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LECTURE NOTES CH. 4: Accounting for Merchandising Operations

In this chapter, we will review the accounting for purchases and sales of merchandise. In
Accounting 100 we also studied the accounting for these transactions. However, in ACCT 100,
the focus was on small businesses that use the periodic system, in which merchandise could
only be valued by physically counting goods on hand. In ACCT 101, we will focus on larger
businesses that use the perpetual inventory system. In a perpetual system, inventory balances are
updated for each purchase, sale and return.
A merchandising company earns profits by buying and selling goods. Some merchandisers are
wholesalersa company that sells to retailers or other distributors. Other merchandisers are
retailersa company who sells products directly to consumers.
Net sales
The largest source of revenue for a merchandiser is sales. Usually the largest expense for a
merchandiser is cost of goods sold, also known as cost of sales. Sales can be reduced by sales
discounts and sales returns. Sales, less sales discounts and sales returns, are called net sales. The
difference between net sales and cost of goods sold is gross profit. Gross profit is often called
gross margin.
The Merchandise Inventory account
The balance sheet of a merchandiser contains the Merchandise Inventory account. It represents
the stock of goods on hand that are available for sale. Merchandise Inventory must be reported at
cost, not at retail value. It is classified as a current asset.
Temporary accounts used by merchandising companies
Name of
Sales returns
and allowances


Purpose of account

Sales discounts


Cost of Goods


This account is also a contra-revenue account. It tracks the

amount of discounts that customers take due to early-payment
discounts offered by the seller.
Cost of Goods Sold is an expense. It is debited for the cost of the
merchandise that was sold to the customer.
Delivery expense is debited when the seller pays freight costs on
goods sold.


Sales is a revenue account that records the sales of merchandise

This account is a contra-revenue account that tracks returns or
allowances granted to customers. It is a contra-revenue account.

Journal entries using the perpetual system: buyers books

Buy merchandise:
Dr. Merchandise Inventory

Cr. Cash or Accounts Payable

Pay freight costs:
Dr. Merchandise Inventory
Cr. Cash
Pay on account, with an early payment discount:
Dr. Accounts Payable
Cr. Cash
Cr. Merchandise Inventory (for amount of discount.)
Return merchandise to the vendor:
Dr. Accounts Payable
Cr. Merchandise Inventory
Freight costs
Freight terms are important. FOB or Free on Board determines who pays for transportation and
when title passes.

FOB Shipping Point: legal title to the goods passes to the buyer when the goods are
shipped. The buyer pays freight. Buyer assumes risk of loss. If terms are FOB shipping,
then the buyer charges the shipping costs to the merchandise inventory account.
FOB Destination: legal title to the goods passes to the buyer when the goods reach the
buyers place of business. The seller pays shipping and bears risk of loss. If terms are
FOB Destination, the seller uses Delivery Expense to record the shipping cost.
Discounts for prompt payment cannot be taken on freight.

Journal entries using the perpetual system: sellers books

Sales of Merchandise: Two entries are recorded: one for the sale and another for the cost of the
goods sold.
Dr. Accounts Receivable



Dr. Cost of Goods Sold (COGS)


Merchandise inventory

Payments Received from Customers, with early payment discount:

Dr. Cash
Dr. Sales Discounts

Accounts Receivable

Sales returns from customers. Two entries are recorded: the sales return and the receipt of the
goods from the customer.
Dr. Sales returns and Allowances

Accounts Receivable

Dr. Merchandise Inventory



An adjusting entry for inventory shrinkage:

Cr. Merchandise Inventory
Closing Entries
Closing entries were covered in ACCT 100. See page 165 for a review of closing entries.

A review of the Multiple-Step Income Statement

Revenue from Sales
Less Sales Discounts

Gross profit

Less Sales Returns and Allowances

Net Sales
- Cost of Goods Sold
=Gross Profit
Operating Expenses:
Selling Expenses

Income from

General and Administrative Expenses

Total Operating Expenses
Income from Operations*
Add: Other Revenues


Less: Other Expenses

Net Income

*Gross profit less total operating expenses

Ratio Analysis

The acid-test ratio is a stricter, more conservative version of the current ratio. The formula for the
acid-test ratio follows.
Acid Test Ratio = Cash and cash equivalents + Short Term Investments + A/R
Current Liabilities
The gross margin ratio calculates the gross profit earned on each dollar of sales. The formula for
the gross margin ratio is below.

Gross Margin Ratio =

Gross profit (Net Sales COGS)

Net Sales