MERCHANDISING OPERATIONS

Comparison of Income Statement:

Service Entities
​ Perform services for a fee
​ In ascertaining profit, a basic income statement is all that is needed
​ In Figure 6.1, profit is measured as the difference between revenues from
services and expenses
Merchandising Entities
​ Earn profit by buying and selling goods
​ Use the same basic accounting methods as service entities, but the process of
buying and selling merchandise requires some additional accounts and concepts.
This process results in a more complex income statement
To provide a better measure of performance, the income statement of a
merchandising business is presented with additional items:

In a Merchandising Business:
​ Net sales – arise from the sale of goods
​ Cost of sales or cost of goods sold – represent the cost of inventory the entity
has sold to customers
​ Gross Profit – the difference between net sales and cost of sales is called gross
profit
GROSS PROFIT = NET SALES – COST OF SALES
​ Then, other operating income is added and operating expenses (like distribution
costs, administrative expenses, and other operating expenses) are deducted
from gross profit to arrive at operating profit.
OPERATING PROFIT =
GROSS PROFIT – OPERATING EXP
​ Investment revenues, other gains and losses, and finance cost (e.g. interest
expense) are considered to arrive at profit before tax then income tax expense is
deducted to have profit from continuing operations.
​ Finally, profit from discontinued operations (net of tax) is taken to account to get
profit for the period.
Discontinued operations are the results of operations of a component of an entity that is
either being held for sale or has already been disposed of. The designated results of
operations must be reported as discontinued operations within the financial statements.
Parts of an Income Statement for a Merchandising Entity:
OPERATING CYCLE OF A MERCHANDISING BUSINESS
The merchandising entity purchases inventory, sells the inventory, and uses the cash to
purchase more inventory, and the cycle continues. For cash sales, the cycle is from cash to
inventory and back to cash. For credit sales or sales on account, the cycle is from cash
to inventory to accounts receivable and back to cash. In any industry, the manager strives to
shorten the cycle. The faster the sale of inventory and the collection of cash, the higher the
profits. The following illustrates the operating cycle of a merchandiser:

SOURCE DOCUMENTS
Merchandising businesses use various business forms and documents to help identify the
transactions that should be recorded in the books. These source documents contain vital
information about the nature and amount of the transactions.
The more common source documents along with their descriptions are the following:
​ Sales Invoice (SI)
​ prepared by the seller of goods and sent to the buyer
​ this document contains the name and address of the buyer, the date of sale
and information such as quantity, description and price about the goods
sold
​ also specifies the amount of sales, and the transportation and payment
terms
​ Bill of Lading (BoL)
​ a document issued by the carrier, trucking, shipping, or airline that specifies
contractual conditions and terms of delivery such as freight terms, time,
place, and the person named to receive the goods
​ Statement of Account
​ formal notice to the debtor detailing the accounts already due
​ Official Receipt
​ evidences the receipt of cash by the seller or the authorized representative
​ notes the invoices paid and other details by payment
​ evidence that the seller received cash
​ Deposit Slips
​ printed forms with the depositor’s name, account number and space for
details of the deposit
​ validated deposit slip indicates that cash and checks with the supplied
details were actually deposited or credited to the account holder
​ Check
​ a written order to a bank by a depositor to pay the amount specified in the
check from his checking account to the person named in the check
​ the entity issuing the check is the payor while the receiver is the payee
​ Purchase Requisition
​ a written request to the purchaser of an entity from an employee or user
department of the same entity that goods be purchased
​ Purchase Order
 ​ an authorization made by the buyer to the seller to deliver the merchandise as
detailed in the form
​ Receiving Report
​ a document containing information about goods received from a vendor
​ formally records the quantities and description of the goods delivered
​ Credit memorandum
​ a form used by the seller to notify the buyer that his account is being
decreased due to errors or other factors requiring adjustments
STEPS IN A PURCHASE TRANSACTIONS
Whenever a purchase or sale of merchandise occurs, the buyer and the seller should agree
on the price of the merchandise, the payment terms, and the party to shoulder the
transportation costs. Owners of small merchandising firms may settle these terms
informally by phone or by discussion with the vendor’s representative. Most large
businesses, however, follow certain procedures when purchasing merchandise.
The procedures are as follows:
​ When certain items are needed, the user department fills in a purchase
requisition form and sends it to the purchasing department.
​ The purchasing department then prepares a purchase order after checking with
the price lists, quotations, or catalogs of approved vendors. The purchase order,
addressed to the selected vendor, indicates the quantity, description, and price of
the merchandise ordered. It also indicates expected payment terms and
transportation arrangements.
​ After receiving the purchase order, the seller forwards an invoice to the
purchaser upon shipment of the merchandise. The invoice, called a sales
invoice by the seller and a purchase invoice by the buyer defines the terms of
the transaction.
​ Upon receiving the shipment of merchandise, the purchaser’s receiving
department sees to it that the terms in the purchase order are complied with, and
prepares a receiving report.
​ Before approving the invoice for payment, the accounts payable department
compares copies of the purchase requisition, purchase order, receiving report,
and invoice to ensure that quantities, descriptions, and prices agree.
All of the above forms: purchase requisition, purchase order, invoice, and receiving
report are source documents. When the goods are received or when the title has passed,
the entity should record purchases and a liability (or a cash disbursement). Generally,
the seller recognizes the sales transaction in the records when the goods have been
shipped.
TERMS OF TRANSACTIONS
Merchandise may be purchased and sold either on credit terms or for cash on delivery.
When goods are sold on account, a period of time called the credit period is allowed for
payment. The length of the credit period varies across industries and may even vary within
an entity, depending on the product.
When goods are sold on credit, both parties should have an understanding of the amount
and time of payment. These terms are usually printed on the sales invoice and constitute
part of the sales agreement. If the credit period is 30 days, then payment is expected within
30 days from the invoice date. The credit period is usually described as the net credit
period or net terms. The credit period of 30 days is noted as “n/30”. If the invoice is due
ten days after the end of the month, it may be marked “n/10 eom”
Cash Discounts
 ​ Some businesses give discounts for prompt payment called cash discounts. If a
trade discount is also offered, cash discount is computed on the net amount after
the trade discount. This practice improves the seller’s cash position by reducing
the amount of money in accounts receivable. Cash discount is designated by
such notation as “2/10” which means the buyer may avail of a two percent
discount if the invoice is paid within ten days from the invoice date. The period
covered by the discount, in this case, ten days, is called the discount period.
​ Called purchase discounts from the buyer’s viewpoint (credit – deducted from
purchases)
​ Sales discounts from the seller’s point of view (debit)
​ It is usually worthwhile for the buyer to take a discount if offered although it may
be necessary to borrow the money to make the payment.
​ Deducted from invoice price
Example:
Assume that an invoice for P150,000 with terms of 2/10, n/30, is to be paid within the
discount period. If an annual interest rate of 18% is assumed, the net savings to the buyer is
P1,530 which is determined as follows:

Trade Discounts
​ Suppliers furnish smaller wholesalers or retailers with price lists and catalogs
showing suggested retail prices for their products. These firms, however, also
include a schedule of trade discounts from the listed prices to enable the
customer to determine the invoice price to be paid. Trade discounts encourage
the buyer to purchase products because of markdowns from the list price. Trade
discounts should not be confused with cash discounts. This type of discount
enables the supplier to vary prices periodically without the inconvenience of
revising price lists and catalogs.
​ There is no trade discount account and there is no special accounting entry
for this discount. Instead, all accounting entries are based on the invoice price
which is obtained by subtracting the trade discount from the list price.
Example:
Illustration: Pinnacle Technologies quoted a list price of P2,500 for each 64-gigabyte flash
drive, less a trade discount of 20%. If Video Fantastic ordered seven units, the invoice price
would be as follows:

Trade discounts may be stated in a series. Assume instead that the trade discount given by
Pinnacle to Video Fantastic is 20% and 10%, the invoice price will be:
In the first example, both the buyer and the seller would record only the P14,000 invoice
price while in the second example, the invoice price will be P12,600.
TRANSPORTATION COSTS
When merchandise is shipped by a common carrier, a trucking entity or an airline, the
carrier prepares a freight bill in accordance with the instructions of the party making the
shipping arrangements. The freight bill designates which party shoulders the costs, and
whether the shipment is freight prepaid or freight collect.
Freight Bills
​ Usually show whether the shipping terms are FOB shipping point or FOB
destination.
​ F.O.B. – “free on board”
FOB Shipping Point (Buyer)
​ When the freight terms are FOB shipping point, the buyer shoulders the shipping
costs
​ Ownership over the goods passes from the seller to the buyer when the inventory
leaves the seller’s place of business, the shipping point.
​ The buyer already owns the goods while still in transit and therefore, shoulders
the transportation costs.
FOB Destination (Seller)
​ Seller bears the shipping costs
​ Title passes only when the goods are received by the buyer at the point of
destination; while in transit, the seller is still the owner of the goods so the seller
shoulders the transportation costs.
Freight Prepaid
​ seller pays the transportation costs before shipping the goods sold
Freight Collect
​ the freight entity collects from the buyer
​ Payment by either party will not dictate who should ultimately shoulder the costs
​ Normally, the party bearing the freight cost pays the carrier
​ FOB Shipping Point = Freight Collect
​ FOB Destination = Freight Prepaid
Sometimes as a matter of convenience, the firm not bearing the freight cost pays the carrier.
When this situation occurs, the seller and buyer simply adjust the amount of the payment for
the merchandise.
Treatment of Transportation Costs:

The shipping costs borne by the buyer using the periodic inventory system are debited to
transportation in account. In accounting, the cost of an asset, the merchandise inventory
includes all costs (e.g. shipping costs) incurred to bring the asset to its intended use. In the
cost of sales section of the income statement, the balance in this account is added to
purchases in computing for the net cost of purchases for the period.

Shipping costs borne by the seller are debited to “transportation out” account, which is
also called delivery expense, which is an operating expense in the income statement.
BUYER SELLER
 Transportation In Transportation Out
Freight In Freight Out
Delivery Expense
Added to purchases
Debit Debit

Who shoulders
Who pays
the
Freight Terms the
transportation
shipper?
cost?
FOB Destination,
Seller Seller
Freight Prepaid
FOB Shipping
Point, Freight Buyer Buyer
Collect
FOB Destination,
Seller Buyer
Freight Collect
FOB Shipping
Point, Freight Buyer Seller
Prepaid
INVENTORY SYSTEMS
Merchandise Inventory
​ Key factor in determining the cost of sales
​ Because merchandise inventory represents goods available for sale, there must
be a method of determining both the quantity and the cost of these goods.
​ There are two systems available to merchandising entities to record events
related to merchandise inventory: the perpetual inventory system and the
periodic inventory system.
​ If silent = Periodic Inventory System
PERPETUAL INVENTORY SYSTEM
​ Alternative to the periodic inventory system
​ The inventory account is continuously updated
​ Perpetually updating the inventory account requires that at the time of purchase,
merchandise acquisitions be recorded as debits to the inventory account
​ As the time of sale, cost of sales is determined and recorded as a debit to the
cost of sales account and a credit to the inventory account. With a perpetual
inventory system, both the inventory and cost of sales accounts receive entries
throughout the accounting period.
​ Many merchandising entities are now using the perpetual inventory system
without point-of-sale equipment. Computers have decreased in prices. These
powerful machines have dramatically reduced the time required to manage
inventory. Supermarkets and department stores use point-of-sale scanners built
into checkout counters to collect transactional data for the cash register and to
update their perpetual inventory system. In the absence of point-of-sale
scanners, the perpetual inventory system is more advisable for firms that sell
low-volume, high-priced goods such as motor vehicles, jewelry, and furniture.
​ When an entity uses the perpetual inventory system, the ending inventory should
reconcile with the actual physical count at the end of the period assuming that no
theft, spoilage, or error has occurred. Even if there is little chance of suspension
of inventory discrepancy, most entities make a physical count. At that time, the
account is adjusted for any inaccuracies discovered. The count provides an
 independent check on the amount of inventory that should be reported at the end
of the period.
PERIODIC INVENTORY SYSTEM
​ Primarily used by businesses that sell relatively inexpensive goods and that are
not yet using computerized scanning systems to analyze goods sold
​ No entries are made to the inventory account as the merchandise is bought and
sold. When goods are purchased, a separate set of accounts, purchases,
purchases discounts, purchases returns, and allowances, and transportation in
are used to accumulate information on the net cost of the purchases.
​ Only at the end of the period, when the inventory is counted, will entries be made
to the inventory account to establish its proper balance.
INCOME STATEMENT

NET SALES
​ First part of the merchandising income statement as presented above
Gross Sales
​ Under the accrual accounting, revenues from the sale of merchandise are
considered to be earned in the accounting period in which the title of goods
passes, usually at the point of delivery, from the seller to the buyer.
​ Consist of total sales for cash and on credit during the accounting period
​ Although cash for the sale is uncollected, the revenue is recognized as earned at
the time of the sale. For this reason, there is likely to be a difference between net
sales and cash collected from those sales in a given period.
​ As an income account, the sales account is credited whenever sales on account
or cash sales are made. Only sales of merchandise held for resale are recorded
in the sales account. If a merchandising firm sold one of its delivery trucks, the
credit would be made to the delivery equipment, not to sales account.
The journal entry to record the sale of merchandise for cash is as follows:

If the sale of merchandise is made on credit, the entry will be:

Sales Discounts
Assume that G. Detoya Traders sold merchandise on Sept. 20 for P3,000; terms 2/10, n/60.
At the time of sale, the entry is:

The customer may take advantage of the sales discount any time on or before Sept. 30,
which is 10 days after the date of the invoice. If the client paid on Sept. 30, the entry is:
At the end of the accounting period, the sales discount account has accumulated all the
sales discounts for the period. The account is considered a contra-income account and
deducted from gross sales in the income statement.
Sales Returns and Allowances
​ Each return or allowance is recorded as a debit to an account called sales returns
and allowances. An example of such transaction follows:

The seller usually issues the customer a credit memorandum (i.e. Accounts Receivable or
Cash is credited), which is a formal acknowledgment that the seller has reduced the amount
owed by the customer. Sales returns and allowances is a contra-income account and is
accordingly deducted from gross sales in the income statement.
Transportation Out
​ When the freight term is FOB destination, the seller shoulders the transportation
costs; when the term is FOB shipping point, the buyer bears the shipping costs.
Case No. 1. Assume that G. Detoya Traders sold merchandise totaling P17,000 FOB
destination, freight prepaid; terms 2/10, n/30. The transportation costs amounted to P1,900.
The entry to record this transaction would be:

If this invoice is collected on Dec. 5, the sales discount will be P340 (P17,000 x 2%).
Transportation out is an operating expense.

To record sale of merchandise on credit.

Case No. 2. Assume that G. Detoya Traders sold merchandise totaling P17,000 FOB
shipping point, freight collect; terms 2/10, n/30. The transportation costs amounted to
P1,900. The entry to record this transaction would be:

There is no debit to transportation out account since the shipping term provided that the
buyer should shoulder the transportation costs. If his invoice is collected on Dec. 5, the sales
discount will be P340 (P17,000 x 2%). The entry would be:

Case No. 3. Now assume that G. Detoya Traders sold merchandise totaling P17,000 FOB
destination, freight collect; terms 2/10; n/30. The transportation costs amounted to P1,900.
The entry to record this transaction would be:
Accounts receivable is decreased by the transportation charges paid by the buyer for the
benefit of the seller. If this invoice is collected on Dec. 5, the sales discount will be P340
(P17,000 x 2%) since the discount applies to total sales.

Case No. 4. Assume further that G. Detoya Traders sold merchandise totaling P17,000 FOB
shipping point, freight prepaid; terms 2/10, n/30. The transportation costs amounted to
P1,900. The entry to record the transaction would be:

If this invoice is collected on Dec. 5, the sales discount will be P340 (P17,000 x 2%). The
discount only applies to total sales.

COST OF SALES / COST OF GOODS SOLD

​ Largest single expense of the merchandising business
​ It is the cost of inventory that the entity has sold to customers
​ Every merchandising business has goods available for sale to customers. The
goods available for sale during the year is the sum of two factors, merchandise
inventory at the beginning of the year and net cost of purchases during the
period.
GAFS = Beg. Inv. + Net Cost of Purchases
​ If an entity is able to sell all the goods available for sale during the given
accounting period, the cost of sales would then equal goods that had been
available for sale. In most cases, however, the business will have goods still
unsold at the end of the year. To find the actual cost of sales, the merchandise
inventory at the end of the period is subtracted from the goods available for sale.
Cost of Sales = GAFS – Ending Inv.
Exhibit 6-3 showed goods costing P1,796,600 as available for sale. G. Detoya started with
P528,000 in beginning merchandising inventory and a net cost of purchases (or cost of
goods purchased) of P1,268,600 during the year. At the end of the year, P483,000 of goods
were left unsold; this amount should appear as the merchandise inventory in the balance
sheet. When this ending merchandise inventory is subtracted from goods available for sale,
the resulting cost of sales is P1,313,600.
 Exhibit 6-3

Figure 6-4
Figure 6-4 showed a pictorial diagram of the cost of sales section. In summary, goods
available for sale during the period come from the beginning inventory and net cost of
purchases. The goods are either sold during the period or remain unsold at the end of the
period. Goods available for sale will eventually turn to expense for the period as cost of
sales or to asset as merchandise inventory. To understand fully the concept of cost of sales,
it is necessary to examine the details affecting merchandise inventory and the net cost of
purchases.
Merchandise Inventory
​ The inventory of a merchandising entity consists of goods purchased for resale.
For a grocery store, inventory would be made up of meats, vegetables, canned
goods, and other items. For lumber and hardware, it would be plywood, nails,
paints, iron sheets, cement, tools, and other items. Merchandising entities
purchase their inventories from manufacturers, wholesalers, and other suppliers.
​ The merchandise inventory at the beginning of the accounting period is called the
beginning inventory. Conversely, the merchandise inventory at the end of the
accounting period is called ending inventory. As presented in Exhibit 6-3,
beginning and ending inventories are used in calculating the cost of sales in the
income statement. The ending inventory shown in the income statement will be
the merchandise inventory to be reported in the balance sheet.
​ Effectively, the ending inventory of the current period will be the beginning
inventory of the next period.
Net Cost of Purchases
​ Under the periodic inventory method, net cost of purchases consists of gross
purchases minus purchases discounts, and purchases returns and allowances
equal net purchases plus transportation costs.
Net Cost of Purchases = P – PD – PRA = NP + TC
Purchases (P)
​ The purchases account, a temporary account, is used for merchandise
purchased for resale.
 ​ Its sole purpose is to accumulate the total cost of merchandise purchased during
an accounting period.
​ Purchases of other assets such as equipment should be recorded in the
appropriate asset accounts.
​ Recording merchandise purchases at invoice price is known as the gross price
method of recording purchases.
When the periodic inventory method is used, all purchases of merchandise are debited to
the purchases account as shown below:

Purchases Returns and Allowances (PRA)

​ A contra account and is accordingly deducted from purchases in the income
statement (see Exhibit 6-3).
​ It is important that a separate account be used to record purchase returns and
allowances because management needs the information for decision-making.
​ It may be very costly to return merchandise. There are costs that cannot be
recovered such as ordering costs, accounting costs, transportation costs, and
interest on money invested in the goods. There may be call for new purchasing
procedures or suppliers.
​ Sales returns and allowances in the seller’s books are recorded as purchases
returns and allowances in the books of the buyer. This should be recorded as
follows:

Purchases Discounts (PD)

​ Like purchases returns and allowances, purchases discounts is a contra account
that is deducted from purchases on the income statement.
​ If the entity makes a partial payment on an invoice, most creditors will allow the
entity to take the discount applicable to the partial payment.
​ This discount does not apply to the transportation or other charges that might
appear on the invoice.
Merchandise purchases are usually made on credit and commonly involve purchases
discounts for early payment. In relation to the Nov, 12 and 14 transactions, the payment is
recorded as follows:

Transportation In (TI)
Case No. 1. Assume that G. Detoya Traders made purchases totaling P17,000 FOB
destination, freight prepaid; terms 2/10, n/30. Transportation costs amount to P1,900. The
entry would be:

There is no debit to transportation in account since the shipping term provided that the seller
should shoulder the transportation costs. In addition, the seller prepaid the freight. If this
invoice is paid on Dec. 5, the purchases discount will be P340 (P17,000 x 2%). The entry
would be:
Case No. 2. Assume that G. Detoya Traders made purchases totaling P17,000 FOB
shipping point, freight collect; terms 2/10, n/30. The transportation costs amounted to
P1,900. The entry to record this transaction would be:

If this invoice is paid on Dec. 5, the purchases discount will be P340 (P17,000 x 2%).
Transportation in will form part of the net cost of purchases.

Case No. 3. Now assume that G. Detoya Traders made purchases totaling P17,000 FOB
destination, freight collect; terms 2/10, n/30. The transportation costs amounted to P1,900.
The entry to record the transaction would be:

Accounts payable is decreased by the transportation charges paid by the buyer for the
benefit of the seller. If this invoice is paid on Dec, 5, the purchases discount will be P340
(P17,000 x 2%) because the discount applies to total purchases.

Case No. 4. Assume further that G. Detoya Traders made purchases totaling P17,000 FOB
shipping point, freight prepaid; terms 2/10, n/30. The transportation costs amounted to
P1,900. The entry to record the transaction would be:

If this invoice is collected on Dec. 5, the sales discount will be P340 (P17,000 x 2%). The
discount only applies to total sales.

Accounts Description Normal

Balance

Merchandise ​ Beginning Debit

Inventory Inventory
​ Ending
Inventory:
Shown as
Merchandise
Inventory in the
Balance Sheet
 Purchases Temporary account Debit
closed at the end
of the period

Purchases Contra-account, Credit

Discounts deducted from
purchases
Purchases
Returns &
Allowances

Transportation In Freight cost Debit

incurred by the
buyer
VALUE-ADDED TAX ENTRIES
The foregoing entries for sales and purchases did not incorporate the effects of value-added
taxes on the transactions to simplify the illustrations. But the learning will not be complete
without the following illustration.

Illustration. Remedios Palaganas Feeds based in Pangasinan trades specialty feeds for
race horses, fighting cocks, aquarium fishes, zoo animals and other animals generally
considered as pets. On May 13, 2019, Remedios Palaganas Feeds purchased on account
specialty feed with a total amount payable of P784,000. A wholesaler operating in the region
bought for cash all of the available feeds on May 25, 2019; amount of cash received was
P1,120,000. Remedios Palaganas Feeds paid the value-added tax due by month end not
minding the actual deadline.
The entries related to value-added tax are as follows:

Input tax increases the amount to be paid but has no effect on the cost of the purchases.
Output tax also increased the amount collected but not necessarily, the sales figure. The
value of goods or properties sold and subsequently returned or for which allowances were
granted by a VAT-registered person may be deducted from the gross sales or receipts for the
quarter in which the refund is made or a credit memorandum is issued. Sales discounts or
indicated in the invoice at the time of sale may be excluded from the gross sales within the
same quarter it was given.

Remedios Palaganas, because of the sales discounts granted, will pay value-added tax due
of P33,600 only.
Value-Added Tax (VAT) = 12%
Input Tax
​ Current asset
​ Tax paid in advance to supplier
Output Tax
​ Liability; payable to BIR
​ Collecting tax from customer
​ Minus input tax = VAT Payable
OPERATING EXPENSES
​ Make up the third major part of the income statement for a merchandising entity
​ These are expenses, other than the cost of sales, which are incurred to generate
profit for the entity’s major line of business, merchandising.
​ It is customary to group operating expenses into useful categories. Distribution
costs, administrative expenses, and other operating expenses are the categories.
Distribution Costs / Selling Expenses
​ Expenses related directly to the entity’s efforts to generate sales
​ These include sales salaries and commissions, and the related employer payroll
expenses; advertising and store displays; traveling expenses; store supplies
used; depreciation of store property and equipment; and transportation out.
Administrative Expenses
​ Expenses related to the general administration of the business
​ These include officers and office salaries, and the related employer payroll
expenses; office supplies used; depreciation of office property and equipment;
business taxes; professional services; uncollectible accounts expense and other
general office expenses.
Other Operating Expenses
​ Expenses that are not related to the central operations of the business
​ These are expenses and losses from peripheral or incidental transactions of the
enterprise; for example, loss on sale of investments or loss on sale of property
and equipment.
PERIODIC AND PERPETUAL INVENTORY SYSTEM COMPARED
This appendix will demonstrate the entries typically used with the periodic inventory system,
contrasted to the entries used with the perpetual inventory system. Assume that the
beginning inventory for the year is P250,000. Assuming that the transactions (nos. 1 to 7)
were the only transactions for the entire year, the balance in the inventory account at
year-end under the periodic inventory system is P250,000 (beginning inventory). The
year-end balance in the inventory account under the perpetual inventory system is
P231,860.
Under the perpetual inventory system, the inventory account is increased by purchases,
transportation in, and sales returns and is decreased by the cost of sales, purchases returns
and allowances, and purchases discounts.
At year-end, the physical inventory is taken, and it is revealed that the actual inventory on
hand is P231,500. The year-end journal entries (nos. 8 to 10) are then made to bring the
inventory account balance into an agreement with the amount of the physical inventory.
When posted to the general ledger, both the periodic and perpetual inventory systems result
in the same ending inventory amount, P231,500.
Corollary Entry – perpetual inventory system; the entry that follows after the first entry
For Perpetual:
​ If Sales Allowances – do not record inventory
​ Still need a physical count
Summary:
​ Transaction that involves payment/purchases of Transportation In & Sales Return
= DEBIT Inventory
​ Purchases Discounts, Purchases Returns & Allowances, Cost of Sales = CREDIT
Inventory
Income Summary
​ Credit = income
​ Debit = expense
COMPLETING THE CYCLE FOR A MERCHANDISING BUSINESS
NEED FOR A PHYSICAL COUNT
Periodic Inventory System
​ In the periodic inventory system, purchases of merchandise are accumulated in
the purchases account. During the accounting, no entry is made to the
 merchandise inventory account such that its balance at the end of the period,
before adjusting and closing entries, is the same as the beginning inventory.
​ With no perpetual record of the cost of sales during the period, the only way to
obtain the cost of ending inventory is to make a physical count.
​ It should be noted that the ending inventory amount is needed in the computation
of the cost of sales. To recapitulate, ending inventory is deducted from goods
available for sale to obtain cost of sales.
Cost of Sales = Goods Available for Sale – Ending Inventory
Steps Involved in the Physical Count:
​ All merchandise owned by the entity is counted.
​ The quantity counted is multiplied by the cost per unit for each inventory item.
​ The costs of various items are added to determine the total cost of inventory.

Ending Inventory
​ Resulting total cost of inventory
​ This amount will appear as a deduction in the cost of sales section of the income
statement, and as a current asset in the balance sheet
​ The physical count is made at or near the balance sheet date
​ A reliable physical count is very significant because the ending inventory amount
will affect both the income statement and the balance sheet
Example:
An understatement of ending inventory in the 2018 income statement will cause an
overstatement of cost of sales. In effect, gross profit and profit will be understated.
The understatement of ending inventory in the current period means that the beginning
inventory of the next period will also be understated. As a result of this error or
omission, the current assets and the owner’s equity in the 2018 balance sheet would
be understated. In summary, an error in valuing ending inventory will translate into one
inaccurate balance sheet and two incorrect income statement.
MERCHANDISE INVENTORY AT THE END OF THE PERIOD
At the end of the period, entries are made to reflect in the inventory account the ending
balance. The objectives of these entries are as follows:
​ To remove the beginning balance from the merchandise inventory account
and to transfer it to income summary.
​ To enter the ending balance in the merchandise inventory account and to
establish it in the income summary.

In this example, merchandise inventory was P528,000 at the beginning of the year and
P483,000 at the end of the year. Effect A removed the P528,000 from the merchandise
inventory account and transferred it to income summary. In income summary, the P528,000
is in effect added to the cost of purchases because, like expenses, the balance of the
purchases account is debited to income summary by a closing entry.

Effect B establishes the ending balance of merchandise inventory of P483,000 and entered
it as a credit in the income summary account. The credit entry in income summary has the
effect of deducting the ending inventory from goods available for sale because both
purchases and beginning inventory are entered on the debit side. To summarize, beginning
merchandise inventory and purchases are debits to income summary; while ending
merchandise inventory is credit to income summary.
Thus, the objectives stated above are accomplished if Effect A and B concurred. The
question then arises as to how to achieve these effects. Two acceptable methods are
available: the adjusting entry method and the closing entry method. Each method produces
exactly the same result.
Adjusting Entry Method
Using the adjusting entry method, the two entries indicated by effects A and B which are
prepared at the time the other adjusting entries are made follow:

Closing Entry Method

The closing entry method makes the debit and the credit to merchandise inventory by
including them among the closing entries as follows:

Notice that in both methods, merchandise inventory is credited for the beginning balance
and debited for the ending balance and that the opposite entries are made to income
summary.
PREPARING THE WORKSHEET
The worksheet of a merchandising business is the same as that of a service business except
that it has to deal with the new accounts related to merchandising transactions. These
accounts include sales, sales returns and allowances, sales discounts, purchases,
purchases returns and allowances, purchases discounts, transportation in, merchandise
inventory and transportation out. The worksheet for G. Detoya Traders using the closing
entry method is shown below. Each pair of columns in the worksheet, and the adjusting and
closing entries are discussed as follows:
Trial Balance Columns
​ The first step in the preparation of worksheet is to enter the balances from the
ledger accounts into the trial balance columns. The merchandise inventory
account balance of P528,000 is the cost of the beginning inventory.
Adjustment Columns
​ Under the closing entry method of handling merchandise inventory, the adjusting
entries for G. Detoya Traders are entered in the adjustments columns in the
 same way that they were for service entities. These involve insurance expired
during the period (adjustment a); store and office supplies (adjustments b and c);
depreciation of building and office equipment (adjustments d and e); accrual of
interest expense (adjustment f). No adjusting entries are made for merchandise
inventory because the closing entry method was used. After the adjusting entries
are entered in the worksheet, the trial balance columns and adjustment columns
are totaled to prove the equality of the debits and credits.
Omission of the Adjusted Trial Balance
​ These two columns are used when there are many adjusting entries to be
considered. When only a few adjusting entries are required as in this case, these
columns are not necessary and may be omitted.
Income Statement and Balance Sheet Columns
​ After the trial balance columns have been totaled, the adjustments entered, and
the equality of the columns proved, the balances are extended to statement
columns. Each accounts balance is entered in the proper column of the income
statement or balance sheet.
​ The extension of the beginning and ending inventory balances requires some
new procedures. First, the beginning inventory balance of P528,000 is extended
to the debit column of the income statement as illustrated in 7-1. This procedure
has the effect of adding beginning inventory to ent cost of purchases; observe
that the purchases account is also in the debit column of the income statement.
​ Second, the ending inventory balance of P483,000 which is not in the trial
balance is entered in the credit column of the income statement. This procedure
has the effect of subtracting the ending inventory from goods available for sale.
Note that two inventory amounts appeared in the income statement columns.
This is because both the amounts appeared in the income statement columns.
This is because both the beginning inventory and ending inventory are needed in
the computation of cost of sales.
​ Finally, the ending inventory is also entered in the debit column of the balance
sheet. After all the items have been extended to the proper statement columns,
the four columns are totaled. The profit or loss is determined as the difference
between the debit and credit columns of the income statement. In this case, G.
Detoya Traders earned a profit of P455,210, which is extended to the credit
column of the balance sheet. The four columns are then added to prove the
equality of the debits and credits.
PREPARING THE FINANCIAL STATEMENTS

Income Statement
​ The statement may be prepared by referring to the income statement columns of
the worksheet. Per revised PAS No. 1, an enterprise should present an analysis
of expenses using a classification based on either the nature of expenses or their
function within the entity, whichever provides information that is reliable and more
relevant. Entities are encouraged to present the analysis of expenses on the face
of the income statement.
Nature of Expense Method
​ Expenses are aggregated or combined in the income statement according to their
nature and are not reallocated among various functions within the entity. This
method is simple to apply in many smaller enterprises because no allocation of
operating expenses between functional classifications is necessary.
​ Examples include raw materials and consumables used, employee benefits
expense, depreciation and amortization expense, transportation costs,
advertising costs and other operating expenses.
Function of Expense Method
​ This method, also referred to as the “cost of sales” method, classifies
expenses according to their function as part of the cost of sales,
distribution/selling, administrative and other operating activities. This presentation
often provides information that is more relevant to users than the nature of
expense method but the allocation of costs to functions can be arbitrary and
involves considerable judgment. This method provides multiple classifications
and intermediate differences to highlight significant relationships.
​ In a merchandising business, net sales arise from the sale of goods while cost
of sales or cost of goods sold represents the cost of inventory the entity has
sold to customers. The difference between the net sales and cost of sales is
gross profit.
​ Then, other operating income is added and operating expenses (like distribution
costs, administrative expenses, and other operating expenses) are deducted from
gross profit to arrive at operating profit.
 ​ Investment revenues, other gains and loss, and finance costs (e.g. interest
expense) are considered to arrive at profit before tax then income tax expense is
deducted to arrive at profit for continuing operations. Finally, profit from
discontinued operations (net of tax) is taken to account to get profit for the period.

Statement of Changes in Equity

Balance Sheet
The balance sheet dated “Dec. 31, 2019” is implicitly understood to mean “at the close of
business on Dec. 31, 2019”
ADJUSTING AND CLOSING ENTRIES

The adjusting entries are journalized and posted to the ledger as they would be in a service
entity. The closing entries for G. Detoya Traders under the closing entry method appear
below.

Note that merchandise inventory is credited in the 1st entry for the amount of the beginning
inventory, P528,000; and debited in the 2nd entry for the ending inventory, P483,000. Except
for the closing of the temporary accounts typical of a merchandising business, the closing
procedures are the same with that of a service business.
POST-CLOSING TRIAL BALANCE
A final trial balance is prepared to test the equality of the accounts after posting the
adjusting and closing entries. This trial balance is similar to the one discussed in service
business except for the addition of the merchandise inventory account.

WORKSHEET IN A PERPETUAL INVENTORY SYSTEM

The worksheet is prepared after all transactions for the year have been journalized and
posted. However, the following items should be noted:
​ The inventory amount in the trial balance is the year-end balance since the
inventory account is perpetually updated. There will be no merchandise inventory
adjusting or closing entry unlike when the periodic inventory system is used. The
year-end inventory balance will simply be extended to the debit column of the
balance sheet.
​ The cost of sales account is a ledger account in the perpetual inventory
system. There will be no account for purchases, purchases returns and
allowances, purchases discounts and transportation in because information
related to these items is recorded directly in the inventory account. When the
closing entries are made, cost of sales will be closed with the other temporary
accounts with debit balances.
​ The adjustments are handled in exactly the same way as they are handled in the
periodic worksheet.
​ An adjusting entry is necessary when the year-end inventory account balance
does not tally with the physical