1. Financial Accounting Fundamentals
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John J. Wild
Third Edition
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Accounting for Merchandising Operations
Chapter 04
Accounting for Merchandising Operations
In this chapter, we will learn how to record purchases and returns of inventory and how to record sales discounts and returns for those companies engaged in the business of merchandising operations.

3. Conceptual Learning Objectives
C1: Describe merchandising activities and identify income components for a merchandising company.
C2: Identify and explain the inventory asset and cost flows of a merchandising company.
Conceptual Learning Objectives:
C1: Describe merchandising activities and identify income components for a merchandising company.
C2: Identify and explain the inventory asset and cost flows of a merchandising company.
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4. Analytical Learning Objectives
A1: Compute the acid-test ratio and explain its use to assess liquidity.
A2: Compute the gross margin ratio and explain its use to assess profitability.
Analytical Learning Objectives:
A1: Compute the acid-test ratio and explain its use to assess liquidity.
A2: Compute the gross margin ratio and explain its use to assess profitability.
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5. Procedural Learning Objectives
P1: Analyze and record transactions for merchandise purchases using a perpetual system.
P2: Analyze and record transactions for merchandise sales using a perpetual system.
P3: Prepare adjustments and close accounts for a merchandising company.
P4: Define and prepare multiple-step and single-step income statements.
P5: Appendix 4A – Record and compare merchandising transactions using both periodic and perpetual inventory systems (see text for details).
Procedural Learning Objectives:
P1: Analyze and record transactions for merchandise purchases using a perpetual system.
P2: Analyze and record transactions for merchandise sales using a perpetual system.
P3: Prepare adjustments and close accounts for a merchandising company.
P4: Define and prepare multiple-step and single-step income statements.
P5: Appendix 4A – Record and compare merchandising transactions using both periodic and perpetual inventory systems (see text for details).
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6. Merchandising Activities
Service organizations sell time to earn revenue.
Examples: Accounting firms, law firms, and plumbing services
Revenues
Expenses
Minus
Net income
Equals
So far, we have been using examples that mainly consist of service companies, like accounting firms, law firms, and plumbing services. These companies all sell different services, but they have one thing in common: They do not sell inventory.
This makes their income statements rather simple. The income statements of a service organization typically consist of revenues minus expenses to arrive at net income.
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7. Merchandising Activities
Merchandising Companies
Manufacturer
Wholesaler
Retailer
Customer
Merchandising companies are different from service organizations because they sell inventory. Merchandising companies can sell inventory in the wholesale market or to final customers in the retail market.
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8. Reporting Income for a Merchandiser
Merchandising companies sell products to earn revenue.
Examples: sporting goods, clothing, and auto parts stores
Cost of goods sold
Net sales
Minus
Equals
Minus
Gross profit
Expenses
Equals
Net income
Because merchandising companies sell inventory, their income statements will have an additional expense item called Cost of Goods Sold. The Cost of Goods Sold account represents the cost of the merchandise sold during the period to help earn revenue.
Cost of Goods Sold is presented as a separate expense item on the income statement. Net Sales minus Cost of Goods Sold equals Gross Profit. Gross Profit is the amount left, after subtracting the cost of the inventory sold, to cover all other expenses and a profit.
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9. Operating Cycle for a Merchandiser
Begins with the purchase of merchandise and ends with the collection of cash from the sale of merchandise.
Credit Sale
Cash Sale
Cash collection
Purchases
Purchases
Merchandise inventory
Cash sales
The operating cycle of a business is the time it takes the business to start with cash, purchase inventory, sell the inventory, and finally collect the cash from customers.
The operating cycle of a business that sells inventory on credit is typically longer than that of a business that sells only on a cash basis. This additional time is due to time between when the customer buys the inventory and the time the customer pays off the accounts receivable.
Accounts receivable
Merchandise inventory
Credit sales
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10. Merchandise available for sale
Inventory Systems
C 3
Beginning inventory
Net purchases +
Merchandise available for sale =
This slide illustrates the flow of costs in an inventory system. If we take what we start the period with and add the net purchases during the period, we have the total merchandise available for sale during the period. At the end of the period, one of two things must happen to the merchandise available for sale. It is either still in inventory or it is sold. If it is in inventory, the cost will appear on the balance sheet as Ending Inventory. If it is sold, the cost will appear on the income statement as Cost of Goods Sold.
Learning this flow of inventory costs will help you apply new material you will learn later.
Ending inventory
Cost of goods sold +
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11. Merchandise Purchases
On June 20, Jason, Inc. purchased $14,000 of Merchandise Inventory paying cash.
Let’s make the entry to record this purchase of Merchandise Inventory.
Part Two
When we purchase inventory, we debit the asset account Merchandise Inventory for the cost of the inventory purchased. This entry is similar to the entry we would make if we purchased any asset, like a truck or land.
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12. Trade Discounts Example
Used by manufacturers and wholesalers to offer better prices for greater quantities purchased.
Example
Matrix, Inc. offers a 30% trade
discount on orders of 1,000
units or more of their popular
product Racer. Each
Racer has a list price of $5.25.
Trade discounts are offered based on quantities purchased. In this example, a trade discount of thirty percent is offered when a customer orders one thousand units or more.
Trade discounts are not recorded in the accounting records. This transaction would be recorded at the price of three thousand six hundred seventy-five dollars, which reflects the trade discount given.
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13. Vendor’s Invoice for Purchase of Merchandise
Seller
Invoice date Purchaser
Order number Credit terms
Freight terms Goods
Invoice amount      
This is an example of an invoice that would support the purchase of merchandise inventory. Notice all the different information on the invoice such as the seller, purchaser, credit terms, items purchased, and amount of the purchase.
The invoice helps provide much of the information needed when recording the entry to purchase inventory.  
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14. Due: Invoice price minus Due: Full Invoice Price
Purchase Discounts P1
A deduction from the invoice price granted to induce early payment of the amount due.
Credit Period
Discount Period
Terms
Time
Due
Purchase discounts are provided to customers as an incentive for them to pay early.
The credit period is the normal period of time the company allows for customers to extend their accounts receivable, typically thirty or sixty days. The discount period is a much shorter period of time, typically ten or fifteen days. If payment is received during the discount period, a discount may be taken. If payment is made after the discount period expires, then the full payment is due on or before the end of the credit period.
Due: Invoice price minus
discount
Due: Full Invoice Price
Date of Invoice
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15. 2/10,n/30 Purchase Discounts Discount Percent
Number of Days Discount Is Available
Otherwise, Net (or All) Is Due in 30 Days
Credit Period
Purchase discount terms are typically written as this slide shows. This particular discount term would be read as “two ten net thirty.”
The first number represents the discount percentage.
The second number represents the discount period.
The letter “n” stands for the word net.
The last number represents the entire credit period.
In this case, if the customer pays within ten days, then a two percent discount may be taken. If not, then all of the amount is due within thirty days.
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16. Purchase Discounts P1
On May 7, Jason, Inc. purchased $27,000 of merchandise inventory on account, credit terms are 2/10, n/30.
Now, let’s see how a purchase discount works. On May seventh, Jason, Incorporated purchased twenty-seven thousand dollars of merchandise on account.
In this entry we debit Merchandise Inventory and credit Accounts Payable for twenty-seven thousand dollars.
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17. Purchase Discounts P1
On May 15, Jason, Inc. paid the amount due on the purchase of May 7.
If Jason, Incorporated pays the bill on May fifteenth, that would qualify for the discount of two percent because it is within the ten-day discount period.
In this entry, the entire Accounts Payable of twenty-seven thousand dollars is paid off with a cash payment of twenty-six thousand four hundred sixty dollars. The difference of five hundred forty dollars is the purchase discount, and it is recorded as a reduction in the cost of the Merchandise Inventory.
*$27,000 × 2% = $540 discount
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18. Purchase Discounts P1
After we post these entries, the accounts involved look like this:
Merchandise Inventory
Accounts Payable
5/ ,000
5/7 27,000 5/
5/ ,000
Bal. 26,460
Bal
If we look at the accounts after posting the payment entry, we can see that the current balance in Accounts Payable is zero, indicating that the total liability has been satisfied. We can also see that the current balance of twenty-six thousand four hundred sixty dollars in the Merchandise Inventory account reflects the actual cash price of the merchandise purchased.
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19. When Discount is Not TakenP1
When Discount is Not Taken
If we fail to take a 2/10, n/30 discount, is it really expensive?
365 days ÷ 20 days × 2% = 36.5% annual rate
Days
in a
year
Number
of additional
days before
payment
Percent
paid to
keep
money
So, should we take advantage of purchase discounts when they are offered? The answer is “Yes!” If we annualize the two percent purchase discount rate offered, we can see that it reflects an annual interest rate savings of thirty-six and one half percent.
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20. Purchase Returns and Allowances
refer to merchandise a buyer acquires but then returns to the seller.
Purchase allowance . . .
is a reduction in the cost of defective or unacceptable merchandise that a buyer acquires.
In addition to purchase discounts, merchandisers also have to deal with returns of inventory and allowances. An allowance is a price reduction granted to the customer because of some quality issue. An allowance may be given because of a slight defect in the merchandise or because a shipment was late. In these cases, the customer keeps the merchandise and just receives a price reduction as the allowance.
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21. Purchase Returns and Allowances
On May 9, Matrix, Inc. purchased $20,000 of merchandise inventory on account, credit terms are 2/10, n/30.
Let’s look at an example and see how purchase returns and allowances are recorded.
On May ninth, Matrix, Incorporated purchased twenty thousand dollars of Merchandise Inventory on credit.
In this entry we debit Merchandise Inventory and credit Accounts Payable for twenty thousand dollars.
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22. Purchase Returns and Allowances
On May 10, Matrix, Inc. returned $500 of defective merchandise to the supplier.
What would be the entry on May tenth if Matrix, Incorporated returned five hundred dollars of the merchandise to the supplier?
This entry would include a debit to Accounts Payable for five hundred dollars to reduce it and a credit to Merchandise Inventory for five hundred dollars to reduce it.
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23. Purchase Returns and Allowances
On May 18, Matrix, Inc. paid the amount owed for the purchase of May 9.
Now, on May eighteenth, which is within the discount period, Matrix, Incorporated paid the amount owed to the supplier. In this case, Matrix, Incorporated can take a purchase discount of two percent on the amount due of nineteen thousand five hundred dollars.
The entry would include a debit to Accounts Payable for the total due of nineteen thousand five hundred dollars, a credit to Cash for nineteen thousand one hundred ten dollars, which is the amount due less the discount, and a credit to Merchandise Inventory for three hundred ninety dollars, which is the amount of the discount.
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24. Transportation Costs Buyer Seller Merchandise FOB destination
(seller pays)
Merchandise
FOB shipping point
(buyer pays)
Transportation costs are sometimes included in the cost of Merchandise Inventory. For example, when buyers pay transportation costs to get merchandise inventory to them, the transportation costs are included in the Merchandise Inventory cost.
FOB terms designate when title passes and who pays the transportation cost. FOB stands for Free On Board. So, if the shipping terms are Free On Board shipping point, that means that ownership transfers from the seller to the buyer when the seller provides the goods to the carrier. It also means that the buyer will pay the transportation cost.
On the other hand, if the shipping terms are Free On Board destination, that means that ownership transfers from the seller to the buyer when the buyer receives the goods. It also means that seller will pay the transportation cost.
So, if goods are shipped FOB Shipping Point, then the buyer owns the goods in transit and will pay the transportation costs. This transportation cost will be added to the merchandise inventory account.
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25. Transportation Costs P1
On May 12, Jason, Inc. purchased $8,000 of merchandise inventory for cash and also paid $100 transportation costs.
Let’s look at an example. On May twelfth, Jason, Incorporated purchased eight thousand dollars of Merchandise Inventory and paid one hundred dollars in transportation costs. What is the total cost of the merchandise purchased?
The total cost of the merchandise purchased is the purchase price of eight thousand dollars plus the one hundred dollars in transportation cost.
The entry would include a debit to Merchandise Inventory for eight thousand one hundred dollars and a credit to Cash for eight thousand one hundred dollars.
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26. Quick Check  P1
On July 6, 2011, Seller Co. sold $7,500 of merchandise to Buyer, Co. on account; terms of 2/10,n/30. The shipping terms were FOB shipping point. The shipping cost was $100. Which of the following will be part of Buyer’s July 6 journal entry? a. Credit Sales $7,500
b. Credit Purchase Discounts $150
c. Debit Merchandise Inventory $7,600
d. Debit Accounts Payable $7,450
Take a minute and read this question and see if you can determine which of the items would be part of Buyer’s July sixth entry.
Since the terms are FOB Shipping Point, the buyer will pay the freight cost. Therefore, the one hundred dollars would be debited to the Merchandise Inventory account.
FOB shipping point indicates the buyer ultimately pays the freight. This is recorded with a debit to Merchandise Inventory.
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27. Cost of Merchandise Purchased
To determine the total cost of merchandise inventory purchases, we can start with the invoice price and subtract purchase discounts and purchase returns and allowances and add transportation costs.
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28. Accounting for Merchandise SalesP2
Now, let’s change our focus and see how discounts and returns and allowances are recorded on the seller’s side of the transactions.
Both Sales Discounts and Sales Returns and Allowances are contra revenue accounts. This means they have a normal debit balance and are subtracted from the Sales account to arrive at Net Sales on the income statement.
Sales discounts and returns and allowances are contra revenue accounts.
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29. Sales of Merchandise P2
On March 18, Diamond Store sold $25,000 of merchandise on account. The merchandise was carried in inventory at a cost of $18,000.
First, let’s see how to record a sale of merchandise inventory.
On March eighteenth, Diamond Store sold twenty-five thousand dollars of merchandise on account. The merchandise had a cost of eighteen thousand dollars.
Whenever a sale is made, the seller must make two entries: one at retail and one at cost. The retail entry includes a debit to Accounts Receivable (or Cash if it is a cash sale) and a credit to Sales. This entry is made for the sales price charged the customer. The cost entry includes a debit to Cost of Goods Sold and a credit to Merchandise Inventory. This entry is made for the cost of the goods sold to the customer.
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30. Sales Discounts P2
On June 8, Barton Co. sold merchandise costing $3,500 for $6,000 on account. Credit terms were 2/10, n/30. Let’s prepare the journal entries.
Let’s record a sale of merchandise inventory for Barton Company on June eighth. The inventory was sold on credit for six thousand dollars and had a cost of three thousand five hundred dollars. The credit terms are two ten net thirty.
Remember that two entries are required to record a sale: one at retail and one at cost.
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31. Sales Discounts P2
On June 17, Barton Co. received a check for $5,880 in full payment of the June 8 sale.
On June seventeenth, Barton Company received a check in full payment of the account.
This entry includes a debit to Cash of five thousand eight hundred eighty dollars, which is the amount due of six thousand dollars less the two percent discount of one hundred twenty dollars, a debit to Sales Discount of one hundred twenty dollars, which is the amount of the two percent discount, and a credit to Accounts Receivable for the total sales price of six thousand dollars.
After this entry is posted, the balance in Accounts Receivable will be zero, indicating that the account has been paid in full. On the income statement, the Sales Discounts account of one hundred twenty dollars will be deducted from the Sales account of six thousand dollars, to reflect the actual amount earned of five thousand eight hundred eighty dollars from this sale.
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32. Sales Returns and AllowancesP2
On June 12, Barton Co. sold merchandise costing $4,000 for $7,500 on account. The credit terms were 2/10, n/30.
Here we have another sale of merchandise inventory for Barton Company. This sale is on June twelfth. The inventory was sold on credit for seven thousand five hundred dollars and had a cost of four thousand dollars. The credit terms are two ten net thirty.
Did you remember the two entries that were needed to record this sale?
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33. Sales Returns and AllowancesP2
On June 14, merchandise with a sales price of $800 and a cost of $470 was returned to Barton. The return is related to the June 12 sale.
On June fourteenth, Barton receives some inventory back from the customer. Similar to a sales entry, a return of merchandise requires two entries: one at retail and one at cost.
The retail entry includes a debit to Sales Returns and Allowances and a credit to Accounts Receivable for the sales price of eight hundred dollars.
The cost entry includes a debit to Merchandise Inventory and a credit to Cost of Goods Sold for four hundred seventy dollars, which is the cost of the returned inventory. This entry is a straight reversal of the cost entry that is made when the sale occurred.
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34. Sales Returns and AllowancesP2
On June 20, Barton received the amount owed to it from the sale of June 12.
On June twentieth, Barton Company received a check in full payment of the account.
This entry includes a debit to Cash of six thousand five hundred sixty-six dollars, which is the amount due of six thousand seven hundred dollars less the two percent discount of one hundred thirty-four dollars, a debit to Sales Discount of one hundred thirty-four dollars, which is the amount of the two percent discount, and a credit to Accounts Receivable for the total amount due of six thousand seven hundred dollars.
After this entry is posted, the balance in Accounts Receivable will be zero, indicating that the account has been paid in full. On the income statement, the Sales Discounts account of one hundred thirty-four dollars and the Sales Returns account of eight hundred dollars will be deducted from the Sales account of seven thousand five hundred dollars, to reflect the actual amount earned of six thousand five hundred sixty-six dollars from this sale.
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35. Completing the Accounting Cycle
Next, let’s complete the accounting cycle by preparing the closing entries for Barton Company.
Now, let’s complete the accounting cycle by preparing the closing entries for Barton Company.
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36. Step 1: Close Credit Balances in Temporary Accounts to Income Summary
Step One is to close Sales to Income Summary. Since Sales has a credit balance, we will debit it to close it and credit Income Summary.
After this entry, the Income Summary account has a credit balance that reflects the sales for the period.
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37. Step 2: Close Debit Balances in Temporary Accounts to Income Summary
Step Two is to close all accounts with a debit balance to Income Summary. This includes all expense accounts as well as Sales Discounts and Sales Returns. Since these accounts have a debit balance, we will credit them and debit Income Summary for their total.
After this entry the balance in the Income Summary represents the Net Income.
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38. Step 3: Close Income Summary to Retained Earnings
Step Three is close Income Summary to Retained Earnings. In this case Income Summary had a credit balance of twelve thousand nine hundred dollars, so we need to debit Income Summary to close it and credit the Retained Earnings account.
Now, the balance in Income Summary is zero.
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39. Step 4: Close Dividends to Retained Earnings
Step Four, the final step, is to close the dividends account to the retained earnings account. Since the dividends account has a debit balance, we need to credit it to close it and debit the retained earnings account.
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40. Multiple-Step Income Statement
Now, let’s look at two formats for preparing an income statement: the multi-step format and the single-step format.
The multi-step format has multiple subtotals before arriving at net income. This format provides more detailed information for users. The main subtotals on this income statement are Net Sales, Gross Profit from Sales, and Net Income.
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41. Single-Step Income Statement
This is the same information presented as a single-step income statement. In a single-step income statement, all revenues are grouped together and totaled and all the expenses are grouped together and totaled. Then, a single step is needed to subtract total expenses from total revenues to arrive at Net Income.
As you can see, the Net Income is the same whether the multi-step or the single-step is used. The only difference is in the amount of detail that is provided on the income statement.
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42. Balance Sheet P4
On the balance sheet, the merchandise company will have an account titled Merchandise Inventory. Merchandise Inventory is an asset.
Service companies will not have this account since they do not sell inventory.
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43. Cash + S/T investments + receivables
Acid-Test Ratio A1 =
Quick assets
Current liabilities
Acid-test
ratio
Acid-test
ratio =
Cash + S/T investments + receivables
Current liabilities
The acid-test ratio is a common ratio that is used to determine the liquidity of a company. In other words, this ratio determines if the company has enough liquid assets to pay current liabilities. The ratio is calculated as quick assets divided by current liabilities.
Quick assets include cash, short-term investments and receivables. A common rule of thumb is for the acid-test ratio to be at least one point zero, but this can vary from industry to industry.
A common rule of thumb is the acid-test ratio should have a value of at least 1.0 to conclude a company is unlikely to face liquidity problems in the near future.
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44. Net sales - cost of goods sold
Gross Margin Ratio A2
Gross
margin
ratio
Net sales - cost of goods sold
Net sales =
Percentage of dollar sales available to cover expenses and provide a profit.
The gross margin ratio is another common ratio that calculates the percentage of dollar sales available to cover expenses and provide a profit.
This ratio is calculated as gross margin divided by net sales. Remember that gross margin is calculated as net sales minus cost of goods sold.
In most cases, the higher this ratio is, the better.
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45. End of Chapter 04
In this chapter, we learned about recording purchases and sales of merchandise inventory and how to record discounts and returns and allowances. We also reviewed the closing process and were introduced to the multi-step income statement. Now we are ready for the next chapter which will help us learn how to cost inventory.
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