Part 2.

Accounting for Merchandising Business

Chapter 7: Nature of Merchandising Business

Overview: This chapter discusses the basic concepts that are applicable to a merchandising
business but not to a service business.

Learning Outcome:

Upon completion of this chapter, you should be able to:

1. Discuss terms related to merchandising business.
2. Discuss the two inventory systems.
3. Prepare journal entries under periodic and perpetual system of inventory.

Learning Content:

Nature of Merchandising Business

Merchandising business is one that buy products or goods and sell it to consumer in their original
form when it was purchased without any alteration. The steps in the accounting cycle for
merchandising business is similar to that of the services business. However, the former used
additional account titles and entries in recording its transactions.

A merchandising business holds inventory as its main product to be sold. Inventory refers to the
products or goods that is held by the merchandiser primarily intended for resale. The
merchandiser earns profit through the mark up on the purchase price of the goods being sold.
Below is the summary of how a services business and a merchandising business determine its
profit. The income statement of both type of business is presented below for comparison. The
main difference is the presence of cost of goods sold in a merchandising concern.

Services Business
Revenues XXX
Less: Operating Expenses XXX
Profit XXX

Merchandising Business
Net Sales XXX
Less: Cost of Goods Sold XXX
Gross Profit XXX
Less: Operating Expenses XXX
Profit XXX

Terms Related to Merchandising Business

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 1. Sales. The account title uses to describe the revenue for selling goods.
2. Cost of Goods Sold. This is the cost of purchase plus any cost incidental to the purchase
of goods that are sold to consumers. This item often the largest cost on a merchandiser’s
income statement because it consists of the total cost of merchandise sold during the
period.
3. Gross Profit. It is the term used to describe the difference between the net sales and cost
of goods sold.
4. Operating Expense. The cost incurred by a merchandising business related to its
operation. This includes distribution cost or selling expense and administrative expense.
The distribution costs are incurred in the process of earning the sales revenue such as
commission expense paid to salesman, storage fee for the goods for sale and the like.
Distribution costs are not usually present in the income statement of a services business.
5. Goods Available for Sale. This term describes the total goods (cost of goods) that are
stored/displayed or available for customers’ purchase. From the term itself, “goods
available for sale” (unsold) it means that the goods are yet to be purchased by clients. The
total goods available for sale is determined by adding the total cost of purchase and the
beginning inventory.
6. Beginning Inventory. Refers to the unsold goods in the prior period and thus ready for
sale right at the beginning of the current period.
7. Ending Inventory. Refers to the unsold goods at the end of the current period which will
become the beginning inventory of the next accounting period.

Inventory Systems

There are two inventory systems use in merchandising to account for the inventories, namely:

1. Periodic Inventory System. The cost of inventory is determined through a physical count
at the end of the period. This system is often used by merchandisers who sell different
types of goods at a generally low price.
2. Perpetual Inventory System. Under this system, a detailed record of the cost of each
item is maintained and continuously updated. The cost of ending inventory can be
determined any time without counting physically the items or goods on hand. Simply refer
to the record being maintained. However, when a merchandiser uses this system, a
physical count is still a must at the end of the accounting period to reconcile the record
maintained and the actual inventory on hand. This system is usually used by companies
that sell high value items.

Credit Terms

Credit Terms refers to the terms agreed upon by the seller and the buyer pertaining to discount
percentage, allowable days of credit, credit limit and the like. When a merchandiser sells goods
on credit, it may include offer of discount. A discount is the amount deducted from the given price
of a product being sold.

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There are two types of discounts the buyer gives to the customer, namely:

1. Trade Discount. Discount given to the buyer purposely to encourage the latter to
purchase by bulk. This type of discount is not recorded to any of the books of account of
whether the seller or the buyer but directly deducted to the list price of the item sold.
2. Cash Discount. Discount agreed upon by seller and the buyer to encourage the buyer to
pay his account promptly. This type of discount is deducted from the invoice price of the
product sold.

Depending on the terms, the cash discount may be given for partial payments as well as full
payments. However, if there is no agreement as to when will be the discount applicable, then the
discount will only be considered upon full payment of the account.

Common example of cash discount terms are the following:

Term Meaning
2/10, n/30 2% will be deducted to the customers’ account if it is paid
within 10 days from date of sale. The 10 days period within
which the discount can be availed is called the discount
period. If the customer did not pay within 10 days, then he
must pay it within 30 days from the date of sale.
2/10, EOM, n/60 2% discount will be given if the customer pays by the end of
the month following the month of sale. Beyond this period, full
amount will be paid within 60 days from the date of sale.
n/30 The seller is not providing any cash discount, only specifying
the time period within which the account will be paid, within 30
days.

Accounting for Sales using Periodic Inventory System

Sales is the account title use to record the revenue from selling goods. Typically, sales occurred
and revenue earned when there is a transfer of goods from seller to buyer and the transaction is
completed with established sales price. When an item is sold, either cash or accounts receivable
is debited, and the sales account is credited.

Illustration. Assume that on December 1, 2022, Bitly Company sold merchandise for 100,000
pesos cash with a total cost of 72,000 to Chroma, Ltd. The entry to record the sale would be:
Cash 100,000
Sales 100,000

If Bitly Company sold it on account, the debit entry will be Accounts Receivable instead of cash.

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Sales Returns and Allowances

Return of goods previously bought by customer is a normal activity in a merchandising business.

Thus, the activity must be properly accounted for. Sales Return is the account title that refers to
the actual return of goods/item by the customer whereas Sales Allowance refer to the reduction
of the selling price due to reasonable incident. The reduction may be caused by goods found to
be defective, or the goods received by clients are not exactly what is expected to be (wrong
specification of product) but still willing to accept the goods with discount or less price from the
seller.

The practice of lumping the sales return and sales allowance into one account title is acceptable,
thus, the account title “Sales Return and Allowances” and its normal balance is debit.

Illustration. Assume that Chroma, Ltd. return on December 3, 2022 to Bitly Company goods
purchased for 10,000 costing 7,200. The entry of Bitly Company to record the receipt of the goods
returned is found below:
Sales Returns and Allowances 10,000
Cash 10,000

If Bitly company previously sold the goods to the buyer on account, the entry to record the return
will be:
Sales Return and Allowances 10,000
Accounts Receivable 10,000

Accounting for Sales Discount

Sales Discount is the term use by seller to describe the cash discount given to the buyer. When
cash discount is taken by the buyer, a debit to Sales Discount is made on the date of payment.

Illustration.

Dec. 1, 2022: Assume that on December 1, 2022, Bitly Company sold merchandise for 100,000
pesos on account with a total cost of 72,000 to Chroma, Ltd., terms: 2/10, n/30.

Dec. 3, 2022: Chroma, Ltd. return on December 3, 2022 to Bitly Company goods purchased for
10,000 costing 7,200.

Dec. 11, 2022:Chroma took advantage of the discount and paid its account on December 11,
2022.

The entry of Bitly Company to record the receipt of payment is as follows:

Cash (90,000-1,800) 88,200
Sales Discount (90,000x2%) 1,800

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 Accounts Receivable (100,000 – 10,000 Sales Return) 90,000

The cash received by the seller is net of 2% discount. The 90,000-amount credited to Accounts
Receivable is net of the sales return amounting to 10,000 on December 3, 2022. When a
transaction involves credit terms, it is automatically understood that the sale is a credit
sale, thus, at the date of collection, the account to be credited is “Accounts Receivable”.

If Chroma paid its account beyond the discount period of ten days, the entry of the seller to record
the payment is as follows:

Cash 90,000
Accounts Receivable 90,000

Accounting for Purchases

When the merchandiser purchase goods for resale, it is debited to an account “Purchases”. The
said account is use only for goods purchased for resale from which the account Merchandise
Inventory emanate when presenting the unsold goods in the balance sheet. In purchasing assets
other than goods for resale, the appropriate account shall be used instead of the “Purchases”
account. For instance, the entity purchases office furniture, the account to be debited is “Office
Furniture”.

Cash purchases are recorded by a debit to Purchases and credit Cash. For purchases with terms
(credit purchase), it is recorded by a debit to Purchases and credit to Accounts Payable with
appropriate purchase invoice as reference for the details of the purchase.

Illustration. On December 1, 2022, Chrome, Ltd. Purchase goods from Bitly Company
amounting to 100,000 on account, terms, 2/10, n/30.
Purchases 100,000
Accounts Payable 100,000
If Chrome purchase the goods in cash, the credit will be Cash instead of Accounts Payable.

Accounting for Purchase Returns and Allowances

The sales returns of the seller are the purchase returns of the buyer. When there is a return of
goods from buyer to seller, the buyer called it Purchase Return and the seller termed it as Sales
Return. There are instances that the buyer needs to return some or all the goods to the buyer
because of damage, poor quality or wrong specifications. If this happens, the seller needs to
refund the buyer if it was purchased by the latter for cash. However, if it was purchased by the
buyer on credit, the seller needs to acknowledge the return through the issuance of a credit
memorandum, a document issued by seller informing the buyer the details of the reduction of the
latter’s account.

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On the other hand, a purchase allowance exists when the buyer is still willing to accept the
products but with a lesser price through the issuance of a debit memorandum, a document
issued by the buyer informing the seller of a debit made to the seller’s account detailing the
reason of return or allowance. This must be approved and acknowledged by the seller by issuing
a credit memorandum to formalize and complete the transaction. The account tile “Purchase
Returns and Allowances” will be used to record both the actual return of goods and the reduction
of purchase price.

Illustration. Dec. 3, 2022: Chroma, Ltd. return on December 3, 2022 to Bitly Company goods
purchased on account for 10,000 costing 7,200.
Accounts Payable 10,000
Purchase Returns and Allowances 10,000
If the returned goods by Chroma was purchased previously for cash, then the credit will be Cash
instead of Accounts Payable.

Accounting for Purchase Discount

Purchase Discount by the buyer is the compliment of the sales discount of the seller which was
previously discussed. Credit terms may provide purchase discount for the buyer for paying his
account promptly.

The account title “Purchase Discount” is used by the buyer to record the amount saved by early
paying his account to the seller. It is a contra account with normal credit balance and is being
deducted to the Purchases account in determining the Net Purchases.

There are three (3) modes of accounting for purchase discounts namely:
1. Gross Price Method
2. Net Price Method
3. Allowance Method

However, only the Gross Method will be discussed in this chapter.

Gross Price Method of Accounting Purchase Discount

Under this method, all purchases, and accounts payable are recorded at gross amount and
discount will only be recorded if taken advantage by the buyer.

Illustration. (From the transactions under the Sales Discount illustration)

Dec. 1, 2022: Assume that on December 1, 2022, Bitly Company (seller) sold merchandise for
100,000 pesos on account with a total cost of 72,000 to Chroma, Ltd. (buyer) terms: 2/10, n/30.

Dec. 3, 2022: Chroma, Ltd. return on December 3, 2022 to Bitly Company goods purchased for
10,000 costing 7,200.

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Dec. 11, 2022: Chroma took advantage of the discount and paid its account on December 11,
2022.

A comparative entry for the seller and the buyer to record the discount is presented below:

Buyer: Chroma, Ltd. Seller: Bitly Company

Dec. 1, 2022 Dec. 1, 2022

Purchases 100,000 Accounts Receivable 100,000

Accounts Payable 100,000 Sales 100,000
To record the purchase To record the sale
Dec. 3, 2022 Dec. 3, 2022

Accounts Payable 10,000 Sales Returns and Allowances 10,000

Purchase Returns and Allowances 10,000 Accounts Receivable 10,000
To record the purchase return. To record the sales return.
Dec. 11, 2022 Dec. 11, 2022

Accounts Payable 90,000 Cash (90,000-1,800) 88,200

Purchase Discount 1,800 Sales Discount (90,000x2%) 1,800
Cash 88,200 Accounts Receivable (100K-10k return) 90,000
To record the payment to the seller. To record the collection/receipt of cash from buyer.

Observe that the entries on the books of the seller is complementary to the entries in the books of
the buyer.

Shipping Charges for the Goods Purchased or Sold

As a rule, he who owns the goods in transit shall bear the shipping costs. However, the buyer and
seller may otherwise agree who will be responsible for the freight cost payment and who shall
bear the risk of loss within the duration of the actual transfer of the goods.

The point when the ownership of the goods transfer from the seller to the buyer determines who
shall pay the transportation cost or freight cost and other incidental costs. These terms depend on
the agreement between the buyer and the seller. There are two commonly known freight terms:
FOB Shipping Point and FOB Destination.

FOB Destination

Free on board (FOB) Destination means that the ownership of the goods is transferred only if
the goods shipped already reach its destination. Therefore, while the goods are still in transit or
still on its way to its destination, the seller owns the goods. Thus, if the seller owns the goods
while in transit, the seller must shoulder the payment of the shipping cost or freight cost.

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If the buyer and seller agreed under the term FOB Destination, the seller must pay and record the
freight cost. The freight cost or shipping costs is recorded by the seller using the account title
“Freight Out” and it shall form part of the seller’s operating expense in the income statement.

Illustration. On January 15, 2023, Manila Export Company purchase goods costing 30,000 from
Visayas Trading, a company from Visayas Region. Terms are, 2/10, n/30, FOB Manila. Freight
charges amounted to 2,100 pesos.

The entry to record the transaction is as follows:

Buyer: Manila Export Seller: Visayas Trading

Purchases 30,000 Accounts Receivable 30,000
Accounts Payable 30,000 Sales 30,000
No entry for the freight cost. Freight Out 2,100
Cash 2,100

The entries above assumed that the seller actually paid the shipping company as part of his
duties base on the terms. (we termed it as, FOB Destination, freight prepaid). This means that
the freight cost is to be shouldered by the seller who actually paid for it.

If the term is FOB Destination, freight collect, it means that the freight cost is shouldered by the
seller but the actual payment to the shipping company will be done by the buyer. Then the buyer
will collect the freight cost from the seller, equal to what he has paid it to the shipping company.

FOB Shipping Point

Free on board (FOB) Destination means that the ownership of the goods is transferred at the
shipping point. Therefore, while the goods are still in transit or still on its way to its destination, the
buyer already owns the goods. Thus, if the buyer owns the goods while in transit, the buyer must
shoulder the payment of the shipping cost or freight cost.

If the buyer and seller agreed under the term FOB Shipping point, the buyer must pay and record
the freight cost. The freight cost or shipping costs is recorded by the buyer using the account title
“Freight In or Transportation In” and it will appear in the income statement as an addition to the
cost of merchandise purchased.

Illustration. Assume that on January 20, 2023, Alias Company located in Manila purchased
goods with selling price of 40,000 pesos from Cebu Company located in Cebu City. The shipping
cost is 4,000 thousand pesos. Terms are 2/20, n/30 FOB Shipping Point, freight collect. The
entries are as follows:

Buyer: Alias Company Seller: Cebu Company

Purchases 40,000 Accounts Receivable 40,000
Accounts Payable 40,000 Sales 40,000

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 Freight In 4,000 No entry for the freight cost.
Cash

If the terms are FOB Shipping point, freight prepaid, the buyer will shoulder and record the
shipping cost, but the seller advanced the payment to the shipping company. The seller will then
collect from the buyer the freight costs paid by him to the shipping company.

Summary of Terms for Freight Costs

Freight Terms Who shall shoulder Who pays the freight cost
the freight cost? to the shipping company?
FOB Destination, Freight Prepaid Seller Seller
FOB Destination, Freight Collect Seller Buyer
FOB Shipping Point, Freight Prepaid Buyer Seller
FOB Shipping Point, Freight Collect Buyer Buyer

Cost of Goods Purchased

In determining the cost of goods purchased for resale, the ledger accounts of the following
account titles are needed:
1. Purchases with Debit normal balance
2. Purchase Returns and Allowance with Credit normal balance
3. Purchase Discounts with Credit normal balance
4. Freight In with Debit normal balance

Purchase returns, allowances and discounts are deducted from the Purchases to determine the
Net Purchases. Freight In is the added to the Net Purchases and the sum is called Cost of
Goods Purchased.

Illustration. Assume the ledger of Company A includes the following account balances:
Purchases, P450,000; Purchase Returns and Allowances, 15,000; Purchase Discounts, 8,000
and Freight In, 6,000.
450,00
Purchases 0
Less
: Purchase Returns and Allowance 15,000
Purchase Discounts 8,000 23,000
427,00
Net Purchases 0
Add: Freight In 6,000
433,00
Cost of Goods Purchased 0

Perpetual Inventory System

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Under this method, records on inventory purchased are kept and continuously updated as to
quantity and purchase price. With the foregoing set up, it is an advantage for the management
because it may be able to respond to inquiries on the availability of the items, maintain optimum
level of inventory and avoid out-of-stock problem.

When a merchandiser uses perpetual inventory system, the cost of goods purchased and other
transaction resulting to the increase in inventory is debited to Merchandise Inventory account at
the date of purchase, thereby increasing the inventory stocks. Likewise, a sale transaction
decreases inventory and thus, Merchandise Inventory account is credited.

Since all increase and decrease of inventory is directly recorded in the Merchandise Inventory
account, perpetual inventory system does not use the account titles: Purchases, Purchase
Returns and Allowances, Purchase Discount and Freight In.

Illustration. Assume that Company X completed the following transaction:

1. Purchased merchandise worth P90,000, terms s2/10, n/30, FOB shipping point.
2. Paid the shipping company (FOB shipping point, freight collect), P2,000.
3. Returned defective merchandise amounting to P13,000.
4. Paid merchandise in No. 1 taking advantage of the discount.
5. Sold merchandise costing 20,000 for 26,000, terms 2/10, n/30, FOB Destination and paid
P1,500 freight.
6. Merchandise costing 2,000 and previously sold for 2,600 was returned by the customer in
No. 5.
7. Collected cash from customer in No. 5, who paid within the discount period.

A comparative journal entry for both Periodic and Perpetual Inventory system is presented below:

Periodic System Perpetual System

1. Purchases 90,000 1. Merchandise Inventory 90,000
Accounts Payable 90,000 Accounts Payable 90,000
2. Freight In 2,000 2. Merchandise Inventory 2,000
Cash 2,000 Cash 2,000
3. Accounts Payable 13,000 3. Accounts Payable 13,000
Purchase Returns and Allow. 13,000 Merchandise Inventory 13,000
4. Accounts Payable 77,000 4. Accounts Payable 77,000
Cash 75,460 Cash 75,460
Purchase Discount 1,540 Merchandise Inventory 1,540

Computation: Note: Perpetual system does not use the

account title “Purchase Discount”

Same computation under the periodic system.

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 90,00
Purchases 0
13,00
Returns 0
77,00
Total 0
Less Discount
(2%) 1540
75,46
Cash to be paid. 0

5. Accounts Receivable 20,000 5. Accounts Receivable 26,000

Sales 20,000 Sales 26,000

Cost of Goods Sold 20,000

Merchandise Inventory 20,000*
*Under perpetual system, an additional entry
to update the merchandise inventory at the
date of sale is prepared. If sale happens,
there is a decrease in inventory, thus, the
Merchandise Inventory account is credited
and the amount is transferred to the Cost of
Goods Sold account.
Freight Out 1,500
Cash 1,500 Freight Out 1,500
Cash 1,500
To record the freight cost paid.
6. Sales Returns and Allow. 2,600 6. Sales Return and Allow. 2,600
Accounts Receivable 2,600 Accounts Receivable 2,600

Merchandise Inventory 2,000

Cost of Goods Sold 2,000

Note: Since the returned goods has the effect

of increasing the inventory, the Merchandise
Inventory account is debited to update the
inventory. It follows that the cost of goods sold
is decreased.
7. Cash 22,932 7. Cash 22,932
Purchase Discount 468 Merchandise Inventory 468
Accounts Receivable 23,400 Accounts Receivable 23,400

Computation: Same computation with that of the periodic

Sales 26,000 system.
Returns 2,600

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 Total 23,400
Less Discount (2%) 468
Cash Collected 22,932

LEARNING ACTIVITIES

Name: Professor:
Year/Course: Score:

A. Matching Type. Write the letter for each terms beside the definition/statement given that is
most closely matches.

A. Cash Discount B. Credit Period C. Discount Period

D. FOB Destination E. FOB Shipping Point F. Gross Profit
G. Merchandise Inventory H. Purchase Discount I. Sales Discount
J. Trade Discount

1. Ownership of goods is transferred at a buyer’s place of business.

2. Time period in which a cash discount is available.
3. Goods a company owns and expect to sell to its customers.
4. Time period that can pass before a customer’s payment is due.
5. Seller’s description of cash discount granted to customers in return for early payment.
6. Reduction below list or catalog price that is negotiated in setting the price of goods and
are not recorded in the books of accounts.
7. Ownership of goods is transferred at the sellers’ place of business.
8. The difference between net sales and the cost of goods sold.
9. Reduction in a receivable or payable that is granted if it is paid within the discount period.
10. Purchaser’s description of a cash discount received from a supplier of goods.

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Name: Professor:
Year/Course: Score:

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