Lesson 3 : Accounting Cycle of a Merchandising Business

Nature of a Merchandising Business

A merchandising business is an entity engaged in the activities of buying and selling of products.
The main difference between merchandising and the service business is the existence of physical
products sold to the customers. Merchandising sells products in order to generate revenue while
service business renders service to generate revenue.
Other terms used to describe merchandising business are “ trading enterprise “, “ trading firm “ or “
buy and sell business “.

Major Activities of a Merchandising Firm

The two major activities of a merchandising business are :
1. selling activities
2. purchasing activities
1. First part is sales.
Sales - is the total amount of revenue that the company was able to generate from selling products.
2. Second part compose of contra revenue – called contra because it is on the opposite side of the
sales account. The sales account is on the credit side while the reductions to sales accounts are on
the debit side. This is “contrary” to the normal balance of the sales or revenue accounts.
The Sales account represents the revenue generated from the sales of goods or merchandise for
cash, the entry would be:

Cash P125,000
Sales P125,000

The entry in case, the goods are sold on credit / account basis.

Accounts Receivable P125,000

Sales P125,000

Sales has three major contra-accounts, the Sales Returns, Sales Allowances and the Sales
Discount accounts and have normal debit balances.

Illustration for Sales

Assume that Eastern Enterprise sold to Dave Cruz a merchandise amounting to P125,000, including
a mark-up of P50,000 on account, collectible within 30 days. As Eastern’s policy, a cash discount of
3% is granted to customers if payment is made within 5 days.
The related journal entry would be :
1 ) Accounts Receivable P 125,000
Sales P125,000
Sales on account. Terms: 3 / 5, n / 30
What does 3/5,n/30 means or 3/5, N30
3/5, n/30 means that customers will receive 3% discount if they settle accounts receivable within 5
days after the invoice date. Otherwise, the full amount is due within 30 days. However, they will not
receive discount if they pay after 5th day of invoice date.
 “3”: the discount percentage if customers settle payment within discount period.
 “5”: the discounted period in which seller provides the cash discount to the customers if
payment is made within this period.
 “n/30 or N 30 or Net 30”: is the full credit term that supplier provides to the customers.
The customer must make full payment within 30 days after invoice date.
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2.1 Sales returns - This account is debited in order to record returns of customers or allowances for
such returns. Sales returns occur when customers return their products for reasons such as but not
limited to defects or change of preference.
2.2 Sales Allowances - is a reduction in the price charged by a seller, due to a problem with the
sold product or service, such as a quality problem, a short shipment, or an incorrect price.
2.3 Sales discounts - This is where discounts given to customers who pay early are recorded. Also
known as cash discount. This is different from trade discounts which are given when customers buy
in bulk. Sales discount is awarded to customers who pay earlier or before the deadline.

Illustration for Sales Returns

Sales Returns and Allowances account is debited when there is a reduction of prices or return of
delivered items due to poor quality or not in the specifications of their customers.
Assume that Dave Cruz returned some merchandise amounting to P6,000 because they do not
conform to product specifications as ordered.
The related journal entry would be :
2 ) Sales Returns P6,000
Accounts Receivable P6,000
To record sales returns.
Illustration for Sales Allowances
Assume that some items delivered to Dave Cruz were damaged. As a result, Eastern Enterprise
granted a sale allowances of P9,000, per credit memo number 68.
The related journal entry would be :

3 ) Sales Allowances P9,000

Accounts Receivable P9,000
Sales allowances - credit memo no. 68.
Note :
At this point, the net sales amount to P110,000, computed as follows:
Sales P125,000
Less: Sales Returns P6,000
Sales Allowances 9,000 15,000
Net Sales P110,000

Illustration for Sales Discount

Sales Discount is debited when the customer paid their account
receivable within the discount period.
Assume that Dave Cruz paid his account within 5 days which entitles him for a 3% discount.
The related journal entry would be :
4 ) Cash P106,700
Sales Discount ( 3% ) 3,300
Accounts Receivable P110,000
Supporting computation:

Sales per invoice P125,000

Less: Sales Returns P6,000
Sales Allowances 9,000 15,000
Balance before sales discount P110,000
Less: Sales Discount ( P110,000 x 3% ) 3,300
Cash collection P106,700

There are Two Types of Discount

Trade Discount is the reduction from a list or catalogue price that can vary for wholesalers, retailers
and consumers. It should be noted that this type of discount is not recorded in the book of the
merchandiser. For example, the list price of the given product was P50,000 and trade discount are
20% and 15% respectively, the invoice price would have been :
List Price P50,000
Less: 20% trade discount 10,000
Net P40,000
Less: 15% trade discount 6,000
Invoice Price P34,000

Cash Discount is the reduction in the price of merchandise granted by a seller to a buyer when
payment is made within the discount period. The cash discount is recorded in the books.
To illustrate the cash discount, Customer A bought merchandise with B Trading Company on
March 1, 2014 with a catalogue price of P150,000 and was given 10% and 15% trade discount
respectively. The terms of payment: 2/10, n/30, which means that a 2% cash discount is allowed, if
the account will be paid within ten days.
Catalogue Price P150,000
Less: 10% trade discount 15,000
Net P135,000
Less: 15% trade discount 20,250
Invoice Price P114,750

The entry on March 1, 2014 would be:

Accounts Receivable P114,750
Sales P114,750
Suppose, the account was paid on March 9, which is within the discount period of 10 days, the cash
discount would have been:

Invoice Price P114,750

Less: 2% cash discount 2, 295
Net P112,455

The entry on March 9 would be:

Sales Discount P 2,295

Cash 112,455
Accounts Receivable P114,750
1. Purchases - is the amount of goods bought during the current accounting period.
2. Contra Purchases - An account that is credited being “contrary” to the normal balance of
Purchases account.
2.1 Purchase returns - Account used to record merchandise returned by the company to their
suppliers.
2. 2 Purchase allowances - is a reduction in the buyer's cost of merchandise that it had purchased.
The purchase allowance is granted by the supplier because of a problem such as shipping the wrong
items, the incorrect quantity, flaws in the goods, etc. Flaw means having a defect or imperfection.

2.3 Purchase discounts - Account used to record early payments by the company to the suppliers
of merchandise.
Merchandise inventory represents goods that a company owns and expects to sell to customers
and reported as part of the current assets in the statement of financial position with a normal debit
balance.
The merchandise inventory beginning is the unsold goods in the prior accounting period and will
be sold at the current period.
The merchandise inventory, ending is the unsold merchandise in the current accounting period.
Inventory System :
The cost of goods sold or the cost of sales represents the costs of merchandise sold to customers
during a given period and is considered the largest single expense on merchandiser’s income
statement. There are two alternative inventory accounting systems that can be used to collect
information cost of goods sold and the cost inventory and these are the :
1. perpetual inventory systems
2. periodic inventory systems

Under the periodic inventory systems, there was no entry made to the inventory account as the
goods or merchandise is purchased. These set of accounts are purchases, purchase returns and
allowances, purchase discount and freight-in or transportation-in.

It updates the accounting records for merchandise transactions only at the end of a period.
The Purchase account is used when the company purchased merchandise on cash or account
basis and has a normal debit balance.

The pro-forma entry would be:

1. Purchases P100,000 or 2. Purchases P100,000

Cash P100,000 Accounts Payable P100,000

1. Purchases - is the amount of goods bought during the current accounting period.
2. Contra Purchases - An account that is credited being “contrary” to the normal balance of
Purchases account.
2.1 Purchase returns - Account used to record merchandise returned by the company to their
suppliers.

2. 2 Purchase allowances - is a reduction in the buyer's cost of merchandise that it had purchased.
The purchase allowance is granted by the supplier because of a problem such as shipping the wrong
items, the incorrect quantity, flaws in the goods, etc. Flaw means having a defect or imperfection.

2.3 Purchase discounts - Account used to record early payments by the company to the suppliers
of merchandise.

Illustration for Purchases

Assume that Eastern Enterprise has a beginning merchandise inventory ( unsold goods at the start
of the period ) of P10,000. It purchased merchandise intended for sale from Northern Company
amounting to P100,000 on account payable within 30 days after delivery. Northern Company grants a
two percent ( 2% ) discount if payment is made within 10 days from the date of delivery.
The initial journal entry for the transaction would be:
General Journal
Date Description Debit Credit
1) Purchases P100,000
Accounts Payable P100,000
Purchases on account. Terms : 2/10, n/30

Freight In
Refers to the account title for transportation cost incurred by the buyer in transferring the
merchandise from the seller. This account is used to record transportation costs of merchandise
purchased by the company. Called freight in because this is recorded when goods are transported
into the company. It is also known as “ transportation - in “ account.
The account has a normal debit balance. It is an adjunct account of purchases, hence, it is added to
the purchases account to obtain the total gross purchases.
Illustration :
Assuming that Eastern Company incurred P10,000, transportation cost in buying the products
intended for sale, the appropriate journal entries would be:
General Journal
Date Description Debit Credit
2) Freight - in P10,000
Cash P10,000
Transportation cost in purchasing the merchandise.

Illustration for Purchase Returns

The Purchase Returns account is used when some of the merchandise purchased are
subsequently returned to the supplier because of defects or noncompliance with the desired
specification of some items. It has a normal credit balance.
The purchase returns account is a contra account of purchases. It is deducted from the purchase to
arrive at the net purchases. It has a normal credit balance.

Assume the Eastern Enterprise found out that about P7,000 goods purchased do not meet the
specifications of the purchased ordered. Northern Company agreed for the return of the merchandise
and issued a P7,000 credit memo to reduce its claim against Eastern Enterprise.

General Journal
Date Description Debit Credit
3) Accounts Payable P7,000
Purchase returns P7,000
To record purchase returns.
Purchases P100,000
Add: Freight - in 10,000
Gross Purchases P110,000
Less: Purchase returns 7,000
Net Purchases P103,000

Illustration for Purchase Allowances

The Purchase allowances account is also a contra-purchase account which is used to describe
reduction on the acquisition price due to reasons similar to purchase returns.
When there are purchase allowances, there is no actual physical return of the merchandise to the
seller because the buyer decides to keep them as the former agreed to a price reduction.

Assume that Eastern Enterprise determined that P3,000 worth of merchandise was slightly damaged.
Northern Company issued a credit memo in this regard. The appropriate journal entry to effect the
reduction in price would be:
General Journal
Date Description Debit Credit
4) Accounts Payable P3,000
Purchase allowances P3,000
To record purchase allowances for defective merchandise .

Purchases P100,000
Add: Freight - in 10,000
Total Purchases P110,000
Less: Purchase returns P7,000
Purchase allowances 3,000 10,000
Net Purchases P100,000

Illustration for Purchase Discount

The Purchase Discount account was credited when the buyer paid the accounts payable within the
discount period with a normal credit balance.
Assume the Eastern Enterprise paid its obligation to Northern Company within 20 days or within the
discount period allowing a 2% discount. The related journal entry would be:
General Journal
Date Description Debit Credit
5) Accounts Payable P90,000
Cash P88,200
Purchase Discount 1,800
Payment of purchase within
Purchases price P100,000
Less:Purchase returns P7,000
Purchase allowances 3,000 10,000
Balance before purchase discounts P 90,000
Less: Purchase discounts ( (P90,000 x 2 % ) 1,800
Cash Payment P88,200
Freight - Out
Refers to the account title for transportation cost incurred by the seller in transporting the
merchandise to the buyer. It is also known as “ transportation-out “, “ transportation expense “,
or ” delivery expense “ account.
This account has a normal debit balance, but it is neither added nor deducted from the sales account.
Freight-out is treated as a selling expense account under the operating expenses caption of the
income statement.
Illustration :
Assume that Eastern Enterprise incurred P2,000 transportation cost in delivering the products to
Dave Cruz.
The appropriate journal entry would be:
Freight - Out P2,000
Cash P2,000
Transportation expense in delivering the merchandise sold to Dave Cruz.

ILLUSTRATION 1
Alonzo Shoe Store
Statement of Comprehensive Income
For the Year Ended December 31, 2012

Gross Sales P 1,750,000

Less: Sales Returns and Allowances P 7,500
Sales discounts 20,000 27,500
Net Sales P 1,722,500
Less: Cost of Sales or Cost of Goods Sold:
Merchandise inventory, January 1, 2012 P 30,000
Add: Net Purchases
Purchases P 950,000
Add: Freight In 5,000
Total Purchases or
Total Cost of Goods Delivered P 955,000

Less: Purchase Returns and Allowances P 3,000

Purchase Discounts 7,000
Net Purchases P945,000
Total Goods Available for Sale P 975,000
Less: Merchandise Inventory, Dec.31, 2012 40,000
Cost of Goods Sold P 935,000
Gross Profit on Sales or Gross Margin on Sales P 787,500
Less Operating Expenses :
Selling :
Salaries Expense P 54,000
Advertising Expense 50,000
Rent Expense - Warehouse 20,000
Freight - Out 5,000
Store Supplies Expense 3,000
Total Selling Expenses P 132,000
Administrative Expenses :
Salaries Expense - Office P 30,000
Rent Expense - Office 20,000
Bad Debt Expense 7,500
Depreciation Expenses - Office Equipment 5,500
Supplies Expense 3,600
Total Administrative Expenses P 66,600
Total Operating Expenses 198,600
Net Income from Operations P 588,900
Add Other Income :
Commission Income P 4,500
Interest Income 2,500 7,000
Total Income P 595,900
Less Other Expenses :
Interest Expense 2,000
NET INCOME P593,900
ILLUSTRATION 2 :
Accounts selected from December 31, 2015 trial balance of the Queen Trading are listed below:
Sales P900,000 Insurance expense P2,000
Purchases 400,000 Sales discounts 4,000
Merchandise invty, beg, 90,000 Freight - out 6,000
Merchandise invty, end 75,000 Purchase returns 3,000
Salaries expense 120,000 Representation expense 7,000
Supplies expense 5,000 Purchase discounts 9,000
Depreciation expense 10,000 Freight - in 12,000
Sales returns and allowances 8,000 Utilities expense 15,000
Miscellaneous expense 1,000
Required : Prepare an Income Statement
Queen Trading
Income Statement
For the Year Ended December 31, 2015

Sales P900,000
Less: Sales Returns and Allowances P8,000
Sales Discounts 4,000 12,000
Net Sales P888,000
Less : Cost of Goods Sold :
Merchandise Inventory, beg. P90,000
Add: Net Purchases :
Purchases P400,000
Add: Freight-In 12,000
Total Purchases P412,000

Less: Purchase Returns P3,000

Purchase Discounts 9,000 12,000
Net Purchases 400,000
Total goods available for sale 490,000
Less: Merchandise Inventory, end 75,000
Cost of goods sold P415,000
Gross Margin or Gross Profit on sales P473,000
Less: Operating Expenses:
Salaries expense 120,000
Supplies expense 5,000
Depreciation expense 10,000
Insurance expense 2,000

Freight - out 6,000

Representation expense 7,000
Utilities expense 15,000
Miscellaneous expense 1,000
Total Operating Expenses P166,000
Net Income P307,000
ACTIVITY 1 :
Regal Sales Company is in its second year of operation. The general ledger show the following
balances:

Sales P120,500 Salaries Expense 17,500

Sales Returns and Allowances 2,500 Utilities Expense 6,600
Sales Discount 1,500
Purchases 75,145 Required : Prepare the Income
Freight - In 1,890 Statement
Purchase Returns and Allowances 475
Purchase Discounts 305
Merchandise Inventory, beginning 27,250
Merchandise Inventory, end 12,500
Advertising Expense 3,000
Freight - Out 2,900
Rent Expense 22,000
ACTIVITY 2 :
Happy Selling Company started its business on January 1, 2016.
Given:
Beginning Inventory - P 250,000 Ending Inventory - P 50,000
January 1, 2016 December 31, 2016
Freight In 15,000 Salaries Expense-Office 20,000
Sales 500,000 Rent Expense-Warehouse 8,000
Purchases 100,000 Depreciation Expense- 17,000
Sales Returns and Allowances 30,000 Equipment
Purchase Discounts 10,000 Bad Debt Expense 1,000
Sales Discounts 10,000 Utilities Expense 11,000
Purchase Returns and Allowances 20,000 Rent Expense-Office 15,000
Salaries Expense 10,000
Required:
Prepare a Statement of Comprehensive Income of a Merchandising Business.