Chapter 5

Accounting for Merchandising Operations

Chapter Summary
Merchandising Operations
 A merchandising company is an enterprise that buys and
sells goods to earn a profit.

 Measuring net income for a merchandising company is the

same as for a service company through matching of
expenses with revenues.

 In a merchandising company, the primary source of revenue

is the sale of merchandise, which is called sales revenue or
sales.

 Expenses for merchandising company are divided into two

groups:
1. Cost of goods sold: is the total cost of
merchandise sold during the period.
2. Operating expenses: are expenses incurred in
the process of earning sales revenue such as
salary expense, advertising expense, rent
expense, insurance expense, and utilities
expense.

 Net income for a merchandising company is measured in

two steps in the income statement:
1. Sales revenue – cost of goods sold = Gross profit
2. Gross profit – operating expenses = Net income

Inventory Systems:
In accounting for merchandising transactions, either of the two
following systems may be used:
1. Perpetual inventory system.
2. Periodic inventory system.

Perpetual Inventory System:

 Detailed records of the cost of each inventory purchase and
sale are maintained and continuously (perpetually) show the
inventory that should be on hand for every item.

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  The cost of goods sold is determined and recorded each time
a sale occurs.

Periodic Inventory System:

 No detailed inventory records are kept for the goods on
hand during the period.

 The cost of goods sold is determined only at the end of the

accounting period when a physical inventory count is taken
to determine the cost of ending inventory.

 The cost of goods sold under a periodic inventory system is

determined at the end of the accounting period in the
following manner:

Beginning inventory XX
Add: Cost of goods purchased XX
Cost of goods available for sale XX
Less: Ending inventory XX
= Cost of goods sold XX

** We will focus only on merchandising companies that follow a

periodic inventory system. Before we record transactions for a
merchandising company that uses a periodic inventory system, it
would be very helpful to present the income statement of a
merchandising company that uses a periodic inventory system.

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 PW AUDIO SUPPLY, INC.
Income Statement
For the Year Ended December 31, 2012
Sales Revenue
Sales $480000
Less: Sales returns and allowances 12000
Sales Discount 8000 20000
Net sales 460000
Cost of Goods Sold
Inventory, January 1 36000
Purchases 325000
Less: Purchases returns and allowances 10400
Purchase discount 6800 17200
Net purchases 307800
Add: Freight-in 12200
Cost of goods purchased 320000
Cost of goods available for sale 356000
Inventory, December 31 40000
Cost of goods sold 316000
Gross profit 144000
Operating Expenses:
Salary expense 45000
Rent expense 19000
Utilities expense 17000
Advertising expense 16000
Depreciation expense 8000
Insurance expense 2000
Freight-out 7000
Total operating expenses 114000
Net income $30000

Recording Transactions (Periodic Inventory System):

To illustrate the recording of merchandise transactions under a
periodic inventory system, we will use the purchase / sale
transactions between Sauk Stereo, and PW Audio Supply.

(A) Recording Purchase of Merchandise:

On May 4, Sauk Stereo Company purchased merchandise for
$3800 on account from PW Audio Supply Company, terms 2/10,
n/30.

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 This transaction is recorded in the journal of Sauk Stereo
Company as follows:

Date Accounts and Explanation Dr. Cr.

May 4 Purchases 3800
Accounts Payable 3800
To record goods purchased on account,
terms “2/10, n/30”.

 The terms “2/10, n/30” mean that Sauk company will get
2% discount if it pays the amount due to PW Audio
company within 10 days. If the amount is not paid within
the 10 days, no discount will be given to Sauk company and
the full amount must be paid in 30 days. The 10 days period
is called the “discount period”, and the 30 days period is
called the “credit period”.

 The purchases account is a temporary account that has a

normal debit balance.

Freight-in (transportation-in) cost:

 When the merchandise is purchased with terms “FOB
shipping point” (free on board shipping point), it means that
the purchaser will pay for the freight-in cost.

 When the merchandise is purchased with terms “FOB

destination”, it means that the seller will pay for the freight
cost and it is called in this case freight-out.

 Freight-in is actually an expense account for the purchaser.

 Freight-in is part of the cost of goods purchased.

Example:
On May 6, Sauk Stereo pays $150 freight-in on its purchase
from PW Audio Supply Company.

This transaction is recorded in the journal of Sauk Stereo

Company as follows:

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Date Accounts and Explanation Dr. Cr.
May 6 Freight-in 150
Cash
To record payment of freight on goods 150
purchased.

Purchase Returns and Allowances:

 A purchaser may be dissatisfied with the merchandise
because goods received are defective, or not in accord with
specifications.

 If the purchaser actually returns part of the merchandise

purchased, the transaction is called purchase return.

 If the purchaser keeps the defective merchandise and gets

an allowance (a deduction) from the purchase price, the
transaction is called purchase allowance.

 Whether the transaction is considered a purchase return or

allowance, the amount is credited to the “Purchase Returns
and Allowances” account.

Example:
On May 8, Sauk Stereo Company returns $300 of goods to PW
Audio Supply Company.

This transaction is recorded in the journal of Sauk Stereo

Company as follows:

Date Accounts and Explanation Dr. Cr.

May 8 Accounts Payable 300
Purchase Returns and Allowances 300
To record the return of goods
purchased on account, from PW Audio
Supply Company.

 The Purchase Returns and Allowances account is a

temporary account that has a normal credit balance.

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 Purchase Discount:
 On May 14, Sauk Stereo Company paid the amount due on
account to PW Audio Company tacking the 2% cash
discount granted by PW Audio Company for payment
within 10 days.

 Before we record this transaction, we must determine the

amount due to PW Audio Supply Company. To do that, we
must post the two transactions on May 4 and May 8 to the
Account Payable. The account was credited for $3800 on
May 4, and was debited for $300 on May 8. Accordingly,
the balance due to PW Audio Supply Company is $3500.

The purchase discount = $3500 × 2% = $70

Cash paid = $3500 – 70 = $3430

 The May 14 transaction is then recorded in the journal of

Sauk Stereo Company as follows:

Date Accounts and Explanation Dr. Cr.

May 14 Accounts Payable 3500
Cash 3430
Purchase Discount 70
To record payment to PW Audio
Supply Company within the discount
period.

 The purchase discount account is a temporary account that

has a normal credit balance.

(B) Recording Sales of Merchandise:

Example:
On May 4 PW Audio Supply Company sold a $3800 of
merchandise to Chelsea Company terms “2/10, n/30”.

 This transaction is recorded in the journal of PW Audio

Supply Company as follows:
Date Accounts and Explanation Dr. Cr.
May 4 Accounts Receivable 3800
Sales 3800
To record sale of merchandise on account
to Sauk Stereo, terms “2/10, n/30”.

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  The sales account is a temporary account that has a normal
credit balance.

Sales Returns and Allowance:

 On May 8, a $300 worth of merchandise was returned from
Sauk Stereo Company.
 This transaction is recorded in the journal of PW Audio
Supply Company as follows:

Date Accounts and Explanation Dr. Cr.

May 8 Sales Returns and Allowances 300
Account Receivable 300
To record return of merchandise from
Sauk Stereo Company.

 The sales returns and allowance account is a temporary

account that has a normal debit balance.

Sales Discount:
 On May 14, PW Audio Supply Company collected the
amount due on account from Sauk Stereo Company.
 The Account Receivable account for Sauk Stereo Company
has a balance of $3500 (Accounts Receivable was debited for
$3800 on May 4, and was credited for $300 on May 8).
 Since the amount due from Sauk Stereo Company was
collected within the discount period, Sauk Stereo Company
will take advantage of the discount.

Sales discount = 3500 × 2% = $70

Cash collected = $3500 - $70 = $3430

 This transaction is recorded in the journal of PW Audio

Supply Company as follows:
Date Accounts and Explanation Dr. Cr.
May 14 Cash 3430
Sales Discount 70
Accounts Receivable 3500
To record collection from Sauk Stereo
Company within the discount period.

 The sales discount account is a temporary account that has

a normal debit balance.

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The income statement for a merchandising company in equation
form:

(1) Net Sales = Sales – Sales Returns and Allowances – Sales

Discounts

(2) Net Purchases = Purchases - Purchase Returns and Allowances

– Purchase Discounts

(3) Cost of Goods Purchased = Net Purchases + Freight in

(4) Cost of Goods Available for Sale = Beginning Inventory + Cost

of Goods Purchased

(5) Cost of Goods Sold = Cost of Goods Available for Sale –

Ending Inventory

(6) Gross Profit = Net Sales – Cost of Goods Sold

(7) Net Income = Gross Profit – Operating Expenses

 Equation # 7 assumes that there are no non-operating

activities.