CHAPTER 3
Accounting cycle for merchandising business
1.1. Characteristics of merchandising business
The primary differences between a service business and a merchandising business relate to
revenue activities. Service business involve in service provision to generate revenues while
merchandising business involve in buying and selling of merchandise inventory to generate
revenue. A business that earns its revenue through buying and selling goods and services to its
customers is merchandising business.
Merchandise inventories: are goods that are held to be sold to customers in the normal
course of business activities (products that a company owns and intends to sell in its normal
operations of business).They are reported as a current asset on the balance sheet.A
merchandise business must first purchase merchandises to resell to its customers. When these
merchandises are sold the revenue is reported as sales and its cost is recognized as an expense
called cost of goods sold.
The main difference between in the accounting system of service business and merchandising
business lies on the reporting of income statement.
Income statement
Service business merchandising business
Fees earned……………………... xx Sales……………………………………xx
Less operating expense…………... xx less cost of goods sold……………….xx
Net income/net loss…………………… xxx Gross profit……………………………xx
Less operating expense………………..xx
Net income/ loss………………………..xxx
3.2 Accounting for purchases of merchandises
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Purchase of merchandise is usually identified in the ledger as “purchase”. Thus a merchandising
business can accumulate in the purchase account the cost of all merchandise purchased for resale
during the accounting period. Acquision of inventories can be made for cash or on account
When purchases are made for cash the transaction could be recorded as
Purchases………….xx
Cash…………………………xx
When purchases are made on credit the transaction can be recorded as
Purchases……………….xx
Account payable…………………….xx
Example during June 2, ABC trading company purchased $30,000 of merchandise from XYZ
Company paying $20,000cash and the remaining on account. Record transaction
Purchases………….…………30000
Cash……………………………………………….20000
Account payable……………………………………10000
Purchase discount
Purchase discount refers to the cash discount given by the seller and taken by the buyer
for early payment of an invoice. It is the means of encouraging buyers for their early
payment of their credits.
Credit terms: the terms when payments for merchandise are to be made agreed up on by
the buyer and seller are called credit terms. It is the arrangements agreed up on by the
buyer and seller as to when payments for merchandises are to be made. If the payment is
made on delivery (when merchandises are immediately delivered) the term is “cash” or
“net cash”. Otherwise, the buyer is allowed a certain amount of time known as the credit
period, in which to pay.
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Credit period: when goods are sold on account, the period of time given for payment to
the buyer or the time allowed for the buyer to pay the amount. Credit period usually
begins with date of sales. As means of encouraging payment before the end of credit
period, the seller may offer a discount for early payment of cash. Examples of credit
terms 2/10,1/15, n/30, n/eom
2/10- means 2% discount if the payment is made within 10 days (you will have a
discount of 2% if you pay or return within 10 days or discount period).
“2/10, n/30”- the credit period is 30 days if you pay or return within 10 days you
will get 2% discount unless and otherwise you must have to pay within 30 days
starting from date of sales.
1/15, n/eom means if you pay the total amount with 15 days i.ewithin the discount
period, you will get 1% deduction from the total cost of merchandise inventory.
If the payment is made at the end of the period in which the sale was made the
term is eom.
Purchase discount (contra or offsetting account of purchase) decreases purchase account and has
credit normal balance. From above example, if ABC trading pays the balance $10,000 on June
12, the purchase discount could becomputed and recorded as follows.
June, 12/Account payable…………..10000
Cash…………………………………….9800
Purchase discount………………………..200
(Purchase discount= 10000*2%)
If ABC trading company fails to take discount and full payment will be made on July 2
July, 2/ Account payable……………………...10000
Cash……………………………………….…..1000
Purchase return and allowance
The merchandises that were bought may be returned to the seller due to Wrong size, damage,
under quality, defectiveness... e.t.c. When merchandise is returned (purchases returns) or a price
adjustment (price allowance) is requested, the buyer usually communicates with the seller in
writing. Purchase returns and allowance is price reduction or price adjustment on merchandise
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purchased due to various reasons mentioned so far. It is contra (offsetting) account of purchase.
There are two documents assuring purchase returns and allowance.
Debit memorandum: prepared by the buyer (debtor) and sent to the seller giving the
details about the reason and amount of the return (wrong size, under quality, damage…).
It is a convenient medium for informing the seller (creditor) of the amount the buyer
proposes to debit account payable. The debtor may use a copy of the debit memorandum
as the basis for entry or may wait for confirmation from the creditor, which is usually in
the form of a credit memorandum. In either event, Account payable must be debited and
purchase return and allowance must be credited.
Credit memorandum: prepared by the seller (creditor) and sent to the buyer as
acknowledgement or the seller confirms the return or allowance by issuing credit
memorandum or the seller issues credit memorandum to indicate the buyer account
receivable is credited and sales return and allowance is debited. Example, XYZ trading
company returned merchandise amounting $1000 from June 2 purchased and recorded
the amount in cash. The entry is
Cash (Account payable)………………………………..1000
Purchase return and allowance………………………………….1000
Record the following transactions
June 3, ABC Company purchased merchandise amounting $20,000 for cash from XZY
Company.
Purchase…………………………..20,000
Cash …………………………………..…………20,000
June 6 purchased merchandise worth of $10,000 with terms of 2/10, n/eom from XYZ
company on account
Purchase…………………………..10000
Account payable……………………………..……….10000
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June 7 paid amount due to XYZ co. in settlement of merchandise purchased June 6
Account payable…………………………..10000
Cash ……………………………..……………………….9800
Purchase discount (2%* 10000)……………………………200
Illustration
Record the following transactions in journal entry for “L” company
July 1, purchased merchandise on account terms of 2/10, n/eom $20,000
July 5, returned 20 % of merchandise by writing a debit memorandum on June purchase
June 8, purchased merchandise for cash $10,000
July 11 paid the amount due.
Solution
June 1/ purchase ………..20000
Account payable…………………..20000
June 1/ Account payable ………..4000
Purchase return and allowance …………………..4000
June 1/ purchase ………………...10000
Cash ……………………………………………....10000
June 1/ Account payable ………..16,000
Cash ……………………………………..……15,680
Purchase discount ($16000*2%)………...…… 320
The following are the purchasing activities of “Z” Company
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Feb 1, purchased merchandise for cash $14000
Feb 1, purchased merchandise on account costing $36000 terms of 3/10,n/30
Feb 15, returned merchandise costing $4000 to the supplier
Feb 22, paid the supplier the amount due.
Feb1/ purchase ……….14000
Cash……………………………….14000
Feb 12/ purchase ………36000
Account payable…………………….36000
Feb 15/ Account payable……………4000
Purchase return and allowance…………………4000
Feb 22 Account payable………………32000
Cash……………………….………………….31040
Purchase discount (36000-4000*3%=960)………960
3.3 Accounting for sales of merchandises
Merchandise sales are usually identified in the ledger as “sales”. When merchandise is sold
for cash it could be recorded by debiting cash and crediting sales. Example, merchandise
business sold merchandise costing $1500 for cash
Cash………1500
Sales………………….1500
When merchandise is sold on credit it could be recorded by debiting account receivable and
crediting sales. Account receivable……………….xx
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Sales ………………………………………xx
Sales discount: the discount taken by the buyer for early payment of an invoice. It is
recorded by debiting sales discount and considered to be a reduction in the amount initially
recorded as sales. It is viewed as contra(offsetting against) account to sales. Example, “HO”
merchandising enterprise sold merchandise on account $500 on January1,terms of 2/10, n/30
Account receivable……………500
Sales......................………………500
What will be the journal entry if the seller received the invoice within the discount period?
Cash…………………………..490
Sales discount (500*2%)………10
Account receivable…………………………………….500
For the buyer
Purchase…………………..500
Account payable………………………….500
Account payable………………..500
If the buyer remits the amount within the invoice period
Cash……………………………………………………..490
Purchase discount……………………….………………..10
Sales return and allowance-is receiving of goods that have been already sold or reduction of
price from the original cost due it’s under quality or wrong size. Merchandise sold may be
returned by the buyer (sales return) or, because of defects or for other reasons, the buyer may
allow a reduction from the original price at which the goods were sold (sales allowance). If the
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return or allowance is for a sale on account, the seller usually gives the buyer a credit
memorandum. This memorandum shows the account for which the buyer is to be credited and
the reason therefore. The effect of sales return or allowance is reduction in sales revenue and a
reduction in cash or account receivable.Example, a seller issued a credit memorandum for $200
to customer on account for merchandise returned.
Sales return and allowance ………………….200
Account receivable……………………………………….200
Record the following transaction for both cases
June 10, XYZ company sold merchandise for Rossi company on account $900 terms 2/10, n/30
June 12, XY Company received $100 of merchandise returned from Rossi co.
June 20, XY Company received the amount of invoice.
Prepare journal entry for XY (seller) and Rossi (buyer) company
XY (seller) companyRossi (buyer) company
June 10/ Account receivable……….900 June10/ purchase……….900
Sale………………….. …..…….….900 Account payable.……....900
June 12/ sales return and allowance……100June 12/ Account payable...100
Account receivable……………..100 purchase return &allowance…..100
June 20/ cash……………………784 June 20/ A/p……..800
Sales discount (900-100*2%)……16 purchase discount…………......16
Account receivable (900-100)………….800cash (800*2% =16)………..784
Trade discount, transportation cost and sales taxes
Trade discount:a reduction in list price or the discount given for those businessesthat orders
goods in large quantities. Wholesellers are businesses that sell merchandise to other businesses
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rather than to general public. Whole sellers may offer special discount to certain classes of
buyers, such as government agencies.
Sellers and buyers do not normally record the list price of merchandise and related discounts in
their accounts (list price and related discount is not recorded neither by the buyer nor by the
seller). Example, an item has a list price of $1000 and a 40% trade discount. The seller records
the sale of the item at $600($1000-400) and the buyer also records the purchase at $600.
Buyerseller
Purchase……….600 Account receivable/cash……..600
Account payable/cash……….600 sales………………………..600
“H” trading company purchase merchandise having a list price of $10,000, such as to 20% a
trade discount in cash. Required calculate
A, the amount of trade discount and invoice price
B, record the transaction as the buyer and seller
$10000X20%=$2000 trade discount
Invoice price=list price- trade discount=$10,000-2000=$8,000
Buyer seller
Purchase…………8000 cash……………..8000
Cash…………………………..8000 sale……………………..8000
Transportation costs: depend on the terms of agreement between the buyer and seller.The terms
of agreement between the buyer and seller include provisions concerning
When the owner ship (possession or title) of merchandise passes to the buyer
Which party to bear the cost of delivering (transportation cost) merchandise to the buyer
There are two types of agreement or terms
A, FOB shipping point: it means that the seller places the merchandise “free on board” at the
shipping point and the buyer is responsible costs beyond that point and the ownership is
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transferred at the place of the seller when goods are loaded to the transportation system. In this
agreement transportation cost is covered by the buyer and this cost is considered as part of
purchasing cost of merchandise and added to buyers cost. The buyer is responsible for any risks
after merchandises are loaded to the transportation system. It can be recorded for buyer as
Freight in……………xx
Cash /Account payable………xx
B, FOB destination: it means that the seller places the merchandise “free on board” to its
destination by paying the delivery cost. The seller pays transportation cost and record by
debiting an account called transportation out or delivery expense (selling expense). Ownership or
title is transferred at the place of the buyer when transportation system is completed or when
merchandises are received by the buyer. For the seller TC is considered as selling expense and
recorded as
Transportationout (delivery expense)…………..xxno entry to the buyer
Cash /Account receivable…………………………………xx
Illustration: the following transactions were completed during July between DurbanCompany
(seller) and Bell corp. (buyer)
July 8/Durban co. sold merchandise on account $10,000 terms of FOB destination 1/15, n/eom
July 8/ Durban Company Paid transportation cost of $300 for delivery sold
July 11/ Bell corp. returned merchandise purchased on account on July 8 from Durban co. $4000
July 23/ Bell corp.Paid Durban co. for purchase of July 8, less discount and return of July 11.
Prepare journal entry for Durban co. and Bell Corporation
Durban company(seller) Bell corporation(buyer)
July 8/ Account receivable………10000 July 8/ purchase………10000
Sales…………………………….10000 Account payable……………10000
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July 8/ transportation out…………..300 no entry
Cash……………………………………300
July 11/ sales return and allowance…..4000 July 11/ Account payable….4000
Account receivable……………4000 purchase return and allowance…….4000
July 23/ cash…………………..5940 July 23/ Account payable....6000
Sales discount…………………60 cash…………………….5, 940
Account receivable…………………..6000 purchase discount……………… 60
If the seller covers the transportation cost on behalf of the buyer even though the term is FOB
shipping point, the seller records transportation cost as
Account receivable….xx
Cash…………………………..xx
Example, July 23 ABC company sold merchandise on account to XYZ company $8000 terms
FOB shipping point, n/neom
July 24/ ABC co. paid transportation charges of $3000 on behalf of XYZ company merchandise
purchased onJuly, 23
July 25/ returned merchandise total $4000
July 31/ XYZ paid to ABC co. for purchase of July23
Solution
ABC co (seller) XYZ co (buyer)
July 23/ account receivable…….8000 July 23/ purchase …….8000
Sales…………………………………8000 Account payable…….8000
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July 24/ Account receivable…..3000July 24/ transportation in…..3000
Cash………3000 Account payable………………. 3000
July 25/ sales return and allowance….4000 July 25/account payable...4000
Account receivable…………………….….4000 purchase return &allowance…….…4000
July 31/ cash……………7000 July 31/ Account payable...7000
Account receivable……………….7000 cash…………….7000
sales taxes: are taxes levied or imposed on sales of merchandise by the government to be
collected by the seller from the buyer. The liability for the sales tax is ordinarily incurred at the
time the sale is made, regardless of the term of sale. At the time of cash sales the seller collects
the sales tax. Example, “N” business center made a sale of merchandise for birr $4000 on cash to
“S” company, subject to a sales tax of 15%. The transaction could be recorded as
Cash…………………4600
Sales………………………………….4000
Sales tax payable (4000*15%)………….600
When the seller pays to the government, the transaction could be recorded as
Sales tax payable……………………600
Cash…………………………………………….600
3.4 Merchandise transactions using perpetual and periodic inventory systems
There are two main systems for accounting for merchandise held for sales(systems of accounting
for merchandise):
Periodic inventory systems
Perpetual inventory systems
Periodic inventory systems: In this system, only revenues from sales are recorded when sales are
made but, no attempt is made on the sales date to record the cost of merchandise sold.Periodic
inventory systemsdo not show the amount of inventory available for sale or sold during the
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period. It is only detail listing of merchandise on hand (physical inventory)at the end of
accounting period. This physical counting of merchandise at the end of the period is used to
determine
The cost of merchandise sold during the period
The cost of merchandise on hand at the end of the period
In periodic inventory system purchases of inventory are recorded in the purchase account, while
in perpetual inventory system purchases of merchandise is recorded in merchandise inventory
account. In this system also transportation cost paid when purchasing of merchandise is FOB
shipping point transportation in or fright in is debited but under perpetual inventory system,
merchandise inventory account is debited.Note: revenues from sales are recorded in the same
manner in both systems.
Perpetual inventory system: in this system, each purchase and sale of merchandise is recorded in
the merchandise inventory account. As a result, the amount of merchandise available for sale and
the amount sold are continuously (perpetually) disclosed in the inventory records.Under
perpetual system both sales revenue and the cost of merchandise sold are recorded on the date of
sales when each item of merchandise is sold. In this inventory system, purchase return and
allowance are not used rather merchandise inventory is recorded at their costs.
Accounting for purchases in perpetual inventory system
Cash purchase or purchase on account is recorded as
Merchandise inventory…………..xxx
Cash / Account payable……………………….xxx
If there is purchase discount or purchase return and allowance the transaction could be recorded
as Account payable……………xxx
Cash…………………………………………….xxx
Merchandise inventory………………………..xxx
Accounting for sales in perpetual inventory system
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Sales for cash
Example, on January 3 “X” sold merchandise for cash of $1800 and the cost of merchandise sold
was $1200
Jan 3/ cash ………....1800
Sale……………………….1800
Jan 3/ cost of merchandise sold …….1200
Merchandise inventory………………………1200
Sales on accountsales discount
Account receivable……………xxx cash…………….xx
Sales……………………………………..xxx sales discount…xx
Cost of merchandise sold……….xxx Account receivable……xxx
Merchandise inventory…………………….xxx
Sales return and allowanceif the buyer pays transportation cost
Sales return and allowance ……xxx FOB shipping point
Account receivable………………………….xxx merchandise inventory...xxx
Cost of merchandise sold……..xxx Account payable (cash)…………..xxx
Merchandise inventory……………………….xxx
FOB destination
Account receivable……..…..xx
Sales…………………………xx
Cost of merchandise sold…..xxx
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Merchandise inventory…………....xx
Transportation out ….xxx
Cash………………………….xxx
Cost of merchandise sold
For merchandising enterprises that uses the periodic system, the cost of merchandise sold during
the period is reported in a separate section in the income statement.Merchandise business using
this inventory system reports the cost of merchandise sold, the beginning and ending inventories
in the income statement in the following manner
Cost of merchandise sold
Beginning inventory……………………………………………………...........xxx
Purchases…………………………………………. xx
Less purchase discount and allowance……………xx
Net purchases…………………………………………………xxx
Add: Freight in …………………………………………….......xx
Cost of merchandise purchased…………………………………………………xxx
Merchandise available for sale…………………………………………………..xxx
Less merchandise inventory on hand at the
End of the period (Ending inventory)……………………………………………xxx
Cost of merchandise sold………………………………………………………..xxxx
Or CGS=BI+ Cost of merchandise purchased- EI=BI +CMP–EI
Cost of merchandise purchased= net purchase + transportation in
CGAFS= BI + CMP
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CGAFS= Cost of goods available for sale
CGAFS-EI=CGS
Note-Purchase returns & allowances and purchase discounts are deducted from the total
purchases to yield the net purchases.
- Transportation costs are added to the net purchases to yield cost of merchandise purchased.
- The beginning inventory id added to the cost of merchandise purchase to yield the merchandise
available for sale
- Ending inventory is subtracted from merchandise available for sale to yield cost of merchandise
sold.
Given
Beginning inventory………….. ……. $60,000
Purchase ……………………………...$500,000
Purchase return and allowance………..$15000
Purchase discount………………………$3560
Freight in ………………………………..$10,440
Ending inventory…………………….......$75,000
Sales………………………………………$653,200
A, Determine the net purchase
B, determine the cost of merchandise purchased
C, cost of merchandise available for sale
D, cost of goods sold
E, gross profit
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Purchase – (Purchase discount +purchase return and allowance&) =$500,000-(3560+15000)
Net purchase=$481440
Cost of merchandise purchased=NP+TC$481440+10,440= $491,880
CMP+CBI=CGAFS =$491,880+60,000=$551,880
CGS=CGAFS-CEI =$551,880-75000=$476,880
Gross profit=sale-CGS =$653,200-476,880=$176,320
Example, Assume that at the end of year 2003 physical count made by Guna trading company
reveals merchandise of $20,000 remains on hand. Assume also again during the following year
(2004) Guna trading company purchases additional worth of $120,000, received credit for
purchase returns and allowance $3,500, takes purchase discount of $1500 and pays
transportation cost of $7,500. And the physical count at the end of the period shows an inventory
of $35,000. Note the ending inventory of previous period (2003) becomes the beginning
inventory of this period. Determine the cost of goods sold.
Beginning inventory (2004)…………………………………………..........$20000
Purchases ……………………………………...........$120000
Less purchase returns & allowance………$3500
Purchase discount…………….……………1500…….. (5000)
Add: Freight in…………………………………………..7500
Cost of goods purchased……………………………………………………...122500
Cost of goods available for sale…………………………………………..…..142500
Less ending inventory (December, 2004)………………………………..……..35000
Cost of goods sold……………………………………………………………..$107,500
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