Fundamentals of Accounting for Non-ABM

Control No. 100-008

Chapter Title Accounting for a Merchandising Business

Merchandising operations

Merchandising is the buying and selling of products rather than services. The goods that a merchandising
company sells to its customers are called inventory, regardless of the type of products that the company
sells.

Merchandising companies often have large amounts of money invested in their inventories. Inventory is
one of the most costly assets appearing in the statement of financial position of a merchandising
company. Inventory is also a relatively liquid asset – usually, it will be sold within a few weeks or months,
thereby generating accounts receivable and cash.

Operating cycle

Operating cycle is the series of transactions through which a business generates its revenue and its cash
receipts from customers. It includes the purchase of merchandise, sale of merchandise and the collection
of accounts receivable from customers. This sequence of transactions is repeated continuously.

Business documents

Business documents provide the details of the business transactions. This includes the following:

o Invoice
This is a document prepared by the seller of the merchandise and sent to the buyer that contains
the detail of the sale.

o Purchase order
This is a document sent from the purchasing department to a supplier requesting that
merchandise or other items be shipped to the purchaser.

o Receiving report
This is a document prepared by the receiving department showing the descriptions and quantities
of items received from a supplier in a particular shipment.

o Debit memorandum
This is a note issued by the buyer who is returning the merchandise to the seller indicating the
amount he’s debiting to the seller’s account.

Recording sales

In a sales transaction, the seller transfers the legal ownership (title) of the goods to the buyer. The seller
usually accompanies the sale by the physical delivery of goods. The sales are recorded based on the
invoice.

Sales are for cash or on account and generates the following entries:

Debit Credit
Cash xxx
Sales xxx

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Debit Credit
Accounts receivable xxx
Sales xxx

Increase in sale is credited. Usually, the account name “Sales” is used by merchandising companies. Each
time a sale is made, revenue is produced for the company.

Determining the gross selling price

List price is the original price quoted by the seller to the buyer. Trade discounts are deductions from the
list price given by the seller to encourage the buyer to buy more. Gross invoice price is the list price less
all trade discounts.

The seller may show trade discounts on the invoice but there are no trade discounts recorded in the
accounting records. It is only used to calculate the gross selling price. It is also not recorded in the
purchaser’s books. Several trade discounts in the list price of a product are called chain discounts.

Recording deductions from gross sales

Contra accounts have normal balances that are opposite the balance of the account they reduce. These
are considered to arrive at the net sales amount.

o Sales discount

When goods are sold on account, terms of payments must be specified on the invoice. These are
called credit terms. Credit terms in the industry also include a cash discount to induce the early
payment of an account. A cash discount is a deduction from the gross invoice price that a buyer
can take only if he pays the invoice within a specified period of time. It is called a sales discount
by the seller and a purchase discount by the buyer.

- 2/10, n/30 means the buyer may take a discount of 2% of the gross invoice price of the
merchandise if it is paid within 10 days from the invoice date and the gross invoice amount is
due 30 days from the invoice date
- 2/EOM, n/60 means the buyer may take a discount of 2% of the gross invoice price of the
merchandise if it is paid by the end of the month and the gross invoice amount is due 60
days from the invoice date

The sales discount given if paid generates the following entry:

Debit Credit
Cash xxx
Sales discount xxx
Accounts receivable xxx

Since the sales discount taken by the buyer reduces the amount of cash the seller actually
collects from the sale of goods, the seller must indicate this in the accounting records of the
company.

The sales discount is a contra account to the sales account and is shown as a deduction from the
gross sales and “Sales Discount” account is shown and used. This is also to help evaluate the
company’s sales policy.

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o Sales return and allowance

A sales return is the merchandise returned by a buyer that is considered a cancellation of the
sale. A sales allowance is granted to a customer if it keeps the merchandise although dissatisfied.

The sales return and allowance generates the following entries when granted:

Debit Credit
Sales return and allowance xxx
Accounts receivable xxx

Debit Credit
Sales return and allowance xxx
Cash xxx

This depends on whether the payment is on account or for cash. Like the sales discount, the
information pertaining to sales returns and allowances is useful. The amount of returns and
allowances in relation to the goods sold can be an indication on the quality of the goods or on
the pressure applied by the sales team.

The sales returns and allowances are contra accounts to the sales account and is shown as a
deduction from the gross sales and “Sales Returns and Allowances” account is shown and used.

Inventory systems

o Perpetual inventory system

The perpetual inventory system provides accounting records that continuously disclose the
amount of inventory. Companies that sell merchandise with a high individual unit value
(automobiles, furniture and appliances) usually use this inventory system.

Companies using perpetual inventory system design and maintain inventory records to provide
close control over the actual goods on hand. These records show exactly which goods are on
hand at any particular point in time. “Merchandise Inventory” is debited for the amount of each
purchase and credited for each sale so that the current balance in the inventory account is shown
at all times. At the end of the accounting period, a physical inventory is taken by actually
counting the number of units on hand. This physical count is compared with the records showing
the number of units on hand.

o Periodic inventory system

The ending inventory is determined by making a physical measurement of the goods on hand at
the end of the period. Merchandising companies that sell merchandise with low value per unit
often find that the extra costs of record keeping under the perpetual system more than outweigh
the benefits. These merchandising companies use the periodic inventory procedure.

Under the periodic inventory system, the company does not use the inventory account to record
each purchase and sale of merchandise as it is under the perpetual inventory system. Instead,
adjustment to the Merchandise Inventory account is made only at the end of the accounting
period to bring it to its proper balance. Also, records that show the exact number of units that

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should be on hand are not maintained. Record keeping is reduced considerably, but so is the
control over inventory systems.

No entries are made to the Merchandise Inventory account during the accounting period. Thus,
there is no up-to-date account balance against which to check the physical count at the end of
the accounting period. Companies using the periodic inventory procedure do not attempt to
determine the cost of the goods sold at the time of each sale. Instead, they determine the cost of
all the goods sold at the end of the period.

Determining the cost of goods sold

Below is the formula in the determining the cost of goods sold:

Beginning inventory XXX

Net purchases XXX
Transportation-in XXX
Cost of goods available for sale XXX
Ending inventory (XXX)
Cost of goods sold XXX

Whereas net purchases is determined by deducting purchase discounts and purchase returns and
allowance to the total cost of purchases.

o Net purchases

Under the periodic inventory system, “Purchases” account is used to record the cost of goods or
merchandise bought for resale during the current period.

Purchases for cash or on account generates the following entries:

Debit Credit
Purchases XXX
Cash XXX

Debit Credit
Purchases XXX
Accounts payable XXX

Purchases account is increased by debits and listed with the income statement accounts in the
chart of accounts.

Purchase discount is the discount on the side of the buyer which generates the following entries:

Debit Credit
Accounts payable XXX
Cash XXX
Purchase discount XXX

The buyer records the purchase discount only when the invoice is paid within the discount period
and takes the discount. The “Purchase Discount” account is a contra account to Purchases that
reduces the recorded gross invoice cost of the purchase if paid.

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A purchase return occurs when merchandise is returned by the buyer while a purchase allowance
occurs when a buyer receives an allowance (deduction in the price of goods shipped). Both
returns and allowances reduce the buyer’s debt to the seller and reduce the cost of the goods
purchased. This generates the following entries:

Debit Credit
Accounts payable XXX
Purchase returns and allowances XXX

Debit Credit
Cash XXX
Purchase returns and allowances XXX

“Purchase returns and allowances” account is used. Knowing this would be helpful for the buyer
as the first step in controlling costs incurred in returning unsatisfactory merchandise or
negotiating purchase allowances.

o Transportation costs

There are transportation costs associated with transportation costs. FOB shipping point means
free on board at shipping point. The buyer incurs all the costs after the merchandise is loaded at
the point of shipment. The buyer incurs all the transportation charges. FOB destination means
free on board at destination; that is, the seller ships the goods at their destination without
charging the buyer which makes the seller is responsible for paying the freight charges. Freight
prepaid is when the seller pays the freight charges at the time of shipment. Freight collect is
when the buyer pays the freight charges upon the arrival of the goods. Passage of title is a legal
term that is used to indicate the transfer of the legal ownership of the goods

The account used for the freight cost incurred in the acquisition of merchandise is the
“Transportation-in” account. This is an adjunct account which is added to the net purchase to get
the total cost of purchases. An adjunct account is added to the balance of the related account in
the financial statement. This generates the following entries:

Debit Credit
Transportation-in XXX
Cash XXX

Debit Credit
Delivery expense XXX
Cash XXX

The first entry is applicable if the freight charges were paid by the buyer and will be recorded in
the books of the buyer while the second entry is applicable if the freight charges are paid by the
seller and will be recorded in the seller’s books. Delivery expense is part of the other selling
expenses in the seller’s books.

Taking a physical inventory

Taking a physical inventory consists of counting physical units of each type of merchandise on hand. In
taking a physical inventory, care must be taken to ensure that all goods owned, regardless of their
location, are included in the inventory. Thus, goods shipped to a potential customer on approval are not
considered sold. The seller must include them in his inventory. Similarly, consigned goods are goods

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delivered to another party who will attempt to sell the goods for the owner at a commission. Such goods
should not be considered as sold since the goods remain the property of the owner until sold by the
consignee. The owner must include such goods in his inventory.

Merchandise in transit is merchandise in the hands of a freight company on the date of the physical
inventory. The ownership depends on whether the passage of title has occurred.