Chapter Three

Accounting cycle for Merchandising Businesses

CHARACTERISTICS OF MERCHANDISING BUSINESS

A business that buys and resells goods is called Merchandising Business. The goods that a
merchandising company sells to its customers are called inventory (or merchandise).
Merchandising companies include both retailers and wholesalers. Merchandising companies that
purchase and sell directly to consumers are called retailers. Merchandising companies that sell
to retailers are known as wholesalers. These companies purchase readymade or ready to sell
goods and get all earning or revenue by selling them. Merchandise may include anything, which
a merchandising business can buy for resell purpose and may vary from needle to automobiles.

The primary source of revenues for merchandising companies is the sale of merchandise, often
referred to simply as sales revenue or sales. A merchandising company has two categories of
expenses: cost of goods sold and operating expenses. Cost of goods sold is the total cost of
merchandise sold during the period. This expense is directly related to the revenue recognized
from the sale of goods.

 Flow of Costs

The flow of costs for a merchandising company is as follows: Beginning inventory plus the cost
of goods purchased is the cost of goods available for sale. As goods are sold, they are assigned to
cost of goods sold. Those goods that are not sold by the end of the accounting period represent
ending inventory. Companies use one of two systems to account for inventory: a perpetual
inventory system or a periodic inventory system.
 Perpetual System
 Maintain detailed records of the cost of each inventory purchase and sale
 Records continuously show inventory that should be on hand for every item
 Company determines cost of goods sold each time a sale occurs
 Periodic system

In a periodic inventory system, companies do not keep detailed inventory records of the goods on
hand throughout the period. Instead, they determine the cost of goods sold only at the end of the
accounting period—that is, periodically. At that point, the company takes a physical inventory
count to determine the cost of goods on hand.

Calculation of Cost of Goods Sold:

Beginning inventory €100,000

Add: Purchases, net 800,000

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Goods available for sale 900,000
Less: Ending inventory 125,000
Cost of goods sold €775,000

Advantages of the Perpetual System

 Traditionally used for merchandise with high unit values.
 Shows quantity and cost of inventory that should be on hand at any time.
 Provides better control over inventories than a periodic system.

RECORDING PURCHASES UNDER A PERPETUAL INVENTORY SYSTEM

Companies purchase inventory using cash or credit (on account). They normally record
purchases when they receive the goods from the seller. Business documents provide written
evidence of the transaction. A canceled check or a cash register receipt, for example, indicates
the items purchased and amounts paid for each cash purchase. Companies record cash purchases
by an increase in Inventory and a decrease in Cash. A purchase invoice should support each
credit purchase. This invoice indicates the total purchase price and other relevant information.
However, the purchaser does not prepare a separate purchase invoice. Instead, the purchaser uses
as a purchase invoice a copy of the sales invoice sent by the seller.

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Illustration: Sauk Stereo (the buyer) uses as a purchase invoice the sales invoice prepared by
PW Audio Supply, Inc. (the seller). Prepare the journal entry for Sauk Stereo for the invoice
from PW Audio Supply.

May 4 Inventory 3,800

Accounts Payable 3,800
Under the perpetual inventory system, companies record purchases of merchandise for sale in the
Inventory account.

 Freight Costs

There are two most common terms with respect to this: FOB (Free on Board) Shipping Point and
Destination.

FOB Shipping Point: under this term the seller places merchandise “Free On Board” at the
shipping point. Thus,
 The buyer pays transportation costs
 Ownership is transferred at point of shipment
 The goods are the property of the buyer after the point of shipment
 Any risk is absorbed by the buyer while the goods is in transit
FOB Destination: under this term the seller places merchandise “Free On Board” at the buyer’s
final destination by paying the delivery costs. Thus,
 The seller pays the transportation costs
 Title or ownership to the goods is transferred at the buyer’s location
 The goods are the property of the seller while in transit
 Any risk while the goods in transit is absorbed by the seller

 Freight costs incurred by the buyer

When the buyer incurs the transportation costs, these costs are considered part of the cost of
purchasing inventory. Therefore, the buyer debits (increases) the account Inventory. For
example, if upon delivery of the goods on May 6, Sauk Stereo (the buyer) pays Acme Freight
Company €150 for freight charges, the entry on Sauk Stereo’s books is:

May 6 Inventory 150

Cash 150

 Freight costs incurred by the seller

In contrast, freight costs incurred by the seller on outgoing merchandise are an operating expense
to the seller. These costs increase an expense account titled Freight-Out or Delivery Expense. If
the freight terms on the invoice had required PW Audio Supply (the seller) to pay the freight
charges, the entry by PW Audio Supply would be:

May 4 Freight-Out (or, Delivery expense) 150

Cash 150

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  Purchase Returns and Allowances

A purchaser may be dissatisfied with the merchandise received because the goods are damaged
or defective, of inferior quality, or do not meet the purchaser’s specifications. In such cases, the
purchaser may return the goods to the seller for credit if the sale was made on credit or for a cash
refund if the purchase was for cash. This transaction is known as a purchase return.
Alternatively, the purchaser may choose to keep the merchandise if the seller is willing to grant
an allowance (deduction) from the purchase price. This transaction is known as a purchase
allowance.

Illustration: Assume that on May 8 Sauk Stereo returned goods costing €300 to PW Audio
Supply. The following entry by Sauk Stereo for the returned merchandise decreases (debits)
Accounts Payable and decreases (credits) Inventory.

May 8 Accounts Payable 300

Inventory 300
Suppose instead that Sauk Stereo chose to keep the goods after being granted a €50 allowance
(reduction in price). It would reduce (debit) Accounts Payable and reduce (credit) Inventory for
€50.

 Purchase Discounts
The credit terms of a purchase on account may permit the buyer to claim a cash discount for
prompt payment. The buyer calls this cash discount a purchase discount. This incentive offers
advantages to both parties: The purchaser saves money, and the seller shortens the operating
cycle by more quickly converting the accounts receivable into cash.

The arrangements agreed upon by the buyer and the seller as to when payments for merchandise
are to be made is called the credit terms. If the payment is required upon delivery, the terms are
said to be “Cash term” or “Net cash term”. If the payment is not required upon delivery, the
buyer is allowed a certain period of time for payment; the term is known as the credit period.
The credit period usually begins with the date of the sale as shown by the date of the invoice or
the bill. Examples of Credit Period terms:
 n/30 (i.e. net 30 days) – payment will be made or due within 30 days after the date of the
invoice.
 n/EOM (i.e. net end of the month) – the payment will due by the end of the month in
which the sales was made.
 20/EOM (i.e. 20 end of the month) – Payment is due 20 days after the end of the month
in which the sales was made

In the sales invoice in the above Illustration (page 2) credit terms are 2/10, n/30, which is read
“two-ten, net thirty.” This means that the buyer may take a 2% cash discount on the invoice price
less (“net of”) any returns or allowances, if payment is made within 10 days of the invoice date

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(the discount period). Otherwise, the invoice price, less any returns or allowances, is due 30 days
from the invoice date.

To illustrate, assume Sauk Stereo pays the balance due of €3,500 (gross invoice price of €3,800
less purchase returns and allowances of €300) on May 14, the last day of the discount period.
The cash discount is €70 (€3,500 × 2%), and Sauk Stereo pays €3,430 (€3,500 - €70). The entry
Sauk Stereo makes to record its May 14 payment decreases (debits) Accounts Payable by the
amount of the gross invoice price, reduces (credits) Inventory by the €70 discount, and reduces
(credits) Cash by the net amount owed.

May 14 Accounts Payable 3,500

Cash 3,430
Inventory 70
Illustration: If Sauk Stereo failed to take the discount, and instead made full payment of $3,500
on June 3, the journal entry would be:
June 3 Accounts Payable 3,500
Cash 3,500

Summary of Purchasing Transactions

The following T-account (with transaction descriptions in blue) provides a summary of the effect
of the previous transactions on Inventory.

RECORDING SALES OF MERCHANDISE UNDER A PERPETUAL INVENTORY

SYSTEM

Sales may be made on credit or for cash. A business document should support every sales
transaction, to provide written evidence of the sale. Cash register tapes provide evidence of cash
sales. The original copy of the invoice goes to the customer, and the seller keeps a copy for use
in recording the sale. The invoice shows the date of sale, customer name, total sales price, and
other relevant information.

The seller makes two entries for each sale. The first entry records the sale: The seller increases
(debits) Cash (or Accounts Receivable, if a credit sale), and also increases (credits) Sales
Revenue. The second entry records the cost of the merchandise sold: The seller increases (debits)
Cost of Goods Sold, and also decreases (credits) Inventory for the cost of those goods.

To illustrate a credit sales transaction, PW Audio Supply records its May 4 sale of €3,800 to
Sauk Stereo (see the above May 4 Illustration) as follows (assume the merchandise cost PW
Audio Supply €2,400).
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May 4 Accounts Receivable 3,800
Sales Revenue 3,800

4 Cost of Goods Sold 2,400

Inventory 2,400
 Sales Returns and Allowances
We now look at the “flipside” of purchase returns and allowances, which the seller records as
sales returns and allowances. These are transactions where the seller either accepts goods back
from the buyer (a return) or grants a reduction in the purchase price (an allowance) so the buyer
will keep the goods. Sales Returns and Allowances is a contra revenue account to Sales
Revenue. The normal balance of Sales Returns and Allowances is a debit.

Illustration: Prepare the entry PW Audio Supply would make to record the credit for returned
goods that had a €300 selling price (assume a €140 cost). Assume the goods were not defective.

May 8 Sales return and Allowances 300

Accounts Receivable 300

8 Inventory 140
Cost of Goods Sold 140
Illustration: Assume the returned goods were defective and had a scrap value of €50, PW Audio
would make the following entries:

May 8 Sales return and Allowances 300

Accounts Receivable 300

8 Inventory 50
Cost of Goods Sold 50
 Sales Discounts

As mentioned in our discussion of purchase transactions, the seller may offer the customer a cash
discount—called by the seller a sales discount—for the prompt payment of the balance due.
Like Sales Returns and Allowances, Sales Discounts is a contra revenue account to Sales
Revenue. Its normal balance is a debit.

Illustration: Assume Sauk Stereo pays the balance due of €3,500 (gross invoice price of €3,800
less purchase returns and allowances of €300) on May 14, the last day of the discount period.
Prepare the journal entry PW Audio Supply makes to record the receipt on May 14.

May 14 Cash 3,430

Sales Discounts 70
Accounts Receivable 3,500
ACCOUNTING CYCLE TO A MERCHANDISING COMPANY

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  Adjusting Entries

• Generally same as a service company

• One additional adjustment to make records agree with actual inventory on hand
• Involves adjusting Inventory and Cost of Goods Sold
Illustration: Suppose that PW Audio Supply has an unadjusted balance of €40,500 in Inventory.
Through a physical count, PW Audio Supply determines that its actual merchandise inventory at
December 31 is €40,000. The company would make an adjusting entry as follows.

Dec. 31 Cost of Goods Sold 500

Inventory 500

 Closing Entries

A merchandising company, like a service company, closes to Income Summary all

accounts that affect net income. As shown below for PW Audio Supply, using assumed
data. Note that PW Audio Supply closes Cost of Goods Sold to Income Summary.
Dec. 31 Service Revenue 480,000
Income Summary 480,000
(Close credit balance accounts)

31 Income Summary 450,000

Cost of Goods Sold 316,000
Salaries and Wages Expense 64,000
Utilities Expense 17,000
Advertising Expense 16,000
Sales Returns and Allowances 12,000
Sales Discounts 8,000
Depreciation Expense 8,000
Freight-Out 7,000
Insurance Expense 2,000
(Close debit balance accounts)

Dec. 31 Income Summary 30,000

Retained Earnings 30,000
(To close net income to retained
earnings)

31 Retained Earnings 15,000

Dividends 15,000
(To close dividends to retained
earnings)

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FINANCIAL STATEMENTS FOR A MERCHANDISING COMPANY

 Income Statement
The income statement is a primary source of information for evaluating a company’s
performance. The format is designed to differentiate between the various sources of income and
expense.

 Income Statement Presentation of Sales

PW Audio Supply

Income Statement (partial)

For the Year Ended December 31, 2020

Sales
Sale revenue €480,000
Less: Sales returns and allowances €12,000
Sales discounts 8,000 20,000
Net sales €460,000

 Gross Profit
On the basis of the sales data for PW Audio Supply (net sales of €460,000) and cost of goods
sold under the perpetual inventory system (assume €316,000), PW Audio Supply’s gross profit is
€144,000, computed as shown.

Net Sales €460,000

Cost of goods sold 316,000
Gross profit €144,000
We also can express a company’s gross profit as a percentage, called the gross
profit rate.

Gross Profit ÷ Net Sales = Gross Profit Rate

€144,000 ÷ €460,000 = 31.3%

Analysts generally consider the gross profit rate to be more useful than the gross profit amount.

 Operating Expenses

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Incurred in the process of earning sales revenue. Operating expense for PW Audio Supply
include the following.

Operating expenses
Salaries and wages expense € 64,000
Utilities expense 17,000
Advertising expense 16,000
Depreciation expense 8,000
Freight-out 7,000
Insurance expense 2,000
Total operating expenses €114,000

 Other Income and Expense

Various revenues and gains and expenses and losses that are unrelated to the company’s main
line of operations.
Other Income
• Interest revenue from notes receivable and marketable securities
• Dividend revenue from investments in capital stock
• Rent revenue from subleasing a portion of the store
• Gain from the sale of property, plant, and equipment

Other Expense

• Casualty losses from such causes as vandalism and accidents

• Loss from sale or abandonment of property, plant, and equipment

• Loss from strikes by employees and suppliers

Interest expense, if material, must be disclosed on the face of the income statement.

Merchandising companies report other income and expense in the income statement immediately
after the company’s primary operating activities. The following Illustration shows this
presentation for PW Audio Supply.

Income Statement
PW Audio Supply
Income Statement
For the Year Ended December 31, 2020
Sales
Service revenue €480,000
Less: Sales returns and allowances €12,000
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 Sales discounts 8,000 20,000
Net sales 460,000
Cost of goods sold 316,000
Gross profit 144,000
Operating expenses
Salaries and wages expense 64,000
Utilities expense 17,000
Advertising expense 16,000
Depreciation expense 8,000
Freight-out 7,000
Insurance expense 2,000
Total operating expenses 114,000
Income from operations 30,000
Other income and expense
Interest revenue 3,000
Gain on disposal of plant assets 600
Casualty loss from vandalism 200 3,400
Interest expense 1,800
Net income € 31,600

 Comprehensive Income Statement

Presents items not included in the determination of net income. Items included in
comprehensive income are either reported in a combined statement of net income and
comprehensive income, or in a separate comprehensive income statement.

PW Audio Supply
Comprehensive Income Statement
For the Year Ended December 31, 2020
Net income
Other comprehensive income €31,600
Unrealized holding gain on investment securities 2,300
Comprehensive income €33,900

Classified Statement of Financial Position

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 PW Audio Supply
Statement of Financial Position (Partial)
December 31, 2020

Assets
Property, plant, and equipment
Equipment €80,000
Less: Accumulated depreciation 24,000 € 56,000
Current assets
Prepaid insurance 1,800
Inventory 40,000
Accounts receivable 16,100
Cash 9,500 67,400
Total assets €123,400

WORKSHEET FOR A MERCHANDISING COMPANY

As indicated in Chapter 2, a worksheet enables companies to prepare financial statements before
they journalize and post adjusting entries. The steps in preparing a worksheet for a
merchandising company are the same as for a service company. The following Illustration shows
the worksheet for PW Audio Supply (excluding non-operating items). The unique accounts for a
merchandiser using a perpetual inventory system are bold.

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PERIODIC INVENTORY SYSTEM

Determining Cost of Goods Sold Under a Periodic Inventory System

• No running account of changes in inventory

• Ending inventory determined by physical count

• Cost of goods sold not determined until the end of the period

PW Audio Supply
Cost of Goods Sold
For the Year Ended December 31, 2020
Cost of goods sold
Inventory, January 1 € 36,000
Purchases €325,000
Less: Purchase returns and allowances €10,400
Purchase 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

 Recording Merchandise Transactions

• Record revenues when sales are made

• Do not record cost of merchandise sold on date of sale.

• Physical inventory count determines:

 Cost of merchandise on hand and

 Cost of merchandise sold during the period

• Record purchases in Purchases account

• Purchase returns and allowances, Purchase discounts, and Freight costs are recorded in
separate accounts

Illustration: On the basis of the sales invoice (slide 31) and receipt of the merchandise ordered
from PW Audio Supply, Sauk Stereo records the €3,800 purchase as follows.

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May 4 Purchases 3,800
Accounts Payable 3,800
 Freight Costs

Illustration: If Sauk pays Public Freight Company €150 for freight charges on its purchase from
PW Audio Supply on May 6, the entry on Sauk’s books is:

May 6 Freight-in (Transportation-In) 150

Cash 150

 Purchase Returns and Allowances

Illustration: Sauk Stereo returns €300 of goods to PW Audio Supply and prepares the following
entry to recognize the return.

May 8 Accounts payable 300

Purchase Returns and Allowances 300
 Purchase Discounts
May 14 Accounts Payable 3,500
Purchase Discounts 70
Cash 3,430
 Recording Sales of Merchandise

Illustration: PW Audio Supply, records the sale of €3,800 of merchandise to Sauk Stereo on
May 4 (from the above sales illustration) as follows.

May 4 Accounts Receivable 3,800

Sales Revenue 3,800
 No entry is recorded for cost of goods sold at the time of the sale under a periodic system.

 Sales Returns and Allowances

Illustration: To record the returned goods received from Sauk Stereo on May 8, PW Audio
Supply records the €300 sales return as follows.

May 8 Sales Returns and Allowances 300

Accounts Receivable 300

 Sales Discounts
Illustration: On May 14, PW Audio Supply receives payment of $3,430 on account from Sauk
Stereo. PW Audio honors the 2% cash discount and records the payment of Sauk’s account
receivable in full as follows.

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May 14 Cash 3,430
Sales Discounts 70
Accounts Receivable 3,500

COMPARISON OF ENTRIES—PERPETUAL VS. PERIODIC

 Closing Entries
• All accounts that affect the determination of net income are closed to Income Summary

• In journalizing, all debit column amounts are credited, and all credit columns amounts are
debited

• Beginning inventory balance is debited to Income Summary and credited to Inventory

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• Ending inventory balance is debited to Inventory and credited to Income Summary

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