Chapter 3

What Are Merchandising Operations?

Merchandising is the business activity of buying and selling products rather than services.
Accounting for merchandising operations requires us to deal with these balance sheet and
income statement items.
Balance Sheet: Income Statement:
 Inventory, an asset Sales revenue (often abbreviated as Sales), a revenue
Cost of goods sold, an expense

The Operating Cycle of a Merchandising Business

The operating cycle of a business is different from the accounting cycle. The operating cycle
begins when a merchandiser buys inventory. The company then sells the goods to customers and
collects cash.
Inventory Systems: Perpetual and Periodic
There are two main types of inventory accounting systems:
1. Periodic system 2. perpetual system
The periodic inventory system is used for relatively inexpensive goods. A convenience store
without optical-scanning cash registers does not keep a daily running record of every loaf of
bread and every key chain that it sells. Instead, the business counts its inventory at some regular
interval to determine the quantities on hand. Restaurants and small retail stores also use the
periodic system.
The perpetual inventory system keeps a running record of inventory and cost of goods sold.
This system achieves control over the inventory. Even in a perpetual system, the business counts
inventory at least once a year. The physical count establishes the correct amount of ending
inventory for the financial statements and also serves as a check on the perpetual records.
The following chart compares the perpetual and periodic systems:
Perpetual Inventory System
 Keeps a running record of all goods bought and sold.
 Inventory counted at least once a year.
Periodic Inventory System
 Does not keep a running record of all goods bought and sold.
 Inventory counted at least once a year.
Accounting for Inventory in the Perpetual System
The cycle of a merchandising entity begins with the purchase of inventory. In this section, we
trace the steps that Austin Sound Center, in Austin, Texas, takes to purchase and pay for
inventory.
Purchase of Inventory
A $700 purchase of inventory to illustrate the purchasing process, Suppose Austin Sound
receives the goods on May 30. The purchase of inventory on account increases Austin Sound’s
assets (Inventory) and liabilities (Accounts Payable).
The Inventory account is used only for goods purchased for resale. Supplies, equipment, and
other assets are recorded in their own accounts. Inventory is an asset until sold.
PURCHASE DISCOUNTS
Many businesses offer customers a purchase discount for early payment. JVC’s credit terms of
3% 15, net 30 days mean that Austin Sound may deduct 3% of the total debt if Austin pays
within 15 days of the invoice date. Otherwise, the full amount NET is due in 30 days. These
credit terms can also be expressed as 3/15 n/30.
Terms of n/30 mean that no discount is offered and payment is due 30 days after the invoice
date. Terms of eom mean that payment is due at the end of the current month.
PURCHASE RETURNS AND ALLOWANCES
Businesses allow customers to return merchandise that is defective, damaged, or otherwise
unsuitable, or the seller may deduct an allowance from the amount the buyer owes. Both
purchase returns and purchase allowances decrease the buyer’s cost of the inventory.
Example
On September 15, Austin Sound purchases $1,000 of merchandise on account, with terms 2/10,
n/30. Austin returns $100 of merchandise for credit on September 20, and then makes payment
in full on September 25.
TRANSPORTATION COSTS
The transportation cost of moving inventory from seller to buyer can be significant. The
purchase agreement specifies FOB terms to indicate who pays the shipping charges. FOB means
free on board. FOB terms govern (1) when legal title to the goods passes from seller to buyer
and (2) who pays the freight.
 Freight costs are either Freight in or Freight out.
 Freight in is the transportation cost on purchased goods.
 Freight out is the transportation cost of goods sold.
Freight In FOB shipping point terms is most common, so the buyer pays the freight. Freight in
becomes part of the cost of inventory. The buyer debits Inventory and credits Cash or Accounts
Payable for the freight.
Example
Suppose Austin Sound pays a $60 shipping bill.

Under FOB shipping point terms, the seller sometimes prepays the transportation cost as a
convenience and lists this cost on the invoice.
Example
A $5,000 purchase of goods, coupled with a related freight charge of $400. If the buyer pays
within the discount period, the discount will be computed on the $5,000 merchandise cost, not on
the $5,400. A 2% discount would be $100.
Example
This Stop & Think example is exactly like the preceding one, but with freight in. On September
15, Austin Sound purchased $1,000 of merchandise, with $80 freight added, for an invoice total
of $1,080. Austin returns $100 of the goods for credit on September 20 and pays the account
payable in full on September 25.
Sale of Inventory
After a company buys inventory, the next step is to sell the goods. We shift now to the selling
side and follow Austin Sound Center through a sequence of selling transactions. The amount a
business earns from selling merchandise inventory is called sales revenue (often abbreviated as
sales). A sale also creates an expense, Cost of Goods Sold, as the seller gives up the asset
Inventory. Cost of goods sold is the entity’s cost of its inventory that has been sold to customers.
Cost of goods sold (often abbreviated as cost of sales) is the merchandiser’s major expense.
After making a sale on account, merchandiser may experience any of the following:

 A sales return: The customer may return goods to Austin Sound.

 A sales allowance: Austin Sound may grant a sales allowance to reduce the cash to be
collected from the customer.
 A sales discount: If the customer pays within the discount period under terms such as
2/10 n/30 Austin Sound collects the discounted amount.
 Freight out: Austin Sound may have to pay delivery expense to transport the goods to
the buyer.
CASH SALE Sales of retailers, such as Austin Sound, grocery stores, and restaurants, are often
for cash. Cash sales of $3,000 are recorded by debiting Cash and crediting Sales Revenue.

COST OF MERCHANDISE SOLD (PERIODIC INVENTORY SYSTEM)

Using the periodic inventory system, the revenues from sales are recorded when sales are made
in the same manner as in the perpetual inventory system. However, no attempt is made on the
date of sale to record the cost of the merchandise sold.
Recording Merchandise Transactions (Periodic Inventory System)
Using the periodic inventory system, purchases of inventory are recorded in a purchases account
rather than in a merchandise inventory account. No attempt is made to keep a detailed record of
the amount of inventory on hand at any given time. Instead, at the end of the period, a physical
count of merchandise inventory is taken.
The purchases account is debited for the amount of the invoice before considering any purchases
discounts. Purchases discounts are normally recorded in a separate purchases discounts account.
The balance of this account is reported as a deduction from the amount initially recorded in
Purchases for the period. Thus, the purchases discounts account is viewed as a contra (or
offsetting) account to Purchases.
Purchases returns and allowances are recorded in a similar manner as purchases discounts. A
separate purchases returns and allowances account is used to keep a record of the amount of
returns and allowances during a period.
When merchandise is purchased FOB shipping point, the buyer is responsible for paying the
freight charges. Under the periodic inventory system, freight charges paid when purchasing
merchandise FOB shipping point are debited to Transportation In, Freight In, or a similarly
titled account.
The preceding periodic inventory accounts and their effect on the cost of merchandise purchased
are summarized below.
Entry to Effect on Cost
Increase Normal of Merchandise
Account (Decrease) Balance Purchased
Purchases Debit Debit Increases
Purchases Discounts Credit Credit Decreases
Purchases Returns and Allowances Credit Credit Decreases
Transportation in Debit Debit Increases

Adjusting Entry for Inventory Shrinkage (Perpetual)

Under the perpetual inventory system, a separate merchandise inventory account is maintained in
the ledger. During the accounting period, this account shows the amount of merchandise for sale
at any time. However, merchandising businesses may experience some loss of inventory due to
shoplifting, employee theft, or errors in recording or counting inventory. As a result, the
physical inventory taken at the end of the accounting period may differ from the amount of
inventory shown in the inventory records. Normally, the amount of merchandise for sale, as
indicated by the balance of the merchandise inventory account, is larger than the total amount of
merchandise counted during the physical inventory. For this reason, the difference is often called
inventory shrinkage or inventory shortage.
Example
To illustrate, Net Solutions’ inventory records indicate that $63,950 of merchandise should be
available for sale on December 31, 2009. The physical inventory taken on December 31, 2009,
however, indicates that only $62,150 of merchandise is actually available. Thus, the inventory
shrinkage for the year ending December 31, 2009, is $1,800 ($63,950 - $62,150), as shown at the
left.
Exercise
Pulmonary Company’s perpetual inventory records indicate that $382,800 of merchandise should
be on hand on March 31, 2008. The physical inventory indicates that $371,250 of merchandise is
actually on hand. Journalize the adjusting entry for the inventory shrinkage for Pulmonary
Company for the year ended March 31, 2008.

ADJUSTING PROCESS UNDER THE PERIODIC INVENTORY SYSTEM

The adjusting process is the same under the periodic and perpetual inventory systems except for
the inventory shrinkage adjustment. Under both the periodic and perpetual inventory systems the
ending merchandise inventory is determined by a physical count.
Under the perpetual inventory system the ending inventory physical count is then compared to
the amounts in the inventory ledger and the amount of inventory shrinkage is determined. This
inventory shrinkage is recorded as a debit to Cost of Merchandise Sold and a credit to
Merchandise Inventory.
Under the periodic inventory system, a separate inventory ledger is not maintained during the
year. Instead, purchases of inventory are recorded in the purchases account. As a result, the
inventory shrinkage cannot be directly determined, but is included indirectly in the cost of
merchandise sold computation. This is done at the end of the year when the merchandise
inventory account is increased or decreased to the ending physical merchandise inventory. A
primary disadvantage of the periodic inventory system is that the amount of inventory shrinkage
is not separately determined.
Transactions Using the Periodic and Perpetual Inventory Systems
1. June 5. Purchased $30,000 of merchandise on account, terms 2/10, n/30.
2. June 8. Returned merchandise purchased on account on June 5, $500.
3. June 15. Paid for purchase of June 5, less return of $500 and discount of $590 [($30,000 -
500) x 2%].
4. June 18. Sold merchandise on account, $12,500, 1/10, n/30. The cost of the merchandise
sold was $9,000.
5. June 21. Received merchandise returned on account, $4,000. The cost of the merchandise
returned was $2,800.
6. June 22. Purchased merchandise, $15,000, terms FOB shipping point, 2/15, n/30, with
prepaid transportation charges of $750 added to the invoice.
7. June 28. Received $8,415 as payment on account from June 18 sale less return of June 21
and less discount of $85 [($12,500 - $4,000) x 1%].
8. June 29. Received $19,600 from cash sales. The cost of the merchandise sold was
$13,800.

Financial Statements for a Merchandising Business

MULTIPLE-STEP INCOME STATEMENT
Multiple-step income statement, contains several sections, subsections, and subtotals.
Sales are the total amount charged customers for merchandise sold, including cash sales and
sales on account. Both sales returns and allowances and sales discounts are subtracted in arriving
at net sales.
Sales returns and allowances are granted by the seller to customers for damaged or defective
merchandise. For example, rather than have buyer return merchandise, a seller may offer a $500
allowance to the customer as compensation for damaged merchandise. Sales returns and
allowances are recorded when the merchandise is returned or when the allowance is granted by
the seller.
Sales discounts are granted by the seller to customers for early payment of amounts owed.
Example
A seller may offer a customer a 2% discount on a sale of $10,000 if the customer pays within 10
days. If the customer pays within the 10-day period, the seller receives cash of $9,800 and the
buyer receives a discount of $200 ($10,000 x 2%). Sales discounts are recorded when the
customer pays the bill.
Net sales are determined by subtracting sales returns and allowances and sales discounts from
sales. Rather than reporting sales, sales returns and allowances, and sales discounts, many
companies report only net sales.
Cost of merchandise sold is the cost of the merchandise sold to customers.
Example
To illustrate the determination of the cost of merchandise sold, assume that Net Solutions
purchased $340,000 of merchandise during the last half of 2008. If the inventory at December
31, 2008, the end of the year, is $59,700, the cost of the merchandise sold during 2008 is
$280,300.
As we discussed in the preceding paragraphs, sellers may offer customers sales discounts for
early payment of their bills. Such discounts are referred to as purchases discounts by the buyer.
Purchase discounts reduce the cost of merchandise. A buyer may return merchandise to the seller
(a purchase return), or the buyer may receive a reduction in the initial price at which the
merchandise was purchased (a purchase allowance). Like purchase discounts, purchases returns
and allowances reduce the cost of merchandise purchased during a period. In addition,
transportation costs paid by the buyer for merchandise also increase the cost of merchandise
purchased.
Example
To continue the illustration, assume that during 2009 Net Solutions purchased additional
merchandise of $521,980. It received credit for purchases returns and allowances of $9,100, took
purchases discounts of $2,525, and paid transportation costs of $17,400. The purchases returns
and allowances and the purchases discounts are deducted from the total purchases to yield the
net purchases. The transportation costs, termed transportation in, are added to the net
purchases to yield the cost of merchandise purchased of $527,755.
The ending inventory of Net Solutions on December 31, 2008, $59,700, becomes the beginning
inventory for 2009. This beginning inventory is added to the cost of merchandise purchased to
yield merchandise available for sale. The ending inventory, which is assumed to be $62,150, is
then subtracted from the merchandise available for sale to yield the cost of merchandise sold of
$525,305.

SINGLE-STEP INCOME STATEMENT

An alternate form of income statement is the single-step income statement. This income
statement deducts the total of all expenses in one step from the total of all revenues. The single-
step form emphasizes total revenues and total expenses as the factors that determine net income.
A criticism of the single-step form is that such amounts as gross profit and income from
operations are not readily available for analysis.

STATEMENT OF OWNER’S EQUITY

This statement is prepared in the same manner that we described previously for a service
business.

BALANCE SHEET
As we discussed and illustrated in previous chapters, the balance sheet may be presented with
assets on the left-hand side and the liabilities and owner’s equity on the right-hand side. This
form of the balance sheet is called the account form. The balance sheet may also be presented in
a downward sequence in three sections. This form of balance sheet is called the report form.

CLOSING ENTRIES UNDER THE PEREPETUAL INVENTORY SYSTEM

The closing entries for a merchandising business are similar to those for a service business.
 The first entry closes the temporary accounts with credit balances, such as
Sales, to the income summary account.
 The second entry closes the temporary accounts with debit balances,
including Sales Returns and Allowances, Sales Discounts, and Cost of
Merchandise Sold, to the income summary account.
  The third entry closes the balance of the income summary account to the
owner’s capital account.
 The fourth entry closes the owner’s drawing account to the owner’s
capital account.

CLOSING ENTRIES UNDER THE PERIODIC INVENTORY SYSTEM

The closing entries differ in the periodic inventory system in that there is no cost of merchandise
sold account to be closed to Income Summary. Instead, the purchases, purchases discounts,
purchases returns and allowances, and transportation in accounts are closed to Income Summary.
In addition, the merchandise inventory account is adjusted to the physical inventory count
through the closing process.
EXERCISE 1
The following transactions were completed by Mono Company during May of the current year.
Mono Company uses a periodic inventory system.
May 3. Purchased merchandise on account from Flora Co., $4,000, terms FOB shipping point,
2/10, n/30, with prepaid transportation costs of $120 added to the invoice.
5. Purchased merchandise on account from Kramer Co., $8,500, terms FOB destination, 1/10, n/30.
6. Sold merchandise on account to C. F. Co., list price $4,000, trade discount 30%, terms 2/10,
n/30. The cost of the merchandise sold was $1,125.
8. Purchased office supplies for cash, $150.
10. Returned merchandise purchased on May 5 from Kramer Co., $1,300.
13. Paid Flora Co. on account for purchase of May 3, less discount.
14. Purchased merchandise for cash, $10,500.
15. Paid Kramer Co. on account for purchase of May 5, less return of May 10 and discount.
16. Received cash on account from sale of May 6 to C. F Co., less discount.
19. Sold merchandise on MasterCard credit cards, $2,450. The cost of the merchandise sold was $980 .
22. Sold merchandise on account to Comer Co., $3,480, terms 2/10, n/30. The cost of the
merchandise sold was $1,400.
24. Sold merchandise for cash, $4,350. The cost of the merchandise sold was $1,750.
25. Received merchandise returned by Comer Co. from sale on May 22, $1,480. The cost of the
returned merchandise was $600.
31. Paid a service processing fee of $140 for MasterCard sales.
Instructions
1. Journalize the preceding transactions.
2. Journalize the adjusting entry for merchandise inventory .
EXERCISE 2
The following data were extracted from the accounting records of Mini Company for the year
ended June 30, 2012:
Merchandise inventory, July 1, 2011 $ 183,250
Merchandise inventory, June 30, 2012 200,100
Purchases 1,279,600
Purchases returns and allowances 41,200
Purchases discounts 20,500
Sales 1,800,000
Transportation in 17,250

a. Prepare the cost of merchandise sold section of the income statement for the year ended
June 30, 2012, using the periodic inventory system.
b. Determine the gross profit to be reported on the income statement for the year ended June
30, 2012.