TOPIC

Accounting for
Merchandising Businesses

Accounting
A Malaysian
Perspective
5e
Learning Objectives

• LO1: Distinguish between the activities

and financial statements of service and
merchandising businesses.
• LO2: Describe and illustrate the
accounting for merchandise
transactions.
• LO3: Describe and illustrate the financial
statements of a merchandising business.
• LO4: Describe the adjusting and closing
process for a merchandising business.
Nature of the Merchandising Businesses

• The activities of a service business differ

from those of a merchandising business.
o These differences are reflected in the
operating cycles of a service and
merchandising business as well as in their
financial statements.
Operating Cycle (slide 1 of 2)

• The operating cycle is the process

by which a company spends cash,
generates revenues, and receives
cash either at the time the revenues
are generated or later by collecting
an accounts receivable.
• The operating cycle of a service and
merchandising business differs in that a
merchandising business must first
purchase merchandise for sale to
customers.
The Operating Cycle for a
Merchandising Business
Operating Cycle (slide 2 of 2)

• The time in days to complete an

operating cycle differs significantly
among merchandise businesses.
o For example, many grocery items, such as
milk, must be sold within their expiration dates
of a week or two.
o In contrast, jewelry stores often carry
expensive items that are often displayed
months before being sold to customers.
Financial Statements (slide 1 of 4)

• The differences between service and

merchandising businesses are also
reflected in their financial statements.
Financial Statements (slide 2 of 4)

• The revenue activities of a service

business involve providing services to
customers.
• On the profit and loss statement for a
service business, the revenues from
services are reported as fees earned.
• The operating expenses incurred in
providing the services are subtracted from
the fees earned to arrive at net income.
Financial Statements (slide 3 of 4)

• The revenue activities of a merchandising

business involve the buying and selling of
merchandise.
• A merchandising business first purchases
merchandise to sell to its customers.
• When merchandise is sold, the revenue is
reported as sales, and its cost is recognized
as an expense called cost of merchandise
sold.
o The cost of merchandise sold is subtracted from
sales to arrive at gross profit, which is the profit
before deducting operating expenses.
Financial Statements
(slide 4 of 4)

• Merchandise on hand (not sold) at the

end of an accounting period is called
merchandise inventory.
• It is reported as a current asset on the
balance sheet.

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Example Exercise Gross Profit

During the current year, merchandise is sold for

RM250,000 cash and for RM975,000 on account. The
cost of the merchandise sold is RM735,000. What is the
amount of the gross profit?
Purchases Transactions (slide 1 of 4)

• There are two systems for accounting for

merchandise transactions: perpetual and
periodic.
o In a perpetual inventory system, each purchase and
sale of merchandise is recorded in the inventory account
and related subsidiary ledger.
 In this way, the amount of merchandise available for sale
and the amount sold are continuously (perpetually)
updated in the inventory records.
o In a periodic inventory system, the inventory does
not show the amount of merchandise available for sale
and the amount sold.
 A listing of inventory on hand, called a physical inventory,
is prepared at the end of the accounting period.
– This physical inventory is used to determine the cost of
merchandise on hand at the end of the period and the cost of
merchandise sold during the period.
Purchases Transactions (slide 2 of 4)

• Journal entry for cash purchases under

the perpetual inventory system:

• Purchases on account are recorded

as follows:
Purchases Transactions (slide 3 of 4)

• The terms of purchases on account are

normally indicated on the invoice or bill
that the seller sends the buyer.
Purchases Transactions (slide 4 of 4)

• The terms for when payments for

merchandise are to be made are called
the credit terms.
o If payment is required on delivery, the terms
are cash or net cash.
o Otherwise, the buyer is allowed an amount of
time, known as the credit period, in which
to pay.
 The credit period usually begins with the date of the
sale as shown on the invoice.
Purchases Discounts (slide 1 of 4)

• To encourage the buyer to pay before the

end of the credit period, the seller may
offer a discount.
o For example, a seller may offer a 2% discount
if the buyer pays within 10 days of the invoice
date. If the buyer does not take the discount,
the total invoice amount is due within 30
days.
 The terms are expressed as 2/10, n/30 and are
read as “2% discount if paid within 10 days, net
amount due within 30 days.”
Credit Terms
Purchases Discounts (slide 2 of 4)

• Discounts taken by the buyer for early

payment of an invoice are called
purchases discounts.
o Purchases discounts taken by a buyer reduce
the cost of the merchandise purchased.
• Example: Assume that NetSolutions places an
order from Alpha Technologies on Jan 5 with
terms 2/10, n/30.
• If NetSolutions borrows RM2,940 from others
• [(RM3,000
It is a smart- SAVING
the discount
decision of RM60 (RM3,000 ×
actually!
2%)]
• If antoannual
pay the invoice
interest** rateon Janand
of 6% 15 a(the lastyear
360-day dayis
of the discount
assumed, period)…
the interest on the loan of RM2,940 for the
remaining 20 days of the credit period is RM9.80
(RM2,940 × 6% × 20 ÷ 360).
Purchases Discounts (slide 3 of 4)

• The net savings to NetSolutions of taking

the discount is computed as follows:

• If NetSolutions does not take the it is

pays an estimated interest rate oflike
discount, 36%
forit using the RM2,940 for the remaining
20 days of the credit period.
Purchases Discounts (slide 4 of 4)

• Since buyers normally take all purchases

discounts, Merchandise Inventory is
debited for the net purchase price under
the perpetual inventory system.
o That is, the buyer debits Merchandise
Inventory for the amount of the invoice
less the discount.
• NetSolutions would record the Alpha
Technologies invoice and its payment
as follows:
Purchases Returns and Allowances (slide 1 of 4)

• A buyer may request an allowance for

merchandise(purchases
that is returned or a
price
allowance return)
(purchases for damaged
defectiveallowance)
or merchandise.
• Buyer’s perspective = purchases
returns and allowances.
o In both cases, the buyer normally sends the
seller a debit memorandum, often called a
debit memo, to notify the seller of reasons
for the return (purchase return) or to
request a price reduction (purchase
allowance).
 A debit memo also informs the seller of the
amount the buyer proposes to debit to the
Debit Memo
Purchases Returns and Allowances (slide 2 of 4)

• The buyer may use the debit memo as

the basis for recording the return or
allowance or wait for approval from the
seller (creditor).
• In either case, the buyer debits Accounts
Payable and credits Merchandise
Inventory.
• NetSolutions records the return of the
merchandise indicated in the debit
memo as follows:
Purchases Returns and Allowances (slide 3 of 4)

• Before paying an invoice, a buyer may

return merchandise or be granted a price
allowance for an invoice with a purchase
discount.
o In this case, the amount of the return is
recorded at its invoice amount less the
discount.
Purchases Returns and Allowances (slide 4 of 4)

• NetSolutions example:
• May 2. Purchased RM5,000 of merchandise on account from
Delta Data Link, terms 2/10, n/30.
4. Returned RM1,000 of the merchandise purchased on
May 2.
12. Paid for the purchase of May 2 less the return and
discount.
• NetSolutions would record these transactions as
follows:
Example Exercise Purchases Transactions

Rofles Company purchased merchandise on account

from a supplier for RM11,500, terms 2/10, n/30. Rofles
Company returned RM2,500 of the merchandise and
received full credit.
a. If Rofles Company pays the invoice within the
discount period, what is the amount of cash
required for the payment?

b. Under a perpetual inventory system, what account

is credited by Rofles Company to record the return?
Sales Transactions

• Revenue from merchandise sales is

usually recorded as Sales.
o Sometimes a business may use the
title Sales of Merchandise.
Cash Sales (slide 1 of 4)

• Assume that on March 3,

NetSolutions sells merchandise for
RM1,800. These cash sales are
recorded as follows:
Cash Sales (slide 2 of 4)

• Using the perpetual inventory system,

the cost of merchandise sold and the
decrease in merchandise inventory are
also recorded.
o In this way, the merchandise inventory
account indicates the amount of merchandise
on hand (not sold).
• Assume that the cost of merchandise
sold on March 3 is RM1,200. The entry to
record the cost of merchandise sold and
the decrease in the merchandise
inventory is as follows:
Cash Sales (slide 3 of 4)

• Sales may be made to customers using

credit cards such as MasterCard or VISA.
o Such sales are recorded as cash sales.
WHY?
• If customers use MasterCards to pay for
their purchases, the sales would be
recorded as shown in the March 3 entry
previously.
• Any processing fees charged by the
clearinghouse or issuing bank are
periodically recorded as an expense.
o This expense is normally reported on the
statement of profit or loss as an administrative
Cash Sales (slide 4 of 4)

• Assume that NetSolutions paid credit card

processing fees of RM4,150 on March 31.
These fees would be recorded as follows:
Sales on Account

• NetSolutions sold merchandise on

account for RM18,000. The cost of the
merchandise sold was RM10,800.
Customer Discounts (slide 1 of 2)

• A seller may grant customers a variety of

discounts, called customer discounts, to
encourage customers to act in a way
benefiting the seller.
o For example, a seller may offer customer
discounts to encourage customers to
purchase in volume or order early.

• A sales discount encourages

customers to pay their invoice early.
o For example, a seller may offer credit terms of
2/10, n/30, which provides a 2% sales discount
if the invoice is paid within 10 days.
Customer Discounts (slide 2 of 2)

• Assume that NetSolutions sold RM18,000

of merchandise to Digital Technologies on
March 10 with credit terms 2/10, n/30.
o The March 10 sale would be recorded as
follows:

o The payment by Digital Technologies on

March 19 is recorded as follows:
Customer Returns and Allowances (slide 1 of 6)

• Merchandise sold may be returned to

the seller (returns). In other cases, the
seller may reduce the initial selling
price (allowances).
o This may occur if the merchandise is
defective, damaged during shipment, or does
not meet the buyer’s expectations.
• From a seller’s perspective, these are
termed customer returns and
allowances, sometimes called sales
returns and allowances.
Customer Returns and Allowances (slide 2 of 6)

• Assume Schafer Co. had sales of RM2,000,000

and related cost of merchandise sold of
RM1,400,000 for its first year of operations
ending December 31, 2018. Schafer Co. provides
customers a refund for any returned or damaged
merchandise. At the end of the year, Schafer Co.
estimates that customers will request refunds for
2% of sales and estimates that merchandise
costing RM25,000 will be returned. On December
31, 2018, the following two adjusting journal
entries must be recorded:
Customer Returns and Allowances (slide 3 of 6)

• The preceding two adjusting entries

ensure that current period sales are
matched with the related cost of
merchandise sold on the statement of
profit or loss.
• In addition, an asset for estimated
returned inventory and a liability for
customer refunds is reported on the
statement of financial position.
Customer Returns and Allowances (slide 4 of 6)

• On January 15, 2019, Baker Company

returned merchandise with a selling price
of RM3,000 for a cash refund. The
merchandise originally cost Schafer Co.
RM2,100. Schafer would record the
return and refund with the following two
entries:
Customer Returns and Allowances (slide 5 of 6)

• In some cases, a customer that is due a

refund has an outstanding account
receivable balance.
o In this case, the seller may credit the
customer’s accounts receivable rather than
pay cash.
 When this is done, the seller normally sends the
buyer a credit memorandum or credit memo
indicating its intent to credit the customer’s
account receivable.
Customer Returns and Allowances (slide 6 of 6)

• Assume that Schafer Company issued the

credit memo to Blake & Sons.

• Schafer Co. would record issuance of the

credit memo as follows:
Example Exercise Sales Transactions Exercise

Journalize the following merchandise transactions:

a. Sold merchandise on account, RM7,500, with terms
2/10, n/30. The cost of the merchandise sold was
RM5,625.

b. Received payment less the discount.

Freight (slide 1 of 7)

• Purchases and sales of merchandise

often involve freight.
• The terms of a sale indicate when
ownership (title and control) of the
merchandise passes from the seller to the
buyer.
o This point determines whether the buyer or
the seller pays the freight costs.
• The ownership of the merchandise may
pass to the buyer when the seller delivers
the merchandise to the freight carrier.
Freight (slide 2 of 7)

o In this case, the terms are said to be FOB

(free on board) shipping point.
 This term means that the buyer pays the freight
costs from the shipping point to the final
destination.
– Such costs are part of the buyer’s total cost of
purchasing inventory and are added to the cost of the
inventory by debiting Merchandise Inventory.
Freight (slide 3 of 7)

• Assume that on June 10, NetSolutions purchased

merchandise
June as follows:
Purchased merchandise from Magna Data,
10. RM900, terms FOB shipping point.
10. Paid freight of RM50 on June 10 purchase from
• Magna Data.
NetSolutions would record these two
transactions as follows:
Freight (slide 4 of 7)

• The ownership of the merchandise may

pass to the buyer when the buyer
receives the merchandise.
o In this case, the terms are said to be FOB
(free on board) destination.
 This term means that the seller pays the freight
costs from the shipping point to the buyer’s
final destination.
– When the seller pays the delivery charges, the seller
debits Delivery Expense or Freight Out.
 Delivery Expense is reported on the seller’s
statement of profit or loss as a selling expense.
Freight (slide 5 of 7)

• Assume that NetSolutions sells

merchandise
June as follows: to Kranz Company on account,
Sold merchandise
15. RM700, terms FOB destination. The cost of the
merchandise sold is RM480.
• 15. NetSolutions
NetSolutions payssale,
records the freight
the of RM40
cost on sale,
of the the sale
andof June
the
15. cost as follows:
freight
Freight (slide 6 of 7)

• The seller may

prepa the freight, even
thoughare
terms y shipping point. The seller
theFOB
will then add the freight to the invoice.
o The buyer debits Merchandise Inventory
for the total amount of the invoice,
including the freight.
o Any discount terms would not apply to
the prepaid freight.
Freight (slide 7 of 7)

• Assume that NetSolutions sells

merchandise
June as follows: to Planter Company on account, RM800,
Sold merchandise
20. terms FOB shipping point. NetSolutions paid freight of
RM45, which was added to the invoice. The cost of the
• merchandise
NetSolutions soldsale,
records the is RM360.
the cost of the sale, and the
freight as follows:
Freight Terms
Example Exercise Freight Terms Exercise

Determine the amount to be paid in full settlement of

each of the two invoices, (a) and (b), assuming that
credit for returns and allowances was received prior to
payment and that all invoices were paid within the
discount period.
Recording Merchandise Inventory Transactions
Dual Nature of Merchandise Transactions

• Each merchandising transaction affects a

buyer and a seller.
Illustration of Merchandise Inventory
Transactions for Seller and Buyer (slide 1 of 2)
Illustration of Merchandise Inventory
Transactions for Seller and Buyer (slide 2 of 2)
Example Exercise Transactions for Buyer and Seller

Sievert Co. sold merchandise to Bray Co. on account,

RM11,500, terms 2/15, n/30. The cost of the
merchandise sold is RM6,900. Journalize the entries for
Sievert Co. and Bray Co. for the sale, purchase, and
payment of amount due.
Chart of Accounts for NetSolutions, a
Merchandising Business
Sales Taxes (slide 1 of 2)

• In certain cases, tax is levied on sales of

merchandise.
• The liability for the sales tax is incurred
when the sale is made.
o At the time of a cash sale, the seller collects
the sales tax.
o When a sale is made on account, the seller
charges the tax to the buyer by debiting
Accounts Receivable.
o The seller credits the sales account for the
amount of the sale and credits the tax to
Sales Tax Payable.
Sales Taxes (slide 2 of 2)

• The seller would record a sale of RM100 on

account, subject to a tax of 6%, as follows:

• On a regular basis, the seller pays to the

taxing authority (state) the amount of the
sales tax collected. The seller records such a
payment as follows:
Trade Discounts

• Businesses often offer special discounts to

government agencies or businesses that
order large quantities.
o Such discounts are called trade discounts.
o Trade discounts are also used to actively
increase sales. Such as actively practiced
by Watson.
• Sellers and buyers normally record the
net prices merchandise in their
accounts.
o [RM1,000
at example,
For lessthat
assume the an
trade discount
item has a
RM600
list priceof
(RM1,000 of×RM400
.
RM1,000 and a 40% trade
40%)]
discount.
o
Financial Statements for a
Merchandising Business

• An statement of profit or loss for a

merchandising business is normally
prepared using either a multiple- step or
single-step format.
• The multiple-step statement of profit
or loss contains several sections,
subsections, and subtotals, including the
following:
o Sales
o Cost of Merchandise Sold
o Gross Profit
o Income from Operations
o Other Income and Expense
Multiple-Step Statement of Profit or Loss—
Income from Operations
• Income from operations, or operating
income, is determined by subtracting operating
expenses from gross profit.
o Operating expenses are normally classified as either
selling expenses or administrative expenses.
 Selling expenses are incurred directly in the selling of
merchandise.
– Examples of selling expenses include the following:
 Sales salaries
 Store supplies used
 Depreciation of store equipment
 Delivery expense
 Advertising
 Administrative expenses, sometimes called
general expenses, are incurred in the
administration or general operations of the business.
– Examples of administrative expenses include the
following:
 Office salaries
Multiple-Step Statement of Profit or Loss—
Other Income and Expense (slide 1 of 2)

• Other income and expense items are

not related to the primary operations of
the business.
o Other income is revenue from sources
other than the primary operating
activity of a business.
 Examples of other income include the
following:
– Income from interest
– Rent
– Gains resulting from the sale of fixed assets
o Other expense is an expense that cannot be
traced directly to the normal operations of the
business.
 Examples of other expenses include the following:
Multiple-Step Statement of Profit or Loss—
Other Income and Expense (slide 2 of 2)

• Other income and other expense are

offset against each other on the
statement of profit or loss.
o If the total of other income exceeds the total of
other expense, the difference is added to
income from operations to determine net
income.
o If the total of other expense exceeds the
total of other income, the difference is
subtracted from income from operations to
determine net income.
Multiple-Step Statement of Profit or Loss Example
Single-Step Statement of Profit or Loss (slide 1 of 2)

• A criticism of the single-step form is that

gross profit and income from operations
are not reported.
Statement of Owner’s Equity for
Merchandising Business
Statement of Financial Position

• The statement of financial position may be

presented with assets on the left-hand side
and the liabilities and owner’s equity on
the right-hand side.
o Called the account form.
• The statement of financial position may
also be presented in a downward
sequence in three sections.
o Called the report form.
Report Form of Statement of Financial Position
Adjusting Entry for Inventory Shrinkage
(slide 1 of 2)

• Under the perpetual inventory system, the

merchandise is supposed to be
balance of theinventory account
as amount of merchandise
the the available
same for sale at
that point in time.
• Retailers normally experience some loss of
inventory due to shoplifting, employee theft,
or errors.
• Thus, the physical inventory on hand at
the end of the accounting period is
usually less than the balance of
Merchandise Inventory.
o This difference is called inventory shrinkage
or inventory shortage.
Adjusting Entry for Inventory Shrinkage
(slide 2 of 2)

• NetSolutions’ inventory records indicate the following

on December 31, 2019:

• At the end of the accounting period, inventory

shrinkage is recorded by the following adjusting entry:

o Now the balance of Merchandise Inventory agrees

with the physical inventory on hand at the end of the
period.
Example Exercise Inventory Shrinkage

Pulmonary Company’s perpetual inventory records

indicate that RM382,800 of merchandise should be on
hand on March 31, 2016. The physical inventory
indicates that RM371,250 of merchandise is actually on
hand. Journalize the adjusting entry for the inventory
shrinkage for Pulmonary Company for the year ended
March 31, 2016. Assume that the inventory shrinkage is
a normal amount.
Closing Entries (slide 1 of 4)

• The four closing entries for a merchandising

business are as follows:
1. Debit each temporary account with a credit balance,
such as Sales, for its balance and credit Income
Summary.
2. Credit each temporary account with a debit balance,
such as the various expenses, and debit Income
Summary. Since Cost of Merchandise Sold is a temporary
account with a debit balance, it is credited for its
balance.
3. Debit Income Summary for the amount of its balance
(net income) and credit the owner’s capital account.
The accounts debited and credited are reversed if
there is a net loss.
4. Debit the owner’s capital account for the balance
of the drawing account and credit the drawing
account.
Closing Entries (slide 2 of 4)

• The four closing entries for

NetSolutions follow:
Closing Entries (slide 3 of 4)

• NetSolutions’ income summary

account after the closing entries
have been posted is as follows:
Closing Entries (slide 4 of 4)

• After the closing entries are posted to the

accounts, a post-closing trial balance is
prepared.
o Listed accounts post-closing trial balance
are the asset, contra asset, liability, and
owner’s capital accounts with balances.
o what
If thedoes
twoit totals of the trial balance
means? are not equal,
columns