ACCOUNTING FOR A MERCHANDISING BUSINESS

A merchandising business differs from a service company. Merchandising companies earn

income by buying and selling products or merchandise. Merchandise represents goods or items
intended for sale by a merchandiser in the normal course of business operations. For a grocery
store, merchandise includes meats, vegetables, canned goods and other items for sale. For a
service station, it could be gasoline, oil and automobile parts. Merchandising concerns purchase
their merchandise inventories from wholesalers, manufacturers, and other suppliers.

Income Statement for a Merchandising Concern

The income statement of a service business differs from that of a merchandising concern.
The general format of the income statements of service and merchandising companies are
illustrated below.

Service Company Merchandising Concern

Income Statement Income Statement

Revenues Revenues from Sales

| |
Minus minus

Expenses Cost of Goods Sold

| |
Equals equals

Net Income Gross Margin from Sales

|
minus

Operating Expenses
|
equals

Net Income

The illustration above shows that a merchandising business income statement has three
parts: (1) revenues from sales, (2) cost of goods sold, and (3) operating expenses. While the
income statement of a service type shows that the net income is computed by deducting expenses
from revenues, in a merchandising concern, the gross margin from sales must be computed first
before operating expenses are deducted in order to arrive at net income.
 Revenues from sales arise from sales of goods or merchandise by the merchandising
business and the cost of goods sold tells how much the merchandiser paid for the goods or
merchandise sold. The difference between revenues from sales and cost of goods sold is known
as gross margin from sales. Gross margin from sales is also known as gross margin or gross
profit.

Operating Expenses are those expenses, other than cost of goods sold, that are incurred in
running the business. In a merchandising company, operating expenses are similar to the
expenses we have seen in a service business. Net Income for a merchandising company is what
is left after deducting operating expenses from gross margin. In some instances, if the operating
expenses are greater than the gross margin, the difference represents net loss.

Sales and Related Accounts

Sales

Under accrual accounting, revenues from the sale of merchandise are considered to be
earned in the accounting period in which title for the goods passes from seller to buyer. Gross
sales consist of total sales for cash and total sales on credit during an accounting period.

An invoice is a document prepared by the seller of the merchandise. The seller calls it a
sales invoice. A copy is given to the buyer of merchandise and he calls it a purchase invoice.

The Sales account is a revenue account that is used only for recording sales of
merchandise whether the sale is made for cash or for credit.

Example 1: On January 1, 2009, S Company sold merchandise to B Company on

cash basis, P 10,000.

Journal entry:

Cash 10,000
Sales 10,000
To record sale of merchandise
for cash

Example 2: On January 5, S Company sold merchandise to B Company, P 15,000

terms 2/10, n/30.

Journal entry:

Accounts Receivable 15,000

Sales 15,000
To record sale of merchandise
on account.
Sales Returns and Allowances

A customer may return merchandise if it is defective or broken. Or returns by customers

may be due to wrong specifications, poor quality of merchandise or erroneous merchandise being
delivered. This is known as sales return. Or the customer may be willing to accept the goods
despite certain defects but a reduction in the invoice price will be granted to the customer. This
is known as sales allowance. Whether the transaction is a sales return or a sales allowance, the
account title to describe both situations is called Sales Returns and Allowances. This account is
a contra revenue account and it is debited when the customers return merchandise. The seller
issues a document, credit memorandum, to evidence sales return. This document informs a
customer that a credit has been made to the customer’s account receivable for a sales return or
allowance.

Example 3: On January 7, S Company issued a credit memorandum

to B Company for defective merchandise returned
previously purchased on January 5. The merchandise
returned is worth P 2,000.

Journal entry:

Sales Returns and Allowances 2,000

Accounts Receivable 2,000
To record a return from a
customer.

Example 4: On January 8, S Company gave a cash refund to B Company for

defective merchandise returned previously bought on January 1 worth
P 1,000.

Journal entry:

Sales Returns and Allowances 1,000

Cash 1,000

Take note that Sales Returns and Allowances account is used in recording returns of
customers instead of directly debiting the Sales account. This is important because it will
disclose the extent and the total amount of sales returns. Management will then be able to
investigate the causes especially if the amount of returns is very excessive. Proper measures will
then be taken and if needed will be implemented to be able to address the problem.

Sales Discount

When goods are sold on credit, both parties should have an understanding as to the
amount and time of payment. These terms are usually printed on the sales invoice and constitute
part of the sales agreement.
 To encourage customers to pay their accounts promptly, a cash discount is usually given
if payments are received within a certain number of days from the date of sale. From the seller’s
viewpoint, cash discount is called Sales Discount.

Some common examples of cash discounts terms are:

2/10, n/30 - This means that the buyer may deduct 2% from the amount due if he pays
in full within 10 days from the date of the sales invoice. If the buyer does
not pay within 10 days, then the full amount must be paid within 30 days
from the date of the sales invoice.

2/10, 1/15, n/30 - This means that the buyer may deduct 2% from the amount due if full
payment is made within 10 days from the date of the sales invoice, 1 % if
full payment is made within 11 to 15 days from the date of the sales
invoice, or the full amount will be due if payment is made within 16 to 30
days from the date of the sales invoice.

2/EOM, n/60 - This means that the buyer may deduct 2% from the amount due if full
payment is made by the end of the month. Otherwise, full payment is due
60 days from the date of the invoice.

2/10/EOM, n/60 - This means that the buyer may deduct 2 % from the amount due if full
payment is made by the 10th day of the month following the date of sale.
Otherwise, full payment is due 60 days from the date of the invoice.

When no offer of cash discount is made by the seller, the credit terms will just give the
maximum time period of payment. Example of these credit terms are n/30, n/60 or n/10/EOM.

The Sales Discount account is debited by the seller when a customer avails of the cash
discount. Sales Discount is a contra revenue account. Sales Discount and Sales Returns and
Allowances account are both deducted from Sales to arrive at Net Sales in the Income Statement.

Example 5: On January 15, S Company received full payment from B Company.

Journal entry:

Cash 12, 740

Sales Discount 260
Accounts Receivable 13,000

Computation:

Accounts Receivable, January 2 sales P 15,000

Less returns on January 7 2,000
Balance P 13,000
Less 2% cash discount (P13,000 x 2%) 260
Amount due from B Company P 12,740
Income Statement Presentation – Revenues from Sales

The following is a partial income statement presentation of the revenues from sales
section:

Sales P xxx
Less: Sales Returns and Allowances P xx
Sales Discounts xx xx
Net Sales P xxx

Cost of Goods Sold

The cost of goods sold refers to the cost of merchandise sold to customers during an
accounting period. Oftentimes, cost of goods sold represents the largest single deduction in a
company’s income statement.

The format of the cost of goods sold section of the income statement is shown as follows:

Merchandise Inventory, beginning P xxx

Add: Purchases P xxx
Add: Transportation-in xx
Total P xxx
Less: Purchase Returns and Allowances P xx
Purchase Discounts xx xx
Net Purchases xxx
Total Cost of Goods Available For Sale P xxx
Less: Merchandise Inventory, end xxx
Cost of Goods Sold P xxx

Inventory Systems

The two basic inventory systems are the periodic inventory system and the perpetual
inventory system. Both systems can be used to record information about cost of goods sold, cost
of inventory available for sale as well as cost of ending inventory.

Perpetual Inventory System

The perpetual inventory system provides detailed records of the quantity and cost of each
item of inventory and continuously shows the cost of goods on hand.

Under the perpetual inventory method, the cost of each item is debited to the
Merchandise Inventory account as it is purchased. As items are sold, the Merchandise Inventory
account is credited and the Cost of Goods Sold is debited for the cost of the items sold. At the
end of the accounting period, a physical inventory is taken by actually counting the number of
units on hand which is then compared with the records showing the number of units remaining.

The perpetual inventory system has traditionally been used by companies that sell high-
unit value items such as automobiles, stereo, television sets, furniture and other large home
appliances.

Periodic Inventory System

Under the periodic inventory method, the count of the physical inventory takes place
periodically, usually at the end of the accounting period, and no detailed records of the physical
inventory on hand are maintained during the period. The Purchases account is used to record the
cost of merchandise bought by the business. When merchandise is sold, revenue is recorded but
not the cost of merchandise sold. When financial statements are prepared, the company takes a
physical count of the ending merchandise inventory which is then used in computing the cost of
goods sold.

The periodic inventory system is used by merchandising companies with low value items
of inventory. This inventory system will be given emphasis on this text.

Purchases and Related Accounts

Purchases

Under the periodic inventory system, when a merchandising business buys goods or
merchandise for resale, the Purchases account is debited for the cost of the goods purchased.
The Purchases account is used only for merchandise purchased for resale.
Other assets bought which will be used for operations of a business should be recorded in
the appropriate asset account, not the Purchases account. For example, when an office
equipment is bought, the account Office Equipment is debited.

Purchases, like Sales, can be made both on cash and on credit. A document called
invoice is prepared by the seller. The seller calls it a sales invoice. A copy is given to the buyer
who calls it a purchase invoice.

Example 1: On January 1, 2009, B Company bought merchandise from S Company on

cash basis, P 10,000.

Journal entry:

Purchases 10,000
Cash 10,000
To record purchase of merchandise
for cash.
 Example 2: On January 5, B Company bought merchandise from S
Company, P 15,000 terms 2/10, n/30.

Journal entry:

Purchases 15,000
Accounts payable 15,000
To record purchase of merchandise
on account.

Purchase Returns and Allowances

From the buyer’s viewpoint, the returns and allowances on goods it purchased is called
Purchase Returns and Allowances. This is a contra account whose normal balance is a credit. A
business may return merchandise if it is defective or broken. Or returns may be due to wrong
specifications, poor quality or erroneous merchandise being delivered. This is known as
Purchase Returns. Or the purchaser may be willing to accept the goods despite certain defects
but a reduction in the invoice price will be granted the purchaser. This is known as Purchase
Allowance. Whether the transaction is a purchase return or a purchase allowance, the account
title to describe both situations is called Purchase Returns and Allowances. The purchaser may
issue a document called a debit memorandum to evidence the purchase returns. This will inform
the seller that a debit has been made to the purchaser’s accounts payable for a purchase return or
allowance.

Example 3: On January 7, B Company issued a debit memorandum

to S Company for defective merchandise returned
previously purchased on January 5. The merchandise
returned is worth P 2,000.

Journal entry:

Accounts Payable 2,000

Purchase Returns and Allowances 2,000
To record return of merchandise.

Example 4: On January 8, B Company received a cash refund from S Company

for defective merchandise returned previously purchased on January
1 worth P 1,000.

Journal entry:

Cash 1,000
Purchase Returns and Allowances 1,000
 The Purchase Returns and Allowances account is used in recording returns of
merchandise to the seller instead of directly crediting the Purchases account. This will enable the
management to determine the extent and the total amount of purchase returns. Proper measures
then may be taken to know the causes of any excessive returns.

Purchase Discount

To encourage buyers to pay their accounts promptly, a cash discount is usually given if
payments are made within a certain number of days from the date of purchase. From the buyer’s
viewpoint, cash discount is called Purchase Discount.

The Purchase Discount account is credited by the buyer when he avails of the cash
discount. Purchase Discount is a contra account similar to Purchase Returns and Allowances.
Both have a normal credit balance and are both deducted from Purchases in the Income
Statement.

Example 5: On January 15, B Company paid in full its account to S

Company.

Journal entry:

Accounts Payable 13,000

Cash 12,740
Purchase Discount 260

Computation:

Accounts Payable, January 5 purchase P 15,000

Less returns on January 7 2,000
Balance P 13,000
Less 2% cash discount (P13,000 x 2%) 260
Accounts payable to S Company P 12,740

Transportation Costs on Merchandise Purchased or Sold

The buyer and the seller must agree on who is responsible for paying any freight costs on
merchandise bought or sold. In computing cost of goods sold, transportation costs play a very
important part. Failure to include transportation costs will affect the cost of goods sold and
ultimately affect the net income. The following terms are important in understanding
transportation costs on merchandise:
 1. FOB shipping point - the term means free on board at shipping point. The
purchaser or buyer agreed to shoulder all the
transportation costs from the point of shipment up to the
point of destination. The buyer receives title to the
goods at shipping point.

2. FOB Destination - the term means free on board at destination. The seller
agreed to shoulder all the transportation costs from the
point of shipment up to the point of destination. The
buyer receives title to the goods at point of destination.

3. Freight prepaid - when the seller pays the transportation costs at the time
of shipment.

4. Freight collect - when the buyer pays the transportation costs upon
receipt of the goods at the place of destination.

Assume the following example:

On January 10, B Company located in Cebu purchased merchandise worth P 100,000

from S Company located in Manila. Freight or transportation costs amounted to P 10,000.
Terms: 2/10, n/30. Assume the following shipping terms:

a) FOB shipping point, freight collect

b) FOB shipping point, freight prepaid

c) FOB destination, freight prepaid

d) FOB destination, freight collect

The following are the entries on both the books of B Company and S Company. Assume
in all cases, B Company paid in full on January 20.

a) Terms of shipment: FOB shipping point, freight collect

B Company S Company

Jan 10 Purchases 100,000 Accounts Receivable 100,000

Accounts Payable 100,000 Sales 100,000

14 Freight In 10,000 No entry

Cash 10,000

20 Accounts Payable 100,000 Cash 98,000

Purchase Discount 2,000 Sales Discount 2,000
Cash 98,000 Accounts Receivable 100,000
 Computation: Computation:

Accounts Payable P 100,000 Accounts Receivable P 100,000

Less Cash discount Less Cash discount
(2% x 100,000) 2,000 (2% x 100,000) 2,000

Cash to be paid P 98,000 Cash to be collected P 98,000

b) Terms of shipment: FOB shipping point, freight prepaid

B Company S Company

Jan 10 Purchases 100,000 Accounts Receivable 100,000

Accounts Payable 100,000 Sales 100,000

10 Freight In 10,000 Accounts Receivable 10,000

Accounts Payable 10,000 Cash 10,000
To record freight. To record freight.

20 Accounts Payable 110,000 Cash 108,000

Purchase Discount 2,000 Sales Discount 2,000
Cash 108,000 Accounts Receivable 110,000

Computation: Computation:

Accounts Payable (Mdse.) P 100,000 Accounts Receivable (Mdse.) P 100,000

Accounts Payable (Freight) 10,000 Accounts Receivable (Freight) 10,000
Total P 110,000 Total P 110,000
Less Cash discount Less Cash discount
(2% x 100,000) 2,000 (2% x 100,000) 2,000

Cash to be paid P 108,000 Cash to be collected P 108,000

c) Terms of shipment: FOB destination, freight prepaid

B Company S Company

Jan 10 Purchases 100,000 Accounts Receivable 100,000

Accounts Payable 100,000 Sales 100,000

14 No entry Freight Out 10,000

Cash 10,000

20 Accounts Payable 100,000 Cash 98,000

Purchase Discount 2,000 Sales Discount 2,000
Cash 98,000 Accounts Receivable 100,000

Computation: Computation:
 Accounts Payable P 100,000 Accounts Receivable P 100,000
Less Cash discount Less Cash discount
(2% x 100,000) 2,000 (2% x 100,000) 2,000

Cash to be paid P 98,000 Cash to be collected P 98,000

d) Terms of shipment: FOB destination, freight collect

B Company S Company

Jan 10 Purchases 100,000 Accounts Receivable 100,000

Accounts Payable 100,000 Sales 100,000

14 Accounts Payable 10,000 Freight Out 10,000

Cash 10,000 Accounts Receivable 10,000
To record payment
of freight to shipping
firm.

20 Accounts Payable 90,000 Cash 88,000

Purchase Discount 2,000 Sales Discount 2,000
Cash 88,000 Accounts Receivable 90,000

Computation: Computation:
Accounts Payable bal. P 90,000 Accounts Receivable bal. P 90,000
Less Cash discount Less Cash discount
(2% x 100,000) 2,000 (2% x 100,000) 2,000

Cash to be paid P 88,000 Cash to be collected P 88,000

The Freight In account is used to record freight costs incurred by the buyer in acquiring
the merchandise. Another name for Freight In is Transportation In which has a normal debit
balance. Freight In is shown in the Cost of Goods Sold section of the Income Statement. It is
added to Purchases to arrive at the net cost of purchases. It is called an adjunct account.

The Freight Out account is used to record shipping costs shouldered by the seller for
sales of merchandise to customers. Another term is Delivery Expense which is shown on the
Selling Expense section of the Income Statement.
Trade Discounts

Merchandisers offer their goods to customers using a catalog where the goods are listed
with their prices. The prices are called catalog or list prices. A trade discount, which is a
percentage reduction from a published list price, may be granted to certain customers such as
dealers or wholesalers for buying frequently and in large quantities. Since a trade discount is
granted at the point of sale, this is immediately deducted from the list price and the difference
which is called the gross invoice price will be the basis for invoicing and recording.

Both the buyer and seller do not record the list prices and the trade discounts in their
books of accounts. The buyer records purchases and the seller records sales net of trade
discounts.

To illustrate: Assume that S Company sold merchandise with a list price of P

100,000 and a trade discount of 15% and 10%. Sales price or invoice price is computed as
follows:

List price P 100,000

Less: First trade discount
(15% x P 100,000) 15,000
Balance after discount P 85,000
Less: Second trade discount
(10% x P 85,000) 8,500
Net sales price P 76,500

Alternative way of computing the invoice price is to multiply the list price by the
complements of the trade discounts allowed. The computation is shown below:

Invoice Price = (P 100,000 x 85% x 90%)

= P 76,500

The complement of 15% is 85%, and the complement of 10% is 90%.

 EXERCISES

Exercise 6-1

The following transactions were completed by Valle Verde Company during July, 2009.

July 1 Bought merchandise from City Trading, P 11,160, terms 3/20, n/40

4 Sold merchandise on account to Arrow Co. for P 5,355, terms 2/20, n/40.

6 Returned P 285 worth of defective merchandise to City Trading.

8 Arrow Co. returned P 480 worth of defective merchandise.

10 Sold merchandise for cash to Ali, P 3,263.

13 Purchased supplies on account from National Bookstore, P 4,800, terms 2/10, n/30.

14 Returned P 250 worth of defective supplies to National Bookstore.

16 Sold merchandise for cash to Emma, P 4,000.

18 Emma returned P 300 worth of defective merchandise.

21 Paid City Trading in full.

22 Sold merchandise on account to Villar for P 7,500, terms 2/10, n/30.

23 Paid in full National Bookstore.

24 Arrow Co. paid in full its account.

26 Purchased office equipment for cash from San Pedro Company for P10,300.

27 Received an allowance for P 1,500 for a slight defect on equipment bought from San Pedro
Company.

31 Received cash from Villar in full payment of account.

Required: 1) Journalize the transactions on the books of Valle Verde Company. Show
computations. Omit explanations.

2) Prepare a trial balance.

Exercise 6-2

Determine the amount to be paid in full settlement of each of the following invoices,
assuming that credit for returns and allowances was received prior to payment and that all
invoices were paid within the discount period.

Transportation Returns and Amount

Merchandise Paid by Seller Allowances Paid

a) P 8,000 - FOB shipping point, 1/10, n/30 P 2,400

b) 3,000 P 100 FOB shipping point, 2/10, n/30 1,400
c) 19,000 - FOB destination, n/30 800
d) 5,000 150 FOB shipping point, 1/10, n/30 1,200
e) 10,000 - FOB destination, 2/10, n/30 -

Exercise 6-3

Determine (1) selling price (2) amount of cash discount and (3) the amount to be
collected for each of the following invoices:

Invoice Date List Price Trade Discount Credit Terms Date Paid

a) Aug. 16 P 70,000 10%, 20% 1/10/eom, n/60 Sept. 2

b) July 2 55,000 20%, 30% 2/10, n/30 July 11
c) May 7 120,000 5%, 10%, 20% 2/10, 1/15, n/30 May 19
d) April 5 150,000 20%, 40% 2/10, n/30 May 4
e) Jan. 4 50,000 5%, 8%, 10% 2/10, 1/15, n/30 Jan. 19
f) Mar. 8 30,000 2%, 3%, 4% 2/10, n/30 Mar. 31
g) Oct. 12 80,000 1%, 2%, 4% 3/10, n/40 Oct. 22
g) June 13 100,000 10%, 15% 3/10, 2/15, n/30 June 26

Exercise 6-4

The Sel Co. sold merchandise to Bun Co. on October 1, 2009 at a list price of P 100,000,
trade discount of 5% and 10%, FOB destination. Cash discount terms: 3/eom, n/60. Bun Co.
paid the freight on October 5, 2009 amounting to P 5,000. Because defective merchandise
amounting to P 3,000 was erroneously delivered, the Sel Co. issued a credit memorandum to Bun
Co. on October 7, 2009. Bun Co. paid in full the balance due on October 31, 2009.

Required: Journalize the above transactions on the books of Sel Company

and Bun Company. Show computations. Omit explanations.
Exercise 6-5

On December 1, 2009, X Co. bought merchandise from Y Co. costing P 50,000, terms
2/10, n/30, FOB shipping point. Y Co. prepaid the freight of P 6,000 on December 2, 2009. On
December 4, Y Co. issued a credit memorandum for damaged merchandise returned by X Co.
amounting to P2,000. X Co. paid in full the balance due on December 11, 2009.

Required: Journalize the above transactions on the books of X Co. and Y Co.

Exercise 6-6

Merchandise with a selling price of P 200,000 was sold to a customer on account, terms
3/10, n/30, FOB shipping point, with the seller paying the transportation cost amounting to P
14,000.

Required: Compute for the following:

1) Amount of the sale

2) Amount debited to customer’s account
3) Amount of cash discount
4) Amount collectible if payment is made within the discount
period.