College Accounting
– Chapter 5
Merchandising Operations
1. WHAT ARE MERCHANDISING OPERATIONS?
A
A
merchandiser wholesaler retailers.
is a business that sells merchandise, or goods, to customers.
The merchandise that this type of business sells is called merchandise inventory .
is a merchandiser that buys goods from a manufacturer and then sells them to
A retailer buys merchandise either from a manufacturer or a wholesaler and then sells those goods to consumers.
A. The Operating Cycle of a Merchandising Business
1) It begins when the company purchases inventory from an individual or business, called a vendor .
2) The company then sells the inventory to a customer.
3) Finally, the company collects cash from customers.
Because the operating cycle of a merchandiser is different than that of a service company, the financial statements differ.
On the income statement, a merchandising company reports the cost of merchandise inventory that has been sold to customers, or Cost of Goods Sold (COGS). Cost of Goods
Sold is also called Cost of Sales.
Because COGS is usually a merchandiser’s main expense, an intermediary calculation, gross profit, is determined before calculating net income.
Gross profit
Sold.
(also called gross margin) is calculated as Sales Revenue minus Cost of Goods
Gross Profit minus Operating Expenses = Net Income
Operating expenses are expenses (other than Cost of Goods Sold) that occur in the entity’s major line of business.
B. Merchandise Inventory Systems: Perpetual and Periodic Inventory Systems
There are two main types of inventory accounting systems that are used:
1) The periodic inventory system requires businesses to obtain a physical count of inventory to determine the quantities on hand. Usually used by small businesses.
2) The perpetual inventory system keeps a running computerized record of merchandise inventory
– that is, the number of inventory units and the dollar amounts associated with the inventory are perpetually (constantly) updated.
A modern perpetual inventory system records the following: a) Units purchased and cost amounts. b) Units sold and sales and cost amounts. c) The quantity of merchandise inventory on hand and its cost.
In a perpetual inventory system, merchandise inventory and purchasing systems are integrated with the records for Accounts Receivable and Sales Revenue.
The “cash register” at the store is a computer terminal that records sales and updates inventory records. Bar codes are scanned by a laser.

Even in a perpetual inventory system, the business must count inventory at least once a year.
The physical count captures inventory transactions that are not recorded by the electronic system (such as misplaced, stolen, or damaged inventory).
2. HOW ARE PURCHASES OF MERCHANDISE INVENTORY RECORDED IN A PERPETUAL
INVENTORY SYSTEM?
An invoice is a seller’s request for payment from the purchaser.
A. Purchase of Merchandise Inventory
The Merchandise Inventory account, an asset, is used only for goods purchased that the business owns and intends to resell to customers. Office Supplies, Equipment, and other assets are recorded in their own accounts.
B. Purchase Discounts
A purchase discount is a discount that businesses offer to purchasers as an incentive for early payment.
Credit terms are payment terms of purchas e or sale as stated on the invoice. Usually “3/15,
NET 30 DAYS” means that the company will deduct 3% from the total bill (excluding freight charges, if any) if the customer pays within 15 days of the invoice date. Otherwise, the full amount – NET – is due in 30 days. Terms of “n/30” mean that no discount is offered and payment is due 30 days after the invoice date. These credit terms can also be expressed as
“3/15, n/30”.
When making payment within a discount period, always debit Accounts Payable for the full amount of the invoice; otherwise there will be a balance remaining in the payable account even though the invoice has been paid in full.
C. Purchase Returns and Allowances
Purchase return is a situation in which sellers allow purchasers to return merchandise that is defective, damaged, or otherwise unsuitable.
A purchase allowance is an amount granted to the purchaser as an incentive to keep goods that are not “as ordered”.
Together, purchase returns and allowanced decrease the buyer’s cost of the merchandise inventory.
D. Transportation Cost
Either the seller or the buyer must pay the transportation cost of shipping merchandise inventory. FOB stands for free on board.
1) FOB shipping point means the buyer takes ownership (title) to the goods after the goods leave the seller’s place of business (shipping point). In most cases, the buyer
(owner of the goods while in transit) also pays the freight.
2) FOB destination means the buyer takes ownership (title) to the goods at the delivery destination point. In most cases, the seller (owner of the goods while in transit) usually pays the freight.
3) Freight in is the transportation cost to ship goods into the purchaser’s warehouse; thus, it is freight on purchased goods.
4) Freight out is the transportation cost to ship goods out of the seller’s warehouse and to the customer; thus, it is freight on goods sold.

E. Cost of Inventory Purchased
The net cost of merchandise inventory purchased includes the purchase cost of inventory, less purchase returns and allowances, less purchase discounts, plus freight in.
Net Cost of Inventory Purchased = Purchase cost of inventory
– Purchase returns and allowances
– Purchase discount
+ Freight in
3. HOW ARE SALES OF MERCHANDISE INVENTORY RECORDED IN A PERPETUAL
INVENTORY SYSTEM?
A. Sale of Merchandise Inventory
The amount a business earns from selling merchandise inventory is called Sales Revenue
(also called Sales).
At the time of the sale, two entries must be recorded in the perpetual inventory system:
1) One entry records the Sales Revenue and the Cash (or Accounts Receivable) at the time of the sale.
2) The second entry records cost of Goods Sold (debit the expense) and reduces the
Merchandise Inventory (credit the asset).
Remember, Cost of Goods Sold (COGS) is an expense account and represents the cost of inventory that has been sold to customers.
The Cost of Goods Sold account keeps a current balance throughout the period in a perpetual inventory system of the cost of merchandise inventory sold.
B. Sales Discount
Many sellers offer customers a discount for early payment. A sales discount decreases the net amount of revenue earned on sales.
The Sales Discounts account is a contra account to Sales Revenue. (A contra account has the opposite normal balance of its companion account).
An increase in the Sales Discount contra account is recorded as a debit. This increase reduces the overall Sales Revenue of the company.
C. Sales Returns and Allowances
After making a sale, the company may have customers that return goods, asking for a refund or credit to the customer’s account. Or the company may instead grant a sales allowance to encourage the customer to accept the non-standard goods.
Sales Returns and Allowances is an account that decreases the seller’s receivable from a customer’s return of merchandise or from granting the customer an allowance from the amount owed to the seller.
1. Sales Return
When recording a return of merchandise, the seller must record two journal entries: one to record the sale return and decrease the receivable and the other to update the Merchandise
Inventory account for the cost of the returned merchandise.
2. Sales Allowance

When a seller grants a sales allowance, there are not returned goods from the customer. Therefore, there is not second entry to adjust the Merchandise Inventory account.
3. Sales Returns and Allowances Within Discount Period
If sales returns and allowances occur before the discount period has expired, any discount allowed would be calculated net of the returns and allowances.
D. Transportation Costs
– Freight Out
Freight out expense is one in which the seller pays freight charges to ship goods to customers.
Freight out is a delivery expense.
E. Net Sales Revenue and Gross Profit
Net Sales Revenue
Sales Discount. is calculated as Sales Revenue less Sales Returns and Allowances and
Net Sales Revenue = Sales Revenue
- Sales Returns and Allowances
- Sales Discount
Net Sales Revenue is the amount a company has made on sales of merchandise inventory after returns, allowances, and discounts have been taken out.
4. WHAT ARE THE ADJUSTING AND CLOSING ENTRIES FOR A MERCHANDISER?
A. Adjusting Merchandise Inventory Based on a Physical Count
An Inventory Shrinkage is the loss of inventory that occurs because of theft, damage, and errors. For this reason, businesses take a physical count of inventory at least once a year.
Adjusting entry = Merchandise inventory balance before adjustment
– Actual merchandise inventory on hand
B. Closing the Accounts of a Merchandiser
4 steps:
1) Make the revenue accounts equal zero via the Income Summary account.
2) Make expense accounts and other temporary accounts with a debit balance (Sales
Returns and Allowances and Sales Discounts) equal zero via the Income Summary account.
3) Make the Income Summary account equal zero via the Capital account. This closing entry transfers net income (or net loss) to Capital.
4) Make the Withdrawals account equal zero via the Capital account.
C. Worksheet for a Merchandising Business
– Perpetual Inventory System
This worksheet is very similar to the service business’s worksheet with the addition of the
Merchandise Inventory account.
The revenue and expenses are moved to the income statement and the assets, liabilities, and equity amounts are moved to the balance sheet.
5. HOW ARE A MERCHANDISER’S FINANCIAL STATEMENTS PREPARED?
A. Income Statement

1) Single
– Step Income Statement is the income statement format that you first learned. It groups all revenues together and all expenses together without calculating other subtotals.
2) Multi-Step Income Statements list several important subtotals. Net income (bottom line) and gross profit, operating income (income from operations) are listed. a.
Selling expenses are expenses related to marketing and selling the company’s products. b. Administrative expenses include expenses NOT related to marketing the company’s products. These include office expenses, such as the salaries of the executives and office employees, depreciation on office buildings and equipment, rent, utilities, and property taxes. c. Gross profit minus operating expenses equals operating income . d. Other Revenues and Expenses is a category reporting revenues and expenses that fall outside the business’s main, day-to-day, regular operations. Examples include interest revenue, interest expense, and gains and losses on the sale of plant assets.
3)
Statement of Owner’s Equity and the Balance Sheet
A merchandiser’s statement of owner’s equity looks exactly like that of a service business.
6. HOW DO WE USE THE GROSS PROFIT PERCENTAGE TO EVALUATE BUSINESS
PERFORMANCE?
The gross profit percentage measures the profitability of each sales dollar above the cost of goods sold and is computed as follows:
Gross Profit percentage =
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡
𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒
The gross profit percentage is one of the most carefully watched measures of profitability. It reflects a business’s ability to earn a profit on its merchandise inventory.
The gross profit earned on merchandise inventory must be high enough to cover the remaining operating expenses and to earn net income.
Gross profit is calculated as total net sales less cost of sales. To determine the gross profit percentage, the gross profit is then divided by total net sales.
7. HOW ARE MERCHANDISE INVENTORY TRANSACTIONS RECORDED IN A PERIODIC
INVENTORY SYSTEM?
A. Purchases of Merchandise Inventory
All inventory systems use the Merchandise Inventory account. But in a periodic inventory system, purchases, purchase discounts, purchase returns and allowances, and freight in costs are recorded in separate accounts during the year and then the Merchandise Inventory account is updated in the closing process.

When using the periodic inventory system, the Merchandise Inventory account is not updated during the period. Therefore, it will never be used when recording purchases, discounts, returns, or sales of inventory.
Net Purchases is the remainder after subtracting the contra account from purchases:
Purchases
- Purchases Returns and Allowances
- Purchase Discounts
= Net Purchases
Under the periodic inventory system, freight in is debited to a separate Freight In account (an expense account) as opposed to debiting the Merchandise Inventory account.
B. Sale of Merchandise Inventory
Recording sales of merchandise inventory is streamlined in the periodic inventory system.
With no running record of merchandise inventory to maintain, there is no need to record an entry to Merchandise Inventory and COGS.
C. Adjusting and Closing Entries
There is no need to record an adjusting entry for inventory shrinkage since there is not perpetual running balance of the Merchandise Inventory account.
The process of recording the ending Merchandise Inventory is completed through the closing entry process.
The four-step process under the periodic inventory system is similar to the perpetual inventory system:
1) Using the periodic inventory system, Sales Revenue is still closed with a debit via the Income
Summary Account; all other temporary accounts with credit balances are also closed.
2) Expense accounts and other temporary accounts with debit balances are still closed via the
Income Summary account; also Merchandise Inventory, Purchases, and Freight In are closed.
3)
And 4) Closing the Income Summary account and Owner’s Withdrawals are the same under both methods.
D. Preparing Financial Statements
The cost of goods sold must be computed separately under period inventory systems. The company combines a number of accounts to compute cost of goods sold for the period.
Lots of tables on pages 308
– 311 to review.