Chapter 6: Accounting for a Merchandising Business

In Chapters 1-4, all text examples were ones involving service businesses. In this lesson, we examine the accounting for merchandising operations -- those that sell products. The products held for sale are called inventory, or more specifically, merchandise inventory. Inventory is a current asset that will be sold to yield a profit--and the adage "buy low, sell high" is a succinct way to state a merchandiser's profit strategy. In addition to introducing a new asset, Chapter 6 also introduces a new cost category, and a new name for the revenue account. The cost is called Cost of Merchandise Sold (also called Cost of Goods Sold by some companies), and represents the cost of the inventory that was sold during the period. If John purchases 100 units of product for $5 each and sells 20 of them for $10 each, John earns $200 of sales revenue. The cost of the units sold is 20 * $5 = $100, and would be the Cost of Goods Sold. The difference between the revenue earned and the cost of merchandise sold is called gross profit. Here is a very basic income statement that computes the gross profit:

Journal Entry 3

A useful calculation called the Gross Profit Percentage can be calculated from this Income Statement. The Gross Profit Percentage is equal to the Gross Profit divided by the Sales. In the above statement, the Gross Profit Percentage equals $100 divided by $200 = 50%. This is the same ratio at the unit level, because we are buying the units for $5.00 and selling them for $10, resulting in a $5.00 gross profit per unit. The gross profit per unit divided by the price is $5/$10 = 50%. Note that 20 units of product were sold for $10 each. The ones that were sold cost $5 each, resulting in gross profit of $100. The balance sheet for John's Products will show an Inventory account, which is a current asset listed after Cash and Accounts Receivable.

Journal Entry 3 If John originally purchased 100 units, the sale of 20 units leaves 80 units remaining, at a cost of $5 each. The cost of merchandise sold is an expense, and is usually shown right after sales. Note that the income statement has room for other expenses such as rent, depreciation, salaries and other expenses. These will be subtracted from gross profit to derive net income. This is called a multiple-step income statement. We take sales minus cost of goods sold to get gross profit, then subtract expenses from gross profit to get net income. Your text also illustrates a single step income statement, in which Cost of Goods Sold is simply presented as an ordinary expense. The term "single step" suggests that all revenues are at the top, all expenses are at the bottom, and one subtraction is made to calculate net income. Some people claim that the single step format is easier to understand--on the other hand, the calculation of gross profit and gross profit percentage are not as obvious to statement reader.

Learning Strategy for Merchandising

  1. Learn the account names, locations, and normal balances (debit or credit);
  2. Study the income statement format to understand its objectives;
  3. Focus on purchases and sales of inventory; skip other details;
  4. The closing entries are basically the same as studied in Chapter 4.

Merchandising Accounts and Journal Entries

There are two general methodologies for merchandising accounting:
  1. The periodic inventory system;
  2. The perpetual inventory system.

Chapter 6 concentrates on the perpetual system. The "perpetual" refers to the fact that every change in inventory results in a debit or credit to the inventory account. Specifically, every purchase of inventory is debited to the Inventory account; likewise, every sale of inventory reduces inventory, and is credited to the Inventory account. Therefore, unless there has been a theft or unrecorded loss of some units of inventory, the Inventory account should reflect the current inventory on hand.

Accounts Used in the Perpetual Inventory System

In the perpetual inventory system, you'll find a new account in the assets section (Merchandise Inventory) and several new accounts in owner equity that are used for recording sales, cost of goods sold, and operating expenses. Here are the basic owner equity accounts for merchandising, using the perpetual method:


The Accounts

If we create an income statement for the situation above, here is what it would look like:

Journal Entry 3

Debit/Credit Logic for Merchandising

Focus on the operating accounts in the T-accounts shown above. The normal balance for each account is described below. Sales is a revenue account and must have a CREDIT balance. Note the balance of $40,000 on the credit side. Cost of Goods Sold is the cost of the units that were sold. In this example, the Cost of Goods Sold was $18,000. Because Cost of Goods Sold is an expense, it always has a debit balance. Net Sales minus Cost of Merchandise Sold = Gross Profit. Finally, are subtracted from Gross Profit to derive Net Income. If the net income is positive, there will be a credit balance in Income Summary. In the example above, the Gross Profit is $22,000; subtract the Rent and Salaries Expenses, and the net income will be $6,000. Conclusion: to make a net income, the Sales account balance (credit balance) must be large enough to cover Cost of Goods Sold and all expenses.

Recording Purchases at Net

Example: Jones purchases $5,000 of Inventory on account, with terms of 2/10, n/30. The terms 2/10, n/30 (pronounced two-ten, net thirty) mean that if the purchaser pays within the ten-day period, the purchaser can take a 2% discount. It is always best to take every discount offered. On a $5,000 purchase, two percent would be .02 times $5,000 = $100. We subtract the $100 from $5,000, and the net amount of the purchase is $4,900. The journal entry would be:

Journal Entry 1

If merchandise is returned to a supplier, a debit is made to Accounts Payable or Cash, and a credit is made to the Inventory account. Example: Jones returns $500 of goods to the supplier because they were defective. Because we are recording the purchase at net, we need to record the $500 return at net as well. Two percent of $500 = $10. Subtract $10 from $500 and the merchandise return will be $490. The entry is:

Journal Entry 2

At this point, the Account Payable would have a balance of $4,410. When we make the payment, our entry would be:

Journal Entry 3

When a sale of merchandise occurs, there are two entries. The first entry is a debit to Accounts Receivable and a credit to Sales. The second entry is a debit to Cost of Goods Sold and a credit to the Inventory account. The Cost of Goods Sold is an expense. This second entry transfers the inventory cost out of the asset section and into Cost of Goods Sold. Remember that the selling amount should be higher than the cost of the goods, since we are in business to make a profit. Example: Jones sells $1,000 of Inventory for a price of $1,300, on account, with terms of 2/10, n/30: Depending upon prevailing interest rates, merchandisers may offer a discount if their customer pays early. Terms of 2/10, n/30 means that if the customer pays within 10 days, the customer can deduct 2% of the amount of their invoice. It is customary for businesses to always take the discount if it is offered, because a missed discount equates to a very high interest rate.

Recording Sales at Net

Your textbook indicates that the seller should record the sale at net, which means that we record the sale net of the discount. Returning to the example, if we sell goods amounting to $1,300 with terms 2/10, n/30, we record the sale at $1,274.

Journal Entry 4

*There are two ways you can calculate the net amount of the sale. Multiply .02 times the sale amount to get the discount, then subtract the discount from the sale amount. So, .02 times $1,300 = $26; $1,300 minus $26 = $1,274. The second way is to recognize that if there is a 2% discount, the customer will pay 98% of the cost. The net amount to be paid would be .98 times $1,300 = $1,274.

Shipping Terms

Your textbook describes two types of shipping terms, FOB Shipping Point, and FOB Destination. A diagram is helpful here.

FOB Destination

If the terms are FOB Destination, the Seller pays the freight charges. The journal entry for the Seller is a debit to Freight Expense and a credit to Cash.

If the terms are FOB Shipping Point, the Seller moves the goods to the Shipping Point (perhaps the Seller's loading dock) and the Buyer pays freight charges from that point to the Buyer's location. The Buyer makes the entry debiting Merchandising Inventory and crediting Cash.

FOB Shipping Point

Looking at the two diagrams, the shipping terms dictate how the freight charges are recorded. Under FOB Destination, freight charges are considered an expense for the seller. Under FOB Shipping Point, the freight charges are added to an asset, Merchandise Inventory.

Merchandising Adjustments

There are several adjustments that may arise in the selling of products. The first is for inventory shrinkage. Inventory shrinkage is a reduction in inventory due to theft, breakage, product malfunction or spoilage. For example, Johnson Company has a balance in the Inventory account of $64,000. On December 31, a physical count of the inventory was conducted. Employees counted all units, determined the costs, and added up the total inventory. The result was that there was only $62,500 of inventory on the shelves. The difference between the recorded amount and the actual amount was $1,500, which is the amount of shrinkage. To record the shrinkage, we debit Cost of Goods Sold and credit Merchandise Inventory.

Adj1

Note that this treatment means that some inventory was lost, without the benefit of earning revenue. Also, at balance sheet date, the Merchandise Inventory on hand will match the figure on the Balance Sheet. A second adjustment is to record the expected revenue loss due to customers returning items purchased, due to product malfunction, incorrect size or color, or for other reasons. The first adjustment makes a correction to the amount of revenue earned. Example: Clark Products had sales of $100,000 this month. Clark estimates that 3% of the sales will need to be refunded to customers. The entry would be:

Adj 2

Assuming that the revenue correction will result in customers returning purchases, Clark anticipates that the Cost of Goods Sold and Merchandise Inventory accounts will be affected as well, with the following entry. (Assume that the cost of the inventory is one-half the price).

Adj3

When actual merchandise returns occur, customers are paid in cash.

Adj4

And the inventory is returned to the shelf, and to the Merchandise Inventory account.

Adj5

Closing Entries for Merchandising

The closing entries for a merchandising company are essentially the same as for a service business: 1. Close Sales to Income Summary. 2. Close Expenses to Income Summary. Note that Cost of Goods Sold is one of these expenses, probably the largest. 3. Close Income Summary to the Capital account. 4. Close Drawings to the Capital account. This completes the major topics of Chapter 6.