ACCOUNTING FOR MERCHANDISING COMPANIES

Trade Discounts vs. Cash Discounts

 Trade discounts
 given to encourage orders in large quantities
 deducted before the invoice price is determined
 not recorded in the books of either the buyer or seller
 Cash discounts
 given to encourage prompt payment
 Buyer: Purchase discount
 Seller: Sales discount
 deducted from the invoice price
 recorded in the books of seller as sales discount (see Net method below).
 Example: 10, 5, 2/10, 1/15, n/30

Two Methods of Accounting for Purchases

 Gross Method
 Purchases are recorded at the total invoice price.
 Purchase discounts are recorded only when taken – under Purchase Discounts account.
 Net Method
 Purchases are recorded at the invoice price net of cash discounts available (whether taken or not).
 Purchase discounts are recorded only when not taken – under Purchase Discounts Lost account.
Journal Entries: Gross and Net Method (Periodic Inventory System)
Transaction Gross Method Dr. Cr.
1. Purchases Purchases (invoice price) XX
Accounts payable XX
2. Purchase return Accounts payable XX
Purchase return (invoice price) XX
3. Payment within the Accounts payable XX
discount period Purchases discount XX
Cash XX
4. Payment beyond the Accounts payable XX
discount period Cash XX

Transaction Net Method Dr. Cr.

1. Purchases Purchases (invoice price less cash XX
discount)
Accounts payable XX
2. Purchase return Accounts payable XX
Purchase return (invoice price less XX
cash discount)
3. Payment within the Accounts payable XX
discount period Cash XX
4. Payment beyond the Accounts payable XX
discount period Purchase discount lost XX
Cash XX
ILLUSTRATION: Gross vs. Net
2015AR Company entered into the following transactions during the year:
1) On November 2, purchased inventory amounting to ₱86,000 with terms of 3/10, n/30 from Rex
Company.
2) On November 4, purchased inventory with a list price of ₱150,000 with terms of 20%, 10%, 2/10, n/30
from Rhad Company.
3) On November 6, Returned merchandise costing ₱10,000 to Rex Company.
4) On November 12, paid the accounts to Rex Company.
5) On November 22, paid the accounts to Rhad Company.
Required: Prepare the necessary journal entry, assuming the company is using the:
a. Gross Method b. Net Method
SOLUTION:
Gross Method Net Method
Nov .2 Purchases (invoice 86,000 Purchases (₱86,000 x 97%) 83,420
price)
Accounts payable 86,000 Accounts payable 83,420
Nov. 4 Purchases (invoice 108,000 Purchases (₱108,000 x 105,840
price)1 98% )
Accounts payable 108,000 Accounts payable 105,840
Nov. 6 Accounts payable 10,000 Accounts payable (₱10,000 9,700
x 97%)
Purchase returns 10,000 Purchase returns 9,700
Nov. Accounts payable 76,000 Accounts payable 73,720
12
Purchase discount2 2,280 Cash4 73,720
Cash3 73,720
Nov. Accounts payable 108,000 Accounts payable 105,840
22
Cash 108,000 Purchase discount lost5 2,160
Cash 108,000
Notes:
1. The invoice price is computed by deducting the trade discount of 20 and 10.
List Price ₱ 150,000
Less: Trade discount – 20% (₱150,000 x 20%) 30,000
Net 120,000
Less: Trade discount - 10% (₱120,000 x 10%) 12,000
Invoice price ₱ 108,000
Note that the total trade discount of ₱42,000 is not recorded in the books.
2. Purchase discount is computed as 3% x ₱86,000.
3. The cash to be paid under the gross method is computed as follows:
Purchases ₱ 86,000
Less: Purchase returns 10,000
Net purchases 76,000
Less: Purchase discount 2,280
Cash paid ₱ 73,720
4. The cash to be paid under the net method is computed as follows:
Purchases ₱ 83,420
Less: Purchase returns 9,700
Cash paid ₱ 73,720
Take note that the amount paid under the two methods should be the same.
5. Purchase discount lost is computed as ₱108,000 x 2%. Purchase discount lost is recorded as either a
financing cost or other expense.

Trade Discount/ volume discount/ quantity discount

Trade discounts are given to encourage prospective customers to buy the goods in large quantities. These
discounts are deducted from the list price to arrive at the invoice price and are never recognized in the
accounting record since the journal entry is based on the amount on the sales invoice.
Note: Sales (revenue) and related receivables are always recorded net of trade discounts, which is the same
with the transaction price.
Cash Discount / Settlement Discount
Cash discounts are reductions from invoice price as an inducement for prompt payment of an account within
the discount period (e.g. 2/10, n/30). This is also called sales discount from the point of view of the seller,
while it is termed as purchase discount from the point of view of the buyer.
1) Gross price method - sales and receivables are recorded at the gross amount. Sales discounts taken by
customers are debited to the Sales Discounts account which is reported as a reduction of sales. This is
considered to be more practical than the net method.
Note: Discount is computed based on invoice price, not including the freight paid by the seller.
2) Net price method - sales and receivables are recorded at the net amount. Sales discounts not taken by
customers are credited to the Sales Discounts Forfeited (discounts not taken) account, which is reported in
the “other income” line item of the statement of comprehensive income. This method is considered to be
theoretically correct since the receivable and sales are recorded using the cash price equivalent.
3) Allowance method - account receivable and sales are recorded at gross amount and a corresponding
allowance for sales discount is recorded.
Journal Entries: Gross and Net Method
Gross Method Net Method
To record sales:
Accounts receivable xxx Accounts receivable xxx
Sales (invoice price) xxx Sales (invoice price less sales xxx
discount)
 To record sales return:
Sales return (invoice price) xxx Sales return (invoice price - sales xxx
discount)
Accounts receivable xxx Accounts receivable xxx
To record collection within the discount period:
Cash xxx Cash xxx
Sales discount xxx Accounts receivable xxx
Accounts receivable xxx
TO record collection beyond the discount period:
Cash xxx Cash xxx
Accounts receivable xxx Sales discount forfeited xxx
Accounts receivable xxx

ILLUSTRATION: Gross vs Net Method

Naragsak Company entered into the following during the year:
Jan. 02 Sold 10,000 units of merchandise to Rex Company at a selling price of ₱100 with terms of
2/10, 1/20, n/30.
Jan. 04 Sold 15,000 units of merchandise to Zeus Company at a selling price of ₱100 with terms of
2/10, 1/20, n/30.
Jan. 06 Rex returned 2,000 units of goods to the company.
Jan. 10 Rex paid his account availing of the cash discount.
Feb. 02 Zeus Company paid his account.
Required: Prepare all the necessary entries assuming the company used:
1) Gross Method 2) Net Method
SOLUTION:
Journal entries: Gross Method
Date Account title Debit Credit
Accounts Receivable 1,000,000
Jan. 02
Sales 1,000,000
Accounts Receivable 1,500,000
Jan. 04
Sales 1,500,000
Sales Return 200,000
Jan. 06
Accounts Receivable 200,000
Cash 784,000
Jan. 10 Sales Discount (₱800,000 x 2%) 16,000
Accounts Receivable 800,000
Cash 1,500,000
Feb. 02
Accounts Receivable 1,500,000

Journal entries: Net Method

Date Account title Debit Credit
Accounts Receivable ₱ 980,000
Jan. 02
Sales (₱1,000,000 x 98%) ₱ 980,000
Accounts Receivable 1,470,000
Jan. 04
Sales (₱1,500,000 x 98%) 1,470,000
Sales Return (₱200,000 x 98%) 196,000
Jan. 06
Accounts Receivable 196,000
Cash (₱980,000 – ₱196,000) 784,000
Jan. 10
Accounts Receivable 784,000
Cash 1,500,000
Feb. 02 Sales Discount Forfeited (₱1.5M - ₱1,470,000) 30,000
Accounts Receivable 1,470,000

Freight Charge
Terms related to freight charge
1) FOB – means either ‘Free on Board’ or ‘Freight on Board’
2) FOB Destination – means ownership of the goods will be transferred to the buyer only upon the receipt of
goods at the point of destination
3) FOB Shipping Point - means ownership of the goods will be transferred upon shipment of the goods by
the seller to the buyer
4) Freight Collect – means that the freight charge on the goods shipped is not yet paid by the seller and the
common carrier shall collect the same from the buyer
5) Freight Prepaid – means that the freight charge on the goods shipped was already paid by the seller

Summary Table for Freight

Freight Terms Buyer Seller
FOB Destination Freight collect Reduction of A/P Reduction of A/R
Freight prepaid No effect No effect
FOB Shipping Point Freight collect No effect No effect
Freight prepaid Addition to A/P Addition to A/R
Formula for the computation of net collection or payment:
Invoice price of merchandise sold or purchased XX
Less: Invoice price of merchandise returned ( XX)
Net invoice price XX
Less: Sales or Purchase discount (% x Net invoice price above)
(if collection or payment is within the discount period) XX
Net collection or payment before freight XX
Less: Freight paid by the buyer - (if the term is FOB Destination, freight collect) (XX)
Add: Freight paid by seller - (if the term is FOB shipping
point, freight prepaid) XX
Total Net Cash Collection or Payment XX
Note:
 If the terms are FOB Destination, freight prepaid and FOB shipping point, freight collect; the total net
cash collection or payment should be before freight. The freight payment is ignored because it was paid
by the appropriate parties.

Summary Journal Entries - Accounting For Freight

SELLER BUYER
FOB destination, Freight prepaid
Freight out xxx No journal entry
Cash xxx
FOB destination, Freight collect
Freight out xxx Accounts payable xxx
Accounts receivable xxx Cash xxx
FOB shipping point, Freight collect
No journal entry Freight-in xxx
Cash xxx
FOB shipping point, Freight prepaid
Accounts receivable xxx Freight-in xxx
Cash xxx Accounts payable xxx
Notes:
 If the term is FOB Destination, the seller will record freight-out.
 If the term is FOB Shipping Point, the buyer will record a freight-in account.
 Freight-out is also called cartage-out, transportation-out and delivery expense.
 Freight-in is also called cartage-in and transportation-in.

ILLUSTRATION: Freight Terms

Assume the following data for Nafoolish Company:
List price of the merchandise sold ₱200,000
Trade discount 10, 20
Sales discount 3/10, 2/15, n/30
Invoice price of the merchandise returned on Jan. 8₱10,000
Date of sale January 5, 2018
Date collected January 20, 2018
Freight cost ₱2,000
Assume the following freight terms:
Case No. 1: FOB destination point, freight prepaid
Case No. 2: FOB destination, freight collect
Case No. 3: FOB shipping point, freight collect
Case No. 4: FOB shipping point, freight prepaid
Required: Using the above independent cases:
1) Prepare the journal entries for the freight both on the part of the buyer and seller.
2) Compute for the net cash collection on January 20, 2017.
SOLUTION:
Case No. 1: FOB destination point, freight prepaid
Requirement No. 1
SELLER BUYER
Freight out ₱2,000 No journal entry
Cash ₱2,000
Requirement No. 2
Invoice price of merchandise sold
(₱200,000 x 90% x 80%) ₱144,000
Less: Invoice price of merchandise returned 10,000
Net invoice price ₱134,000
Less: Sales discount (2% x ₱134,000) 2,680
Total cash collection ₱131,320
Case No. 2: FOB destination, freight collect
Requirement No. 1
SELLER BUYER
Freight out ₱2,000 Accounts payable ₱2,000
Accounts receivable ₱2,000 Cash ₱2,000
Requirement No. 2
Invoice price of merchandise sold
(₱200,000 x 90% x 80%) ₱144,000
Less: Invoice price of merchandise returned 10,000
Net invoice price ₱134,000
Less: Sales discount (2% x ₱134,000) 2,680
Collection before freight ₱131,320
Less: Freight paid by buyer- (FOB Destination, freight collect) 2,000
Total net cash collection ₱129,320

Case No. 3: FOB shipping point, freight collect

Requirement No. 1
SELLER BUYER
No journal entry Freight-in ₱2,000
Cash ₱2,000
Requirement No. 2
Invoice price of merchandise sold ₱144,000
(₱200,000 x 90% x 80%)
Less: Invoice price of merchandise returned 10,000
Net invoice price ₱134,000
Less: Sales discount (2% x ₱134,000) 2,680
Total cash collection ₱131,320

Case No. 4: FOB shipping point, freight prepaid

Requirement No. 1
SELLER BUYER
Accounts receivable 2,000 Freight-in 2,000
Cash 2,000 Accounts payable 2,000
Requirement No. 2
Invoice price of merchandise sold
(₱200,000 x 90% x 80%) ₱144,000
Less: Invoice price of merchandise returned 10,000
Net invoice price ₱134,000
Less: Sales discount (2% x ₱134,000) 2,680
Collection before freight ₱131,320
Add: Freight paid - (FOB shipping point, freight prepaid) 2,000
Total cash collection ₱133,320

Two systems of accounting for inventories

Perpetual Inventory System Periodic Inventory System
Used for low-volume, high cost items, such as Use for relatively low value inventory items such as
automobiles and jewelry. Because of technology, inventory of grocery stores.
perpetual inventory system may be used also for low
value inventory with the aid of point-of-sale (POS)
devices connected with the company’s inventory
system.
The inventory account is updated for each purchase, The inventory account is updated only when
sale and return (i.e., sales return and purchase return) financial statements are prepared.
of inventory.
Physical count is performed to determine the Physical count is performed to determine the ending
accuracy of the balance per records. balance of inventory and to compute for the cost of
goods sold. Unlike in perpetual inventory system,
cost of goods sold is a residual amount.
Purchase returns, discounts and allowances are Purchase returns, discounts and allowances are
recorded by crediting the inventory account. recorded by crediting the appropriate purchases
account.
Freight in is debited directly to the inventory Freight incurred when the inventory was purchased
account. is debited to “Freight-in” account.
Account used: Inventory Accounts used: Inventory beginning, inventory
ending, purchases, freight-in, purchase returns,
purchase allowance and purchase discount

Transaction Perpetual Inventory System Periodic Inventory System

1. To record purchase and Inventory XX Purchases XX
freight-in Accounts payable / Cash X Freight-in XX
X
Accounts payable / Cash X
X
3. To record purchase returns, Accounts payable XX Accounts payable XX
discounts and/or allowances Inventory X Purchase ret./allow./disc. X
X X
4. To record sales and cost of Cash / AR XX Cash / AR XX
inventory sold Sales X Sales X
 X X
Cost of goods sold XX No journal entry yet
Inventory X
X
5. To record sales return Sales return XX Sales return XX
Accounts receivable X Accounts receivable X
X X
Inventory XX No journal entry
Cost of goods sold X
X
6. To record sales allowance Sales allowance / discount Sales allowance / discount
or sales discount Accounts receivable X Accounts receivable X
X X
7. Closing entries No closing entries since all inventory Inventory – end XX
related transaction is directly debited Cost of goods sold X
X
or credited to the account
Cost of goods sold XX
Purchase ret. and allow. XX
Applied Auditing by Purchases X
X
Asuncion, Ngina and Escala Freight - in X
X
Inventory – beginning X
X
8. To record inventory shortage Loss on inventory shortage XX No journal entry. Inventory shortage or
or shrinkage Inventory X overage is buried in the cost of sales.
X

Illustration:
At the beginning of January 1, Tristan Company has 2,000 inventories costing ₱20 per unit. The following
chronological transactions transpired during the year:
1) Purchased on account 3,000 units of inventory at ₱20 per unit.
2) Sold on account 2,500 units of inventory for ₱50 per unit.
3) Purchased on account 4,000 units of inventory at ₱20 per unit.
4) Sold on account 3,000 units of inventory for ₱50 per unit.
5) On December 31, physical count revealed that 3,500 units were on hand.
Required: Prepare all the necessary journal entries using:
a. Perpetual inventory system
b. Periodic inventory system.

SOLUTION:
Perpetual Inventory System
1. Inventory (3,000 x ₱20) 60,000
Accounts payable 60,000
2. Accounts receivable 125,000
Sales (2,500 x ₱50) 125,000
Cost of goods sold 50,000
Inventory (2,500 x ₱20) 50,000
3. Inventory (4,000 x ₱20) 80,000
Accounts payable 80,000
4. Accounts receivable 150,000
Sales (3,000 x ₱50) 150,000
Cost of goods sold 60,000
Inventory (3,000 x ₱20) 60,000
5. No closing entries since all inventory related transaction is
directly debited or credited to the account
6. Loss on inventory shortage 10,000
Inventory 10,000

Periodic Inventory System

1. Purchases (3,000 x ₱20) 60,000
Accounts payable 60,000
2. Accounts receivable 125,000
Sales (2,500 x ₱50) 125,000
3. Purchases(4,000 x ₱20) 80,000
Accounts payable 80,000
4. Accounts receivable 150,000
Sales (3,000 x ₱50) 150,000
5. Inventory, end (3,500 x ₱20) 70,000
Cost of goods sold 110,000
Purchases (₱60,000 + ₱80,000) 140,000
Inventory, beg(₱20 x 2,000) 40,000
6. No journal entry. Inventory shortage or overage is included in the cost of
goods sold.