem Merchandise Company sold merchandise totaling Br 24, 000 on credit
to Hermon merchandising Company
Oct.10 Account receivable 24,000
Sales 24,000
Ex3. On October 22 Fenet Merchandise Company made sale of merchandise for Rauda
Merchandising Company having a value of Br 40,000 of which one fourth was Paid in cash and
the remaining on account.
Oct. 22 Cash [40000/4=10,000] 10,000
Account receivable 30,000
Sales 40,000
 Sales Discounts
The terms of a sale are normally indicated on the invoice or bill that the seller sends to the buyer.
Discounts taken by the buyer for early payment are recorded as sales discounts by the seller.
Since managers may want to know the amount of the sales discounts for a period, the seller
normally records the sales discounts in a separate account. The sales discounts account is a
contra (or offsetting) account to Sales. To illustrate the sales discount consider the following
examples;
On January 1 Almaz merchandising company has sold merchandise for Br 100,000 for ABC
Company on account, terms of sale was 2/15, n/30.
Jan. 1 Account Receivable 100,000
Sales 10,000
On January 15 Almaz Company collects cash from customers for sales made on January 1.
Jan.15 Cash 98,000
Sales Discount 2000
Account Receivable 100,000
 Sales Return and Allowance
Merchandise sold may be returned to the seller (sales return). In addition, because of defects or
for other reasons, the seller may reduce the initial price at which the goods were sold (sales
allowance). If the return or allowance is for a sale on account, the seller usually issues the buyer
a credit memorandum. This memorandum shows the amount of and the reason for the seller’s
credit to an account receivable. Like sales discounts, sales returns and allowances reduce sales
revenue. They also result in additional shipping and other expenses. Since managers often want
to know the amount of returns and allowances for a period, the seller records sales returns and
allowances in a separate account. Sales Returns and Allowances is a contra (or offsetting)
account to Sales. The seller debits Sales Returns and Allowances for the amount of the return or
allowance. If the original sale was on account, the seller credits Accounts Receivable. To
illustrate assume on October 8 Best Co. sold merchandise for Br 12,000 on account for Mana
trading. Best Co. records this transaction as;
Oct. 8 Account receivable 12,000
Sales 12,000
Further assume that on October 14, the merchandise sold for Br 1,000 were returned because of
defect. This transaction is recorded as;
Oct. 14 Sales return and allowance 1,000
Account Receivable 1,000
2. Perpetual Inventory System
A business may sell merchandise for cash or on credit. Cash sales are normally rung up (entered)
on cash register and recorded in the accounts. Under the perpetual inventory system, the cost of
merchandise sold and the reduction in merchandise inventory should also be recorded. In this

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way, the merchandise inventory account will indicate the amount of merchandise on hand (not
sold).
To illustrate, assume that on January 3, ABC Co. sells merchandise for Br. 1,800. The cost of
merchandise sold on January 3 was Br. 1,200. The Co. records this transaction as follows:
Jan. 3 Cash 1,800
Sales 1,800
(To record cash sales).
The entry to record the cost of merchandise sold and the reduction in the merchandise inventory
is as follows:
Jan. 3 Cost of Merchandise Sold 1,200
Merchandise Inventory 1,200
(To record the cost of merchandise sold).
A business may sell merchandise on account. The seller records such sales as a debit to Accounts
Receivable and a credit to Sales. For example On January 12, a firm sold Simion Company
merchandise on account, Br. 510. The cost of merchandise sold was Br. 280.
Jan. 12. Accounts Receivable 510
Sales 510
(Invoice No. 7172).
12. Cost of Merchandise Sold 280
Merchandise Inventory 280
To record the cost of merchandise sold on Invoice 7172.
Sales Discount
On January 21, the firm receives the amount due from Simion less the 2 percent discount.
Jan. 12 Cash 499.80
Sales Discounts 10.20
Accounts Receivable— Simion Co. 510.00
(Collection of Invoice No. 7172, less discount).
 Sales Return and Allowance
The seller debits Sales Returns and Allowances for the amount of the return or allowance. If the
original sale was on account, the seller credits Accounts Receivable. Since the merchandise
inventory is kept up to date in a perpetual system, the seller adds the cost of the returned
merchandise to the merchandise inventory account. The seller must also credit the cost of
returned merchandise to the cost of merchandise sold account, since this account was debited
when the original sale was recorded. To illustrate, assume that on o January 13, issued Credit
Memo 32 to Krar Company for merchandise returned to ABC Co. The selling price is Br. 225;
the cost of the merchandise returned was Br. 140.
Jan. 13 Sales Returns and Allowances 225
Accounts Receivable—Krar Co. 225
Credit Memo No. 32.
13 Merchandise Inventory 140
Cost of Merchandise Sold 140
Cost of merchandise returned—Credit Memo 32.
 Transportation Costs
The terms of a sale should indicate when the ownership (title) of the merchandise passes to the
buyer. This point determines which party, the buyer or the seller, must pay the transportation
costs. The ownership of the merchandise may pass to the buyer when the seller delivers the
merchandise to the transportation company or freight carrier. In this case, the terms are said to be
FOB (free on board) shipping point. This term means that the dealer pays the transportation
costs from the shipping point (factory) to the final destination. The ownership of the merchandise

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may pass to the buyer when the buyer receives the merchandise. In this case, the terms are said to
be FOB (free on board) destination. This term means that the seller delivers the merchandise to
the buyer’s final destination, free of transportation charges to the buyer. The seller thus pays the
transportation costs to the final destination.
When merchandise is purchased on terms of FOB shipping point, the transportation costs paid by
the buyer should be debited to “Transportation In” or “Freight In” and credited to cash. The
balance is added to purchase account to find the total costs of merchandise purchased. In some
cases the seller may prepay the transportation costs and add them to the invoice as an
accommodation or courtesy to the buyer (even though term is FOB shipping point).
E.g. assume that on June10, ABC Co. purchases merchandise from Martha Data on account,
Br.900, terms FOB shipping point, and pays the transportation costs of Br.50.
June 10 Purchases 900
Accounts Payable 950
10 Transportation in 50
Cash 50
When the terms provide for a discount for early payment, the discount is based on the amount of
sales rather than on the invoice total (i.e. does not include transportation cost). For example if
ABC Co. pays within the discount period the entry would be;
June 20 Account payable 950
Cash 932
Purchase discount 18
When the seller prepays the transportation costs and the terms are FOB shipping point, the seller
adds these costs to the invoice that is sent to the buyer and includes in its records as;
June 10 Accounts Receivable 50
Cash 50
Under perpetual inventory system if the term is FOB shipping point, the transportation costs are
part of the dealer’s total cost of purchasing inventory and should be added to the cost of the
inventory by debiting Merchandise Inventory. For the above example, ABC Co. records the
transaction using perpetual inventory system is as follows;

June 10 Merchandise Inventory 900

Accounts Payable— Martha Data 900
Purchased merchandise, terms FOB shipping point.
10 Merchandise Inventory 50
Cash 50
(Paid shipping cost).
20 Account payable 950
Cash 932
Merchandise Inventory 18
When the agreement states that the seller is to bear the delivery costs (FOB destination), the
amounts paid by the seller for delivery are debited to transportation out or delivery expenses
which is reported on the seller’s income statement as an expense.
Examples: On September 10, Hirut Company sold commodity of Br 10,000 on account to Abel
trading, terms 2/10 n/EOM, FOB destination. Hirut Company paid transportation cost of Br 400.
Sept. 10 Account receivable 10,000
Sales 10,000
Sept. 10 Transportation Out 400
Cash 400

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Further assume that on September 20 Hirut Company collects cash from Abel trading for
September 10 on account sales. The journal entry would be as follows;
Sept. 20 Cash 9,800
Sales discount 200
Account receivable 10,000
To illustrate the perpetual inventory system, assume that on June 15, ABC Co. sells merchandise
to Kuraz Company on account, Br. 700, terms FOB destination. The cost of the merchandise sold
is Br. 480, and ABC Co. pays the transportation cost of Br. 40. ABC Co. records the sale, the
cost of the sale, and the transportation cost as follows:
June 15 Accounts Receivable—Kuraz Co. 700
Sales 700
(Sold merchandise, terms FOB destination).
15 Cost of Merchandise Sold 480
Merchandise Inventory 480
(Cost of sale of Kuraz Co).
15 Transportation Out 40
Cash 40
(Paid shipping cost on merchandise sold).
 Sales Tax
Almost all states and many other taxing units levy a tax on sales of merchandise. The liability for
the sales tax is incurred when the sale is made. At the time of a cash sale, the seller collects the
sales tax. When a sale is made on account, the seller charges the tax to the buyer by debiting
Accounts Receivable. The seller credits the sales account for the amount of the sale and credits
the tax to Sales Tax Payable.
For example, the on August 12, merchandise is sold on account to Lomi Company, Br. 100
subject to a tax of 6%. The seller would record this transaction as follows;
Aug. 12 Account Receivable 106
Sales 100
Sales tax payable 6
Normally on a regular basis, the seller pays to the taxing unit the amount of the sales tax
collected. Assume that on September 15, the seller sends in a payment of Br. 2,900 to the taxing
unit for the August taxes collected. It records such a payment as follows:
StatementSept. 15 Position
of Financial Sales tax payable
Accounts 2,900
Income Statement Accounts
100 Assets Cash 400 Revenues
2,900
110 Cash 410 Sales
.1 . Charts
112 Accounts Receivableof Accounts for Merchandise Business
411 Sales Returns and Allowances
115
TheMerchandise Inventory for a merchandising business
chart of accounts 412should
Sales Discounts
reflect the types of merchandising
116 Office Supplies 500 Costs and Expenses
transactions
117 which have been described in the chapter.
Prepaid Insurance The ofcharts
510 Cost of accounts
Merchandise Sold of a merchandiser
differ
120 Landfrom that of a service business. As a basis for 520illustration,
Sales Salaries the chart of accounts is shown
Expense
123 Store Equipment
Bbelow. 521 Advertising Expense
124 Accumulated Depreciation— Store Equipment Depreciation Expense—Store Equipment
125 Office Equipment 523 Transportation Out
126 Accumulated Depreciation— Office Equipment 529 Miscellaneous Selling Expense
530 Office Salaries Expense
200 Liabilities 531 Rent Expense
210 Accounts Payable 532 Depreciation Expense—Office Equipment
211 Salaries Payable 533 Insurance Expense
212 Unearned Rent 534 Office Supplies Expense
215 Notes Payable 539 Misc. Administrative Expense
300 Owner’s Equity 600 Other Income
310 Chris Clark, Capital 610 Rent Revenue
311 Chris Clark, Drawing 700 Other Expense
312 Income Summary 710 Interest Expense

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As shown above, the company is using three-digit account numbers, which permits it to add new
accounts as they are needed. The first digit indicates the major financial statement classification
(1 for assets, 2 for liabilities, and so on). The second digit indicates the sub-classification (e.g.,
11 for current assets, 12 for noncurrent assets). The third digit identifies the specific account
(e.g., 110 for Cash, 123 for Store Equipment). The Company is using a more complex numbering
system because it has a greater variety of transactions. In addition, its growth creates a need for
more detailed information for use in managing it. For example, a wages expense account may
adequate when the company is a small service business with few employees. However, as a
merchandising business, the company may use two payroll accounts, one for Sales Salaries
Expense and one for Office Salaries Expense.
3.4. Financial Statements for a Merchandising Business
The basic financial statements for a merchandise enterprise, including the income statement,
statement of owner’s equity (retained earnings for corp.) and Statement of Financial Position
are similar to those of a service enterprise. The basic difference between the financial
statements of a merchandise enterprise and a service enterprise include the cost of merchandise
sold section of the income statement, and the inclusion of merchandise inventory on the
Statement of Financial Position as a current asset. [See the appendix for the financial
statements’ figures at the end of the handout].
Income Statement
ABC Co.
Income Statement
For the Year Ended Dec. 31,1990
Sales Revenue
Sales Br. 720,185
Less: sales returns and allowance Br. 6, 140
Sales discounts 5,790 (11,930)
Net sales Br. 708,255
Cost of merchandise sold 525,305
Gross Profit Br. 182,950
Selling expenses:
Salaries expense Br. 56,230
Advertising expense 10,860
Depreciation exp.-store equipment 3,100
Miscellaneous expense 630
Total selling expense Br. 70,820
Administrative expenses:
Office salaries expense Br. 21,020
Rent expenses 8,100
Dep. Exp.-office-equipment 2,490
Insurance expense 1,910
Office supplies exp. 610
Miscellaneous Adm. expense 760
Total administrative exp 34,890 105,710
Other income and other expense
Rent income 600
Income from operations Br. 77,840

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 Interest expense 2,440
Net income Br.75,400
Cost of merchandise sold is the cost of the merchandise sold to customers. The cost of
merchandise sold was determined by deducting the merchandise on hand at the end of the period
from the merchandise available for sale during the period. The merchandise on hand at the end of
the period is determined by taking a physical count of inventory on hand. This method of
determining the cost of merchandise sold and the amount of merchandise on hand is called the
periodic method of accounting for merchandise inventory. Under the periodic method, the
inventory records do not show the amount available for sale or the amount sold during the
period. In contrast, under the perpetual method of accounting for merchandise inventory, each
purchase and sale of merchandise is recorded in the inventory and the cost of merchandise sold
accounts. As a result, the amount of merchandise available for sale and the amount sold are
continuously (perpetually) disclosed in the inventory records.
Most large retailers and many small merchandising businesses use computerized perpetual
inventory systems. Merchandise businesses using a perpetual inventory system report the cost of
merchandise sold as a single line on the income statement, as shown above for ABC Co.
Merchandise businesses using the periodic inventory method report the cost of merchandise sold
by using the format shown below.
To illustrate the determination of the cost of merchandise sold, assume that ABC Co. purchased
Br. 340,000 of merchandise during the last half of 2006. If the inventory at December 31, 2006,
the end of the year, is Br. 59,700, the cost of the merchandise sold during 2006 is Br. 280,300 as
shown below.
Purchases Br. 340,000
Less merchandise inventory, December 31, 2006 9,700
Cost of merchandise sold Br. 280,300
Purchase discounts and purchases returns and allowances reduce the cost of merchandise
purchased during a period. Transportation costs paid by the buyer for merchandise increase the
cost of merchandise purchased.
To continue the illustration, assume that during 2007 ABC Co. purchased additional merchandise
of Br. 521,980. It received credit for purchases returns and allowances of Br. 9,100, took
purchases discounts of Br. 2,525, and paid transportation costs of Br. 17,400. The purchases
returns and allowances and the purchases discounts are deducted from the total purchases to
yield the net purchases. The transportation costs, termed transportation in, are added to the net
purchases to yield the cost of merchandise purchased of Br. 527,755, as shown below.
Purchases Br. 521,980
Less: Purchases returns and allowances Br. 9,100
Purchases discounts 2,525 11,625
Net purchases Br. 510,355
Add transportation in 17,400
Cost of merchandise purchased Br. 527,755
The ending inventory of ABC Co. on December 31, 2006, Br. 59,700, becomes the beginning
inventory for 2007. This beginning inventory is added to the cost of merchandise purchased to
yield merchandise available for sale. The ending inventory, which is assumed to be Br. 62,150,
is then subtracted from the merchandise available for sale to yield the cost of merchandise sold
of Br. 525,305 as shown below.
Merchandise inventory, January 1, 2007 Br. 59,700
Purchases Br. 521,980
Less: Purchases returns and allowances Br. 9,100
Purchases discounts 2,525 (11,625)

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 Net purchases Br. 510,355
Add transportation in 17,400
Cost of merchandise purchased 527,755
Merchandise available for sale Br. 587,455
Less merchandise inventory, December 31, 2007 62,150
Cost of merchandise sold Br. 525,305
Gross profit is determined by subtracting the cost of merchandise sold from net sales.
Operating income, sometimes called income from operations includes gross profit, selling and
administrative expenses and other income and other expense. Selling and administrative
expenses are subtracted from gross profit. And if the total of other income exceeds the total of
other expense, the difference is added [if the reverse is true, the difference is subtracted] to
determine income from operations. Expenses that are incurred directly in the selling of
merchandise are selling expenses. They include such expenses as salespersons’ salaries, store
supplies used, depreciation of store equipment, and advertising. Expenses incurred in the
administration or general operations of the business are administrative expenses or general
expenses. Examples of these expenses are office salaries, depreciation of office equipment, and
office supplies used.

Other income and expense: Revenue from sources other than the primary operating activity of
a business is classified as other income. In a merchandising business, these items include income
from interest, rent, and gains resulting from the sale of fixed assets. Expenses that cannot be
traced directly to operations are identified as other expense. Losses incurred in the disposal of
fixed assets are example of these items.
Interest expenses resulted from financing activities is deducted from income from operation in
order to get Net income.
 Statement of Owner’s Equity
This statement is prepared in the same manner that we described previously for a service
business. The statement of owner’s equity for ABC Co. is shown below
ABC Co.
Statement of Owner's Equity
For the Year Ended December 31, 2007
ABC, capital, January 1, 2007 Br. 153,800
Net income for year Br. 75,400
Less: withdrawals 18,000
Increase in owner's equity 57,400
ABC capital, December 31, 2007 Br. 211,200

 Statement of Financial Position

In this Statement of Financial Position, merchandise inventory at the end of the period is reported
as a current asset and that the current portion of the note payable is Br. 5,000.

ABC Co.
Statement of Financial Position
December 31, 2007
Assets
Plant assets:
Land Br. 20,000
Store equipment Br. 27,100
Less: Accumulated Depreciation 5,700 21,400

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Office equipment Br. 15,570
Less: Accumulated Depreciation 4,720 10,850
Total plant assets Br. 52,250
Current assets:
Prepaid insurance Br. 2,650
Office supplies 480
Merchandise inventory 62,150
Accounts receivable 91,080
Cash 52,950
Total current assets 209,310
Total assets Br. 261,560
Stockholders’ Equity and Liabilities
Stockholders’ equity
ABC, capital Br. 211,200
Liabilities
Long-term liabilities:
Notes payable (final payment, 2017) Br. 20,000
Current liabilities:
Accounts payable Br. 22,420
Notes payable (current portion) 5,000
Salaries payable 1,140
Unearned rent 1,800
Total current liabilities 30,360
Total liabilities 50,360
Total liabilities & stockholder’ equity Br. 261,560

3.5. Adjusting and Closing Entries for a Merchandising Business

Merchandise Inventory Shrinkage
Under the perpetual inventory system, a separate merchandise inventory account is maintained in
the ledger. During the accounting period, this account shows the amount of merchandise for sale
at any time. However, merchandising businesses may experience some loss of inventory due to
shoplifting, employee theft, or errors in recording or counting inventory. As a result, the physical
inventory taken at the end of the accounting period may differ from the amount of inventory
shown in the inventory records. Normally, the amount of merchandise for sale, as indicated by
the balance of the merchandise inventory account, is larger than the total amount of merchandise
counted during the physical inventory. For this reason, the difference is often called inventory
shrinkage or inventory shortage. To illustrate, ABCs’ inventory records indicate that Br.
63,950 of merchandise should be available for sale on December 31, 2007. The physical
inventory taken on December 31, 2007, however, indicates that only Br. 62,150 of merchandise
is actually available. Thus, the inventory shrinkage for the year ending December 31, 2007, is Br.
1,800 (Br. 63,950 - Br. 62,150), as shown at the left. This amount is recorded by the following
adjusting entry:
Adjusting Entry
Dec. 31 Cost of Merchandise Sold 1800
Merchandise Inventory 1800
 Merchandise Inventory Adjustments
Under periodic inventory system, the best method of making the data readily available for
reporting the cost of merchandise sold is maintaining a separate account entitled merchandise
inventory. Throughout an accounting period, this account shows the inventory at the beginning

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of the period. Purchases of merchandise during the period are then debited to the account entitled
purchases. At the end of the period it is necessary to remove from merchandise inventory the
amount representing the inventory at the beginning of the period and to replace it with the
amount representing the inventory at the end of the period. Two adjusting entries are
necessary: The first entry transfers the beginning inventory to income summary because this
beginning inventory is part of the cost merchandise sold. I.e. it is debited to income summary
and credited to merchandise inventory.
E.g. for ABC Co. the beginning merchandise inventory which have a balance of Br.59,700 at Jan
1, would be adjusted as follows at the end of the fiscal year.
Dec.31. Income summary 59,700
Merchandise inventory 59,700
The second adjusting entry debits the cost of the merchandise inventory (ending inventory) at the
end of the period to the income summary account. The credit portion of the entry effects a
deduction of the unsold merchandise from the total cost of the merchandise available for sale
during the period.
E.g. for ABC Co. the ending merchandise inventory Br. 62,150 can be adjusted as:
Dec.31. Merchandise inventory 62,150
Income summary 62,150
On the worksheet for merchandising enterprises, both the debit and credit amounts for income
summary are extended to the income statement columns. Since both the amounts of the debit
adjustment (beginning inventory) and the amounts of the credit adjustments (ending inventory)
may be reported on the income statement, there is no need to determine the difference between
the two amounts.
Adjusting Entries
After the analyses of the adjustments were completed and data for adjustment enter into the work
sheet, the adjusting entries should be recorded in journal entry. [See the appendix to prepare the
adjusting entries at the end of the handout].
The data needed for adjusting the accounts of ABC Co. are as follows:
Physical merchandise inventory on December 31, 2007 Br. 62,150
Office supplies on hand on December 31, 2007 480
Insurance expired during 2007 1,910
Depreciation during 2007 on: Store equipment 3,100
Office equipment 2,490
Salaries accrued on December 31, 2007: Sales salaries Br. 780
Office salaries 360 1,140
Rent earned during 2007 600
Journal page 28
Date Description Post Debit Credit
Ref
Adjusting Entries
2007
Dec. 31 Cost of Merchandise Sold 1,800 00
Merchandise Inventory 1,800 00

31 Office supplies expense 610 00

Office supplies 610 00

31 Insurance expense 1,910 00

Prepaid insurance 1,910 00

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 31 Depr. Exp.-store equipment 3,100 00
Accum. Depr. -Store equipment 3,100 00

31 Depr. exp.-office equipment 2,490 00

Accum. Depr.-office equipement 2,490 00

31 Sales salaries exp. 780 00

Office salaries exp. 360 00
Salaries payable 1,140 00

31 Unearned rent 600 00

Rent income 600 00

Closing Entries
The closing entries for a merchandising business are similar to those for a service business. The
first entry closes the temporary accounts with credit balances, such as Sales, to the income
summary account. The second entry closes the temporary accounts with debit balances, including
Sales Returns and Allowances, Sales Discounts, and Cost of Merchandise Sold, to the income
summary account. The third entry closes the balance of the income summary account to the
owner’s capital account. The fourth entry closes the owner’s drawing account to the owner’s
capital account. All of the temporary owner’s equity accounts are cleared of their balance,
reducing to zero. The final effects of closing out such balances are a net increase of a net
decrease in the retained earnings account.
Journal page 29
Date Description Post Debit Credit
Ref
Closing Entries
2007
Dec. 31 Sales 720,185 00
Rent Revenue 600 00
Income summary 720,785 00

31 Income summary 645,385 00

Sales return & allowance 6,140 00
Sales discount 5,790 00
Cost of merchandise sold 525,305 00
Sales salaries exp. 56,230 00
Advertising exp. 10,860 00
Depn. Expense-store equipment 3,100 00
Miscellaneous Selling exp. 630 00
Office salaries exp. 21,020 00
Rent exp. 8,100 00
Depr.exp.-office equipment 2,490 00
Insurance exp. 1,910 00
Office supplies exp. 610 00
Miscellaneous. Admin. Expense 760 00
Interest exp. 2,440 00

31 Income summary 75,400 00

ABC, Capital 75,400 00

31 ABC, Capital 18,000 00

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 ABC, Drawing 18,000 00
The balance of Income Summary, after the first two closing entries have been posted, is the net
income or net loss for the period. The third closing entry transfers this balance to the owner’s
capital account. ABCs’ income summary account after the closing entries have been posted is as
follows:
Account income summary Account No. 312
Item Ref. Debit Credit Balance
Debit Credit
2007
Dec. 31 Revenues 29 720,785 00 720,785 00
31 Expenses 29 645,385 00 75,400 00
31 Net income 29 75,400 00 - -
After the closing entries have been prepared and posted to the accounts, a post-closing trial
balance may be prepared to verify the debit-credit equality. The only accounts that should appear
on the post-closing trial balance are the asset, contra asset, liability, and owner’s capital accounts
with balances. These are the same accounts that appear on the end-of-period balance sheet.
Reversing Entries
In order to reduce routine transactions and to simplify the analysis and recording of subsequent
transactions related to adjusting entries in the following year, an optional procedure called
reversing entries might be used. A reversing entry is the exact reverse of the adjusting entry to
which it relates. The amounts and accounts are the same as the adjusting entry; the debits and
credits are reversed.
Reversing Entries for Accrued Expense
If there has been an adjusting entry for accrued salaries at the end of the year, however the first
payments of salaries in the following year will include such year-end accrual. In the absence of
reversing entry it will be necessary, to debit salaries payable for the amount owed for the earlier
year and salary expenses for the portion of expense for the later year.
To illustrate, assume the following facts for an enterprise that pays salaries weekly and ends its
fiscal year on Dec. 31.
1) Salaries are paid on Friday for the five-day week ending on Friday
2) The balance in salary expense as of Friday, Dec.27 is Br.62,500
3) Salaries accrued for Monday and Tuesday (Dec.30& Dec.31), total Br.500
4) Salaries paid on Friday, Jan 3,of the following year total Br.1,250
The adjusting entry to record the accrued salary expense and salaries payable (for Monday&
Tuesday) is:
Dec. 31 Salary expense 500
Salary payable 500
After the adjusting entry has been posted, salary expenses will have a debit balance of Br. 63,000
(62,500 + 500) & salary payable will have a credit balance of Br.500. After the closing process is
completed, salary expense is in balance (zero balance) for entries of the following year, but
salaries payable continues to have credit balance of Br. 500.
On Jan. 3, of the New Year, the accountant must be forced to divide the debit entry of the
payment of the salary (payroll) as a debit of Br.500 to salary payable and a debit of Br.750 to
salary expense by referring the adjusting entries in the journal or ledger. The need to refer to
earlier entries and to divide the debit between two accounts can be avoided by recording
reversing entries as of the first day of the following fiscal period.
Jan. 1, Salaries payable 500
Salary expense 500

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The effect of the reversing entry is to transfer the Br. 500 liability from salaries payable to the
credit side of salary expense. The real nature of the Br. 500 balance is unchanged; it remains a
liability. When the payroll is paid on Jan. 3, salary expense will be debited and cash will be
credited for Br. 1,250 (the entire amount of the weekly salaries). After the entry is posted, salary
expense will have a debit balance of Br. 750, i.e. the amount of expense incurred for Jan.1-3.
Reversing Entries for Accrued Revenues
Some revenue may not be recorded until cash is received. During this, year-end adjustment is
necessary to record the revenue accrued. To illustrate, assume that an enterprise has a note
receivable on which Br. 6,000 of interest is due every six months. If Br.4000 of interest income
has been earned (accrued) on Dec. 31, the end of the year, the adjusting entry would be as
follows:
Dec. 31 Interest receivable 4,000
Interest income 4,000
In order to avoid crediting two accounts at the time of receipt (interest receivable for 4,000 &
interest income for 2,000) and referring the earlier entries, reversing entry may be used.
Jan. 1 Interest income 4,000
Interest receivable 4,000
The effect of the reversing entry is to transfer the Br. 4,000 asset from interest receivable to the
debit side of interest income. The real nature of the Br. 4,000 balance is unchanged; it remains an
asset. When the Br. 6,000 of interest is received on March 1 of the following year, interest
income will have a balance of Br. 2,000 which is the amount of income realized for the period
Jan. 1- Mar.1.
Mar.1 Cash 6,000
Interest income 6,000

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