ACCOUNTING CYCLE

OF A MERCHANDISING
BUSINESS
 Learning Objective
• To determine how a merchandising
business functions and net pay
Key Understanding
 Understanding on how a merchandising
business functions and how it differs to
others such as a service business

Key Question
 How does the accounting cycle of a
merchandising business look like?
 Merchandising Business
• A merchandising business (or a trading 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 a 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.
 Analyzing Business Transactions

• The first step in the accounting cycle of a

merchandising business involves the analysis
of business transactions. This is done to
determine whether the economic events will
affect the books of an entity.
Accounting Cycle of a Merchandising Business
• Generally, a merchandising business starts with a purchase of the
goods it intends to sell. The purchase may be dealt with immediate
cash payments, payment to be made at a future date, or a mix of both.
Afterwards, these goods which we now call as inventory are to be
stored and sold to the customers. The cash generated from the sale of
inventories will then be used to purchase another batch of goods for
resale.

• Here, we shall introduce the concept of an operating cycle which

includes the time it takes from the purchase, the resale of inventory,
and the subsequent collection of cash related to that sale.
Accounting Cycle of a Merchandising Business
• Example: Timothy operates a small retail store in Pangasinan. If he
purchases snacks and delicacies from his supplier today, these
purchased goods take an average of 3 days before being sold. Cash is
received immediately upon the sale of the snacks. Determine
Timothy’s operating cycle.
Operating Cycle = Days of Inventory + Days of Receivable = 3 days

• Suppose that Timothy allows his buyers to pay within 2 days from the
date of sale. How will this change the operating cycle?
Operating Cycle = Days of Inventory + Days of Receivable = 3 + 2 = 5 days
 Journalizing Transactions

• Transactions having effects on the

company’s books require journal entries.
Since a merchandising business involves
regular and recurring inventory transactions,
we begin by studying the different events
involving the said account
 Inventory Reporting
• Companies can either use the (1) perpetual or (2) periodic system in reporting their
inventories.
• Perpetual inventory systems keep track of all changes in the inventory account. This system
is more expensive as more costs are incurred to make sure that amounts regarding
inventory are available at every point of sale.
• Periodic inventory systems, on the other hand, provide data on inventory levels at some
points in time. Hence, a physical count is made usually at year-end to provide figures as to
how many exist at that point in time. Periodic inventory systems are cheaper to implement.
• Companies incur costs for having the goods delivered to their intended location. If the
delivery fee is paid for the incoming merchandise, such payment forms part of inventory.
This is called freight-in. On the other hand, fee paid regarding transportation to the buyer of
the inventory sold by the company, which we call freight-out, is expensed. This forms part of
selling expense.
 Transaction Perpetual Periodic
1. Purchased inventory worth Inventory 10 000 Purchases 10 000
10 000 and paid in cash Cash 10 000 Cash 10 000

2. Paid 500 for the delivery Inventory 500 Freight-In 500

fee of the purchased Cash 500 Cash 500
Merchandise

3. Returned defective Cash 2 000 Cash 2 000

inventory received worth 2 Inventory 2 000 Purchase Return 2 000
000; Cash is received upon
return of the merchandise

4. Sold 4 000 worth of A/R 8 000 A/R 8 000

merchandise; The Sales Sales
selling price of the said 8 000 8 000
merchandise is 8 000; Sales
are made on account. Cost of Goods Sold 4 000
Inventory
4 000
 Transaction Perpetual Periodic
5. Sales worth 2 500 were Sales Returns 2 500 Sales Returns 2 500
returned by customer as A/R 2 500 A/R 2 500
wrong products have been
Inventory 1 250
delivered.
Cost of Goods Sold
1 250
6. The remaining balance of Cash 5 500 Cash 5 500
the receivable related to A/R 5 500 A/R 5 500
the sale was collected.

7. Year-end inventory No entry. Year-end Inventory 5 750

count shows that 5 250 worth amounting Cost of Goods Sold 2 750
of inventory is still within to 5 750 can be Purchase Return 2 000
company premises. computed Purchases
from the movements on 10 000
the Freight-in
inventory account title. 500

* COGS is determined by Beg

Inventory + Net Purchases –
End Inventory
• Note that for both perpetual and periodic inventory systems,
Net Sales = Sales – Sales Returns and Allowances – Sales
Discounts. In the table listed above, Net Sales = 5 500. Net
Purchases = Purchases + Freight-in – Purchase Returns /
Allowances. In the given example, Net Purchases = 8 500.

Perpetual
• Used for both expensive and
inexpensive items
• More costly to implement
• Record exists in every movement of
inventory.
• Inventory physical count is made at
least once a year.
Periodic
• Used for inexpensive items
• Cheaper to implement
• No record is kept for transactions
involving inventory movement
• Inventory physical count is made at
least once a year.
• Inventory physical count is made at
yearend to establish ending inventory
amounts.
 Terms of Sale – Transfer of Ownership

• Generally, the purchase or sale should be recorded upon the transfer

of ownership of inventory (i.e., when the goods are received as cash
is paid). However, in most instances, inventories are to be delivered.
The question arises as to when the company owns the items;
establishes the expense and liability related to it in case of a
purchase; or recognizes the revenue and receivable in the case of
sale.

• The most common sale terms that are being used are Freight on
Board (FOB) Shipping Point and Freight on Board (FOB) Destination.
 Terms of Sale – Transfer of Ownership

• FOB Shipping Point means that the ownership of the goods is transferred
when the seller has shipped the goods to the buyers. A journal entry is
made upon the point of shipment. As such, the buyer is considered to
own the goods even if the goods are on transit and have not been
received as the transfer happened on the day the goods were shipped.
• FOB Destination means that the ownership of the goods is transferred
when the goods have reached its destination. A journal entry is made
upon the actual receipt of the goods. As such, the seller still owns the
goods as it is being delivered as there is no transfer of ownership yet.
 Terms of Sale – Discounts Granted
• Buyers are given cash discounts by the sellers to enable faster collections of
receivables and encourage prompt payment. Cash discounts are usually indicated in
the sales invoice. An example is 2/15, net 30. This means that a 2% discount is given if
the customer pays within 15 days from the date of purchase. Else, the whole amount
shall be collected in 30 days.
• Suppose that the invoice price is ₱50 000. If the amount is paid within 15 days, he is to
pay only ₱49 000 which is the sales invoice price less the 2% discount. If he does not
pay within the discount period, the whole invoice price worth ₱50 000 shall be paid.
• The cash discount is treated by the seller as a sales discount and the buyer as a
purchase discount.
• There are two methods of recording discounts, namely, gross method and net method.
Recording Purchases – Gross and Net Method

Suppose the following events happened in Tuazon Company.

Oct 1 Purchased inventory worth P100 000. Discounts of
5% will be given if payment is received 10 days from the date
of purchase.

Gross Method Net Method

Inventory 100 000 Inventory 95 000
Accounts Payable 100 000 Accounts Payable 95 000

In gross method, the full cost is In net method, the amount debited to
debited to the inventory account. the inventory is the amount net of
discounts.
Oct 7 CASE A: Payment is made in order to avail the purchase
discount.
Gross Method Net Method
Accounts Payable 100 000 Accounts Payable 95 000
Cash 95 000 Cash 95 000
Inventory 5 000
(or Purchase Discount)

Since payment was taken, the cash The entry to record payment is simple
payment would be net of discounts. as the Accounts Payable was
The balancing figure which will be recorded net of discounts.
credited to Inventory (perpetual)
or Purchase Discount (periodic) will in
effect reduce the cost per unit of the
purchased inventory.
Oct 20 CASE B: Payment is made after the
discount
period granted.
Gross Method Net Method
Accounts Payable 100 000 Accounts Payable 95 000
Cash 100 000 Purchase Discount Lost 5 000
Cash 100 000

Journal entry is straightforward as The Purchase Discount Lost contains

Accounts Payable is recorded using
the gross amount.
the forfeited discount amount. Note
that in both perpetual and periodic
systems, this account title is to be
used. This is treated as a period
expense.
 Recording Sales – Gross and Net Method

Suppose the following events happened in Suing Company.

Nov 16 Made sales on account with total invoice price of
P150 000. Discount of 3% is available upon prompt
payment (within 15 days).

Gross Method Net Method

Accounts Receivable150 000 Accounts Receivable 145 500
Sales 150 000 Sales 145 500

In gross method, the full invoice price In net method, the amount used is the
is used. invoice price net of discounts.
Nov 21 CASE A: Payment is received. Customer availed of
the sales discount granted.
Gross Method Net Method
Cash 145 500 Cash 145 500
Sales Discount 4 500 Accounts Receivable 145 500
Accounts Receivable 150 000

Cash received is net of discounts. The
discount granted is debited to the
Sales Discount title which is deducted
from Sales to arrive at the company’s
Net Sales at the end of reporting
period.
In net method, normal journal entry
upon collections is made as the
Accounts Receivable reflects the
amount net of discounts.
Dec 5 CASE B: Payment is received. Customer did not
avail of the discount.
Gross Method Net Method
Cash 150 000 Cash 150 000
Accounts Receivable 150 000 Accounts Receivable 145 500
Sales Discount Forfeited 4 500

Cash received is the whole invoice
price. The whole Accounts Receivable
amount is simply eliminated.
Sales Discount Forfeited reflects the
amount of the discount forgone by the
customer. This appears in the Other
Income section of the income
statement.