CHAPTER 3: ACCOUNTING CYCLE FOR MERCHANDISING BUSINESS

What is Merchandising Enterprise? Merchandise enterprises are those business enterprises, which have
engaged in the activities of purchasing merchandises from manufacturer and reselling them to customers.
What does mean merchandise? It refers to those things the merchandising enterprise sells to its
customers, anything the merchandising company acquired for resell purpose.
Who are merchandising enterprise? They are wholesalers and retailers, such as importers, exporters,
stationery shops.
From the definition of merchandising enterprise we understand that the principal activities of a
merchandising enterprise to earn profit are purchasing merchandise and reselling them. Thus, under this
unit, we will try to look at how transactions are recorded when goods are purchased and resold, and finally
how financial statements are prepared.
3.1 Accounting for purchases of merchandise
Purchase in merchandising firm refers to the purchase of goods for resell purpose. Then, accounting for
purchases is all about how buyers make a record when goods are acquired for resale.
The merchandise purchased for resale is recorded in purchase account of the ledger. The purchase
account is used only to record merchandise acquired for resale, while assets acquired for use in operation
of the firm, such as supplies, equipment, should be debited to specific asset accounts rather than to
purchases account.
Purchase account is a temporary account with a normal balance of debit side. At the end of the period the
balance of purchase account shows the total cost of the merchandise purchased during the period and
reported as expense (cost of goods sold). Therefore, purchase account serves to accumulate cost of
purchases and closed to income summary account at the end of the period.
Purchase of merchandise can be made on account or cash bases. If purchase is made for cash, the
purchase balance will increase and shown by debiting purchase account and cash balance will decrease
and shown by crediting cash. On the other hand, if a purchase is made on credit, both purchases as well as
liability accounts of the buyer will increase, this shown by debiting purchase account and crediting
liability account.
Example: Assume the following transactions for Alex stationary shop;
January 2, 2012: Purchased merchandise of Br 10,000 for cash
January 4, 2012: Purchase merchandise of Br 4,000 on account
January 8, 2012: Made another purchase of merchandise costing Br 4,300 of which
Br 3,500 in cash and the remaining on credit.
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 January 10, 2012: Purchase office supplies of Br 2,000 that used for business operation
for an agreement to pay in the near future.
Required: Pass the necessary journal entries for Alex Stationary shop?
Solution
January 2, 2012 purchases……………………………………….. 10,000
Cash…………………………….………………… 10,000
January 4, 2012 purchases……………………………………….. 4,000
Accounts Payable…………………………….…… 4,000
January 8, 2012 purchases……………………………………….. 4,300
Cash…………………………………………….....3,500
Accounts Payable…………………………….……. 800
January 10, 2012 Supplies……………………………………….. 2,000
Accounts Payable…………………………….…… 2,000
3.1.1 Purchase Return and Allowance
When the merchandising enterprise get the purchased merchandise are defective, unsatisfactory/inferior
quality or wrong specification, may return the goods to the supplier(seller) for reduction of liability, if
purchase was made on account or for cash refund, if purchase was made initially on cash. This transaction
is called purchase returns. Whereas, the merchandising enterprise may choose to keep the purchased
merchandise and request (ask) price reduction, price adjustment for those defective goods. This
transaction is a purchase allowance.
The buyer initiates request for reduction of amount payable or cash refund by issuing a debit
memorandum. It is a form used issued by the buyer to inform a seller that a debit has been made to sellers
account (cash or account payable) because of unsatisfactory merchandise.
Then, this directly return of purchased merchandise as well as request of price adjustment for
unsatisfactory merchandise represents a reduction in the cost of goods purchased for resale and recorded
in a separate account called purchase return and allowance. It is a contra account to purchase with a
normal balance of credit side.
The reason behind using a separate purchase return and allowance account instead of directly crediting
purchase account is to enable management to identify the amount of return and allowance that have been
proven unsatisfactory.
Example: Assume the following transactions are for ABC merchandising company;
January 2: Purchased merchandise of Br 8,000 on account
January 4: Out of merchandise purchased on January 2, having a value of Br 400 were
defective and returned to sellers

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 January 10: made another purchase for cash of Br 4,000
January 18: A Br 1,000 of purchase was made on January 10 was found to be inferior
quality and ask price reduction of Br 200.
Required: Make the necessary journal entries for purchase and returns by ABC Merchandise Company
January 2, purchases……………………………………….. 8,000
Accounts Payable…………………………….…… 8,000
January 4, Accounts Payable ……………………………….... 400
purchase return and allowance ………………..……...400
January 10, purchases……………………………………….. 4,000
Cash…………………………………………....4,000
January 18, Cash ……………………………………………...... 200
Purchase return and allowance ………………..……...200
Trade discount
To attract more clients and to increase the volume of sales suppliers of merchandise arrange trade
discount. It is a deduction from the list price of merchandise. Its main objective is to induce clients to
purchase in large quantity.
when the available trade discounts are taken, purchase of merchandise recorded net of trade discount i.e.
on final 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
3.1.2 Purchase discount
The buyer and seller of merchandise made an agreement regarding to when payment shall be made. That
is if cash paid immediately at the time of sale, it is a cash term / net cash term. Otherwise, the buyer
allowed a certain period of time for payment, it is a credit term.
The time between the date of delivery (sale) and the date of payment refers a credit period. It is the
period started from the date of sale (invoice) until payment is made.

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Example: For credit terms;
 Net 30 days (n/30): the payment will be due within 30 days because the buyer given 30 days credit
period to pay.
 Net 45 days: the payment will be paid within 45 days because the buyer given 45 days credit period
to pay.
 Net end of the month (n/EOM): the payment will be paid by the end of the month in which the sale
was made
However, as a means of encouraging payment before the end of the credit period, the sellers may offer a
cash discount for the early payment of cash. That is making certain percent deductions from the invoice, if
it is paid within a specified time. For example: if an invoice for 10,000 provides for terms 1/10, n/30, the
customer has two alternatives; either to pay 9, 900 in 10 days or pay 10,000 in 30 days.
The cash discount is a purchase discount for the purchaser and sales discount for the seller of the
merchandise.
Purchase discount
It is a contra purchase account that is an account reduces purchase balance. Then, for the purpose of
providing information regarding the total amount of discount taken during the period, it is recorded in a
separate account called purchase discount account.
Example: The following transactions are for Sifan merchandising Company
December 3: Purchased merchandise costing Br 40,000 on account and a credit term were 2/15, n/30.
December 18: Paid its liability for December3 purchase on account
Required: Pass the required journal entries for Sifan merchandising Company on; December 3 and
December 18.
December 3, purchases……………………………………….. 40,000
Accounts Payable…………………………….…… 40,000
December 18, Accounts Payable ……………………….….... 40,000
Purchase discount………………..……………….…....800
Cash…………………………………………………39,200
The other concept when a buyer returns merchandise or has been granted an allowance prior to the
payment of the invoice, the amount of the debit memorandum / purchase return and allowance / is
deducted from the invoice amount before the purchase discount is computed.
Example: The following transactions were for ABC merchandising company;
On December 10: Acquired merchandises of Br 20,000 on account under terms 2/10, n/45.
On December 15: Out of goods purchased on December 10, merchandise having a value of Br

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 800 was wrong specification and returned to the seller.
On December 20: Paid for purchases made on December 10.
Required: Make the required journal entries on December 10, December 15, and December 20?
December 3, purchases……………………………………….. 20,000
Accounts Payable…………………………….…… 20,000
December 15, Accounts Payable ……………………………….... 800
Purchase return and allowance ………………..……...800
December 20, Accounts Payable ……………………….…...... 19,200
Purchase discount………………..……………….…....384
Cash…………………………………………………18,816
Generally, discount has an advantage for both the buyer and seller. For the buyer discount is a cost
reduction, for the seller it is early conversion of receivables to cash and reduction of the risk of
uncollectibility of the credit sales.
3.2 Accounting for sales of merchandise
In accordance with the revenue recognition principle, companies record sales revenue when the
performance obligation is satisfied. Typically, the performance obligation is satisfied when the goods
transfer from the seller to the buyer. At this point, the sales transaction is complete and the sales price
established.
Sales can be made on cash basis or on credit basis. Sales of merchandise on cash recorded as a debit to
cash and credit to sales account, while sales made on account recorded as debit to account receivable and
credit to sales account.
Example
On October 4: BCD Merchandise Company sold merchandise for Br 30,000 in cash to
ABC Merchandise Company
On October 10: BCD Merchandise Company also sold merchandise totaling Br 24, 000 on credit
to XYZ merchandising Company
On October 22: BCD Merchandise Company made another sale of merchandise for CDE
Merchandising Company having a value of Br 40,000 of which one fourth was
paid in cash and the remaining on account
Required: Make the necessary journal entries for both the seller and buyer merchandising Company on
October 4, October 10 and October22.

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Solution
October 4 , Cash ……………………………………….. 30,000
Sales revenue…………………………….…… 30,000

October 10 , Account receivable………………………….. 24,000

Sales revenue……………………….…….…… 24,000
October 22, Cash……………………………….…….10,000
Account receivable………………….….. 30,000
Sales revenue……………………………… 40,000
3.2.1Sales discount
Sales discount is a price reduction (discount) taken by the buyer for early payment of invoices and it is a
discount (price reduction) offered by the seller to early payment of credit invoices. Hence, what is
purchase discount for buyer is sales discount for seller.
As discussed previously, purchase discount is computed on net purchases, like wise sales discount should
also be computed on net sales, sales minus sales return and allowance.
Example
On January 1: Z merchandising company has sold merchandise for Br 10,000 for ABC
Company on account, terms of sale was 2/14, n/30.
On January 15: Z Company collects cash from customers for sales made on January 1.
Required: Pass the necessary journal entries for Z Merchandising Company for the month of January?
January 1, Account receivable………………………….. 10,000
Sales revenue……………………….…….…… 10,000
January 15, Cash……………………………….…….9,800
Sales discount………………………...…...200
Account receivable………………….….. 10,000
3.2.2 Sales return and allowance
Sales return refers to merchandise that customers return to the seller after a sale because of defects and
other reasons while sales allowance refers to reduction in the price merchandise already sold to
customers. Therefore, what is sales return and allowance for seller is purchase return and allowance for
the buyer.
Because managers need information about return and allowance to solve the problem, to record sales
return and allowance a separate contra sales account called sales return and allowance is used instead of
directly reducing sales (debiting sales).

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In connection to sales return and allowance, the seller usually prepares a credit memorandum to inform
buyer that credit has been made to buyer’s account (cash and account receivable).
Example: The following transactions were for ABC merchandising company;
On October 4: Sold merchandise for Br 10,000 on cash basis for Alex trading.
On October 8: The Company made another sale of Br 12,000 on account for BCD Company.
On October 10: Merchandise having a value of Br 200 is returned from October 4 sales.
On October 14: From October 8 sales goods sold for Br 1,000 were returned because of defect.
Required: Make the required journal entries on October 4,October 8,October 10 and October 14.

Solution
October 4 , Cash ……………………………………….. 10,000
Sales revenue…………………………….…… 10,000
October 8 , Account receivable………………………….. 12,000
Sales revenue……………………….…….…… 12,000
October 10, Sales return and allowance……………….…….200
Cash …………………………………………….. 200
October 14, Sales return and allowance……………….…….200
Account receivable ………………………….……….. 200
Transportation Costs
The term of the agreement between buyer and seller include provisions concerning:
1) When the ownership (title) of the merchandise passes to the buyer; and
2) Which party is to bear the cost of delivering the merchandise to the buyer.
If ownership passes to the buyer when seller delivers the merchandise to the shipper, the buyer absorbs
transportation cost and the term is said to be FOB Shipping Point . FOB Shipping Point means the seller
place the merchandise “free on board” and the buyer responsible for the transportation cost beyond that
point.
If ownership passes to buyer when the merchandise is received by the buyer, the seller assume cost of
transportation and the term is said to be FOB Destination. The shipping point is presented as follow:

FOB Shipping Point FOB Destination

Ownership (title) passes to the buyer
when merchandise is
Delivered to shipper Delivered to buyer
………………………………………….
Transportation cost are borne (paid) by
……………………………… Buyer Seller

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When merchandise is purchased on terms of FOB shipping point, transportation cost paid by the buyer
should be debited to Transportation In or Freight In account and credited to cash.
The balance of transportation in account should be added to net purchases to determine the total cost of
merchandise purchased.
If the seller prepay the transportation cost and add them to the invoice, the buyer will debit transportation
in for transportation cost.
Example : On June 10, Durban Co. purchased merchandise of $900 from Bell Corp. on account, terms of
FOB shipping point, 2/10, n/30, with prepaid transportation cost of $50 added to the invoice. The entry by
Durban Co. could be as follows:
Purchases…………………………………………..900
Transportation in……………………………….……50
AP…………………………………………………………..950
N.B When the terms provide for a discount for early payment, the discount is based on the amount of sale
rather than on the invoice total.
When the agreement states that the seller is to bear the delivery costs (FOB destination), the amounts paid
by the seller for delivery are debited to transportation out (it is expense account and presented as selling
expense).
3.3 Merchandise transactions using Perpetual and Periodic inventory systems
Merchandise transactions are recorded in the accounts, using the rules of debit and credit that are
described and illustrated in Chapter 2. There are two inventory systems to account for inventories or
merchandising transactions:
1. Perpetual inventory system
2. Periodic inventory system
Perpetual inventory system
 In a perpetual inventory system, the cost of goods sold and the decrease in inventory is
continuously recorded at the time of each sale.
 In this way, the amount of goods available for sale and the amount sold are continuously
(perpetually) updated in the inventory records.
 In a perpetual inventory system, each purchase is recorded in inventory account.
 Purchase discounts, purchase return and allowances are recorded in inventory account.

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Periodic inventory system
 In a periodic inventory system, the inventory does not show the amount of goods available for sale
and the amount sold at the time of each sale.
 Instead, physical inventory count is used to determine the cost of goods on hand at the end of the
period and the cost of goods sold during the period.
 The purchase of inventory is recorded in the purchase account.
 Sales are recorded in the same manner as in the perpetual inventory system.
 However, cost of goods sold is not recorded on the date of sale.
 Purchase discounts, purchase return and allowances are recorded in a separate account called
purchase discount, purchase return and allowances account respectively.
Example: The following transactions were for XYZ merchandising company;
On May 4:XYZ merchandising company purchased merchandise of Br 3,800 from Bell company. on
account, terms of FOB shipping point, 2/10, n/30.
XYZ Company’s book
May 4: Purchase ………. 3,800 May 4: Inventory………. 3,800
Accounts Payable…….. 3,800 Accounts Payable….. 3,800
On May 6: XYZ merchandising company paid a transportation cost of Br 150.
May 6: Freight in ………. 150 May 6: Inventory………. 150
Cash …………..….. 150 Cash ……..…….. 150
On May 8: Out of goods purchased on May 4, merchandise having a value of Br 300 was wrong
specification and returned to the seller.
May 8 Accounts Payable ………. 300 May 8: Accounts Payable ………. 300
Purchase return and allowance …… 300 Inventory ……..……….... 300
On May 14: Paid for purchases made on May 4.
May 14: Accounts Payable ....3,500 May 14: Accounts Payable ....3,500
Purchase discount…………....70 Inventory …….………..…....70
Cash…………………………3,430 Cash……………….………3,430
Bell Company’s book
On May 4: Bell Company sold merchandise of Br 3,800 for XYZ Company on account with terms of
FOB shipping point, 2/10, n/30 and the cost to this inventory was Br2,400.
May 4 : Account receivable.. 3,800 May 4: Account receivable.. 3,800
Sales revenue…… 3,800 Sales revenue…………… 3,800
May 4: No entry for cost of goods sold May 4:Cost of goods sold.. 2,400
Inventory ………..… 2,400

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 On May 8: Merchandise having a value of Br 300 is returned from May 4 sales and the cost to this
inventory was Br140.
May 8: Sales return and allowance…300 May 8: Sales return and allowance..300
Account receivable …………300 Account receivable …………300
May 8 : Inventory….... 140 May 8: No entry for cost of goods sold
Cost of goods sold ……… 140
May 14: Bell Company collects cash from XYZ Company for sales made on May 4.
May 14: Cash…………….3,430 May 14: Cash…………….3,430
Sales discount……..70 Sales discount……..70
Account receivable……3,500 Account receivable..…3,500

3.4 ADJUSTING ENTRIES FOR MERCHANDISING BUSINESS

For a merchandising company, like a service company, all accounts that affect the determination of net
income are closed to Income Summary. Data for the preparation of closing entries may be obtained
from the income statement columns of the worksheet. In journalizing, all debit column amounts are
credited, and all credit columns amounts are debited. To close the merchandise inventory in a periodic
inventory system:
1. The beginning inventory balance is debited to Income Summary and credited to Inventory.
2. The ending inventory balance is debited to Inventory and credited to Income Summary.
The two entries for PW Audio Supply are as follows.
The best methods to report the cost of goods sold is maintaining a separate account entitled inventory. At
the end of the period, the amount of inventory at the beginning of the period should be replaced by the
amount of inventory at the end of the period.

1. Transfer the beginning inventory to income summary. For PW Audio Supply Corporation it is
illustrated as follows:
Dec. 31: Income Summary……………………36,000
Inventory…………………………………….36, 000
(To close beginning inventory)
N.B. This inventory is part of cost of goods sold. It is also subtracted from assets account.
2. Debit the cost of merchandise inventory at the end of the period to the asset account, i.e. inventory:
Dec. 31: Inventory………………………………..40,000
Income Summary …………………………...40,000
(To record ending inventory)
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N.B. The credit portion of the entry effects is a deduction of the unsold merchandise from the total cost of
merchandise available for sale during the period.

ADJUSTMENT FOR DEFERRALS AND ACCRUALS

- Deferral is a delay of the recognition of an expense already paid or, revenue already received. It is
as either prepaid expenses or unearned revenues. Adjusting entries for deferrals are required at the
statement date to record the portion of the prepayment that represents the expense incurred or the
revenue earned in the current accounting period.
- Accrual is an expense that has not been paid, or revenue that has not been received.

Deferred Expenses (prepaid expenses)

- expected benefit a short period of time
- listed on the balance sheet among the current assets section
- Long term prepayments that can be charged to the operation of several years are presented on the
balance sheet section as deferred charges.
Deferred Revenue
- Is unearned revenue or revenues received in advance
- Listed on the balance sheet as current liabilities
- Example of deferred revenue is if someone rented his house and received advance payments.
Accrued Expense
Accrued Expense are those liabilities which exist at the end of an accounting period but not yet been
recorded. The amount of such accrued but unpaid items at the end of the accounting period are both an
expense and liability. It is for this reason that such accruals are called accrued liabilities or accrued
expenses. Accrued liabilities represent obligations to make payments, which are not legally due at the
balance sheet date. Accrued Expense listed on the balances sheet as accrued liabilities.
Accrued Revenues
Accrued revenues are those assets which exist at the end of an accounting period but which have not yet
been recorded. The amount of such accrued but not received items at the end of the accounting period are
both revenue and an asset. It is for this reason that such accruals are called accrued assets or accrued
revenues. Accrued revenues listed on the balances sheet as accrued assets.

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Adjusting Entries for Deferrals (prepaid expenses)
Prepaid expenses are the cost of goods or services that have been purchased but not used at the end of the
accounting period. The portion of the assets that has been used during the period becomes an expense.
Prepaid expense includes as prepaid insurance, prepaid rent, prepaid interest, etc.
Illustration1:
PW Audio Supply Corporation prepaid insurance balance was $3,800 at Dec. 31, 2017. $2,000 of
insurance premiums has expired during the year.
Insurance Expense……………………………………..……2,000
Prepaid Insurance………………………………………………2,000
Illustration2 PW Audio Supply Corporation, depreciation on the store equipment for the month of
December was $8,000.

Depreciation expense- Equipment ………………………………8,000

Accumulated Depreciation - Equipment……………………….8,000
Adjusting Entries for Accrued Liabilities (Accrued Expense)
Some expenses accrue from day to day but are usually recorded only when they are paid such as salaries
paid for employees and interest paid on notes payable. The amount of such accrued but unpaid items at the
end of the fiscal period are both expense and liability.
Illustration 3: On Dec. 31, 2017, the end of the fiscal year, the salaries and wages expense account for
PW Audio Supply Corporation has a balance of $59,000. For this fiscal year, the records of the business
show that the accruals for salaries and wages $5,000 at the end of the year.
Salaries and wages expenses………………………………5,000
Salaries and wages Payable………………………………………..5,000

WORK SHEET FOR MERCHANDISING ENTERPRISE

After yearend posting of the journals is completed, worksheet is used to assist in preparing the adjusting
entries, closing entries, and financial statements. The primary difference between the worksheet of
merchandise enterprise and service enterprise is that of the beginning and ending merchandise inventories,
which are shown in the income summary account, appear in both the debit and credit income statement
columns of the worksheet.
Adjustments on the Work Sheet
The data needed for adjusting the accounts of PW Audio Supply Corporation are summarized as follows:

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 - Merchandise inventory as of Dec. 31, 2017 ………………………..40,000
- Insurance expired during 2017 …………………….…..…………….2,000
- Depreciation during 2017 on:
 equipment ……………………………………..8,000
- Salaries and wages accrued on Dec. 31, 2017
 Salaries and wages…………………………….5,000
The balances of the accounts in the trial balance columns and the amount of any adjustments are added or
deducted as appropriate. The adjusted balances are then extended in to the adjusted trial balance columns,
which are totaled to prove the equality of debits and credits. Both the debit and credit amounts for the
income summary are extended.
After all of the items have been extended into the statement sections of the work sheet, the four columns
are totaled and the net income or net loss is determined.
The following work sheet is for PW Audio Supply Corporation illustration:
(a) Beginning merchandise inventory, $36,000
(b) Ending merchandise inventory, $40,000
(c) Insurance expired, $2,000
(d) Depreciation of store equipment, $8,000
(e) Salaries and wages accrued but not yet paid $5000

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 PW AUDIO SUPPLY
Worksheet
For the Year Ended December 31, 2017
Trial Balance Adjustments Adjusted Trial Income Statement Statement of
Account Title balance financial position
Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit
Cash 9,500 9,500 9,500
Account Receivable 16,100 16,100 16,100
Inventory 36,000 (b)40,00 (a)36,000 40,000 40,000
0
Prepaid insurance 3,800 (c)2,000 1,800 1,800
Equipment 80,000 80,000 80,000
Accumulated Depreciation- 16,000 (d)8,000 24,000 24000
Equipment
Account payable 20,400 20,400 20,400
Share capital– ordinary 50,000 50,000 50,000
Retained earning 33,000 33,000 33,000
Dividends 15,000 15,000 15,000
Income summary (a)36,00 (b)40,00 36,000 40,000 36,000 40,000
0 0
Sales revenue 480,000 480,000 480000
Sales returns and allowances 12,000 12,000 12,000
Sales discounts 8,000 8,000 8,000
Purchases 325,000 325000 325000
Purchase returns and 10,400 10,400 10,400
allowances
Purchase discounts 6,800 6,800 6,800
Freight-in 12,200 12,200 12,200
Freight-Out 7,000 7,000 7,000
Advertising Expense 16,000 16,000 16,000
Salaries and Wages Payable (e)5,000 64,000 64,000
59,000
Utilities Expense 17,000 17,000 17,000
Totals 616,600 616,600

Insurance Expense (c)2,000 2,000 2,000

Depreciation Expense (d)8,000 8,000 8,000
Salaries and Wages Payable
(e)5000 5,000 5,000
Totals 91,000 91,000 669,600 669,600 507,200 537,200 162,400 132,40
0
Net income 30,000 30000
Totals 537,200 537,200 162,400 162,40
0

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3.5 Financial Statements for a Merchandising Business

The basic financial statement for merchandising enterprise includes income statement, statement of
financial position, statement of owner’s equity, and statement of cash flow, are similar to those of
service enterprise. For corporation type of merchandise enterprise the financial statement includes
statement of retained earnings rather than statement of owner’s equity.
The basic difference between the financial statement of merchandise enterprise and service enterprise is
the income statement section of cost of goods sold and the balance sheet section of inventory.
Income Statement
There are two widely used forms for the income statement: multiple – step and single – step.
Multiple – Step forms of Income Statement

The multiple – step income statement is so called because of its many sections, sub sections and
intermediate balances. Such as:

1. Revenue from sales: the total of all charges to customers for merchandise sold, both on account and
cash, is reported in this section. Sales return and allowances and sales discounts are deducted from the
gross amount to yield net sales.

2. Cost of goods sold: this section is for the determination of cost of goods sold. The other name of cost of
goods sold is cost of merchandise sold or cost of sales.

3. Gross Profit: the excess of the net revenue from sales over the cost of merchandise sold is called gross
profit or gross margin. It is called gross because operating expenses must be deducted from it.

4. Operating Expenses: for retail business, operating expenses can be sub divide in to two categories:
selling and administrative expenses. Selling expenses are incurred directly and entirely in connection
with sale of merchandise. They include such expenses such as: salaries for sales man, store supplies
used, depreciation of the store equipment and advertisement cost. Administrative expenses or general
expenses incurred in the administration of the business, such as: office salaries, depreciation of office
equipment, and office supplies used rent expenses, insurance expenses etc.

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5. Income from Operations: the excess of gross profit over total operating expenses is called income from
operation. If operating expenses are greater than gross profit, the excess is called loss from operations.

6. Other Income: revenue sources other than the principal activities of the business are classified as other
income, or non operating income. Such as: income from rent, interest income and gain from sales of
plant assets.
7. Other expenses: expenses that are not associated with operations of the business, such as interest
expenses and loss from disposals (sales) of the business plant assets.
The two categories of non operating items are offset against each other on the income statement. If the
total of other income exceeds the total of other expenses , the difference is added to income from
operations. If the total of other expenses exceeds the difference is subtracted from income from
operations.

8. Net Income or: the final figure on the income statement is net income (or net loss).
Single – Step form of Income Statement
In single – step income statement the total expenses deducted from the totals of revenues. An objection
(disadvantage) of the single – step form of income statement is the relationships as of gross profit to sales
and income from operations to sales are not as readily determinable as they are when the multiple – step
form of income statement
In the following pages single – step income statement and multiple – step income statement for pw Audio
supply illustration is presented as follows respectively:
Single – step income statement PW AUDIO SUPPLY
Income Statement
For the Year Ended December 31, 2017
Revenues:
Net Sales………………………………………………………………………….$460,000

Expenses:
Cost of goods Sold……………………………………316,000
operating expenses …………………………….……..114,000
Total Expenses………………………………………………………………………430,000
Net Income……………………………………………………………………….……$30,000
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 PW AUDIO SUPPLY
Income Statement
For the Year Ended December 31, 2017
Sales:
Sales revenue…………………………………………… $480,000
Less: Sales returns and allowances…………. 12,000
Sales discounts……………………….. 8,000 (20,000)
Net sales……………………………………………………...……………….……… 460,000
Inventory, January 1 ……………………………………….………………....$36,000
Purchases……………………….……………….……. $325,000
Less: Purchase returns and allowances ……. $10,400
Purchase discounts ……………………. 6,800 (17,200)
Net purchases …..…………………………...…………………………........307,800
Add: Freight-in..…………………...…………………………………...…….....12,200
Cost of goods purchased……………………………………………….............320,000
Cost of goods available for sale……………………………………………... 356,000
Less: Inventory, December 31 ……………………………………………..…40,000
Cost of goods sold……………………………………………………………………….$316,000
Gross profit………………………………………………………………………………. 144,000
Operating expenses:
Salaries and wages expense …………….64,000
Utilities expense………………………….17,000
Advertising expense ……………………..16,000
Depreciation expense…………………….. 8,000
Freight-out ………………………………...7,000
Insurance expense……………………...….. 2,000
Total operating expenses…………………………………………………………….. (114,000)
Income from operations (Net income) …….……………………………….…………..30,000

Retained Earnings Statement

Retained earnings statement summarizes the changes which have occurred in the retained earnings
account during the fiscal period. It serves as a link between the income statement and the statement of
financial position.
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 PW AUDIO SUPPLY
Retained Earnings Statement
for the Year Ended December 31, 2017
Retained Earnings, beginning………………………………………………………………….33,000
Net Income for the Year…………………………………………….30,000
Less: Dividends……………………………………………………..15,000
Increase in Retained Earnings……………………………………………………………….….15,000
Retained Earnings, December 31,2017…………………………………………………………48,000
Statement of Financial Position
The arrangement of assets on the left hand side of the statement of financial position and, liabilities and
owner’s equity on the right hand side of the statement of financial position is called account form. The
arrangement of the three section of the statement of financial position in the downward sequence called
report form.
PW AUDIO SUPPLY
Statement of Financial Position
December 31, 2017
Assets:
Property, plant, and equipment
Equipment………………………………….…………...…. $80,000
Less: Accumulated depreciation – equipment……………… 24,000 $ 56,000
Current assets:
Prepaid insurance…………………………………………...…. 1,800
Inventory……………………………………………….……. 40,000
Accounts receivable………………………………………….. 16,100
Cash………………………………………………………...…. 9,500 67,400
Total assets……………………………....……………………………………………………. $123,400
Equity and Liabilities:
Equity
Share capital- ordinary……………………………….. $50,000
Retained earnings………………………………………48,000
Total stockholder’s equity $98,000
Liabilities
Salaries and wages payable…………………………..…5,000
Accounts payable ……………………………………..20,400
Total liabilities……………………………………………………………………….…………...25,400
Total equity and liabilities………………………………………….………………………. $123,400

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ADJUSTING ENTRIES
The followings are adjusting entries which were previously discussed for pw audio supply Corporation as of December 31,
2017.
Income Summary………………………………………….…36,000
Inventory………………………………………..…………...36,000
Inventory…………………………………………….…….…40,000
Income Summary………………………..……….……….…40,000
Insurance Expense……………………………………….……2,000
Prepaid Insurance………………………………………………2,000
Depreciation Expense- Store Equipment………….………….8,000
Accumulated Depreciation –Store Equipment.……………..…….8,000
Salaries and wages expenses………….………………………5,000
Salaries and wages Payable………………………………………..5,000
3.6 CLOSING ENTRIES FOR MERCHANDISING BUSINESS
The closing entries are recorded in the journal immediately following the adjusting entries. Closing entries cleared all of the
temporary stockholder’s equity accounts, reducing them to zero balance. The final effect of closing entries is a net increase or a
net decrease in the retained earnings. The closing entries for pw audio supply Corporation as of December 31, 2017 are the
followings:
Sales…………………………………………………...…..480,000
Purchases Returns And Allowances………………..………10,400
Purchases Discounts…………………………………………6,800
Income Summary……………………………………………497,200
Income Summary……………………………………..471,200
Sales Returns And Allowances……….………………….........$12,000
Sales Discounts…………………………….………………….….8,000
Purchases………………………………………………….……325,000
Transportation In……………………………………….……..…12,200
Salaries and wages expense …………………………………….64,000
Utilities expense………………………………………………….17,000
Advertising expense ……………………………………………..16,000
Depreciation Exp. Office Equipment…………………………..….8,000
Freight-out …………………………...............................…….…...7,000
Insurance expense……………………………….…………...….... 2,000

Income Summary…………………………………………30,000
Retained Earnings…………………………………..…………………30,000
Retained Earnings…………………………..……………..15000
Dividends………………………………………………………………..15000
The effects of the four closing entries are:
1) The first entry closes all income statement account with credit balance by transferring to the credit side of the income
summary.
2) The second entry closes all income statement account with debit balance by to the debit side of the income summary.
3) The third entry closes income summary by transferring its balance to the retained earnings.
4) The fourth entry closes dividends by transferring its balance to the retained earnings.

After all temporary retain earnings accounts have been closed, the only account with balances are the assets, contra assets(e.g.
accumulated depreciation), liability, capital stock and retained earnings.

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