Principles of Accounting

Chapter 3: Merchandising Operations

What are Merchandising Companies?

Merchandising companies are companies that purchase finished

goods and then sell them for a profit.

There are two types of merchandising companies:

1. Retail

2. Wholesale
Operating cycles

The operating
cycle of a
merchandising
company
ordinarily is
longer than
that of a
service
company.
Inventory Systems

There are two types of ways in which inventory is managed:

• Perpetual inventory system or

• Periodic inventory system.

Periodic Inventory System

Features:
• Purchases of merchandise increase Purchases.

• Ending Inventory determined by physical count.

• Calculation of Cost of Goods Sold:

$
Beginning inventory 100,000
Add: Purchases, net 800,000
Goods available for sale 900,000
Less: Ending inventory 125,000
Cost of goods sold 775,000
Perpetual Inventory System

Features:
• Purchases increase Merchandise Inventory.

• Cost of Goods Sold is increased and Merchandise Inventory is

decreased for each sale.
• Physical count done to verify Merchandise Inventory balance.
Purchases - Terminology

• Purchase Returns and Allowances

• Purchase Discounts

• Freight costs
Purchases - Terminology

Purchase Returns and Allowances

Purchaser may be dissatisfied because goods are damaged or

defective, of inferior quality, or do not meet specifications.

Purchase Return Purchase Allowance

Return goods for credit if May choose to keep the
the sale was made on merchandise if the seller
credit, or for a cash will grant an allowance
refund if the purchase (deduction) from the
was for cash. purchase price.
Purchases - Terminology

Purchase Discounts (Discounts Received)

Discounts received are settlement discounts that a business has

been offered by its suppliers and which it takes up. The business
pays earlier but pays less.

Discount received can only be recognised when payment is made

within a given time frame so that a business becomes entitled to a
discount.
Purchases - Terminology

Purchase Discounts (Discounts Received) - Examples

2/10, n/30 1/10 EOM n/10 EOM

2% discount if 1% discount if Net amount due

paid within 10 paid within first within the first
days, otherwise 10 days of next 10 days of the
net amount due month. next month.
within 30 days.
Purchases - Terminology

Freight Costs

Seller places goods Free On Board

the carrier, and buyer pays freight
costs.

Seller places goods Free On Board

to the buyer’s place of business,
and seller pays freight costs.
Purchases – Periodic Inventory System

Illustration: On May 4, Sauk Stereo purchased merchandise amounting to

$3,800 from PW Audio Supply.

May 4 Purchases 3,800

Accounts payable
3,800
Purchases – Periodic Inventory System

Illustration: If Sauk pays Haul-It Freight Company $150 for freight charges on
its purchase from PW Audio Supply on May 6, the entry on Sauk’s books is:

May 6 Freight-in (Transportation-in) 150

Cash
150
Purchases – Periodic Inventory System

Illustration: On May 8, Sauk Stereo returns $300 of goods to PW Audio Supply

and prepares the following entry to recognize the return.

May 8 Accounts Payable 300

Purchase Returns and Allowances 300
Purchases – Periodic Inventory System

Illustration: On May 14 Sauk Stereo pays the balance due on account to PW

Audio Supply, taking the 2% cash discount allowed by PW Audio for payment
within 10 days. Sauk Stereo records the payment and discount as follows.

May 10 Accounts Payable 3,500

Purchase Discounts 70
Cash 3,430
Sales - Terminology

• Sales Returns

• Sales Discounts / Discounts Allowed

Sales - Terminology

Discounts
Businesses sometimes give discounts to customers.
There are two main types of discount:
• trade discount; and
• settlement discount (or cash discount)
Sales - Terminology

Trade Discount
This is price reduction given to a customer. The invoice is issued at the reduced
amount so there are no double entry problems caused by this type of discount.
There is simply a sale at a lower price.
Sales - Terminology

Trade Discount - Example

A building merchant offers bags of cement for sale at Rs.500 per bag. The price
is reduced to Rs. 450 for any customer who buys 10 or more bags.
The reduction of Rs. 50 per bag is a trade discount.
Arif buys 20 bags off the building merchant.
If there were no discount Arif would have to pay Rs. 10,000. However, because
of the discount Arif has to pay only Rs.9,000.
Note that from the builder’s point of view this is a sale for Rs.9,000. There is no
special accounting needed for trade discounts.
Sales - Terminology

Settlement Discount
A settlement discount might be offered in order to persuade credit customers to
pay earlier.
When a business makes a sale it does not know whether the customer will take
advantage of the settlement discount or not so the invoice is issued at the full
amount. An adjusting entry is made if a customer subsequently takes the
discount.
If a discount is taken it is known as a discount allowed from the point of view of
the seller and a discount received from the point of view of the buyer.
Sales - Terminology

Settlement Discount – Example

A building merchant offers credit terms to large customers.
It offers a 3% discount to any credit customer who settles an invoice within 30
days. (This means that the customer would only pay 97% of the invoice amount).
The reduction of 3% is a settlement discount.
Bashir Builders buys goods worth Rs. 80,000.
If Bashir Builders pays within 30 days it need only pay Rs.77,600.
If Bashir Builders does not pay within 30 days it must pay Rs.80,000.
Sales - Terminology

Discount Allowed
Discounts allowed are settlement discounts that a business offers to its credit
customers. It is up to the customer to decide whether to pay the full amount or to
pay the smaller amount earlier.
Sales – Periodic Inventory System

Illustration: PW Audio Supply, records the sale of $3,800 of merchandise to

Sauk Stereo on May 4.

May 4 Accounts Receivable 3,800

Sales 3,800
Sales – Periodic Inventory System

Illustration: To record the returned goods received from Sauk Stereo on May 8,
PW Audio Supply records the $300 sales return as follows.

May 8 Sales Returns and Allowances 300

Accounts Receivable
300
Sales – Periodic Inventory System

Illustration: On May 14, PW Audio Supply receives payment of $3,430 on

account from Sauk Stereo. PW Audio honors the 2% cash discount and records
the payment of Sauk’s account receivable in full as follows.

May 14 Cash 3,430

Sales Discount 70
Accounts Receivable
3,500
Perpetual Inventory System

A perpetual system means that account balances are known on a real- time
basis.

In a perpetual inventory system, the merchandise inventory account and cost of

goods sold account are updated immediately when transactions occur.
Purchases – Perpetual Inventory System

Illustration: On May 4, Sauk Stereo purchased merchandise amounting to

$3,800 from PW Audio Supply.

May 4 Merchandise inventory 3,800

Accounts payable
3,800
Purchases – Perpetual Inventory System

Illustration: If Sauk pays Haul-It Freight Company $150 for freight charges on
its purchase from PW Audio Supply on May 6, the entry on Sauk’s books is:

May 6 Merchandise Inventory 150

Cash
150
Purchases – Perpetual Inventory System

Illustration: On May 8, Sauk Stereo returns $300 of goods to PW Audio Supply

and prepares the following entry to recognize the return.

May 8 Accounts Payable 300

Merchandise inventory 300
Purchases – Perpetual Inventory System

Illustration: On May 14 Sauk Stereo pays the balance due on account to PW

Audio Supply, taking the 2% cash discount allowed by PW Audio for payment
within 10 days. Sauk Stereo records the payment and discount as follows.

May 14 Accounts Payable 3,500

Merchandise inventory 70
Cash 3,430
Purchases – Perpetual Inventory System

Illustration: If Sauk Stereo failed to take the discount, and instead made full
payment of $3,500 on June 3, the journal entry would be:

May 3 Accounts Payable 3,500

Cash 3,500
Sales – Perpetual Inventory System

Two Journal Entries to Record a Sale

#1 Cash or Accounts receivable XXX Selling

Sales Price
XXX

#2 Cost of goods sold XXX

Cost
Merchandise inventory
XXX
Sales – Perpetual Inventory System

Illustration: PW Audio Supply, records the sale of $3,800 of merchandise to

Sauk Stereo on May 4. Assume the merchandise cost PW Audio Supply $2,400.

May 4 Accounts Receivable 3,800

Sales 3,800

May 4 Cost of Goods Sold 2,400

Merchandise Inventory 2,400
Sales – Perpetual Inventory System

Illustration: To record the returned goods received from Sauk Stereo on May 8,
PW Audio Supply records the $300 sales return (assume a $140 cost) as follows.

May 8 Sales Returns and Allowances 300

Accounts Receivable
300
May 8 Merchandise Inventory 140
Cost of Goods Sold
140
Sales – Perpetual Inventory System

Illustration: Assume the returned goods were defective and had a scrap value
of $50, PW Audio would make the following entries:

May 8 Sales Returns and Allowances 300

Accounts Receivable
300
May 8 Merchandise Inventory 50
Cost of Goods Sold
50
Sales – Perpetual Inventory System

Illustration: On May 14, PW Audio Supply receives payment of $3,430 on

account from Sauk Stereo. PW Audio honors the 2% cash discount and records
the payment of Sauk’s account receivable in full as follows.

May 14 Cash 3,430

Sales Discount 70
Accounts Receivable
3,500
Adjusting Entries – Perpetual Inventory System

One additional adjustment to make the records agree with the actual inventory
on hand, that is:

Adjusting Merchandise Inventory and Cost of Goods Sold.

Adjusting Entries – Perpetual Inventory System

Illustration: Suppose that PW Audio Supply has an unadjusted balance of

$40,500 in Merchandise Inventory. Through a physical count, PW Audio
determines that its actual merchandise inventory at year-end is $40,000. The
company would make an adjusting entry as follows.

Cost of Goods Sold 500

Merchandise Inventory
500
Perpetual Vs. Periodic Inventory System
Perpetual Vs. Periodic Inventory System
Example
Solution – Periodic Inventory System

The cost of
sales total is
then transferred
to the statement
of
comprehensive
income.
(Income Summary A/c)
Solution – Perpetual Inventory System
Example 2 – Perpetual Inventory System
Example 2 – Perpetual Inventory System

520,000
(COGS) (COGS)
92,000

92,000