CHAPTER

6

ACCOUNTING FOR MERCHANDISING BUSINESS

Learning Outcomes

After reading this chapter, the learners should be able to

1. Define merchandising business and explain its difference from
service type of business;
2. Explain the operating cycle of a merchandising business;
3. Compare the statement of profit or loss of service business and
merchandising business;
4. Explain the accounting for trade and cash discounts on the
acquisition of inventories;
5. Identify the rules to be applied for goods in transit;
6. Distinguish the perpetual inventory system from the periodic
inventory system in accounting for acquisition and sales of
inventories; and
7. Explain the concept of cost formula as applied to inventory
accounting.

THE NATURE OF MERCHANDISING TYPE OF BUSINESS

As defined in Chapter 1, a merchandising or trading business is

one that buys products with the intention of reselling the same products
without the need for further processing. Unlike service business in which
the major activity is the provision of service, the major activities of a
merchandising type of business are buying and selling of goods for a
profit. It purchase goods from manufacturer or suppliers, and sell the same
goods without further processing, to customers. Hence, the operating cycle
of a merchandising business involves two transactions: the purchase of
Chapter 5 – Accounting Merchandising Type of Business

inventory and the sale of inventory. If sales are made on account (credit
sales) another transaction occurs after the sale, that is, the collection of
receivable.

The accounting for inventory is one of the major differences

between merchandising and service businesses. As defined in IAS 2,
Inventories are assets which are held for sale in the ordinary course of
business, in the process of production for such sale, or in the form of
materials or supplies to be consumed in the production process or in the
rendering of service.

In the said definition, the standard mentioned three types of

inventories: those that are already held for sale (finished goods), those that
are still in process of production (work-in-process) hence are not yet ready
for sale, and those that are used in the production of products (materials
and supplies). These inventory accounts are used in manufacturing
business. However, in merchandising business, we only use one inventory
account: merchandise inventory. Merchandise inventory is the good
purchased by a merchandiser from a manufacturer (or other supplier) for
sale in the normal course of business.

Once sold, the merchandise inventory account is classified as cost

of sales, an expense account. Conversely, unsold inventories are reported
in the statement of financial position as ending merchandise inventory and

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will be made available for sale in the next accounting period, which then
becomes beginning merchandise inventory.

THE INCOME STATEMENT OF MERCHANDISING BUSINESS

Inventories purchased are sold for a profit. In the parlance of

merchandising, profit is divided into two: gross profit and profit (net
profit). Gross profit is the difference of sales and cost of sales. Whereas
profit is the excess after deducting other operating expenses.

Sales is the account used to record the income from sale of

inventory. The sales account may be decreased by items such as discount,
returns and allowances. Cost of sales on the other hand is the account used
to record the decrease in inventory due to sales. It covers the total cost of
the inventories sold during the period. The formula to determine cost of
sales is to deduct the total cost of ending inventory from the total cost of
goods available for sale.

Other than sales, an entity may also earn other income such as rent
income, gains from sale of asset, and investment income. Operating
expenses are other expenses incurred from operating the business such as
selling and admin expenses.

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INVENTORY ACCOUNTING SYSTEMS

The costs and quantities of inventory are accounted for using either
the perpetual inventory system or the periodic inventory system.

Perpetual system is the system of inventory which requires an

entity to maintain a perpetual or continuous record of the movements of
the inventory. Increases and decreases in inventory account are regularly
recorded so as to report the updated inventory account. Hence, purchase,
freight, and sales returns are debited directly to the merchandise inventory
account. Whereas sales and purchase returns are credited directly to the
merchandise inventory account. When sales are made, the account
inventory is credited with a debit to cost of sales account.

At the end of the period, an inventory count is no longer necessary

to determine the balance of ending inventory since the inventory account
is already updated. However, for control purposes, a count may be made
to determine the correctness of the inventory account.

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Journal entries for recording inventory transactions using the

perpetual inventory system

Purchase of merchandise
Merchandise Inventory xx
Cash or Accounts Payable xx

Return of merchandise purchased

Accounts Payable xx
Merchandise Inventory xx

Sale of merchandise
Cash or Accounts Receivable xx
Sales xx

Cost of Sales xx
Merchandise Inventory xx

Return of merchandise sold

Sales Return and Allowances xx
Accounts Receivable xx

Merchandise Inventory xx
Cost of Sales xx

Periodic system on the other hand does not require a perpetual

record of inventory. Movements in the inventory such as purchases, sales,
returns, etc. are not directly recorded in the inventory account. For
purchase transactions, nominal accounts such as purchases, freight-in,
purchase returns, purchase discounts, and purchase allowance are used.

At the end of the period, an inventory count is necessary to

determine the ending balance of merchandise inventory. This ending

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balance of inventory is used to determine the cost of goods sold during the
period.

Journal entries for recording inventory transactions using the

periodic inventory system

Purchase of merchandise
Purchases xx
Cash or Accounts Payable xx

Return of merchandise purchased

Accounts Payable xx
Purchase Return and Allowances xx

Sale of merchandise
Cash or Accounts Receivable xx
Sales xx

Return of merchandise sold

Sales Return and Allowances xx
Accounts Receivable xx

To close the beginning inventory

Income Summary xx
Inventory xx

To set-up the ending inventory

Inventory xx
Income Summary xx

For simplicity, the periodic inventory system will be used in the

succeeding discussion.

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 Chapter 5 – Accounting Merchandising Type of Business

COST OF INVENTORIES

IAS 2 provides that the cost of inventories comprise all costs of

purchase, costs of conversion and other costs incurred in bringing the
inventories to the present location and condition. The cost of purchase
includes the purchase price, import duties and other taxes (other than those
subsequently recoverable by the entity from the taxing authorities), and
transport, handling and other costs directly attributable to the acquisition
of finished goods, materials and services. Trade discounts, rebates and
other similar items are deducted in determining the costs.

Purchase price is the amount paid to acquire the inventory. Any

cost incurred in relation to purchase such freight or transportation, import
duties (in case the inventories are acquired from foreign countries), non-
recoverable purchase taxes, are capitalized as cost of inventory.

To illustrate, assume that Melissa Company incurred the following

costs in relation to its inventory:

Purchase price 500,000

Import duties 10% of purchase price
Freight 13,500
Insurance while in transit 15,000
Other handling costs 10,000
Value added tax 12% of purchase price
Salaries of warehouse men 140,000
Salaries of salesmen 182,000

The cost of inventory is determined as follows:

Purchase price 500,000

Import duties 50,000
Freight 13,500
Insurance while in transit 15,000

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Other handling costs 10,000

Total cost of inventory 588,500

The value added tax is not included since it is a recoverable tax.

The salaries of and warehouse men and salesmen are also not included
since they are not directly attributable cost of inventory.

Freight Charges

Freight or transportation charges are capitalized as cost of

inventory depending upon the shipping terms agreed by both the seller and
the buyer. The two most common shipping terms applied to inventory are:
Free on Board Shipping Point (FOB SP) and Free on Board Destination
(FOB D). Free on Board Shipping Point or FOB Shipping Point means
that the title of the goods passes at the point of shipment. Meaning, when
goods are shipped, the title of the goods is transferred to the buyer, hence
the buyer will shoulder the shipping costs. Meanwhile, Free on Board
Destination or FOB Destination means title of the goods passes at the
point of destination. Only when the goods arrived at its destination shall
title of the same goods is transferred from the seller to the buyer.
Therefore, it is the seller who pays the cost of shipment.

Shipping terms are important to purchase transaction because as

mentioned earlier, transportation cost is part of the purchase cost of
inventory. Non-recording of transportation cost which in fact part of the
cost of the inventory purchased, would result to understatement of
inventory purchased which has a significant effect to profit.

Sometimes, FOB terms are coupled with freight prepaid and

freight collect conditions. Freight prepaid means the freight, disregarding
the FOB terms, is prepaid by the seller. Moreover, freight collect means
the freight will be collected by the shipper from the buyer.

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To summarize, FOB terms will help us determine “who should pay

the freight” while the prepaid-collect conditions will help us determine
“who paid the freight”.

Terms Who should pay? Who paid?

1. FOB SP - Prepaid Buyer Seller
2. FOB SP - Collect Buyer Buyer
3. FOB D - Prepaid Seller Seller
4. FOB D - Collect Seller Buyer

To illustrate, assume that Celestina Merchandisers purchased

P100,000 worth of goods from Esteban Manufacturing, on account. The
transaction provided for a P5,000 transportation cost. Using the different
freight terms, the entry in the books of Celestina Merchandisers are:

1. FOB shipping point, freight prepaid

Purchases 100,000
Freight-In 5,000
Accounts Payable 105,000

2. FOB shipping point, freight collect

Purchases 100,000
Freight-In 5,000
Accounts Payable 100,000
Cash 5,000

3. FOB destination, freight prepaid

Purchases 100,000
Accounts Payable 100,000

4. FOB destination, freight collect

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Purchases 100,000
Accounts Payable 95,000
Cash 5,000

Purchase Discounts

Discounts are classified into two: trade discounts and cash

discounts. Trade discounts are offered by sellers to encourage sales. For
example, when a department store offers a “70% sale”, customers are
stirred to purchase goods because of the savings. On the other hand, cash
discounts are offered to encourage prompt payment. This type of discount
is given if a customer will pay during a specified period provided by a
seller. Generally, cash discounts are presented as dr/dp, n/cp which means
“discount rate/discount period, net/credit period”. For example, if the
seller will provide a 2% discount if an account which is due for 30 days is
paid in 10 days, the discount term is “2/10, n/30”.

Trade discount is deducted from the list price to arrive at the

invoice price which is the basis in recording the accounts payable.
Whereas cash discount is deducted from the invoice price to arrive at the
net cash payment. In recording purchase transactions, only cash discount
is recorded because purchases are accounted using the invoice price.
Hence, the account purchase discount, a contra-purchase account, is only
used for recording cash discount.

List price xx
- Trade discount xx
Invoice price xx
- Cash discount xx
Cash payment or payable xx

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To illustrate, assume that on December 20, 2018, Judith Mdsg.

purchased merchandise inventory with a list price of P300,000 from
Margie, Mfg. on account. Margie provided the following discounts:

1. 20% trade discount; and

2. 3/15, n/60.

If Judith paid on December 30, 2018, the net cost of inventory is

determined as follows:

List price 300,000

- Trade discount 60,000
Invoice price 240,000
- Cash discount 7,200
Cash payment or payable 232,800

Needless to say, if Judith paid the account after the discount

period, the net cost of inventory is P240,000.

Methods of accounting for cash discounts

Cash discount may be accounted using either the gross method and
the allowance method. Using the gross method, the purchases and
accounts payable accounts are recorded at gross invoice price. Upon
payment within the discount period, the account purchase discount is
credited for the amount of the discount taken.

To illustrate the accounting for discount using the gross method,

consider the transactions of Judith Mdsg:

12/20/18 Purchases 240,000

Account Payable 240,000

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12/30/18 Accounts Payable 240,000

Purchase discount 7,200
Cash 232,800

If the account is paid beyond the discount period, say January 15,
2019, the journal entry for the payment is:

1/15/19 Accounts Payable 240,000

Cash 240,000

If the account is paid after the end of the reporting period but
within the discount period, say January 3, 2019, an adjusting journal entry
is necessary to match the discount with the purchases. This entry is dated
as of the end of the reporting period although it not necessarily prepared
on the said date. The said adjusting entry is reversed at the beginning of
the following year so that the entry to record the payment is made in the
usual manner.

12/31/18 Allowance for discount 7,200

Purchase discount 7,200

1/1/19 Purchase discount 7,200

Allowance for discount 7,200

1/3/19 Accounts payable 240,000

Purchase discount 7,200
Cash 232,800

On the other hand, using the net method, purchases and accounts
payable are recorded at invoice price net of the related discount. If the
related account payable is not paid within the discount period, an account
purchase discount lost is debited for the discount forfeited.

Using the transactions of Judith Mdsg, the following entries are

prepared under the net method:

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12/20/18 Purchases 232,800

Account Payable 232,800

12/31/18 Accounts Payable 232,800

Cash 232,800

If the account is paid beyond the discount period, say January 15,
2019, an adjusting journal entry is necessary at yearend to bring the
balance of the account payable account to the original invoice price.

12/31/18 Purchase discount lost 7,200

Account Payable 7,200

1/15/19 Accounts Payable 240,000

Cash 240,000

If the account is paid after the end of the reporting period but
within the discount period, say January 3, 2019, no adjusting journal entry
is necessary.

1/3/19 Accounts payable 232,800

Cash 232,800

Purchase Returns and Allowances

The account Purchase return and allowances, same with purchase

discount, is a contra-purchases account that is used to record the reduction
in the purchases during the period by virtue of a purchase return or
purchase allowance. This account is credited if during the period, the
buyer ships back to the seller some of the goods purchased due to reasons
like low or unsatisfactory quality, wrong products delivered, and
brokerage while in transit, or if the buyer agrees not to return the goods
with an equivalent reduction of the purchase price.

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In practice, if goods are returned by the buyer, it prepares and

sends a debit memorandum to the supplier which includes the details of
the goods returned and the reason for the return. In return, the supplier will
send a credit memorandum which completes the purchase return
transaction.

To illustrate, assume that on December 1, 2018, Martin Wholesaler

purchased P300,000 worth of merchandise from its supplier. On
December 5, 2018, Martin’s warehouse man noticed that some of the
goods purchased last December 1, 2018 have already expired. Martin
returned the goods to the supplier and sent a debit memo. The memo
disclosed P50,000 as cost of the merchandise.

The entry in the books of Martin are the following:

12/1/18 Purchases 300,000

Account Payable 300,000

12/5/18 Accounts Payable 50,000

Purchase Return and Allowances 50,000

Net Cost of Purchases

The net cost purchases is determined as follows:

Purchases xx
+ Freight-in xx
Total Purchases xx
- Purchase discount xx
- Purchase returns and allowances xx
Net Purchases xx

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SALE OF MERCHANDISE INVENTORY

Sales Account

Sales or gross sales, an income account, include both cash sales

and credit sales. Using the accrual concept of accounting, goods sold on
credit are recorded as income in the period of sale and not in the period
when the related cash is collected. Hence, goods sold whether for cash or
on account are recorded as sales and reported in statement of profit or loss
in the period of such sale.

The sales account is credited if merchandise inventory are sold,

with a debit to cash or accounts receivable depending on the manner of
such sale. For cash sales, the account debited is cash. If the sales are made
on credit, the account debited is accounts receivable.

Cash sales
Cash xx
Sales xx

Credit sales
Accounts Receivable xx
Sales xx

Sales Discount

Similar with the purchase discounts, sales discounts are classified

into two: trade discounts and cash discounts. Trade discounts are deducted
from list price to arrive at invoice price, whereas cash discount are
deducted from invoice price to arrive net cash payment.

The accounts receivable and sales accounts are recorded at invoice

price. Any cash discount availed is debited to sales discount t account.

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To illustrate, assume that on July 1, 2018, Cheryl Inc. sold

merchandise inventory with a list price of P300,000 to Juana Sari-sari
Store on account. Cheryl 10%, 10% and 5% trade discount and 2/10, n/30
terms. Juana Sari-sari Store paid Cheryl, Inc. the total amount on July 11,
2018.

Using the gross method of recording sales discount, the journal

entries in the books of Cheryl, Inc. are

07/01/18 Account Receivable 230,850

Sales 230,850

07/11/18 Cash 226,233

Sales Discount 4,617
Account Receivable 230,850

If Juana Sari-sari Store paid beyond July 11, 2018, the journal
entry is

Cash 230,850
Account Receivable 230,850

Using the net method of recording sales discount, the journal

entries in the books of Cheryl, Inc. are

07/01/18 Account Receivable 226,233

Sales 226,233

07/11/18 Cash 226,233

Account Receivable 226,233

If Juana Sari-sari Store paid beyond July 11, 2018, the journal entry is

Cash 230,850
Account Receivable 226,233

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Sales Discount Lost 4,617

The sales discount lost account is reported as other income in the

statement of profit or loss.

Sales Returns and Allowances

When customers return goods which are accepted by the seller, the
latter issue a credit memorandum which has an effect of reducing the
balance of the customer’s account. The account receivable is credited with
a corresponding debit to an account called sales return and allowances.

To illustrate, assume that on August 31, 2018, Christine Mdsg.

issued a credit memorandum of P12,500 to one of its customers who
returned goods purchased from Christine due to wrong specifications. The
entry in the books of Christine Mdsg. is

08/31/18 Sales returns and allowances 12,500

Account Receivable 12,500

Net sales

Net sales is equal to sales minus sales discounts and sales returns
and allowances. Both sales discounts and sales returns and allowances are
contra-sales account. However it should be noted that in recording
discounts, returns and allowances, the sales account is not affected
because these adjustments are directly charged against the receivable
account and not on the sales account.

Freight Charges

Accounting for freight charges in the books of the seller is

essentially the same with that in the books of the buyer. The term FOB
Shipping Point means the buyer bears the shipping cost while FOB
Destination means the seller should pay the transportation costs.

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To illustrate, assume that Meliton Manufacturing sold P100,000 worth

of goods to Nelia Merchandising on account. The transaction provided for
a P5,000 transportation cost. Using the different freight terms, the entry in
the books of Meliton Manufacturing are:

1. FOB shipping point, freight prepaid

Account Receivable 105,000

Sales 100,000
Cash 5,000

2. FOB shipping point, freight collect

Account Receivable 100,000

Sales 100,000

3. FOB destination, freight prepaid

Account Receivable 100,000

Freight-Out 5,000
Sales 100,000
Cash 5,000

4. FOB destination, freight collect

Account Receivable 95,000

Freight-Out 5,000
Sales 100,000

Notice that the seller accounts the freight using a freight-out

account if the freight term is FOB Destination. Freight out or
transportation out account is reported as a selling expense in the statement
of profit or loss.

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COMPLETING THE ACCOUNTING CYCLE OF

MERCHANDISING BUSINESS

There are two known methods to facilitate the preparation of the

worksheet for financial reporting purposes: the cost of sales method and
the direct extension method.

The cost of sales method involves setting-up a cost of sales

accounts which is used in closing the beginning inventory, purchases,
purchase discount, and purchase returns and allowances accounts and
establishing the ending inventory account. The balance of the cost of sales
account is then closed to income summary when closing entries are
prepared.

Using the cost of sales method, the following adjusting journal

entries and closing entries are prepared relating to merchandise inventory-
related accounts are prepared:

Adjusting journal entry of inventory-related accounts

Cost of Sales xx
Merchandise Inventory, end. xx
Purchase Discount xx
Purchase Returns and Allowances xx
Purchases xx
Freight-In xx
Merchandise Inventory, beg. xx

Entry to close accounts with credit balances

Sales xx
Other income accounts
Income and Expense summary xx

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Entry to close accounts with debit balances

Income and Expense Summary xx

Cost of Sales xx
Sales Discount xx
Sales Returns and Allowances xx
Other expense accounts xx

The direct extension method or closing entry method on the

other hand does not involve setting-up a cost of sales account. Hence, the
beginning inventory, the purchases and purchases-related accounts are still
open and the ending inventory has not been set-up yet. These accounts are
directly closed to the income and expense summary during the closing
process.

Using the direct extension method, the following adjusting journal

entries and closing entries are prepared relating to merchandise inventory-
related accounts are prepared:

Adjusting journal entry of inventory-related accounts

-not prepared-

Entry to close accounts with credit balances

Sales xx
Other income accounts xx
Merchandise Inventory, end xx
Purchase discount xx
Purchase Returns and Allowances xx
Income and Expense summary xx

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Entry to close accounts with debit balances

Income and Expense Summary xx

Merchandise Inventory, beg xx
Sales Discount xx
Sales Returns and Allowances xx
Purchases xx
Freight-in xx
Other expense accounts xx

The closing entries for both the drawing and capital accounts are
the same using the cost of sales method and direct extension method.

Take note that closing entries are not prepared right after the adjusting entries. The
illustration above is made for purposes of comparison of the two methods.

PREPARATION OF FINANCIAL STATEMENTS

As mentioned earlier, the statement of profit or loss of a

merchandising type of business is different from that of the service type of
business because of the presence of merchandise inventory account. The
preparation of the said statement varies depending on the method used.
The two methods employed in preparing the Statement of Profit or Loss
are the function of expense method and the nature of expense method. The
function of expense method classifies the expense according to function
such as cost of sales, selling expenses, administrative expenses, and other
expenses and losses. On the other hand, the nature of expense method
classifies the expenses according to their nature such as net purchases,
employee benefits, advertising, transportation, etc.

Examples of financial statements using both methods are the

following:

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Function of expense method

Sylvia Merchandising Co.

Statement of Profit or Loss
For the Year Ended December 31, 2018

Net sales xx
Cost of Sales (xx)
Gross Income xx
Other income (xx)
Total income xx
Expenses
Selling expenses xx
Administrative expenses xx
Finance Cost xx
Other Expoenses xx (xx)
Net Income xx

Nature of expense method

Sylvia Merchandising Co.

Statement of Profit or Loss
For the Year Ended December 31, 2018

Net sales xx
Cost of Sales (xx)
Gross Income xx
Other income (xx)
Total income xx
Expenses
Increase in Inventory xx
Net Purchases xx
Salaries xx
Depreciation xx
Doubtful accounts xx
Supplies xx
Other Expenses xx (xx)
Net Income xx

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