AC 101 Prof.

Nova Grace Latina

Financial Accounting

CHAPTER 7: MERCHANDISING OPERATIONS

COMPARISON OF INCOME STATEMENTS

Service companies perform services for a fee. In ascertaining profit, a basic income statement
is all that is needed. In Figure 7-1, profit is measured as the difference between revenues
from services and expenses. In contrast, merchandising companies earn profit by buying and
selling goods. These entities use the same basic accounting methods as service companies,
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 while cost of sales or cost of
goods sold represents the cost of inventory the entity has sold to customers. The difference
between net sales and cost of sales is called 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 losses, and finance costs (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.

Wilhelmina Neis Traders

Income Statement
For the Year Ended Dec. 31, 2020

Net Sales P 2,393,250

Cost of Sales 1,313,600
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Gross Profit P 1,079,650

Operating Expenses 586,040
Operating Profit P 493,610
Finance Costs 38,400
Profit P 455,210

Exhibit 84Parts 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 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 shown next page. Also, samples of some of these
source documents are to be found on the succeeding pages.

1. Sales invoice is 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—quantity,

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description and price—about the goods sold. It also specifies the amount of sales, and the
transportation and payment terms.

2. The bill of lading is a document issued by the carrier—a 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.

3. The statement of account is a formal notice to the debtor detailing the accounts already
due.

4. The official receipt evidences the receipt of cash by the seller or the authorized
representative. It notes the invoices paid and other details of payment.

5. Deposit slips are printed forms with depositor's name, account number and space for
details of the deposit. A validated deposit slip indicates that cash and checks with the
supplied details were actually deposited or credited to the account holder.

6. A check is 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.

7. The purchase requisition is a written request to the purchaser of an entity from an employee
or user department of the same entity that goods be purchased.

8. The purchase order is an authorization made by the buyer to the seller to deliver the
merchandise as detailed in the form.

9. Receiving report is a document containing information about goods received from a

vendor. It formally records the quantities and description of the goods delivered

10. A credit memorandum is 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 TRANSACTION

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:

1. When certain items are needed, the user department fills in a purchase requisition form
and ends it to the purchasing department.

2. 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.

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3. 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.

4. 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.

5. 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 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 as to 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.

Cash discounts are called purchase discounts from the buyer's viewpoint and sales discounts
from the seller's point of view.

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.

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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 buyers to purchase products because of
markdowns from the list price. Trade discounts should not be confused with cash di scounts.
This type of discount enables the suppliers 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.

Illustration Pinnacle Technologies quoted a list price of P2,500 for each 5 gigabyte flash drive,
less a trade discount of 20%. If Video Fantastic Company ordered seven units, the invoice
price would be as follows:

list price (P2,500 x 7) P 17,500

Less: 20% trade discount 3,500

Invoice Price P 14,000

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:

List price (P2,500 X 7) P 17,500

Less: 20% trade discount 3,500

Balance P 14,000

Less: 10% trade discount 1,400

Invoice Price P 12,600

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.

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Financial Accounting

Transportation Costs

When merchandise is shipped by a common carrier—a trucking company 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. is an abbreviation for "free on board". When the freight terms are FOB shipping point,
the buyer shoulders the shipping costs; ownership over the goods passes from 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.

If the terms are FOB destination, the 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.

In freight prepaid, the seller pays the transportation costs before shipping the goods sold;
while in freight collect, the freight company 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. Thus, goods are typically shipped
freight collect when the terms are FOB shipping point; and freight prepaid when the terms
are FOB destination.

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. Figure shows which party—the buyer or the seller—shoulders the
transportation costs and pays the shipper for various freight terms:

Treatment of Transportation Costs

Freight Terms Who Shoulders the Who Pays the

Transportation Costs? Shipper?

FOB Destination, Freight Prepaid Seller Seller

FOB Shipping Point, Freight Collect 1 Buyer Buyer

FOB Destination, Freight Collect Seller Buyer

FOB Shipping Point, Freight Prepaid Buyer Seller

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.

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Shipping costs borne by the seller are debited to transportation out. This account which is
also called delivery expense, is an operating expense in the income statement.

INVENTORY SYSTEMS

Merchandise inventory is the key factor in determining 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.

Perpetual Inventory System

The perpetual inventory system is an alternative to the periodic inventory System." Under the
perpetual 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. At the time of sole, the cost of
sales is determined and recorded by 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 with 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 a company 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 a little chance for or suspicion 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

The periodic inventory system is primarily used by businesses that sell relatively inexpensive
goods and that are not yet using computerized scanning systems to analyze goods sold. A
characteristic of the periodic inventory system is that 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—is 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. The periodic inventory system will be used in the
succeeding discussions.
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Financial Accounting

NET SALES

Net sales is the first part of the merchandising income statement as presented below:

Wilhelmina Neis Traders

Partial Income Statement

For the Year Ended Dec. 31, 2020

Net Sales

Gross Sales P2,463,500

Less: Sales Returns and Allowances P 27,500

Sales Discounts 42,750 70,250

Net Sales P 2,393,250

Gross Sales

Under 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 Gross sales consist of total sales for cash and on credit
during an 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 account, not to sales account.

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Financial Accounting

The journal entry to record the sale of merchandise for cash is as follows:

At the end of the accounting period, the sales discounts 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

Buyers may be dissatisfied with the merchandise received either because the goods are
damaged or defective, of inferior quality or not in accordance with their specifications in such
cases, the buyer may return the goods to the seller for credit if the sale was made on account or
for cash refund if the sale was for cash.

Alternatively, the seller may just grant an allowance or deduction from the selling price. A high
sales returns and allowances figure is not commendable because it may signal poor quality of
goods and thus may result to dissatisfied customers.

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Financial Accounting

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.

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 W. Neis 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.

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Financial Accounting

Case No. 2. Assume that W. Neis Traders sold merchandise totaling P17,000 FOB stopping 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 this 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 W. Neis 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

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Case No. 4. Assume further that W. Neis 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 this 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.

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Financial Accounting

COST OF SALES

Cost of sales or cost of goods sold is the largest single expense of the merchandising business. It is
the cost of inventory that the entity has sold to customers Ever), 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.

If an entity is able to sell all the goods available for sale during a 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.

Wilhelmina Neis Traders

Partial Income Statement

For the year Ended Dec 31, 2020

Cost of Sales

Merchandise Inventory, 1/1/2020 P 528,000

Purchases P 1,264,000

Less: Purchases Returns and Allowances P 56,400

Purchases Discounts 21,360 77,760

Net Purchases P 1,186,240

Transportation In 82,360

Net Cost of Purchases 1,268,600

Goods Available for Sale P 1,796,600

Less: Merchandise Inventory, 12/31/2020 483,000

Cost of Sales P 1,313,600

Figure showed goods costing P1,796,600 as available for sale—W. Neis started with P528,000 in
beginning merchandise inventory and net cost of purchases (or cost of goods purchased) of
P1,268,600 during the year. At the end of the year, P483,000 at 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.

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Financial Accounting

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 a 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
the ending Inventory. 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 consist of gross purchases minus
purchases discounts and purchases returns and allowances equals net purchases; plus
transportation costs.

Purchases

When the periodic Inventory method is used, all purchases of merchandise are debited to the
purchases account as shown below:

The purchases account, a temporary account, is used only 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.

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Financial Accounting

Purchases Returns and Allowances

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 returns and allowances is a contra account and is accordingly deducted from
purchases in the income statement. It is important that a separate account be used to record
purchases 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 the money invested in the
goods. There may also be lost sales resulting from poor ordering or unsaleable goods. Frequent
returns may call for new purchasing procedures or suppliers.

Purchases Discounts

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:

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 company to take the discount applicable to the partial payment. The
discount does not apply to transportation or other charges that might appear on the invoice.

Transportation In

Case No. 1 Assume that W. Neis Traders made purchases totaling P17,000 FOB destination, freight
prepaid; terms 2/10, n/30. Transportation costs amounted to P1,900. The entry would be:

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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 W. Neis 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 W. Neis 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
this 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.

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Case No. 4. Assume further that W. Neis 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 this transaction would be:

If this invoice is paid on Dec. 5, the purchases discount will be P340 (P17,000 x 2%). The buyer is not
entitled to discounts on the transportation costs. Discounts apply only to total purchases.

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