ACCOUNTING FOR MERCHANDISING
KEY TERMS AND CONCEPTS TO KNOW
Content of this Review Note are as follows:
MERCHANDISING OPERATIONS
A merchandising business is an enterprise that buys and sells merchandise as their primary
source of revenue rather than performing services. This merchandise is presented as “Merchandise
Inventory” in the current asset section of the balance sheet. The revenue generated is called sales
revenue or sales. Expenses are divided into two categories: (1) Cost of Goods Sold or Cost of Sales and
(2) Operating expenses.
Income measurement
process for a merchandising
entity
Types of Merchandising Operations
1. Retail – a business that purchase merchandise and sells directly to consumers.
2. Wholesale – a business that buys large quantity of merchandise from different manufacturers
and then resell this to different retailers.
2019
ACCOUNTING FOR MERCHANDISING
KEY TERMS AND CONCEPTS TO KNOW
Operating Cycles
The series of transactions through which a business generate its revenue and its cash receipts
from consumers. The operating cycle of a merchandising business ordinarily is longer than that of a
servicing. The purchase of merchandise inventory and its eventual sale lengthen the cycle. The
operating cycle of a merchandising company and servicing company (for comparison) is as follows:
Operating Cycle for a
Service Business and a
Merchandise Business
Flow of costs
A merchandising business may opt to use a perpetual or periodic inventory system in
determining cost of goods sold.
Perpetual System
In a perpetual inventory system, businesses keep detailed records of the cost of each inventory
transactions (purchase and sale). A business determines cost of goods sold immediately each time a sale
occurs. Record is “up-to-date” all the time.
Periodic System
In a periodic inventory system, businesses do not keep detailed 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.
To determine Cost of Goods sold using periodic system, the following steps are necessary:
1. Determine the Inventory at the beginning of the period.
2019
ACCOUNTING FOR MERCHANDISING
KEY TERMS AND CONCEPTS TO KNOW
2. Add the cost of goods purchased
3. Subtract the inventory determined at the end of the period.
Comparing Perpetual
System and Periodic
System
T-account Summary for Merchandise Inventory
PURCHASE TRANSACTIONS
Businesses 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 cancelled check or a cash register receipt, for example, indicates the items purchased
and amounts paid for each cash purchase.
2019
ACCOUNTING FOR MERCHANDISING
KEY TERMS AND CONCEPTS TO KNOW
A purchase invoice should support each credit purchase. This invoice indicates the total purchase price
and other relevant information. The purchaser uses the copy of a Sales Invoice sent by the seller as a
purchase invoice.
A sale on cash/credit is recorded/journalized as follows:
Periodic Inventory System
Perpetual Inventory System
Freight Costs
The Sales Agreement should indicate who – the seller or the buyer – is to pay for transporting
the goods to the buyer’s place of business. When a common carrier transports the goods, the carrier
prepares a freight bill in accord with the sales agreement.
Freight terms are expressed as either FOB shipping point or FOB destination. The letters FOB mean “free
on board”. Thus, FOB shipping point means that the seller places the goods free on board the carrier,
and the buyer pays for the freight costs. Ownership is transferred only upon shipping and any freight
cost must be paid by the buyer.
Conversely, FOB destination means that the seller places the goods free on board to the buyer’s place
of business, and the seller pays for the costs. Ownership is transferred only upon receiving of the goods
at the buyer’s place of business and any freight cost must be paid by the seller.
Purchase returns and allowances
A purchaser may be dissatisfied with the merchandise received because the goods may be
damaged or defective, of inferior quality, or not in accord with the purchaser’s specifications. The
purchaser may return the merchandise (purchase return), or choose to keep the merchandise if the
2019
ACCOUNTING FOR MERCHANDISING
KEY TERMS AND CONCEPTS TO KNOW
supplier is willing to grant an allowance (deduction) from the purchase price (purchase allowance).
When merchandise is returned, inventory is credited.
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.
If a purchase discount has terms “3/10, n/30” then a 3% discount is taken on the invoice price If
payment is made within 10 days. If the payment is not made within 10 days, there is no purchase
discount, and the net amount of the bill is due within 30 days.
When an invoice is paid within the discount period, the amount of the discount is credited to inventory.
When an invoice is not paid within the discount period, then the usual entry is made with a debit to
Accounts payable and a credit to Cash.
For the following examples, let’s use perpetual inventory system.
Example 1 – CASH PURCHASE, FOB SHIPPING POINT
P800 of inventory is purchased for cash, FOB shipping point.
In a separate transaction, the purchaser pays P100 of shipping charges to the shipping company, which
are added to the cost of the inventory as “freight-in”. Therefore the total cost of the inventory
purchased is P900 (P800 purchase price + P100 freight-in).
When goods are not yet shipped by seller, No entry.
When goods are on shipment:
Merchandise Inventory 900
Cash 900
To record purchases for cash
When goods are received, no additional entry required.
P200 of merchandise purchased is returned for refund:
Cash 200
Merchandise Inventory 200
To record purchase return
2019
ACCOUNTING FOR MERCHANDISING
KEY TERMS AND CONCEPTS TO KNOW
Note:
1. Journal entry was made only after the goods were being shipped by the seller.
2. Buyer paid for the freight cost. If seller prepaid it, recognition of payable will be made.
3. Freight cost was added to the cost of inventory and treated as “freight-in”.
4. Check discussion for FOB shipping point.
Example 2 – PURCHASE ON ACCOUNT, FOB SHIPPING POINT
P800 of inventory is purchased on account, FOB shipping point.
The seller pays P100 to the shipping company on behalf of the buyer, which is added to the seller’s
invoice (freight-in). The credit terms offered by the seller are 2/10, n/30. Therefore the total cost of
the inventory purchased is P900 (P800 purchase price + P100 freight-in):
When goods are not yet shipped, no entry yet.
When goods are shipped, entry is:
Merchandise Inventory 900
Accounts Payable 900
To record purchases on account
When goods are received, no additional entry.
P200 of merchandise purchased is returned prior to payment.
Accounts Payable 200
Merchandise Inventory 200
To record purchase returns
**When the invoice is paid within the discount period
P800 purchase - P200 return = P600 merchandise * 2% = P12 discount
P700 owed (P600 + P100 shipping) - P12 discount = P688 paid
Accounts Payable 700
Cash 688
Merchandise Inventory 12
To record payment of purchases within discount period
**When the invoice is paid after the discount period
Accounts Payable 700
Cash 700
2019
ACCOUNTING FOR MERCHANDISING
KEY TERMS AND CONCEPTS TO KNOW
To record payment of purchases after discount period
Note:
1. Journal entry was made only after the goods were being shipped by the seller.
2. Seller paid freight on behalf of buyer. Thus, this cost is payable to the seller.
3. Freight cost was added to the cost of inventory. However for discount computation, freight-in
was ignored.
4. Check discussion for FOB shipping point.
Example 3 – PURCHASE ON ACCOUNT, FOB DESTINATION.
P700 of inventory is purchased on account, FOB destination.
In a separate transaction, the seller pays P100 of shipping charges to the shipping company. The buyer
records only the cost of the merchandise. The credit terms offered by the seller are 2/10, n/30.
Therefore the total cost of the inventory purchased is P700 purchase price.
When goods are not yet shipped, NO ENTRY YET.
When goods are on shipment, NO ENTRY YET.
When goods are received by buyer:
Merchandise Inventory 700
Accounts Payable 700
To record purchases on account
P200 of merchandise purchased is returned prior to payment.
Accounts Payable 200
Merchandise Inventory 200
To record purchase returns
**When the invoice is paid within the discount period
P700 purchase - P200 return = P500 merchandise * 2% = P10 discount
P500 owed - P10 discount = P490 paid
Accounts Payable 500
Cash 490
Merchandise Inventory 10
To record payment of purchases within discount period
**When the invoice is paid after the discount period
Accounts Payable 500
2019
ACCOUNTING FOR MERCHANDISING
KEY TERMS AND CONCEPTS TO KNOW
Cash 500
To record payment of purchases after discount period
Note:
1. Journal entry is made only when goods arrived at buyer’s place of business.
2. Seller paid for the freight. If the buyer pays on behalf of the seller, amount payable will be
reduced by the amount of freight paid.
3. Shipping cost was not treated as “freight-in” and not included as part of inventory.
4. Check discussion for FOB Destination.
SALES TRANSACTIONS
Companies record sales revenues, like service revenues, when earned, in compliance with the
revenue recognition principle. Typically, companies earn sales revenues when the goods are transferred
from the seller to the buyer. At this point the sales transaction is complete and the sales price
established.
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. A sales invoice,
provides support for a credit sale. 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 cash or
Accounts Receivable for credit sale, and also increases Sales for the invoice price of the goods The
second entry records the cost of the merchandise sold: The seller increases Cost of Goods Sold and also
decreases Merchandise Inventory for those goods. As a result, the Merchandise Inventory account will
show at all times the amount of inventory that should be on hand.
In accordance with the revenue recognition principle, companies record sales revenues when the
performance obligation is satisfied. Typically, the performance obligation is satisfied when the goods are
transferred from the seller to the buyer. “Delivery transfers Ownership”
A sale on cash/credit is recorded/journalized as follows:
Periodic Inventory System
Cash or Accounts Receivable xx
Sales Revenue xx
Perpetual Inventory System
Cash or Accounts Receivable xx
Sales Revenue xx
2019
ACCOUNTING FOR MERCHANDISING
KEY TERMS AND CONCEPTS TO KNOW
Cost of Goods Sold xx
Merchandise Inventory xx
Sales Returns and Allowances
We now look at the flipside of purchase returns and allowances, which the seller records as
sales returns and allowances. Sales Returns and Allowances is a contra-revenue account to Sales. Its
normal balance is a debit. Companies use a contra account, instead of debiting Sales, to disclose in the
accounts and in the income statement the amount of sales returns and allowances. Disclosure of this
information is important to management: Excessive returns and allowances may suggest problems –
inferior merchandise, inefficiencies in filling orders, errors in billing customers, or delivery or shipment
mistakes. Moreover, a decrease recorded directly to Sales would obscure the relative importance of
sales returns and allowances as a percentage of sales. It also could distort comparisons between total
sales in different accounting periods.
A sales return results when a customer is dissatisfied with merchandise and is allowed to return goods
to the seller for credit or for a cash refund. A sales allowance results when a customer is dissatisfied with
merchandise and the seller is willing to grant an allowance (deduction) from the selling price.
To give the customer a sales return or allowance, the seller normally makes the following entry if the
sale was a credit sale (the second entry is made only if the goods are returned):
Sales Returns and Allowances xx
Accounts Receivable xx
Inventory xx
Cost of Goods Sold xx
For a sales return or allowance on a cash sale, a cash refund is made and cash is credited instead of
Accounts Receivable. The second entry is the same as above.
Sales returns and allowances is a contra revenue account and the normal balance of the account is a
debit.
Sales Discounts
A Sales Discount is the offer of a cash discount to a customer for the prompt payment of a
balance due. If a credit sale has a terms 2/10, n/30, then a 2% discount is taken on the invoice price (less
any returns or allowances) if payment is made within 10 days. If payment is not made within 10 days,
then there is no sales discount, and the net amount of the bill without discount is due within 30 days.
Sales Discounts is a contra-revenue account and the normal balance of this account is a debit
Both Sales Returns and Allowances and Sales Discounts are subtracted from Sales Revenue in the
income statement to arrive at net sales.
2019
ACCOUNTING FOR MERCHANDISING
KEY TERMS AND CONCEPTS TO KNOW
For the following examples, let’s use perpetual inventory system.
Example 1 – Sale for cash, FOB shipping point
Inventory is sold for P900 cash with 20% mark up on inventory cost.
In a separate transaction, the purchaser pays P100 of shipping charges to the shipping company. The
total cost of the inventory when purchased was P750 (P900 / 1.20).
When goods are not yet shipped, no entry.
When goods are shipped by the seller:
Cash 900
Sales 900
Cost of Goods Sold 750
Merchandise Inventory 750
To record Sales for Cash
P180 of merchandise sold is returned by the customer:
Sales Returns and Allowances 180
Cash 180
Merchandise Inventory 150
Cost of Goods Sold 150
To record Sales Returns
Note:
1. Journal entry was made only upon shipping.
2. Shipping cost was not recorded in seller’s book. This is because the buyer, who is the rightful
owner of the goods, paid for the freight. Thus, buyer must make an entry by debiting Inventory
(freight-in) and crediting Cash.
3. If seller paid for freight on behalf of buyer, receivable will be made.
4. Check discussion for FOB shipping point.
Example 2 – Sales on account, FOB Shipping point
P900 of inventory is sold on account, FOB shipping point.
The seller pays P100 to the shipping company on behalf of the buyer, which is added to the seller’s
invoice. The credit terms offered by the seller are 2/10, n/30. Therefore the total account receivable is
2019
ACCOUNTING FOR MERCHANDISING
KEY TERMS AND CONCEPTS TO KNOW
P900 selling price + P100 shipping charges. The total cost of the inventory when purchased was P750
(P900 / 1.20).
When the goods are shipped:
Accounts Receivable 1000
Sales 900
Cash 100
Cost of Goods Sold 750
Merchandise Inventory 750
To record sales on account
P180 of merchandise purchased is returned prior to payment.
Sales Returns and Allowances 180
Accounts Receivable 180
Merchandise Inventory 150
Cost of Goods Sold 150
To record sales returns
**When the invoice is paid within the discount period
P900 sold – P180 return = P720 merchandise * 2% = P14.40 discount
P820 receivable (P720 + P100 shipping) – P14.40 discount = P805.60 collected
Cash 805.60
Sales Discounts 14.40
Accounts Receivable 820
To record payment within the discount period
**When the invoice is paid after the discount period
Cash 820
Accounts Receivable 820
To record payment after the discount period
Note:
1. Journal entry was made only upon shipping.
2. Seller paid for freight on behalf of buyer, receivable is due from the buyer.
3. Check discussion for FOB shipping point.
Example 3 – Sales on account, FOB Destination
P900 of inventory is sold on account, FOB Destination.
In a separate transaction, the seller pays P100 to the shipping company. The total cost of the inventory
when purchased was P750 (P900 / 1.20).
When goods are on shipment:
2019
ACCOUNTING FOR MERCHANDISING
KEY TERMS AND CONCEPTS TO KNOW
Transportation Out 100
Cash 100
To record shipping cost
When goods are received by buyer:
Accounts Receivable 900
Sales 900
Cost of Goods Sold 750
Merchandise Inventory 750
To record sales on account
P180 of merchandise sold is returned prior to payment.
Sales Returns and Allowances 180
Accounts Receivable 180
Merchandise Inventory 150
Cost of Goods Sold 150
To record sales returns
**When the invoice is paid within the discount period
P900 sold – P180 return = P720 merchandise * 2% = P14.40 discount
P720 receivable – P14.40 discount = P705.60 collected
Cash 705.60
Sales Discounts 14.40
Accounts Receivable 720
To record payment within the discount period
COMPLETING THE ACCOUNTING CYCLE
We have illustrated the basic accounting entries for transactions relating to purchases and sales in a
perpetual inventory system. Now consider the remaining steps in the accounting cycle for a
merchandising company.
Adjusting Entries
A merchandising company generally has the same types of adjusting entries as a service company but a
merchandiser using a perpetual inventory system will require an additional adjustment to reflect the
difference between a physical count of the inventory and the accounting records. Thus, the company
needs to adjust the perpetual records to make the recorded inventory amount agree with the inventory
on hand. This involves adjusting Merchandise Inventory and Cost of Goods Sold.
2019
ACCOUNTING FOR MERCHANDISING
KEY TERMS AND CONCEPTS TO KNOW
Closing Entries
Like a service company, a merchandising company closes all accounts that affect net income to Income
Summary. In journalizing, the company credits all temporary accounts with debit balances, and debits all
temporary accounts with credit balances.
Summary of Merchandising Entries
Glossary
Contra-revenue account – an account that is offset against a revenue account on the income statement
Cost of goods sold – the total cost of merchandise sold during the period
FOB destination – freight terms indicating that the seller places the goods free on board to the buyer’s
place of business and the seller pays the freight.
FOB shipping point – Freight terms indicating that the seller places goods free on board the carrier, and
the buyer pays the freight costs
2019
ACCOUNTING FOR MERCHANDISING
KEY TERMS AND CONCEPTS TO KNOW
Gross Profit – the excess of net sales over the cost of goods sold
Gross profit rate – Gross profit expressed as a percentage by dividing the amount of gross profit by net
sales
Income from operations – Income from a company’s principal operating activity; determined by
subtracting cost of goods sold and operating expenses from net sales
Multiple-step income statement – An income statement that shows several steps in determining net
income
Net Sales – Sales less sales returns and allowances and less sales discounts
Non-operating activities – various revenues, expenses, gains, and losses that are unrelated to a
company’s main line of operations
Operating expenses – Expenses incurred in the process of earning sales revenues
Other expenses and losses – A non-operating activities section of the income statement that shows
expenses and losses unrelated to the company’s main line of operations.
Other revenues and gains – A non-operating activities section of the income statement that shows
revenues and gains unrelated to the company’s main line of operations.
Periodic inventory system – An inventory system under which the company does not keep detailed
inventory records throughout the accounting period but determines the cost of goods sold only at the
end of an accounting period.
Perpetual inventory system – An inventory system under which the company keeps detailed records of
the cost of each inventory purchase and sale and the records continuously show the inventory that
should be on hand.
Purchase allowance – A deduction made to the selling price of merchandise, granted by the seller so
that the buyer will keep the merchandise.
Purchase discount – A cash discount claimed by the buyer for prompt payment of a balance due.
Purchase invoice – A document that supports each credit purchase.
Purchase return – A return of goods from the buyer to the seller for a cash or credit refund.
Sales discount – A reduction given by a seller for prompt payment of a credit sale.
Sales Invoice – A document that supports each credit sale
Sales returns and allowances – Purchase returns and allowances from the seller’s perspective
Sales revenue (Sales) – The primary source of revenue in a merchandising company
2019
ACCOUNTING FOR MERCHANDISING
KEY TERMS AND CONCEPTS TO KNOW
Single-step income statement – An income statement that shows only one step in determining net
income.
2019
