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Accounting 101
Accounting for a Merchandising Business
Refresher:
FORMS OF BUSINESS ENTERPRISES:
1. Service business or service concern
- The simplest form of business.
- These enterprises provide services to clients or customers in exchange for fees,
2. Merchandising business or trading concern
- These enterprises purchase goods from suppliers and, without altering the state of the
goods bought, sell the same at a higher price than cost.
- Buy-and-sell business.
3. Manufacturing business or manufacturing concern
- Involves the most complex activities.
- Similar to merchandising business, a manufacturer sells goods at a higher price than cost.
Dissimilar to merchandising business, the manufacturer actually produces the goods
that it sells to customers.

BUSINESS ORGANIZATIONS:
1. Sole Proprietorship
2. Partnership
3. Corporation

 We are done with the accounting procedures for a service business; let’s move now to the
accounting procedures for a merchandising business. We will tackle the accounting procedures
for a manufacturing concern in the next handout.

 We are still in the Sole proprietorship business organization, Partnership and Corporation will be
discussed in your next accounting course: ACCT 2A&B.

 Merchandisers earn profit by buying and selling merchandise.

Merchandise inventories – represent goods intended for sale.
 Include only items that are held for sale in the normal course of business.
 May be engaged by a wholesaler or retailer.
 Current asset.
 The unsold portion of goods held for sale.
Wholesaler – an intermediary that buys products from manufacturers or other wholesalers and sells them
to retailers or other wholesalers.
Retailer – buys products from manufacturers or wholesalers and sells them to consumers or final users.

Accounting procedures:
 The steps in the accounting cycle for a merchandising business are the same as the steps for a
service business. However, additional accounts and entries which are required in recording
merchandising transactions.
The steps in the Accounting cycle:
1. Transactions are documented.
2. Transactions are analyzed and recorded in the journal.
3. Entries are posted to the ledger.
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4. Preliminary trial balance is prepared.

5. Adjusting entries are journalized and posted.
6. Adjusted trial balance is prepared.
7. Financial statements are prepared.
8. Books are closed.
9. Post-closing trial balance is prepared.
10. Reversing entries are journalized and posted.

Cost of goods sold – the total cost of merchandise sold during the period.
- Often the largest single deduction on a merchandiser’s income statement.
- This expense is directly related to the revenue recognized from sale of goods.
- The expense portion of goods held for sale.
Operating expense
- May be distribution cost (or selling expense) or administrative expenses.
Distribution cost – expenses incurred in the process of earning sales revenue which was not found in a
service enterprise.

Normal operating cycle of a merchandising company is longer than that of service concern.
- Begins by purchasing merchandise and ends by collecting cash from selling the goods.
- The most common point of income recognition is at the point of sale, the time when
ownership changes hands, from the seller to the buyer.

COMPUTATION OF COST OF GOODS SOLD:

Purchases
(Purchase returns and allowances)
(Purchase discounts)
Net Purchases
Freight-in
Cost of goods purchased
Beginning inventory
Cost of goods available for sale
(Ending inventory)
Cost of goods sold

Accounting for Sales and related accounts

Sales – the revenue account title used to record the sale of all kinds of merchandise.
- Handled the same manner as the service revenue transactions under a service concern.
- Used only for the sale of merchandise.

Pro-forma entry:
Accounts receivable / Cash xx
Sales xx
Output tax xx

Output tax – the value-added tax (VAT) imposed on selling merchandise.

- 12% usually.

Sales returns and allowances – the return of the merchandise sold to customers.
- A sales return is evidenced by the issuance of a credit memorandum by the seller.
- Sales allowance happens when the buyer is still willing to accept the goods, but with
reduction in price.
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- Sales returns happens when the buyer returned the goods to the supplier.
- Whatever it may be (a sales return or sales allowance), the journal entry will always be a
debit to sales returns and allowances.

Pro-forma entry:
Sales returns and allowances xx
Output tax * xx
Cash or Accounts Receivable** xx

* It is justifiable that the output tax be reduced since the return of merchandise by the buyer will reduce
the sales account.

** Credit cash if the sale is a cash sale (refund). Credit A/R if the sale is a credit sale.

Sales discount – used to encourage credit customers to pay their accounts promptly.
- If payments are received within a certain number of days from the date of sale, the seller
reduces the amount to be paid by the buyer.
- This incentive offers advantages to both parties: the purchaser saves money, and the
seller is able to convert the accounts receivable into cash earlier.
Ex. 2/10, n/30
- 2% discount may be availed within 10 days after the date of sale.
- If the customer does not pay within 10 days, he or she must pay the full price within
30days from the date of sale.
- If he does not pay within 30 days from the date of sale, there may be an indication that
the customer will not be able to pay the said account and the company shall set up an
estimation of doubtful account.

Pro-forma entry:
Sales discount xx
Output tax xx
Cash xx
Accounts receivable xx

Trade discounts – the discount deducted from the list price or catalog price to arrive at its selling price.
- Used to reduce the list price to actual sales price which may be due to the volume of
transaction.
- Different from cash discounts.
- They are not recorded in the books of the seller and the buyer.
- When a sale or purchase is made, the amount recorded is always net of trade discount.

Accounting for Purchases and related accounts

Purchases – the cost of goods bought for resale.
- Used only for goods purchased for resale.

Pro-forma entry:
Purchases xx
Input tax xx
Accounts payable or cash xx

Purchase returns and allowances – return of the merchandise sold by a supplier.

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- Purchase allowance happens when the buyer is still willing to accept the goods, but with
reduction in price.
- Purchase returns happens when the buyer returned the goods to the supplier.
- The purchaser issues debit memorandum to request for a reduction in the balance due.
- Whatever it may be (a purchase return or purchase allowance), the journal entry will
always be a credit to purchase returns and allowances.

Pro-forma entry:
Accounts payable or Cash * xx
Purchase returns and allowances xx
Input tax** xx

* It is justifiable that the input tax be reduced since the return of merchandise by the buyer will reduce the
purchase account.

** Debit cash if the purchase is a cash purchase (refund). Debit A/P if the purchase is a credit purchase.

Purchase discount – sales discounts, except that it is from a buyer’s viewpoint.

- Used to record the amount saved by paying promptly.
- A deduction from the purchases account and is closed to income summary at the end of
the period.
Three alternative methods of accounting for purchase discounts:
1. Gross price method – purchases and accounts payable are recorded at gross amounts. Purchase
discounts are recorded only when taken.
2. Net price method – purchases and accounts payable are recorded at net of the discounts offered.
A purchase discounts lost is used to record purchase discounts which have been forfeited.
- Theoretically correct.
3. Allowance method – this is covered in higher accounting courses.

Shipping charges on merchandise purchased or sold

Freight terms: FOB – Free on Board
1. FOB Shipping point – the purchaser agreed to pay all the shipping costs and the purchaser
receives title to the goods at point of shipment
- Freight in (in the books of buyer), part of purchase cost.

2. FOB Destination - the seller agreed to pay all the shipping costs and the purchaser receives title
to the goods at point of destination.
- Freight out (in the books of seller), a selling expense.

Freight payments:
1. Freight prepaid – seller paid the shipping costs.
2. Freight collect – buyer paid the shipping costs.

 It is immaterial to determine who paid the freight, but the agreed terms of freight determines who
shall be the owner of the goods during in transit.

Summary of freight charges:

FOB terms: Who has the Who paid Who should Amount due: Account title:
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title to the the pay the

goods during in freight? freight?
transit?
FOB Destination, freight Seller Seller Seller No effect Freight out; in
prepaid the books of the
seller
FOB Destination, freight Seller Buyer Seller Decrease in the Freight out;
collect amount due In the books of
the seller
FOB Shipping point, freight Buyer Buyer Buyer No effect Freight in; in the
collect books of the
buyer
FOB Shipping point, freight Buyer Seller Buyer Increase in the Freight in; in the
prepaid amount due. books of the
buyer

Freight in – shall be added to the cost of goods.

Freight out – expensed outright
- Selling cost

DIFFERENCES IN JOURNAL ENTRIES BETWEEN THE TWO INVENTORY SYSTEMS

PERIODIC INVENTORY SYSTEM: PERPETUAL INVENTORY SYSTEM:
Purchased merchandise
Purchases xx Inventory xx
Input tax xx Input tax xx
A/P or Cash xx A/P or Cash xx

Paid freight (assume FOB shipping point)

Freight-in xx Inventory xx
Cash xx Cash xx

Returned defective merchandise

A/P or Cash xx A/P or Cash xx
PRA xx Inventory xx
Input tax xx Input tax xx

Paid the amount due less discount

A/P xx A/P xx
PD xx Inventory xx
Input tax xx Input tax xx
Cash xx Cash xx

Sold merchandise
A/R or Cash xx A/R or Cash xx
Sales xx Sales xx
Output tax xx Output tax xx

CGS xx
Inventory xx

Returned sold merchandise

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SRA xx SRA xx
Output tax xx Output tax xx
A/R or Cash xx A/R or Cash xx

Inventory xx
CGS xx

PRA – Purchase returns and allowances

PD – Purchase discount
SRA – Sales returns and allowances

Accounting for VAT

Output tax – Input tax = VAT payable

- Should be remitted within 25 days from the end of month.
Output tax xx
Input tax xx
VAT payable xx

 The accounting cycle in accounting for merchandising business is the same as of the service
business except that, there are seven period-end adjustments, the six are the same as of the
service, the seventh adjustment is the set up of ending inventory and cost of goods sold.

Setting up of ending inventory

Under the periodic system:
- The purchases account is used to record purchases of merchandise.
- Purchases account is debited whenever goods are purchased.
- These are temporary (or nominal accounts):
o Purchases
o Purchase returns and allowances
o Purchase discounts
o Freight in
- To determine the cost of inventory on hand, a physical count should be done. Physical
count should be taken at or near the reporting date.
- The account inventory is used to record the cost of inventory on hand. This amount
becomes the beginning inventory for the next accounting period.

Adjusting journal entries:

- Close first the merchandise inventory beginning by debiting CGS and crediting
inventory.
- Close the purchases account and purchases related accounts (debit all credit balances and
credit all debit balances) to CGS.
- Set up ending inventory by debiting inventory and crediting CGS.

GROSS PROFIT= Net Sales – Cost of goods sold