FAR EASTERN UNIVERSITY- DILIMAN

Department of Accounts and Business

ACCOUNTING THEORY AND PRACTICE

Study Guide Module 3: Accounting Cycle of a Merchandising Business

Merchandising is one of the largest and most influential industries in the United States. It is likely that a
number of you will work for a merchandiser. Therefore, understanding the financial statements of
merchandising companies is important. In this module, you will learn the basics about reporting merchandising
transactions.

Describe merchandising operations and inventory systems.

REI, Wal-Mart, and Amazon.com are called merchandising companies because they buy and sell merchandise
rather than perform services as their primary source of revenue. Merchandising companies that purchase and
sell directly to consumers are called retailers. Merchandising companies that sell to retailers are known as
wholesalers. For example, retailer Walgreens might buy goods from wholesaler McKesson; retailer Offi ce
Depot might buy offi ce supplies from wholesaler United Stationers. The primary source of revenue for
merchandising companies is the sale of merchandise, often referred to simply as sales revenue or sales. A
merchandising company has two categories of expenses: cost of goods sold and operating expenses

Wholesalers Retailers Consumers

Account Title in recognizing revenue:

Service Business Merch Business

Service Income Sales

Service Revenue

Cost of goods sold is the total cost of merchandise sold during the period.

This expense is directly related to the revenue recognized from the sale of goods.
Formula to Remember:

Sales 1000 Purchases 20,000 pesos

- Sales Discount 300 + Freight In 500
- Sales Return and Allowances 100 - Purchase Return and Allowances 6000
= Net Sales 600 - Purchase Discount 500
= Net Purchases 14,000

Net Sales 600 (30 bikes) Beg. Inventory

- COGS 300 (30 bikes) P10 per bike + Net Purchases
= Gross Profit 300 = TGAS (Total Goods Available for Sale) 40
- OPEX 200 - End Inventory 10
= Net Income 100 = COGS 30
*for periodic inv. System ito di na to kailangan pag
perpectual
*flow of cost

OPERATING CYCLES

The operating cycle of a merchandising company ordinarily is longer than that of a service company. The
purchase of inventory and its eventual sale lengthen the cycle. Note that the added asset account for a
merchandising company is the Inventory account.
FLOW OF COSTS

The flow of costs for a merchandising company is as follows. Beginning inventory plus the cost of goods
purchased is the cost of goods available for sale. As goods are sold, they are assigned to cost of goods sold.
Those goods that are not sold by the end of the accounting period represent ending inventory. Companies use
one of two systems to account for inventory: a perpetual inventory system or a periodic inventory system

Perpetual System
In a perpetual inventory system, companies maintain detailed records of the cost of each inventory
purchase and sale. These records continuously— perpetually— show the inventory that should be on hand
for every item. For example, a Ford dealership has separate inventory records for each automobile, truck,
and van on its lot and showroom fl oor. Similarly, a grocery store uses bar codes and optical
scanners to keep a daily running record of every box of cereal and every jar of jelly that it buys and sells.
Under a perpetual inventory system, a company determines the cost of goods sold each time a sale
occurs.

Periodic System
In a periodic inventory system, companies do not keep detailed inventory records of the goods on hand
throughout the period. They determine the cost of goods sold only at the end of the accounting period
—that is, periodically. At that point, the company takes a physical inventory count to determine the cost
of goods on hand.

To determine the cost of goods sold under a periodic inventory system, the
following steps are necessary:
1. Determine the cost of goods on hand at the beginning of the accounting period.
2. Add to it the cost of goods purchased.
3. Subtract the cost of goods on hand as determined by the physical inventory count at the end of the
accounting period.
1. Perpectual – walang purchases, walang purch. discount, freight in

Record purchases under a perpetual inventory system.

Companies may purchase inventory for cash or on account (credit). They normally record purchases when they
receive the goods from the seller. Every purchase should be supported by business documents that provide
written evidence of the transaction. Each cash purchase should be supported by a canceled check or a cash
register receipt indicating the items purchased and amounts paid. Companies
record cash purchases by an increase (debit) in Inventory and a decrease (credit) in Cash.

Under the perpetual inventory system, companies record purchases of merchandise for sale in the Inventory
account.

FREIGHT COSTS

Note:
Who must pay? Account Title (Journal)
FOB Shipping Point Buyer Freight – In (Part ng puchases)
FOB destination Seller Freight – Out (OPEX)

Shipping Destination
Courier
Point (Seller) (Buyer)

Freight terms are expressed as either FOB shipping point or FOB destination. The letters FOB mean free on
board. Thus, FOB shipping point means that the seller places the goods free on board the carrier, and the
buyer pays the freight costs. Conversely, FOB destination means that the seller places the goods free on board
to the buyer’s place of business, and the seller pays the freight.
PURCHASE RETURNS AND ALLOWANCES

A purchaser may be dissatisfi ed with the merchandise received because the goods are damaged or defective,
of inferior quality, or do not meet the purchaser’s specifi cations. In such cases, the purchaser may return the
goods to the seller for credit if the sale was made on credit, or for a cash refund if the purchase was for cash.
This transaction is known as a purchase return. Alternatively, the purchaser may choose to keep the
merchandise if the seller is willing to grant a reduction of the purchase price. This transaction is known as a
purchase allowance

Documents:
Debit Memo – this is created by the buyer if he/she wants to return the merch
Credit Memo – this is created by the seller to notify the buyer that the company aggrees with his/her request
to return the merch; NOTE NA PWEDE IBALIK

PURCHASE DISCOUNTS

The credit terms of a purchase on account may permit the buyer to claim a cash discount for prompt payment.
The buyer calls this cash discount a purchase discount.

SALES RETURNS AND ALLOWANCES

We now look at the “fl ip side” of purchase returns and allowances, which the seller records as sales returns
and allowances. These are transactions where the seller either accepts goods back from a purchaser (a return)
or grants a reduction in the purchase price (an allowance) so that the buyer will keep the goods. Sales Returns
and Allowances is a contra revenue account to Sales Revenue, which means it is offset against a revenue
account on the income statement. The normal balance of Sales Returns and Allowances is a debit

SALES DISCOUNTS

As mentioned in our discussion of purchase transactions, the seller may offer the customer a cash discount—
called by the seller a sales discount—for the prompt payment of the balance due. Like a purchase discount, a
sales discount is based on the invoice price less returns and allowances, if any. The seller increases (debits) the
Sales Discounts account for discounts that are taken. Like Sales Returns and Allowances, Sales Discounts is a
contra revenue account to Sales Revenue. Its normal balance is a debit. Sellers use this account, instead of
debiting Sales Revenue, to disclose the amount of cash discounts taken by customers.

Sales

The income statement for a merchandising company typically presents gross sales for the period. The company
deducts sales returns and allowances and sales discounts (both contra accounts) from sales revenue in the
income statement to arrive at net sales.

Gross Profit

The excess of net sales over cost of goods sold is gross profit. It is determined by deducting cost of goods
sold from net sales.
Operating Expenses

1. Operating expenses for a merchandising company are those expenses, other than cost of goods sold,
incurred in the normal business functions of a company. Usually, operating expenses are either selling
expenses or administrative expenses

2. Selling expenses are expenses a company incurs in selling and marketing efforts. Examples include salaries
and commissions of salespersons, expenses for salespersons' travel, delivery, advertising, rent (or depreciation,
if owned) and utilities on a sales building, sales supplies used, and depreciation on delivery trucks used in
sales.

3. Administrative expenses are expenses a company incurs in the overall management of a business.
Examples include administrative salaries, rent (or depreciation, if owned) and utilities on an administrative
building, insurance expense, administrative supplies used, and depreciation on office equipment.

Determine cost of goods sold under a periodic inventory system.

Determining cost of goods sold is different when a periodic inventory system is used rather than a perpetual
system. As you have seen, a company using a perpetual system makes an entry to record cost of goods sold
and to reduce inventory each time a sale is made. A company using a periodic system does not determine
cost of goods sold until the end of the period. At the end of the period, the company performs a count to
determine the ending balance of inventory. It then calculates cost of goods sold by subtracting ending
inventory from the goods available for sale. Cost of goods available for sale is the sum of beginning
inventory plus purchases, as shown in Illustration

Worksheet

1. Any revenue accounts and contra purchases accounts in the Adjusted Trial Balance credit column of the
work sheet are carried to the Income Statement credit column.
2. Beginning inventory, contra revenue accounts. Purchases, Transportation-In, and expense accounts in the
Adjusted Trial Balance debit column are carried to the Income Statement debit column.
3. Ending merchandise inventory is entered in the Income Statement credit column and in the Balance Sheet
debit column.

Closing Entries

Closing entries may be prepared directly from the work sheet. The first journal entry debits all items appearing
in the Income Statement credit column and credits Income Summary. The second entry credits all items
appearing in the Income Statement debit column and debits Income Summary. The third entry debits Income
Summary and credits the Capital account (assuming positive net income). The fourth entry debits the Capital
account and credits the Drawing account

Special Journals

These are journals of original entry other than the general journal that are designed for recording specific types
of transactions of a similar nature.

Types of Special Journals

1. Sales Journal
2. Cash Receipts Journal
3. Purchases Journal
4. Cash Disbursements journals
5. General Journal

Sales Journal

This journal is specifically designed to record sales of merchandise on account. The information for each sale
is obtained from a copy of the related sales invoice, which should be prenumbered for control purposes.

Cash Receipts Journal

All transactions involving cash receipts are recorded in a cash receipts journal. In merchandising business, the
main sources of cash are collections on account and cash sales. Thus, this journal has debit columns for cash
and sales discounts; and credit column for accounts receivable and sales.

Purchases Journal

Merchandising businesses frequently purchase merchandise and supplies. Such purchases are usually made on
account. The purchase journal is designed to account for purchases of merchandise, supplies and other assets
on account. The primary source document used as the basis for the entries in the journal is the receiving report.

Cash Disbursements Journal

All cash payments are recorded in a cash disbursement journal. Note the special columns for credits to cash
and purchases discounts, and for debits to accounts payable and purchases.. ordinarily, these accounts will
have the most entries.

General Journal

When special journal are used, transactions that cannot be recorded appropriately in a special journal are
recorded in the general journal. Examples include merchandise return; write-offs of uncollectible accounts; and
certain non cash transactions involving notes receivable and notes payable

Voucher System

Most entities control purchases and cash disbursements by formalizing the process of verification and approval
of payments using a method known as voucher system. Under this system, checks may be drawn only upon a
written authorization in the form of a voucher approved by the responsible officials.

The system consist the following;

a. Vouchers
b. Voucher Register
c. Unpaid voucher file
d. Check register – evidence that money was received
e. Paid voucher file.

Practice:
At the beginning of the year Mr. Bosa Bus have laptop worth 50,000. Within the period, he also
purchased 100,000 worth of laptop each to increase his inventory stocks. End of the year, he sold 15
units of laptop worth 120,000 with gross profit rate of 20% base on COGS. How much was the cost
of goods sold?

Formula:
Purchases Sales
+ Freight In - Sales Discount
 - Purchase Return and Allowances - Sales Return and Allowances
- Purchase Discount = Net Sales
= Net Purchases
Beg. Inventory Net Sales 100% 120%
+ Net Purchases - COGS 80% 100%
= TGAS = Gross Profit 20% 20%
- End Inventory - OPEX
= COGS = Net Income

Solution:
Sales 120,000 X 80% = 96,000