Week 4: Merchandising

ACC1701 Accounting for decision makers

NUS Business School

AY2022–23 Semester 2

Learning Outcomes
After this class, you should be able to:

1. Record merchandise purchase and sale transactions in a perpetual in-

ventory system.

2. Extend the accounting cycle and financial statement preparation to

merchandising businesses.

3. Account for purchase and sale discounts and allowances, including the
gross and net approaches to accounting for purchase discounts.

4. Compute the acid test ratio and use it to assess liquidity; and compute
the gross margin ratio and use it to assess profitability

Merchandising
This week, we study the accounting for a merchandising business. This is
a trading business that buys and sells goods, called merchandise. The com-
pany’s stocks of the goods they are holding for sale in their regular trading
business is called Merchandise Inventory, or just Inventory.

1
Sales and cost of goods sold
When we record the sale of goods for a merchandising company, we record
it as two transactions that happen together:

1. We have earned revenue by delivering the goods to customer, so sales

revenue goes up, and cash or accounts [trade] receivable goes up.

2. The goods (usually valued at their cost to us) leave us and go to the
customer, so we record Inventory going down, and an expense called
Cost of Goods Sold, or Cost of Sales (COGS).

Recording the COGS every time goods are sold is a feature of an account-
ing system called the perpetual system of inventory recording. We will only
study this system in our module.
There is an alternative system called the periodic system which does not
track COGS with every sale, and computes it indirectly at the end of the
year, by comparing beginning inventory plus purchases during the year with
a physical count of ending inventory.
We will not study the periodic system in our module.

Merchandise sales example

Loh Co sells 300 widgets to Wong Co. The 300 widgets have a total value
of $3,000 in Loh’s inventory. The sales price that Loh charges Wong is $11
per widget,

JE to record the sale

Dr Trade Receivables 3,300
Cr Sales Revenue 3,300
[300 × $11]

JE to record the COGS

Dr Cost of goods sold 3,000
Cr Inventory 3,000

2
Classified income statement
We now learn a more structured format for the income statement that com-
putes three layers of profit for merchandise trading companies: gross profit,
profit before tax, and net profit. Recall that earlier, we just presented net
profit as all income minus all expenses. Other structured formats are found
in practice.
XXX Company
Income Statement
For the year ended 31/12/23
(amounts in $)
Net sales 1,000,000
Cost of goods sold (750,000)
GROSS PROFIT 250,000

Other income 100,000

...
[LIST OF VARIOUS EXPENSES] ...
...
PROFIT BEFORE TAX 10,000
Income tax expense (1,700)
NET PROFIT 8,300
Gross profit is the difference between Net sales and cost of goods sold
(We will discuss what ‘Net sales’ means later in the lecture).

Gross margin ratio

The gross margin ratio gives the gross profit as a percentage of sales. It tells
us what percentage of the average sales price is a markup over the average
cost price for the goods sold during the year.

Gross Margin Ratio

Net Sales − Cost of Goods Sold
Net Sales

Compute the gross margin ratio for FJ Benjamin for 2022.

3
 80, 903 − 40, 958
= 0.4937
80, 903

Acid test ratio

The acid test ratio provides a more stringent test of short-term liquidity
compared to the current ratio; by comparing only more liquid current assets
(more easily convertible to cash) to current liabilities. The formula:

Acid-test ratio
Cash and cash equivalents + Short-term investments + Current receivables
Current liabilities

Compute the acid-test ratio at 30/6/22 for FJ Benjamin

12, 510 + 9, 659 + 11, 294 + 13
= 0.9599
34, 873
Numerator includes cash, trade debtors, non-trade debtors and tax recov-
erable

Free on Board (FOB)

Recall that under accrual accounting, we record sales when goods are deliv-
ered to the customer, and conversely, we record new Inventory (purchases)
when it reaches us. The rules for doing so depend on the business terms
governing a particular sales transaction.

FOB shipping point

For some transactions, the contract terms are that title passes to the
buyer the moment the goods are shipped. In that case, the seller records the
sale on the date the goods are shipped, and the buyer also records the goods
in their inventory at the shipping date (i.e., before the goods reach them).
In this case, the shipping costs are borne by the buyer, and the buyer
also bears the loss if the goods are lost or damaged during shipment.

4
FOB destination
In this case, the sale terms are that title passes to the buyer only when
the goods reach them. The buyer only records them as part of their inventory
when they have arrived at their warehouse. The seller also only records the
sale at the date the buyer has received them.
In this case, the shipping costs are borne by the seller, and they also bear
the loss if the goods are lost or damaged during shipment.

Check your understanding

Yeung Co sells goods to Tan Co. Goods are shipped on 2nd April. Tan
Co receives them on 4th April. Terms are FOB destination. When should
Yeung Co record the sale?
4th April

Credit terms
The terms for a credit sale are often described using a notation like this: 3/9,
n/20. In this case, the buyer can claim a 3% discount if they pay within 9
days (from the invoice date), and if they do not avail of the discount, the net
amount (total amount sans discount) is due within 20 days (from the invoice
date).

Shrinkage
When a company conducts a physical count of its inventory at the year-end,
they may find that the inventory is less than that according to the books.
This is because of damaged or lost goods that the company had not previously
accounted for. This loss is called shrinkage.
Shrinkage is recorded as a debit adjustment to cost of goods sold, and
inventory is reduced by the corresponding amount.

Shrinkage example
Lam Co has $100 of inventory at year-end according to its accounts. A
physical count shows that the inventory is only $99. Record the shrinkage.
Dr Cost of goods sold 1
Cr Inventory 1

5
Purchases
Purchase discounts
There are two methods of accounting for purchase discounts:

1. Under the gross method, the inventory is recorded at the pre-discount

or gross price when purchased. Then, if the discount is availed of, the
inventory cost is reduced by the amount of the discount.

2. Under the net method, the inventory is recorded at the discounted

price when purchased. Then, if the discount is not taken, an expense is
recorded called something like ‘discount lost expense’. This method is
used when the company wants to motivate purchase managers to take
discounts.

In our module, if the method is not stated (or implied) in a question,

please assume the gross method as the default.

Gross method example

Lin Co buys goods costing $100 (gross) on which a 2% discount is available
for paying early.
Dr Inventory 100
Cr Trade Payables 100
to record the purchase
Dr Trade Payables 100
Cr Cash 98
Cr Inventory 2
to record early payment with a discount

Net method example

Cheung Co buys goods costing $100 (gross) on which a 2% discount is avail-
able for paying early. They use the net method.
Dr Inventory 98
Cr Trade Payables 98
to record the purchase

6
 Dr Trade Payables 98
Dr Discount lost expense 2
Cr Cash 100
to record late payment without the discount

Purchase returns
If purchased goods are returned, inventory goes down (credit) and trade
payables go down (debit).

Purchase allowances
This is a situation where the purchased goods are unsatisfactory, but we
agree to keep them in exchange for a reduction in price called an allowance.
To record a purchase allowance, we reduce the value of the inventory
(credit) and reduce the trade payable (debit) similar to purchase returns.

Sales
Net Sales
Net sales is sales revenue (gross) less sales discounts, sales returns and sales
allowances.
Gross sales revenue xxx
Less: sales discounts xxx
Less: sales returns xxx
Less: sales allowances xxx

Net sales xxx

Sales discounts, sales return, and sales allowances are each tracked through
the year by temporary contra-revenue accounts, i.e., they are negative adjust-
ments to a revenue account (Sales). They go up on the debit side (reduction
in revenue, or reduction in equity).

Sales discounts
Sales discount example

7
Shah Co sells goods worth $100 (gross price) with a 2% discount for early
payment.
Dr Trade Receivables 100
Cr Sales revenue 100
To record the sale
Dr cash 98
Dr Sales discounts 2
Cr Trade receivables 100
To record early receipt with discount
We will only cover the gross method for sales discounts in our module
(illustrated above).

Sales returns
Sales returns example
Faisal Co sells goods at a sales price of $100. The cost of goods sold for the
transaction is $80. The customer returns goods with a sales price value of
$2 and which originally cost Faisal Co $1.60.
Dr Trade receivables 100
Cr Sales revenue 100
To record the sale
Dr Cost of goods sold 80
Cr Inventory 80
To record the cost of goods sold
Dr Sales returns 2
Cr Trade Receivables 2
To record the sales return
Dr Inventory 1.60
Cr Cost of goods sold 1.60
To record the returned goods in inventory

Sales allowances
Sales allowance example
Pang Co sells goods with a sales price value of $100. Due to a defect, Pang
Co agrees to give the customer an allowance of $2 on the price.

8
 Dr Trade receivables 100
Cr Sales revenue 100
To record the sale
Dr Sales allowances 2
Cr Trade receivables 2
To record the sale allowance

Closing entries
We can close Sales returns, sales discounts, and sales allowances to Sales
revenue to get the Net Sales as the balance before closing Sales revenue to
income summary.
Dr Sales revenue xxx
Cr Sales discounts xxx
Cr Sales returns xxx
Cr Sales allowances xxx
To close contra-revenue accounts to sales
Alternatively, we can close these accounts directly to income summary
together with the expenses (as shown in the textbook).

SP 5
We cover transactions for January and February in the Week 4 lecture, while
transactions for March as well as the preparation of worksheet and financial
statements are covered in the tutorial in Week 5.
Due to time constraints, we will only do the starred (*) transactions in
class, which relate to something new we learnt today (the others are practice
for earlier topics). I will upload the handout with all the workings after class.
In case we do not get to complete some of the starred items, I will prepare a
tiny e-lecture covering it. As usual, do try the exercise before looking at the
solution.
S.Rey has begun to buy and sell computer software (as packaged goods
rather than online). Their terms for merchandise sales only are 1/10,n/30,
and FOB shipping point.

9
*Jan 4 The company paid cash to Lyn Addie for five days’ work
at the rate of $125 per day. Four of the five days relate to wages
payable that were accrued in the prior year.
Jan 4
Dr Wages payable 500
Dr Wages expense 125
Cr Cash 625

Jan 5 Santana Rey invested an additional $25,000 cash in the com-

pany.
Jan 5
Dr Cash 25,000
Cr S.Rey, Capital 25,000

*Jan 7 The company purchased $5,800 of merchandise from Kansas

Corp. with terms of 1/10, n/30, FOB shipping point, invoice dated
January 7.
Jan 7
Dr Merchandise inventory 5,800
Cr Accounts payable 5,800

Jan 9 The company received $2,668 cash from Gomez Co as full

payment on its account.
Jan 9
Dr Cash 2,668
Cr Accounts receivable–Gomez Co 2,668

Jan 11 The company completed a five-day project for Alex’s En-

gineering Co and billed it $5,500, which is the total price of $7,000
less the advance payment of $1,500. The company had debited
Unearned Computer Services Revenue for $1,500.
Jan 11
Dr Accounts receivable–Alex’s Engineering Co 5,500
Dr Unearned computer services revenue 1,500
Cr Computer services revenue 7,000

10
 *Jan 13 The company sold merchandise with a retail value of
$5,200 and a cost of $3,560 to Liu Corp., invoice dated January
13.
Jan 13
Dr Accounts receivable–Liu Corp. 5,200
Cr Sales 5,200
Jan 13
Dr Cost of goods sold 3,560
Cr Merchandise inventory 3,560

*Jan 15 The company paid $600 for freight charges on the mer-
chandise purchased on January 7.
Jan 15
Dr Merchandise inventory 600
Cr Cash 600

*Jan 16 The company received $4,000 cash from Delta Co. for
computer services provided
Jan 16
. Dr Cash 4,000
Cr Computer services revenue 4,000

*Jan 17 The company paid Kansas Corp. for the invoice dated
January 7, net of the discount.
Jan 17
Dr Accounts payable 5,800
Cr Merchandise inventory 58
Cr Cash 5,742
[5800 × 99%.]

*Jan 20 The company gave a price reduction (allowance) of $500 to

Liu Corp. and credited Liu’s accounts receivable for that amount.
Jan 20
Dr Sales returns and allowances 500
Cr Accounts receivable–Liu Corp. 500

11
 *Jan 22 The company received the balance due from Liu Corp.,
net of the discount and the allowance.
Jan 22
Dr Cash 4,653
Dr Sales discounts 47
Cr Accounts receivable–Liu Corp. 4,700
Discount = (5,200 − 500) × 0.01.

*Jan 24 The company returned defective merchandise to Kansas

Corp. and accepted a credit against future purchases (debited
accounts payable). The defective merchandise invoice cost, net of
the discount, was $496.
Jan 24
Dr Accounts payable 496
Cr Merchandise inventory 496

*Jan 26 The company purchased $9,000 of merchandise from

Kansas Corp. with terms of 1/10,n/30, FOB destination, invoice
dated January 26.
Jan 26
Dr Merchandise inventory 9,000
Cr Accounts payable 9,000

*Jan 26 The company sold merchandise costing $4,640 for a sales

price of $5,800 on credit to KC Inc. invoice dated January 26.
Jan 26
Dr Accounts receivable–KC Inc 5,800
Cr Sales 5,800
Jan 26
Dr Cost of goods sold 4,640
Cr Merchandise inventory 4,640

Jan 31 The company paid cash to Lyn Addie for 10 days’ work at
$125 per day.
Jan 31
Dr Wages expense 1,250
Cr Cash 1,250

12
Feb 1 The company paid $2,475 to Hillside Mall for another three
months’ rent in advance.
Feb 1
Dr Prepaid rent 2,475
Cr Cash 2,475

*Feb 3 The company paid Kansas Corp. for the balance due, net of
the cash discount, less the $496 credit from merchandise returned
on January 24.
Feb 3
Dr Accounts payable 8,504
Cr Merchandise inventory 90
Cr Cash 8,414
Accounts payable outstanding: 9, 000 − 496
Discount: 9, 000 × 1%

Feb 5 The company paid $600 cash to facebook for an advertise-

ment to appear on February 5 only.
Feb 5
Dr Advertising expense 600
Cr Cash 600

Feb 11 The company received the balance due from Alec’s Engi-
neering Co. for fees billed on January 11.
Feb 11
Dr Cash 5,500
Cr Accounts receivable–Alex’s Engineering Co 5,500

Feb 15 Santana Rey withdrew $4,800 cash from the company for
personal use.
Feb 15
Dr S.Rey, Withdrawals 4,800
Cr Cash 4,800

*Feb 23 The company sold merchandise with a $2,660 cost for a

sales price of $3,220 on credit to Delta Co., invoice dated February
23.

13
 Feb 23
Dr Accounts receivable–Delta Co 3,220
Cr Sales 3,220
Feb 23
Dr Cost of goods sold 2,660
Cr Merchandise inventory 2,660

Feb 26 The company paid cash to Lyn Addie for 8 days’ work at
$125 per day.
Feb 26
Dr Wages expense 1,000
Cr Cash 1,000

Feb 27 The company reimbursed Santana Rey $192 cash for busi-
ness automobile mileage. The company recorded the reimburse-
ment as “mileage expense”.
Feb 27
Dr Mileage expense 192
Cr Cash 192

14