Chapter Key Points

I. Merchandising Activities
A. Merchandise refers to products, also called goods, which a company buys to resell. Merchandisers
can be either wholesalers (those that buy from manufacturers and sell to retailers) or retailers (those
that buy from manufacturers or wholesalers and sell to consumers).
B. Reporting Income for a Merchandiser
Revenue from selling merchandise (net sales) minus the cost of goods sold to customers is called
gross profit. Gross profit minus operating expenses determines the net income or loss for the period.
C. Reporting Inventory for a Merchandiser
A merchandiser’s balance sheet is the same as a service business with the exception of one
additional current asset called:
1. Merchandise inventory, or Inventory, refers to products that a company owns and intends to sell.
2. The cost of this asset includes the cost incurred to buy the goods, ship them to the store, and
make them ready for sale.
D. Operating Cycle for a Merchandiser
Begins with purchasing merchandise for cash and ends with collecting cash from selling the
merchandise.
E. Inventory Systems
Two alternative inventory systems that can be used to collect information about the cost of goods
sold and the inventory (cost of goods available) are:
1. Perpetual inventory system—updates accounting records for each purchase and each sale of
inventory. Technological advances and competitive pressures have dramatically increased the
use of this method.
2. Periodic inventory system—updates the accounting records for purchases and sales of inventory
only at the end of a period.
Note: This outline describes the accounting using a Perpetual Inventory System. Periodic
Inventory is discussed in the Appendix 4A section of this outline. Also note, the terms inventory
and merchandise inventory are synonymous. Inventory is used for brevity.
II. Accounting for Merchandise Purchases
The invoice serves as a source document for the event.
A. Purchases without Cash Discounts.
1. Entry to record purchase—debit Inventory, credit Cash or Accounts Payable.
2. Trade Discounts—deductions from list price (catalog price) to determine the invoice price (actual
selling price). Trade discounts are not entered into accounts.
B. Purchase with Cash Discounts
1. Credit terms describe cash discounts offered to purchasers by the seller for payment within a
specified period of time called the discount period.
2. Cash Discounts—granted by the seller to encourage buyers to pay the amount they owe earlier.
Buyers view cash discounts as purchase discounts and sellers view them as sales discounts.
3. Example: credit terms, 2/10 n/30, offer a 2% discount if invoice is paid within 10 days of invoice
date; if not, full payment is due within 30 days of invoice date.
4. Purchases on Credit—entry for buyer for purchase using full invoice, gross method is: debit
Merchandise Inventory and credit Accounts payable.
5. Payment within Discount Period—debit Accounts Payable (full invoice amount), credit Cash
(full invoice – discount), credit Inventory (amount of discount).
 6. Managing Discounts—Missing out on cash discounts can be very costly. A system should be set
up to ensure that all invoices are paid on the last day of discount period.
7. Payment after Discount Period—debit Accounts Payable and credit Cash.
C. Purchases with Returns and Allowances
1. Purchases allowances refers to a reduction in the cost of defective merchandise that a buyer
acquires.
2. Purchases returns are merchandise a buyer acquires but then returns to the seller.
3. A debit memorandum informs the seller of a debit made to the seller’s account payable in the
buyer’s records.
4. Entry on buyer’s books—debit Accounts Payable or Cash (if refund given) and credit Inventory.
5. Discounts can only be taken on the remaining balance on the invoice if a return is made before
payment is made.
D. Purchases and Transportation Costs—the point at which ownership is transferred (called FOB or free
on board). Two alternative points of title transfer are:
1. FOB shipping point—title transfers at shipping point and buyer pays shipping costs.
a. Increases cost of merchandise (cost principle)
b. Debit Inventory, credit Cash or Accounts Payable (if to be paid for with merchandise
later)
2. FOB destination—title transfers at destination and seller pays shipping costs.
a. Operating expense for seller
b. Debit Delivery Expense and credit Cash
E. Itemized Costs of Purchases—the net cost of purchased merchandise according to the cost
principle is recorded in the Inventory account. Inventory is debited (increased) for invoice and
transportation costs, and credited (decreased) for returns, allowances, and purchase discounts.
Supplemental records are often used to collect information about each of these cost elements
for management to evaluate and control.
III. Accounting for Merchandise Sales—involves sales, sales discount, sales returns and allowances,
and cost of goods sold
A. Each sale of merchandise transaction involves two entries: the revenue entry and the cost
entry.
1. Recognize revenue—debit Accounts Receivable (or cash), credit Sales (both for the
invoice amount).
2. Recognize cost—debit Cost of Goods Sold, credit Inventory (both for the cost of the
inventory sold).
B. Sales without Cash Discounts—Revenue side: Inflow of Assets. Debit Accounts Receivable
(or Cash) and credit Sales. Cost side: Outflow of Assets: debit Cost of Goods Sold and credit
Inventory.
C. Sales with Cash Discounts
1. Sales on Credit—revenue side using the gross method is a debit Accounts Receivable and a
credit Sales.
2. Buyer Pays within Discount Period—debit Cash (invoice amount minus discount), debit
Sales Discounts (discount amount), credit Accounts Receivable (full invoice amount).
 3. Buyer Pays after discount period—debit Cash, Credit Accounts Receivable (full invoice
amount).

4. Sales Discounts is a contra revenue account—subtraction from Sales.

Sales with Returns and Allowances
5. Sales returns—merchandise that a customer returned to the seller after a sale.
6. Sales allowances—reductions in selling price of merchandise sold to customers (usually
for damaged merchandise that a customer is willing to keep at a reduced price).
7. Buyer Returns Goods—seller issues refund for returned goods. Entry: debit Sales
Returns and Allowances and credit Cash; additional entry to restore cost of returned
goods to inventory if merchandise is returned and it is salable: debit Inventory, credit
Cost of Goods Sold.
8. Seller receives returned goods into inventory—seller also reduces cost of sales.
9. Returned goods not defective—if inventory can be resold, seller debits Inventory and
credits Cost of Goods Sold.
10. Returned goods are defective—debit Inventory for estimated value; debit Loss from
Defective Merchandise (difference between cost and estimated value) and credit Cost of
Goods Sold (for cost).
11. Sales Returns and Allowances is a contra revenue account that is subtracted from
Sales.
12. Credit Memorandum—issued by the seller to inform buyer of a credit made to
buyer’s Accounts Receivable in seller’s books.
13. Buyer Granted Allowances—merchandise which is defective but buyer decides to
keep, seller will record a debit to Sales Returns and Allowances and a credit to Cash for
the reduction in price. If seller has not yet collected cash for goods sold, seller could
credit buyer’s Accounts Receivable.
IV. Adjusting and Closing for Merchandisers
A. Adjusting Entries for Merchandisers
Generally same as discussed for a service business with an additional adjustment needed to
update inventory to reflect any loss of inventory referred to as shrinkage.
1. Shrinkage determined by comparing a physical count of the inventory with recorded
quantities.
2. Adjusting entry—debit Cost of Goods Sold, credit Inventory—Adjusting Entries.
3. Sales Discounts, Returns, and Allowances—Sales are to be reported at the net amount
expected which follows new revenue recognition rules. Period-end adjusting entries are
commonly made for: expected sales discounts; expected returns and allowances
(revenue side) and expected returns and allowances (cost side). Appendix 4C explains
these adjusting entries.
B. Preparing Financial Statements—statements similar to service business with the following
differences:
1. Income Statement includes the cost of goods sold and gross profit. Also, net sales is
affected by discounts, returns, and allowances and possibly delivery expense.
 2. Balance Sheet includes merchandise inventory as part of current assets.
C. Closing Entries for Merchandisers—similar to a service business, except there are additional
temporary accounts to close including sales, sales discount, sales returns and allowances, and cost of
goods sold. Debit balance accounts are closed with the expense accounts to Income Summary.
V. More on Financial Statement Formats—Common formats include multiple-step and single-step.
A. Multiple-Step Income Statement—details of net sales and expenses. Has three main parts:
1. Gross profit—net sales minus cost of goods sold.
2. Income from operations—gross profit minus operating expenses (separated into selling and
general & administrative).
3. Net income—Income from operations plus or minus nonoperating items.
B. Single-Step Income Statement—lists cost of goods sold as another expense and shows only one
subtotal for total expenses. Expenses grouped into few, if any, categories.
C. Classified Balance Sheet—reports merchandise inventory as a current asset, usually after accounts
receivable, according to how quickly they can be converted to cash.