TOPIC

Accounting for
Merchandising Businesses

Accounting
A Malaysian
Perspective
5e
Learning Objectives

• LO1: Distinguish between the activities and financial

statements of service and merchandising businesses.
• LO2: Describe and illustrate the accounting for
merchandise transactions.
• LO3: Describe and illustrate the financial statements of
a merchandising business.
• LO4: Describe the adjusting and closing process for a
merchandising business.
Nature of the Merchandising Businesses

• The activities of a service business differ from those of

a merchandising business.
o These differences are reflected in the operating cycles of a
service and merchandising business as well as in their
financial statements.
Operating Cycle (slide 1 of 2)

• The operating cycle is the process by which a

company spends cash, generates revenues, and
receives cash either at the time the revenues are
generated or later by collecting an accounts
receivable.
• The operating cycle of a service and merchandising
business differs in that a merchandising business must
first purchase merchandise for sale to customers.
The Operating Cycle for a
Merchandising Business
Operating Cycle (slide 2 of 2)

• The time in days to complete an operating cycle

differs significantly among merchandise businesses.
o For example, many grocery items, such as milk, must be sold
within their expiration dates of a week or two.
o In contrast, jewelry stores often carry expensive items that
are often displayed months before being sold to customers.
Financial Statements (slide 1 of 4)

• The differences between service and merchandising

businesses are also reflected in their financial
statements.
Financial Statements (slide 2 of 4)

• The revenue activities of a service business involve

providing services to customers.
• On the profit and loss statement for a service
business, the revenues from services are reported as
fees earned.
• The operating expenses incurred in providing the
services are subtracted from the fees earned to arrive
at net income.
Financial Statements (slide 3 of 4)

• The revenue activities of a merchandising business involve

the buying and selling of merchandise.
• A merchandising business first purchases merchandise to sell to
its customers.
• When merchandise is sold, the revenue is reported as
sales, and its cost is recognized as an expense called cost
of merchandise sold.
o The cost of merchandise sold is subtracted from sales to arrive at
gross profit, which is the profit before deducting operating
expenses.
Financial Statements
(slide 4 of 4)

• Merchandise on hand (not sold) at the end of an

accounting period is called merchandise inventory.
• It is reported as a current asset on the balance sheet.

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Example Exercise Gross Profit

During the current year, merchandise is sold for

RM250,000 cash and for RM975,000 on account. The
cost of the merchandise sold is RM735,000. What is the
amount of the gross profit?
Purchases Transactions (slide 1 of 4)

• There are two systems for accounting for merchandise

transactions: perpetual and periodic.
o In a perpetual inventory system, each purchase and sale of
merchandise is recorded in the inventory account and related subsidiary
ledger.
 In this way, the amount of merchandise available for sale and the amount
sold are continuously (perpetually) updated in the inventory records.
o In a periodic inventory system, the inventory does not show the amount
of merchandise available for sale and the amount sold.
 A listing of inventory on hand, called a physical inventory, is prepared at
the end of the accounting period.
– This physical inventory is used to determine the cost of merchandise on hand at
the end of the period and the cost of merchandise sold during the period.
Purchases Transactions (slide 2 of 4)

• Journal entry for cash purchases under the perpetual

inventory system:

• Purchases on account are recorded as follows:

Purchases Transactions (slide 3 of 4)

• The terms of purchases on account are normally

indicated on the invoice or bill that the seller sends
the buyer.
Purchases Transactions (slide 4 of 4)

• The terms for when payments for merchandise are to

be made are called the credit terms.
o If payment is required on delivery, the terms are cash or net
cash.
o Otherwise, the buyer is allowed an amount of time, known
as the credit period, in which to pay.
 The credit period usually begins with the date of the sale as shown
on the invoice.
Purchases Discounts (slide 1 of 4)

• To encourage the buyer to pay before the end of the

credit period, the seller may offer a discount.
o For example, a seller may offer a 2% discount if the buyer
pays within 10 days of the invoice date. If the buyer does
not take the discount, the total invoice amount is due within
30 days.
 The terms are expressed as 2/10, n/30 and are read as “2%
discount if paid within 10 days, net amount due within 30 days.”
Credit Terms
Purchases Discounts (slide 2 of 4)

• Discounts taken by the buyer for early payment of an

invoice are called purchases discounts.
o Purchases discounts taken by a buyer reduce the cost of the
merchandise purchased.
• Example: Assume that NetSolutions places an order from Alpha
Technologies on Jan 5 with terms 2/10, n/30.
• If NetSolutions borrows RM2,940 from others [(RM3,000 - the
discount of RM60 (RM3,000 × 2%)] to pay the invoice on Jan
15 (the last day of the discount period)…
• It is a smart SAVING decision actually!
• If an annual interest** rate of 6% and a 360-day year is assumed, the
interest on the loan of RM2,940 for the remaining 20 days of the credit
period is RM9.80 (RM2,940 × 6% × 20 ÷ 360).
Purchases Discounts (slide 3 of 4)

• The net savings to NetSolutions of taking the discount

is computed as follows:

• If NetSolutions does not take the discount, it is like it

pays an estimated interest rate of 36% for using the
RM2,940 for the remaining 20 days of the credit
period.
Purchases Discounts (slide 4 of 4)

• Since buyers normally take all purchases discounts,

Merchandise Inventory is debited for the net purchase
price under the perpetual inventory system.
o That is, the buyer debits Merchandise Inventory for the
amount of the invoice less the discount.
• NetSolutions would record the Alpha Technologies
invoice and its payment as follows:
Purchases Returns and Allowances (slide 1 of 4)

• A buyer may request an allowance for merchandise

that is returned (purchases return) or a price
allowance (purchases allowance) for damaged or
defective merchandise.
• Buyer’s perspective = purchases returns and
allowances.
o In both cases, the buyer normally sends the seller a debit
memorandum, often called a debit memo, to notify the
seller of reasons for the return (purchase return) or to
request a price reduction (purchase allowance).
 A debit memo also informs the seller of the amount the buyer
proposes to debit to the account payable due the seller.
Debit Memo
Purchases Returns and Allowances (slide 2 of 4)

• The buyer may use the debit memo as the basis for
recording the return or allowance or wait for
approval from the seller (creditor).
• In either case, the buyer debits Accounts Payable and
credits Merchandise Inventory.
• NetSolutions records the return of the merchandise
indicated in the debit memo as follows:
Purchases Returns and Allowances (slide 3 of 4)

• Before paying an invoice, a buyer may return

merchandise or be granted a price allowance for an
invoice with a purchase discount.
o In this case, the amount of the return is recorded at its
invoice amount less the discount.
Purchases Returns and Allowances (slide 4 of 4)

• NetSolutions example:
• May 2. Purchased RM5,000 of merchandise on account from Delta Data Link, terms
2/10, n/30.
4. Returned RM1,000 of the merchandise purchased on May 2.
12. Paid for the purchase of May 2 less the return and discount.
• NetSolutions would record these transactions as follows:
Example Exercise Purchases Transactions

Rofles Company purchased merchandise on account

from a supplier for RM11,500, terms 2/10, n/30. Rofles
Company returned RM2,500 of the merchandise and
received full credit.
a. If Rofles Company pays the invoice within the
discount period, what is the amount of cash
required for the payment?

b. Under a perpetual inventory system, what account

is credited by Rofles Company to record the return?
Sales Transactions

• Revenue from merchandise sales is usually recorded

as Sales.
o Sometimes a business may use the title Sales of
Merchandise.
Cash Sales (slide 1 of 4)

• Assume that on March 3, NetSolutions sells

merchandise for RM1,800. These cash sales are
recorded as follows:
Cash Sales (slide 2 of 4)

• Using the perpetual inventory system, the cost of

merchandise sold and the decrease in merchandise
inventory are also recorded.
o In this way, the merchandise inventory account indicates the
amount of merchandise on hand (not sold).
• Assume that the cost of merchandise sold on March 3
is RM1,200. The entry to record the cost of
merchandise sold and the decrease in the
merchandise inventory is as follows:
Cash Sales (slide 3 of 4)

• Sales may be made to customers using credit cards

such as MasterCard or VISA.
o Such sales are recorded as cash sales. WHY?
• If customers use MasterCards to pay for their
purchases, the sales would be recorded as shown in
the March 3 entry previously.
• Any processing fees charged by the clearinghouse or
issuing bank are periodically recorded as an
expense.
o This expense is normally reported on the statement of profit
or loss as an administrative expense.
Cash Sales (slide 4 of 4)

• Assume that NetSolutions paid credit card processing

fees of RM4,150 on March 31. These fees would be
recorded as follows:
Sales on Account

• NetSolutions sold merchandise on account for

RM18,000. The cost of the merchandise sold was
RM10,800.
Customer Discounts (slide 1 of 2)

• A seller may grant customers a variety of discounts,

called customer discounts, to encourage customers to
act in a way benefiting the seller.
o For example, a seller may offer customer discounts to
encourage customers to purchase in volume or order early.

• A sales discount encourages customers to pay their

invoice early.
o For example, a seller may offer credit terms of 2/10, n/30,
which provides a 2% sales discount if the invoice is paid
within 10 days.
Customer Discounts (slide 2 of 2)

• Assume that NetSolutions sold RM18,000 of

merchandise to Digital Technologies on March 10 with
credit terms 2/10, n/30.
o The March 10 sale would be recorded as follows:

o The payment by Digital Technologies on March 19 is

recorded as follows:
Customer Returns and Allowances (slide 1 of 6)

• Merchandise sold may be returned to the seller

(returns). In other cases, the seller may reduce the
initial selling price (allowances).
o This may occur if the merchandise is defective, damaged
during shipment, or does not meet the buyer’s expectations.
• From a seller’s perspective, these are termed
customer returns and allowances, sometimes called
sales returns and allowances.
Customer Returns and Allowances (slide 2 of 6)

• Assume Schafer Co. had sales of RM2,000,000 and related

cost of merchandise sold of RM1,400,000 for its first year of
operations ending December 31, 2018. Schafer Co. provides
customers a refund for any returned or damaged merchandise.
At the end of the year, Schafer Co. estimates that customers will
request refunds for 2% of sales and estimates that merchandise
costing RM25,000 will be returned. On December 31, 2018,
the following two adjusting journal entries must be recorded:
Customer Returns and Allowances (slide 3 of 6)

• The preceding two adjusting entries ensure that

current period sales are matched with the related cost
of merchandise sold on the statement of profit or loss.
• In addition, an asset for estimated returned inventory
and a liability for customer refunds is reported on the
statement of financial position.
Customer Returns and Allowances (slide 4 of 6)

• On January 15, 2019, Baker Company returned

merchandise with a selling price of RM3,000 for a
cash refund. The merchandise originally cost Schafer
Co. RM2,100. Schafer would record the return and
refund with the following two entries:
Customer Returns and Allowances (slide 5 of 6)

• In some cases, a customer that is due a refund has an

outstanding account receivable balance.
o In this case, the seller may credit the customer’s accounts
receivable rather than pay cash.
 When this is done, the seller normally sends the buyer a credit
memorandum or credit memo indicating its intent to credit the
customer’s account receivable.
Customer Returns and Allowances (slide 6 of 6)

• Assume that Schafer Company issued the credit memo

to Blake & Sons.

• Schafer Co. would record issuance of the credit memo

as follows:
Example Exercise Sales Transactions Exercise

Journalize the following merchandise transactions:

a. Sold merchandise on account, RM7,500, with terms
2/10, n/30. The cost of the merchandise sold was
RM5,625.

b. Received payment less the discount.

Freight (slide 1 of 7)

• Purchases and sales of merchandise often involve

freight.
• The terms of a sale indicate when ownership (title and
control) of the merchandise passes from the seller to
the buyer.
o This point determines whether the buyer or the seller pays
the freight costs.
• The ownership of the merchandise may pass to the
buyer when the seller delivers the merchandise to the
freight carrier.
Freight (slide 2 of 7)

o In this case, the terms are said to be FOB (free on board)

shipping point.
 This term means that the buyer pays the freight costs from the
shipping point to the final destination.
– Such costs are part of the buyer’s total cost of purchasing inventory
and are added to the cost of the inventory by debiting Merchandise
Inventory.
Freight (slide 3 of 7)

• Assume that on June 10, NetSolutions purchased merchandise as follows:

June 10. Purchased merchandise from Magna Data, RM900, terms FOB
shipping point.
10. Paid freight of RM50 on June 10 purchase from Magna Data.
• NetSolutions would record these two transactions as follows:
Freight (slide 4 of 7)

• The ownership of the merchandise may pass to the

buyer when the buyer receives the merchandise.
o In this case, the terms are said to be FOB (free on board)
destination.
 This term means that the seller pays the freight costs from the
shipping point to the buyer’s final destination.
– When the seller pays the delivery charges, the seller debits Delivery
Expense or Freight Out.
 Delivery Expense is reported on the seller’s statement of profit or
loss as a selling expense.
Freight (slide 5 of 7)

• Assume that NetSolutions sells merchandise as follows:

June 15. Sold merchandise to Kranz Company on account, RM700, terms FOB
destination. The cost of the merchandise sold is RM480.
15. NetSolutions pays freight of RM40 on the sale of June 15.
• NetSolutions records the sale, the cost of the sale, and the freight cost as follows:
Freight (slide 6 of 7)

• The seller may prepay the freight, even though the

terms are FOB shipping point. The seller will then add
the freight to the invoice.
o The buyer debits Merchandise Inventory for the total
amount of the invoice, including the freight.
o Any discount terms would not apply to the prepaid freight.
Freight (slide 7 of 7)

• Assume that NetSolutions sells merchandise as follows:

June 20. Sold merchandise to Planter Company on account, RM800, terms FOB
shipping point. NetSolutions paid freight of RM45, which was added to the
invoice. The cost of the merchandise sold is RM360.
• NetSolutions records the sale, the cost of the sale, and the freight as follows:
Freight Terms
Example Exercise Freight Terms Exercise

Determine the amount to be paid in full settlement of

each of the two invoices, (a) and (b), assuming that
credit for returns and allowances was received prior to
payment and that all invoices were paid within the
discount period.
Recording Merchandise Inventory Transactions
Dual Nature of Merchandise Transactions

• Each merchandising transaction affects a buyer and a

seller.
Illustration of Merchandise Inventory
Transactions for Seller and Buyer (slide 1 of 2)
Illustration of Merchandise Inventory
Transactions for Seller and Buyer (slide 2 of 2)
Example Exercise Transactions for Buyer and Seller

Sievert Co. sold merchandise to Bray Co. on account,

RM11,500, terms 2/15, n/30. The cost of the
merchandise sold is RM6,900. Journalize the entries for
Sievert Co. and Bray Co. for the sale, purchase, and
payment of amount due.
Chart of Accounts for NetSolutions, a
Merchandising Business
Sales Taxes (slide 1 of 2)

• In certain cases, tax is levied on sales of merchandise.

• The liability for the sales tax is incurred when the sale
is made.
o At the time of a cash sale, the seller collects the sales tax.
o When a sale is made on account, the seller charges the tax
to the buyer by debiting Accounts Receivable.
o The seller credits the sales account for the amount of the
sale and credits the tax to Sales Tax Payable.
Sales Taxes (slide 2 of 2)

• The seller would record a sale of RM100 on account, subject

to a tax of 6%, as follows:

• On a regular basis, the seller pays to the taxing authority

(state) the amount of the sales tax collected. The seller
records such a payment as follows:
Trade Discounts

• Businesses often offer special discounts to government

agencies or businesses that order large quantities.
o Such discounts are called trade discounts.
o Trade discounts are also used to actively increase sales.
Such as actively practiced by Watson.
• Sellers and buyers normally record the net prices
merchandise in their accounts.
o For example, assume that an item has a list price of
RM1,000 and a 40% trade discount.
o Both seller and buyer record the sale/purchase of the item
at RM600 [RM1,000 less the trade discount of RM400
(RM1,000 × 40%)].
Financial Statements for a
Merchandising Business

• An statement of profit or loss for a merchandising

business is normally prepared using either a multiple-
step or single-step format.
• The multiple-step statement of profit or loss contains
several sections, subsections, and subtotals, including
the following:
o Sales
o Cost of Merchandise Sold
o Gross Profit
o Income from Operations
o Other Income and Expense
Multiple-Step Statement of Profit or Loss—
Income from Operations
• Income from operations, or operating income, is determined
by subtracting operating expenses from gross profit.
o Operating expenses are normally classified as either selling expenses
or administrative expenses.
 Selling expenses are incurred directly in the selling of merchandise.
– Examples of selling expenses include the following:
 Sales salaries
 Store supplies used
 Depreciation of store equipment
 Delivery expense
 Advertising
 Administrative expenses, sometimes called general expenses, are
incurred in the administration or general operations of the business.
– Examples of administrative expenses include the following:
 Office salaries
 Depreciation of office equipment
 Office supplies used
Multiple-Step Statement of Profit or Loss—
Other Income and Expense (slide 1 of 2)

• Other income and expense items are not related to

the primary operations of the business.
o Other income is revenue from sources other than the
primary operating activity of a business.
 Examples of other income include the following:
– Income from interest
– Rent
– Gains resulting from the sale of fixed assets
o Other expense is an expense that cannot be traced directly
to the normal operations of the business.
 Examples of other expenses include the following:
– Interest expense
– Losses from disposing of fixed assets
Multiple-Step Statement of Profit or Loss—
Other Income and Expense (slide 2 of 2)

• Other income and other expense are offset against

each other on the statement of profit or loss.
o If the total of other income exceeds the total of other
expense, the difference is added to income from operations
to determine net income.
o If the total of other expense exceeds the total of other
income, the difference is subtracted from income from
operations to determine net income.
Multiple-Step Statement of Profit or Loss Example
Single-Step Statement of Profit or Loss (slide 1 of 2)

• A criticism of the single-step form is that gross profit

and income from operations are not reported.
Statement of Owner’s Equity for
Merchandising Business
Statement of Financial Position

• The statement of financial position may be presented

with assets on the left-hand side and the liabilities and
owner’s equity on the right-hand side.
o Called the account form.
• The statement of financial position may also be
presented in a downward sequence in three sections.
o Called the report form.
Report Form of Statement of Financial Position
Adjusting Entry for Inventory Shrinkage
(slide 1 of 2)

• Under the perpetual inventory system, the balance of the

merchandise inventory account is supposed to be the same as
the amount of merchandise available for sale at that point in
time.
• Retailers normally experience some loss of inventory due to
shoplifting, employee theft, or errors.
• Thus, the physical inventory on hand at the end of the
accounting period is usually less than the balance of
Merchandise Inventory.
o This difference is called inventory shrinkage or inventory shortage.
Adjusting Entry for Inventory Shrinkage
(slide 2 of 2)

• NetSolutions’ inventory records indicate the following on December 31,

2019:

• At the end of the accounting period, inventory shrinkage is recorded by

the following adjusting entry:

o Now the balance of Merchandise Inventory agrees with the physical

inventory on hand at the end of the period.
Example Exercise Inventory Shrinkage

Pulmonary Company’s perpetual inventory records

indicate that RM382,800 of merchandise should be on
hand on March 31, 2016. The physical inventory
indicates that RM371,250 of merchandise is actually on
hand. Journalize the adjusting entry for the inventory
shrinkage for Pulmonary Company for the year ended
March 31, 2016. Assume that the inventory shrinkage is
a normal amount.
Closing Entries (slide 1 of 4)

• The four closing entries for a merchandising business are as

follows:
1. Debit each temporary account with a credit balance, such as Sales, for
its balance and credit Income Summary.
2. Credit each temporary account with a debit balance, such as the various
expenses, and debit Income Summary. Since Cost of Merchandise Sold is
a temporary account with a debit balance, it is credited for its balance.
3. Debit Income Summary for the amount of its balance (net income) and
credit the owner’s capital account. The accounts debited and credited
are reversed if there is a net loss.
4. Debit the owner’s capital account for the balance of the drawing
account and credit the drawing account.
Closing Entries (slide 2 of 4)

• The four closing entries for NetSolutions follow:

Closing Entries (slide 3 of 4)

• NetSolutions’ income summary account after the

closing entries have been posted is as follows:
Closing Entries (slide 4 of 4)

• After the closing entries are posted to the accounts, a

post-closing trial balance is prepared.
o Listed accounts post-closing trial balance are the asset,
contra asset, liability, and owner’s capital accounts with
balances.
o If the two totals of the trial balance columns are not equal,
what does it means?