Accounting Cycle of a Merchandising

Business
Merchandising company is an enterprise that buys and sells
goods to earn a profit
Merchandise consists of products, also called goods, that a
company acquires to resell to customers
A Merchandiser earns net income by buying and selling
merchandise and often identified as:
a. Wholesaler – is an intermediary that buys products from
manufacturers or other wholesalers and sells them to
retailers or other wholesalers
b. Retailer – is an intermediary that buys products from
manufacturers or wholesalers and sells them to
consumers
Reporting Income for a Merchandising
• Net income for a merchandiser equals revenues
from selling merchandise minus both thee cost of
merchandise sold to customers and the cost of
other expenses for the period
Sales
• Is the usual accounting term for revenues from selling
merchandise
Cost of Good Sold
• Is the usual term used for the expense of buying and
preparing the merchandise
Expenses for a merchandising company are divided into
two categories:
1. Cost of Goods Sold (COGS)
• The total cost of merchandise sold during the period
2. Operating Expenses (OP)
• Expenses incurred in the process of earning sales
revenue that are deducted from gross profit in the
income statement
• Examples: sales salaries, insurance expenses
Reporting Inventory for a Merchandiser
• A merchandiser’s balance sheet includes a current asset
called merchandise inventory, an item not on a service
company’s balance sheet
Merchandise inventory or simply inventory
• Refers to products that a company owns and intends to
sell
• The cost of this asset includes the cost incurred to buy
the goods, ship them to the store and make them ready
for sale
Operating Cycle for a Merchandiser
• Begins by purchasing merchandise and ends by collecting
cash from selling the merchandise

Merchandiser’s Operating Cycle

Inventory Systems
Cost of goods sold
• It is the cost of merchandise sold to customers during a
period
• it is often the largest single expense on a merchandiser’s
income statement
Inventory
• Refers to products a company owns and expects to sell in
its normal operations
Inventory
• A company’s merchandise available for sale consists of
what it begins with (beginning inventory) and what it
purchases (net purchases)
• The merchandise available is either sold (cost of goods
sold or kept for future sales (ending inventory)
Two alternative inventory accounting system or methods
1. Perpetual inventory system
• It is a system where it continually updates accounting records
for merchandising transactions – specifically for those records of
inventory available for sale and inventory sold
• 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
• Record purchase of inventory
• Record revenue and record cost of goods sold when the item is
sold
• At the end of the period, no entry is needed except to adjust
inventory for losses
2. Periodic inventory system
• Requires updating the inventory account only at the end
of a period to reflect the quantity and cost of both the
goods available and the goods sold
• Cost of goods sold is determined only at the end of an
accounting period
• The 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
4. (Ending Inventory = EI) illustrated as follows

BI + COGP = Cost of goods available for sale - EI = COGS

PERPETUAL SYSTEM
Accounting for Merchandise Purchases
• The cost of merchandise purchased for resale is
recorded in the Merchandise Inventory asset
account
• To illustrate, Z-Mart records P1,200 cash purchase
of merchandise on November 2, as follows:
Nov 2 Merchandise Inventory 1,200
Cash 1,200
Purchased merchandise for cash
Accounting for Merchandise Purchases
Nov 2 Merchandise Inventory 1,200
Cash 1,200
Purchased merchandise for cash
• The invoice shows purchased of merchandise
• The buyer usually receives the original invoice
and the seller keeps a copy
• This source document serves as the purchase
invoice of Z-Mart (buyer) and the sales invoice for
Trex (seller)
• The amount recorded for merchandise inventory
includes its purchase cost, shipping fees, taxes
and any other costs necessary to make it ready
for sale
PURCHASE DISCOUNTS
• The purchase of goods on credit requires a clear statement of
expected future payments and dates to avoid
misunderstandings
• Credit terms for a purchase include the amounts and timing of
payments from a buyer to a seller and usually reflect an
industry’s practices
• To illustrate, when sellers require payment within 10days after
the end of the month of the invoice date, the invoice will show
credit terms as “n/10 EOM” which stands for net 10 days after
end of month (EOM). When sellers require payment within 30
days after the invoice date, the invoice shows credit terms of
“n/30” which stands for net 30 days
PURCHASE DISCOUNTS
• Exhibit 5.6 portrays credit terms

• The amount of time allowed before full payment is due is

called the credit period.
• Sellers can grant a cash discount to encourage buyers to
pay earlier, a buyer views cash discount as a purchase
discount. A seller views a cash discount as a sales discount.
PURCHASE DISCOUNTS
• Any cash discounts are described in the credit
terms on the invoice, for example credit terms of
“2/10, n/60” mean that full payment is due
within 60-day credit period, but the buyer can
deduct 2% of the invoice amount if payment is
made within 10 days of the invoice date. This
reduced payment applies only for the discount
period
PURCHASE DISCOUNTS
To illustrate how a buyer accounts for a purchase discount, assume that Z-Mart’s
P1,200 purchase of merchandise is on credit with terms of 2/10, n/30. The entry
is:
a) Nov 2 Merchandise Inventory 1,200
Accounts Payable 1,200
Purchased merchandise on credit,
invoice dated Nov 2, terms 2/10, n/30

If Z-Mart pays the amount due on or before November 12, the entry is:
b) Nov 12 Accounts Payable 1,200
Merchandise Inventory 24
Cash 1,176
Paid for the P1,200 purchase on Nov 2 less the
discount of P24 (2% x P1,200)
PURCHASE RETURNS AND ALLOWANCES
• Purchase returns refers to merchandise a buyer
acquires but then returns to the seller
• Purchase allowance is a reduction in the cost of
defective or unacceptable merchandise that a
buyer acquires
• When a buyers returns or takes an allowance on
merchandise, the buyer issues a debit
memorandum to inform the seller of a debit made
to the seller’s account in the buyer’s records
PURCHASE ALLOWANCES
To illustrate purchase allowances, assume that on November 15, Z-
Mart (buyer) issues a P300 debit memorandum for an allowance
from Trex for defective merchandise z-Mart’s November 15 entry
to update its Merchandise Inventory account to reflect the
purchase allowance is
c) Nov 15 Accounts Payable 300
Merchandise Inventory 300
Allowance for defective merchandise
• The buyer’s allowance for defective merchandise is usually offset
against the buyer’s current accounts payable balance to the
seller. When cash is refunded, the Cash account is debited
instead of Accounts Payable
PURCHASE RETURNS
• Purchase returns are recorded at the net costs charged
to buyers
To illustrate for returns, suppose Z-mart purchases P1,000
of merchandise on June 1 with terms 2/10, n/60. Two days
later, Z-Mart returns P100 of goods before paying the
invoice. When Z-Mart later pays on June 11, it takes the
2% discount only on the P900 remaining balance. When
goods are returned, a buyer can take a purchase discount
on only the remaining balance of the invoice. The
resulting discount is P18 (2% x P900) and the cash
payment is P882 (P900-P18)
PURCHASE RETURNS
The following entries reflect this illustration
June 1 Merchandise Inventory 1,000
Accounts Payable 1,000
Purchased merchandise, invoice dated
June 1, terms 2/10,n/60
June 3 Accounts Payable100
Merchandise Inventory 100
Return merchandise to seller
June 11 Accounts Payable 900
Merchandise Inventory 18
Cash 882
Paid for P900 merchandise (P1,000-P100)
less P18 discount (2% x P900)
TRANSPORTATION COSTS AND OWNERSHIP TRANSFER
• The buyer and seller must agree on who is
responsible for paying any freight costs and who
bears the risk of loss during transit for
merchandising transactions. This is essentially the
same as asking at what point ownership transfers
from the seller to the buyer
• The point of transfer is called FOB (free on board)
point, which determines who pays transportation
costs (and often other incidental costs of transit
such as insurance)
TWO ALTERNATIVE POINTS OF TRANSFER
1. FOB shipping point also called as FOB factory
• It means the buyer accepts ownership when the
goods depart the seller’s place of business
• The buyer is then responsible for paying shipping
costs and bearing the risk of damage or loss when
goods are in transit
• The goods are part of the buyer’s inventory when
they are in transit since ownership has
transferred to the buyers
2. FOB destination
• It means ownership of goods transfers to the
buyer when the goods arrive at the buyer’s place
of business
• The seller is responsible for paying shipping at the
charges and bears the risk of damage or loss in
transit
• The seller does not record revenue from this sale
until the goods arrive at the destination because
this transaction is not complete before that point
Ownership Transfer and Transportation costs
• When a buyer is responsible for paying transportation costs,
the payment is made to a carrier or directly to the seller
depending on the agreement.
• The cost principle requires that any necessary transportation
costs of a buyer (often called transportation-in or freight-in)
be included as part of the cost of purchased merchandise
To illustrate, Z-Mart’s entry to record a P75 freight charge from
an independent carrier for merchandise purchased FOB
shipping point is
d) Nov 24 Merchandise Inventory 75
Cash75
Paid freight costs on purchased merchandise
• A seller records the costs of shipping goods to
customers in a Delivery expense account when the
seller is responsible for these costs. Delivery Expense,
also called transportation-out or freight out, is reported
as a selling expense in the seller’s income statement
• In summary, purchases are recorded as debits to
Merchandise Inventory. Any later purchase discounts,
returns and allowances are credited (decreases) to
Merchandise Inventory
• Transportation-in is debited (added) to Merchandise
Inventory
ACCOUNTING FOR MERCHANDISE SALES
• Merchandising companies also must account for sales,
sales discounts, sales returns and allowances and cost of
goods sold
• A merchandising company reflects these items in its
gross profit computation
SALES OF MERCHANDISE
• Each sales transactions for a seller of merchandise involves
two parts
1. Revenue received in the form of an asset from the
customer
2. Recognition of the cost of merchandise sold to the
customer
• Accounting for a sales transaction under the perpetual
system requires recording information about both parts.
This means that each sales transaction for merchandisers,
whether for cash or on credit, requires two entries: one for
revenue and one for cost
SALES OF MERCHANDISE
To illustrate, Z-Mart sold P2,400 of merchandise on credit on November 3.
The revenue part of this transaction is recorded as
e) Nov 3 Accounts Receivable 2,400
Sales 2,400
sold merchandise on credit
The cost part of each sales transaction ensures that the Merchandise
Inventory account under a perpetual inventory system reflects the
updated cost of the merchandise available for sale. For example, the cost
of the merchandise Z-Mart sold on November 3 is P1,600, and the entry to
record the cost part of this sales transaction is
f) Nov 3 Cost of Goods Sold 1,600
Merchandise Inventory 1,600
To record cost of Nov 3 sale
SALES DISCOUNTS
• Sales discounts on credit sales can benefit a seller by
decreasing the delay in receiving cash and reducing
future collection efforts
• At the time of a credit sale, a seller does not know
whether a customer will pay within the discount period
and take advantage of a discount. This means the seller
usually does not record sales discount until a customer
actually pays within the discount period.
SALES DISCOUNTS
To illustrate, Z-Mart completes a credit sale for P1,000 on November
12 with terms of 2/10,n/60. The entry to record the revenue part of
this sale is
Nov 12 Accounts Receivable 1,000
Sales 1,000
sold merchandise under terms 2/10,n/60
If the customer pays on or before November 22, Z-Mart records the
payment as
Nov 22 Cash 980
Sales Discount 20
Accounts Receivable 1,000
Received payment for Nov 12 sale less discount
SALES DISCOUNTS
• Sales discounts is a contra revenue account,
meaning the Sales Discounts account is deducted
from the Sales account when computing a
company’s net sales
SALES RETURNS AND ALLOWANCES
• Sales returns refer to merchandise that customers
return to the seller after a sale
• Sales allowances refer to reductions in the selling price
of merchandise sold to customers. This can occur with
damaged or defective merchandise that a customer is
willing to purchase with a decrease in selling price
• Sales returns and allowances usually involve
dissatisfied customers and the possibility of lost future
sales, and managers monitor information about
returns and allowances
SALES RETURNS
To illustrate, recall Z-Mart’s sale of merchandise on
November 3 for P2,400 that had cost P1,600. Assume
that the customer returns part of the merchandise on
November 6, and the returned items sell for P800 and
cost P600. The revenue part of this transaction must
reflect the decrease in sales from the customer’s return
of merchandise is
f) Nov 6 Sales Returns and Allowances 800
Accounts Receivable 800
Customer returns merchandise of Nov 3 sale
SALES RETURNS
If the merchandise returned to Z-Mart is not defective and can be
resold to another customer, Z-Mart returns these goods to its inventory.
The entry to restore the cost of such goods to the Merchandise
Inventory account is:
Nov 6 Merchandise Inventory 600
Cost of Goods Sold 600
Returned goods added to inventory
This entry changes if the goods returned are defective. The returned
inventory is recorded at its estimated value, not its cost.
To illustrate, if the goods (costing P600) returned to Z-Mart are
defective and estimated to be worth P150, the following entry is made:
Dr. Merchandise Inventory for P150, Dr. Loss from Defective
Merchandise for P450, and Cr. Cost of Goods Sold for P600
SALES ALLOWANCES
To illustrate sales allowances, assume that P800 of the
merchandise Z-Mart sold on November 3 is defective but the
buyer decides to keep it because Z-Mart offers a P100 price
reduction. Z-Mart records this allowance as follows
Nov 6 Sales Returns and Allowances 100
Accounts Receivable 100
to record sales allowance on Nov 3 sale
* The seller usually prepares a credit memorandum to
confirm a buyer’s return or allowance. A seller’s credit
memorandum informs a buyer of the seller’s credit to the
buyer’s Account Receivable (on the seller’s book)
COMPLETING THE ACCOUNTING CYCLE
COMPLETING THE ACCOUNTING CYCLE
• The exhibit shows the flow of merchandising costs
during a period and where these costs are reported at
period-end.
• Specifically, beginning inventory plus the net cost of
purchases is the merchandise available for sale.
• As inventory is sold, its cost is recorded in cost of
goods sold on the income statement; what remains is
ending inventory on the balance sheet.
• A period’s ending inventory is the next period’s
beginning inventory
ADJUSTING ENTRIES FOR MERCHANDISE
• The three steps of the accounting cycle for merchandising business:
1. Adjustments
• Adjusting entries are generally the same for merchandising
companies and service companies, including those for prepaid
expenses (including depreciation), accrued expenses, unearned
revenues, and accrued revenues
• However, a merchandiser using perpetual inventory system is usually
required to make another adjustment to update the Merchandise
Inventory account to reflect any loss or merchandise including theft
and deterioration.
• Shrinkage is the term used to refer any loss of inventory and it is
computed by comparing a physical count of inventory with recorded
amounts
1. Adjustments
To illustrate, Z-Mart’s Merchandise Inventory
account at the end of year 2011 has a balance of
P21,250 but a physical count reveals that only
P21,000 of inventory exists. The adjusting entry to
record this P250 shrinkage is
Dec 31 Cost of Goods Sold 250
Merchandise Inventory 250
to adjust for P250 shrinkage revealed by
a physical count of inventory
2. Statement Preparation
• The financial statement of a merchandiser and their
preparation are similar to those for a service company
• The income statement mainly differs by the inclusion of
cost of goods sold and gross profit
• Net sales is affected by discounts, returns, and allowances
and some additional expenses are possible such as
delivery expense and loss from defective merchandise
• The balance sheet mainly differs by the inclusion of
merchandise inventory as part of current assets
• The statement of owner’s equity is unchanged
3. Closing
• Closing entries are similar for service companies and
merchandising companies using a perpetual system
• The difference is that we must close some new
temporary accounts that arise from merchandising
activities
• Z-Mart has several temporary accounts unique to
merchandisers: Sales (of goods), Sales Discounts,
Sales Returns and Allowances and Cost of Goods
Sold
3. Closing
SUMMARY OF MERCHANDISING ENTRIES
SUMMARY OF MERCHANDISING ENTRIES
Multi-step Income Statement
Cost of Goods Sold Computation
Multi-Step Income Statement
• It shows a detailed computations of net sales and other costs
and expenses and reports subtotals for various classes of
items
• The statement has three main parts:
1. Gross profit
• Determined by net sales less cost of goods sold
2. Income from operations
• Determined by gross profit less operating expenses
3. Net income
• Determined by income from operations adjusted for non-
operating items
Multi-Step Income Statement
• Operating expenses are classified into two sections:
1. Selling expenses
• Include the expenses of promoting sales by
displaying and advertising merchandise, making
sales, and delivering goods to customers
2. General and administrative expenses
• Support a company’s overall operations and include
expenses related to accounting, human resource
management, and financial management
Multi-Step Income Statement
Non-operating activities consist of other expenses,
revenues, losses and gains that are unrelated to a
company’s operations
Other revenues and gains commonly include
interest revenue, dividend revenue, rent revenue
and gains from asset disposals.
Other expenses and losses commonly include
interest expense, losses from asset disposals and
casualty losses
Single-Step Income Statement
• It is another widely used format
• It lists cost of goods sold as another expense and
shows only one subtotal for total expenses
• Expenses are grouped into very few categories