Chapter-3

Accounting cycle for a merchandising business

3.1. Characteristics of merchandising business

A merchandising business buys goods in finished form for resale to customers. A merchandising
business sells tangible goods to its customers. When we say goods it can be anything that has physical
characteristics that you can see and touch (i.e. Tangible). These can be goods ranging from television
sets, cars, office table and chair (furniture), to chewing gums, toothbrushes and various stationery
materials. Those goods that a merchandising company sells to its customers are called merchandise
inventory.

Merchandising companies
Sell
Manufacturer
Wholesalers Sell Retailers Final consumer
s
Goods goods

Merchandising companies that purchase and sell directly to consumers are called retailers.
Merchandising companies that sell to retailers know as wholesalers.

3.2. Inventory system

Because inventory management is vital to merchandising operations, companies spend a great deal of
time and money tracking their inventory transactions. A strong accounting system plays three roles in
this process:
 It provides up-to-date information on inventory quantities and costs so that managers can make
informed decisions.
 It provides accurate information for preparing financial statements. Until inventory is sold, it is
reported as an asset on the balance sheet. After its sale, it is removed from the balance sheet and
reported on the income statement as an expense, called Cost of Goods Sold.
 It provides information that controls inventory and helps prevent theft.
To perform these functions, companies can use either of two types of inventory accounting system:
perpetual or periodic.

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3.2.1. Periodic inventory system
Under this system, as the name periodic suggests, the inventory account is updated only periodically,
i.e., only at the end of a period.

When goods are bought, a temporary purchases account is debited instead of the inventory account
itself. Likewise, when goods are sold revenue is recorded, but the fact that there is a reduction in
merchandise inventory is not recognized. This is because the Merchandise Inventory account is not
credited every time goods are sold.

Therefore, if one wants to know the cost of goods on hand, it is a must that a physical inventory be
conducted first. The account doesn’t reflect the value of goods on hand because it was not updated
when merchandise was bought and sold. Physical inventory means counting the quantity of goods on
hand. Once the quantity of goods on hand has been determined, it is multiplied by the unit price of
those goods to determine the cost of goods on hand.

Businesses like ‘super markets’ which sell small items use periodic systems.

3.2.2. Perpetual inventory system

A perpetual inventory system continuously records the amount of inventory on hand (perpetual
=continuous). Under this system, the merchandise inventory account is debited or credited every time
(goods) are bought or sold. When an item is sold, its cost is recorded in a separate cost of goods sold
account in addition to recording sales.
The cost of merchandise on hand can be looked up from the merchandise Inventory account any time,
without conducting a physical inventory.
3.3. Accounting for purchases of merchandise
Under the periodic inventory system a merchandising company uses the Purchases account to record
the cost of goods bought for resale to customers. The Purchases account, which is increased by debits,
appears with the income statement accounts in the chart of accounts.

Illustration
Assume that Hanlon Retail made two purchases of merchandise from Smith Wholesale Company.
Hanlon purchased $30,000 of merchandise on credit on May 4, and on May 21 purchased $20,000 of
merchandise for cash.
Required: make the necessary journal entries for Hanlon are

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Solution
May 4 purchase ------------------30,000
A/payable -------------------30,000
(To record the purchase of merchandise on account)

May 21 purchase -----------------30,000

Cash -----------------------30,000
(To record the purchase of merchandise on cash)

3.3.1. Purchase discounts

Often companies purchase merchandise under credit terms that permit them to deduct a stated cash
discount if they pay invoices within a specified time. The deduction from the original purchase price is
recorded in a separate contra Purchase account called Purchase Discounts.

How much discount is given usually depends on the credit terms. These terms (agreements) are
usually stated on the invoice. The most frequently used terms are stated below:

 “n/30” or “Net 30” – means there is no discount even if the customer pays before the payment
date.
 2/10, n/30 –means the due date of the payment is after 30 days of the sale. But if the customer
pays within 10 days she will get a 2% discount.
 2/EOM, n/60- means the normal due date is within 60 days of the sale but the customer will get
a 2% discount if she pays before the end of month of sale.
 Net EOM 10- means the net amount is due within 10 days after the end of the month.

Illustration
ABC Company bought goods worth $50,000 from XYZ Company on account on January 14, 2001,
terms 1/10, n/60. ABC Company paid on January 24, 2001.
Required: Record the transactions on both dates.
Solution
2001 14 purchase --------------------50,000
Jan. A/payable --------------------50,000
(To record credit purchase of merchandise)

2001 24 A/payable -----------------50,000

Jan cash-------------------------49,500
Purchase discount-------------- 500
(To record payment on the account within the discount period)
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The buyer records the purchase discount only when the invoice is paid within the discount period and
the discount is taken.

3.3.2. Purchase returns and allowances

Occasionally, Merchandisers buy goods that are not satisfactory. In these cases, most suppliers allow
the goods to be returned. Or, they may allow the merchandise to keep the unsuitable goods and receive
a deduction, or allowance, from the amount they owe for the merchandise. Both purchase returns and
allowances decrease the Merchandiser’s cost of the inventory.
When purchase return and allowance occurs the buyer commonly uses a debit memorandum to
notify the seller that the account payable to the seller is being reduced (Accounts Payable is debited).
The buyer may use a copy of a debit memorandum to record the returns or allowances or may wait for
confirmation, usually a credit memorandum, from the seller.
Both returns and allowances reduce the buyer's debt to the seller and decrease the cost of the goods
purchased.
Illustration
In the previous example for ABC Company, a portion of the goods worth $5,000 bought on January 14
from XYZ Company were of the wrong size. XYZ Company acknowledged this and gave ABC
Company a 5% price allowance on January 17.
What should ABC Company record on January 17?

Solution

Jan. 17 A/payable(5,000×5%)---------------------250
Purchase return & Allowance----------250

NOTE: When both purchase discounts and purchase returns and allowances are deducted from
purchases what is obtained is called Net purchase. That is,

Gross Purchase---------------------------XX
Less: Purchase discounts----------------(XX)
Purchase returns and allowances---(XX)
Net Purchases----------------------------XX
3.4. Transportation costs
Once merchandise has been bought it has to be moved from the seller’s place to the buyer’s place. A
third party comes in to the scene here: the transportation company who moves the goods between the
two places.

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That is:

Seller Goods goods goods Buyer

Freighter

So, the question is who is going to pay to the freighter (transportation) company. Who covers the
transportation costs depends, on the agreement between the buyer and seller. The agreements are
usually stated in the either of these two terms:
 FOB Destination – means “free on board at destination “. That is, since the destination of the
goods is the buyer’s place, it is free at destination means transportation cost is paid when the
goods are loaded. It simply means the seller pays transportation cost. FOB Destination means
goods are shipped to their destination (to the buyer) without transportation charge to the buyer.
 FOB shipping Point –means “free on board at shipping point”. That is, goods are loaded (on a
truck or train) or shipped free of charge. It is, therefore, the buyer, which pays to the
transportation company when the goods reach the buyer (their destination) briefly, when the
terms are FOB Shipping Point the buyer pays transportation costs.

Transportation costs paid by a buyer of merchandise increase the cost of merchandise. They are
recorded in a separate Transportation-In account that is used to record freight costs incurred in the
acquisition of merchandise.

Illustration
ABC Company bought goods worth Birr 85,000 on account, terms 2/10,n/60 FOB shipping point on
March 2, 2001.Transportoin cost of Birr 1,500 was paid on March 2. ABC Company paid the credit on
March 31, 2001. Record the necessary journal entries

Solution:
Here, since the terms are FOB Shipping Point, the buyer ABC company pays transportation.

March 2 Purchase-------------------85,000
Transportation-In-----------1,500
A/Payable-------------------85,000
Cash-------------------------1,500

March 31 A/Payable-----------------85,000
Cash------------------------85,000

3.5. Accounting for sales of merchandise

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Merchandisers (the sellers) generally record the sale (and the customer records the purchase) at the
point at which ownership is transferred to the customer. For a retail merchandiser, the transfer occurs
when a customer buys and takes possession of the goods.
The gross sales amount is obtained from sales invoices. An invoice is a document, prepared by the
seller of merchandise to notify to the buyer the details of the sale. These details can include number of
items sold, unit price of items, total price, terms of sale and manner of shipment. When goods are
delivered to the customer, the Sales account is credited because revenues are increased by credits. A
company can sell goods either for cash or on account.
 When merchandise is sold for cash, the Cash account is debited and the revenue account Sales is
credited.
 Whereas when goods are sold on account (for credit) The Accounts Receivable account is
debited and the revenue account is credited.

Illustration
ABC Company based in Bahir Dar, buys and sells used commodities. On January 14, 2001 ABC
company sold goods worth Birr 20,000. Record the transaction.

Solution

a) If the merchandise is sold for cash

2001 14 cash --------------------20,000

Jan. Sales ---------------------20,000

b) If the merchandise is sold on credit

2001 14 A/receivable------------20,000
Jan. Sales--------------------20,000

3.5.1. Sales Discounts

Sales Discounts are deductions from invoice price to customers who pay early when goods are sold on
credit.

As a seller, you would usually want to be paid as soon as possible. This is because, as you can
imagine, you can use the money for various purposes once you have been paid. If you want your
customers to pay you early the customary practice is to offer them a (deduction) discount from the
invoice price if they pay early. How much discount is given usually depends on the credit terms. These
terms (agreements) are usually stated on the invoice.

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Sales discounts are purchase discounts from the side of the buyer. Sales discounts and purchase
discounts are the same thing seen from different sides. They are generally called cash discounts
together. A cash discount is, therefore, deduction from original invoice price for early payment when
goods are sold on credit (on account).

Illustration
On January 21, 2001 ABC Company sold merchandise for birr 20,000 on account. The credit terms are
2/10, n/30. The customer paid on January 31, 2001.
a) How much would ABC Company collect from this sale?
b) Record the necessary journal entries on January 21 and January 31.

Solution

a) How much would ABC Company collect from this sale?

Invoice price----------------------20,000

Less: sales discount(20,000×2%)----(400)

Cash collected---------------------19,600

b) Record the necessary journal entries on January 21 and January 31.

2001 21 A/Receivable--------------20,000
Jan sales--------------------20,000

2001 31cash-----------------------19,600
Jan sales discount----------------400
A/receivable--------------20,000
3.5.2. Sales return & allowance
Merchandising companies usually allow customers to return goods that are defective or unsatisfactory
for a variety of reasons, such as wrong color, wrong size, wrong style, wrong amounts, or inferior
quality. At this time the customers have two options:
 Some companies allow customers to return goods simply because they do not like the
merchandise. This merchandise that is returned by a buyer is called sales return.
 A sales allowance is a deduction from the original invoiced sales price granted when the
customer keeps the merchandise but is dissatisfied for any of a number of reasons, including
inferior quality, damage, or deterioration in transit.
When a seller agrees to the sales return or sales allowance, the seller sends the buyer a credit
memorandum indicating a reduction (crediting) of the buyer's account receivable. The Sales Returns
and Allowances account is a contra revenue account.

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Illustration
ABC Company sold merchandise worth Birr 15, 000 on February 3, 2001 on account terms 2/10, n/30.
On February 5, the buyer returned a portion of the goods worth Birr 5,000 as they were found to be of
the wrong model. The buyer then paid on February 13, 2001.
Required: Record the necessary journal entries on February 3, 5 and 13.
Solution
Feb 3 A/Receivable--------------15,000
2001 sales ---------------------15,000

Feb 5 Sales return & Allowance---5,000

2001 A/Receivable-----------------5,000

Feb 13 cash ((10,000×2%)-10,000) ---9,800

2001 sales discount (10,000×2%) ----200

A/Receivable------------------10,000

Note: So net sell can be calculated:

Gross sales (from invoice)……………………………………………………XXX

Less: Sales discounts……………………………………………………………(XX)

Sales returns and allowances …………………(XX)

Net sales……………………………………………………………………XX

3.6. Completing the worksheet for a merchandising company

The use of a worksheet, as you remember, assists in preparing adjusting and closing entries. In addition
it contains all of the information needed for the preparation of the financial statements. Except for the
merchandise – related accounts, the work sheet for a merchandising Co. is the same as for a service
company.
The following illustration, therefore, assumes that all selling and administrative expenses have been
adjusted. That accomplished, the only account, which remains to be adjusted, is the Merchandise
Inventory account.

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Illustration
The following is the trial balance of Hard Works, a merchandising business owned by Yibeltal. All
accounts have been adjusted except the Merchandise Inventory account.

Hard Works
Trial Balance
December 31, 2002
Account title Dr Cr
Cash 19,663
Account Receivable 1,880
Merchandise Inventory 7,000
Accounts Payable 700
Yibeltal, Capital 25,513
Yibeltal,Drawings 2,000
Sales 14,600
Sales Discounts 440
Sales Returns and Allowances 200
Purchases 6,000
Purchase discounts 820
Purchase Returns & allowances 100
Transportation –In 750
Selling expenses 2,650
Administrative expenses 1,150 _______
TOTAL 41,733 41,733

A physical inventory of merchandise carried out on December 31, 2002 showed Birr 10,000 of goods
on hand.
Required:
a) Prepare a worksheet for Hard Works.
b) Prepare financial statements from the worksheet
c) Record the necessary adjustment journal entry in relation to merchandise inventory
d) Record closing entries

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 Hard Works Co.
Worksheet
For the year ended December 31, 2002
Trial Balance Adjustment Adjusted Trial Income Balance sheet
Account title balance statement
Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
Cash 19,663 19,663 19,663
Account Receivable 1,880 1,880 1,880
Merchandise Inventory 7,000 10,000 7,000 10,000 10,000
Accounts Payable 700 700 700
Yibeltal, Capital 25,513 25,513 25,513
Yibeltal,Drawings 2,000 2,000 2,000
Income summary 7,000 10,000 7,000 10,000 7,000 10,000
Sales 14,600 14,600 14,600
Sales Discounts 440 440 440
Sales Returns & Allowances 200 200 200
Purchases 6,000 6,000 6,000
Purchase discounts 820 820 820
Purchase Returns & allowances 100 100 100
Transportation –In 750 750 750
Selling expenses 2,650 2,650 2,650
Administrative expenses 1,150 1,150 1,150
41,733 41,733 17,000 17,000 51,733 51,733 18,190 25,520 33,543 26,213
Net Income 7,330 7,330
25,520 25,520 33,543 33,543

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Note:
The merchandise inventory account before adjustment shows the inventory on hand at the beginning of
the period. This is because, since purchases and sales of merchandise have not been debited or credited
to the merchandise inventory account, this account would still show the beginning inventory amount at
the end of the period.

Therefore, an adjustment journal entry is needed to update this account. At the end of the period, a
physical inventory would be conducted to determine the amount of inventory on hand.

The adjustment journal entry removes beginning inventory amount from the merchandise inventory
account and replaces it with the (ending) actual value of merchandise inventory on hand as determined
by the physical inventory.

The adjustment is:

 Income summary (beginning inventory)…………XXX
Merchandise amount inventory…………………………………XXX

 Merchandise Inventory…………………………………………….XXX
Income Summary…………………………………………………………………….XXX

3.7. Financial statements for a merchandising business

We will discuss financial statements as we work on requirement (b) of our illustration. Once the
worksheet has been completed, the financial statements are prepared. Next, any adjusting and closing
entries are entered in the journal and posted to the ledger.

3.7.1. Income Statement

There are two widely used formats of the income statement. These are:

1. The Multiple –Step Income Statement

The multiple-step income statement is so named because it shows several steps in determining net
income. Two of these steps relate to the company’s principal operating activities. A multiple-step
statement also distinguishes between operating and non-operating activities. Finally, the statement
also highlights intermediate components of income and shows sub-groupings of expenses.

Hard Works Co.

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 Income statement
For the year ended December 31, 2002
Revenue
Gross Sales 14,600
Less: sales discount 440
Sales return & Allowance 200 (640)
Net sales 13,960
Less: cost of Goods sold:
Beginning inventory (Jan 1, 2002) 7,000
Add: purchases 6,000
Less: purchase discount (820)
Purchase return & Allowance (100)
Net purchase 5,080
Add: Transportation-in 750
Total cost of Goods purchased 5,830
Total cost of goods available for sale 12,830
Less: Ending inventory (10,000)
Cost of Goods sold (2,830)
Gross profit 11,130
Operating Expense
Selling expenses 2,650
Administrative expenses 1,150
Total operating expense (3,800)
Net income 7,330

2. The single – Step Income Statement

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In single-step income statement one step—subtracting total expenses from total revenues—is required
in determining net income.
In a single-step statement, all data are classified into two categories: (1) revenues, which include both
operating revenues and other revenues and gains; and (2) expenses, which include cost of goods sold
and operating expenses
Hard Works Co.
Income statement
For the year ended December 31, 2002
Revenue:
Net sales 13,960
Expenses
Cost of goods sold 2,830
operating expenses 3,800
Total expenses (6,630)
Net income 7,330

3.7.2. Statement of owner’s equity

Hard Works Co.
Statement of owner’s equity
For the year ended December 31, 2002
Yibeltal, capital Jan 1, 2002 25,513
Add: Net Income for the year 7,330
32,843
Less: withdrawal during the year (2,000)
Yibeltal, capital Dec 31, 2002 30,843

3.7.3. Balance sheet statement

In the balance sheet, merchandising companies report merchandise inventory as a current asset
immediately below accounts receivable.
Hard Works Co.
Balance sheet
December 31, 2002
Assets Liabilities
Cash 19,663 A/Payable 700
Account Receivable 1,880 Owner’s equity
Merchandise Inventory 10,000 Yibeltal, capital 30,843
Total Asset 31,543 Total Liab & owner’s equity 31,543
3.8. Adjusting and closing entries for a merchandising business

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3.8.1. Adjusting entry

A merchandising company generally has the same types of adjusting entries as a service company.
However, a merchandiser using a perpetual system will require one additional adjustment to make the
records agree with the actual inventory on hand. Here’s why: At the end of each period, for control
purposes, a merchandising company that uses a perpetual system will take a physical count of its goods
on hand. The company’s unadjusted balance in Merchandise Inventory usually does not agree with the
actual amount of inventory on hand. The perpetual inventory records may be incorrect due to recording
errors, theft, or waste. Thus, the company needs to adjust the perpetual records to make the recorded
inventory amount agree with the inventory on hand. This involves adjusting Merchandise Inventory
and Cost of Goods Sold.

Dec 31 Income summary……………………………………………………7,000

2001 Merchandise Inventory…………………………7,000

Dec 31 Merchandise Inventory…………………………………10,000

2001 Income Summary…………………………………………..10,000

3.8.2. Closing entry

A merchandising company, like a service company, closes to Income Summary all accounts that affect
net income. In journalizing, the company credits all temporary accounts with debit balances, and debits
all temporary accounts with credit balances.

a. To close temporary accounts with credit balance

Dec 31 sales----------------------14,600
2001 Purchase Discounts------------820
Purchase Ret. &All-----------100
Income summary------------15,520

b. To close temporary accounts with debit balance

Dec 31 Income summary-------------------11,190
2001 Sales discount----------------------440
Sales Returns and Allowances--------200
Purchases-------------------------6,000
Transportation-In-------------------750
Selling Expenses------------------2,650
Administrative expense------------1,150

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 c. To close income summary
Dec 31 Income summary………………………………….7,330
2001 Yibeltal, Capital……………………………………7,330

d. To close withdrawal account

Dec 31 Yibeltal Captal……………………………………..2,000
2001 Yibeltal, Drawings……………………………………2,000

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