CHAPTER THREE

3. ACCOUNTING FOR MERCHANDISING BUSINESSES

3.1 Characteristics of merchandising business

The differences of service enterprises and merchandising enterprises are best described by
focusing on the revenues and expenses in the following income statements:
Service Business Merchandising Business
Fees earned XXX Sales XXX
Operating expenses XXX Less Cost of goods sold XXX
Net income XXX Operating expenses XXX
Net income XXX

The revenue activities of a service business involve providing services to customers. On the
income statement for service business, the revenues from services are reported as fees earned.
The operating expenses incurred in providing the services are subtracted from fees earned to
arrive at net income.

In contrast, the revenue activities of a merchandising business involve the buying and selling
of merchandise. A merchandising business must first purchase merchandise to sell to its
customers. When this merchandise is sold, the revenue is reported as sales, and its cost is
recognized as an expense called the cost of merchandise sold. The cost of merchandise sold is
subtracted from sales to arrive at gross profit. This amount is called the gross profit before
deducting the operating expenses.

Merchandise on hand (not sold) at the end of an accounting period is called merchandise
inventory. Merchandise inventory is reported as a current asset on the balance sheet.
Following we will see the merchandiser financial statements and transactions that affect the
income statements (sales, cost of merchandise sold, and gross profit) and the balance sheet
(merchandise inventory).

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3.2 What is a Merchandising Business?
Business?
A merchandising business buys goods in finished form for resale to customers.
A merchandising business sells tangible goods to its customers. When we say goods it can be
anything that has physical characteristics that you can see and touch (i.e., tangible). These
can be goods ranging from television sets, cars, office table and chair (furniture), to chewing
gums, toothbrushes and various stationery. These goods that a merchandising company sells
to its customers are called merchandise inventory.
inventory. (A customer is an individual or a firm to
whom a business sells its products.)
One final thing that you should know about a merchandising business is that a merchandising
company does not produce the goods that it sells. Instead, it buys these goods from
manufacturers,
manufacturers, which produce the goods using raw materials.
The following diagram can help you to better visualize the flow of goods from a manufacturer
to the final consumer:

Sells Merchandising companies

Manufacturers Wholesaler Sell Retailer Final consumer
s
Goods goods

A wholesaler is a trader, which buys goods from manufacturers and sells them to a retailer or
another wholesaler. It is the retailer who sells the goods to the final consumer by buying
them from wholesalers (or sometimes from a manufacturer).
When you want to buy a soap to wash your clothes, where do you buy it? Who is the
manufacturer of the soap? Are there any wholesalers of that soap in your area? Can the
wholesaler be taken as the customer of the manufacturer? And finally, can we say the shop
from which you buy the soap is a merchandising business?
3.3 THE PERIODIC AND THE PERPETUAL INVENTORY SYSTEMS
The value of goods (merchandise) on hand at the end of the year for resale would be reported
on the Balance Sheet as one asset as described above. This means that we need to open a
separate ledger account in which to record merchandise inventory information.
The two alternatives in dealing with this account are:
1. To up date this account every time goods are bought and sold (continuously =
perpetually) or
2. To up date this account only at the end of the period (periodically).
3.3.1 The Periodic Inventory System
Under this system, as the name periodic suggests, the inventory account is updated only
periodically i.e., only at the end of a period.

When goods are bought, a temporary purchases account is debited instead of the inventory
account itself. Likewise, when goods are sold revenue is recorded, but the fact that there is a

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reduction in merchandise inventory is not recognized. This is because the Merchandise
Inventory account is not credited every time goods are sold.

Therefore, if one wants to know the cost of goods on hand, it is a must that a physical
inventory be conducted first. The account doesn’t reflect the value of goods on hand because
it was not up dated when merchandise was bought and sold. Physical inventory means
counting the quantity of goods on hand. Once the quantity of goods on hand has been
determined, it is multiplied by the unit price of those goods to determine the cost of goods on
hand.

In conclusion, under the periodic system, since the merchandise inventory account is not
continually updated, the cost of merchandise on hand is determined only at the end of the
period after carrying out a physical inventory.

Companies such as department stores or ‘super markets’, which sell small items, use periodic
systems.
3.3.2 Perpetual Inventory Systems
A perpetual inventory system continuously records the amount of inventory on hand
(perpetual =continuous). Under this system, the merchandise inventory account is debited or
credited every time (goods) are bought or sold. When an item is sold, its cost is recorded in a
separate cost of goods sold account in addition to recording sales.
The cost of merchandise on hand can be looked up from the merchandise Inventory account
any time, without conducting a physical inventory.

3.4 RECORDING PURCHASES AND SALES TRANSACTIONS

The following discussions in the remainder of this chapter all assume the use of a periodic
inventory system. The perpetual system will be discussed in part two of this course.
3.4.1 Recording Sales
When a merchandising company transfers goods to the buyer, in exchange for cash or a
promise top at a later date, revenue is produced to the company. This revenue is recorded in a
Sales account. However, the sales revenue, which is reported on the Income Statement, is
Net Sales.
Sales. That is,
Net Sales = Gross Sales – Sales Discounts- Sales Returns and Allowances
Recording Gross Sales
The gross sales amount is obtained from sales invoices. An invoice is a document, prepared
by the seller of merchandise to notify to the buyer the details of the sale. These details can
include number of items sold, unit price of items, total price, terms of sale and manner of
shipment. When goods are delivered to the customer, the Sales account is credited because
revenues are increased by credits.

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A company can sell goods either for cash or on account.

Recording Cash Sales

When merchandise is sold on cash, the Cash account is debited and the revenue account Sales
is credited.
Example – Z Company based in Bahir Dar, buys and sells used commodities. On January 14.
2001. Z sold goods for Birr 20,000. Record the transaction.
Answer:
January 14, Dr. Cash………………………………..20,000.00
Cr. Sales……………………………………20,000.00
Recording Credit Sales
The Accounts Receivable account is debited when goods are sold on account (for credit).
Example -
Ika sold goods worth Birr 35,000 on account on January 15, 2001. Record the transaction.
Solution
January 15. Accounts Receivable…………………..35,000.00
Sales…………………………………………35,000.00
Determining Gross Sales when there are trade discounts
A trade discount is a percentage deduction from the specified list price or catalogue price of
merchandise.
Trade discounts allow us:

- To avoid publishing a new catalogues every time prices change.

- To grant quantity discounts
- Quotation of different prices to different types of customers.

Trade discounts are not recorded in the seller’s accounting records; they are only used to
calculate the gross selling price.

Example:
Example: Z 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)
(12,000)
Invoice price 28,000

Journal entry:

Cash……………………..28,000
Sale………………………28,000

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Recording Deductions from Gross Sales
Go back to illustration 1- and have a look at the model Income Statement of a merchandising
company. You will see that the sales reported on the income statement is net sales,
sales, i.e., after
deduction of sales discounts and sales returns and allowances.
Gross sales (from invoice)…………………..XXX
Less: Sales discounts…………………………….(XX)
Sales returns and allowances ………….…..(XX)
………….…..(XX)
Net sales……………………………….XX
sales……………………………….XX
Sales Discounts
Sales Discounts are deductions from invoice price to customers who pay early when goods
are sold on credit.
As a seller, you would usually want to be paid as soon as possible. This is because, as you
can imagine, you can use the money for various purposes once you have been paid. If you
want your customers to pay you early the customary practice is to offer them a (deduction)
discount from the invoice price if they pay early.
How much discount is given usually depends on the credit terms.
terms. These terms (agreements)
are usually stated on the invoice. The most frequently used terms are stated below:
- “n/30” or “Net 30” – means there is no discount even if the customer pays before the
payment date.
- 2/10, n/30 –means the due date of the payment is after 30 days of the sale. But if the
customer pays with in 10 days she will get a 2% discount.
- 2/EOM, n/60- means the normal due date is with in 60 days of the sale but the
customer will get a 2% discount if she pays before the end of month of sale.

Sales discounts are purchase discounts from the side of the buyer. Sales discounts and
purchase discounts are the same thing seen from different sides. They are generally called
cash discounts together. A cash discount is, therefore, deduction from original invoice price
for early payment when goods are sold on credit (on account).
Example:
On January 21, 2001 Z Company sold merchandise for birr 20,000 on account. The credit
terms are 2/30, n/30. The customer paid on January 31, (10 days after invoice date).
A. How much would Z Company collect from this sale?
B. Record the necessary journal entries on January 21 and January 31.
Solution:
A- Since the customer paid with in the discount period, i.e., with in 10 days, she will get a
2% discount. Therefore,
Invoice price……………………..20,000
Less: Sales Discount (2% X 20,000)………(400)
20,000)………(400)
Cash collected …………. 19,600
B- Journal Entries:
January 21 A/R…………………..20,000
Sales……………………..20,000

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 January 31, Cash………………….19600
Sales Discounts ………...400
A/R………………..20,000
Sales Returns and Allowances
Customers can return merchandise they have bought if they find it to be defective or of the
wrong model, or unsatisfactory for a variety of reasons. A sales return is merchandise
returned by a buyer. The buyer would be paid back her money if she has already paid.

A sales allowance is a deduction from the original invoice price when the customer keeps the
merchandise but is dissatisfied. If, for example, a customer buys an item worth birr 100 and
finds it to be of the wrong color after receiving it, she may still want to retain the item even if
she is dissatisfied with its color. In that case the seller may let her pay only, say, Birr 95 by
giving her an allowance of Birr 5.
Example:
Z Company sold merchandise worth Birr 15, 000 on February 3, 2001 on account terms 2/10,
n/30. On February 5, the buyer returned a portion of the goods worth Birr 5,000 as they were
found to be of the wrong model. The buyer then paid on February 13, 2001.
Record the necessary journal entries on February 3, 5 and 13.

Solution:
February 3 A/R…………………….15,000
Sales …………………….15,000

February 5 Sales Returns and Allowances ………5,000

A/R………………………………….5,000
February 13 Cash…………………………………..9800
Sales Discount ……………………….. 200
A/R…………………………10,000

Here, the buyer paid with in the discount period. Therefore, the amount that would be
collected is:
15,000 – 5,000 = 10,000
Deduct:
Deduct: 2% Cash discount (200)
Cash collected 9800

3.4.2 Recording Purchases

Under the periodic inventory system a merchandising company uses the Purchases account to
record the cost of goods bought for resale to customers.

Example:

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Z Company bought goods worth Birr 43,000 from Saba Co., which is based in Addis Ababa,
on account on January 4, 2001, terms 20/10, n/30. Record the transaction.

Solution:

January 4 – Purchases …………………..43,000

Accounts payable………………………..43,000
Deductions from Purchases
Purchase Discounts
A merchandising company can buy goods under credit terms that permit it to get a discount if
it pays with in a specified period of time. The deduction from the original purchase price is
recorded in a separate contra Purchase account called Purchase Discounts.
Example:
Z Company bought goods worth Birr 50,000 from Y Company on account on January 14,
2001, terms 1/10, n/60. Z Company paid on January 24, 2001. Record the transactions on
both dates.
Solution:
Jan. 14. Purchases………………..50,000
A/P………………………50,000
Jan. 24. A/P…………………… …50,000
Purchase Discounts …….......500
Cash…………………….. 49,500

Purchase Returns and allowances

A purchase return occurs when a buyer returns merchandise to a seller.

A purchase allowance is a reduction on the price of goods bought for dissatisfaction on the
side of the buyer.

Both purchase returns and purchase allowances are recorded in a contra purchase account
called Purchase Returns and Allowances.
Example:
In the previous example for Z Company, a portion of the goods worth birr 5,000 bought on
January 14 from Y Company were of the wrong size. Y Company acknowledged this and
gave Z Company a 5% price allowance on January 17.
What should Z Company record on January 17?
Solution:
January 17 A/P…………………………………250
Purchase Returnes and Allowance…………250

When both purchase discounts and purchase returns and allowances are deducted from
purchases what is obtained is called Net purchase. That is,

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 Gross Purchase…………………………XX
Less:
Less: Purchase discounts…………………….(XX)
Purchase returns and allowances………(XX)
allowances………(XX)
Net Purchases…………………….XX
Purchases…………………….XX
Transportation costs
Once merchandise has been bought it has to be moved from the seller’s place to the buyer’s
place. A third party comes in to the scene here: the transportation company who moves the
goods between the two places.
That is:
Seller Goods goods goods Buyer
Freighter

So, the question is, who is going to pay to the freighter (transportation) company. Who covers
the transportation costs depends, as you might have guessed, on the agreement between the
buyer and seller. The agreements are usually stated in the either of these two terms:

- FOB Destination – means “free on board at destination “. That is, since the
destination of the goods is the buyer’s place, it is free at destination means
transportation cost is paid when the goods are loaded. It simply means the seller pays
transportation cost. FOB Destination means goods are shipped to their destination (to
the buyer) with out transportation charge to the buyer.
- FOB shipping Point –means
–means “free on board at shipping point”. That is, goods are
loaded (on a truck or train) or shipped free of charge. It is, therefore, the buyer, which
pays to the transportation company when the goods reach the buyer (their destination)
Briefly, when the terms are FOB Shipping Point the buyer pays transportation costs.

Transportation costs paid by a buyer of merchandise increase the cost of merchandise. They
are recorded in a separate Transportation-In account that is used to record freight costs
incurred in the acquisition of merchandise.

Sipping terms Transportation paid by Title Transfers

When goods are
Delivered to
FOB Destination Seller Buyer
FOB shipping point Buyer Freighter (transportation
company)
Example
Z Company bought goods worth Birr 85,000 on account, terms 2/10,n/60 FOB shipping point
on March 2, 2001.Transportoin cost of Birr 1,500 was paid on March 2. Z Company paid on
March 31, 2001. Record the necessary journal entries

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Solution:
Here, since the terms are FOB Shipping Point, the buyer (Z) pays transportation.

March 2 -Purchase…………………..85,000
A/P………………………..85,000
-Transportation In……….....1500
Cash………………………1500
March 31 A/P…………………………85,000
Cash………………………..85,000
Example:
Z Company sold goods worth Birr 135,000 terms 1/16, n/EOM on February 1, 2001. FOB
Destination. It also paid transportation costs of Birr 800 on Feb. 1. The customer paid Z on
February 16, 2001. Record the relevant Journal entries.
Answers:
Feb 1 A/R…………………………..135,000
Sales…………………………..135,000
Delivery Expense…………………800
Cash……………………………800
Feb 16 Sales discount ………………….1,350
Cash………………………….133,650
A/R…………………………135,000
The Delivery Expense account shows how much was incurred to deliver goods sold to
customers. It is, therefore, shown on the income statement as a selling expense.
Example
Raey Co. sold goods worth Birr 40,000 on April 1, 2001 to IKA company terms 2/10, n/30
FOB Shipping Point. It also paid Birr 2,500 to Ergib Movers for transporting the goods and
added the amount to the invoice. What would each of these companies record assuming IKA
paid on April 31, 2001

Raey Co. (seller) IKa Co (Buyer)

April 1- A/R…………….40,000 April 1-Purchases …………40,000
Sales………………40,000 A/P………………….40,000
A/R…………….2500 Transport-in ………2500
Cash…………….2500 A/P………………2500
April 31-Cash……………42,500 April 31- A/P…………………42,500
A/R………………42500 Cash…………………42,500

Example:

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X Company bought merchandise worth Birr 14,000 terms FOB destination from Y Co. on
account. It paid Birr 350 transportation costs. What would be recorded on the books of the
buyer and seller on the date of the sale?
Buyer (X Co) Seller Y Co.
-Purchase……….14,000 -. A/R……………….14,000
-A/P………………14,000 Sales………………….14,000

-A/P……………350 -Delivery exp……….350

Cash………..350 A/R………………350

Important Relationships on the Income Statement

1. Net sales = Gross sales- (Sales Discounts + Sales Returns and allowances)
2. Net purchases = Purchases – (Purchase Disc. + Purchase Ret. & allowance)
3. Total cost of Purchase = Net purchase + Transportation –In
4. Cost of goods sold = Beg inventory + Total cost of purchase –Ending inventory
5. Gross profit = Net sales – Cost of goods sold
6. Net Income = Gross Profit – operating (i.e., selling & administrative) expenses.
3.5 PREPARING FINANCIAL STATEMENTS FOR MERCHANDISING
BUSINESSES
Income Statement
There are two widely used formats of the income statement. These are:
The single – Step Income Statement
This format is shown below for Hard Works Co. It shows cost of goods sold and operating
expense but has only one subtotal for total expenses.

Hard Works Co.

Income statement
For the year ended December 31, 2002
Net sales…………………………………………………..Br.14536
Expenses:
Cost of goods sold………………………2893
Operating Expenses …………………….3800
…………………….3800 (6693)

Net Income……………………………………….7843
Income……………………………………….7843

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 The Multiple –Step Income Statement

Hard Works Co.

Income statement
For the year ended December 31, 2002
Revenue:
Gross Sales……………………………………………… Br. 14600
Less: Sales Discounts ………..44
Sales Returns &All……20……………… (64)
Net Sales 14536
Less:
Less: Cost of goods sold:
Beg. Inventory (Jan 1)…………………..7,000
Add: Purchase………………………6,000
Less: Purchase.……………….(82)
Purchase Ret & all…….(100)
all…….(100)
Net Purchases……………..5818
Add: Transportation –In ……………75
……………75
Total cost of purchase……..5893
purchase……..5893
Total cost of Goods Available for sale……………..12,893

Less:
Less: ending Inventory (Dec.31)…………………………(10,000)
(Dec.31)…………………………(10,000)
Cost of Goods sold…………………………………………..(2893)
sold…………………………………………..(2893)
Gross Profit……………………………………………11,643
Operating Expenses:
Selling Expenses……………….2,650
Admin. Exp…………………….1,150
Exp…………………….1,150
Total operating expenses……………….. (3800)
(3800)
Net Income……………………………… 7,843

Hard Works Co.

Statement of Owner’s Equity
For the year Ended December 31, 2002

Yibeltal Capital Jan1,2002………………………Br..25,000

Add: Net Income for the year…………………………7843

Deduct: Owner’s withdrawal during the year………....2,000

year………....2,000

Yibeltal Capital December 31, 2002…………………30843

2002…………………30843

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 Hard Works Co.
Balance sheet
For the year Ended December 31, 2002

Assets: Liabilities & capital

Liabilities:
Cash…………………..19663 A/P……………………700
A/R…………………… 1880 Owner’s Equity:
Merch. Inventory…….10,000
Inventory…….10,000 Yibeltal Capital …
30843
Total Assets………….31,843
Assets………….31,843 Total Liab. & O/E……31,843
O/E……31,843

C. Adjustment Journal entry

-Income summary…………………..7,000
Merchandise Inventory………………7,000
-Merchandise Inventory…………….10,000
Income Summary…………………….10,000

D. Closing entries
-Sales………………………………..14,600
Income summary……………………..14,600
-Income summary………………………66
Sales discount………………………………44
Sales Returns and Allowances…………… 20

-Income summary………………………………6,075
Purchases…………………………………………….6,000
Transportation-In………………………………………..75

- Purchase Discounts………………………………..82
Purchase Ret. &All……………………………...100
Income Summary……………………………………….182

- Income summary……………………………….3,800
Selling Expenses…………………………………2650
Administrative expense…………………………..1150

- Income summary………………………………….7,843
Yibeltal Capital……………………………………7,843
- Yibeltal Captal……………………………………..2,000
Yibeltal Drawings……………………………………2,000

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