Chapter 5—Accounting for Merchandising Operations

Study Objectives:1. Identify the differences between a service enterprise and a merchandising

company.2. Explain the entries for purchases under a perpetual inventory system.3. Explain the entries for sales revenues under a perpetual inventory system.4. Explain the steps in the accounting cycle for a merchandising company.5. Distinguish between a multiple-step and a single-step income statement.6. Explain the computation and importance of gross profit. 7. Determine cost of goods sold under a periodic system.

I. Merchandising OperationsA. Introduction

1. A merchandising company is an enterprise that buys and sells goods to earn a profit.a) Wholesalers sell to retailers such as grocery stores,

drugstores, and restaurants. Examples of retailers would be Wal-Mart, Safeway, and Toys “R” Us.

b) Retailers sell to consumers and usually are those who purchase goods in bulk from manufacturers and sell them to retailers, other wholesalers, schools and other not-for-profit institutions, and, at times, directly to consumers. For example, retailer Walgreens might buy goods from wholesaler McKesson HBOC; Office Depot might buy office supplies from wholesaler United Stationers.

2. Define merchandise (or merchandise inventory)—goods held for sale to customers in the normal course of business. Note that this includes only goods held for resale. For example, if a grocery store decided to sell an old display case, this would not be merchandise because grocery stores do not normally sell display cases. But a display case would be merchandise for a furniture store. Merchandise for one firm may be an asset for another. The merchandise (display cases) for the furniture store is an asset for the grocery store.

3. A merchandiser’s primary source of revenue is sales revenue or sales.

4. Expenses for a merchandising company are divided into two categories:a) cost of goods sold (COGS)—total cost of merchandise

sold during the period andb) Operating expenses (OP)—expenses incurred in the

process of earning sales revenue that are deducted from gross profit in the income statement). Examples are sales salaries and insurance expense.

5. Gross profit (GP) is equal to Sales Revenue less Cost of Goods Sold.

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6. Income measurement process for a merchandiser: Sales - COGS = Gross Profit - Operating Exp. = Net Income (Loss)

B. Operating Cycles—Operating Cycles for a service company and a merchandiser:1. Service Company operating cycle (to go from cash to cash)

involves performing services which may be on account involving accounts receivable and finally receiving the cash.

2. Merchandising Company operating cycle (cash to cash) involves:a) Buy Inventory,b) Sell Inventory,c) Obtain Accounts Receivable, andd) Receive Cash.

C. Inventory Systems—Merchandising entities may use either of the following inventory systems:

a) Perpetual System —Detailed records of the cost of each item are maintained, and the cost of each item sold is determined from records when the sale occurs. For example, a Ford dealership has separate inventory records for each vehicle on the lot.

b) Record purchase of Inventory.c) Record revenue and record cost of goods sold when the

item is sold.d) At the end of the period, no entry is needed except to

adjust inventory for losses, etc.2. Periodic System —Cost of goods sold is determined only at

the end of an accounting period. This system involves:a) Record purchase of Inventory.b) Record revenue only when the item is sold.c) At the end of the period, you must compute cost of

goods sold (COGS):1) Determine the cost of goods on hand at the

beginning of the accounting period (Beginning Inventory = BI),2) Add it to the cost of goods purchased (COGP),3) Subtract the cost of goods on hand at the

end of the accounting period (Ending Inventory = EI) illustrated as follows:

BI + COGP = Cost of goods available for sale - EI = COGS3. Additional Considerations

a) Perpetual systems have traditionally been used by companies that sell merchandise with high unit values such as automobiles, furniture, and major home appliances. But with the

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use of computers and scanners, many companies now use the perpetual inventory system.

b) The perpetual inventory system is named because the accounting records continuously—perpetually—shows the quantity and cost of the inventory that should be on hand at any time. The periodic system only periodically updates the cost of inventory on hand.

c) A perpetual inventory system provides better control over inventories than a periodic inventory since the records always show the quantity that should be on hand and then any shortages from the actual quantity and what the records show can be investigated immediately.

II. Recording Purchases and Sales of Merchandise under the Perpetual SystemA. PURCHASES OF MERCHANDISE : MERCHANDISE

PURCHASE ENTRIES FOR A MERCHANDISER (PERPETUAL SYSTEM):1. When merchandise is purchased for resale to customers, the

account, Merchandise Inventory, is debited for the cost of goods purchased.

2. Like sales, purchases may be made for cash or on account (credit).

3. The purchase is normally recorded by the purchaser when the goods are received from the seller.a) Each credit purchase should be supported by a

purchase invoice.b) A purchase invoice received by the buyer is actual a

sales invoice prepared by the seller.c) Note that only purchases of merchandise are debited to

Merchandise Inventory. Purchases if other assets: supplies, equipment, and similar items) are debited to their respective accounts.

B. PURCHASE RETURNS AND ALLOWANCES1. A purchaser may be dissatisfied with merchandise received

because the goodsa) 1) are damaged or defective,b) 2) are of inferior quality, orc) 3) are not in accord with the purchaser’s specifications.

2. The purchaser initiates the request for a reduction of the balance due through the issuance of a debit memorandum.

3. The debit memorandum is a document issued by a buyer to inform a seller that the seller’s account has been debited because of unsatisfactory merchandise.

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4. A purchase return or a purchase allowance (a deduction from the purchase price when unsatisfactory goods are kept) is shown by the entry where Accounts Payable is debited and Merchandise Inventory is credited to show that the cost of the Merchandise Inventory is reduced with a return or an allowance.

C. ACCOUNTING FOR FREIGHT COSTS1. The sales agreement should indicate whether the seller or the

buyer is to pay the cost of transporting the goods to the buyer’s place of business. FOB SHIPPING POINT AND FOB DESTINATION:a) FOB Shipping Point

1) Goods placed free on board (FOB) the carrier by seller.

2) Buyer pays freight costs. a. Merchandise Inventory is debited if

buyer pays freight.b. Cash is a credit if the goods come COD,

for example, and paid immediately. Accounts Payable would be credited if on account.

b) FOB Destination1) Goods placed free on board (FOB) at buyer’s

business.2) Seller pays freight costs.

2. Freight-out (or Delivery Expense) is debited if seller pays freight on outgoing merchandise to a buyer which is an operating expense to the seller.

D. PURCHASE DISCOUNTS:1. Credit terms (specify the amount of cash discount and time

period during which a discount is offered) may permit the buyer to claim a cash discount for the prompt payment of a balance due. If the credit terms show 2/10, n/30 means a 2% is paid within 10 days (called the discount period); otherwise the invoice is due in 30 days.

2. The buyer calls this discount a purchase discount.3. Like a sales discount, a purchase discount is based on the

invoice cost less returns and allowances, if any.4. A buyer should usually take all available discounts.

a) Refer to the example:1) If Sauk Stereo takes the discount, it pays $70 less

in cash ($3,500 x 2%).2) If it forgoes the discount and invests the $3,500

for 20 days at 10% interest, it will earn only $19.06 in interest.3) The savings obtained by taking the

discount is calculated as follows:Discount of 2% on $3,500 $70.00

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Interest received on $3,430 (for 20 days @ 10%) (19.06)Savings by taking the discount $50.94

E. SALES TRANSACTIONS: REVENUE ENTRIES FOR A MERCHANDISER:1. Revenues are reported when earned in accordance with the

revenue recognition principle, and in a merchandising company, revenues are earned when the goods are transferred from seller to buyer.

2. All sales should be supported by a document such as a cash register tape (provide evidence of cash sales) or sales invoice.

3. Two entries are made with each sale:a) The first entry records the sale:

1) Debit—Accounts Receivable (if a credit sale) or Cash (if a cash sale) which increases assets for the sales amount.

2) Credit—Sales which increases revenuesb) The second entry records the cost of the

merchandise sold:1) Debit—Cost of Goods Sold which increases

expenses.2) Credit—Merchandise Inventory which

decreases assets.4. The sales account is credited only for sales of good held

for resale. Sales of assets not held for resale (such as equipment, buildings, land, etc.) are credited directly to the asset account.

F. FREIGHT TERMS: FOB DESTINATION—SELLER PAYS FREIGHT1. An entry is made when seller pays the freight to deliver goods

to a customer or buyer.2. Debit—Freight Out or Delivery Expense and credit—

Cash or Accounts Payable.

G. SALES RETURNS AND ALLOWANCES:1. Sales Returns result when customers are dissatisfied with

merchandise and are allowed to return the goods to the seller for credit or a refund.

2. Sales Allowances result when customers are dissatisfied, and the seller allows a deduction from the selling price.

3. To grant the return or allowance, the seller prepares a credit memorandum to inform the customer that a credit has been made to the customer’s account receivable.

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4. Sales Returns and Allowances is a contra revenue account to the Sales account.a) A contra account is used, instead of debiting sales, to

disclose in the accounts the amount of sales returns and allowances.

b) This information is important to management as excessive returns and allowances suggest inferior merchandise, inefficiencies in filling orders, errors in billing customers, and mistakes in delivery or shipment of goods.

5. The normal balance of Sales Returns and Allowances is a debit.

6. Two entries are made with each sale return and allowance:a) The first entry records the sales return or

allowance::1) Debit—Sales Return and Allowances which

decreases revenues for the amount of the sale.2) Credit—Accounts Receivable (if a credit

sale) or Cash (if a cash sale) which decreases assets.b) The second entry records the increase in

Merchandise Inventory:1) Debit—Merchandise Inventory which

increases assets.2) Credit—Cost of Goods Sold which decreases

expenses.

H. SALES DISCOUNTS—:1. A sales discount is the offer of a cash discount to a customer

for the prompt payment of a balance due.2. Example: If a credit sale has the terms 3/10, n/30, a 3%

discount is allowed if payment is made within 10 days. After 10 days there is no discount, and the balance is due in 30 days.

3. Sales Discounts is a contra revenue account with a normal debit balance.

4. Credit terms specify the amount and time period for the cash discount.

5. They also indicate the length of time in which the purchaser is expected to pay the full invoice price.

III. Completing the Accounting CycleA. Adjusting Entries

1. A merchandiser has the same adjusting entries as a service company.

2. But a merchandiser will have one additional adjustment to make the records agree with the actual inventory on hand.

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a) The perpetual inventory records may be incorrect due to a variety of causes such as recording errors, theft, or waste.

b) The adjusting entry involves adjusting Merchandise Inventory and Cost of Goods Sold. 1) An example follows of the adjusting entry to

adjust if book amount is higher than the inventory amount determined to be on hand.

2) The entry is a debit Cost of Goods Sold and credit Merchandise Inventory.

B. Closing Entries are completed at the end of the fiscal year are journalized into the general journal and posted to the general ledger to: 1. Reduce the temporary owner's equity accounts (revenues,

expenses, and drawing) to zero; and 2. To update the balance in the owner's equity capital account

to begin the next fiscal year.  3. Recall from chapter 4 that this is a 4-step process following

the acronym REID (Revenue, Expenses, Income Summary, and Drawing). Refer to the work sheet on page 221 which is a tool to help complete the closing entries. A merchandising company also uses the 4-step (4 entries) process for the closing entries but the descriptions of REID will be expanded to include all the accounts in a particular column:

a) The first step for the "R" is to close the revenue accounts and those accounts that act as revenues (meaning they have "credit" balances on the credit column of the Income Statement columns of the work sheet) into the Income Summary account.

b) The second step for the "E" is to close the expense accounts and those accounts that act as expenses (meaning they have "debit" balances on the debit column of the Income Statement columns of the work sheet) into the Income Summary account.

c) The third step for the "I" is to close the Income Summary account. If the Income Summary account has a "credit balance," then the company has a NET INCOME or if the balance in the account is a "debit balance," then the company has a NET LOSS. The balance in the INCOME SUMMARY account should be compared with the net income figure on the work sheet or the net loss figure on the work sheet as they should be the same number if you properly closed all the revenue and expense accounts. Compare the "credit" balance of $30,000 in the Income Summary account below to the $30,000 net income figure on the Work Sheet.

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  INCOME SUMMARY  

Total expenses 450,000 480,000 Total revenues

Entry to close acct. 30,000 30,000 Balance of Inc. Sum. acct.

Final bal. of acct. ----- ----- Final bal. of acct.

a) The fourth step for the "D" is to close the drawing account by debiting the owner's capital account and crediting the owner's drawing account.

IV. Forms of Financial StatementsA. MULTIPLE-STEP INCOME STATEMENT

1. Includes sales revenue, cost of goods sold and gross profit sections.a) Net Sales = Sales – Sales returns and allowances and

Sales Discounts.Note: Freight-out is a selling expense—not a contra account to sales.

b) Gross Profit = Net sales – Cost of goods sold. An example showing the determination of gross profit as follows:

Net sales 460,000- Cost of goods sold - 316,000= Gross profit 144,000

2. Operating expenses may be subdivided into:a) Selling Expenses.b) Administrative Expenses.

3. Additional nonoperating sections may be added for:a) Nonoperating sections are reported after income from

operations and are classified in two sections.b) Revenues and expenses resulting from secondary or

auxiliary operations.1) Other revenues and gains.2) Other expenses and losses.

c) Gains and losses unrelated to operations. Other Revenues and Gains in one column and Other Expenses and Losses in the other column.

4. MULTIPLE-STEP VS. SINGLE-STEP INCOME STATEMENT showing the formulas for the multiple-step income statement:

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a) Net sales – Cost of goods sold = Gross profit b) – Operating expenses = Income from operations c) + Other revenues/gains – Other expenses/losses

= Net income or Net loss.5. An example for the determination of net

incomefrom gross profit as follows: Gross profit 144,000- Total operating expenses - 114,000= Income from operations 30,000+ Other revenues and gains + 3,600- Other expenses and losses - 2,000= Net income $31,600

B. SINGLE-STEP INCOME STATEMENT1. All data are classified under two categories:

a) (1) Revenuesb) (2) Expenses

2. Only one step is required in determining net income or net loss—Revenues – Expenses = Net Income.

3. Two primary reasons for using a single step format:a) (1) A company does not realize any type of profit or

income until total revenues exceed total expenses, so it makes sense to divide the statement into two categories.

b) (2) The format is simpler and easier to read than the multiple-step format.

C. CLASSIFIED BALANCE SHEET.1. Current assets are listed in the order of liquidity.2. Merchandise Inventory is less liquid than accounts

receivable because the goods must first be sold and then collection must be made from the customer.

3. Merchandise Inventory is reported as a current asset immediately below accounts receivable.

V. Determining Cost of Goods Sold Under a Periodic SystemA. An important Cost of Goods Sold calculation that is tested backwards and

forwards (but on exam that is sent in so does NOT have to be memorized) on the certified bookkeeper's (CB) exam):

B. Under the Periodic system, separate accounts are used to record freight costs, returns, and discounts.

C. Under the Perpetual system all transactions affecting the cost of merchandise purchased is recorded directly into Merchandise Inventory account.

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D. Also under the Periodic system, a running account of changes in inventory is not maintained. Therefore, the balance in ending inventory (done by taking a physical inventory), as well as the cost of goods sold for the period, is calculated at the end of the period.

E. To memorize the cost of goods sold calculation, it is helpful to first learn the OUTLINE OF THE COST OF GOODS SOLD SECTION (also helpful to use acronyms for the words that are used):

1. Beginning inventory (BI)2. + Cost of goods Purchased (COGP) Gross purchases - Purchase

returns & allowances - Purchase discounts + Freight-in)

3. = Goods available for sale (GAFS)

4. - Ending inventory (EI)

5. = Cost of goods sold (COGS)

Note below the outline of the Cost of goods sold is bolded:Cost of goods sold:        

Inventory, January 1     $36,000 

Purchases   $325,000   

Less: Purchases returns and allowances $10,400     

    Purchases 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

A helpful tip to memorize the COGS calculation is to practice with 4 columns where you just use the acronyms in the columns as well as the plus and minus signs so you

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can visualize where the different numbers go as you move from the beginning of the year to the end of the year (NOTE that the format moves in a stair-step arrangement backwards to purchases returns and allowances and then forwards down to cost of goods sold) (the xxx's represent a number that does not have a word to describe it):Cost of goods sold:        

      BI  

    P    

  P R&A      

  +     PD - xxx    

    NP    

    + FI    

      +COGP  

      GAFS  

      - EI  

        COGS

VI. Periodic Inventory SystemA. Perpetual vs. Periodic Inventory systems comparisons:

1. With both systems, revenues from the sale of merchandise are recorded when sales are made.

2. But with the periodic system, no attempt is made on the date of sale to record the cost of the merchandise sold.

3. Under the periodic system, a physical inventory is taken at the end of the period and this count determines:a) (1) the cost of merchandise on hand andb) (2) the cost of goods sold during the period as ending

inventory is part of the cost of goods sold calculation.4. Under the periodic system, purchases of merchandise are

recorded in a Purchases account rather than a Merchandise Inventory account.

5. Under the periodic system, it is customary to record the following in separate accounts:

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a) Purchase Returns and Allowances,b) Purchase Discountsc) Freight-in

B. Recording Transactions Under a Periodic Inventory System1. Recording Purchases of Merchandise

a) Purchases —Purchases is a temporary account whose normal balance is a debit and located under the Expense section of the accounting equation.

b) Purchase Returns and Allowances —Purchases Returns and Allowances is a temporary contra expense account with a normal credit balance.

c) Freight Costs —Freight-in is a temporary account whose normal balance is a debit balance under the expense section along with the Purchases account. This account is used with the term are FOB Shipping Point and a cost paid by the buyer to bring the goods to the purchaser.

d) Purchase Discounts —Purchases Discounts is a temporary contra expense account with a normal credit balance.

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2. Recording Sales of Merchandisea) Sales —there is just one entry to record the sale. Under

the periodic inventory system is NO second entry to record the cost of goods sold. Sales is a revenue account with a normal credit balance.

b) Sales Returns and Allowances —the same entry made under the perpetual system. Note there is NO second entry to record the return of the Merchandise Inventory with the cost of goods sold as done under the perpetual system. Sales Returns and Allowances is a contra revenue account with a normal debit balance.

c) Sales Discounts —to record the payment from a customer within the discount period would be the same entry under the perpetual system. Sales Discounts is a contra revenue account with a normal debit balance

VII. Work Sheet for a MerchandiserA. Introduction—as indicated in Chapter 4, a work sheet is prepared

to:1. To help with the adjusting process; 2. To help with the preparation of the financial statements; and 3. To help with preparing of the closing entries.

B. Trial Balance Columns:1. Data from the trial balance are obtained from the ledger

balances of PW Audio Supply at December 31.2. The amount shown for Merchandise Inventory, $40,500, is

the year-end inventory amount which results from the application of a perpetual inventory system.

3. Note the accounts in red that are the new accounts used for the merchandising company under the perpetual inventory system.

4. As was covered in chapter 4, a separate trial balance is not prepared as we use the first two columns of the worksheet for this initial trial balance (a listing of all ledger accounts to test the equality of debits and credits).

5. Also recall that the format #2 will include all accounts that will be needed for the adjusting process are also included in this listing of the general ledger accounts that are listed in chart of account (general ledger) order.

6. Remember that the work sheet is started by entering the heading as shown on page 208 which has the answers to the questions, "who," "what," and "when," where the answer to the " when " must be a period of time as the work sheet's bottom line is to disclose the amount of net income or net loss for the period.

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C. Adjustments Columns1. A merchandising company usually has the same types of

adjustments as a service company 2. Work sheet adjustments (b), (c), and (d) are for insurance,

depreciation, and salaries.3. Adjustment (a) was required to adjust the perpetual

inventory carrying amount to the actual count.4. The Adjustments columns like the Trial Balance columns,

must be proved before the work sheet can be continued by adding the debit and credit columns so see that they balance.

D. Adjusted Trial Balance1. The adjusted trial balance shows the balance of all accounts

after adjustment at the end of the accounting period.2. Review and describe how adjustments are carried to the

Adjusted Trial Balance columns:a) Accounts without adjustments. If an account does not have an

adjustment, simply carry over the Trial Balance figure to the appropriate Adjusted Trial Balance column.

b) Accounts without balances on the trial balance. If an account does not have a balance in the Trial Balance columns, but there is an adjustment, the amount of the adjustment becomes the balance on the adjusted trial balance.

c) Merchandise Inventory. On the adjusted trial balance, the Merchandise Inventory account shows the December 31 Inventory count as adjusted to agree with the physical inventory count. 

d) Accounts that had adjustments to their previous balance. When extending amounts to the adjusted trial balance from the trial balance, a debit with a debit adjustment has the two debits added together. Likewise an account with a credit balance on the trial balance is added to a credit adjustment when extended to the adjusted trial balance. A debit balance on the trial balance with a credit adjustment will be subtracted to extend to the adjusted trial balance or a credit balance with a debit adjustment will be subtracted to extend to the adjusted trial balance.

E. Income Statement Columns1. The accounts and balances that affect the income statement

are transferred from the adjusted trial balance columns to the income statement columns for PW Audio Supply at December 31.

2. All of the amounts in the income statement credit column should be totaled and compared to the total of the amounts in the income statement debit column.

F. Balance Sheet Columns1. The major difference between the balance sheets of a service

company and a merchandising company is inventory.

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2. For PW Audio Supply, the ending Merchandise Inventory amount of $40,000 is shown in the balance sheet debit column.

3. The information to prepare the owner’s equity statement is also found in these columns.

G. Review the determination of net income or loss and completion of the work sheet. Recall from Chapter 4 that after the amounts are extended to the income statement and balance sheet columns that you add the columns down, and rule them. As you can see, a net income figure appears on the debit column of the income statement and the credit column of the balance sheet. The reason it shows on the credit column of the balance sheet is that a net income increases owner’s capital and owner’s capital increases on the credit side. Note that owner’s capital is bolded to emphasize why the net income appears on the credit side of the balance sheet columns. Below is the work sheet for PW Audio Supply showing format #2: where the balance sheet accounts are above the bold line and the income statement below it:

PW Audio SupplyWork Sheet

For the Year Ended December 31, 20--Account

TitlesTrial Balance Adjustments Adj. Trial Balance Income Statement Balance Sheet

Debit Credit Debit Credit Debit Credit Debit Credit Debit CreditCash 9,500 → → → 9,500 → → → 8,485AcctsRec. 16,100 → → → 16.100 → → → 300MerchInv 40,500 → → (a) 500 40,000 → → → 40,000Prepd Ins. 3,800 → → (b)2000 1,800 → → → 1,800Str.Equip 80,000 → → → 80,000 → → → 80,000A/D StrEq 16,000 → (c)8000 → 24,000 → → → 24,000Accts.Pay. 20,400 → → → 20,400 → → → 20,400Sal. Pay. 0 → (d)5000 → 5,000 → → → 5,000RAL, Cap.. 83,000 → → → 83,000 → → → 83,000RAL, Draw 15,000 → → → 15,000 → → → 15,000Sales. 480,000 → → → 480,000 → 480,000Sales R&A 12,000 → → → 12,000 → 12,000Sales Disc 8,000 → → → 8,000 → 8,000COGS 315,500 → a) 500 → 316,000 → 316,000Freight Out 7,000 → → → 7,000 → 800Adv.Exp. 16,000 → → → 16,000 → 50AdmSal.xp. 19,000 → → → 19,000 → 1,260StrSalExp 40,000 → (d)5000 → 45,000 → 45,000Util.Exp. 17,000 → → → 17,000 → 17,000Ins.Exp. 0 → (b2000 → 2,000 → 2,000DepEx. SE 0 → (c)8000 → 8,000 → 8,000

599,400 599,400 15,500 15,500 612,400 612,400 450,000 480,000 162,400 132,400Net Income → → → → → → 30,000 → → 30,000

480,000 480,000 162,400 162,400

H. Note that in an Excel template, you can use IF functions to automatically calculate a net income or a net loss depending on whether revenues are greater than expenses or vice versa. Also you can set an IF function to automatically writes the words, “Net income” or “Net loss”

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depending on whether revenues are greater than expenses or vice versa. Having these formulas in a work sheet along with others can aid the preparation of a work sheet in just a few minutes and allow for quick changes to be made.

I. Also spreadsheets can be used to link the financial statements to the work sheet so that they can be prepared instantly when a work sheet is prepared.

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