Chapter 6

Principles of Accounting I
CHAPTER 6: Accounting for Merchandising

Businesses
Chapter 3 2
6.1 Service and merchandising business
• The operating cycle of a service and merchandising business differs in that a

merchandising business must purchase merchandise for sale to customers.
• The differences between service and merchandising businesses are also

reflected in their financial statements.
• The revenue term of a service business and a merchandising businesses is also

different
• On the income statement:

• For a service business, the operating expenses incurred in providing the
services are subtracted from the fees earned to arrive at net income.
• For a merchandising business, when this merchandise is sold, its cost is
recognized as an expense called cost of merchandise sold = Cost of goods
sold
6.1 Service and merchandising business
Sẻ
Merchandising business
Service
6.2. Merchandising business
• The cost of merchandise sold is subtracted from sales to arrive at gross

profit, which is the profit before deducting operating expenses.
Gross profit = Sales – Cost of merchandise sold
• Merchandise on hand (not sold) at the end of an accounting period is called
merchandise inventory (current asset).
Revenue= Sales+ Accounts receivable

6.2 Merchandising business
• Two main activities
Purchas
e Sales
6.2.1 Purchases Transactions

There are two systems for accounting for merchandise transactions:
perpetual and periodic.
• In a perpetual inventory system, each purchase and sale of
merchandise is recorded in the inventory account and related
subsidiary ledger.
• In a periodic inventory system, the inventory does not show the
amount of merchandise available for sale and the amount sold.
• The terms of purchases on account are normally indicated on the invoice or

bill that the seller sends the buyer.
• The terms for when payments for merchandise are to be made are called the
credit terms.
• If payment is required on delivery, the terms are cash or net cash.
• Otherwise, the buyer is allowed an amount of time, known as the credit
period, in which to pay.
• The credit period usually begins with the date of the sale as shown on
the invoice.
• Under the perpetual inventory system, purchases transaction either ways as

follows:
• Cash transaction
• On account transaction
• To encourage the buyer to pay before the end of the credit period, the
seller may offer a discount.
• Discounts taken by the buyer for early payment of an invoice are called
purchases discounts.
• Purchases discounts taken by a buyer reduce the cost of the merchandise
purchased.
• Since buyers normally take all purchases discounts, Merchandise Inventory is

debited for the net purchase price under the perpetual inventory system.
• That is, the buyer debits Merchandise Inventory for the amount of the
invoice less the discount.
• For example, a seller may offer a 2% discount if the buyer pays within 10
days of the invoice date. If the buyer does not take the discount, the total
invoice amount is due within 30 days.
• The terms are expressed as 2/10, n/30 and are read as “2% discount if
paid within 10 days, net amount due within 30 days.”
• If NetSolutions does not take the discount:
Merchandise Inventory 12,650

Account payable 12,650
Account payable 12,650

Cash 12,397
Merchandise Inventory 253
Purchases Returns and Allowances
A buyer may request an allowance for merchandise that is returned
(purchases return) or a price allowance (purchases allowance) for damaged
or defective merchandise. From a buyer’s perspective, such returns and
allowances are called purchases returns and allowances.
In both cases, the buyer normally sends the seller a debit
memorandum, often called a debit memo, to notify the seller of
reasons for the return (purchase return) or to request a price
reduction (purchase allowance).
To illustrate, the return of the merchandise indicated in the debit memo in
as follows:
Example: On May 2nd, Netsolutions purchased $5,000 of merchandise on
account from Delta Data Link, terms 2/10, n/30. On May 4th returned
$3,000 of the merchandise purchased on May 2. 12. Paid for the purchase
of May 2 less the return and discount.
Example:
6.2.2 Sales Transactions
• Under the perpetual inventory system, sales transaction as follows:

Exercises
Account receivable 41,100

Sales 41,100
Cost of merchandise sold 26,750
Merchandise inventory 26,750
Cash 40,278
Sales discount 822
Account receivable 41,100
• Sales discounts
A seller may offer the buyer for a discount for early payment. The seller refers to
such discounts as sales discounts.
• Sales discounts are recorded in a separate account, which is a contra
account to Sales.
Example: NetSolutions sold $18,000 of merchandise to Digital Technologies on
March 10 with credit terms 2/10, n/30. Digital Technologies pays the invoice on
March 19.
• Sales returns and Allowances
Merchandise sold may be returned to the seller (returns). In other cases, the
seller may reduce the initial selling price (allowances).
From a seller’s perspective, these are termed customer returns and
allowances, sometimes called sales returns and allowances.
In some cases, a customer that is due a refund has an outstanding account
receivable balance.
• In this case, the seller may credit the customer’s accounts receivable rather than
pay cash.
• The seller usually issues the buyer a credit memorandum to authorizes a

credit (decrease) to the buyer’s account receivable.
6.2.3. Freight
• The terms FOB (free on board) shipping point means the buyer pays the
freight costs from the shipping point to the final destination.
6.2.3. Freight
• The terms FOB (free on board) destination means the seller pays the freight
costs from the shipping point to the buyer’s final destination.
• The seller may prepay the freight, even though the terms are FOB
shipping point. The seller will then add the freight to the invoice.
6.2.3. Freight
Dual Nature of Merchandise transactions
Chart of Accounts for a Merchandising Business
Multiple-Step Income Statement
Multiple-Step Income Statement
Adjusting Entry for Inventory Shrinkage
• Under the perpetual inventory system, the merchandise inventory

account is continually updated for purchase and sales transactions.
• As a result, the balance of the merchandise inventory account is the

amount of merchandise available for sale at that point in time.
• However, retailers normally experience some loss of inventory due to

shoplifting, employee theft, or errors.
• Thus, the physical inventory on hand at the end of the accounting

period is usually less than the balance of Merchandise Inventory.
• This difference is called inventory shrinkage or inventory shortage.
Financial Analysis and Interpretation: Ratio of Sales to Assets
• The ratio of sales to assets measures how effectively a business is using its
assets to generate sales.
• A high ratio indicates an effective use of sales.
• The ratio of sales to assets is computed as follows:
Sales
Ratio of Sales to Assets =
Average Total Assets

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Principles of Accounting I

CHAPTER 6: Accounting for Merchandising

• The operating cycle of a service and merchandising business differs in that a

• The differences between service and merchandising businesses are also

• The revenue term of a service business and a merchandising businesses is also

• On the income statement:

• The cost of merchandise sold is subtracted from sales to arrive at gross

Revenue= Sales+ Accounts receivable

• Two main activities

6.2.1 Purchases Transactions

• The terms of purchases on account are normally indicated on the invoice or

• Under the perpetual inventory system, purchases transaction either ways as

• Since buyers normally take all purchases discounts, Merchandise Inventory is

Merchandise Inventory 12,650

Account payable 12,650

• Under the perpetual inventory system, sales transaction as follows:

Account receivable 41,100

• The seller usually issues the buyer a credit memorandum to authorizes a

• Under the perpetual inventory system, the merchandise inventory

• As a result, the balance of the merchandise inventory account is the

• However, retailers normally experience some loss of inventory due to

• Thus, the physical inventory on hand at the end of the accounting

• A high ratio indicates an effective use of sales.

• The ratio of sales to assets is computed as follows:

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