Chapter 3

Accounting for Merchandising Business

3.1. Characteristics of merchandising business
 Merchandising enterprise: refers to a business organization, which buys finished products
and resells them to its customers for profit.
 Assets held for resale in the normal course of business of a merchandising enterprise are
called merchandise inventory.

A merchandising business earns income by buying and selling goods, which are called
merchandise inventory. Whether a merchandiser is a wholesaler or a retailer, it uses the same
basic accounting methods as a service company. However, the buying and selling of goods
adds to the complexity of the business and of the accounting process. To understand the issues
involved in accounting for a merchandising business, one must be familiar with the operating
cycle.

The following diagram can help you to better visualize the flow of goods from a manufacturer
to the final consumer:

sells

Manufacturers wholesalers sell Retailer final consumer

Goods goods

A wholesaler is a trader, which buys goods from manufacturers and sells them to a retailer or
another wholesaler. It is the retailer who sells the goods to the final consumer by buying them
from wholesalers (or sometimes from a manufacturer).

 Difference between merchandising and service enterprises

o A merchandising enterprise sells finished products rather than services and revenues
from sells of finished goods are called sales.
o A merchandising business has two types of major expenses - cost of goods sold which
represent expired cost of merchandise sold and operating expenses which represent all
other expenses necessary to run the business.
o In a merchandising business net income is calculated after two steps: first gross profit is
determined to be the difference between sales and cost of goods sold and then net
income is determined by deducting operating expenses from gross profit.
o A merchandising business uses relatively more types of accounts including sales and
purchase related ones (discussed in subsequent sections).
- These differences are best illustrated by focusing on the revenue and expenses in the
following condensed income statements.

1|Page
 Service Business

Fees earned (Revenue from service) ---------------xxx

Operating expenses (-------------------------------- xxx
Net income ---------------------------------------- xxx
- The revenue activities of a service business involve providing services to customers.

Merchandising Business

Sales (When merchandise to sold) ------------------------------xxx

Cost of good (its cost recognize as expenses) -----------------xxx
Gross profit ------------------------------------------------------- xxx
Operating expenses --------------------------------------------- xxx

Net income ----------------------------------------------------- xxx

Balance Sheet:

The Balance Sheet of a service business and that of a merchandising business are similar in
every aspect except one thing. The current assets section of the Balance Sheet of a
merchandising business includes one asset that service companies do not have. That is
merchandise inventory. Merchandise inventory refers to goods bought by a merchandising
business for resale to customers. So, if a merchandising business has some unsold goods
(merchandise) on hand at the end of the year this would be reported as one asset on the Balance
Sheet.

 Difference between merchandising and manufacturing enterprises

o A merchandising enterprise does not manufacture products rather buy them from
manufacturers or other merchandisers.
Major activities
o Buying and selling merchandise inventory
Accounting
o Though there are some basic differences between merchandising enterprise and the other
types of businesses, accounting cycle is equally applicable to any kind of business. Like in
the other organizations, the following are applied in accounting for financial affairs of a
merchandising business:
 Double entry accounting and the rules of debts and credits
 Use of various types and classes of accounts
 Use of journals and ledgers
 Preparation of financial statements
 And others
Operating cycles differ, depending upon the nature of the business and its operations. The
operating cycle begins with spending cash and it ends with receiving cash from customers.
Most companies buy merchandise on credit and sell it on credit, thereby engaging in the
following four transactions:
 Purchase of merchandise inventory for cash or on credit

2|Page
  Payment for purchases made on credit
 Sales of merchandise inventory for cash or on credit
 Collection of cash from credit sales

Flow of Costs
The flow of costs for a merchandising company is as follows.
Beginning inventory plus the cost of goods purchased is the cost of goods available for sale. As
goods are sold, they are assigned to cost of goods sold.
Those goods that are not sold by the end of the accounting period represent ending inventory
Companies use one of two systems to account for inventory: a perpetual inventory system or
a periodic inventory system.
3.2.2. Perpetual Inventory Systems

A perpetual inventory system continuously records the amount of inventory on hand (perpetual
=continuous). Under this system, the merchandise inventory account is debited or credited
every time (goods) are bought or sold. When an item is sold, its cost is recorded in a separate
cost of goods sold account in addition to recording sales.

The cost of merchandise on hand can be looked up from the merchandise Inventory account
any time, without conducting a physical inventory.

Perpetual system: In a perpetual inventory system, companies keep detailed records of the
cost of each inventory purchase and sale. These records continuously perpetually show the
inventory that should be on hand for every item. Under a perpetual inventory system, a
company determines the cost of goods sold each time a sale occurs.
Journal entries under perpetual inventory system to be prepared are:
1. At the time of purchase of merchandise
Merchandise inventory XX at cost
Accounts payable/cash XX
To record the purchase of merchandise
2. At the time of sale of merchandise
Accounts receivable or cash XX at retail price
Sales XX
To record sale of merchandise
3. To record Cost of goods sold
Cost of goods sold XX
Merchandise inventory XX at cost
To record the cost of merchandise sold
4. To record purchase returns and allowances
Accounts payable or cash XX
Merchandise inventory XX
5. No adjusting entry or closing entry for merchandise inventory is needed at the end of each
accounting period.
3|Page
3. 2.1. The Periodic Inventory System

Under this system, as the name periodic suggests, the inventory account is updated only periodically
i.e., only at the end of a period.

When goods are bought, a temporary purchases account is debited instead of the inventory account
itself. Likewise, when goods are sold revenue is recorded, but the fact that there is a reduction in
merchandise inventory is not recognized. This is because the Merchandise Inventory account is not
credited every time goods are sold.

Therefore, if one wants to know the cost of goods on hand, it is a must that a physical inventory be
conducted first. The account doesn’t reflect the value of goods on hand because it was not up dated
when merchandise was bought and sold. Physical inventory means counting the quantity of goods on
hand. Once the quantity of goods on hand has been determined, it is multiplied by the unit price of
those goods to determine the cost of goods on hand.

In conclusion, under the periodic system, since the merchandise inventory account is not continually
updated, the cost of merchandise on hand is determined only at the end of the period after carrying out a
physical inventory.

Periodic system: In a periodic inventory system, companies do not keep detailed inventory
records of the goods on hand throughout the period. Instead, they determine the cost of goods
sold only at the end of the accounting period that is, periodically. At that point, the company
takes a physical inventory count to determine the cost of goods on hand. To determine the cost
of goods sold under a periodic inventory system, the following steps are necessary:
 Determine the cost of goods on hand at the beginning of the accounting period.
 Add to it the cost of goods purchased.
 Subtract the cost of goods on hand at the end of the accounting period.
The journal entries periodic system to be prepared is:
1. At the time of purchase of merchandise:
Purchases XX at cost
Accounts payable or cash XX
2. At the time of sale of merchandise:
Accounts receivable or cash XX at retail price
Sales XX
3. To record purchase returns and allowance:
Accounts payable or cash XX
Purchase returns and allowance XX
4. To record adjusting entry or closing entry for merchandise inventory:
Income Summary XX
Merchandise inventory (beginning) XX

4|Page
5. To close beginning inventory
Merchandise inventory (ending) XX
Income summary XX
To record ending inventory
o Accounting for a merchandising business is usually divided into two broad categories –
Accounting for Purchases and Accounting for Sales which are covered in the following
sections.
3.2. Accounting for purchases of merchandises
1. Purchasing Procedures – The purchasing of merchandise inventory in a merchandising
business may involve the following procedures
 Issuance of purchase requisition – a business form usually prepared by the storekeeper
requesting the purchasing department of a business for purchase of certain types and
quantities of inventory items not available in store.
 Issuance of purchase order – a business form issued by the purchase department
requesting vendors to supply the business with certain types and quantities of inventory on
a specified date and at an agreed upon price. This form usually contains information such as
the type and quantity of inventory ordered, price, and terms of payment and transportation.
 Preparation of receiving report – a business form usually prepared by the storekeeper
evidencing the types, amounts and conditions of inventory received from vendors.
 Recording purchase – keeping record of purchases which is done by the accounts
department of a business. Journal entries are prepared after checking the consistency of
information contained in three basic purchase source documents: purchase order, receiving
report and purchase invoice.
 Settlement of invoices – this refers to making cash payments for inventories purchased and
is done after checking the accuracy and validity of the invoice to be settled.
2. Recording Purchases – Purchases of merchandise inventory are recorded and accumulated
in a general ledger account called Purchases. Purchases is an income statement account to
be closed at the end of each accounting period to the Income Summary or to Cost of Goods
Sold account. It has a debit normal balance. The following entries are needed to record
purchases of merchandise inventory:
Purchases xx
Accounts Payable/Cash xx
Example:

IKA Company bought goods worth Birr 43,000 from Saba Co., which is based in Addis Ababa,
on account on January 4, 2001, terms 20/10, n/30. Record the transaction.

Solution:

January 4 – Purchases …………………........43,000

Accounts payable………………..43,000
3. Deductions from Purchases – refer to reductions in the cost of purchases as a result of
such transactions as early payment of purchase invoices, returns of damaged or defective
goods and/or price reduction received from sellers for minor defects on goods purchased.
i) Purchase Discounts – When goods are sold on credit, sellers usually offer price reduction
called Cash Discounts to encourage buyers to pay invoices early. Such price reductions are

5|Page
 identified by the purchaser as Purchase Discounts and recorded as a credit to Purchase
Discounts account, while the seller identifies them as Sales Discounts and records them as
a debit to Sales Discounts account. Purchase discounts and sales discounts are contra
accounts reported as deductions from purchases and sales, respectively.
Agreements between the buyer and the seller concerning such issues as to when to
make payment for the goods, who will pay for transportation, who owns goods in
transit, etc are collectively called sales/purchase terms. Credit terms, part of the sales
terms, refer to arrangements between the buyer and the seller as to when to pay for
purchases on credit. The credit terms indicate
 Credit period – the time period within which the invoice for credit purchase is due.
For example, net 30 days (usually written as n/30) means that the amount is due 30
days from the date of invoice. Other terms include n/45 and n/eom (net due by the
end of the month in which the purchase was made).
 Discount rate and period – Discount rate represents cash discount expressed in
percentage of the invoice amount. Discount period is time period, shorter than the
credit period, within which the invoice must be entirely or partly paid to get the
stated discount. For example, 2/10 indicates that the buyer can get 2% discount if it
settles the invoice within 10 days from the date of the invoice. Discounts are
applicable to only amount of invoice paid within the discount period and on invoice
amount net of returns and allowances (discussed below).
The buyer for invoices paid within the discount period makes the following entry:
Accounts Payable xx
Purchase Discount xx
Cash xx

EXAMPLE: IKA Company bought goods worth Birr 50,000 from Gibir Company on account
on January 14, 2001, terms 1/10,n/60. IKA Company paid on January 24, 2001. Record the
transactions on both dates.

Solution:
Jan. 14. Purchases………………..50,000
A/P………………………50,000
Jan. 24. A/P…………………… …50,000
Purchase Discounts …….......500
Cash……………………... 49,500
ii) Trade Discounts – refer to reduction from list prices of goods. They help sellers to
adjust list prices without changing price catalogs and/or charge different prices to
different customers based on the quantity of goods bought. For example, sellers do not
charge the same price for small and large quantity purchases. In our country, trade
discounts are commonly identified as Big Discounts and are used to reduce selling
prices of goods so as to attract buyers especially during holiday weeks. Trade discounts
are used to determine the actual invoice price of goods and do not appear in the
accounting records.

iii) Purchase Returns and Allowances – When goods purchased are damaged or found to
be defective or with the wrong color and size, the buyer may take any of the following
actions depending mainly upon the extent of the damage or defect:

6|Page
  Return the goods and get credit (reduction in amount payable to the seller) or refund
for the value of the returned goods resulting in Purchase Returns to the buyer and
Sales Returns to the seller.
 Keep the goods but ask for price adjustment which when approved by the seller
results in Purchase Allowances for the buyer and Sales Allowances for the seller.
Returns and allowances are recorded by the purchaser as credit to Purchases Returns
and Allowances - a contra purchases account while the seller records them as a debit to
contra sales account called Sales Returns and Allowances. The purchaser issues a
document called debit memo to request credit for returns and allowances and the seller
issues a credit memo to notify its acceptance of the buyer’s request for credit.

The following entry is made by the buyer when it receives credit memo from the seller
for returns and allowances:
Accounts Payable/Cash xx

Purchase Returns and Allowances xx

In the previous example for IKA Company, a portion of the goods worth birr 5,000 bought on
January 14 from Gibir Company were of the wrong size. Gibir Company acknowledged this
and gave IKA Company a 5% price allowance on January 17.

What should IKA Company record on January 17?

Solution:
January 17 A/P…………………………………250
Purchase Returns and Allowance…………250
When both purchase discounts and purchase returns and allowances are deducted from
purchases what is obtained is called Net purchase. That is,

Gross Purchase…………………………XX
Less: Purchase discounts…………………….(XX)
Purchase returns and allowances………(XX)
Net Purchases…………………….XX
Purchases of merchandise identified (recorded) in the ledger as merchandise inventory.
Merchandising enterprise can accumulate in the MI account the cost of all merchandise
purchased for resale during the accounting period.
When purchases are made for cash, the transaction could be recorded as follows:
Merchandise inventory…………………………………………………..xx
Cash………………………………………………………………….xx
When purchases are made on account, the transaction could be recorded as follows:
Merchandise inventory …………………………………………………..xx
Account payable……………..……………………….xx

7|Page
Cash purchases of merchandise are recorded as follows:
On January 3, ABC Company purchased merchandise for cash from XYZ company, $2,510.
201
2 0
Jan. 3 Merchandise Inventory 2510 0
0
Cash 2510 0
Purchased inventory from XYZ
Purchases of merchandise on account are recorded as follows:
On January 4, if the same company purchased merchandise on account from xyz, $9,250.
0
Jan. 4 Merchandise Inventory 9250 0
0
Account Payable 9250 0
Purchased inventory on account

Purchases Discounts
Purchases discounts taken by the buyer for early payment of an invoice reduce the cost of the
merchandise purchased. Most businesses design their accounting systems so that all available
discounts are taken. Even if the buyer has to borrow to make the payment within a discount
period, it is normally to the buyer’s advantage to do so.

To illustrate, assume that ABC issues an invoice for $3,000 to XY, dated March 12, with terms
2/10, n/30. The last day of the discount period in which the $60 discount can be taken is March
22. Assume that the company pays the invoice on March 22,

XY would record the ABC invoice and its payment at the end of the discount period as follows:
Mar 1 0
. 2 Merchandise Inventory 3000 0
0
Accounts Payable 3000 0
2 0
2 Accounts Payable 3000 0
Cash 2940 0

8|Page
 0
0
Purchase discount 60 0

If ABC does not take the discount because it does not pay the invoice until April 11, it would
record the payment as follows:
1 0
Apr. 1 Accounts Payable 3000 0
0
Cash 3000 0

Purchases Returns and Allowances

When merchandise is returned (purchases return) or a price adjustment is requested
(purchases allowance), the buyer (debtor) usually sends the seller a letter or a debit
memorandum. A debit memorandum, shown below, informs the seller of the amount the buyer
proposes to debit to the account payable due the seller. It also states the reasons for the return
or the request for a price reduction.
The buyer may use a copy of the debit memorandum as the basis for recording the return or
allowance or wait for approval from the seller (creditor). In either case, the buyer must debit
Accounts Payable and credit Merchandise Inventory. To illustrate, ABC records the return of
the merchandise indicated in the debit memo as follows:
Mar 0
. 7 Accounts Payable 900 0
0
Merchandise Inventory 900 0
Debit Memo No. 18

When a buyer returns merchandise or has been granted an allowance prior to paying the
invoice, the amount of the debit memorandum is deducted from the invoice amount. The
amount is deducted before the purchase discount is computed.

For example, assume that on May 2, ABC purchases $5,000 of merchandise from Delta Data
Link, subject to terms 2/10, n/30. On May 4, ABC returns $3,000 of the merchandise, and on

9|Page
May 12, ABC pays the original invoice less the return. ABC would record these transactions as
follows:
0
May 2 Merchandise Inventory 5000 0
0
Accounts Payable 5000 0
Purchased merchandise
0
4 Accounts Payable 3000 0
0
Merchandise Inventory 3000 0
Returned portion of merchandise
purchased
1 0
2 Accounts Payable 2000 0
0
Cash 1960 0
0
Purchase discount 40 0
Paid invoice (($5000 -
$3000) X 2%
= $40; $2000 - $40 =
$1960)

3.3 ACCOUNTING FOR SALES

1. Selling Procedures – The selling process may involve the following procedures
 Approving purchase orders – usually done by the credit department of a business,
this step involves making sure that incoming purchase orders are valid and the
information related to price and product type match with the currently available price
policy and types of product. Besides, if the buyer is requesting for credit, this
procedure aims at making sure that such buyer worth giving credit. When a purchase
order is approved it will be converted into a sales order.
10 | P a g e
  Inventory dispatch order – a form prepared by the sales department ordering the
store to ship certain inventory items to a buyer whose purchase order is approved.
 Issuance of sales invoice – done by the accounts section in consultation with the sales
department and the store, contains the terms related to payment, transportation and
related issues. Is prepared based on information contained on customer purchase
order, inventory dispatch order and sales order.
 Recording sales – keeping record of sales which is done by the accounts department
of a business. Journal entries are prepared after checking the consistency of
information contained in three basic sales source documents: sales order, inventory
dispatch order and sales invoice.
 Collection of invoices – this refers to collection of cash from customers for
inventories sold to them.
 When a merchandising company transfers goods to the buyer, in exchange for cash or
a promise to pay at a later date, revenue is produced to the company. This revenue is
recorded in a Sales account. However, the sales revenue, which is reported on the
Income Statement, is Net Sales. That is,
Net Sales = Gross Sales – Sales Discounts- Sales Returns and Allowances

2. Recording Sales – Sales of merchandise inventory are recorded and accumulated in a

general ledger account called Sales. This is an income statement account to be closed at the
end of each accounting period to Income Summary. As a revenue account, it has a credit
normal balance.
 The gross sales amount is obtained from sales invoices.
 An invoice is a document, prepared by the seller of merchandise to notify to the buyer the
details of the sale.
 These details can include number of items sold, unit price of items, total price, terms of sale
and manner of shipment.
 When goods are delivered to the customer, the Sales account is credited because revenues
are increased by credits. A company can sell goods either for cash or on account.

The following entries are needed to record sales of merchandise inventory:

Accounts Receivable/Cash xx
Sales xx
When merchandise is sold on cash, the Cash account is debited and the revenue account Sales
is credited.

Example – IKA Company based in Bahir Dar, buys and sells used commodities. On January
14. 2001. IKA sold goods for Birr 20,000. Record the transaction.

Answer:
January 14, Dr. Cash………………………………..20,000.00
Cr. Sales……………………………………20,000.00
Recording Credit Sales

The Accounts Receivable account is debited when goods are sold on account (for credit).

Example - IKA sold goods worth Birr 35,000 on account on January 15, 2001. Record the
transaction.
11 | P a g e
Solution

January 15. Accounts Receivable…………………..35,000.00

Sales…………………………………………35,000.00
Determining Gross Sales when there are trade discounts

A trade discount is a percentage deduction from the specified list price or catalogue price of
merchandise.

Trade discounts allow us:

 To avoid publishing a new catalogues every time prices change.

 To grant quantity discounts.
 Quotation of different prices to different types of customers.

Trade discounts are not recorded in the seller’s accounting records; they are only used to
calculate the gross selling price. Example: IKA sold 500 T.V. sets, each with a list price of Birr
80, on January 17, 2001 for cash. It gave the customer a 30% trade discount, as the customer
was a very loyal one. Record the sale.

Answer:
List price of goods ( 80 X 500) Birr 40,000
Less: Trade discount (30 % of 40,000) (12,000)
Invoice price 28,000
Journal entry:
Cash……………………..28,000
Sale………………………28,000

Sales Discounts

Sales Discounts are deductions from invoice price to customers who pay early when goods are
sold on credit.

As a seller, you would usually want to be paid as soon as possible. This is because, as you can
imagine, you can use the money for various purposes once you have been paid. If you want
your customers to pay you early the customary practice is to offer them a (deduction) discount
from the invoice price if they pay early.

How much discount is given usually depends on the credit terms. These terms (agreements)
are usually stated on the invoice. The most frequently used terms are stated below:

 “n/30” or “Net 30” – means there is no discount even if the customer pays before the
payment date.
 2/10, n/30 –means the due date of the payment is after 30 days of the sale. But if the
customer pays with in 10 days she will get a 2% discount

12 | P a g e
  2/EOM, n/60- means the normal due date is with in 60 days of the sale but the customer
will get a 2% discount if she pays before the end of month of sale.

Sales discounts are purchase discounts from the side of the buyer. Sales discounts and
purchase discounts are the same thing seen from different sides. They are generally called cash
discounts together. A cash discount is, therefore, deduction from original invoice price for
early payment when goods are sold on credit (on account).

Example: On January 21, 2001 IKA Company sold merchandise for birr 20,000 on account.
The credit terms are 2/30, n/30. The customer paid on January 31, (10 days after invoice date).

How much would IKA Company collect from this sale?

Record the necessary journal entries on January 21 and January 31.

Solution:

Since the customer paid with in the discount period, i.e., with in 10 days, she will get a 2%
discount. Therefore,

Invoice price……………………..20,000
Less: Sales Discount (2% X 20,000)………(400)
Cash collected …………. 19,600
Journal Entries:
January 21 A/R…………………..20,000
Sales……………………..20,000
January 31, Cash………………….19600
Sales Discounts ………...400
A/R………………..20,000
You might initially have thought of debiting the Sales account for Birr 400 on January 31,
since the actual cash collected from the sales of those goods is birr 400 less than what was
recorded as Sales on January 21. But it is better to record the reduction in sales in a separate
contra Sales account. A contra account reduces another account.

In this case, the amount in the Sales Discount account will be deducted from (Gross) Sales on
the income statement. That way, we can disclose how much sales discount was offered and
taken during the year on the income statement, separately.

Sales Returns and Allowances

Customers can return merchandise they have bought if they find it to be defective or of the
wrong model, or unsatisfactory for a variety of reasons.

A Sales return is merchandise returned by a buyer. The buyer would be paid back her money
if she has already paid.

13 | P a g e
A sales allowance is a deduction from the original invoice price when the customer keeps the
merchandise but is dissatisfied. If, for example, a customer buys an item worth birr 100 and
finds it to be of the wrong color after receiving it, she may still want to retain the item even if
she is dissatisfied with its color. In that case the seller may let her pay only, say, Birr 95 by
giving her an allowance of Birr 5.

Example: IKA Company sold merchandise worth Birr 15, 000 on February 3, 2001 on account
terms 2/10, n/30. On February 5, the buyer returned a portion of the goods worth Birr 5,000 as
they were found to be of the wrong model. The buyer then paid on February 13, 2001.

Record the necessary journal entries on February 3, 5 and 13.

Solution:
February 3 A/R…………………….15,000
Sales …………………….15,000
February 5 Sales Returns and Allowances ………5,000
A/R………………………………….5,000
February 13 Cash…………………………………..9800
Sales Discount ……………………….. 200
A/R…………………………10,000
Here, the buyer paid with in the discount period. Therefore, the amount that would be
collected is

15,000 – 5,000 = 10,000

Deduct: 2% Cash discount (200)
Cash collected 9800

3.5. Transportation costs

Once merchandise has been bought it has to be moved from the seller’s place to the buyer’s
place. A third party comes in to the scene here: the transportation company who moves the
goods between the two places.

That is:

Seller Goods goods goods Buyer

Freighter

So, the question is, who is going to pay to the freighter (transportation) company. Who covers
the transportation costs depends, as you might have guessed, on the agreement between the
buyer and seller. The agreements are usually stated in the either of these two terms:

14 | P a g e
 FOB Destination – means “free on board at destination “. That is, since the destination of
the goods is the buyer’s place, it is free at destination means transportation cost is paid
when the goods are loaded. It simply means the seller pays transportation cost. FOB
Destination means goods are shipped to their destination (to the buyer) with out
transportation charge to the buyer.
FOB shipping Point –means “ free on board at shipping point”. That is, goods are loaded
(on a truck or train) or shipped free of charge. It is, therefore, the buyer, which pays to the
transportation company when the goods reach the buyer (their destination) Briefly, when
the terms are FOB Shipping Point the buyer pays transportation costs.

Transportation costs paid by a buyer of merchandise increase the cost of merchandise. They are
recorded in a separate Transportation-In account that is used to record freight costs incurred in
the acquisition of merchandise.

Example: IKA Company bought goods worth Birr 85,000 on account, terms 2/10,n/60 FOB
shipping point on March 2, 2001.Transportoin cost of Birr 1,500 was paid on March 2. Ika
Company paid on March 31, 2001. Record the necessary journal entries

Solution:

Here, since the terms are FOB Shipping Point, the buyer (Ika) pays transportation.

March 2 -Purchase…………………..85,000
A/P………………………..85,000
-Transportation In……….....1500
Cash………………………1500
March 31 A/P…………………………85,000
Cash………………………..85,000
Example: IKA Company sold goods worth Birr 135,000 terms 1/15, n/EOM on February 1,
2001. FOB Destination. It also paid transportation costs of Birr 800 on Feb. 1. The customer
paid IKA on February 16, 2001. Record the relevant Journal entries.

Answers:
Feb 1 A/R…………………………..135,000
Sales…………………………..135,000
Feb 16 Sales discount ………………….1,350
Cash………………………….133,650
A/R…………………………135,000
Delivery Expense…………………800
Cash……………………………800
The Delivery Expense account shows how much was incurred to deliver goods sold to
customers. It is, therefore, shown on the income statement as a selling expense.

Example

15 | P a g e
ABC Co. sold goods worth Birr 40,000 on April 1, 2001 to IKA company terms 2/10, n/30
FOB Shipping Point. It also paid Birr 2,500 to HH Movers for transporting the goods and
added the amount to the invoice. What would each of these companies record assuming IKA
paid on April 31, 2001

ABC Co. (seller) IKA Co (Buyer)

April 1- A/R…………….40,000 April 1-Purchases …………40,000
Sales………………40,000 A/P………………….40,000
A/R…………….2500 Transport-in ………2500
Cash…………….2500 A/P………………2500
April 31-Cash……………42,500 April 31- A/P…………………42,500
A/R………………42500 Cash…………………42,500
Transfer of Title

Shipping terms determine not only determine who pays for transportation. They also determine
at what point ownership title of the goods sold transfers to the buyer. Put briefly, whose
property is it when merchandise is in transit?

1. When terms are FOB Destination we have seen that the seller covers transportation costs. By
implication the seller takes the responsibility of safely moving and delivering the goods to the
buyer. The buyer is not responsible for any damage that can happen to these goods in transit.
Therefore, the goods become the buyer’s property only when they are delivered to him /her.

Conclusion: Ownership title of the goods transfers to the buyer at destination when the terms
are FOB destination.

2. When the terms are FOB shipping point the buyer pays freight costs. The buyer takes the
responsibility of safely moving these goods to his /her own place. The merchandise, therefore,
becomes his/her property as soon as they are loaded on a truck or a train.

Conclusion: Ownership title of goods transfers to the buyer at shipping point when terms are
FOB shipping point.

The following table summarizes it all.

Sipping terms Transportation paid Title Transfers When goods are

by
Delivered to

FOB Destination Seller Buyer

FOB shipping point Buyer Freighter (transportation company)

FINANCIAL REPORTING FOR MERCHANDISING FIRMS

I) Financial Statements
A. Income Statement -Two forms:
i) Single-step
16 | P a g e
 o Has two sections only: total revenues and total expenses
o No details of net sales, cost of goods sold, operating expenses, etc
o Net income is computed in a single step by deducting total expenses from total
revenues
o Revenues
 Net sales  Other income
 Rent income
o Expenses
 Cost of goods sold
 Selling expenses
 Administrative
expenses
 Other expense
o Net income = total revenues – total
expenses

17 | P a g e
 ii)Multiple-step
oShows in detail net sales, cost of goods sold, operating expenses and other items
oYou have to go several steps to compute net income
oHas several sections, subsections, totals and intermediate balances, including the
following
o Gross profit section
Gross sales xx
Less: Sales discounts xx
Sales returns and allowances xx (xx)
Net sales xx
Cost of goods sold:
Beginning Merchandise Inventory xx
Add: Net Purchases
Gross Purchases xx
Less: Purchase Discounts xx
Returns and Allowances xx (xx) xx
Merchandise Available for Sale xx
Less: Ending Merchandise Inventory (xx)
Cost of Goods Sold (xx)
Gross profit xx
o Operating expenses section
 Selling expenses which comprise all expenses incurred in connection with
selling activities including sales salary expenses, delivery expenses,
advertising expenses, store supplies expenses, depreciation on store
equipment, etc.
 Administrative expenses, which comprise all expenses incurred in
connection with administration or general operations including office
salary expenses, utility expenses, office supplies expenses, depreciation on
office equipment, etc.
o Other income and expenses section
 Rent income, interest income, gain from disposal of plant assets, etc
 Interest expenses, loss from disposal of plant assets, etc
B. Capital Statement (Statement of Owners Equity)
C. Balance Sheet ( Report and Account Forms), and
D. Statement of Cash Flows (Cash Inflows and Outflows)
II) Adjusting Entries

 Make adjustment for all accrued and deferred items

 Adjustment of merchandise inventory
o to remove beginning inventory (which is assumed to be sold)
Income summary xx
Merchandise inventory xx
o To record ending inventory (known by physical count)
Merchandise inventory xx
Income summary xx

18 | P a g e
III) Closing Entries

 Close all revenue and contra purchase accounts to Income Summary account
Sales xx
Rent Income xx
Purchases Discount xx
Purchases Returns and Allowances xx
Income Summary xx
 Close all purchases, expenses and contra sales accounts to Income Summary account
Income Summary xx
Purchases xx
Freight-in xx
Sales Discounts xx
Sales Returns and Allowances xx
Salary Expense xx
Rent Expense xx
Miscellaneous Expenses xx
 Close debit or credit balance of Income Summary to capital account
Income Summary (credit balance) xx
AA, Capital xx
 Close drawing account to capital account
AA, Capital xx
AA, Drawing xx

19 | P a g e
Illustration
The following is the trial balance of Hard Works, a merchandising business owned by Yibeltal
and the company use periodic inventory system. All accounts have been adjusted except the
Merchandise Inventory account.
Hard Works
Trial Balance
December 31, 2002
Account title Dr. Cr.
Cash 19,663
Account Receivable 1,880
Merchandise Inventory 7,000
Accounts Payable 700
Yibeltal, Capital 25,000
Yibeltal,Drawings 2,000
Sales 14,600
Sales Discounts 44
Sales Returns and Allowances 20
Purchases 6,000
Purchase discounts 82
Purchase Returns and allowances 100
Transportation –In 75
Selling expenses 2,650
Administrative expenses 1,150 ________
40,482 40,482

A physical inventory of merchandise carried out on December 31, 2002 showed Birr 10,000 of
goods on hand.
Required:
A- Prepare a worksheet for Hard Works.
B- Prepare financial statements from the worksheet
C- Record the necessary adjustment journal entry in relation to merchandise
Inventory
D- Record closing entries

20 | P a g e
 Hard Works Co.
Worksheet
For the year ended December 31, 2002
Trial Balance Adjustment Adjusted Trial Income Balance sheet
Account title balance statement
Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
Cash 19,663 19,663 19,663
Account Receivable 1,880 1,880 1,880
Merchandise 7,000 10,000 7,000 10,000 10,000
Inventory
Accounts Payable 700 700 700
Yibeltal, Capital 25,000 25,000 2,5000
Yibeltal, Drawings 2,000 2,000 2,000
Income summery 7,000 10,000 7,000 10,000 7,000 10000

Sales 14,600 14,600 14600

Sales Discounts 44 44 44
Sales Returns and 20 20 20
Allowances
Purchases 6,000 6,000 6,000
Purchase discounts 82 82 82
Purchase Returns and 100 100 100
allowances
Transportation –In 75 75 75
Selling expenses 2,650 2,650 2,650
Administrative 1,150 1,150 1,150
expenses
40,482 40,482 17,000 17,000 50,482 50,482 16,939 24782 33,543 25,700
7,843 78,43
24,782 24782 33,543 33,543

Note:

The merchandise inventory account before adjustment shows the inventory on hand at the
beginning of the period. This is because, since purchases and sales of merchandise have not
been debited or credited to the merchandise inventory account, this account would still show the
beginning inventory amount at the end of the period.

Therefore, an adjustment journal entry is needed to update this account. At the end of the period,
a physical inventory would be conducted to determine the amount of inventory on hand.
The adjustment journal entry removes beginning inventory amount from the merchandise
inventory account and replaces it with the (ending) actual value of merchandise inventory on
hand as determined by the physical inventory.

21 | P a g e
The adjustment is:
Income summary (beginning inventory)…………..XXX
Merchandise amount inventory……………………XXX
Merchandise Inventory…………………………….XXX
Income Summary…………………………………..XXX
An adjustment journal entry for Hard Works is presented latter in (c).
Financial Statements for Merchandising Business
Hard Works Co.
Income statement
For the year ended December 31, 2002

Net sales…………………………………………………..Br.14536
Expenses:
Cost of goods sold………………………2893
Operating Expenses …………………….3800 (6693)
Net Income…………………………………..……………….7843
The Multiple –Step Income Statement
Hard Works Co.
Income statement
For the year ended December 31, 2002
Revenue:
Gross Sales……………………………………………… Br. 14600
Less: Sales Discounts ………..44
Sales Returns &All……20……………… (64)
Net Sales 14536
Less: Cost of goods sold:
Beg. Inventory (Jan 1)…………………..7,000
Add: Purchase………………………6,000
Less: Purchase.……………….(82)
Purchase Ret & all…….(100)
Net Purchases……………..5818
Add: Transportation –In ……………75
Total cost of purchase……..5893
Total cost of Goods Available for sale……………..12,893
Less: ending Inventory (Dec.31)…………………………(10,000)
Cost of Goods sold…………………………………………..(2893)
Gross Profit……………………………………………11,643
Operating Expenses:
Selling Expenses……………….2,650
Admin. Exp…………………….1,150
Total operating expenses……………….. (3800)
Net Income……………………………… 7,843

22 | P a g e
 Hard Works Co.
Statement of Owner’s Equity
For the year ended December 31, 2002

Yibeltal Capital Jan1,2002………………………Br..25,000

Add: Net Income for the year…………………………7843
Deduct: Owner’s withdrawal during the year………....2,000
Yibeltal Capital December 31, 2002…………………30843
Hard Works Co.
Balance sheet
For the year ended December 31, 2002

Assets: Liabilities & capital

Liabilities:
Cash…………………..19663 A/P……………………700
A/R…………………… 1880 Owner’s Equity:
Merch. Inventory…….10, 000 Yibeltal Capital … 30,843
Total Assets………….31, 843 Total Liab. & O/E……31,843

Adjustment Journal entry

-Income summary…………………..7,000
Merchandise Inventory………………7,000
-Merchandise Inventory…………….10,000
Income Summary…………………….10,000

23 | P a g e
Closing entries
a. To close sales account
-Sales………………………………..14,600
Income summary……………………..14,600
b. To close sale discount & sale return and allowances
-Income summary………………………66
Sales discount………………………………44
Sales Returns and Allowances…………… 20
c. To close purchase and transportation cost
-Income summary………………………………6,075
Purchases…………………………………………….6,000
Transportation-In………………………………………..75
d. To close purchase discount and purchase return and allowance
- Purchase Discounts………………………………..82
Purchase Ret. &All……………………………...100
Income Summary……………………………………….182
e. To close expense account
- Income summary……………………………….3,800
Selling Expenses…………………………………2650
Administrative expense…………………………..1150
f. To close net income
- Income summary………………………………….7,843
Yibeltal Capital……………………………………7,843
g. To close withdrawal
- Yibeltal Captal……………………………………..2,000
Yibeltal Drawings……………………………………2,000

24 | P a g e