FABM

Week 7: Accounting Cycle of a Merchandising Business (Part I)

What makes the accounting procedure and the preparation of financial statements of a merchandising business
different from other types of business? What is the most significant factor that needs to be consider in the
accounting cycle? And, how does this type of business treat the goods in transit in their accounting books?
For this week, let us learn more on the operations and accounting procedures of a merchandising business.
💎As you go through the lesson, try to reflect on the following essential questions:
o What is the difference in the income statement of a service and merchandising business?
o What are the source documents of a merchandise
business?
o What are transportation costs?

BUSINESS TRANSACTIONS AND THEIR ANALYSIS AS APPLIED TO THE

ACCOUNTING CYCLE OF A MERCHANDISING BUSINESS (PART I)
A merchandising business is a company that buys goods and resells these goods, without making any
modifications, at a price higher than its purchase price for the purpose of making profit. This type of business is
much common in the Philippines and can range from small to large-sized entities. Examples would be the
neighborhood sari-sari stores, department stores, grocery shops, and those selling in wholesale.

Hence, inventory is the most important asset of a merchandising business as this is where the company derives
its regular revenue streams.

⫸What is the 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. In any industry, the
manager strives to shorten the cycle. The faster the sale of inventory and the collection of cash, the higher the
profit. The following illustrates the operating cycle of a merchandiser:
⫸What is the difference in the Income Statement of a Service and Merchandising
Business?

Service entities perform services for a fee. In ascertaining profit, a basic income statement is all that is needed. In
Figure 1, profit is measured as the difference between revenues from services and expenses. In contrast,
merchandising entities earn profit by buying and selling goods. These entities use the same basic accounting
methods as service entities, but the process of buying and selling merchandise requires some additional accounts
and concepts. This process results in a more complex income statement. To provide a better measure of
performance, the income statement of a merchandising business is presented with additional items:
 

Service   Merchandising

Income Statement   Income Statement

     

Revenues from Services   Net Sales

  minus

  Cost of Sales

minus   equals

  Gross Profit

  add or minus

Income or Expenses
Expenses  
(see details below)

equals   equals

Profit   Profit
 

Figure 1 – Components of Income Statement for Service and Merchandising Entities

In a merchandising business, net sales arise from the sale of goods while cost of sales or cost of goods sold
represents the cost of inventory the entity has sold to customers. The difference between net sales and cost of
sales is called gross profit. Then, other operating income is added and operating expenses (like distribution costs,
administrative expenses and other operating expenses) are deducted from gross profit to arrive at operating profit.
Investment revenues, other gains and losses, and finance costs (e.g., interest expense) are considered to arrive
at profit before tax then income tax expense is deducted to have profit from continuing operations. Finally, profit
from discontinued operations (net of tax) is taken to account to get profit for the period.
 Theodore Calaguas Traders
Income Statement
For the Year Ended December 31, 2016

Net Sales ₱ 2,393,250

Cost of Sales (1,313,600)

Gross Profit ₱ 1,079,650

Operating Expenses (586,040)

Operating Profit ₱    493,610

Finance Costs (38,400)

Profit ₱    455,210

 

Exhibit 1 – Parts of an Income Statement for a Merchandising Entity

⫸What are the Source Documents of a Merchandise Business?

Merchandising businesses use various business forms and documents to help identify the transactions that
should be recorded in the books. These source documents contain vital information about the nature and amount
of the transactions.

 Sales Invoice is prepared by the seller of goods and sent to the buyer. This document 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.

 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 transportation and
payment terms.

 The Statement of Account is a formal notice to the debtor detailing the accounts already due.

 The Official Receipt evidences the receipt of cash by the seller or the authorized representative. It notes
the invoices paid and other details of payment.

 Deposit Slips are printed forms with 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.

 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

 The Purchase Requisition is a written request to the purchaser of an entity from an employee or user
department of the same entity that goods be purchased.

 The Purchase Order is an authorization made by the buyer to the seller to deliver the merchandise as
detailed in the form.
  Receiving Report is a document containing information about goods received from a vendor. It formally
records the quantities and description of the goods delivered.

 A Credit Memorandum is a form used by the seller to notify the buyer that his account is being decreased
due to errors or other factors requiring adjustments.

TERMS OF TRANSACTIONS
Merchandise may be purchased and sold either on credit or for cash on delivery. When goods are sold on
account, a period of time called the credit period is allowed for payment. The length of the credit period varies
across industries and may even vary within an entity, depending on the product.
When goods are sold on credit, both parties should have an understanding as to the amount and time of payment.
These terms are usually printed on the sales invoice and constitute part of the sales agreement. If the credit
period is 30 days, then the payment is expected within 30 days from the invoice date. The credit period is usually
described as net credit period or net terms. The credit period of 30 days is noted as “n/30”. If the invoice is due
ten days after the end of the month, it may be marked “n/10 eom”.

⫸What are CASH DISCOUNTS?

Some businesses give discounts for prompt payment. If a trade discount is also offered, cash discount is
computed on the net after the trade discount. This practice improves the seller’s cash position by reducing the
amount of money in accounts receivable. Cash discount is designated by such notation as “2/10” which means
the buyer may avail of a two percent discount if the invoice is paid within ten days from the invoice date. The
period covered by the discount, in this case – ten days, is called the discount period.

Cash discounts are called purchase discounts from the buyer’s viewpoint and sales discount from the seller’s
point of view.

It is usually worthwhile for the buyer to take a discount it offered although it may be necessary to borrow money to
make the payment.

Example 1:

5 n
This is read as “two ten, n thirty”. A term like /10, /30 means that a 5% cash discount is granted the buyer if
the account is paid within 10 days from the date of invoice/purchase. If the 10-day period has elapsed, the buyer
will be given 30 days from the date of the invoice within which to pay his or her account with additional charges
Example 2:

/10 = 2/15 = n/60
3

This is read as “three ten, two fifteen, n sixty”. It means that the buyer will be given 3% discount if he or she
pays within 10 days from the date of invoice; or 2% discount if he or she pays within 15 days from the invoice
date; or, if he or she failed to take advantage of the discounts being offered, he or she has to pay within 60 days
from the date of invoice.

Computing for Cash Discounts and Net Amount Due:

Cash Discount = NIP x Cash Discount Rate

 
Net Amount Due = NIP – Cash Discount
 
where:
NIP = Net invoice Price

Example: Net Invoice Price: ₱3,060

Invoice Date: March 2

3
Term: /15 = n/60   

Find: a. Cash Discount b. Net Amount Due

Solution:

Cash Discount = NIP x Cash Discount Rate

Cash Discount = ₱3,060 x 0.03
Cash Discount = ₱91.80

Net Amount Due = NIP – Cash Discount

Net Amount Due = ₱3,060 - ₱91.80
Net Amount Due = ₱2,968.20

The foregoing implies that if the buyer pays not later than March 17, then he or she pays only ₱2,968.20 instead
of ₱3,060. Beyond March 17, he or she pays the ₱3,060.

⫸What are TRADE DISCOUNTS?

Suppliers furnish smaller wholesalers or retailers with price list and catalogs showing suggested retail prices for
their products. These firms, however, also include a schedule of trade discounts from the listed prices to enable
customer to determine the invoice price to be paid. Trade discounts encourage the buyers to purchase products
because of markdowns from the list price. Trade discounts should not be confused with cash discounts. This type
of discount enables the suppliers to vary prices periodically without the inconvenience of revising price lists and
catalogs.

There is no trade discount account and there is no special accounting entry for this discount. Instead, all
accounting entries are based on the invoice price which is obtained by subtracting the trade discount from the list
price.

Illustration: Pinnacle technologies quoted a list price of ₱2,500 for each 64-gigabyte flash drive, less a trade
discount of 20%. If Video Fantastic ordered seven units, the invoice price would be as follows:

List Price (₱2,500 x 7) ₱ 17,500

Less: 20% Trade Discount (3,500)

Invoice Price ₱ 14,000

Trade discounts may be stated in a series. Assume instead that the trade discount given by Pinnacle to Video
Fantastic is 20% and 10%, the invoice price will be:

List Price (₱2,500 x 7) ₱ 17,500

Less: 20% Trade Discount (3,500)

Balance ₱ 14,000

Less: 10% Trade Discount (1,400)

Invoice Price ₱ 12,600

In the first example, both the buyer and the seller would record only the ₱14,000 invoice price while in the second
example, the invoice price will be ₱12,600.

⫸What are TRANSPORTATION COSTS?

When a 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 shoulders the costs, and whether the shipment freight prepaid or freight collect.

Freight bills usually show whether the shipping terms are FOB shipping point or FOB destination. F.O.B. is an
abbreviation for “free on board”. When the freight the terms are FOB shipping point, the buyer shoulders the
shipping costs; ownership over the goods passes from seller to the 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.

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 shoulders the transportation costs.

In freight prepaid, the seller pays the transportation costs before shipping the goods sold; while in freight collect,
the freight entity collects from the buyer. Payment by either party will not dictate who should ultimately shoulder
the costs.
Normally, the party bearing the freight cost pays the carrier. Thus, goods are typically shipped freight collect when
the terms are FOB shipping point; and freight prepaid when the terms are FOB destination.

Sometimes, as a matter of convenience, the firm not bearing the freight cost pays the carrier. When this situation
occurs, the seller and the buyer simply adjust the amount of the payment for the merchandise. Figure 3 shows
which party – the buyer or the seller – shoulders the transportation costs and pays the shipper for various freight
terms:

Who shoulders th
Who pays the
Freight Terms e transportation
shipper?
costs?

FOB Destination, Freight Prepaid Seller Seller

FOB Shipping Point, Freight Collect Buyer Buyer

FOB Destination, Freight Collect Seller Buyer

FOB Shipping Point, Freight Prepaid Buyer Seller

 

Figure 3 – Treatment of Transaction Costs

The shipping costs borne by the buyer using periodic inventory system are debited to transportation in account. In
accounting, the cost of an asset – the merchandise inventory – includes all costs (e.g., shipping 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 cost of purchases for the period.

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.

INVENTORY SYSTEMS
Merchandise inventory is the key factor in determining cost of sales. Because merchandise inventory represents
goods available for sale, there must be a method of determining both the quantity and the cost of these goods.
There are two systems available to merchandising entities to record events related to merchandise inventory: the
perpetual inventory system and the periodic inventory system. Refer to the appendix of this chapter for the
comparative illustrations.

 Perpetual Inventory System

The perpetual inventory system is an alternative to the periodic inventory system. Under the perpetual inventory
system, the inventory account 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 of
sale, the cost of sales is determined and recorded by a debit to the cost of sales account and a credit to the
inventory account. With perpetual inventory system, both the inventory and cost of sales accounts receive entries
throughout the accounting period.

When an entity uses the perpetual inventory system, the ending inventory should reconcile with the actual
physical count at the end of the period assuming that no theft, spoilage, or error has occurred. Even if there is a
little chance for or suspicion of inventory discrepancy, most entities make a physical count. At that time, the
account is adjusted for any inaccuracies discovered. The count provides an independent check on the amount of
inventory that should be reported at the end of the period.

 Periodic Inventory System

The periodic inventory system is primarily used by businesses that sell relatively inexpensive goods and that are
not yet using computerized scanning systems to analyze goods sold. A characteristic of the periodic inventory
system is that 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, purchases discounts, purchases returns and allowances,
and transportation in – is used to accumulate information on the net cost of the purchases. 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.

APPENDIX
Periodic and Perpetual Inventory Systems Compared

This appendix will demonstrate the entries typically used with the periodic inventory system, contrasted to the
entries used with the perpetual inventory system. Assume that the beginning inventory for the year is ₱250,000.
Assuming the transactions (nos. 1 to 7) were the only transactions for the entire year, the balance in the inventory
account at year-end under the periodic inventory system is ₱250,000. The year-end balance in the inventory
account under the perpetual inventory system is ₱231,860.

Under the perpetual inventory system, the inventory account is increased by purchases, transportation in, and
sales returns and is decreased by the cost of sales, purchases returns and allowances, and purchases discounts.

At year-end, the physical inventory is taken, and it revealed that the actual inventory on hand is ₱231,500. The
year-end journal entries (nos. 8 to 10) are then made to bring the inventory account balance into agreement with
the amount of the physical inventory. When posted to the general ledger, both the periodic and perpetual
inventory systems result in the same ending inventory amount, ₱231,500.

Exhibit 2

PERIODIC INVENTORY SYSTEM   PERPETUAL INVENTORY SYSTEM

1.       Sold merchandise on account costing ₱8,000 for ₱10,000; terms were 2/10, n/30:

Accounts Receivable 10,000   Accounts Receivable 10,000

Sales 10,000   Sales 10,000

         

      Cost of Sales 8,000

      Inventory 8,000

         

2.       Customer returned merchandise costing ₱400 that had been sold on account for ₱500 (part of the
₱10,000 sale):

Sales Returns and

Sales Returns & Allowances 500   500
Allowances

Accounts Receivable 500   Accounts Receivable 500

         

      Inventory 400

      Cost of Sales 400

         

3.       Received payment from customer for merchandise sold above [cash discount taken: (₱10,000 sale -
₱500 return) x 2% discount = ₱190):

Cash 9,310   Cash 9,310

Sales Discounts 190   Sales Discounts 190

Accounts Receivable 9,500   Accounts Receivable 9,500

         

4.       Purchased on account merchandise for resale for ₱6,000; terms were 2/10, n/30 (purchases
recorded at invoice price):

Purchases 6,000   Inventory 6,000

Accounts Payable 6,000   Accounts Payable 6,000

         

5.       Paid ₱200 freight on the ₱6,000 purchase; terms were FOB shipping point, freight collect:

Transportation In 200   Inventory 200

Cash 200   Cash 200

         

6.       Returned merchandise costing ₱300 (part of the ₱6,000 purchase):

Accounts Payable 300   Accounts Payable 300

Purchases Returns &

300   Inventory 300
Allowances

         

7.       Paid for merchandise purchased, refer to no.4 [cash discount taken: (6,000 purchase - ₱300 return) x
2% discount = ₱114]:

Accounts Payable 5,700   Accounts Payable 5,700

Purchase Discounts 114   Inventory 114

Cash 5,586   Cash 5,586

          

8.       To transfer the beginning inventory balance to the Income Summary account (part of the closing
entries under the periodic inventory system):

Income Summary 250,000  

(No entry required)
Inventory 250,000  

         

9.       To record the ending inventory balance (part of the closing entries under the periodic inventory
system):

Inventory 231,500  
(No entry required)
Income Summary 231,500  

         

10.    To adjust the ending perpetual inventory balance for the shrinkage during the year:

   Cost of Sales 360

Shrinkage already effected in the no. 9
entry
  Inventory 360
 

SAMPLE EXERCISE
Some of the sales transactions of Leonila Generales Distributors whose credit terms are 2/10, n/30 follow:

June 1 Cash sales, ₱180,000.

4 Sales on account, ₱650,000.
7 Received returned merchandise sold on account, ₱90,000.
10 Collected the amount due from credit sales.

Required: Prepare the journal entries.

GENERALIZATION
A merchandising business is a business that buys goods for reselling at a higher price. The point where the
ownership of inventory is transferred depends on the terms of sale. The most commonly used terms are FOB
Shipping Point and FOB Destination. Sale occurs upon the seller shipping the goods under FOB Shipping Point.
Point of sale on FOB Destination happens when the goods arrived at its destination. There are two methods for
inventory system reporting: perpetual and periodic. Perpetual inventory is usually used on low-volume
transactions of high-value items. Periodic inventory, on the opposite, is used on high-volume transactions
involving low-value items.

“There’s no accounting for the mysteries of the human heart.”

--Susan Elizabeth Philipps