CHAPTER 5

ACCOUNTING FOR MERCHANDISING BUSINESSES

- In previous chapters, our discussion was limited to the accounting for service oriented businesses. Now,
we turn our attention to accounting for the merchandiser.
- Business organizations can be classified:
 Based on ownership— Sole proprietorship, Partnership, and Corporation
 Based on their activity— Service, Merchandising, and Manufacturing
1. Merchandising Companies
- Merchandise Consists of products, also called goods, that a company acquires to resell to customers. As
such, merchandise inventory will ordinarily be converted into cash in less than a year and is thus a current
asset that appears just below accounts receivable because it is less liquid than accounts receivable.
- Merchandising is the act of buying and selling merchandise.
- Merchandising firms are firms engaged in buying merchandise for resale purpose. Merchandisers can
be either wholesalers (those that buy from manufacturers or other wholesalers and sell to retailers or other
wholesalers) or retailers (those that buy from wholesalers or manufacturers and sell to consumers).
NOTE: The fundamental accounting concepts for service type businesses also apply to merchandising
businesses, but some additional accounts and techniques are needed to account for purchase and sales.
Chart of Account for a Merchandising Business
- The chart of accounts for a merchandising business is more complex than that for a service business and
normally includes accounts such as Sales, Sales Discounts, Sales Returns and Allowances, Cost of
Merchandise Sold, and Merchandise Inventory.
2. Accounting for Purchases
- Merchandising companies purchase goods for resale purpose. There is cost associated with these goods
(merchandise).
- Purchases: is an account used to record or accumulate cost of all merchandise bought for resale during
the accounting period. A more exact title, such as “purchases of merchandise” could be used, but the
briefer title is customarily used. The purchases account is increased by debits because they are deductions
from the income of a business and is included in the income statement.
- Purchases may be on account or for cash.
Example:
a) On May 3 AA Company purchased $20,000 of merchandise for cash from BB Company. The
required journal entry is:
May 3 Purchases ------------ 20,000
Cash ------------- 20,000
b) On May 5 AA Company purchased merchandise on account for $8,000, terms 2/10, n/30, invoice
No. 170 from BB Company.
May 5 Purchases ------------------ 8,000
Accounts payable ------ 8,000
Invoice No. 170
NOTE:
 Items bought for use in the business rather than for resale are recorded in the appropriate general
ledger accounts. A business may buy many items, such as merchandise, supplies and equipment.
However, only merchandise bought for resale to customers is recorded in the purchases account.
 The source documents used to journalize merchandise purchases include the seller's invoice, the
company's purchase order, and a receiving report that verifies the accuracy of the inventory
quantities. For reference purposes, the journal entry's description usually includes the invoice
number.
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 Discounts in Buying
- Discount is reduction in price allowed by a seller or a supplier to a buyer when the buyer meets or
satisfies certain stated conditions. The most known kinds of discounts are:
i) Cash discount offered to encourage prompt payment of cash. It is called sales discount by the
seller and purchase discount by the buyer. Example: credit terms, 2/10 n/30, offer a 2 % discount
if invoice is paid within 10 days of invoice date, if not full payment is due within 30 days of
invoice date. The credit period is 30 days; the 10 day period during which a discount is available is
called a discount period.
ii) Quantity discount—a discount given when a customer buys in large quantity. Buying in large
quantity would benefit both the seller and the buyer.
iii) Trade discountDeductions from list (catalog) price to arrive at invoice price (actual selling
price). Trade discounts may be shown on the invoice, but they are recorded in neither the seller’s
nor the buyer’s accounting records. The actual price would be the amount recorded in the journal.
Gross invoice price(Selling price) = List Price  Trade discount

Credit Terms
- The terms of payment should be clearly stated so that buyer and seller can avoid any misunderstanding as
to the time and the amount of the required payment. The arrangement agreed up on by the buyer and seller
as to when payments for merchandise are to be made are called credit terms
 Cash or net cash—if payment is required immediately up on delivery (COD)
 Credit period—if the buyer is allowed a certain amount of time with which to pay.
- The credit term may be stated:
o Net 30 days (n/30)—Payment is due within 30 days after the invoice date
o n/eom—payment is due by the end of the month in when the sale was made.
o n/15 EOM— due 15 days after the end of the month in which the invoice is dated.
o 2/10,n/30—2% discount if paid within 10 days, net amount due within 30 days
o 2/eom, n/60— 2% discount if paid end of month, net amount due within 60 days
Purchase Discounts
- Purchase discount (PD) is a discount taken by the buyer for early payment of an invoice.
- PD is recorded in an account named purchases discounts, which is contra-purchase account.
- Since it is considered as a reduction in purchases, it is recorded as credit.
Example:
c) On May 15, AA Co. paid cash on account for the May 5 purchase.(i.e., AA Company pays the
invoice in time to receive the discount)
May 15 Accounts payable ------ 8,000
Cash ----------------------- 7,840
Purchase discount --------- 160
If the payment was made too late, the buyer would have to pay the entire $8,000 and would be
recorded using the following entry:
Accounts payable ------ 8,000
Cash ------------------- 8,000
Note:
 From the buyer’s stand point, it is usually important to take advantage of all
available discounts, even though it may be necessary to borrow the money to make the payment. Let
us see interest rate implied in cash discount to support this decision.
Interest Rate Implied in Cash Discounts
- Take the above example. If you make payment within the discount period with money borrowed at 10%
for the remaining 20 days of the credit period, what will be the net saving to the buyer?
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 A 20 day period is approximately 1/18 of a year = 18 × 2% = 36%
- Although interest rates vary widely, most businesses are able to borrow money from banks at an annual
interest rate of 15% or less. So well managed companies always take this advantage.
Discount of 2% on 8000 ----------- $160
Interest for 20 days:
(10% × 7840)20/360 --------- 43.55
Saving effected by borrowing $116.44
If you postpone payment, you will use $7,840 cash for an additional 20 days. However, the extra $160
expense is a high penalty to incur for the use of $7,840 for 20 days.
Purchase Returns and Allowances
- What happens if the goods received are defective, damaged, or otherwise undesirable merchandise? we
have two choices:
i) Return the goods to the seller(called Purchase Return), or
ii) Ask for an allowance (a reduction in the price of the defective goods) and repair the units
ourselves (called Purchase Allowance).
- Debit Memorandum is issued by the buyer (debtor) to the seller to inform the seller of the amount the
buyer proposes to debit to the account payable due the seller. It also states the reasons for the return or the
request for a price reduction. The buyer may use a copy of a debit memorandum to record the return or
allowances or may wait for approval from the seller (creditor).
- Both Returns and Allowances reduce the buyer’s Debt to the seller and the Cost of Merchandise
Purchased. To reduce purchases we use a separate contra-purchase account “purchases return and
allowance.”
Accounts Payable or Cash (if refund given) ----xx
Purchase return and allowance ---------------- xx
For reference purposes, the journal entry's description may include the debit memorandum number and
the seller's invoice number.
Net Purchase = Purchases  PD  PR&Allowance
Examples:
Return or allowance before payment of cash (i.e before taking discount)
d) Assume on May 7 AA Co. returned merchandise purchased on May 5, $500, debit memo No. 22
May 7 Accounts payable ---- 500
PR&Allow.-------- 500
e) Assume on May 15 AA Co. paid for merchandise purchased on May 5, less return and discount.
May 15 Accounts payable ----------- 7,500
Cash -------------------- 7,350
PD(7500×2%) -------- 150
Note:
 PD can only be taken on the remaining balance on the invoice after the
return.
 If AA Co. had already paid cash within the discount period, the debit would
be to cash instead of accounts payable, since a refund of cash would be received. But note that only
the net amount would be refunded.
Return or allowance after discount was taken
f) Assume on May 19 AA Co. made additional return of merchandise purchased on May, 5, $200,
debit memo No.23
May 19 Cash ----------- 196
PD -------------- 4
PR&Allow ----- 200
Note:
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  It is quite possible to credit the purchases account instead of the PD and PR
&Allowance. However, if we credit the purchase account, the amount of purchase return and
allowance will not be disclosed. Since management wants to know its volume, separate account is
maintained to record PR &Allowance and PD.
 Although purchase returns and purchase allowances are technically two
distinct types of transactions, they are generally recorded in the same account. (Of course, one could
use a separate account for returns and another for allowances if they wished to track information about
each of these elements.)
3. Accounting for Sales
- When merchandise is sold, the revenue account for a merchandising business is called sales. Revenue is
earned in the period in which the merchandise is delivered to the customer even though payment in cash is
not received.
- Sales invoices are source documents that provide a record for each sale. For control purposes, sales
invoices should be sequentially prenumbered to help the accounting department determine the disposition
of every invoice. If merchandise is shipped to the customer, a delivery record or shipping document is
matched with the invoice to prove that the merchandise has been shipped to the customer.
- Sales may be on account or for cash.
Example:
a) On May 3 BB Company sold merchandise to AA Company for cash $20,000. The required journal
entry is:
May 3 Cash ------------ 20,000
Sales----------- 20,000
b) On May 5 BB Company sold merchandise to AA Company on account $8,000, terms 2/10, n/30,
invoice No. 170.
May 5 Accounts Receivable ------- 12,000
Sales ---------------------- 12,000
Invoice No. 170
For reference purposes, the journal entry's description often includes the invoice number.
Sales Discount
- Cash discounts awarded to customers for payment within the discount period. Recorded upon collection
for sale. If cash is not collected within the discount period, the seller will collect the full invoice amount.
- Reduces sales and is recorded by debiting “sales discount” which is a contra or offsetting account to sales.
Using this separate account enables management to monitor the effectiveness of the company's discount
policy.
Example:
c) On May 15, AA Co. received cash on account from the May 5 sale.(i.e., AA Company received cash
within the discount period)
May 15 Cash ------------------------ 7,840
Sales Discount ------------ 160
Accounts receivable ------ 8,000
It the payment was not received within the discount period, the buyer would have to pay the entire
$8,000 and would be recorded using the following entry:
Cash ------------------------ 8,000
Accounts receivable ------ 8,000
Sales Return and Allowances
- Sales returns occur when customers return defective, damaged, or otherwise undesirable products to
the seller.

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- Sales allowances occur when customers agree to keep such merchandise in return for a reduction in the
selling price.
- Credit memorandum— document issued by the seller indicating that the seller has credited his accounts
receivable. It shows the amount of and the reason for the seller’s credit to an accounts receivable. This
credit memorandum becomes the source document to record the returns and allowances.
- Both sales returns and allowance reduce sales. To reduce sales a separate contra-sales account, “Sales
return and Allowance” is used. Using separate account allows interested parties to easily track the level of
sales returns in relation to overall sales which may provide a measure of customer satisfaction or
dissatisfaction.
Net Sale = Sales - Sales Discount - SR&Allownace

Examples:
Return or allowance before receipt of cash (i.e before discount was taken)
d) Assume on May 7 BB Co. received merchandise returned from sale of May 5, $500, credit memo
No. 30
May 7 Sales R&Allow.------- 500
Accounts Receivable ---- 500

e) Assume on May 15 BB Co. received cash for merchandise sold on May 5, less return and discount.
May 15 Cash -------------------------- 7,350
Sales discount(7500×2%)--- 150
Accounts Receivable ---- 7,500
Return or allowance after discount was taken
f) Assume on May 19 BB Co. received additional return of merchandise sold on May, 5, $200, credit
memo No.35
May 19 Sales R&Allow ----------- 200
Cash ----------------- 196
Sales discount-------- 4
Credit Card Sales
- Sales to customers who use bank credit cards (such as Master card and VISA) are generally treated as
cash sales. The bank charges service fee for handling credit cards sales.
- Sales made by the use of nonblank credit cards (such as American Express) create receivable with the
card company. Before the card company remits cash, it normally deducts a service fee which is treated as
credit cared collection expense.
4. Transportation Cost
- Who is going to cover transportation costs: the buyer or the seller? Transportation terms are usually set by
the seller using the code FOB (free on board). The FOB point is normally understood to represent the
place where ownership of goods transfers. 
- FOB Shipping Pointthe purchaser gains title to the merchandise at the shipping point (the seller's place
of business). Along with shifting ownership comes the responsibility for the purchaser to assume the risk
of loss, a duty to pay for the goods, and the understanding that freight costs beyond the F.O.B. point will
be borne by the purchaser.
- FOB Destination title transfers to the purchaser at destination (the purchaser's place of business). As a
result the seller is responsible to assume any risk of damage, transportation and insurance costs while the
goods are in transit.
Accounting Treatment

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- When a seller pays to ship merchandise to a purchaser (FOB Destination), the seller records the cost as a
delivery expense (or Transportation-Out or Freight-Out), which is considered an operating expense and,
more specifically, a selling expense. The buyer will never record the transportation cost.
- When a purchaser pays the shipping fees (FOB Shipping point), the purchaser considers the fees to be part
of the cost of the merchandise. Instead of recording such fees directly in the purchases account, however,
they are recorded in a separate account named freight-in or transportation-in, which provides
management with a way to monitor these shipping costs.
- If goods are sold FOB shipping point, freight prepaid, the seller prepays the trucking company as a
convenience to the buyer. The buyer is expected to reimburse the seller and should record it as freight-in.
But the prepaid freight increases the accounts receivable of the seller. 
Sept.6 A company purchase merchandise on account, terms 2/10,n/30, FOB shipping point,
$10,000 with prepaid transportation cost of $300 added to the invoice.
Buyer’s Book Seller’s Book
Sept.6 Purchases ----------- 10,000 Sept.6 Accounts receivable------- 10,300
Freight- in ---------- 300 Sales ------------------ 10,000
Accounts payable--- 10,300 Cash --------------------- 300
Sept. 16 The company paid for merchandise purchased on Sept. 6
Sept.16 Accounts pay.-------10,300 Sept.16 Cash --------------------- 10,100
Cash -------------- 10,100 SD --------------------- 200
PD(2%×10,00)--- 200 Accounts receivable--- 10,300
Nov. 3 A company sold merchandise on account terms 2/10,n/30, FOB destination $40,000.
The seller paid $800 to a public carrier.
Nov. 3 Purchases ----------- 40,000 Nov. 3 A/R ------------------ 40,000
A/P ------------ 40,000 Sales ------------- 40,000
Delivery expense --- 800
Cash ------------- 800
Nov. 13 The Company collected cash form the Nov. sale.
Nov. 13 A/P---------------- 40,000 Nov. 13 Cash ----------------- 39,200
Cash ----------- 39,200 SD ------------------- 800
PD(2%×40,00)-- 800 A/R ------------- 40,000
Note:
 When we have FOB shipping point freight prepaid by the seller the discount
is based on the purchase price of goods rather than the invoice total. i.e., Freight prepaid by the seller
on behalf of the buyer is not eligible for early payment discount.
5. Sales Tax
- Almost all states and other taxing units levy a tax on retail sales of merchandise
- The company selling the product to the consumer is responsible for collecting the sales tax from the
customer. The liability for the sale tax is ordinarily incurred at the time the sale is made, regardless of the
terms of the sale. When collected by the retailer, the tax is a liability and is not included in total sales.
- The buyer of goods does not record a sales tax expense separately in his/her accounts, it is merely added
to the cost of the goods, and the entire amount is debited to Purchases
June 2 A company has a sale of $1000 on account subject to tax of 5%.
June 2 Accounts receivable ----- 1,050
Sales ------------------ 1000
Sales tax payable ---- 50
June 6 Goods worth of $100 were returned
June 6 Sales Ret.& Allow. ----- 100
Sales tax payable ------- 5

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 A/R ------------------ 105
June 10 The company remitted sales tax collected to the government
June 10 Sales tax payable ------- 45
Cash ----------------- 45
6. Inventory Systems
The two most important factors in determining profitability of a business are cost of inventory and cost of
goods sold (COGS). The frequency at which these items are determined is the major difference between the
two inventory systems perpetual and the periodic systems
Perpetual Inventory System
- With perpetual system, there is a continuous (perpetual) record of change in Merchandise Inventory and
Cost of Goods Sold. Under this system, Purchases, Freight-in, and Purchase returns and allowance, and
Purchase discount are nonexistent as accounts.
- Purchases of inventory, freight-in, and returns of goods sold are added to the Merchandise Inventory
account. Purchase discounts, purchase returns and allowances, and the cost of merchandise inventory sold
are subtracted from Merchandise Inventory. Cost of Goods Sold account is also continuously updated in a
similar fashion. This continuous updating of the inventory account explains the name perpetual inventory
system.
- The up to date balance of inventory on hand by unit and by cost and COGS are available (in the ledger) at
any time for each type of inventory. Therefore, no adjusting entries are needed unless there is shortage
because of spoilage, waste, losses, and so forth. To ensure this accuracy, a physical count of the items in
inventory is performed on an annual basis.
- This method is likely to be used by companies that sell products of high unit value, such as automobiles
and TV sets, wheat, oil. Perpetual system is discussed in the second part of this course. The periodic
system is used in this chapter.
Periodic Inventory System
- A periodic system does not compute the amount of Merchandise inventory or the Cost of Goods Sold
until the end of a period.
- With this system, a company uses Purchases and purchase related accounts (Purchases, PD, PR&Allow.,
and Freight-in) to record changes related to inventory during the period.
- As a result, the Inventory account remains unchanged during the period. The Inventory account
represents the beginning inventory amount throughout the period. Then, at the end of the accounting
period the company must adjust (update) the inventory account by closing out the beginning inventory
amount and recording the ending inventory amount. The ending inventory is determined by a physical
count.  In that process, the goods held are actually counted and assigned cost based on a consistent
method.  The actual method for assigning cost to ending inventory is the subject of considerable
discussion in the second part of this course.
- The periodic system is likely to be used by a business that sells a variety of merchandise with low unit
prices, such as drugstores or hardware store.
Cost of Goods Sold
- Merchandise Inventory turns into Expense called cost of goods sold when sold
- Perpetual inventory systems have a cost of goods sold account that continuously accumulates costs as
items are sold. So you can refer the ledger to find out this figure.
- In a periodic inventory system we have a day-to-day record for sales not for COGS. COGS is calculated
at the end of period by allocating the cost of goods available for sale during the period between cost of
goods sold (the cost paid for the goods that were sold)and inventory(Cost of goods not sold )

Beginning Inventory Purchases

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 Add: Cost of Merchandise Purchases Less: PR&Allow.
Cost of goods available for sale Purchase Disc.
Less: Ending inventory Net Purchase
COGS Add: Freight-in
Cost of merchandise purchased
- The beginning inventory is equal to the prior year's ending inventory, as determined by reference to the
prior year's ending balance sheet. 
7. Financial Statements
- Financial statements of a merchandising firm are similar to service business except the following
differences:
Income Statements
- The income statement for a service company has two parts:
i) Fee Revenue—results from the provision of service by the company
ii) Expenses—the company’s expenses in running the business
- The income statement for a merchandising company has three parts:
i) Sales revenue—results from the sale of goods by the company.
ii) Cost of goods sold—indicates how much the company paid for the good that were sold
iii) Expenses—the company’s expenses in running the business
- So the only difference between the Income Statement for a service firm and that of a merchandising firm
is the Cost of Goods Sold section.
Balance Sheet
- The balance sheet of a merchandising business includes merchandise inventory as part of current assets.
Statement of Owner's Equity
- The Statement of Owner's Equity is the same for merchandising and service companies.
Income Statement Formats
- GAAP does not require any specific financial statement format.
- Two common formats of Income Statement:
i) Single-Step (Unclassified)— This very simple approach reports all revenues (and gains) together,
and the aggregated expenses (and losses) are tallied and subtracted to arrive at income. 
ii) Multiple-Step(Classified) Income Statement
It is so named because it has many section, subsection and intermediate balances, which increases
the length and complexity of the income statement. It classifies:
 Revenues as operating and nonoperating
 Expenses as operating and nonoperating. Operating expenses are further classified as selling
and administrative.
Format: Sales
Revenue: Revenue from Sale  SR&Allow.
 Sales disc.
Net sale
COGS: Purchases
Beg. Inventory  PR&Allow.
Less: Expenses: COGS + Cost of mdse purchased  Purchase disc.
Gross Profit COGAFS Net Purchase
 Ending Inventory + Freight-in
COGS Cost of mdse purchased
Operating expenses Selling Expenses
Income From Operation Administrative Expenses
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 Add: Other Income
Less: Other Expense
Income before income tax
Less: Income tax expense
Net Income
Components of the multiple-income statement:
a) Operating revenues revenues arising from the company’s principal/ central ongoing operations.
This section includes revenue from sales along with its contra accounts.
b) Cost of goods sold the largest expense in a merchandising company indicating the amount paid
for the goods that were sold.
c) Gross Profit/margin—important subtotal representing excess of net sales over COGS
d) Operating expenses—for a merchandising company are those expenses other than COGS, incurred
in the normal business functions (principal operation) of a company.
It is usually classified as:
 Selling expenses: expenses related to selling and marketing activities e.g., Salaries and commission
of the sales force, store supplies used, depreciation of store equipment and delivery equipment,
Delivery expense, sales persons’ travel expense etc.
 Administrative(general) expense: incurred in the overall management of a business. Eg. Office
salaries, depreciation of office equipment, office supplies used, administrative salaries, insurance
expense, rent and utilities on administrative buildings etc
Note: Some costs must be allocated between the two categories; like rent, taxes, depreciation and
insurance on a building wherein both sales and administrative activities are conducted.
e) Income from Operation The excess of gross profit over total operating expenses. If gross profit
is less, we call it loss from operation. It is a measure of ongoing or regular operations of the
business. Thus, it is important factor in judging the efficiency of management and the degree of
profitability of an enterprise.
f) Nonoperating Income (Other Income)  Revenues arising from secondary or auxiliary activities
of the company and not related to its principal activity.
Examples: Interest earned on checking, savings, investment accounts, or late charges to customers;
Rent earned by leasing to others property not currently needed in the operations of the business;
Dividend gains on share of stock owned; Gains from sale of plant assets for more than book value
(cost - accumulated depreciation). Income/gain from this section is less significant in assessing
profitability
g) Nonoperating Expenses(Other Expenses)
Expenses/losses related to secondary or auxiliary activities of the company and not related to its
principal activity.
Examples: Interest incurred on money borrowed (considered as a financing charge); Loss on sales of
plant assets from the sales of plant assets for less than book value (cost -accumulated depreciation),
etc
Note:
 If the company has neither of these items (Other income and Other
expenses), then the words "Income from operations" will not be shown as the bottom line will
always be Net income or Net loss.
 If there are both Other Income and Other Expenses, then the two totals of
these sections are netted together on the last column of the income statement. 
h) Net Income /Loss Represents the net increase (net decrease) in owner’s equity as a result of
profit making activities.
Advantages of Single-Step Income statement

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- It is relatively simple and easy to read
- Potential classification problems are eliminated
Disadvantages
- Useful concepts such as the gross profit on sales and income from operation are not readily apparent. As a
result most companies produce a multiple-step income statement, which clearly identifies each step in the
calculation of net income or net loss.
Advantages of Multiple-Step Income Statement
- Shows important relationship that help in analyzing how well the company is performing.
Disadvantage
- Classification problem and complexity
Note: In an advanced course you will learn about additional special reporting for other unique situations,
like discontinued operations, extraordinary events, and so forth.
Balance Sheet
Unclassified Balance Sheets
- It is a balance sheet that does not classify assets and liabilities as current and noncurrent.
Classified Balance Sheet
- A classified balance sheet classifies assets and liabilities as either current or long-term to show their
relative liquidity. Liquidity measures closeness to cash, and cash is the most liquid asset.
- This format gives the reader more information about the company and allows ratios to be computed to
properly evaluate the financial condition and performance of the company.
Assets
Current Assets
- Current assets are assets that are cash, expected to be realized in cash(like receivables), sold(like
inventory), or used(like supplies, prepaid insurance, etc.) during the next 12 months or within the
business’s operating cycle, whichever is longer.
- The operating cycle is the average time it takes to convert cash back into cash. It begins by purchasing
merchandise and ends by collecting cash from selling the merchandise.
Plant Assets
- Plant assets (or Property, plant, and equipment) are tangible resources of a relatively permanent nature
(long-term), that are used in the business and not intended for sale. Plant assets include: equipment,
machinery, vehicles, furniture, building , land etc
Liabilities
Current Liabilities
- Current liabilities must be paid with cash or with goods and services within one year or within the entity’s
operating cycle, whichever is longer.
- Current liabilities include: Accounts Payable, Notes Payable due within one year, Current Portion of LT
Liability, Salary Payable, Interest Payable, Unearned Revenue
Long-Term Liabilities
- Long-term liabilities are all liabilities not classified as current. (In other words, they are liabilities that are
not due for at least 12 months.)
- Long-term liabilities include: Notes Payable, Bonds payable, Leas payable
Owner’s Equity
- The up-to-date capital balance is taken from the statement of owner’s equity (or Retained Earnings).

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- In a proprietorship, there is one capital account. In a partnership, there is a capital account for each
partner.
- For a corporation, owner’s equity is divided into two sections—Capital stock (for the sale of the
corporations stock) and retained earnings (income retained for use in the business).

8. Adjustments
- To serve the needs of management, investors and bankers and other groups, financial statements must be
as complete and accurate as possible. Adjusting entries are required at the end of an accounting period to
bring the accounts up to date and to ensure the proper matching of revenues and expenses.
- The adjustment process for a merchandising firm is generally same as discussed in Chapter 4 for a service
business with an additional adjustment needed to update inventory.
Adjustment for Merchandise Inventory
- In a perpetual inventory system no adjustment for inventory is required.
- Under the periodic system the Inventory account would continue to carry the beginning of year balance
throughout the year.  As a result, Inventory must be adjusted (updated) before preparing financial
statements.
- The inventory account's balance may be updated with adjusting entries or as part of the closing entry
process.
- When adjusting entries are used, two separate entries are made. The first adjusting entry clears the
inventory account's beginning balance by debiting income summary and crediting inventory for an
amount equal to the beginning inventory balance.
- The second adjusting entry debits inventory and credits income summary for the value of inventory at the
end of the accounting period which is determined by physical count.
- Combined, these two adjusting entries update the inventory account's balance and, until closing entries are
made, leave income summary with a balance that reflects the increase or decrease in inventory.
Example: GM Co. is a merchandiser that sells different books. GM began 2007 with $30,000 in its
inventory. During 2007, the store purchased inventory costing $100,000. At the end of 2007, GM Co.
had $50,000 worth of inventory on hand determined through a physical count.
1. What are the COGS for 2007?
Answer: Beg. Inventory ----------------------- 30,000
Cost of merchandise purchased ---- 100,000
COGAFS $130,000
Ending Inventory ---------------- 50,000
COGS ---------------------------- $80,000
2. What is the balance in merchandise inventory on December 31,2007, before any adjusting
entries are made? Answer: $30,000 (which is also equal to beginning balance)
At the end of the accounting period this account should be replaced by an amount representing
inventory at the end of the period by the following adjusting entries:

Take out the old: Income Summary -------------- 30,000

Merchandise inventory --- 30,000
Put in the new: Merchandise inventory ---------- 50,000
Income Summary ------------ 50,000

Let us see the effect of this adjustment using the T-account.

Merchandise Inve. Income Summary
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 Beg. 30,000 Adj. 30,000 50,000 Adj.
Adj. 50,000 30,000 Adj.
End. Bal. 50,000

Q. Why income summary account is used? This is because both beginning and ending inventory are
used to determine an income statement item, COGS. Beginning inventory is part of COGAFS.
Ending inventory is deducted from COGASF to compute COGS.
- If closing entries are used to update inventory, no adjusting entries affect the inventory account, so the
beginning inventory balance appears in the work sheet's trial balance and adjusted trial balance columns.
This beginning inventory balance is first extended to the income statement debit column. Then, the value
of inventory at the end of the accounting period is placed in the work sheet's income statement credit
column and balance sheet debit column.
Adjustments for deferrals and Accruals
i) Deferrals
- To defer means to postpone or put off something until the future.
- When we use the term in accounting it means we will not record an item as an expense until it has become
an expired cost. We will not record an item as revenue until it is earned. Delay the recognition of an
expense already paid or of revenue already received.
- It involves with data previously recorded in accounts.
Deferred Expenses (Prepaid Expenses):
- Occurs when an asset that will be used up or will expire is purchased. Includes such items as: prepaid
insurance, prepaid rent, prepaid advertising, prepaid interest, supplies, even the cost of long-term assets.
- At time of acquisition they are recorded as assets.
Asset(Prepaid expenses) ------- xx
Cash ----------------------- xx
- As this asset is used, its cost must be transferred to an expense. Therefore, you defer recording the cost of
the asset as an expense until it is used. The adjusting entries transfer the expired portion from asset to
expense as follows:
Expense account --------------- xx
Asset(Prepaid expenses) ------- xx

- Alternative recording method is available. Prepayments can be initially recorded as expense at time of
acquisition, particularly if we expect it to expire within a short period of time, as follows.
Expenses account ------- xx
Cash ----------------------- xx
- As of the financial statement date, if there is unexpired portion, it has to be reduced from the expense
account and returned back to the appropriate asset account through the following adjusting entry, which is
a bit different.
Asset (Prepaid expenses) -------- xx
Expenses account ------------- xx
Example:
On December 1, 2007 ABC Co. purchased a 6-moth insurance policy for $1200. ABC’s fiscal
year ends on December 31.
Originally Recorded as Asset Originally Recorded as Expense
Dec. Prepaid Insurance --------1200 Dec. Insurance Expense ---------- 1200
1 Cash ----------------- 1200 1 Cash --------------------- 1200
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 As of December 31, 2007, one month (or $200) of that coverage had expired and should be
recognized through adjustment.
Dec. Insurance Expense --- 200 Dec. Prepaid Insurance ----------- 1000
31 Prepaid Insurance -- 200 31 Insurance Expense ----- 1000
Deferred Revenues (Unearned Revenues):
- This refers to advance collection from customers before providing/delivering service and goods. Includes
tuition received in advance by a school, premium received in advance by an insurance company, rent
received in advance by a real estate company, magazine subscriptions received in advance by a publisher
etc
- This receipt of cash doesn’t represent revenue; rather the company becomes obligated to provide
services/deliver the goods for which it was paid.
- At time of advance collection: Cash -------------------------------------- xx
Unearned revenue (Liab.account) ----- xx
- Revenue is earned only by the actual rendering of service to customers, or by delivery of goods to them.
Thus, recognition of revenue is deferred until it is earned. The adjusting entry to recognize a portion(or
all) of the advance collection earned as follows:
Unearned revenue (Liab.account) ----- xx
Earned Revenue ------------------- xx
- Under the alternative method, advance collections can be initially recorded as revenue, particularly if it is
expected to be earned within a short period of time, as follows.
Cash ------------------------------ xx
Revenue account ---------- xx
- As of the financial statement date, if there is any unearned portion, it has to be reduced from revenue and
returned back to the appropriate liability(unearned revenue) account through the following adjusting
entry:
Revenue account ----------------------- xx
Unearned revenue (Liab.account) ----- xx
On November 1, 2007 a company received a 3-motnths’ rent of $1,800 in advance at
$600 per month.
Originally Recorded as Liability Originally Recorded as Revenue
Nov. Cash ---------------------- 1800 Nov. Cash -------------------- 1800
1 Unearned Rent ------ 1800 1 Rent Income ------- 1800
As of December 31, 2007 two months’ worth of this rent had been earned and should be
recognized through adjustment.
Dec. Unearned Rent --------- 1200 Dec. Rent Income ------------ 600
31 Rent Income -------- 1200 31 Unearned Rent ------- 600
ii) Accruals
- To accrue means to come into existence through the normal course of events. It consists of adjusting
entries relating to activities on which no data have been previously recorded in the accounts.(i.e., involves
with unrecorded data)
Accrued Expenses (Accrued Liabilities)
- Expenses incurred but not paid and not recorded at the end of an accounting period. The act of recording
expenses that have not been paid is called accruing expenses.
- Salaries/ wages of employees and interest on borrowed money are common examples of expenses which
accumulate day by day but which may not be recorded until the end of the period. These expenses are said
to accrue.

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- In the Adjustment we record the expense and the related liability as follows:
Expense account ----------- xx
Liability account ---------- xx
Assume that December 31 is a Wednesday. On that date, ABC Co. owed $11,000 in
wages to employees. These wages will be paid on Friday, the usual pay day.
Original entry: None
Adjusting Entry: Dec. 31 Wages Expense -------- 11,000
Wages Payable ----- 11,000

Note: Wages expense is generally recorded only when wages are paid. So adjusting entry is needed if
the accounting period ends on a day other than pay day.
Accrued Revenues (Accrued Assets)
- Revenues earned but not received and not recorded at the end of an accounting period. The act of
recording revenues that have not been received is called accruing revenues. Examples are: fee for service
that an attorney has provided but hasn’t billed to the client, unbilled commissions by a travel agent,
accrued interest on notes receivable, and accrued rent on property rented to others.
- In the Adjustment we record Asset (e.g A/R, Interest receivable) and the related revenue(e.g sales, interest
income) as follows:
Asset account ------------- xx
Revenue account -------- xx
On July 1,2007 ABC company gave loan to another company agreeing to collect interest
annually. ABC’s fiscal year ends on December 31. On December 31,2007 six months’
interest accrued but not received was $4,000.
Original entry: None
Adjusting Entry: Dec. 31 Interest Receivable -------- 4,000
Interest Income ----- 4,000
Work Sheet for a Merchandising Business
- A merchandising company, like the service business discussed in chapter 4, uses a work sheet at the end
of the period to organize the information needed to prepare financial statements and to adjust and close
the accounts.
- The work sheet for a merchandising enterprise is completed in a similar fashion to that of a service
enterprise. The principal differences are:
 Ending inventory balance is listed in the adjustment and balance sheet columns
 Beginning and ending inventory, which are shown in the income summary account, appear in both
the debit and credit sides of the adjusted trial balance, and income statement columns of the work
sheet. Each of these amounts is needed to calculate cost of goods sold in the income statement.
ILLUSTRATION
THE ILLUSTRATION OF ACCOUNTING CYCLE FOR A MERCHANDISING
BUSINESS WILL BE PROVIDED SEPARATELY.
Financial statement
- Once the work sheet has been completed, the financial statements are prepared. The income statement and
balance sheet columns of the work sheet contain the numbers to prepare the financial statements for a
merchandising company.
Recording and Posting Adjusting Entries

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- Next adjusting entries need to be formally journalized from the work sheet to the general journal and then
posted to the general ledger so that the adjustments will be in the company books as the work sheet is only
a tool to help prepare these entries.
Recording and Posting Closing Entries
- Next closing entries are entered in the journal and posted to the ledger. This process clears the accounting
records for the next accounting period.
- Although merchandising and service companies use the same four closing entries, merchandising
companies usually have more temporary (income statement) accounts to close. The additional accounts
include sales, sales returns and allowances, sales discounts, purchases, purchases returns and allowances,
purchases discounts, and freight-in.
1. Close the revenue accounts and those accounts that act as revenues (meaning they have "credit"
balances on the credit column of the Income Statement columns of the work sheet) into the
Income Summary account. The entry shown below assumes the inventory account was updated
with adjusting entries and, therefore, does not include it.
Sales ---------------------------- xx
Purchase Retrun &Allo. ----- xx
Purchase Discounts --------- xx
Interest income -------------- xx
Gain on sale of equipment --- xx
Income summary ----------- xx
To close credit-balance accounts
Accountants who choose to update the inventory account during the closing process instead of
with adjusting entries include the ending inventory balance with this first closing entry.
2. Close the expense accounts and those accounts that act as expenses (meaning they have "debit"
balances on the debit column of the Income Statement columns of the work sheet) into the Income
Summary account. The entry shown below assumes the inventory account was updated with
adjusting entries and, therefore, does not include it.
Income Summary -------------- xx
Sales Return &Allow ---------------- xx
Sales Discounts ----------------------- xx
Purchases ------------------------------ xx
Freight-in ----------------------------- xx
Each operating &
nonoperating expense account ------ xx
To close debit-balance accounts
If the inventory account is updated during the closing entry process, this closing entry includes a
credit equal to the beginning inventory balance.
3. Close income summary to the owner's capital (or REs in a corporation) account. The income
summary account now has a balance equal to the company's net income or net loss. The entry to
close income summary, assuming it has a credit balance(NI) is:
Income Summary ------------- xx
Mr X , Capital (or REs) ---- xx
To close income summary
4. Close the owner's drawing account (Dividend in a corporation) to the owner's capital (REs in a
corporation) account.
Mr X, Drawing (Dividends) ------ xx
Mr X , Capital (or REs) -------- xx
To close drawing (or Dividends)

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 Post-Closing Trial Balance
- Finally, a post-closing trial balance is prepared.
Interim Statements
- Interim statements are statements that are prepared during the fiscal year for periods of less than 12
months--such as monthly, quarterly, and semiannually.
- After the adjustments are entered on the work sheet for interim statements, the adjusting and closing
entries are not usually journalized, and thus are not entered in the ledger—that these entries are usually
made at the end of the fiscal year. Actually in practice, companies using computerized accounting system
record and post adjusting entries for interim statements. That is because the financial statements cannot
be prepared with an accurate income amount without the adjusting entries.

Reversing Entries
- Reversing entries are optional entries made at the first day of the new fiscal year so that certain adjusting
entry amounts will not be forgotten to take care of in the new fiscal year. They can be extremely useful
and should be used where necessary.
- The adjusting entries that are often forgotten are the accrued entries.
- A reversing entry on the first day of the new fiscal year reverses an adjusting entry that was made at the
end of the prior fiscal year. 
- Reversing is usually made for accrual and deferrals.
Accrued Revenues
Accrued items Reversing is possible
Accrued Expenses
Initially as Expense
Deferred items Deferred Expenses Reversing is
Initially as Asset possible
Deferred Revenues Initially as Revenue
Reversing not
Initially as Liability required
- No reversing entry is required if deferred items are initially recorded as balance sheet items. But if they
are initially recorded as income statement items, reversing is required if the company wants to comply
with its policy of recording deferred items as income statement items.
- Reversing entries should not be made for adjusting entries which are related to estimated items such as
depreciation or bad-debt expense, or to the correction of an error.
Example 1: Accrued Expenses
Assume throughout the year the weekly salaries are $5,000, paid every Friday. Assume there are five
working days per week and fiscal year ends on Wednesday, December 31, 2007.
Required: Record the following transactions/events.
Dec. 26,2007 The company paid $5,000 to employees
2007 Salary Expense ----------- 5000
Dec. 31 Cash ----------------- 5000
Dec. 31,2007 The Company made the necessary adjustment for salary expense
2007 Salary Expense ----------- 3000
Dec. 31 Salary Payable ----------------- 3000
Jan. 2,2007 The company paid $5,000 to employees.
If no reversing entry was made on Jan. 1,2008:
If we do not reverse the adjusting entry, we must remember that part of the $5,000 payment has already
been recorded in the salary payable and salary expense accounts.
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 2008 Salary Expense ----------- 2,000
Jan.2 Salary Payable ---------- 3,000
Cash ----------------- 5,000
Q. Why do we have different journal entries while we have the same event (payment of salary) on
December 26, 2007 and January 2, 2008?

If reversing was made on January 1,2008:

Referring back to see the effect of a previous period adjustment on subsequent period transaction is
tiresome and increases the chance of making errors. We may even forget to see some of the previous
period adjusting entries. To avoid all these problems we may choose to reverse the adjusting entry.
Reversing Entry: Jan. 1 Salary Payable ----------- 3,000
2008 Salary Expense ------- 3,000
Note that this entry leaves an unnatural balance in the Salaries Expense account on January 1 but it
does reduce the Salary Payable account to zero. This temporary inaccuracy in the books is acceptable
only because financial statements are not prepared during this period.
Remember the closing entry on December 31,2007 reduces Supplies Expense to zero.

To Record Payment: Jan. 2 Salary Expense --------- 5,000

2008 Cash ---------------- 5,000
When the salaries are paid on Friday of the new year (January 2), payment of salary can be recorded as
usual. Though salary expense is debited by $5,000, it shows a correct balance of $2,000 in the first
week of the New Year (2008).
Example 2: Deferred Expenses
Supplies purchased through out 2007 was $50,000. Supplies on hand on December 31,2007 is
determined to be worth $3,000. (Remember the two alternative methods to recorded deferred items.)
If initially recorded as asset:
To record acquisition: Supplies ------------- 50,000
Cash/A/P --------- 50,000
Adjustment: 2007 Supplies Expense ---- 47,000
Dec. 31 Supplies -------- 47,000
Closing Entry: 2007 Income Summary ----- 47,000
Dec.31 Supplies Expense -- 47,000
No reversing entry is required on January 1,2008
If initially recorded as Expense:
To record acquisition: Supplies Expense ------ 50,000
Cash/A/P --------- 50,000
Adjustment: 2007 Supplies --------------- 47,000
Dec. 31 Supplies Expense---- 47,000

Closing Entry: 2007 Income Summary ----- 47,000

Dec.31 Supplies Expense -- 47,000

Reversing Entry: Jan. 1 Supplies Expense ----------- 3000

2008 Supplies-------------------- 3000
Correcting Entries
- They need to be prepared when errors have been made as soon as the errors are discovered by journalizing
and posting correcting entries.
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- Differences between adjusting and correcting entries:
 Adjusting entries are an integral (necessary) part of the accounting cycle; correcting entries only
need to be made if errors have been made and thus are avoidable.
 Adjusting entries are journalized and posted only at the end of the accounting period; correcting
entries are made whenever an error is discovered.
 Adjusting entries ALWAYS affect one balance sheet and one income statement account; correcting
entries may involve any combination of accounts in need to correction. Correcting entries must be
posted before closing entries.
- The procedure used to correct an error in journalizing or posing vary according to the nature of the error
and when the error is discovered.

Error Correction Procedure

1. Journal entry incorrect but not Draw a line through the error and
posted insert correct title or amount
2. Journal entry is correct but Draw a line through the error and
posted incorrectly insert correct title or amount
3. Journal entry is incorrect and posted Journalize and post a correcting
entry

- In the first two types of errors shown above, usually the person making the corrections initials the
correction in case questions arise later.
- Correcting entries, which are required for the third type of error, could be made in two ways:
Example:
Assume that on May 5 a $10,000 purchase of Office Supplies on account was incorrectly journalized
and posted as a debit to Office Equipment and a credit to Accounts Payable for $10,000.
Method 1: Use two entries to fix the error: One that reverses the incorrect entry, and another
that records the transaction correctly
Accounts Payable ----------- 10,000
Office Equipment ---------- 10,000
Reverse May 5 error
Office Supplies ------------- 10,000
Accounts Payable ----------- 10,000
Correcting entry for May 5
Method 2: Fix the error with a single entry that, when combined with the original but incorrect entry,
fixes the error. Use the following steps:
i) Identify the debit(s) and credit(s) of the entry in which the error occurred
Office Equipment ----------- 10,000
Accounts Payable -------- 10,000
ii) Identify the debit(s) and credit(s) that should have been recorded
Office Supplies ------------- 10,000
Accounts Payable --------- 10,000
iii) Compare the two entries and record and post the correcting entry
Office Supplies ----------- 10,000
Office Equipment ---- 10,000
Correcting May 5 error

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Note that method 1 is less efficient than method 2.

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