Chap 10 - Accounting Cycle of a Merchandising Business

Introduction

We have already completed the accounting cycle of a service business in the previous chapter. In this
chapter, we will complete the accounting cycle of a merchandising business. Again, a merchandising
business is one that buys and sells goods without changing their physical form. Also, we will discuss
some concepts that are applicable to a merchandising business but not to a service business.

Inventory

The main difference between a merchandising business and a service business is that a merchandising
business necessarily holds inventory of physical goods for sale. In this context, inventory simply refers to
the goods that a merchandising business has purchased and primarily intended for resale, normally in
their original form and without any further processing.

Inventory Systems

Inventories are accounted for using either of the following inventory systems:

1. Perpetual inventory system; or

2. Periodic inventory system.

Perpetual inventory system

In layman's terms, the word "perpetual" means continuing forever (or 'tuloy tuloy' or 'walang hanggan'
in Filipino). The perpetual inventory system is called as such because under this system, the "Inventory"
account (or "Merchandise inventory account) is updated each time a purchase or sale is made. Thus, the
"Inventory" account shows a continuing or running balance of the goods on hand. Moreover, records
called "stock cards" and "stock ledger cards" are maintained under this system, from which the
quantities and balances of goods on hand and goods sold can be determined at any given point of time
without the need of performing a physical count of inventories. All increases and decreases in inventory,
such as purchases, freight-in, purchase returns, purchase discounts, cost of goods sold, and sales returns
are recorded in the "Inventory" (or "Merchandise inventory") account. "Cost of goods sold" is also
updated each time a sale or sale return is made. The perpetual inventory system is commonly used for
inventories that are specifically identifiable and are relatively high valued, such as cars, machineries,
furniture, and heavy equipment.

Periodic Inventory System

In layman's terms, the word "periodic" means occurring or recurring at regular intervals (or "pana-
panahon" in Filipino). The periodic inventory system is called as such because under this system, the
"Inventory" account (or "Merchandise inventory" account) is updated only when a physical count of
inventory is performed. Thus, the amounts of inventory and cost of goods sold are determined only
periodically. Under this system, the business does not maintain records that show the running balances
of inventory on hand and cost of goods sold as at any given point of time. To determine this information,
a physical count of the quantity of goods on hand must be performed periodically (e.g., on a daily,
weekly, monthly, or annual basis). The quantity counted is then multiplied by the unit cost to get the
balance of the "Inventory" account. This amount is then used to compute for the "Cost of goods sold,"
which is the residual amount in the formula below.

Beginning inventory xx

Add: Net purchases xx

Total Goods Available for Sale xx

Less: Ending inventory (physical count) xx

Cost of Goods Sold xx

Net purchases are computed as follows:

Purchases xx

Add: Freight-in xx

Less: Purchase returns xx

Less: Purchase discounts xx

Net Purchases xx

"Freight-in" is an adjunct account (addition), while "Purchase returns" and "Purchase discounts" are
contra accounts (deductions), to "Purchases" when computing for "Net purchases"

Purchases - the account used to record purchases of inventory under the periodic system.

Freight-in (Transportation-in) - the account used to record the shipping costs incurred on purchases of
inventory under the periodic system.

Purchase returns - the account used to record returns of purchased goods to the supplier.

Purchase discounts - the account used to record cash discounts availed of on the purchased goods.
Illustration: Perpetual vs Periodic (Journal Entries)

Notes:

Under the perpetual inventory system, all increases and decreases in the goods on hand are recorded
through the "Inventory" account. Also, cost of goods sold is debited when inventory is sold and credited
when there is a sales return.

Under the periodic inventory system, the increases and decreases in the goods on hand are recorded
through the purchases, freight-in, purchase returns, and purchase discounts accounts. Cost of goods
sold is not recorded.
Under the perpetual inventory system, the balances of inventory on hand and cost of goods sold are
readily determinable from the ledger. See T-accounts below:

Under the periodic inventory system, the balances of inventory on hand and cost of goods sold are not
readily determinable without performing first a physical count of the quantity of goods on hand.

Assume that a physical count revealed inventory on hand of 105 units costing P40 per unit. Using the
formula above, the inventory on hand and cost of goods sold under the periodic inventory system are
determined as follows:
Summary:
Gross Profit

Gross profit (gross income, gross margin, or sales profit) is simply "Net sales minus Cost of Goods Sold."

Net Sales xx

Less: Cost of Goods Sold xx

Gross Profit xx

Gross profit represents the profit a business earns after deducting the cost of the goods sold or services
rendered, but before deducting other expenses.

Profit (or Net profit) is different from gross profit. Profit is the amount derived after deducting all other
expenses from the gross profit. This is illustrated below:

Net sales xx

Cost of Goods Sold xx

Gross Profit xx

Rent expense xx

Depreciation expense xx

Salaries expense xx

Profit (Net Profit) xx

"Net sales" is Total sales minus Sales returns and discounts. This is shown in the formula below:

Sales xx

Less: Sales returns xx

Less: Sales discounts xx

Net Sales xx

"Sales returns" and "Sales discounts" are contra accounts (deductions) to "Sales" when computing for
"Net sales."

Sales - include both cash sales and credit sales.

Sales returns - the account used to record goods returned by customers.

Sales discounts - the account used to record cash discounts given to customers.
Scenario #1:

What if the recorded sale is only 236 bottles, instead of 238? In this scenario, you have a shortage,
meaning there are 2 bottles missing! (Shortage' means 'kulang in Filipino) Analyze the computations
below:

Scenario #2:

What if the recorded sale is 241 bottles, instead of 238? In this scenario, you have an overage of 3
bottles. ('Overage' means 'sobra' in Filipino.) Analyze the computations below:
Scenario #3:

You can also use the computations above to check the accuracy of your cash collections. We have
computed that the "cost of goods sold" in units (i.e., number of bottles sold) is 238 bottles. We also
know that the sale price per bottle is $70. Therefore, your total collections should be P16,660 (238
bottles x P70 sale price per bottle).

What if your cash register contains only $15,645? In this scenario, you again have a shortage!