Accounting for Merchandising Businesses Inventory Systems

FABM2-I-Q111
FUNDAMENTALS OF ACCOUNTANCY, BUSINESS AND

MANAGEMENT 2
Specialized Subject
CHAPTER XI
ACCOUNTING FOR MERCHANDISING BUSINESSES: PART 1
Lesson 1
THE MERCHANDISE INVENTORY AND INVENTORY SYSTEMS
DEFINITION OF A MERCHANDISING BUSINESS: A REVIEW

A merchandising business is a type of business which purchases products from other
businesses or manufacturers and sell them to consumers. Merchandising companies usually
generate profit by providing markup price on their goods available for sale.
Examples of Merchandising Businesses

 Grocery stores
 Department stores
 Distributors
 Real estate dealers
 Car dealers
Advantages of Merchandising Business

 Relatively low capital requirement
 Benefit from price fluctuations.
 Lower cost of quality.
 Special skill or expertise is generally not needed.
Disadvantages of Merchandising Business

 A physical space (such as a retail store) located in a strategic location is generally needed to
display the goods.
 Less flexibility in managing costs.
 Keeping track of inventory levels may be tedious
 Self-satisfaction is low.
SERVICE-TYPE BUSINESS VS. MERCHANDISING BUSINESS

Service-type businesses perform services for a fee. In ascertaining profit, a basic income
statement is all that is needed. In service-type businesses, profit is measured as the difference
between income from services and expenses. On the other hand, merchandising businesses earn
profit by buying and selling goods. The operating cycle of a merchandising business is normally longer
than that of a service company. The purchase of merchandise inventory and its eventual sale lengthen
the cycle.
Lesson 2
THE MERCHANDISE INVENTORY
THE CONCEPT OF MERCHANDISE INVENTORY

One of the main differences between a merchandising business and a service-type business is
that a merchandising business necessarily holds inventory of physical goods for sale. According to
Philippine Accounting Standards (PAS) No. 2, Inventories include any of the following:
a. Assets held for sale in the ordinary course of business (finished goods);
b. Assets in the production process for sale in the ordinary course of business (work-in-process);
and
Chapter IX ACCOUNTING FOR MERCHANDISING BUSINESSES, PART I

FUNDAMENTALS OF ACCOUNTANCY, BUSINESS AND MANAGEMENT 1 2
c. Materials and supplies that are consumed in the production (raw materials).
In this context, inventory simply refers to the goods that a merchandising business has
purchased with the main intention of reselling them in their original form and without any further
processing.
OWNERSHIP OVER INVENTORIES

Legal title normally passes when possession over the goods is transferred. However, there
may be cases where the transfer of control (ownership) does not coincide with the transfer of physical
possession. Control may be transferred even before or after the transfer of physical possession. In
this regard, proper consideration should be given to the following:
1. Consigned goods
2. Sale on trial or sale on approval
3. Installment sale
4. Bill and hold sale
5. Lay away sale
6. Goods in transit
Consigned Goods
A consignment involves a consignor transferring goods to a consignee who will act as an agent
of the consignor in trying to sell the goods.
Consigned goods are included in the consignor’s inventory and are excluded from the
consignee’s inventory. When the goods are delivered to the consignee, the consignor retains ownership
over the consigned goods. The consigned goods remain the property of the consignor and hence,
included in his inventory. In a typical consignment, the consignee is entitled to a commission based
on sales.
Sale on Trial or Sale on Approval

Under a sale on trial, a seller allows a prospective customer to use a good for a given period of
time. At the end of that time, if the prospective customer is satisfied with the good, he purchases it.
If not, he returns it to the seller.
Under this type of arrangement, the legal title over the good does not pass to the prospective
customer until he approves it and purchases it. Therefore, the good remains in the seller’s inventory
during the trial period.
Installment Sale
An installment sale where the possession of the goods is transferred to the buyer but the seller
retains legal title solely to protect the collectability of the amount due is considered as a regular sale.
Therefore, the goods are excluded from the seller’s inventory and included in the buyer’s inventory
at the point of sale.
Bill-and-Hold Sale
A bill-and-hold arrangement is a contract of sale under which an entity bills a customer for a
product but the entity retains physical possession of the product until it is transferred to the customer
at a future date.
The goods sold under a bill and hold sale is excluded from the seller’s inventory and included
in the buyer’s inventory at the point of sale when title passes to the buyer and he accepts billing.
Lay Away Sale

Lay away sale is a type of sale in which goods are delivered only when the buyer makes the
final payment in a series of installments. This is different from a regular installment sale wherein
goods are delivered to the buyer at the time of sale.
The goods under a lay away sale are included in the seller’s inventory until the goods are
delivered to the buyer. Delivery is made after the final installment payment is paid.

Lesson 3
INVENTORY SYSTEMS
Inventories are accounted for using either of the following inventory systems:
1. Perpetual inventory system; or
2. Periodic inventory system
Perpetual Inventory System

In this inventory system, businesses keep detailed records of the cost of each inventory
purchase and sale. These records continuously – or perpetually – show the inventory that should be
on hand for every item. The Inventory account is updated each time a purchase or sale is made. Thus,
the Inventory account shows a continuing or running balance of the goods at hand.
Moreover, records called “stock cards” are maintained under this system. The balances of
goods at hand and cost of goods sold at any given point in time can be determined from the running
totals in the stock cards without the need of having a physical count of inventory. Physical count is
performed as an internal control to determine the accuracy of the balance per records.
All increases and decreases in inventory, such as purchases, freight-in, purchase returns and
allowances, purchase discounts, cost of goods sold and sales returns are recorded in the Inventory
account. Cost of goods sold is also updated each time a sale or sale return in made.
The perpetual inventory system is commonly used for inventories that are specifically
identifiable and are relatively high valued, such as cars, machineries, furniture, jewelry, and heavy
equipment.
Periodic Inventory System

In this system, businesses do not keep a detailed inventory record of goods on hand throughout
the period. Instead, they determine the cost of goods sold only at the end of the accounting period
- that is, periodically. The Inventory account is updated only when a physical count is performed.
Under this system, the business does not maintain records that show the running balances of
inventory at hand and cost of goods sold as at any given point in time. To determine this information,
a physical count of the quantity of goods on hand must be performed periodically. The quantity
counted is then multiplied by the unit cost to get the balance of the Inventory account. This amount
is then used to compute for the cost of goods sold, which is the residual amount in the formula below:
Inventory, beginning P xx Purchases P xx

Add: Net purchases xx Add: Freight-in xx
Total goods available for sale xx Less: Purchase returns and allowances (xx)
Less: Inventory, end (xx) Less: Purchase discounts (xx)
Cost of goods sold P xx Net purchases P xx
Notice that purchase returns and allowances and purchase discounts are deductions in the
formula for net purchases.
Terminologies Related to Periodic Inventory System

1. Purchases. The account used to record purchases of inventory under the periodic inventory
system.

2. Freight-in. Also called transportation-in, the account used to record the shipping costs
incurred on purchases of inventory under the periodic inventory system.
3. Purchase returns and allowances. The account used to record returns of purchased goods
to the supplier.
4. Purchase discounts. The account used to record cash discounts availed of on the purchased
goods.
Under the periodic inventory system, purchases of inventory are debited to the Purchases
account, shipping costs are debited to the Freight-in account, purchase returns are credited to
purchase returns and allowances and purchase discounts are credited to the Purchase Discounts
account. No entry is made to recognize cost of goods sold when inventory is sold.
Since the Inventory account is updated only after a physical count, prior to the count, the
balance of the Inventory account represents the beginning balance or the balance from the last
physical count. Consequently, the balance of cost of goods sold prior to a physical count is zero.
The periodic inventory system is commonly used for inventories that are normally
interchangeable, relatively low valued, and have a fast turnover rate, such as grocery items,
medicines, electrical parts and office supplies.
ILLUSTRATION: Perpetual Inventory System vs. Periodic Inventory System
Perpetual Inventory System Periodic Inventory System

1. You purchased goods worth P10,000 on account.
Inventory 10,000 Purchases 10,000
Accounts payable 10,000 Accounts payable 10,000
2. You paid shipping costs of P1,000 on the purchase above.

Inventory 1,000 Freight-in 1,000
Cash 1,000 Cash 1,000
3. You returned damaged goods worth P2,000 to the supplier.

Inventory 2,000 Purchase returns & allowances 2,000
4. You sold goods costing P5,000 for P20,000 on account.

Accounts receivable 20,000 Accounts receivable 20,000
Sales 20,000 Sales 20,000
Cost of goods sold 5,000

Inventory 5,000
5. A customer returned goods with sale price of P800 and cost of P200.
Sales returns & allowances 800 Sales returns & allowances 800
Accounts receivable 800 Accounts receivable 800
Inventory 200
Cost of goods sold 200
Lesson 4
GOODS IN TRANSIT
Goods in transit pertain to goods already shipped by the seller but are not yet received by the
buyer. The lack of physical possession may pose a question on who owns the goods in transit.
Depending on the terms of sale contract, goods may form part of inventories of either the buyer
or seller, but not both. Such terms are either:
1. FOB shipping point or
2. FOB destination.
FOB stands for “free on board.”

FOB Shipping Point
Under FOB shipping point, ownership over the goods is transferred upon shipment. Therefore,
the goods in transit form part of the buyer’s inventories. The buyer records the purchase (and
accounts payable) upon shipment.
FOB Destination
Under FOB destination, ownership over the goods is transferred when the goods are received
by the buyer. Therefore, the goods in transit form part of the seller’s inventories. The buyer records
the purchase (and accounts payable) upon receipt of the goods.
FREIGHT COSTS
When merchandise is shipped by a common carrier – a trucking company or an airline – the
carrier prepares a freight bill in accordance with the instructions of the party making the shipping
arrangements. As a general rule, whoever owns the goods in transit, pays the freight.
For freight arrangements, terms could be either:

1. Freight prepaid; or
2. Freight collect.
Freight Prepaid
Under freight prepaid, the seller pays the transportation costs before shipping the merchandise
to the buyer. Thus, freight prepaid terms are usually used when the agreement is FOB destination.
Freight Collect
Under freight collect, the freight company collects the transportation costs from the buyer upon
the receipt of the goods by the buyer. Thus, freight collect terms are usually used when the agreement
is FOB shipping point.
Ultimately, payment by either party will not dictate who should shoulder the costs. Sometimes,
as a matter of convenience, the firm not bearing the freight cost pays the carrier. When this situation
occurs, the seller and the buyer simply adjust the amount of the payment for the merchandise. The
table below summarizes these scenarios:
Who
Who Pays the Accounting Treatment of
Freight Terms Shoulders/Records
Shipper? the Freight Cost
the Shipping Cost?
FOB Shipping Point, Freight Recorded as Freight-in on
Buyer Buyer
Collect Buyer’s books
Recorded as Freight-Out
FOB Destination, Freight
Seller Seller (Delivery Expense) on
Prepaid
Seller’s books
Recorded as Freight-in on
FOB Shipping Point, Freight Buyer’s books and
Buyer Seller
Prepaid addition to the amount
due to the seller
Recorded as Freight-Out
(Delivery Expense) on
FOB Destination, Freight
Seller Buyer Seller’s books and
Collect
reduction of the amount
due to the seller
Illustration:
On December 27, 2018, Alpha Industries purchased on account P150,000 worth of goods from Omega
Co. The goods were shipped on the same day. Related shipping costs amounted to P5,500. The goods
were received by Alpha on January 3, 2019. Alpha paid the amount in full on January 7, 2019.

Case 1. FOB Shipping Point, Freight Collect
G E N E R A L J O U R N A L
Date Page Number 1
Descriptions PR
20xx Debit Credit
12 27 Purchases 1 5 0 0 0 0 00
Accounts payable 1 5 0 0 0 0 00
To record the purchase of goods on acct.
1 3 Freight-in 5 5 0 0 00
Cash 5 5 0 0 00
To record the payment of freight.
1 7 Accounts payable 1 5 0 0 0 0 00
Cash 1 5 0 0 0 0 00
To record the payment of accounts

payable.
Case 2. FOB Destination, Freight Prepaid
Date Page Number 1
Descriptions PR
2018 Debit Credit
12 27 NO ENTRY
1 3 Purchases 1 5 0 0 0 0 00
Cash 1 5 0 0 0 0 00

payable.
Case 3. FOB Shipping Point, Freight Prepaid
Date Page Number 1
Descriptions PR
2018 Debit Credit
12 27 Purchases 1 5 0 0 0 0 00
Freight-in 5 5 0 0 00
1 3 NO ENTRY
Cash 1 5 0 0 0 0 00

payable.
Case 4. FOB Destination, Freight Collect
Date Page Number 1
Descriptions PR
2018 Debit Credit
12 27 NO ENTRY
1 3 Purchases 1 5 0 0 0 0 00
Accounts payable 5 5 0 0 00
Cash 5 5 0 0 00
To record the payment of freight.

Cash 1 4 4 5 0 0 00

payable.
Lesson 5
TRADE DISCOUNTS AND CASH DISCOUNTS
Merchandise may be purchased and sold either on credit terms or for cash on delivery. When
goods are sold on account, a period of time called the credit period is allowed for payment. The length
of the credit period varies across industries and may even vary within a business, depending on the
product.
When goods are sold on credit, both parties should have an understanding as to the amount
of time of payment. These terms are usually printed on the sales invoice and constitute part of the
sales agreement.
TRADE DISCOUNTS
Trade discounts encourage the buyers to purchase products because of markdowns from the
list price. This type of discount enables the suppliers to vary prices periodically without the
inconvenience of revising price lists and catalogs.
There is no trade discount account and there is no special accounting entry for this discount.
Instead, all accounting entries are based on the invoice price which is obtained by subtracting the
trade discount from the list price.
Terminologies Relating to Trade Discounts

1. List Price. This refers to the price of the goods as they appear on the supplier’s catalogs and
brochures.
2. Invoice Price. This refers to the price that the buyer shall pay after deducting all allowed trade
discounts.
3. Trade Discount. This refers to the markdown in prices allowed by the supplier.
4. Trade Discount Rate. This refers to the percentage basis for the computation of trade
discount.
ILLUSTRATION:
Pinnacle Technologies quoted a list price of P2,500 for each 5 gigabyte flash drive, less a trade
discount of 20%. If Video Fantastic Company ordered seven units, the invoice price would be as
follows:
List price (P2,500 x 7 units) P 17,500

Less: 20% trade discount (P17,500 x 20%) 3,500
Invoice price P 14,000
Alternative solution:
P17,500 x (100%-20%) = P14,000
Journal entries:
To record purchases on To record purchases on
account. account.
Trade discounts may be stated in series. Assume instead that the trade discount given by
Pinnacle to Video Fantastic is 20% and 10%, the invoice price will be:
List price (P2,500 x 7 units) P 17,500

Balance P 14,000
Invoice price P 12,600

Alternative solution:
P17,500 x (100%-20%) x (100%-10%) = P12,600
Journal entries:
account. account.
CASH DISCOUNTS
Cash discounts are usually given to encourage prompt payment. They are deducted from the
invoice price in order to determine the amount of net payment required within the discount period.
Cash discounts are called purchase discounts on the viewpoint of the buyer and sales discounts on
the viewpoint of the seller.
Terminologies Related to Cash Discounts

1. Cash discount rate. This refers to the percentage basis of the computation of cash discount.
2. Discount period. This refers to the length of time allowed to the buyer by the seller to pay the
amount due at a reduced price.
3. Credit period. This refers to the length of time allowed to the buyer by the seller to pay the
total amount due.
4. Credit terms. This refers to the credit arrangements between the seller and the buyer which
defines the discount terms and credit period allowed by the seller. It is denoted by the notation:
<cash discount rate>/<discount period>, n/<credit period>
Example:
2/10, n/30
“2/10” denotes the discount terms of the credit. This means that 2% cash discount will be
given if the buyer pays the amount due in 10 days. No discounts will be given for any payment
beyond 10 days.
“n/30” denotes the credit period. This means that the amount due shall be paid within 30
days.
Accounting for Cash Discounts

There are two methods used for cash discounts. These are the following:
1. Gross Method. The cost of inventory and accounts payable are recorded gross of cash
discounts. Purchase discounts are recorded only when taken. Purchase discounts are
deducted from gross purchases when computing for net purchases.
2. Net Method. The cost of inventory and accounts payable are initially recorded net of cash
discounts, regardless of whether such discounts are taken or not. Purchase discounts not
taken are recorded under the Purchase discounts lost account and included as part of “other
expenses” or as “finance cost”.
Illustration:
Citadel Enterprises purchases inventory with an invoice price of P100,000 on account uder the credit
terms 2/10, n/30.
1. To record the purchase of inventory, the following journal entry shall be recorded in the
accounting books on transaction date:
GROSS METHOD
account. account.

NET METHOD
Inventory 98,000* Purchases 98,000
account. account.
*P100,000 invoice price x (100% - 2% discount rate)
2. If the amount due is paid within 10 days (discount period):

GROSS METHOD
Inventory 2,000 Purchase discounts 2,000
Cash 98,000 Cash 98,000
To record the payment of To record the payment of
amount due. amount due.
NET METHOD
Cash 98,000 Cash 98,000
3. If the amount due is paid beyond 10 days (discount period):

GROSS METHOD
Cash 100,000 Cash 100,000
NET METHOD
Inventory 2,000 Purchase discounts lost 2,000
Cash 100,000 Cash 100,000
COMBINATION OF TRADE DISCOUNTS AND CASH DISCOUNTS

There are instances wherein both trade discounts and cash discounts are given to the buyer.
The following should be noted:
1. Computation of trade discount is based on the list price.
2. Computation of cash discount is based on the invoice price.
Illustration:
Apex Enterprises purchases inventory with a list price of P100,000 on account under the credit terms
20, 10, 2/10, n/30.
Note: The “20, 10” in the credit terms denotes the agreement on trade discounts.
1. To record the purchase of inventory, the following journal entry shall be recorded in the
accounting books on transaction date:
GROSS METHOD
Inventory 72,000* Purchases 72,000
account. account.
NET METHOD
Inventory 70,560** Purchases 70,560
account. account.
* P100,000 list price x (100% - 20% first trade discount rate) x (100% - 10% second trade discount rate)
** P72,000 invoice price x (100% - 2% discount rate)

2. If the amount due is paid within 10 days (discount period):
GROSS METHOD
Inventory 1,440 Purchase discounts 1,440
Cash 70,560 Cash 70,560
NET METHOD
Cash 70,560 Cash 70,560
3. If the amount due is paid beyond 10 days (discount period):

GROSS METHOD
Cash 72,000 Cash 72,000
NET METHOD
Inventory 1,440 Purchase discounts lost 1,440
Cash 72,000 Cash 72,000
Lesson 6
SALES, COST OF GOODS SOLD AND GROSS PROFIT
GROSS SALES
Gross sales consist of total sales for cash and on credit during an accounting period. Under
accrual accounting, revenues from sale of merchandise are considered to be earned in the accounting
period in which the title of goods passes – usually at the point of delivery – from the seller to
the buyer. As an income account, the sales account is credited whenever sales on account or cash
sales are made.
The journal entry to record sale of merchandise for cash is as follows:
Date Page Number 1
Descriptions PR
2018 Debit Credit
1 1 Cash 2 5 0 0 0 00
Sales 2 5 0 0 0 00
To record sale of merchandise for cash.
The journal entry to record sale of merchandise on credit (or on account) is as follows:
Date Page Number 1
Descriptions PR
2018 Debit Credit
1 1 Accounts receivable 2 5 0 0 0 00
Sales 2 5 0 0 0 00

SALES DISCOUNTS
Sales discounts refer to the cash discounts granted and availed by the buyer for goods
purchased on credit. It is the account title used to record cash discounts from the point of view of the
seller. Sales discounts are deducted from gross sales (along with sales returns and allowances) for
the purpose of computing for net sales.
Illustration:
Static Company sold merchandise on September 20, 2018 for P3,000 with the following credit terms
: 2/10, n/60.
The journal entry to record the sale of merchandise on credit is:
Date Page Number 1
Descriptions PR
2018 Debit Credit
9 20 Accounts receivable 3 0 0 0 00
Sales 3 0 0 0 00
If the customer take advantage of the cash discount, the journal entry to record the availing of cash
discount and receipt of payment are as follows:
Date Page Number 1
Descriptions PR
2018 Debit Credit
9 30 Cash 2 9 4 0 00
Sales discounts 6 0 00
Accounts receivable 3 0 0 0 00
To record collection on the Sept. 20 sale;

discounts taken.
If the customer did not take advantage of the cash discount, the journal entry to record the receipt of
payment is as follows:
Date Page Number 1
Descriptions PR
2018 Debit Credit
10 20 Cash 3 0 0 0 00
To record collection on the Sept. 20 sale.
SALES RETURNS AND ALLOWANCES

Buyers may be dissatisfied with the merchandise received either because the goods are
damaged or defective, of inferior quality or not in accordance with their specifications. In such cases,
the buyer may return the goods and ask for a reduction of credit or cash refund. Alternatively, the
seller may just grant an allowance or deduction from the selling price.
Each return or allowance is recorded as a debit to an account called sales returns and
allowances.
Illustration:
A customer returned defective goods amounting to P350.

Date Page Number 1
Descriptions PR
2018 Debit Credit
9 17 Sales returns and allowances 3 5 0 00
Accounts receivable (or Cash) 3 5 0 00
To record return or allowance on

unsatisfactory merchandise.
The seller usually issues the customer a credit memorandum which is a formal
acknowledgment that the seller has reduced the amount owed by the customer. Sales returns and
allowances (together with sales discounts) is deducted from gross sales to compute for net sales.
FREIGHT
As a general rule, for goods in transit, the owner of the goods shall be the one who should pay
for the delivery cost. This means that when the term is FOB shipping point, the buyer shall pay the
freight, and if the term is FOB destination, the seller shall pay the freight. The following are the
necessary journal entries relating to freight from the point of view of the seller:
Illustration:
On December 27, 2018, Omega Co. sold goods on account amounting to P150,000 to Alpha
Industries. The goods were shipped on the same day. Related shipping costs amounted to P5,500.
The goods were received by Alpha on January 3, 2019. Alpha paid the amount in full on January 7,
2019.
Case 1. FOB Shipping Point, Freight Collect
Date Page Number 1
Descriptions PR
20xx Debit Credit
12 27 Accounts receivable 1 5 0 0 0 0 00
Sales 1 5 0 0 0 0 00
To record the sale of merchandise on

account.
1 3 NO ENTRY
1 7 Cash 1 5 0 0 0 0 00
Accounts receivable 1 5 0 0 0 0 00
To record the receipt of cash as payment

for goods sold on account.
Case 2. FOB Destination, Freight Prepaid
Date Page Number 1
Descriptions PR
20xx Debit Credit
12 27 Freight-out (or Delivery expense) 5 5 0 0 00
Cash 5 5 0 0 00
To record payment for delivery cost.
Sales 1 5 0 0 0 0 00

account.
1 7 Cash 1 5 0 0 0 0 00


Case 3. FOB Shipping Point, Freight Prepaid
Date Page Number 1
Descriptions PR
20xx Debit Credit
Sales 1 5 0 0 0 0 00
Cash 5 5 0 0 00
To record sale of goods on account and

Payment of delivery charges.
1 3 NO ENTRY
1 7 Cash 1 5 5 5 0 0 00

Case 4. FOB Destination, Freight Collect
Date Page Number 1
Descriptions PR
20xx Debit Credit
12 27 NO ENTRY
Sales 1 5 0 0 0 0 00

account.
Freight-out (or Delivery expense) 5 5 0 0 00
To record the delivery charges paid by

the buyer.
1 7 Cash 1 4 4 5 0 0 00

COST OF GOODS SOLD

Cost of goods sold (also known as cost of sales) is the largest single expense of the
merchandising business. It is the cost of inventory that the entity has sold to customers. The goods
available for sale during the year is the sum of two factors – merchandise inventory at the beginning
of the year and net cost of purchases during the period (gross purchases less purchase discounts and
purchase returns and allowances).
Beginning Net Cost of

Inventory Purchases
Total Goods Available for Sale
Ending
Cost of Goods Sold
Inventory

Terminologies Related to Cost of Goods Sold
1. Beginning Inventory. Refers to the cost of inventory on hand at the beginning of the year
before any purchase of inventory has been done. This also refers to the ending inventory on
hand at the end of the previous year.
2. Net Purchases. Refers to all cash and credit purchases of inventory during the year, plus
freight-in and minus all purchase discounts and purchase returns and allowances.
3. Ending Inventory. Refers to the cost of unsold inventory on hand at the end of the year. The
amount of ending inventory at the end of the year shall be the beginning inventory of the next
year.
4. Total Goods Available for Sale. Refers to the total amount of inventory available for sale to
customers during the year. This is the sum total of beginning inventory and net cost of
purchases.
In summary, total goods available for sale during a period come from beginning inventory and
net cost of purchases. The goods are either sold during the period or remain unsold at the end of the
period. Total goods available for sale will eventually turn to expense for the period – as cost of goods
sold, or to asset – as merchandise inventory.
Cost of Goods Sold Using the Perpetual Inventory System

Recall the following:
1. All increases and decreases in inventory are recorded in the Inventory account. This
means that all purchases of inventory are recorded using a debit to Inventory.
2. Cost of goods sold is debited when inventory is sold and credited for sales returns. This
means that for every transaction that involves physical movement of inventory, the cost of
goods sold in updated. At any given point in time during the year, there is a running balance
for cost of goods sold.
3. Physical count is performed only to check the accuracy of the ledger balances. Though
not required, Physical count is a good internal control procedure to check if there are
discrepancies actual count and accounting records.
4. Does not require the use of any formula to determine cost of goods sold because this
information is readily available from the ledger.
Cost of Goods Sold Under the Periodic Inventory System

Recall the following:
1. Increases and decreases in inventory during the period is recorded in different accounts:
a. Purchases, for all cash and credit purchases of inventory;
b. Freight-in, for the shipping costs necessary to bring the inventory from supplier to the buyer;
c. Purchase returns and allowances, for all returns of inventory from customers; and
d. Purchase discounts, for all reduction in the invoice price of inventories purchased on
account because of prompt payment.
This is a fundamental difference between perpetual and periodic inventory systems. In
perpetual inventory system, these transactions are all recorded in the Inventory account, as
stated above.
2. Cost of goods sold is not recorded.
3. Physical count is necessary to determine the balances of inventory n hand and cost of goods
sold.
4. Required the use of the following formula when determining cost of goods sold:
Inventory, beginning P xx Purchases P xx

Add: Net purchases xx Add: Freight-in xx
Total goods available for sale xx Less: Purchase returns and allowances (xx)
Less: Inventory, end (xx) Less: Purchase discounts (xx)
Cost of goods sold P xx Net purchases P xx
GROSS PROFIT
Gross profit (also called gross income, gross margin or sales profit) is the residual amount of
sales after deducting all directly attributable costs from the generated sales revenue. It is simply net
sales minus cost of goods sold.
Net sales P xx
Less: Cost of goods sold (xx)
Gross profit P xx

Gross profit represents the profit a business earns after deducting the costs directly associated
with making the product but before deducting other expenses.
Profit (Net profit or net income) is different from gross profit. Profit is the amount derived after
deducting all other expenses from the gross profit. This is illustrated below:
Net sales P xx Gross Profit = Net

Cost of goods sold (xx) sales minus Cost of
Gross profit P xx goods sold
Rent expense (xx)
Depreciation expense (xx)
Salaries expense, etc. (xx) Net income = Net
Net income P xx sales minus ALL
expenses
Net sales in this context refers to all earnings of the business from selling goods after deducting
cash discounts granted and availed and returns of merchandise by the customer. This is computed
as total sales minus sales discounts and sales returns and allowances, as shown in the formula
below:
Gross sales (or simply, sales) P xx

Less: sales returns and allowances (xx)
Less: sales discounts (xx)
Net sales P xx
Statement of Cost of Goods Sold and Gross Profit

The Statement of Cost of Goods Sold and Gross Profit is a report that indicates the total amount
of sales revenue generated during the period minus all the directly attributable costs of such revenue.
This document is not a formal accounting report that is prepared for external reporting. Nonetheless,
this report can be prepared for internal reporting purposes.
The Statement of Cost of Goods Sold and Gross Profit is similar to the Income Statement. It is
actually a part of an income statement, however, this report ends with the gross profit, meaning it
does not show information about the other expenses.
An example of Statement of Cost of Goods Sold and Gross Profit is shown below:
ABC COMPANY
Statement of Cost of Goods Sold and Gross Profit
For the period ended December 31, 2018
Gross sales P 20,000

Sales discounts P (2,200)
Sales returns and allowances ( 650) ( 2,850)
Net sales P 17,150
Cost of goods sold:

Merchandise inventory, beg P 1,000
Net purchases:
Gross purchases P 6,500
Freight-in 500
Purchase discounts (1,500)
Purchase returns and allowances (1,250) 4,250
Total goods available for sale P 5,250
Merchandise inventory, end (1,040) (4,210)
GROSS PROFIT P 12,940
END OF HANDOUT
/jmpr

Accounting for Merchandising Businesses Inventory Systems

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Accounting for Merchandising Businesses Inventory Systems

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FABM2-I-Q111

FUNDAMENTALS OF ACCOUNTANCY, BUSINESS AND

DEFINITION OF A MERCHANDISING BUSINESS: A REVIEW

Examples of Merchandising Businesses

Advantages of Merchandising Business

Disadvantages of Merchandising Business

SERVICE-TYPE BUSINESS VS. MERCHANDISING BUSINESS

THE CONCEPT OF MERCHANDISE INVENTORY

Chapter IX ACCOUNTING FOR MERCHANDISING BUSINESSES, PART I

OWNERSHIP OVER INVENTORIES

Sale on Trial or Sale on Approval

Lay Away Sale

Chapter IX ACCOUNTING FOR MERCHANDISING BUSINESSES, PART I

Perpetual Inventory System

Periodic Inventory System

Inventory, beginning P xx Purchases P xx

Terminologies Related to Periodic Inventory System

Chapter IX ACCOUNTING FOR MERCHANDISING BUSINESSES, PART I

ILLUSTRATION: Perpetual Inventory System vs. Periodic Inventory System

Perpetual Inventory System Periodic Inventory System

2. You paid shipping costs of P1,000 on the purchase above.

3. You returned damaged goods worth P2,000 to the supplier.

4. You sold goods costing P5,000 for P20,000 on account.

Cost of goods sold 5,000

FOB stands for “free on board.”

Chapter IX ACCOUNTING FOR MERCHANDISING BUSINESSES, PART I

For freight arrangements, terms could be either:

Chapter IX ACCOUNTING FOR MERCHANDISING BUSINESSES, PART I

To record the purchase of goods on acct.

To record the payment of freight.

To record the payment of accounts

Case 2. FOB Destination, Freight Prepaid

To record the purchase of goods on acct.

To record the payment of accounts

Case 3. FOB Shipping Point, Freight Prepaid

To record the purchase of goods on acct.

To record the payment of accounts

Case 4. FOB Destination, Freight Collect

To record the purchase of goods on acct.

To record the payment of freight.

Chapter IX ACCOUNTING FOR MERCHANDISING BUSINESSES, PART I

To record the payment of accounts

Terminologies Relating to Trade Discounts

List price (P2,500 x 7 units) P 17,500

List price (P2,500 x 7 units) P 17,500

Chapter IX ACCOUNTING FOR MERCHANDISING BUSINESSES, PART I

Terminologies Related to Cash Discounts

<cash discount rate>/<discount period>, n/<credit period>

Accounting for Cash Discounts

Chapter IX ACCOUNTING FOR MERCHANDISING BUSINESSES, PART I

2. If the amount due is paid within 10 days (discount period):

3. If the amount due is paid beyond 10 days (discount period):

COMBINATION OF TRADE DISCOUNTS AND CASH DISCOUNTS

Chapter IX ACCOUNTING FOR MERCHANDISING BUSINESSES, PART I

3. If the amount due is paid beyond 10 days (discount period):

The journal entry to record sale of merchandise for cash is as follows:

To record sale of merchandise for cash.

To record sale of merchandise for cash.

Chapter IX ACCOUNTING FOR MERCHANDISING BUSINESSES, PART I

The journal entry to record the sale of merchandise on credit is:

To record sale of merchandise for cash.

To record collection on the Sept. 20 sale;