LECTURE, CHAPTER 5

Merchandising business—a business that earns revenue by buying merchandise to resell

to customers. Uses same accounting methods as a service business, but requires
additional accounts because of the process of buying inventory and reselling it.

The Chart of Accounts is expanded to include those accounts necessary for the process of
purchasing and reselling. Look at it in relationship to the Income Statement for the
merchandising business:

Revenue ) Single-step format—will be expanded

- Cost of Goods Sold ) to Multi-step format
Gross Profit/Gross Margin
- Expenses________
Net Income

New accounts:

ASSETS:

Merchandise Inventory – a very active account because of the process of buying

merchandise and reselling it.

Inventory records can be kept on a perpetual or periodic inventory basis.

Perpetual Method – inventory is updated whenever merchandise is purchased or

sold. Most businesses today use the perpetual inventory method as
computerization of inventory makes it feasible. (Class will focus on perpetual
inventory method.)

Periodic Method – inventory valuation is determined by taking a physical count of

items in inventory at the end of the fiscal year, and the value of inventory is updated
by an adjusting entry.

JOURNAL ENTRIES:

Buy merchandise:

Merchandise Inventory debit

Accounts Payable/Cash credit
The purchase of merchandise is usually made on credit, and the contract of sale will
include the terms of payment, called the Credit Terms. The period of time before
payment is due is called the credit period. The seller may offer a cash discount to
encourage the buyer to pay earlier. This increases the cash flow to the seller and
decreases the risk that it will become an uncollectible account. The discount to the buyer
is called a purchases discount, while the seller views the discount as a sales discount.
The discount may be stated as 2/10, Net 30; 2/10, 1/30/net 60, etc., depending on the
industry. Net 10(EOM) requires payment 10 days after the end of the month.

A purchase discount decreases the cost of merchandise. Merchandise purchased for

$1000 with terms of 2/10, net/30 would be journalized as:

Accounts Payable 1000

` Cash 980
Merchandise Inventory 20

When merchandise purchased is returned to the seller, the amount owed is decreased, and
merchandise inventory is decreased:

Accounts Payable debit

Merchandise Inventory credit

As a matter of convenience, manufacturers and wholesales frequently quote prices of

merchandise based on a discount from the list or catalog price called a Trade Discount.
The price becomes the “Agreed-upon” price, and there is no record of the discount in
either the buyer’s or the seller’s accounting records

TRANSPORTATION TERMS

The sales agreement should always state the provisions concerning the cost of
transporting the goods to the buyer. If the terms are FOB destination, then the seller is
responsible for the cost of delivery. If the goods are FOB shipping point, the buyer must
pay the transportation costs. The importance of the transportation terms is not who pays
the transportation charges, but, rather, when does ownership of the goods transfer, and,
therefore, who is responsible for the goods once they leave the seller should loss or
damage occur.

REVENUE

The Revenue account for a merchandising business is usually called SALES. The gross
sales for the accounting period are made up of sales for cash and sales on account. The
Sales account is used only for recording the sale of merchandise, and revenue is
recognized accounting to the Revenue Principle, when title passes.
 Sell merchandise:

Accounts Receivable debit

Sales credit

Cost of Merchandise Sold debit

Merchandise Inventory credit

NOTE: the sale of merchandise requires the journalizing of two transactions. First,
record the sale; then update the value of inventory and remove the merchandise sold from
the inventory records.

Two new accounts in the Revenue division:

Sales Discounts
Sales Returns and Allowances

These accounts are contra to Sales. REMEMBER: A contra account has a balance
opposite of the account to which it belongs. These accounts “belong” to Sales; therefore,
the balance side is debit.

SALES DISCOUNTS – as a part of the contract of sale, the seller may negotiate with the
buyer a discount to be given for early payment of the bill. (This is the Purchases Discount
of the buyer.)Terms of 2/10, net 30, mean that the buyer can take a 2% discount on the
bill if payment is made within ten days. Since this is an effective interest rate of 36%
(there are eighteen 20-day periods in a year), the buyer should take advantage of the
discount, even if borrowing is necessary (can borrow at a much lower rate).

JOURNAL ENTRY when payment is received from customer within the discount period:

Cash debit (Accts.Rec. balance – discount)

Sales Discount debit
Accounts Receivable/customer name credit (total owed on AR)

If the customer is dissatisfied with the merchandise and returns it to the seller, the Sales
Returns and Allowances account holds the record of the return:

Sales Returns and Allowances debit

Accounts Rec./customer name credit

Merchandise Inventory debit

Cost of Goods Sold credit

NOTE: two journal entries are required. The second entry for the return records the
return of the items of inventory and takes the cost out of Cost of Goods Sold.
A business that uses the perpetual inventory method must take a physical inventory at the
end of the fiscal year, as the perpetual method does not record damaged, lost of stolen
goods. The physical count is compared to the perpetual inventory records and identifies
Shrinkage and establishes the correct value of the ending inventory to be reported on the
financial statements.

An adjusting entry is required at the end of the fiscal period to bring the perpetual
inventory records into agreement with the periodic inventory.

Cost of Merchandise Sold debit

Merchandise Inventory credit

COST OF MERCHANDISE SOLD – a new division in the ledger; holds the cost of
merchandise sold, and is updated with each sales transaction. It is an expense of doing
business, but it is given special treatment from other expenses and reported separately on
the Income Statement.

WORKSHEET: follow the same procedures as for the service business. There are just
more accounts to be extended to the Income Statement section.

Extend Revenue from Sales to the credit column; Sales Discounts to the debit column;
Sales Returns and Allowances to the debit column; Cost of Merchandise Sold to the debit
column, et cetera.

INCOME STATEMENT: Report important totals in the 1st column (right to left); report
detail on those totals in the 2nd column.

Revenue from Sales is reported in the 1st column. Sales Discounts and Sales Returns and
Allowances in the 2nd column; bring the total over under Sales; and report Net Sales in
the 1st column.

Bring the total of Cost of merchandise sold to the 1st column under Net Sales; subtract,
and report Gross Profit from Sales (this is the markup on merchandise purchased for
resale, and it must be high enough to cover the expenses and allow a Net Income.

The expenses must be classified into Selling Expenses and General and Administrative
Expenses.

Study format of the Income Statement on pg. 191. The Multi-Step Income Statement
may overwhelm the reader with data. Therefore, for distribution to persons outside the
business organization, the single-step format is used. Management, however, needs the
detail for decision making. You should understand how to condense the information from
the multi-step format to the single-step format.

CLOSING ENTRIES: The concept of closing entries for the merchandising business is
the same as for the service business. There are just some additional accounts to be
closed.

As for the service business, there are only four closing entries:

1. Close Income Statement accounts with a credit balance by debiting and credit Income
Summary for the total.

2. Close Income Statement accounts with a debit balance by debiting Income Summary
for the total and crediting each individual account for its balance (this includes Sales
Discount, Sales Returns and Allowances, and Cost of Merchandise Sold). Just move
down the column.

3. Debit Income Summary for Net Income and credit Owner’s Equity.

4. Debit Owner’s Equity for the balance of the Drawing account and credit Drawing.

FINANCIAL STATEMENT ANALYSIS:

The Acid-Test Ratio, also called the”Quick Ratio”, is a better measure of a business’s
debit-paying ability than the Current Ratio, as it includes only those assets that can be
“quickly” turned into cash—Cash and Cash Equivalents, Receivables, and Short-Term
Investments/Current Liabilities.

The Gross Margin Ratio – Net Sales – Cost of Goods Sold used to determine the percent
Net Sales
of every sales dollar that is gross profit.