ACCOUNTING FOR

MERCHANDISING
BUSINESS
 MERCHANDISING BUSINESS
▪A merchandising business is an entity engaged in the
activities of buying and selling of products. Sometimes,
the business is called trading business or buy and sell
business.
The difference between a merchandising and a service
business is the existence of physical products sold to
customers. Merchandising businesses sell products in
order to generate revenue while service oriented
businesses render service. The major activities of a
merchandising business consist of buying and selling of
products called merchandise.
 MERCHANDISING BUSINESS
Normally, the entity buys goods or merchandise on
a wholesale basis, either from a manufacturer or a
wholesaler, and sells the same for profit. The
revenue of a merchandising business is called
sales.
The goods that are bought for sale are reported as
merchandise inventory and are classified as
current assets. However when the merchandise is
sold, their cost is transferred to an expense
account called cost of sales or cost of goods sold.
 MERCHANDISING BUSINESS
A merchandising business is also different
from a manufacturing business. The latter
purchases materials and transforms them into
products before they are sold. While a
merchandising business purchases goods and
sells them without changing their form.
COMPARISON OF INCOME
STATEMENTS
 OPERATING CYCLE OF A
MERCHANDISING BUSINESS
▪The major business activities of a merchandising
business are:
a. Purchasing Activities. These activities refer to
the buying or acquisition of merchandise that is
intended for sale. Merchandise can be purchased
either for cash or on account. The cost of
merchandise purchased should include the
purchase price plus all other incidental costs
related to the acquisition.
 OPERATING CYCLE OF A
MERCHANDISING BUSINESS

b. Selling Activities. These activities refer to the

transfer of the title of ownership over the
merchandise from the seller to the buyer for a
consideration either in money or in other things of
value.
 OPERATING CYCLE OF A
MERCHANDISING BUSINESS

b. Selling Activities. These activities refer to the

transfer of the title of ownership over the
merchandise from the seller to the buyer for a
consideration either in money or in other things of
value.
 OPERATING CYCLE OF A
MERCHANDISING BUSINESS
The merchandising entity purchases inventory,
sells the inventory and uses the cash to purchase
more inventory- and the cycle continues.
▪ For cash sales, the cycle is from cash to
inventory and back to cash.
▪ For sales on account, the cycle is from cash to
inventory to accounts receivable and back to cash.
 OPERATING CYCLE OF A
MERCHANDISING BUSINESS
The goal of many business owner/manager is to
shorten this cycle. The faster the sale of inventory
and the collection of cash, the higher the profits
and better liquidity position.
 OPERATING CYCLE OF A
MERCHANDISING BUSINESS
The following illustrates the operating cycle:
OPERATING CYCLE OF A
MERCHANDISING BUSINESS
The following illustrates the operating cycle:
 SOURCE DOCUMENTS

1. Sales invoice is prepared by the seller of goods

and sent to the buyer. It contains the name and
address of the buyer, the date of sale and
information - quantity, description and price- about
the goods sold. It also specifies the amount of
sales, and the transportation and payment terms.
 SOURCE DOCUMENTS

2. The bill of lading is a document issued by the

carrier - a trucking, shipping or airline - that
specifies contractual conditions and terms of
delivery such as freight terms, time, place, and the
person named to receive the goods.
 SOURCE DOCUMENTS

3. Statement of account - is a formal notice to the

debtor detailing the accounts already due.

4. The official receipt evidences the receipt or cash

by the seller or the authorized representative. It
notes the invoices paid and other details of
payment.
SOURCE DOCUMENTS

5. Deposit slips are printed forms with the

depositor's name, account number and space for
details of the deposit. A validated deposit slip
indicates that cash and checks with the supplied
details were actually deposited or credited to the
account holder.
SOURCE DOCUMENTS

6. A check is a written order to a bank by a

depositor to pay the amount specified in the check
from his checking account to the person named in
the check. The entity issuing the check is the payor
while the receiver is the payee.
SOURCE DOCUMENTS

7. The purchase requisition is a written request to

the purchases of an entity from an employee or
user department of the same entity that goods be
purchased.
SOURCE DOCUMENTS
8. The purchase order is an authorization made by
the buyer to the seller to deliver the merchandise
as detailed in the form.

9. Receiving report is a document containing

information about goods received from a vendor. It
formally records the quantities and description of
the goods delivered.
SOURCE DOCUMENTS

10. A credit memorandum is a form used by the

seller to notify the buyer that this account is being
decreased due to errors or other factors requiring
adjustments.
SALES
The Sales account is a revenue account used to
record sales of merchandise. Sales are initially
recorded via one of the following entries,
depending on whether the sale is for cash or is a
sale on account:
Cash xxxx
Sales xxxx
Sold merchandise for cash.
SALES

Accounts Receivable xxxx

Sales xxxx
Sold merchandise on account.
SALES RETURNS AND ALLOWANCES
Occasionally, a customer returns merchandise.
When that occurs, the following entry should be
made:

Sales Return & Allowances xxxx

Accounts Receivable xxxx
Returns of merchandise.
SALES RETURNS AND ALLOWANCES
Notice that the above entry included a debit to
Sales Returns and Allowances (rather than
canceling the sale).
The Sales Returns and Allowances account is a
contra-revenue account that is deducted from
sales.
SALES RETURNS AND ALLOWANCES
The calculation of sales less sales returns and
allowances is sometimes called “net sales.” This
approach allows interested parties to easily track
the level of sales returns in relation to overall sales.

Important information is revealed about the relative

level of returns, thereby providing a measure of
customer satisfaction or dissatisfaction.
SALES RETURNS AND ALLOWANCES

Sales returns (on account) are typically

documented by the creation of an instrument
known as a credit memorandum. The credit
memorandum indicates that a customer’s Account
Receivable balance has been credited (reduced)
and that payment for the returned goods is not
expected.
SALES RETURNS AND ALLOWANCES
If the transaction involved a cash refund, the only
difference in the entry would involve a credit to
Cash instead of Accounts Receivable. The
calculation of net sales would be unaffected.
THE FOLLOWING INCOME STATEMENT PROVIDES
AN EXAMPLE SHOWING THE PRESENTATION OF
NET SALES:
SALES RETURNS AND ALLOWANCES
Note the use of the word “allowances” in the
account title “Sales Returns and Allowances.” What
is the difference between a return and an
allowance?
Perhaps a customer’s reason for wishing to return
an item is because of a minor defect; the customer
may be willing to keep the item if the price is
reduced.
SALES RETURNS AND ALLOWANCES
The merchant may give an allowance to induce the
customer not to return the item. The entry to record
the allowance would ordinarily involve the same
accounts as those previously illustrated for the
return. However, one could use a separate account
for returns and another for allowances.
TRADE DISCOUNTS
Product catalogs often provide a list price for an
item. Those list prices may bear little relation to the
ultimate selling price. A merchant may offer
customers a trade discount that involves a
reduction from list price.
Ultimately, the purchaser is responsible for the
invoice price, that is, the list price less the
negotiated trade discount.
TRADE DISCOUNTS
Trade discounts are not entered in the accounting
records. They are not considered to be a part of the
sale because the exchange agreement was based
on the reduced price.
Remember the general rule that sales are recorded
when an exchange takes place.
TRADE DISCOUNTS
Because the measurement of the sale is based on
the exchange price, the amount recorded as a sale
is the invoice price. The entries previously shown
for a P40,000 sale would also be appropriate if the
list price was P50,000, subject to a 20% trade
discount.
CASH DISCOUNTS/ PURCHASE DISCOUNTS
Discounts are typically very favorable to the purchaser,
as they are designed to encourage early payment.
Discount terms vary considerably. Here are some
examples:
▪1/15, n/30 — 1% if paid within 15 days, net due in 30
days
▪1/10, n/eom — 1% if paid within 10 days, net due end of
month
▪0.5/10, n/60 — ½% if paid within 10 days, net due in 60
days
CASH DISCOUNTS/ PURCHASE DISCOUNTS
While discounts may seem slight, they can represent
substantial savings and should usually be taken.
Consider the following calendar, assuming a purchase
was made on May 31, terms 2/10, n/30.
Consider that a 2% return is “earned” by paying 20
days early. This is indeed a large savings. There are
approximately 18 twenty-day periods in a year
(365/20), and, at 2% per twenty-day period, this
equates to over a 36% annual interest rate equivalent.
FREIGHT CHARGES
When merchandise is shipped by a common carrier
- a trucking entity or an airline - the carrier prepares
a freight bill in accordance with the instructions of
the party making the shipping arrangements.
The freight bill designates which party shoulder the
costs, and whether the shipment is freight prepaid
or freight collect.
FREIGHT CHARGES
Freight bills usually show whether the shipping
terms are FOB shipping point or FOB destination.
When the freight terms are FOB shipping point ,
the buyer shoulders the shipping costs; ownership
over the goods passes from seller to buyer when
the inventory leaves the seller’s place of business -
the shipping point. The buyer already owns the
goods while still in transit and therefore, shoulders
the transportation costs.
FREIGHT CHARGES
If the terms are FOB destination, the seller bears
the shipping costs. Title passes only when the
goods are received by the buyer at the point of
destination; while in transit, the seller is still the
owner of the goods so the seller is still the owner of
the goods so the seller shoulders the transportation
costs.
FREIGHT CHARGES
In freight prepaid, the seller pays the transportation
costs before shipping the goods sold; while in
freight collect when the terms are FOB shipping
point; and freight prepaid when the terms are FOB
destination.
FREIGHT CHARGES
FREIGHT CHARGES
The shipping costs borne by the buyer using the
periodic inventory system are debited to
transportation in account. In accounting, the cost of
an asset - the merchandise inventory includes all
costs incurred to bring the asset to its intended
use. In the cost of sales section of the income
statement, the balance in this account is added to
purchases in computing for the net purchases for
the period.
FREIGHT CHARGES
The shipping costs borne by the buyer using the
periodic inventory system are debited to
transportation in account. In accounting, the cost of
an asset - the merchandise inventory includes all
costs incurred to bring the asset to its intended
use. In the cost of sales section of the income
statement, the balance in this account is added to
purchases in computing for the net purchases for
the period.
FREIGHT CHARGES

Shipping costs borne by the seller are debited to

transportation out account. This account which is
also called delivery expense, is an operating
expense in the income statement.
FREIGHT CHARGES
If goods are sold F.O.B. destination, the seller is
responsible for costs incurred in moving the goods
to their destination. Freight cost incurred by the
seller is called freight-out and is reported as a
selling expense that is subtracted from gross profit
in calculating net income.
FREIGHT CHARGES
FREIGHT CHARGES
If goods are sold F.O.B. shipping point, the
purchaser is responsible for paying freight costs
incurred in transporting the merchandise from the
point of shipment to its destination. Freight cost
incurred by a purchaser is called freight-in, and is
added to purchases in calculating net purchases:
FREIGHT CHARGES
FREIGHT CHARGES
If goods are sold F.O.B. shipping point, freight prepaid,
the seller prepays the trucking company as an
accommodation to the purchaser. This prepaid freight
increases the accounts receivable of the seller. That is,
the seller expects payment for the merchandise and a
reimbursement for the freight. The purchaser would
record this transaction by debiting Purchases for the
amount of the purchase, debiting Freight-In for the
amount of the freight, and crediting Accounts Payable for
the combined amount due to the seller.
FREIGHT CHARGES
INVENTORY SYSTEMS
The first phase of the merchandising cycle occurs when
the merchant acquires goods to be stocked for resale to
customers. The appropriate accounting for this action
requires the recording of the purchase.
There are two different techniques for recording the
purchase; a periodic system or a perpetual system.
 INVENTORY SYSTEMS
Generally, the periodic inventory system is easier to
implement but is less robust than the “real-time” tracking
available under a perpetual system. Conversely, the
perpetual inventory system involves more constant
data update and is a far superior business management
tool.
INVENTORY SYSTEMS
Perpetual Inventory System
▪Under the perpetual inventory system, the
inventory is continuously updated. Perpetually
updating the inventory account requires that at the
time of purchase, merchandise acquisitions be
recorded as debits to the inventory account. At the
time , the cost of sales is determined and recorded
by a debit to the cost of sales account and a credit
to the inventory account.
INVENTORY SYSTEMS
▪Periodic Inventory System
In the periodic inventory system, no entries are
made to the inventory account as the merchandise
is bought and sold. When goods are purchased a
separate set of accounts - purchases, purchase
discounts , purchase returns and allowances, and
transportation in - is used to accumulate
information on the net cost of the purchases.
INVENTORY SYSTEMS
Only at the end of the period, when the inventory is
counted, will entries be made to the inventory
account to establish its proper balance.
PERIODIC INVENTORY SYSTEMS
Gross Method
▪A fundamental accounting issue is how to account
for purchase transactions when discounts are
offered. One technique is the gross method of
recording purchases. This technique records
purchases at their total gross or full invoice
amount:
PERIODIC INVENTORY SYSTEMS
PERIODIC INVENTORY SYSTEMS
If payment is made within the discount period, the
purchase discount is recognized in a separate
account. The Purchase Discounts account is
similar to Purchases Returns & Allowances, as it is
deducted from total purchases to calculate the net
purchases for the period:
PERIODIC INVENTORY SYSTEMS
PERIODIC INVENTORY SYSTEMS
If payment is made outside the discount period, the
purchaser loses the right to take a discount.
Therefore, the full amount of the invoice becomes
due and payable. The following entry would be
needed to reflect this payment:
PERIODIC INVENTORY SYSTEMS
PERIODIC INVENTORY SYSTEMS

Net Method
▪Rather than recording purchases under the gross
method, a company may elect to record the purchase
and payment under a net method. With this technique,
the initial purchase is again recorded by debiting
Purchases and crediting Accounts Payable.
PERIODIC INVENTORY SYSTEMS
Net Method
However, the amount of the entry is for the invoice
amount of the purchase, less the anticipated discount.
Assuming the company intends to take the discount, this
entry results in recording the net anticipated payment
into the accounts.
Purchases 4,900
Accounts Payable 4,900
Purchased inventory on account, terms 2/10 n/30
PERIODIC INVENTORY SYSTEMS
▪If payment is made within the discount period, the
entry is quite straightforward because the payable
was initially established at the net of discount
amount:
Accounts Payable 4,900
Cash 4,900
Paid outstanding payable within the discount
period.
PERIODIC INVENTORY SYSTEMS
▪If payment is made outside the discount period,
the lost discounts are recorded in a separate
account. The Purchase Discounts Lost account is
debited to reflect the added cost associated with
missing out on the available discount amount:
Accounts Payable 4,900
Purchase Discount Loss 100
Cash 5,000
Paid outstanding payable outside the discount period.
PERIODIC INVENTORY SYSTEMS
In evaluating the gross and net methods, notice
that the Purchase Discounts Lost account (used
only with the net method) indicates the total
amount of discounts missed during a particular
period.
The presence of this account draws attention to the
fact that discounts are not being taken, frequently
an unfavorable situation.
PERIODIC INVENTORY SYSTEMS
The Purchase Discounts account (used only with
the gross method) identifies the amount of
discounts taken, but does not indicate discounts
missed, if any. For reporting purposes, purchases
discounts are subtracted from purchases to arrive
at net purchases, while purchases discounts lost
are recorded as an expense following the gross
profit number for a particular period.
PERIODIC INVENTORY SYSTEMS
The following illustration contrasts the gross and
net methods for a case where the discount is
taken. Notice that P4,900 is accounted for under
each method. The gross method reports the
P5,000 gross purchase, less the applicable
discount. In contrast, the net method only shows
the P4,900 purchase amount.
PERIODIC INVENTORY SYSTEMS
PERIODIC INVENTORY SYSTEMS
The next illustration contrasts the gross and net
methods for the case where the discount is lost.
Notice that P5,000 is accounted for under each
method. The gross method simply reports the
P5,000 gross purchase, without any discount. In
contrast, the net method shows purchases of
P4,900 and an additional P100 expense pertaining
to lost discounts.
PERIODIC INVENTORY SYSTEMS
COST OF GOODS SOLD
A number of new accounts have been introduced in
this chapter. Purchases, Purchase Returns and
Allowances, Purchase Discounts, and Freight-in
have all been illustrated. Each of these accounts is
necessary to calculate the “net purchases” during a
period.
COST OF GOODS SOLD
Note that storage costs, insurance, interest and
other similar costs are considered to be period
costs that are not attached to the product.
Instead, those ongoing costs are simply expensed
in the period incurred as operating expenses of the
business.
COST OF GOODS SOLD
The cost of all purchases must ultimately be
allocated between cost of goods sold and
inventory, depending on the portion of the
purchased goods that have been resold to end
customers.
This allocation must also give consideration to any
beginning inventory that was carried over from prior
periods.
COST OF GOODS SOLD
Goods that remain unsold at the end of an
accounting period should not be “expensed” as
cost of goods sold. Therefore, the calculation of
cost of goods sold requires an assessment of
total goods available for sale, from which ending
inventory is subtracted. With a periodic system, the
ending inventory is determined by a physical count.
COST OF GOODS SOLD
In that process, the goods held are actually
counted and assigned cost based on a consistent
method. The actual methods for assigning cost to
ending inventory is the subject of considerable
discussion in the inventory chapter. Understanding
the allocation of costs to ending inventory and cost
of goods sold is very important and is worthy of
additional emphasis.
COST OF GOODS SOLD
The beginning inventory is equal to the prior year’s
ending inventory, as determined by reference to
the prior year’s ending balance sheet. The net
purchases is extracted from this year’s ledger (i.e.,
the balances of Purchases, Freight-in, Purchase
Discounts, and Purchase Returns & Allowances).
Goods available for sale is the sum of beginning
inventory and net purchases.
COST OF GOODS SOLD
Goods available for sale is not an account, per
se; it is merely a defined result from adding two
amounts together. The total cost incurred (i.e., cost
of goods available for sale) must be “allocated”
according to its nature at the end of the year. The
cost of goods still held are assigned to inventory
(an asset), and the remainder is attributed to cost
of goods sold (an expense).
COST OF GOODS SOLD
PERIODIC AND PERPETUAL INVENTORY SYSTEMS
COMPARED
PERIODIC AND PERPETUAL INVENTORY SYSTEMS
COMPARED
PERIODIC AND PERPETUAL INVENTORY SYSTEMS
COMPARED
PERIODIC AND PERPETUAL INVENTORY SYSTEMS
COMPARED
VALUE-ADDED TAX ENTRIES
Value Added TAX (VAT) is imposed upon any
person who in the ordinary course of trade or
business, sells, barters, exchanges, leases goods
or properties, renders services and any person who
imports goods. It is an indirect tax and the amount
of VAT maybe shifted or passed on to the buyer,
transferee or lessee of the goods, properties or
services.
VALUE-ADDED TAX ENTRIES
The VAT on purchases is normally called input
VAT while the VAT added on sales is called output
VAT. In computing the VAT due and payable to
BIR creditable input taxes are deducted from
output VAT (output tax from sales).
VALUE-ADDED TAX ENTRIES
For example, Company Seller (VAT-registered) sold to
Company Buyer for P200,000, exclusive of 12% VAT or
a total of P224,000. Company Seller’s purchases
amounted to P100,000 exclusive of 12% VAT or a total
of P112,000.
Cash/Accounts Receivable P 224,000
Sales P200,000
Output Tax 24,000
To record sales.
VALUE-ADDED TAX ENTRIES
Purchases 100,000
Input Tax 12,000
Cash/Accounts Payable 112,000
To record purchases.
Output Tax 24,000
Input Tax 12,000
VAT Payable 12,000
To set up VAT Payable.