COMPLETING THE

8 ACCOUNTING CYCLE of a
MERCHANDISING ENTITY
TIME ALLOTMENT: 1 week (3 hours)

INTRODUCTION

Just like the service-concern business, the merchandising business completes the
accounting cycle by preparing the worksheet, adjusting entries, financial
statements, and closing of the accounts. It must be noted that in whatever
business, the accounting cycle is similar.

This chapter is composed of topics as follows: creation of adjusting entries,

preparation of worksheet, making of financial statements and the preparation of
closing entries, post-closing trial balance and reversing entries for a merchandising
entity.

LEARNING OBJECTIVES

Upon completion of this chapter, the students should be able to:

1. Journalize the adjusting entries for a merchandising entity.
2. prepare a worksheet for a merchandising entity.
3. differentiate the income statement of a service-concern and a
merchandising business.
4. prepare the closing entries, post-closing trial balance, and reversing entries.

ADJUSTMENTS OF INVENTORY ACCOUNT

At the end of the period, one the accounts that necessitates an entry is the
Merchandise Inventory account. As we discussed in the previous chapter, the
Inventory account is updated by physically counting the remaining inventory in the
warehouse. Thus, this updates the account – that is, the beginning inventory
balance is removed and transferred to the Income Summary account and the
ending inventory balance is established.

Assume that an entity has a beginning inventory of P700,000. During the

physical count at the end of the year, the ending inventory is P540,000.

There are two methods to update the Merchandise Inventory account: the
Adjusting Entry method and the Closing Entry method.

Under the adjusting entry method, the beginning balance of the

Merchandise Inventory account is closed to the Income Summary account, and
the ending Balance of the Merchandise Inventory account is established in the
Income Summary account also.
 Dec. 31 Income Summary xx
Merchandise Inventory, Beginning xx
To remove beginning balance of
merchandise inventory and transfer it to
income summary.

Dec. 31 Merchandise Inventory, End xx

IncomeToSummary
establish the ending inventory xx
balance.

Under the closing entry method, the entries are shown below.

Dec. 31 Income Summary xx

Merchandise Inventory, Beginning xx
Temporary accounts with debit balances xx
To close temporary accounts with debit
balances and to remove the beginnning
inventory

Dec. 31 Merchandise Inventory, Ending xx

Temporary accounts with credit balances xx
Income Summary xx
To close temporary accounts with credit
balances and to establisht the ending
inventory.

THE WORKSHEET
There is no difference in dealing with the worksheet of a merchandising
business and a service concern business except that the merchandising business
has to deal with the new accounts that is used only in its operations. These new
accounts are the following: Purchases, Purchases Returns and Allowances,
Purchases Discounts, Sales, Sales Returns and Allowances, Sales Discounts,
Freight In, and Freight Out.

THE FINANCIAL STATEMENTS

The complete set of financial statements for a merchandising entity are the
following:
1. Statement of Comprehensive Income
2. Statement of Financial Position
3. Statement of Changes in Equity
4. Statement of Cash Flows
5. Notes to the Financial Statements

In this chapter, we will be focusing on the Statement of Comprehensive

Income since the rest of the financial statements are similar to that of the service-
concern business.

Statement of Comprehensive Income

This statement is commonly called the Income Statement. There are two
methods to prepare an income statement of a merchandising entity: the Nature of
Expense Method and the Function of Expense Method.
 Using the nature of expense method, the expenses are combined in the
income statement and are not reallocated among the various functions within the
entity. Examples include the materials and consumables used, employee benefits
expense, depreciation and amortization expense, transportation costs, advertising
costs, and other expenses.

In contrast, the function of expense method of the income statement

classifies expenses according to their functions like cost of sales, selling,
administrative, and other operating expenses. This method is also called the cost
of sales method.

The following example presents the function of expense method in

preparing the income statement.

(Name of Company)
Income Statement
For the year ended _____________

Sales xx
Less: Sales Discounts xx
Sales Returns and Allowances xx
Net Sales xx
Cost of Goods Sold
Merchandise Inventory, Beginning xx
Add: Purchases xx
Freight In xx
Less: Purchase Returns and Allowances xx
Purchase Discounts xx
Net Purchases xx
Cost of Goods Available For Sale xx
Less: Merchandise Inventory, Ending xx
Cost of Goods Sold xx
Gross Profit xx
Less: Operating Expenses xx
Finance Costs xx
Profit xx

The difference between the two methods is in the operating profit. The
choice between the two methods depend on the industry factors and the nature of
the entity.

ADJUSTING AND CLOSING ENTRIES

There is no difference in the adjusting and closing entries of a

merchandising business and a service-concern except that new accounts are
used.

In other words, accruals, deferrals, depreciation, allowance for doubtful

accounts are treated in a similar manner as it is in a service-concern business.
However, as for the inventory account, you may use the adjusting entry method or
the closing entry method to update its current balance.

Note that the adjusting entries are necessary to update the accounts,
reflecting appropriate amounts of revenues, expenses, assets, liabilities, and
owners’ equities for financial statement preparation. Also, closing entries are
important to transfer net income or loss to capital, and to establish a zero balance
in each of the temporary accounts to start the accumulation in the next accounting
period.

The proforma closing entries are shown below.

Date Account Titles Debit Credit

(Year)
Dec. 31 Merchandise Inventory, end xx
Sales xx
Purchses Returns and Allowances xx
Purchase Discounts xx
Income Summary xx
To close temporary accounts
with credit balances and to
establish the ending
merchandise inventory.

Dec. 31 Income Summary xx

Merchandise Inventory, Beginning xx
Sales Returns and Allowances xx
Sales Discounts xx
Purchases xx
Freight In xx
Operating Expenses xx
Freight Out xx
To close temporary accounts
with debit balances and to
remove the ending
inventory.

Dec. 31 Income Summary xx

________, Capital xx
To close the income summary
account.

Dec. 31 ________, Capital xx

_________, Withdrawals xx
To close the withdrawal
account.

DISCUSSION QUESTIONS:
1. Explain the main difference in the income statement of a service-concern
and a merchandising business.
2. What are the components of the Cost of Goods Sold account?
3. What entries are necessary to update the balance of the Inventory account?
4. Differentiate the nature of expense method from the function of expense
method.
TRUE OR FALSE
1. The primary difference between a service-concern business and a
merchandising business is in the determination of cost of goods sold.
2. Debiting income summary and crediting beginning inventory eliminates the
beginning inventory at the end of the period.
3. Using the function of expense method does not require the allocation of
operating expenses between functional classifications.
4. The determination of net cost of purchases would include the addition of
transportation in.
5. The worksheet of a merchandising company that uses the perpetual
inventory system will not have a Freight In account.
6. When preparing the closing entries under the periodic inventory system,
Sales and Purchases Returns and Allowances are both closed in the same
entry.
7. Sales Discounts is a contra-revenue account with a normal credit balance.
8. The closing entry for freight in account debits purchases and credits income
summary.
9. In the worksheet, the ending inventory amount will appear in the income
statement credit column and the balance sheet debit column.
10. The difference of the gross profit and the operating expenses is called the
operating profit.

Problem 1. Worksheet procedures.

Write a check mark (/) in the columns where a balance of the listed accounts
should be extended.

Income Statement Balance Sheet

Account Titles
Dr Cr Dr Cr
Merchandise Inventory, beginning
Merchandise Inventory, ending
Purchases
Purchase Returns and Allowances
Purchase Discount
Sales
Sales Returns and Allowances
Sales Discount
Transportation In
Transportation Out
Problem 2. Preparation of the Worksheet and Financial Statements

The following accounts balances relates to the transactions of Ling Kori

Company for the year ended December 31, 2017.

Travel Expense 188,000 Accounts Receivable 136,000

Sales 4,609,000 Accounts Payable 74,000
Sales Returns and Allowances 180,000 Cash in Bank 72,000
Sales Discounts 169,000 Transportation In 72,000
Salaries Expenses 800,000 Insurance Expense 23,000
Purchases 2,364,000 Interest Expense 208,000
Purchase Returns and Allowances 121,000 Kori, Capital 1,570,000
Purchase Discounts 172,000 Kori, Withdrawals 250,000
Prepaid Advertising 75,000 Land 400,000
Office Supplies 40,000 Merchandise Inventory 598,000
Office Equipment 570,000 Mortgage Payable 999,000
Office Building 1,600,000 Notes Payable due in 2 years 200,000

Additional information:
a. Office supplies charged to expense for the year amounted to P8,500.
b. Salaries of P30,000 remained unpaid as at year end.
c. Advertising expense amounted to P25,000 remained unexpired during the
year.
d. The office building was purchased January 1 of the present year and has
a life of fifteen years with a salvage value of P100,000. The Office
Equipment has a life of ten years from the date of purchase on June 30,
2017.
e. The inventory based on physical count is P700,000.

Required:
1. Prepare a worksheet.
2. Prepare the financial statements.
3. Prepare the adjusting and closing entries.