Chapter 6.

1® - Accounting for Merchandising Activities, Sample Balance Sheet Representation of

Inventory, Perpetual & Periodic Inventory Systems & Merchandise Purchases

 Part 6.1 - Accounting for Merchandising Activities, Balance Sheet Representation of Inventory,
Perpetual & Periodic Inventory Systems & Merchandise Purchases

 Part 6.2 - Types of Merchandising Inventory Systems - Perpetual & Periodic Inventory Systems
& Journal Entries for Merchandise Purchases – Perpetual Inventory System

 Part 6.3 - Transfer of Ownership, FOB Shipping & FOB Destination Points - Accounting for
Transportation Costs of Merchandise Inventory

 Part 6.4 - Accounting for Merchandise Sales, Sales Discounts, Sales Returns & Allowances &
Shrink – Perpetual Inventory System

 Part 6.5 - Sales Returns & Allowances & Shrink (Merchandise Adjusting Journal Entries) -
Continued from Accounting for Merchandise Sales– Perpetual Inventory System

 Part 6.6 - Glossary of Merchandise Accounting Terms

A merchandising company has different business operations than that of a servicing company. A
merchandising company earns net income by buying and selling merchandise. A good example is Costco
that buys groceries, electronics and clothes from manufacturers and resells it to customers for a margin
(profit). Merchandise is referred to as goods that a company acquires for the purpose of reselling them
to customers. The cost of this merchandise is called Cost of goods sold and is a direct expense item on
the Income statement. Merchandising companies can either be wholesalers like Costco or retailers like
Rogers Video.

Net income for a merchandiser arises when revenue from selling merchandise exceeds both the cost of
merchandise sold to customers (margin) and the cost of operations for the period, including salaries of
employees working at the head office, marketing & accounting costs, costs for the Information
Technology department, and more. The accounting term for revenue derived from selling merchandise
is known as Sales.

Servicing Company

The business model of a servicing company is to sell merchandise and earn revenues, and have front line
employees helping customers as well as head office employees support front line employees and form
part of the operating expenses. The income left over after paying operating expenses is called Net
Income.
This diagram shows the revenue models of the two major types of businesses out there, i) Servicing
companies and ii) Merchandising companies). Servicing companies are those that offer services such as
accounting, law representation, computer programming, etc and thus they do not have any 'Cost of
Goods Sold' because they do not hold inventory for resale. Merchandising companies on the other hand
are those that hold inventory for resale to consumers and the best example is for instance Bestbuy in
the electronics industry or Costco in the groceries industry. Notice that both merchandising & servicing
companies have Operating expenses because both types of businesses must employ people in order to
run their operations and pay salaries; which are then treated as operating expenses.

Calgary Sweets Ltd.

Condensed Income Statement
For Year Ended December 31st, 2009

Net Sales.................................................. $458,000

Cost of Goods Sold..................................... ($253,000)

Gross Profit from Sales................................ $205,000

General, Admin & Other expenses................... ($166,000)

Net Income................................................ $39,000

The condensed income statement of Calgary Sweets Ltd. above shows us the relationship between net
sales, cost of goods sold and the arrival to the gross profit calculation. General and administration
expenses such as employee salaries, warehouse rents, etc are then deducted from the gross profit to
arrive at the net income.

Costco Wholesale
Balance Sheet
As at 2008-08-31 (in millions of USD)

Cash & Equivalents $2,619.43

Short Term Investments $655.58

Cash and Short Term Investments $3275.01

Net Accounts Receivable $664.48

Receivables - Other $0

Total Receivables, Net $747.97

Total Merchandise Inventory $5,039.41

Prepaid Expenses  

Other Current Assets, Total $399.65

Total Current Assets $9,462.05

Property/Plant/Equipment $14,329.22

Goodwill, Net $73.71

Intangibles, Net  

Long Term Investments $432.47

Other Long Term Assets $300.26

Total Assets $20,682.35

Attached above is the balance sheet of Costco Wholesale as of August 31st, 2008. Notice the line item
we are interested in looking at is Total Merchandise Inventory totalling $5,039.41 million dollars. That’s
how much inventory Costco has for resale to customers; notice how it makes up greater than 25% of
their balance sheet! The cost of merchandise inventory also includes the costs incurred to buy the
goods, ship them to the stores or warehouses, and other costs necessary to make them ready for sale
such as employee costs for organizing the merchandise on warehouse displays and grocery stands.

PART 2
i) Perpetual Inventory System

A perpetual inventory system, as the name suggests, gives a continuous record of the amount of
inventory on hand. A perpetual inventory system adds up all the merchandise purchases in the
Inventory account, and removes them from this account when an item is sold, and transfers it to Cost
of Goods sold. Therefore, a merchandise piece sits as Inventory on the balance sheet of Costco when
it is not sold. However as soon as it is sold, it is moved from the Inventory account to Cost of goods
sold, an expense item on the Income statement. The advantage of using a perpetual inventory system
is that at any given point in time, we can see the amount of merchandise inventory on hand without
doing any calculations. The perpetual inventory system has become popular due to advancements in
computer technology that continually post inventory transactions and keep an updated account.
Doing this on paper or by hand using human accountants is impossible, especially for a large company
such as Costco Wholesale. Perpetual inventory systems therefore provide more timely information to
investors, are currently widely used across all businesses and will be the focus of our tutorials here.
ii) Periodic Inventory System

A periodic inventory system, as the name suggests, provides a periodic balance of the inventory
account only at the end of an accounting period such as March 31st, 2009 which is the end of first
quarter for most large corporations. Periodic inventory system does not update the inventory account
after every transaction. The cost of new purchases of merchandise is recorded in a temporary expense
account known as Purchases. When merchandise is sold, revenue is recorded but the cost of the
merchandise sold is not yet recorded as cost. When financial statements are prepared at the end of
the year, the company takes a physical inventory count of its entire warehouse(s). Each item on this
physical inventory count is assigned a cost, and total inventories are tabulated.
Periodic inventory systems were largely used by large hardware, drug & department stores that sold
large quantities of low-value items such as shampoo, soap, toothpaste, etc. Without today’s Point of
Sale (POS) scanners, computers and cameras, it was not feasible enough for accounting systems to
track such small items.

Accounting for Merchandise Purchases – Perpetual Inventory System

i) Purchase of Inventory

Any purchase of merchandise is debited to the Merchandise Inventory account and creates an
accounts payable liability or cash payment entry. Consider Binti Kiziwi Corp. records a purchase of
$1,500 Sony camera on credit on September 14th, 2009.

September 14th, 2009

Account Name Debit Credit

Dr. Merchandise Inventory   $1,500  

Cr. Accounts Payable   $1,500

Entry to record purchase of merchandise inventory on credit

ii) Purchase Returns & Allowances

Purchase returns are merchandise received by a buyer but returned to the supplier due to reasons
such as incorrect size, color, defective merchandise, etc. This triggers a purchase return and a
purchase allowance entry is made to reduce the cost of merchandise purchased. For example,
consider the camera bought from Sony was defective but still able to be sold. Here are the set of
journal entries made to record the initial purchase of the camera, and the defective return.

September 14th, 2009

Account Name Debit Credit

Dr. Merchandise Inventory   $1,500  

Cr. Accounts Payable   $1,500

Entry to record purchase of merchandise inventory on credit

Assume on October 9th, 2009, the defective camera is returned to Sony. The journal entry made to
record this is:

October 9th, 2009

Account Name Debit Credit

Dr. Accounts Payable   $400  

Cr. Merchandise Inventory   $400

Purchase allowance on inventory bought September 14th, 2009 due to defectiveness.

If this merchandise was bought for cash, then the journal entry will look like:

October 9th, 2009

Account Name Debit Credit

Dr. Cash   $400  

Cr. Merchandise Inventory   $400

Cash refund on inventory bought September 14th, 2009 due to defectiveness

iii) Purchase Discounts

Merchandise that is bought on credit requires a clear statement of expected amounts & dates of
future payments as well as terms of credit. Credit terms are a listing of the amounts & timing of
payments between a buyer and a seller, and the discount percent if the payment is made within a
certain time period. The equation for setting up the terms is: n/10 = EOM. The EOM means “end of
month” and most invoices are due for payment in 30 days, thus making the EOM 30 days. The “n” in
this case means the discount percent if the payment is made within 10 days. Thus, the following
equation means
2.5/10 = 30 days -> 2.5% discount if invoice is paid within 10 days, otherwise the invoice is due in 30
days.

A seller offering a cash discount when the credit period is long is encouraging the buyer to make
prompt payment. The buyer thus views this as a purchase discount. In the eyes of the seller, this is a
sales discount. To illustrate these concepts, let’s do a journal entry. Consider Binti Kiziwi Corp. records
a purchase of $1,500 Sony camera on credit on September 14th, 2009, for terms of 2/10 n30 days.

September 14th, 2009

Account Name Debit Credit

Dr. Merchandise Inventory   $1,500  

Cr. Accounts Payable   $1,500

To record purchase of merchandise inventory on credit

Now consider that Binti Kiziwi Corp. takes advantage of this discount offering, and pays the invoice by
September 20th, 2009. Here is the journal entry we record in our books:

September 20th, 2009

Account Name Debit Credit

Dr. Accounts Payable   $1,500  

Cr. Cash ($1,500 x 98%)   $1,470

Cr. Merchandise Inventory ($1,500 x 2%)   $30

To record payment of invoice of Sony camera purchased on credit with 2/10 n30 terms on September 14th, 2009.

PART3
The buyer and seller must reach an agreement on who is responsible for paying any freight costs and
who bears the risk of loss during transit when the merchandise is being shipped. This question
basically asks, “At what point does ownership transfer from the buyer to the seller?” The point of
transfer is called the FOB point, and FOB stands for free on board. The point when ownership
transfers from the seller to the buyer are a very important consideration because it determines who
pays transportation costs and associated costs such as insurance while in transit. The party
responsible for paying shipping costs is also responsible for insuring the merchandise during transit.
There are 2 alternative points of transfer.

i) FOB shipping point

FOB shipping point is also known as FOB factory and means the buyer accepts ownership at the
seller’s place of business. The buyer is then responsible for paying shipping costs, and bears
ownership and risks of damage/loss when the goods are in transit or in transport. The goods also
become a part of the buyer’s merchandise inventory at the shipping point.

ii) FOB destination

FOB destination means ownership of the goods transfers to the buyer when goods are delivered at
the buyer’s place of business. This means the seller is responsible for paying shipping costs and bears
the risk of damage/loss while in transit/transport. The seller also does not record revenue from this
sale until the goods arrive at the destination because this transaction is not complete before that
point.

Accounting for Transportation Costs

Shipping costs incurred on purchases are known as transportation-in or freight-in costs. If the terms of
the purchase are FOB shipping, then this means the buyer is responsible for paying freight-in costs and
the accounting cost principle requires these transportation costs to be included as part of the cost of
acquiring merchandise inventory. This requires a separate accounting journal entry, and one is
illustrated below. Consider Binti Kiziwi Corp. records a purchase of $1,500 Sony camera on credit on
 September 14th, 2009 and the shipping costs are 5% of the purchase price. Below is the journal entry
recorded in the books of Binti Kiziwi Corp.

September 14th, 2009

Account Name Debit Credit

Dr. Merchandise Inventory (5% x $1,500)   $75  

Cr. Cash   $75

Entry to record freight-in charges on purchase of merchandise.

Recording Purchases of Inventory

In this section, we will tie in costs of inventory purchased, purchase discounts & allowances, returns
and freight-in costs to compute the total cost of merchandise inventory. We will use the example of
Binti Kiziwi Corp.

Binti Kiziwi Corp.

Net Cost of Merchandise Purchases
For Year Ended December 31st, 2009

Invoice Cost of Merchandise Purchases................. $1,500

Less: Purchase Discounts ($30)

Less: Purchase returns and allowances ($400)

Add: Cost of transportation in $75

Net Income........................................................ $1,145

Looking at the inventory purchase schedule above, you get an idea of the entries involved in
accounting for merchandise purchases. Also with this schedule, we fully satisfy the accounting cost
principle that states that all costs incurred to get inventory ready for re-sale and for its intended
purpose should be included in the final costs of the inventory purchases.

PART 4
i) Accounting for Merchandise Sales

Merchandising companies also have to account for the sales side of things, including sales, sales
discounts, sales returns and allowances, and cost of goods sold. Accounting for the sale of
merchandise needs 2 critical pieces of information:

1) Revenue received from the sale of the merchandise to the customer

2) Recognition of the cost of merchandise that was sold to the customer

As an example, consider Binti Kiziwi Corp. records a purchase of $1,500 Sony camera on credit on
September 14th, 2009 and also sells this camera for $2,200 on September 27th, 2009 on credit. Here is
the journal entry to record the sale:

September 27th, 2009

Account Name Debit Credit

Dr. Accounts Receivable   $2,200

Cr. Sales   $2,200

Entry to record sale of Sony Camera on credit.

With this journal entry, there is an increase on the Current assets side (Debit to AR) as well as an
increase to revenue (credit to sales). The expense or cost of the merchandise sold is accounted for via
the journal entry below:

September 27th, 2009

Account Name Debit Credit

Dr. Cost of Goods Sold   $1,500

Cr. Merchandise Inventory   $1,500

To record the cost of Sept 27th, 2009 sale of Sony camera and to reduce inventory.

This journal entry records the cost of the camera sold and credits Merchandise inventory as we are
reducing it, and debits an expense (Cost of Goods sold) that is reported on the income statement.

ii) Accounting for Sales Discounts

Companies giving cash discounts to their customers recognize these discounts as ‘Sales discounts’ on
their books. Why do they do this? Well to increase the number of customer walk-ins, to increase their
sales during times when consumers are not buying (recession) or during periods of holiday sales when
the decreases in their prices are offset with a large number of customers buying (customer walk-ins).
Another advantage to offering cash discounts on sales is for prompt payment, which reduces the time
needed to pay suppliers for merchandise, as well as take advantage of any supplier discounts on
merchandise.

A seller does not know whether a customer will pay within the discount period and take advantage of
any cash discounts, thus a sales discount is not recorded until it is taken by the customer. As an
example, consider Binti Kiziwi Corp. records a purchase of $1,500 Sony camera on credit on
September 14th, 2009 and also sells this camera for $2,200 on September 27th, 2009 on credit on
2/10 n60 days terms. Here is the journal entry to record the sale:

September 27th, 2009

Account Name Debit Credit

Dr. Accounts Receivable   $2,200

Cr. Sales   $2,200

Entry to record sale of Sony Camera on credit.

With this journal entry, there is an increase on the Current assets side (Debit to AR) as well as an
increase to revenue (credit to sales). The expense or cost of the merchandise sold is accounted for via
the journal entry below:

September 27th, 2009

Account Name Debit Credit

Dr. Cost of Goods Sold   $1,500

Cr. Merchandise Inventory   $1,500

Entry to record Cost of Goods Sold expense for sale of merchandise and to lower the merchandise inventory
account (credit).

The customer has 2 options, one is to take the 2% discount and pay within the 60 day period, and the
second is to pay after 60 days and forfeit the discount. In scenario i) when the customer pays within
60 days, here is the journal entry recorded:

October 25th, 2009

Account Name Debit Credit

Dr. Cash   $1,470

Dr. Sales Discounts   $30  

Cr. Accounts Receivable   $1,500

To record payment of camera purchased on credit and take advantage of 2% discount – 2% x $1,500 = $30

In scenario ii), the customer can wait 60 days and pay after the discount period ends. In this case, the
journal entry is simple enough:

November 25th, 2009

Account Name Debit Credit

Dr. Cash   $1,500

Cr. Accounts Receivable   $1,500

Entry to record receipt of cash for camera purchased on credit by customer.

Sales discount is a contra-revenue account and the set up is because management can monitor sales
discounts to assess their effectiveness and costs. The sales discount is deducted from total sales to
arrive at a company’s net sales in a given period. Usually the company reports the Net Sales number
on their income statement as the sales discount information although useful, is not that important
enough to be reported on the income statement; it is more for effective management.

PART 5
Sales returns refers to merchandise that customers return back after a sale is completed due to a
variety of reasons including defective merchandise, incorrect item, poor quality, wrong specifications,
etc. Most companies allow customers to return merchandise for a full refund. Sales allowance on the
other hand refers to reductions in the selling price of merchandise sold to customers and can happen
in cases of damaged merchandise. Damaged merchandise can make customers very unhappy and in
order to avoid future lost sales and customers, most companies offer an allowance (reduction in price)
to the customer to keep the item.

As an example, consider Binti Kiziwi Corp. records a purchase of $1,500 Sony camera on credit on
September 14th, 2009 and also sells this camera for $2,200 on September 27th, 2009 on credit on
2/10 n60 days terms. But what happens if the customer returns part of this merchandise on October
10th, 2009 and gets a $700 cash refund (original cost = $500). The revenue part of this transaction is
recorded below:

October 10th, 2009

Account Name Debit Credit

Dr. Sales Returns & Allowances   $700

Cr. Accounts Receivable   $700

Entry to record return of defective merchandise.

Some companies prefer to record this return with a debit to the Sales account instead of Sales Returns
and Allowances. This practice has the same effect but does not provide information to managers
about sales returns and allowances. If the merchandise returned above is not defective and can be re-
sold to another customer, Binti Kiziwi Corp. returns the goods to its inventory by debiting it, and
crediting Cost of goods sold expense. Here is the journal entry in this scenario:

October 10th, 2009

Account Name Debit Credit

Dr. Merchandise Inventory   $500

Cr. Cost of Goods Sold   $500

To relocate returned goods back to inventory.

Another possibility that can happen is say the customer returns $700 worth of merchandise and the
company allows him to pay it off for $500 and keep the merchandise, and thus not accept a return
back. Here is the only journal entry that would be made:
October 10th, 2009

Account Name Debit Credit

Dr. Sales Returns & Allowances   $500

Cr. Accounts Receivable   $500

To record return of defective merchandise with original sales revenue of $700, but with a sales allowance being
granted for a total of $500.

Merchandise Adjusting Entries – Shrinkage

Merchandising companies using a perpetual inventory system are often required to make additional
adjustments to their inventory by updating the merchandise inventory account to reflect any losses of
merchandise including loss from theft, deterioration, loss in transit, loss in store, misplacement, etc;
this is known as inventory shrinkage or “shrink” for short form. Using the perpetual system, we can
compute shrinkage by doing a physical inventory count at given periods during the year and compare
with accounting records of stated inventory balances. For instance, say Binti Kiziwi Corp. has
merchandise inventory of $738,000 at the end of 2009 in its accounting books, but a physical
inventory done in its warehouse says it only has $712,000 worth of merchandise remaining. Shrink in
this case is computed as follows:

December 31st, 2009

Account Name Debit Credit

Dr. Cost of Goods Sold   $26,000

Cr. Merchandise Inventory   $26,000

To record shrinkage of merchandise inventory by expensing it on the Income statement, and reducing the
inventory account balance: $738,000 - $712,000 = $26,000

PART 6
Cash discount - Companies giving cash discounts to their customers recognize these discounts
as ‘Sales discounts’ on their books. Why do they do this? Well to increase the number of
customer walk-ins, to increase their sales during times when consumers are not buying
(recession) or during periods of holiday sales when the decreases in their prices are offset with
a large number of customers buying (customer walk-ins). Another advantage to offering cash
discounts on sales is for prompt payment, which reduces the time needed to pay suppliers for
merchandise, as well as take advantage of any supplier discounts on merchandise.
Cost of Goods Sold - Merchandise is referred to as goods that a company acquires for the
purpose of reselling them to customers. The cost of this merchandise is called Cost of goods
sold and is a direct expense item on the Income statement.
Credit Period – The time period that can pass before a customer’s payment becomes due.
Credit Terms - Credit terms are a listing of the amounts & timing of payments between a buyer
and a seller, and the discount percent if the payment is made within a certain time period. The
equation for setting up the terms is: n/10 = EOM. The EOM means “end of month” and most
invoices are due for payment in 30 days, thus making the EOM 30 days. The “n” in this case
means the discount percent if the payment is made within 10 days.
Discount period – The time period in which a cash discount is available and a reduced payment
can be made by the buyer, taking advantage of a reduction in selling price. The equation for
setting up the terms is: n/10 = EOM. The EOM means “end of month” and most invoices are
due for payment in 30 days, thus making the EOM 30 days. The “n” in this case means the
discount percent if the payment is made within 10 days.
EOM – EOM is an abbreviation for End of Month and is used to describe credit terms for
transactions of merchandise purchases on credit.
FOB - The buyer and seller must reach an agreement on who is responsible for paying any
freight costs and who bears the risk of loss during transit when the merchandise is being
shipped. This question basically asks, “At what point does ownership transfer from the buyer to
the seller?” The point of transfer is called the FOB point, and FOB stands for free on board.
FOB shipping point: FOB shipping point is also known as FOB factory and means the buyer
accepts ownership at the seller’s place of business. The buyer is then responsible for paying
shipping costs, and bears ownership and risks of damage/loss when the goods are in transit or
in transport. The goods also become a part of the buyer’s merchandise inventory at the
shipping point.
FOB destination: FOB destination means ownership of the goods transfers to the buyer when
goods are delivered at the buyer’s place of business. This means the seller is responsible for
paying shipping costs and bears the risk of damage/loss while in transit/transport. The seller
also does not record revenue from this sale until the goods arrive at the destination because
this transaction is not complete before that point.
Merchandise - Merchandise is referred to as goods that a company acquires for the purpose of
reselling them to customers.
Periodic Inventory System - A periodic inventory system, as the name suggests, provides a
periodic balance of the inventory account only at the end of an accounting period such as
March 31st, 2009 which is the end of first quarter for most large corporations. Periodic
inventory system does not update the inventory account after every transaction.
Perpetual Inventory System - A perpetual inventory system, as the name suggests, gives a
continuous record of the amount of inventory on hand. A perpetual inventory system adds up
all the merchandise purchases in the Inventory account, and removes them from this account
when an item is sold, and transfers it to Cost of Goods sold. Therefore, a merchandise piece sits
as Inventory on the balance sheet of Costco when it is not sold. However as soon as it is sold, it
is moved from the Inventory account to Cost of goods sold, an expense item on the Income
statement.
Purchase Discount - A seller offering a cash discount when the credit period is long is
encouraging the buyer to make prompt payment. The buyer thus views this as a purchase
discount. In the eyes of the seller, this is a sales discount.
Sales Discount - A seller offering a cash discount when the credit period is long is encouraging
the buyer to make prompt payment. The buyer thus views this as a purchase discount. In the
eyes of the seller, this is a sales discount.
Shrinkage - Merchandising companies using a perpetual inventory system are often required to
make additional adjustments to their inventory by updating the merchandise inventory account
to reflect any losses of merchandise including loss from theft, deterioration, loss in transit, loss
in store, misplacement, etc; this is known as inventory shrinkage or “shrink” for short form.