Accounting for a Merchandising Business (Perpetual Inventory Method)
INTRODUCTION
So far, we have discussed the accounting procedures for a service business. We have learned how to
analyze, journalize, and post transactions. We can prepare the needed adjusting entries and present
the financial statements.
This module will now focus on accounting for another type of business activity, merchandising
business. OBJECTIVES
At the end of this module, you will be able to:
 Explain the difference between a service business and a merchandising
business.  Prepare the journal entries for a merchandising business.
 Prepare the financial statements for a merchandising business.
 Distinguish between perpetual and periodic inventory system.
DISCUSSION
Service Activity Compared to a Merchandising Activity
Service Business
Some examples of a service business are accounting and managerial services, barber shops, transport
services and others. Based on the examples, a service business provides intangible services to
customers. A service business’ operating cycle revolves in performing services to customers and
collecting cash.
The operating cycle of a Service Business is shown in Figure 1.
Income for a service business is measured by deducting the expenses directly from sales to determine
the net income or net loss.
Sales XXX
Less: Expenses XXX
Net income (Loss) XXX
Perform Service
Collect Cash Accounts Receivable
Figure 1 Operating Cycle of a Service Business
Merchandising Business
Now, let us look at the operating cycle of a merchandising business as shown in Figure 2.
A merchandising business offers finished goods (inventory) purchased from suppliers to be sold to their
customers. The business will sell the inventory to its customers as is. Your neighborhood sari-sari store
is a good example of a merchandising business. Other examples include supermarkets and online
sellers. A merchandising business are also referred to as a trading business or a buy and sell business.
Merchandising companies that directly sell to customers are called retailers. Wholesalers are
companies that sell to retailers. You may look at how sari-sari store, the retailer, would buy inventory
from Puregold Supermarket.
As shown in our Figure 2, a merchandising business’ financial transactions includes: (a) purchasing
merchandise, (b) paying for merchandise, (c) selling merchandise, and (d) collecting payments from
customers. The operating cycle of a merchandising business is typically longer than that of a service
business.
Figure 2 Operating Cycle of a Merchandising Business
A merchandising business’ main source of revenue will be from selling merchandise and is often
referred to as Sales Revenue or simply Sales. The company will also maintain two categories of
expenses: (1) Cost of Goods Sold and (2) Operating Expenses. You may refer to Figure 3
Merchandising Business Income Measurement.
Sales Revenue
less
equals
Cost of Goods Sold Gross Profit
less
equals
Operating Expenses Net Income (Loss)
Figure 3 Merchandising Business Income Measurement
A merchandising business will have an additional layer when measuring cost in its income statement,
the cost of goods sold. This represents the amount of goods that was sold for the period and directly
related to the sales revenue recognized.
In a service business it is easy to track the flow of cost compared to a merchandising business. For a
merchandising business the flow of cost is as follows. Beginning inventory plus the cost of goods
purchased is the total goods available for sale. As goods are sold, they are assigned to the cost of
goods sold. The remaining goods that are unsold at the end of the period is the ending inventory.
Figure 4 shows us these relationships.
Beginning
Inventory
Cost of Goods Purchased
Cost of Goods
Available for
Sale
Cost of Goods
Sold
Figure 4 Merchandising Cost Flow
Accounting for Transactions of a Merchandising
Business
Ending
Inventory
Now that we have learned how about a merchandising business let us look at how companies record
transactions if they are engaged in trading. From the merchandising cost flow we learned that a
merchandising business need to account for the inventory.
There are two methods that a company may employ in accounting for inventories: a perpetual inventory
method or a periodic inventory method.
Recording Purchases under the Perpetual Inventory Method
When a company use a perpetual inventory method they will keep detailed records of the cost of each
inventory purchase and sale. Records for inventory are continuously updated for every purchase and
sale transactions. Therefore, the records will show the inventory on hand for every item. The company
will also determine the cost of goods sold each time a sale occurs.
How does this work? Let us go through the various inventory transactions and let us use Rein Trading
and Aries Audio Supply as an example.
Rein Trading normally purchase inventory using cash or credit (on account). Purchases are recorded
when the goods are received from the seller. These transactions are usually supported by business
documents that provide written evidence of transactions. You may refer to Figure 5 for the details found
on a usual invoice.
Figure 5 Sample Invoice for Purchase
Record Purchase of Inventory
On May 4 Rein Trading purchased inventory on account inventory worth ₱3,800 Aries Audio Supply.
Rein and Aries agreed on the terms 2/10, n/30 and FOB Shipping point.
From our previous lessons we learned that this kind of transaction will increase our asset, in this case
Inventory and will increase our Accounts Payable. The journal entry will then be as follows:
Rein Trading is using the perpetual inventory system purchase of merchandise that is intended for sale
to customer is recorded in the Inventory account (some companies use Merchandise Inventory). The
account Inventory was debited because this is an increase in assets. If in case the company purchased
the goods using cash then you just need to account for the decrease in cash by making a debit entry.
Not all purchases are debited to Inventory, however. Companies record purchases of assets for use
and not for resale, such as supplies, equipment, and similar items, as increase to specific asset
accounts rather than to Inventory.
Freight Cost
At this point let us look at one of the terms agreed upon by Rein and Aries. They both agreed that the
goods will be delivered FOB Shipping Point. This part of the agreement is called the Shipping terms
and is used to determine who will pay for transporting the goods to the buyer’s place of business. FOB
means free on board.
There are two types of shipping terms, FOB Shipping point and FOB Destination. FOB Shipping point
means that the seller places the goods free on board the carrier, and the buyer pays for the freight
costs. On the other hand, FOB Destination means that the seller places the goods free on board to the
buyer’s place, and the seller pays for the freight. Figure 6 illustrates how the shipping terms work.
Figure 6 Shipping Terms
Freight Cost Incurred by the Buyer
The agreement between Rein and Aries is FOB Shipping point. Therefore, Rein will need to record the
transportation cost incurred and this will considered as part of Inventory. If the amount of paid bay Rein
Trading for freight charges is ₱150 and adjusting entry for Rein’s books will be as follows.
Note that the account Inventory is used to record the freight and not transportation expense. This is
because inventory cost should include all costs to acquire the inventory, including freight necessary to
deliver the goods to the buyer. Companies recognize these costs as cost of goods sold when the
inventory is sold.
Purchase Returns and Allowances
Purchase returns usually happens when the purchaser is not satisfied with the merchandise received
because the goods are damaged, defective, do not meet the purchaser’s specification, or of inferior
quality. The purchaser may return the goods to the seller for credit (if the sale was made on account) or
for a cash refund. If the purchaser chooses to keep the merchandise and the seller is willing to grant an
allowance (deduction) from the purchase price. This type of transaction is known as a purchase
allowance.
Assume the Rein Trading returned goods costing ₱300 to Aries Audio Supply, Rein would need to
record the reduction in the amount of the Inventory and the reduction of the Accounts Payable.
Purchase Discounts
The term agreed upon by Rein and Aries permits the purchaser to claim a discount for prompt
payments. Buyers will call this cash discount a purchase discount. This incentive offers advantages to
both purchaser and seller. The purchaser saves money, and the seller can shorten the operating cycle
by converting accounts receivable into cash.
Credit terms specify the amount of cash discount and time period in which it is offered and time period
in which the purchaser is expected to pay the full amount. When Rein purchased the merchandise, he
was given a term of 2/10, n/30 (read two ten, net 30). This means that Rein may take a 2% cash
discount on the invoice price, less
(“net of”) any returns or allowances, if payment is made within 10 days of the invoice date (the discount
period). If Rein will pay after 10 days, the invoice price, less any returns and allowances, is due 30
days from the invoice date.
For Rein Trading pays on May 14 (the purchase was made in May 4, therefore Rein gets the discount),
the payment will only be ₱3,430. Computed as follows.
Purchase made on May 4 ₱ 3,800
Returns on May 8 (300)
Invoice price net of return 3,500
Less: Discount (3,500 x 2%) 70
Cash payment on May 14 ₱ 3,430
The journal entry by Rein on May 14 will decrease the Accounts Payable by the gross invoice price,
reduces the inventory by the ₱70 discount, and reduces the Cash by the net amount owed to Aries.
If Rein failed to take the discount and instead made full payment of ₱3,500 on June 30, it would debit
the Accounts Payable and credit Cash for ₱3,500 each.
To summarize the transactions, let us follow the entries posted in the T-account.
First, Rein purchased ₱3,800 worth of inventory on account intended for resale. The company then
returned ₱300 worth of goods. Freight-in of ₱150 was charged. Lastly, a discount of ₱70 was granted
when the payable was paid within the discount period. The balance of inventory is therefore ₱3,580.
Recording Sales under the Perpetual Inventory Method
We are now going to learn how to account for Sales using the perpetual inventory method. This is how
Aries Audio Supply will record the sale and the effect on his inventory.
Record Sales and Cost of Goods Sold
Aries Audio Supply records its May 4 sale of ₱3,800 to Rein Trading as follows (assume the
merchandise cost Aries Audio Supply ₱2,400).
Aries will prepare two journal entries. One to record the sale to Rein and another to recognize the cost
of merchandise sold.
The first journal entry made recognizes the sales. The second entry which recognize the cost of goods
sold, complies with the matching principle. For a company that uses the perpetual inventory method,
every time a sale is recorded the corresponding cost of merchandise sold should also be recorded.
Sales Returns and Allowances
Most sales agreements allow customers to return goods or ask for a reduction of a purchase price to
the seller. This happens if the customer is not satisfied with the merchandise received because the
goods are damaged, defective, do not meet the purchaser’s specification, or of inferior quality. The
seller accepts the goods back from the buyer (a return) or grants a reduction of the purchase price (an
allowance).
The seller needs to record the reduction in revenue and an increase in inventory (for the returned
merchandise). In our example, Rein returned ₱300 worth of goods to Aries on May 8. Aries determined
that the cost of returned goods costs ₱140. Aries will now record the following transactions.
Let us look at the entries made by Aries. The first entry debited the account Sales Returns and
Allowances (a contra account to Sales Revenue) instead of debiting Sales Revenue, and credited
Accounts Receivable to reduce the receivable from Rein. The second entry recognizes the returned
goods by debiting Inventory and crediting Cost of Goods Sold to reduce the amount initially recorded.
If Aries will only provide a reduction on the invoice price, then only the first entry is needed because no
merchandise will be returned. The allowance will then have no effect on the Inventory account.
Here are the reasons provided by Weygandt, et al from his book Accounting Principles, “Sales Returns
and Allowances is a contra revenue account to Sales Revenue. This means that it is offset against a
revenue account on the income statement. The normal balance of Sales Returns and Allowances is a
debit. Companies use a contra account, instead of debiting Sales Revenue, to disclose in the accounts
and in the income statement the amount of sales returns and allowances. Disclosure of this information
is important to management. Excessive returns and allowances may suggest problems—inferior
merchandise, inefficiencies in filling orders, errors in billing customers, or delivery or shipment
mistakes. Moreover, a decrease (debit) recorded directly to Sales Revenue would obscure the relative
importance of sales returns and allowances as a percentage of sales. It also could distort comparisons
between total sales in different accounting periods.”
Sales Discounts
The seller may offer the customer a cash discount for prompt payments. This is called sales discount by
the seller. Recall the terms between Aries and Rein when merchandise was sold, Aries provided a
2/10, n/30 terms to Rein. Sales discount is based on the invoice price less returns and allowances, if
any.
Aries, for example, makes the following entry to record cash receipt on May 14 from Rein within the
discount period.
Sales Discounts is also a contra revenue account like Sales Returns and Allowances. The normal
balance of Sales Discounts is debit. Aries Audio Supply uses this account, instead of debiting Sales
Revenue, to disclose the amount of cash discounts taken by customers. If the customer, Rein Trading,
did not pay within the discount period the entry will only be a debit to Cash for ₱3,500 and a credit to
Accounts Receivable ₱3,500.
Freight Costs Incurred by the Seller
Freight costs incurred by the seller on outgoing merchandise are operating expense to the seller. The
company will now use an expense account Freight-out or Delivery Expense to record the transaction. If
in our example the term was FOB Destination, Aries (as the seller) will record in his books the following
journal entry to recognize the payment of freight charges.
The following T-accounts summarize the three sales-related transactions. Also shown is the combined
effect of the transaction on net sales.
Completing the Accounting Cycle for a Merchandising Business
We have completed the discussion on the basic entries for transactions relating to purchases and sales
under the perpetual inventory method. Our next discussion is for the remaining steps in the accounting
cycle for a merchandising business.
Most of the transactions for a service company and a merchandising company are the same except for
the following:
1. Sales Revenue
2. Sales Returns and Allowances
3. Sales Discounts
4. Purchases
5. Purchase returns and allowances
6. Purchase discounts
This means that we still need to prepare the adjusting entries and closing entries as discussed during
our previous modules.
Adjusting Entries
A company using the perpetual inventory method would still prepare an adjusting entry. At the end of
each accounting period, for control purposes, a merchandising company will take a physical count of its
goods on hand. The company’s unadjusted inventory balance may not be the same with the actual
inventory on hand. The records may not be the same as the actual count of inventory because of
recording errors, theft, or waste. As such, the company needs to adjust the perpetual records to make
the recorded inventory amount agree with the inventory on hand. The company may need to adjust
Inventory and Cost of Goods Sold.
To illustrate, suppose that Aries Audio Supply has an unadjusted balance of ₱40,500 in Inventory. After
the physical count, it was ascertained that the actual merchandise inventory at December 31 is
₱40,000. The following adjusting entry will be made.
Always note that the physical count of the merchandise inventory will always be followed.
Closing Entries
Just like a service company, a merchandising company will still need to prepare closing entries. The
same procedures will be followed. First you need to close the debit all the revenue related accounts
and credit the income summary account. Then you need to debit the income summary account for the
total of all the balances of the debit temporary accounts (before closing) and credit all the temporary
accounts. However, this time you will need to include the Cost of Goods Sold, Sales Returns and
Allowances and Sales Discounts. The balance of the income summary account will now be closed to
the Owner’s equity account. Lastly the drawings account will be closed to the owner’s equity account.
Prepare an Income Statement for a Merchandising Business
In preparing an income statement for a service business we only need to show he following. Note that
the expenses should be itemized.
Sales XXX
Less: Expenses XXX
Net income (Loss) XXX
For a merchandising business, you will need to present the income statement in steps. This is
commonly known as the multi-step income statement.
Rein Trading
Income Statement
for the year ended December 31, 2020
Sales
Sales Revenue ₱ 480,000
Less: Sales Returns and Allowances ₱ 12,000
Sales Discounts 8,000 20,000
Net Sales 460,000
Cost of Goods Sold 316,000 Gross Profit 144,000 Operating Expenses
Salaries and Wages Expenses 64,000
Utilities Expense 17,000
Advertising Expense 16,000
Depreciation Expense 8,000
Freight-out 7,000
Insurance Expense 2,000
Total Operating Expenses 114,000
Income from Operations ₱ 30,000 Note: You can refer to figure 3.
The initial calculation or the first step is the gross profit (Net Sales – Cost of Sales) shows the
merchandising profit of a company.
The next component in measuring the net income for a merchandising company are operating
expenses. These are expense incurred in the process of earning sales revenue. Service companies
and merchandising companies both have operating expenses.
Prepare a Balance Sheet for a Merchandising Business
A balance sheet for a merchandising company will only have an additional account title, Inventory. This
is shown as part of the company’s assets as this represents items that are intended to be sold to earn
revenues. All other items in the balance sheet are the same for both service business and
merchandising business.
References
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https://www.investopedia.com/ask/answers/04/072304.asp
Millan, Z. B., & Ferrer, R. C. (2017). Fundamentals of Accountancy, Business and Management
part 1. Baguio City: Bandolin Enterprise.
Ong, F. L. (2016). Fundamentals of Accountancy, Business and Management 1. Quezon City: C&E
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