CHAPTER 3

ACCOUNTING CYCLE FOR MERCHANDISING BUSINESS

3.1. Characteristics of merchandising business
 Merchandising enterprise acquires merchandise for resale to customers. Difference Between
merchandising, manufacturing and service Enterprises:
- Merchandising enterprise acquires an item for resale to customers having the original
form. Ex. Retailers, whole sellers
- Manufacturing companies acquire raw material and convert the raw material in to
some product and sale the product.
- Service companies render a service to customers; these companies do not have any
inventory to be reported except supplies.
 New Accounts on the Income Statement:
- SALES= revenues collected from the sale of merchandise
- COST OF MERCHANDISE SOLD =is the total cost of merchandise sold during the period.
 [CGS or CMS = CMAFS – Cost of ending inventory ]
 COST OF MERCHANDISE AVAILABLE FOR SALE= the purchase price plus
incidentals of merchandise available for resale [beginning inventory +current
purchase]
- GROSS PROFIT = Sales – Cost of merchandise sold
- Operating income[income from operation] = gross profit – operating expenses
- Net income[Net profit] = operating income +[other income – other expenses]
- MERCHANDISE INVENTORY= Merchandise on hand (not sold) at the end of an accounting
period
Merchandise: the manufactured goods bought and resold in any business.
: The stock of goods in a store.
Inventory or stock: Are the goods and materials that a business holds for the ultimate purpose of
resale (repair). It is a complete list of items such as goods in store, property or the contents of a
building.
3.2. Accounting for purchases of merchandises
Purchases of merchandise are usually identified in the ledger as purchases.
A merchandise enterprise can accumulate in the purchases account the cost of all merchandise purchased
for resale during the accounting period. When purchases are made for cash, the transaction could be
recorded as follows:
Jan.1 Purchases…………………….100
Cash……………………………..100
Most purchases are made on account and could be recorded as follows:
Jan. Purchases……………………..100
Accounts payable………………...100
Purchase discounts
 The arrangements agreed upon by the buyer and the seller as to when payments for merchandise
are to be made is called credit terms.
 If payment is required immediately up on delivery, the terms are said to be “cash” or “net cash”
otherwise the buyer is allowed a certain amount of time, known as the credit period, in which to
pay.
 It is usual for the credit to begin with the date of sale as shown by the date of invoice or bill. If
payment is due within a stated number of days after the date of invoice, say 60days, the terms are
said to be “net 60days” which may be written as “n/60”
 If payment is due by the end of the month in which sales was made, it may be expressed as
“n/eom.”
As a means of encouraging payments before the end of credit period, the seller may offer a discount
[reduction or price cut] for early payment of cash. Thus, the expression “4/20, n/60” means that, though
the credit period is 60 days, the buyer may deduct 4% of the amount of invoice if payment is made within
20 days after the invoice date. This deduction is known as cash discount.
From the buyer’s stand point, it is important to take advantage of all available discounts, even it is
necessary to borrow the money to make the payments, when the discount given is attractive as compared
with the market interest rate.
Example: If Faros company purchases merchandise costing 1,000birr on July 15. On
terms 2/10, n/30, the transaction is recorded under the two methods as follow:

Purchase------------------------1000
Accounts payable--------------------1000

If the payment is made with in the discount period (10 days for example above), the buyer is entitled to
pay the net amount (980). If payment is not made within the discount period, the discount is lost and the
total invoice amount (1000 here) going to be paid by the buyer.
Example for above
Payment within the Discount period
Accounts payable--------------1000
Purchase Discount---------------------20
Cash--------------------------------------980
Payment after Discount Period Expire
Accounts Payable----------------------1000
Cash-------------------------------------------1000
Purchase Returns and Allowances
Sometimes merchandise received from suppliers is defective or otherwise not acceptable. In such event,
the buyer may return it (purchase return) or the buyer may negotiate on price adjustment (purchase
Allowance). In either case part or all of the purchaser’s liability to the supplier is eliminated. The details
of why the return or allowance is requested may be stated in a letter called debit memorandum form used
by the buyer. The seller may confirm through credit memorandum.
Purchase returns and Allowance is a contra purchase account, same with purchase discount account.
NOTE:
Purchase returns – merchandise is returned to the seller
Purchase allowances – price adjustment
Debit memorandum – notification of the return or allowance by buyer.
Credit memorandum – confirmation or approval of the return or allowance by seller.
Example: X Company returned merchandise on account $200 to Y Company. The record will be as
follows:

Date Account PR Debit Credit

Mar 09 Accounts payable/Cash $200

Purchase returns and $200

Allowance

3.3. Accounting for sales of merchandises

Merchandise sales are usually identified in the ledger as sales. A more exact title “Sales of Merchandise”
could be used. A business may sale merchandise for cash. Such could be recorded as follows:
Cash…………………….XXX
 Sales………………………….XXX
A business may also sell merchandise on account (on credit). Such credit sale could be recorded as
follows:
Accounts Receivable…….XXX
Sales…………………………XXX

Sometimes sales of merchandise may be done through different credit cards. Sales to customers who use
bank credit cards (such as Master card and VISA) are generally treated as cash sales.
Sales made by the use of nonbank credit cards (such as American express) generally must be reported
periodically to the card company before cash is received. Therefore, such sales create a receivable with
the card company. Before the card company remits cash it normally deducts a service fee.
o To record American Express credit sales
Jan.1 Accounts Receivables……..1000
Sales……………………………1000
o To record receipt of cash from American Express from sales recorded on jan.1
Jan. 20 Cash…………………………………950
Credit Cash Collection Expense…….50
Accounts Receivable……………….1000
Sales Discount
o The terms for when payments for merchandise are to be made, are called credit terms. If
payment is required on delivery, the terms are cash or net cash. Otherwise, the buyer is allowed
an amount of time, known as the credit period, in which to pay.
o The seller refers to the discounts taken by the buyer for early payment of an invoice as sales
discounts. They are considered to be reductions in the amount initially recorded in sales. Thus,
the balance of sales discounts account is viewed as a contra or off setting or minus account to
sales.

Example: On January 22, Y company(seller) received the amount due,less the 2% discount from X
Company(buyer). The record by seller could be as follows:
Jan. 22 Cash………...............980
Sales Discounts……..20
Accounts Receivables…………….1000
.i.e. Discount {2%*1000} =20

Trade Discounts
Many manufacturers and whole sellers periodically publish catalogs advertising their merchandise at list
prices. However, a reduction from list price may be granted based on the volume of merchandise
purchased or on the nature of the purchaser (whole-seller, retailer, or ultimate consumer.)

A trade discount is a convenient means of making price reductions without reprinting catalogs. Thus
business may offer special discount from the list price for customers that order large quantities. Both
buyers and sellers do not normally record the list prices of merchandise and the related trade discounts in
their accounts.
.i.e. Trade discounts are not recorded in the accounts of either the seller or the buyer.
But are deducted from the product list price in arriving at the selling price; both the
Purchaser and seller record the transaction at the determined selling price.

Example 1: Wholesaler sells merchandise with a list price of 1,000 birr at a trade discount
of 20 percent, a sale of 800 will be recorded by the seller. Similarly purchase
of 800 is recorded by the buyer.
  If an additional cash (sales) discount is involved, it is based on invoice price rather on the list
(gross) price.
 Trade discounts are frequently stated in terms of a series of discounts, such as 25/20/10, i.e. 25%
of list price, 20% of remainder and again 10% of reminder.

Example 2: If a wholesaler sells merchandise with a list price of 1,000, at a trade discount
Stated as 25/20/10, then the items selling price would be:

List price-----------------1, 000

Less 25% discount---- (250)
Remainder--------------750
Less 20% discount ------ (150)
Remainder----------600
Less 10% discount------- 60
Selling price--------------- {540} is recorded both by seller and buyer
Sales Returns and Allowances
To maintain good customer relationship, many businesses permit buyers to return merchandise (sales
Return) so long as it is damaged and is returned within a reasonable period. In some situations the
purchaser may prefer to retain the goods, rather than return them, provided a price adjustment (sales
allowance) is made.
The sales Returns and Allowance account is used to record both sales returns and sales allowances. If
the return or allowance is for sale on Account, the seller usually gives the buyer a credit memorandum,
which shows the amount in particular receivable account is to be credited and the reason therefore.
Example: If a merchandise costing 100 birr is returned:
The journal entry to record the return:
A. If the sale was made on credit
Sales Return and allowance--------100
Account Receivable------------------100
B. If the sale was made on cash:
Sales Returns and Allowance-------100
Cash---------------------------------------100
Transportation Costs (Freight Cost)
The terms of sale should indicate when the ownership (title) of the merchandise posses to the buyer. This
point determines which party the buyer or the seller, must pay transportation cost.

Freight Terms
  If ownership of the merchandise passes to the buyer when the seller delivers the merchandise to
the freight carrier, it is said to be FOB (free on board) shipping point.

Example: On June 10, X company buys merchandise from Magna data company on account, $900, terms
FOB shipping point and pays the transportation cost of $50.

 If ownership of the merchandise passes to the buyer when the buyer receives the merchandise, the
terms are said to be FOB (free on board) destination.
Example: On June 15, X Company sells merchandise to Kranz Company on account, $700, terms FOB
destination. The cost of the merchandise sold is $480. X Company pays freight of $40

Sales Tax
Businesses that purchase merchandise for resale to others are normally exempt from paying sales taxes on
their purchases. Only final buyers (ultimate users of the item) normally pay sales taxes. The liability for
the sales tax is ordinarily incurred at the time sale is made regardless of the terms of sale.
Cash (Account Receivable) --------xx
Sales-------------------------------xx
Sales tax payable-----------------xx
Example: a sale of merchandise for 1000birr on Account subject to a 4% sales tax is recorded:
Account Receivable ------------1,040
Sale---------------------------------1000
Sales Tax payable----------------- 40
Periodically, the appropriate amount of sales tax is paid to the taxing unit, and sales Tax payable is
debited .i.e.,
Sales Tax Payable……….40
Cash…………………………...40
Note: Sales tax is:-
Liability to the business
Create a SALES TAX PAYABLE account

SUMMARY
Seller Buyer
 Sold merchandise on account: Purchased merchandise on
Accounts receivable DR account:
Sales CR Merchandise Inventory/Purchase
Cost of merchandise sold DR DR
Merchandise inventory CR if Accounts Payable CR
perpetual
Transportation costs Shipping point Transportation costs Shipping
point:
Merchandise Inventory/Purchase
DR
Cash CR
Transportation costs – Destination: Transportation costs -
Delivery Expense DR Destination
Cash CR
Merchandise returned: Merchandise returned:
Sales Returns & Allowances DR Accounts Payable/Cash DR
Accounts receivable/Cash Purchase Return &
CR Allowance /Merchandise
Merchandise inventory DR Inventory CR
Cost of merchandise sold CR
perpetual
Payment : Payment:
Cash DR Accounts payable DR
Accounts receivable CR Cash CR
Payment with discount: Payment with discount:
Cash DR Accounts Payable DR
Sales discount DR Purchase Discount
Accounts receivable CR /Merchandise Inventory
CR
Cash
CR

 When merchandise is sold, the revenue is reported as sales, and its cost is recognized
as an expense called cost of merchandise sold.
 Merchandise on hand (not sold) at the end of an accounting period is called merchandise
inventory.
3.4. Merchandise transactions using perpetual and periodic inventory systems
There are two main systems for accounting for merchandise held for sale:
 Periodic inventory system
 Perpetual inventory system
Note: Many merchandising enterprises use the periodic system
1. Periodic inventory system:
Under this system the cost of all merchandise purchased is accumulated in a “Purchase” account;
i.e. when purchases are made for cash or on account the transactions are recorded as follow:
Purchase-------------------------------------------xx
Cash (Account payable) --------------------------xx
When sales are made, the revenues from sales are recorded, but no attempt is made on the sales
date to record the cost of merchandise sold. The cost of merchandise sold during the period and
the cost of inventory on hand is determined through the physical count of inventory and cost
flow assumptions.

2. Perpetual Inventory system:

Features:
1. Purchases increase Merchandise Inventory.
2. Freight costs, Purchase Returns and Allowances and
Purchase Discounts are included in Merchandise Inventory.
3. Cost of Goods Sold is increased and Merchandise
Inventory is decreased for each sale.
4. Physical count done to verify Merchandise Inventory
balance.
The perpetual inventory system provides a continuous or perpetual record of Merchandise
Inventory and Cost of Goods Sold.
Example: March Transactions Periodic inventory system Perpetual inventory system
3.5. Charts of accounts for merchandising business

3.6. Financial Statements

The basic financial statements for merchandising enterprise include: Income statement, statement of
owner’s Equity, and balance sheet. The basic difference between the financial statement of a
merchandising enterprise and a service enterprise include the cost of merchandise sold section of the
income statement, and the inclusion of merchandise inventory on the balance sheet as current asset.

Income Statement
There are two widely used formats for preparing an income statement for a merchandising business:
Multiple step and single step.
1. Multiple-step Form
The multiple-step income statement contains several section, subsections and subtotals. In practice,
there is considerable variation in the amount of detail presented in these sections. For example instead
of reporting separately the gross sales and related returns, allowances and discounts, the statement
may begin with net sales. Similarly, the supporting data for the determination of the cost of goods sold
may be omitted from the statement.
A- Typical model of a multiple-step income statement
 1. Single-step Form
In a single-step income statement, the total of all expenses is deducted in one step from the total of all
revenues. The single-step form emphasizes total revenues and total expenses as the factors that
determine net income. A criticism of a single-step form is that such amounts, as gross profit and income
from operations are not readily available for analysis. But its advantage is that it is simple.

A typical model for a single-step income statement

Note: the statement of Retained earnings is prepared only for corporate form of business.

Statement of Owner’s Equity

For sole proprietorship and partnership form of business, statement of owner’s Equity is prepared. The
statement of owner’s equity for merchandising business is prepared in the same manner for service
business.

A typical model for statement of Owner’s Equity:

Balance Sheet
The balance sheet of a merchandising business could be prepared in any of the formats discussed in
earlier chapters; i.e. Account form (Liabilities and owner’s equity on the right hand side and assets on the
left hand side), Report form or financial position format (down ward sequence of assets, liabilities and
owner’s Equity). The balance sheet of a merchandising business is slightly different from that of service
business because of the inclusion of merchandise inventory at the end of the period in the current asset
section of the merchandising business.
A typical model of Balance sheet:

3.7. Adjusting and closing entries for a merchandising business

Adjusting Entries for Merchandising Business:

Merchandise adjustments
The best method of making the data reading available, for reporting the cost of merchandise inventory,
is to maintain a separate account entitled merchandise Inventory. Throughout an accounting period this
account shows the inventory at the beginning of the year under periodic inventory system. At the end
of the period it is necessary to remove from merchandise inventory at the beginning of the period and
to replace it with the amount representing the inventory at the end of the period.
This is accomplished by two adjusting entries. The first entry transfers the beginning inventory to
Income summary. Since this beginning inventory is part of the cost of merchandise sold, it is debited to
Income summary. It is also a subtraction from the asset account, Merchandise Inventory, hence is
credited to merchandise inventory.
For the amount of beginning
Income summary------------xx inventory
Merchandise Inventory--------xx
To transfer the beginning inventory to Income summary

The second adjusting entry debits the cost of the merchandise inventory at the end of the period to the
asset account, merchandise Inventory. The credit portion of the entry effects a deduction of the unsold
merchandise from the cost of merchandise available for sale during the period.
For the amount of ending
Merchandise Inventory-----------xx inventory
Income Summary--------xx

NOTE: Adjustments for Deferrals and Accruals is the same with what was discussed in previous
chapter. In addition, Worksheet is also same.

Closing entries
The closing entries for a merchandising business are similar to those for service business.

Step 1: Closing Entries

Debit each temporary account with a credit balance, such as Sales, for its balance and credit Income
Summary.

Step 2: Closing Entries

Credit each temporary account with a debit balance, such as an expense, for the balance and credit
Income Summary.

Step 3: Closing Entries

Debit Income Summary for the amount of its balance (net income) and credit the owner’s equity
account.

Step 4: Closing Entries

Debit the owner’s capital account for the balance of the drawing account and credit the drawing
account.