ACCOUNTING FOR A

MERCHANDISING BUSINESS
Time allotment: 2 weeks (6 hours)

LEARNING OBJECTIVES
Upon completion of this chapter, the students should be able to:
1. Differentiate service concern from a merchandising operation.
2. Explain the treatment for the different freight terms.
3. Compute for the discounts in a business transaction.
4. Discuss the periodic and perpetual inventory systems of a merchandising
business.
5. Record correctly the transactions of a merchandising business using the
inventory systems.
6. Prepare the journal entries showing the effects of Value Added Tax on
merchandising transactions.

INTRODUCTION
One of the most common types of businesses known to us is the
merchandising business. We are familiar of Sari-Sari stores, SM Supermarkets,
Gaisano malls and other grocery stores. These are types of merchandising
businesses. From the word “merchandise”, merchandising businesses are
named such because of the items they sell – goods or merchandise. Commonly,
they are referred to as the buy-and-sell stores.

SERVICE CONCERN and MERCHANDISING BUSINESSES

In the previous chapters, we have discussed the service-concern
business. This business renders services to gain a revenue. Examples of this
type of business includes the barbershop and salon, property appraisal services,
accounting and bookkeeping services, and the famous habal-habal in the
Philippines!

In contrast, a merchandising business purchases inventory, sells the

inventory, and uses the cash to purchase more inventory – and the cycle
continues. For cash sales, the cycle is from cash to inventory and back to cash.
For sales on account, the cycle is from cash to inventory to accounts receivables
and back to cash. The faster the operating cycle, the higher the profits a
business can earn.

Operating Cycle of a Cash-Based Merchandising Business

 Operating cycle of a merchandising business with sales on account.

Merchandise Inventory account is used for goods (or) merchandise held

for sale in the ordinary course of business. The goods usually are acquired in a
finished condition and are ready for sale without further processing.

COMPARISON OF INCOME STATEMENTS

Service entities perform services for a fee. To compute for the profit, a
basic income statement is all that is needed. Profit is measured as the difference
of the income or revenue from services rendered and the expenses. In contrast,
merchandising business earns profit by buying and selling goods. To provide a
better measure of performance, the income statement of a merchandising
business is presented with additional items.

In a merchandising business, net sales arise from the sale of goods while
cost of goods sold or cost of sales represents the cost of the inventory the entity
has sold to customers. The difference between sales and cost of sales is called
gross profit. Gross profit less the operating expenses and finance costs is equal
to the profit for the period. It must be noted that the operating expenses include
the selling and administrative costs and other operating costs related to the
business transactions.
SOURCE DOCUMENTS
Merchandising businesses uses various forms and documents to help
identify he transactions that should be recorded in the books. The following
includes some of the most commonly used documents in a merchandising
business.
1. Sales Invoice. This document is prepared by the seller of goods and sent
to the buyer. It contains the name and address of the buyer, the date of
sale and information about the goods sold. It also specifies the amount of
sales, and the transportation and payment terms.

2. Bill of Lading. This is a document issued by the carrier such as LBC or

other trucking, shipping, or airline that specifies contractual conditions and
terms of delivery. It includes the freight terms, time, place, and the person
named to receive the goods.

3. Statement of Account. It is a formal notice to the debtor detailing the

accounts already due.

4. Official Receipt. It is a proof of a cash-based transaction that details the

transaction.

5. Deposit Slips. These are printed forms with depositor’s name, account
number, and spaces for the details of the deposit.

6. Purchase Requisition. This is a written request to the purchaser of an

entity from an employee or user department of the same entity that goods
be purchased.

7. Purchase Order. This is an authorization made by the buyer to the seller

to deliver the merchandise as detailed in the form.

8. Receiving Report. This is a document containing information about the

foods received from a vendor. It details the quantities and description of
the goods delivered.

9. Credit Memorandum / Credit Memo. This is a form used by the seller to

notify he buyer that the account is reduced due to errors, sales returns, or
other factors that require adjustments.

FREIGHT TERMS
Some businesses like Lazada or Amazon ships their products through a
common carrier such as LBC or 2Go. Larger business who sell in bulk like Toyota
cars also partners with carriers to move the product to another place. Example of
a carrier we often observe around is the Maersk. Although, a common carrier can
be a trucking entity, a shipping line, or an airline.

When merchandise is shipped by a common carrier, the carrier prepares a

freight bill (bill of lading) in accordance with the instructions of the party making
the shipping arrangements. The freight specifies who owns the goods while still
in transit and who shoulders the cost of shipping.

Who owns the goods while still in transit?

 Two terms should be properly understood when identifying who owns the
goods in transit: FOB Destination and FOB Shipping Point. FOB is an
abbreviation for Free On Board.

When the freight term is FOB Destination, it can be assumed that the
seller still owns the goods while still in transit. The ownership title passes only to
the buyer when the goods are received by the buyer; the shipping cost is
shouldered by the seller.

When the freight term is FOB Shipping Point, it is assumed that the buyer
owns the goods when the inventory leaves the seller’s place of business – the
shipping point. The buyer already owns the goods, therefore he pays the
shipping costs.

Who pays for the shipping costs?

Just like the previous discussion on the ownership of goods, there are two
terms that should be defined to identify who pays for the shipping costs: Freight
Prepaid and Freight Collect.

Generally, the seller pays for the transportation costs before shipping the
goods sold if the in a freight prepaid arrangement, while the buyer pays the
shipping entity usually upon receipt of the goods in a freight collect arrangement.
The exception to this practice is that payment by either party will not necessarily
dictate who should shoulder the cost.

Normally, the entity bearing the freight cost pays the carrier. Therefore,
goods are typically shipped freight prepaid when the terms are FOB Destination,
and freight collect when the term is FOB Shipping Point.

The following table summarizes the freight terms of an entity.

The shipping costs are debited to the Freight In account when the
shipping term is FOB Shipping Point. This account is added to the cost of
purchases to arrive at the net cost of purchases, and therefore is a part of your
Cost of Goods Sold in the income statement.

The shipping costs are debited to the Freight Out account when the
shipping term is FOB Destination. This account is part of your selling expenses
under the operating expenses in your income statement.

DISCOUNTS
You probably have visited a mall and saw signs like “10% off” or a “Buy 1,
Take 1” of a certain item. Upon seeing this sign, you took a glance for a moment
and eventually bought the item. These signs are examples of discounts.

There are two types of discounts offered in the market: the cash discount
and the trade discount.
 Trade discounts are offered to encourage you to buy the item. This is
what you see in the market such as the one illustrated above. There is no trade
discount account and there is no special entry for this discount. Instead, what
appears in the accounting records is the net amount of the sales price less the
trade discount. This amount is referred to as the invoice price.

Illustration. Assume that National Bookstore purchased for resale books

on account with a list price of P108,000 on May 15, 2018. Conanan Bookstore,
the supplier, allowed a 15% trade discount as well with credit terms of 10, 2/10,
n/30. National Bookstore paid the invoice in full on May 20, 2018.

The credit terms of 10, 2/10, n/30 means that a trade discount of 10
percent is given. Two percent cash discount is also given if the amount is paid
within ten days from the date of purchase. The full amount is payable within 30
days.

To compute for the trade discount, we multiply P108,000 by 10% to arrive

at P10,800 trade discount. This amount is not recorded in the books of the
business. Rather, what appears in the books is the amount of P97,200. The entry
for this transaction is shown below.

Cash discount. Cash discount is offered to encourage prompt payment. If

a trade discount is also offered, cash discount is computed based on the net
amount after the trade discount.

There are two types of cash discounts: purchase discounts on the part
of the buyer and sales discounts on the part of the seller.

A cash discount is designated by the notation as “2/10” which means that

a buyer may avail of a two percent discount if the invoice is paid within 10 days
from the invoice date. The period covered by the discount - in this case 10 days –
is called discount period.

Using the illustration given above, P1,944 is recorded as a discount on

May 20, 2018 (P97,200 times 2 percent). Thus, a cash outflow of P95,256
(P97,200 less P1,944) is recorded in the books. The entry is shown below.

Assume that the amount is paid beyond the discount period, example May
30, 2018, the full amount is recorded as shown below.

PERIODIC AND PERPETUAL INVENTORY SYSTEMS

 As previously illustrated on the income statement of the merchandising
business, merchandise inventory is a factor in the computation of the cost of
sales. To determine the quantity sold and quantity on stock, we must adopt a
system to efficiently manage the inventories.

There are two systems to determine the quantity and cost of the goods for
sale: Perpetual Inventory System and the Periodic Inventory System.

Perpetual Inventory System. Under the perpetual inventory system, the

inventory account is continuously updated. When a purchase is made, the
inventory account is debited. When there is a sale, the cost of the inventory sold
is credited to the inventory account. With this system, the balance of the
inventory account should reconcile to the physical count of the goods at the end
of the year.

Periodic Inventory System. Under the periodic inventory system, there is

no entry to the inventory account when a purchase or a sale of inventory is
made. The following accounts are used to accumulate information related to the
purchase of inventory: Purchases, Purchases Returns and Allowances, and
Purchases Discounts. Only at the end of the period during a physical account
that a Inventory account is used to establish its proper balance.

Illustration. The following are some the transactions of National

Bookstore for the month of August 2018.

August
2 Purchased merchandise on credit from Domdane Publishers, terms
2/10, n/30, FOB Shipping Point, P74,000.

3 Sold merchandise on credit to Book Sale Shop, 1/10, n/30, FOB

Shipping Point, P10,000. The cost of the goods sold is P7,500.

5 Sold merchandise for cash, P7,000. The cost of the goods sold is
P5,250.

6 Received a freight bill from Shipping Express for shipments received

on August 2, P570.

7 Paid Domdane Publishers for purchases made on August 2.

10 Purchased merchandise from Conanan Publishers, terms 2/10, n/30,

FOB Shipping Point, P26,500, including freight costs of P500.

11 Returned P2,000 inventory to Conanan Publishers.

12 Issued a credit memo to Book Sale Shop for sales made on August 3,
P1,500.

13 Received payment from Domdane Publishers.

Journal Entries:
VALUE-ADDED TAX
You might have noticed that the previous transactions did not incorporate
value added tax (VAT) entries. In real Philippine setting, there exists a VAT of
twelve (12) percent for each sales and purchase transactions.

Assume that Pacifica Agrivet Supplies based in Malaybalay City trades

specialty feeds for pigs, chicken, and other farm products. On June 12, 2018,
Pacifica Agrivet Supplies purchased on account specialty feeds worth P750,000.
A wholesaler operating in the region bought for cash all of the available feeds on
June 23, 2018. The amount received was P1,000,000. Pacifica paid the value
added tax due at the end of the month.

The entries for the value added tax (VAT) are as follows:
DISCUSSION QUESTIONS
1. Explain the operating cycle of a merchandising business.
2. Who owns the goods in transit in a sales transaction with an FOB
Destination arrangement? Who owns the goods in transit in a purchase
transaction with an FOB Shipping Point arrangement?
3. What are the types of discounts? Explain.
4. What are the major differences in the accounting treatments between
periodic and perpetual inventory systems?
5. When do you use the Input Tax account? The Output Tax?

TRUE OR FALSE
1. The credit term “10, 3/10, n/30” means that a buyer is entitled to a 10
percent cash discount, with additional 3 percent trade discount if paid
within 10 days.
2. Merchandise inventory could include items that are still in transit.
3. The term freight prepaid or freight collect will dictate who will shoulder the
transportation cost.
4. There is no need for a physical inventory count in the perpetual inventory
system.
5. A bill of lading is a document prepared by the seller detailing the terms of
delivery.
6. An advantage of periodic inventory system is that it requires less
recordkeeping than the perpetual inventory system.
7. Discounts offered to the buyer to encourage early payment are called
trade discounts.
8. The debit balance in the inventory account in the trial balance under the
periodic inventory system is the amount of the inventory at the end of the
current year.
9. If the seller is to shoulder the cost of the delivery, the term is stated as
FOB Destination.
10. Transportation In is treated as a deduction of the cost of goods sold
section of the income statement.