Merchandising Operations and the

Accounting Cycle
Introduction
In this module:

You will look at:

• Accounting for merchandising operations

You will be introduced to:

• Concepts about inventory

• How tracking inventory affects accounting records
• The two inventory tracking systems used by businesses

You will work with the:

• Types of entries and financial statements encountered in previous units

Learning Outcomes
Upon successful completion of Module 5 you will be able to:

1. Distinguish between and record all of the following: Gross Sales, Sales Returns and Allowances,
Sales Discounts, Net Sales.
2. Distinguish between and record necessary journal entries under both the Perpetual Inventory
System and the Periodic Inventory System.
3. Prepare the Cost of Goods Sold section of the income statement. Record the following
components comprising the Cost of Goods Sold: Opening Inventory, Purchases, Purchase
Returns and Allowances, Purchase Discounts, Freight In, Ending Inventory
4. Prepare closing entries for a merchandiser that will close out the following temporary accounts:
a. Gross Sales
b. Sales Returns and Allowance
c. Sales Discounts
d. Opening Inventory
e. Purchases
f. Purchase Returns and Allowances
g. Purchase Discounts
h. Freight In
i. Ending Inventory
j. All Expenses
k. Owner Withdrawal
5. Prepare a Post-Closing Trial Balance for a merchandiser
Pre-Test
You’re going to test your accounting knowledge before you begin the module content.

1. The major difference between merchandising and service operations is that merchandisers
sell products, not services.
a. True
b. False
2. A common type of merchandising operation is a retail store.
a. True
b. False
3. A doctor’s office is an example of a merchandiser.
a. True
b. False
4. Inventory is anything purchased by a business.
a. True
b. False
5. In a perpetual inventory system, inventory is counted every day.
a. True
b. False
6. In a periodic inventory system, inventory is counted at the end of each period.
a. True
b. False
7. Cost of Goods Sold refers to the price a merchandiser paid for its inventory.
a. True
b. False
8. Merchandisers use the same accounting processes as other types of business, but use
additional accounts.
a. True
b. False
9. The cost of shipping product to customers is called freight-in.
a. True
b. False
10. In a merchandising operation, the cost of freight is never recorded separately because it is
considered just part of the cost of doing business.
a. True
b. False

Answers:

1. A - True
2. A - True
3. B - False
4. B - False
5. B - False
6. A - True
 7. B - False
8. A - True
9. B - False
10. B - False

What is Merchandising?
Up until now, we have focused on service type operations. Mary Smith, lawyer, Sally’s Veterinary Clinic,
and Louie’s Landscaping are all examples of service operations. Others are doctors, accountants,
hospitals, and school boards. As you can see from these examples, service operations earn revenue from
the activities they perform for their customers.

Merchandisers typically purchase physical or tangible goods from suppliers and resell them (hopefully at
a higher price) to customers, in order to earn profit. George’s Electronics, a retail store selling electronic
products to the general public, is an example of a merchandiser. Other examples include wholesalers,
restaurants, and many different types of retailers such as clothing or hardware store.

Business issues related to inventory are the major differences between service and merchandising
operations.

Tangible: goods that can be seen and touched.

Inventory: Goods that a business owns for the sole purpose of selling them to customers.

What is Inventory?
Inventory is goods purchased or manufactured by a business for the sole purpose of selling them to
customers. Goods that a company purchases for its own use are not inventory.

Check Your Understanding

Which of the following transactions will affect inventory accounts?

a. George’s Electronics purchases 1000 cell phones from Z-Tekko in order to sell them to their
retail customers.
b. Bauhaus 2000, a furniture store, purchased a new desk for the manager’s office.
c. Cyber Office Supplies Company purchased printer paper for its own use.
d. George’s Electronics bought 10 Palm Pilots from Z-Tekko for its employees to use.
e. Bauhaus 2000, a furniture store, purchased 25 loveseats from its supplier for resale.

Answer to Check Your Understanding

Both A and E will affect inventory accounts.

Inventory Management
Since inventory is usually the largest current asset, and the major source of revenue for merchandisers,
it is critical that merchandisers have effective systems in place to:

• Track the inflow (purchase) and outflow (sale) of inventory

 • Calculate the costs related to the acquisition, handling, and storage of inventory
• Make sure that if the physical quantity of goods on hands matches the accounting records

We will look at the two inventory systems user for these purposes later in the unit. First, let’s look at
some of the different accounting needs that merchandisers have.

Accounting for Merchandising Transactions

In a service operation, a business earns revenue by offering services that customers pay for. The
company also incurs expenses. As you’ve seen, expenses are deducted from revenue to arrive at the
company’s Net Income (or Loss).

1. Merchandisers must keep enough inventory on hand to meet their customers’ needs, and
usually must store the inventory until it is sold.
2. The merchandiser may also incur costs related to the shipping of inventory, either when it’s
purchased from the supplier, or when it is sold to the customer.
3. Goods that have been sold may be returned by the customer because they have been damaged,
or because the customer finds that they are unsuitable (wrong colour or size, or incorrect item).
4. Goods that have been purchased for resale may be returned to the supplier by the
merchandiser because they have been damaged, or because the merchandiser finds that they
are unsuitable (wrong colour or size, or correct item).
5. For sales on account (credit sales), merchandisers must find ways to maximize income by
encouraging customers to pay for the goods as soon as possible.
6. Management must measure Cost of Goods Sold in order to effectively measure the overall
profitability of the business.

On Account: Sales that are received by the customer now, but paid for later.

Cost of Goods Sold: A measure of the total cost of inventory sold during the period. It includes
purchases, allowances, discounts, and inbound freight costs.

All of these factors require effective management by merchandisers, and must be accounted for in the
financial statements. Let us look at recording typical sales transactions in a merchandising operation.

Gross Revenue (Sale) and Net Revenue (Sales)

When a merchandiser resells the goods they have purchased, the sales portion of this transaction is
recorded the same way as if a service business had made the sale:

Example

• Jan. 2 – George’s Electronics sold $200 worth of blank CD’s to a business customer. The sale is
recorded like this:
Accounts Receivable (or Cash) 200
Sales Revenue 200

Gross Revenue (Gross Sales)

As you have seen in earlier units, sales revenue is recorded when it is earned. The original amount of
sales revenue earned is called Gross Revenue (Gross Sales).

Net Revenue (Net Sales)

Sometimes though, situations may arise that may impact the overall revenue from sales for the period,
before it is finally reported in financial statements. After the effect of those situations has been
recorded, the remaining revenue is called Net Revenue (Net Sales).

Sales Returns and Allowances

As previously discussed, a merchandiser sells physical merchandise or products. Sometimes though, this
merchandise may arrive at the customer location damaged or not exactly as the customer was expecting
(i.e. red instead of blue).

The sales returns and allowances account is a contra revenue account (it has a debit balance) that is
offset against the gross revenue.

Example

Let’s return to the Jan. 2 sale we recorded earlier:

• Accounts Receivable (or Cash) - 200

• Sales Revenue - 200

Jan. 4 - $10 worth of the CD’s sold on Jan. 2 were damaged during shipping and the customer has
returned them. George’s Electronics would record this entry:

• Sales Returns and Allowances - 10

• Accounts Receivable - 10

In some cases, the seller may allow the customer to return the goods. In other cases, the customer will
keep the goods, if the seller gives them a credit (allowance) to compensate for the inconvenience. Either
case will reduce the amount the customer pays for the goods, so the seller must record this reduction in
revenue.

Why did we not simply debit the sales revenue account? It would hide the fact that product was
returned. Businesses need to keep careful track of events such as returns and allowances. Many returns
may indicate problems such as inferior product quality, or shipping errors. Management needs to know
about and correct these problems, so that future income is not adversely affected.

Recording sales returns and allowances in a separate account highlights this information for all users of
the financial statement.

Sales Discounts
One of the most challenging issues faced by all companies is the timely collection of their accounts
receivable. One method used to encourage prompt payment of receivables is to allow customers a sales
discount if they pay early.
A sales discount is not the same as a quantity discount. It affects the revenue from a sale, but does not
change the original purchase price of the goods. A quantity discount alters the original price, and is not
accounted for separately.

The sales discount is states as part of the payment terms on the sales invoice.

Quantity Discount: Customer pays less per item by buying a larger amount of goods.

Example

Here’s a typical Payment Terms Statement: 2/10,n/30

• 2/: the discount amount is 2%. Merchandiser may deduct 2% from the gross product price
shown on the invoice, if they pay within the discount period.
• 10: the discount period is 10days. Customer may pay the net amount (gross product less
discount) if they do so within 10 days of the invoice date.
• n/30: The payment term of this invoice is 30days. If the invoice is not paid within the discount
period, the full amount is due within 30days of the invoice date.

Recording a Sale with a Discount

Scenario: On Jan. 5, George’s Electronics sold a cell phone worth $100 to Mary Smith, with payment
germs of 2/10,n/30. If Mary Smith pays this invoice within the 10 day discount period (by Jan. 15), she is
entitled to a discount of $3 ($100 * 2%), so her payment will be $98 ($100-$2).

George’s Electronics would record Mary’s payment like this (remember that the sale was already
recorded on Jan. 5):

• Cash - 98
• Sales Discounts - 2
• Accounts Receivable - 100

We do not debit the sales revenue account as this would hide the fact that an early payment discount
has been taken. The sales discount account is a contra revenue account (debit balance) that appears as
an offset against the gross revenue.

The purpose of recording sales discounts in a separate account is to highlight this information to users of
the financial statements.

If Mary does not pay the invoice within 10 days (by Jan. 15), she must pay the full amount ($100).

George’s Electronics would record Mary’s payment like this:

Cash - 100

Accounts Receivable - 100

How does a Sales Discount affect a Sales Return or Allowance?
If the seller has allowed a sales return and allowance, a sales discount may be taken on only the
outstanding invoice amount.

Remember George’s Electronics Jan. 2 sale of CD’s worth $200?

George’s Electronics recorded the original sale like this:

• Accounts Receivable or Cash - 200

• Sales Revenue - 200

Recall that $10 worth of CD’s was damaged during shipping and was returned by the customer on Jan. 4.

George’s Electronics recorded the return like this:

• Sales Returns and Allowances - 10

• Accounts Receivable - 10

Now there is only $190 ($200 - $10) outstanding on this invoice.

The payment terms are 2/10,n/30 and the customer pays on Jan. 10 (within the discount period).

George’s Electronics records the payment like this:

• Cash (190*98%) - 186

• Sales Discounts (190 * 2%) - 4
• Accounts Receivable - 190

Exercise: Sales Discount Effects

Instructions:

• Record the journal entries for each transaction. Each transaction requires 2-3 lines.

Check Your Understanding

George’s Electronics made several sales in March. Record the necessary journal entries for each
transaction.

• March2: Sold merchandise of $500 with terms 2/10,n/30, to Sally’s Veterinary Clinic
• March 3: Sally’s Veterinary Clinic returns $50 of merchandise purchased on March 2 that was
damaged during shipping
• March 5: Sold merchandise of $1000 with terms 2/10,n/30 to Louie’s Landscaping
• March 9: Sally’s Veterinary Clinic pays the full amount owing for the March 2 sale.
• March 17: Louie’s Landscaping pays full amount owing for the March 5 purchase.

GENERAL JOURNAL
 Date Account Titles and Explanations Debit Credit
.. .. .. ..

Answer to Check Your Understanding

GENERAL JOURNAL

Date Account Titles and Explanations Debit Credit

March 2 Accounts Receivable 500
Revenue 500
March 3 Sales Return & Allowance 50
Accounts Receivable 50
March 5 Accounts Receivable 1000
Sales Revenue 1000
March 9 Cash (500 – 50*98%) 441
Sales Discounts (500 – 50*2%) 9
Accounts Receivable (500-50) 450
March 17 Cash 1000
Accounts Receivable 1000

The Sales Section of the Income Statement

Accounting Records for merchandisers follow through the same accounting cycle as service operations.
As with service operations, the merchandiser’s account balances will be reported on the financial
statements. If this were the end of the period, the sales section of George’s Electronics, January 2013
income statement would look like that in the example.

As you can see, the Sales (Revenue) section is more detailed on the Income Statement for George’s
Electronics. This allows the company to report the balances for the additional accounts that affected
sales of inventory during the period.
Check Your Understanding
Using the portion of the Adjusted Trial Balance given for George’s Electronics, prepare the Sales Section
of the company’s Income Statement.

ADJUSTED TRIAL BALANCE

Debits Credits
Cash 1441
Accounts Payable 0
Sales Revenue 1500
Sales Returns and Allowance 50
Sales Discounts 9

Answer to Check Your Understanding

Income Statement
For the period ending March 31, 2013
Debit Credit
Sales Revenue 1500
LESS
Sales Return and 50
Allowances
Sales Discounts 9 59
Net Sales 1441

Purchases
In order to have inventory available for resale, merchandisers must first purchase the goods and usually
store them until they are sold. In normal business operations, merchandisers encounter typical
purchase-related transactions, just as they do with sales.

As we will see later in the unit, how such transactions are recorded depends on the inventory systems in
use. For now, let’s look at typical situations that may affect net purchases.
Purchase Returns and Allowances
Sometimes when the merchandiser purchase inventory, the goods may arrive damaged or not exactly as
the merchandiser was expecting.

In some cases, the supplier may allow the merchandiser to return the goods. In other cases, the
merchandiser will keep the goods, if the supplier gives them a credit (allowance) to compensate for the
inconvenience. Either case will reduce the amount the merchandiser pays for the goods, so the
merchandiser must record this reduction in cost.

We will look at recording these entries a little later.

Purchase Discounts
One of the most challenging issues faced by all companies is the timely collection of their accounts
receivable. One method suppliers used to encourage prompt payment of receivables is to allow
merchandisers a purchase discount if they pay early.

Purchase discounts are not the same as a quantity discount. A sales discount affects the revenue from a
sale, but does not change the original purchase price of the goods. A quantity discount alters the
original price, and is not accounted for separately.

The sales discount is stated as part of the payment terms on the purchase invoice.

We will look at recording these entries a little later.

Quantity Discount: Merchandiser pays less per item by buying a larger amount of goods.

Example

Here’s a typical Payment Terms Statement: 2/10,n/30

• 2/: the discount amount is 2%. Merchandiser may deduct 2% from the gross product price
shown on the invoice, if they pay within the discount period.
• 10: the discount period is 10days. Customer may pay the net amount (gross product less
discount) if they do so within 10 days of the invoice date.
• n/30: The payment term of this invoice is 30days. If the invoice is not paid within the discount
period, the full amount is due within 30days of the invoice date.

How does a Purchase Discount affect a Purchase Return or Allowance?

If the supplier has allowed a purchase return and allowance, the merchandiser may take a purchase
discount on only the outstanding invoice amount.

We will look at recording these entries a little later.

Freight
Freight, or shipping costs are an important component of the cost of goods purchased for resale. A
merchandiser records the freight costs of its purchase in either the inventory or Freight in account.
Inventory or Freight-In is used to record only the incoming freight cost.

Freight Out is an operating expense of the business, and is usually recorded in an account called
Delivery Expense.

It is important to record freight costs, in order to manage them effectively. Management may need to
compare and consider different alternatives, such as truck, rail, air, etc… in order to keep such costs
down.

Freight-In: Cost incurred to bring the merchandise from your supplier to your place of business.

Freight-Out: Costs for delivering product to customers.

What is FOB?
FOB is a common freight term. The seller will pay the freight to the FOB point. At the FOB point the
purchaser becomes responsible for the freight cost. FOB is usually neglected as part of the terms of sale.
It is usually expressed as FOB seller warehouse or FOB origin or FOB destination.

We will look at recording these entries a little later.

FOB: Free on Board

FOB seller warehouse: The purchaser will pay freight cost from the seller’s warehouse to the
purchaser’s place of business.

Check Your Understanding

1. Bauhaus 2000, a furniture store, made a $10000 purchase of furniture. The purchase was FOB
seller warehouse. The freight cost to bring the goods to the Bauhaus 2000 store was $500.
Which business swill record the freight cost?
a. Bauhaus 2000
b. Supplier
2. A supplier shipped goods worth $3000 to Bauhaus 2000. The purchase was FOB destination. The
freight cost to bring the goods to the Bauhaus 2000 was $50. Which business will record the
freight cost?
a. Bauhaus 2000
b. Supplier

Answers:

1. Bauhaus 2000
2. Supplier
Gross Profit
Earlier in the unit, we looked at the differences between service and merchandising operations. We
discovered additional factors that can affect the recording of sales records, and the resulting
determination of Net Income in a merchandising operation.

Another important factor in determining Net Income in a merchandising operation is the Cost of Goods
Sold.

The way in which Cost of Goods Sold is determined and recorded depends on which type of inventory
tracking system the merchandiser uses.

Cost of Goods Sold: The figure represents the cost of all merchandise sold during the period.

Perpetual and Periodic Inventory Systems

To understand how merchandisers account for purchases, let us first look at the two common types of
inventory systems.

Perpetual Inventory System

A Perpetual Inventory System keeps track of all inventory movements (incoming and outgoing)
as they happen. A computerized system is needed, so it is a more costly system. However,
management can easily determine the value of inventory on hand at any given moment during
an accounting period. Effective inventory management is a cornerstone of many successful
merchandisers, such as Wal-Mart.

Periodic System

In a Periodic System, each specific inflow or outflow of inventory is not tracked. Instead, at the
end of each period, a physical count of goods determines the quantity on hand. Calculations
which take into account sales, purchases, returns, etc… are then made to arrive at the value of
inventory to be recorded at period end. An adjusting entry is made to bring the ending inventory
to the correct balance.
The Perpetual Inventory System
In George’s Electronics Store, the cashier scans each item’s unique barcode during checkout. Because
cashiers are not manually keying data into their registers, errors are substantially reduced. The biggest
advantage, however, is that this process sets several management and accounting processes in motion.

Scanning automatically:

1. Identifies the prices the customer must pay for each item sold.
2. Updates the general ledger for the sale.
3. Updates the general ledger for the cost.
4. Removes sold items from inventory on hand.
5. Generates an order from a supplier for those items that fall below a specified quantity
(depending upon forecasts of future sales as well as supplier delivery time).
6. Produces analytical information such as the quantity of each item sold, day and time of sales.

The Perpetual Inventory System: Inventory Purchases

In a perpetual system, two accounts: Inventory (asset) and Cost of Goods Sold (expense) are used to
record the effect of inventory purchase transactions on the merchandising operations.

• A purchase transactions requires debit entry to Inventory.

As we saw earlier, purchases of inventory may also be affected by returns and allowances for damaged
or incorrect goods, by purchase discounts, and by freight costs to the purchaser’s destination.

• In a perpetual system, these purchase related transactions are credit entries to the Inventory
account.

When inventory is sold, it is removed from the inventory account by a debit entry to Cost of Goods Sold,
and credit entry to Inventory.

Let’s look at the journal entries.

The Perpetual Inventory System: Recording Inventory Purchases and Sales

1. On January 3, George’s Electronics purchase $1000 worth of product that it intends to resell.
2. On January 6, items costing $800 that were purchased on January 3 are sold to various
customers for $1500 cash. (NOTE: Two entries are required).

Example 1:

On January 3, George’s Electronics purchases $1000 worth of product that it intends to resell.

The journal entry to record the purchase looks like this:

Account Name Debits Credits

Inventory 1000
Accounts Payable 1000
Example 2:

On January 6, items costing $800 that were purchased on January 3 are sold to various customers for
$1500 cash. Two entries are required.

The journal entry to record the same of product looks like this:

Account Name Debits Credits

Cash 1500
Sales Revenue 1500

This entry records the Cost of Goods Sold, and removes the product from Inventory.

Account Name Debits Credits

Cost of Goods Sold 800
Inventory 800

The Cost of Goods Sold account acts like an expense account that is offset against sales. (NOTE: The
inventory account is credited to record the outflow (sale) of inventory).

The Perpetual Inventory System: General Ledger

After recording the January purchases and sales to date, George’s Electronics inventory account balance
would look like this:

Inventory:

Debit Credit
1000 800
200
The balance of the inventory account is now $200 debit. This amount should agree with the actual value
of inventory on hand. If we were to physically count the inventory at this point, we should find that that
its dollar cost value matches the account balance.

In a perpetual system, we will assume most of the time that the value in the inventory account equals
the value of the actual inventory on hand. Once a year, when formal financial statements are produced,
a physical count of inventory must e done to prove agreement to the general ledger inventory account
balance. Some businesses do this count more often.

If there is a difference, an adjustment to the inventory account is needed. This adjustment will ensure
the balance in the inventory account equals the value of the actual inventory on hand.

Exercise: Perpetual Inventory System

Instructions:

• Record the transactions that occurred with in a perpetual inventory system.

Check Your Understanding:

• March 1: Purchased $1000 of merchandise with terms 2/10,n/30, from FOB seller warehouse.
Freight charges were $150.
• March 4: Returned $200 of the merchandise purchased on March 1 due to damage during
shipping
• March 5: Sold $900 of merchandise for $1500 with terms 2/10,n/30.
• March 7: $50 of merchandise sold on March 5 was returned damaged.
• March 9: Paid full amount of outstanding invoice for merchandise from March 1.
• March 10: Received full payment from sale of March 5.

Date Account Titles and Explanations Debit Credit

March 1 Fill in the blank Fill in the blank
Fill in the blank Fill in the blank
March 4 Fill in the blank Fill in the blank
Fill in the blank Fill in the blank
March 5 Fill in the blank Fill in the blank
Fill in the blank Fill in the blank
Fill in the blank Fill in the blank
Fill in the blank Fill in the blank
March 7 Fill in the blank Fill in the blank
Fill in the blank Fill in the blank
March 9 Fill in the blank Fill in the blank
Fill in the blank Fill in the blank
Fill in the blank Fill in the blank
March 10 Fill in the blank Fill in the blank
Fill in the blank Fill in the blank
Fill in the blank Fill in the blank

Answers:

Date Account Titles and Explanations Debit Credit

March 1 Inventory 1150
Accounts Payable 1150
March 4 Accounts Payable 200
Inventory 200
March 5 Accounts Receivable 1500
Sales Revenue 1500
Cost of Goods Sold 900
Inventory 900
March 7 Sales Returns & Allowances 50
Accounts Receivable 50
March 9 Accounts Payable (1150 – 200) 950
Cash (800 * 98%) + 1500 934
Inventory 16
March 10 Cash (1450 * 98%) 1421
 Date Account Titles and Explanations Debit Credit
Sales Discounts (1450 * 2%) 29
Accounts Receivable 1450
The Perpetual Inventory System: Partial Income Statement

If we add the January 3 and January 6 purchases and sales transactions to the income statement, it looks
like this:

Check Your Understanding

In the partial income statement below, what was the value of Cost of Goods Sold?

Income Statement
For the period ending March 31, 2013
Debit Credit
Net Sales 9300
LESS
Cost of Goods Sold Fill in the blank
Gross Profit 3700

Answer to Check Your Understanding

Income Statement
For the period ending March 31, 2013
Debit Credit
Net Sales 9300
LESS
Cost of Goods Sold Fill in the blank
 Income Statement
For the period ending March 31, 2013
Gross Profit 3700

The Periodic Inventory System

The periodic inventory system does not keep track of individual inventory movements. An actual
physical count of the inventory on hand, at each period end, is necessary to determine the value of the
inventory on hand.

The periodic system does not use Inventory or Cost of Goods Sold accounts. Instead, it accumulates
entries in a series of temporary accounts, which must be closed at the end of the period.

• Cost of Goods Sold is determined from the purchase-related accounts and the value of inventory
on hand at the end of the period.

Let us look at how the previous transactions would be recorded under the periodic inventory system.

The Periodic Inventory System: Recording Inventory Purchases and Sales

1. On January 3, George’s Electronics purchase $1000 worth of product that it intends to resell,
from Z-Tekko cellphones.
2. On January 6, items costing $800 that were purchased on January 3 are sold to various
customers for $1500 cash. This entry records the sale of product.

Example 1:

On January 3, George’s Electronics purchased $1000 worth of product they intend to resell, from Z-
Tekko cellphones.

The Journal entry to record the purchase looks like this:

Account Name Debits Credits

Purchases 1000
Accounts Payable 1000

Remember that only products we intend to resell are recorded in the purchases account. George’s
Electronics is in the business of selling electronic equipment. If the store purchases electronic
equipment from its regular suppliers for its own use within the store, they do not record this purchase in
the purchase account, as they do not intend to resell the goods. Instead, the equipment is recorded as a
fixed (capital) asset within the office furniture account.

Example 2:

On January 6, items costing $800 that were purchased on Jan. 3 are sold to various customers for $1500
cash. This entry records the sale of product.

The journal entry to record the purchase looks like this:

 Account Name Debits Credits
Cash 1500
Sales Revenue 1500
No entry is made to record the Cost of Goods Sold. We will calculate this amount at the end of the
period.

The Periodic Inventory System: Partial Income Statement

If this were the end of the period, a partial income statement for the previous transactions would look
like:

The Periodic Inventory System: Recording Purchase Returns and Allowances

As previously discussed, a merchandiser sells physical merchandise or products. Occasionally, goods
purchased for resale may arrive at the merchandiser’s location damaged or not exactly as the
merchandiser was expecting (i.e. red instead of blue), and therefore unsuitable for resale at the
expected price.

In these situations the supplier (company which sells goods to a merchandiser for resale) (seller) may
allow the purchaser (merchandiser) to return the goods or they may provide the purchaser with a credit
(allowance) which will reduce the amount the merchandiser owes. This credit (allowance) is a means of
compensating the purchaser for their inconvenience.

Example:

On January 7, in the Jan. 3 purchase of $1000, $100 worth of product was damaged during shipping.
George’s returns it on Jan. 7.
George’s (the purchaser) journal entry to record the purchase return looks like this:

Account Name Debits Credits

Accounts Payable 100
Purchase Returns and Allowances 100

The Purchase returns and allowances account is a contra purchase account (credit balance) that appears
as an offset against the purchases.

Recording purchase returns and allowances in a separate account highlights this information to users of
the financial statements.

We do not debit the purchase account as this would hide the fact that the product was returned.
Purchasers such as George’s need to keep track of returns and allowances in order to make
management decisions about which suppliers to use. If Z-Tekko is consistently supplying damaged
goods, George’s may decide to change suppliers.

The Periodic Inventory System: Recording Purchase Discounts

Example:

On January 12, George’s made a purchase of $500 from Z-Tekko’s with terms of 2/10,n/30.

If the payment for this invoice is made within the 10 day discount period (by Jan. 22), a $10 discount
($500 * 2%) may be taken. George’s would record the payment like this (remember that the purchase
would have been recorded earlier):

Account Name Debits Credits

Accounts Payable 500
Purchase Discount 10
Cash 490

The purchase discount account is a contra purchase account (credit balance) that appears as an offset
against the purchases. Recording purchase discounts in a separate account highlights this information to
users of the financial statements.

We do not credit the purchase account as this would hide the fact that an early payment discount has
been taken.

If the payment is not made within the 10 day discount period, the full invoice amount ($55) must be
paid. George’s would record the payment like this:

Account Name Debit Credit

Accounts Payable 500
Cash 500
The Periodic Inventory System: How does a Purchase Discount affect a Purchase Return
or Allowance?
1. Remember: On January 3, George’s Electronics purchased $1000 worth of product that it
intends to resell, from Z-Tekko’s cellphones.
2. Remember: On January 7, George’s then recorded the return of $100 worth of damaged goods
from that purchase.
3. The result of these transactions is that only $900 ($1000 - $100) is outstanding on this invoice, if
the terms on this invoice are 2/10,n/30 and George’s pays by Jan. 13 (within the discount
period).

The Periodic Inventory System: Freight In

Example:

George’s $1000 purchase on Jan. 3 was FOB seller warehouse. The freight cost to bring the merchandise
to the George’s Electronics store was $50.

In addition to recording the purchase, George’s Electronics journal entry would look like this:

Account Name Debits Credits

Freight-In 50
Accounts Payable 50
Exercise: Periodic Inventory System

Instructions:

• Record the transactions that occurred within a periodic inventory system.

Check Your Understanding:

• March 1: Purchased $1000 of merchandise with terms 2/10,n/30, from FOB seller warehouse.
Freight charges were $150.
• March 4: Returned $200 of the merchandised purchased on March 1 due to damage during
shipping.
• March 5: Sold $900 of merchandise with $1500 with terms 2/10, n/30.
• March 7: $50 of merchandise sold on March 5 was returned damaged.
• March 9: Paid full amount of outstanding invoice for merchandise from March 1.
• March 10: Received full payment from sale of March 5.

Date Account Titles and Explanations Debit Credit

March 1 Fill in the blank Fill in the blank
Fill in the blank Fill in the blank
Fill in the blank Fill in the blank
March 4 Fill in the blank Fill in the blank
Fill in the blank Fill in the blank
March 5 Fill in the blank Fill in the blank
Fill in the blank Fill in the blank
March 7 Fill in the blank Fill in the blank
 Date Account Titles and Explanations Debit Credit
Fill in the blank Fill in the blank
March 9 Fill in the blank Fill in the blank
Fill in the blank Fill in the blank
Fill in the blank Fill in the blank
March 10 Fill in the blank Fill in the blank
Fill in the blank Fill in the blank
Fill in the blank Fill in the blank

Answers:

Date Account Titles and Explanations Debit Credit

March 1 Purchases 1000
Freight-In 150
Accounts Payable 1150
March 4 Accounts Payable 200
Purchase Returns & Allowances 200
March 5 Accounts Receivable 1500
Sales Revenue 1500
March 7 Sales Returns & Allowances 50
Accounts Receivable 50
March 9 Accounts Payable (1150 – 200) 950
Purchase Discounts ($800 * 2%) 16
Cash (800 * 98%) + 150 934
March 10 Cash (1450 * 98%) 1421
Sales Discounts (1450 * 2%) 29
Accounts Receivable 1450

The Periodic Inventory System: Calculating the Cost of Goods Sold

As we’ve seen, accounting records for merchandisers follow through the same accounting cycle as
service operations. Once the entries have been posted and the Adjusted Trial Balance has been
prepared, the merchandiser’s account balances will be reported on the financial statements.

Let’s assume we’re ready to prepare the Cost of Goods Sold section of the income Statement, for a
periodic inventory system.

• In a perpetual system, a Cost of Goods Sold account is updated automatically, each time a sale
or purchase occurs.
• In a periodic inventory system though, cost of goods sold is calculated at the end of the period
by referring to several accounts that are specific to merchandising operations.
• At the end of March, the Cost of Goods Sold section of George’s Electronics income statement is
calculated like this:
Exercise: Income Statement
Instructions:

• Complete the Income statement below by finishing the calculations required.

• Enter the appropriate amounts into the space provided.

Check Your Understanding

Income Statement
Gross Sales Blank
Less:
Sales Returns and Allowances (2500)
Sales Discounts (3200) Blank
Net Sales 36300
Cost of Goods Sold
Sales Discount 1500
Add:
Purchases 30000
Less:
Purchases Returns and (3400)
Allowances
Purchase Discounts (2200)
 Income Statement
Net Purchases 24400
Add:
Freight In 3100
Total Purchases 27500
Cost of Goods Available for Blank
Sales
Less:
Ending Inventory 400
Cost of Goods Sold Blank
Gross Profit 11300
Operating Expenses 5600
Net Income (Loss) 5700

Answer to Check Your Understanding

Income Statement
Gross Sales 42000
Less:
Sales Returns and Allowances (2500)
Sales Discounts (3200) (5700)
Net Sales 36300
Cost of Goods Sold Section
Sales Discount 1500
Add:
Purchases 30000
Less:
Purchases Returns and Allowances (3400)
Purchase Discounts (2200)
Net Purchases 24400
Add:
Freight In 3100
Total Purchases 27500
Cost of Goods Available for Sales 29000
Less:
Ending Inventory 400
Cost of Goods Sold 25000
Gross Profit 1130
Operating Expenses 5600
Net Income (Loss) 5700

Financial Statements for a Merchandiser

Regardless of which inventory tracking system is used, a merchandiser follows the same accounting
cycle as other types of businesses. Depending on which inventory method is used, there will be some
difference in how the Income Statement is prepared.
 1. Economic Event
• Analyze Transactions
2. Record
• Enter in General Journal, prepare Adjusting Entries, and Correcting Entries
3. Summarize
• Post Special Journals to subsidiary ledgers, Special Journals to General Ledger, General
Journal to General Ledger, Adjusting Entries & Correcting Entries
4. Prepare Financial Reports
• Prepare Trial Balance, Worksheet, Adjusted Trial Balance & Financial Statements

Comparing the Income Statements

Before we continue, compare the two Income Statements:

You can see that the Cost of Goods Sold and Gross Profits amounts are the same, regardless of which
inventory system is used. The only difference is in the method of arriving at these amounts.
Where is the inventory amount?
Inventory is an asset, so it is on the Balance Sheet.

If inventory is an asset? Why is it on the income statement? Here it is part of a calculation, not an
account balance.

But we have not really reached the end of the period yet, and there are more transactions to record. So
let’s continue!

Closing Entries
The closing entries for a merchandise company are similar to those for a service company. At the end of
each period the balance of all temporary accounts (revenue, expense, and draw) must be transferred to
the owner equity account through the process known as closing entries.

Remember, this journalizing process results in the owner equity account being adjusted to reflect the
true owner equity balance after all related transactions (investment, income, loss and draw) are
processed.
The main difference between a service and merchandise company closing entries is that a
merchandising company will have some additional closing entries for its cost of goods sold.

As you saw in module 4, closing entries are prepared for several temporary accounts. For now, let’s
focus on George’s January closing entries that relate to inventory.

Account Name Debits Credits

Revenue 1500
Purchase Returns and 200
Allowances
Purchase Discounts 16
Inventory: 200
Income Summary 1916

Account Name Debits Credits

Income Summary: 1379
Inventory 150
Sales Returns and Allowances 50
Sales Discounts 29
Purchases 1000
Freight-In 150

Account Name Debits Credits

Income Summary: 537
Owner Equity 537

Once these closing entries are posted to the G/L, all temporary accounts are at zero and the owner
equity account reflects the same balance as on both the Statement of Changes in Owner Equity and the
Balance Sheet.

Inventory accounts are only part of the Closing Entries under the periodic system. Under the perpetual
system the inventory account is already updated and therefore the closing entries will not be necessary.

Using the Income Statement

We will introduce you to two profitability ratios which measure a company’s operating success for a
certain period.

Gross Profit Margin:

Gross Profit ÷ Net Sales = Gross Profit Margin

This ratio tells you what percentage of your sales revenue is gross profit and what percentage is the cost
of goods sold. It is determined by dividing the company’s Gross profit by its net sales and it is expressed
as a percentage.
Profit Margin:

Net Income ÷ Net Sales = Profit Margin

This ratio tells you that the percentage of each sales dollar that results in Net Income. It is calculated by
dividing the company’s net income by its net sales.

How do the ratios differ?

The gross profit margin tells you how much more the selling price is than the Cost of Goods Sold.

The profit margin tells you how much of the selling price covers all the expenses including Cost of Goods
Sold.

Let us look at what these ratios can tell us about Z-Tekko.

Z-Tekko’s Profitability
1. In 2007, Z-Tekko Company reported net sales of $550000, cost of goods sold of $300000, and
operating expenses of $200000. Let us see how this gross profit margin and profit margin for 2007
is calculated.

2007: Gross Profit

= Net Sales – Cost of Goods Sold

= 550000 – 300000
= 250000

2007: Gross Profit Margin

= Gross Profit ÷ Net Sales

= 250000 ÷ 550000
= 45.45%

2007: Net Profit

= Gross Profit – Operating Expenses

= 250000 – 2000
= 50000

2007: Profit Margin

= Net profit ÷ Net Sales

= 50000 ÷ 550000
= 9.09%

2. In 2008, Z-Tekko reported net sales of $600000, cost of goods sold of $350000, and operating
expenses of $225000. Calculate the gross profit margin and profit margin for each of 2007 and 2008.
Has Z-Tekko’s profitability improved or weakened?
2008: Gross Profit

= 600000 – 350000
= 250000

2008: Gross Profit Margin

= 250000 ÷ 600000
= 41.67%

2008: Net Profit

= 250000 – 225000
= 25000

2008: Profit Margin

= 25000 ÷ 600000
= 4.17%

Post-Closing Trial Balance

The post-closing trial balance is the last step in the accounting cycle:

As you learned in module 4, the post-closing trial balance is a list of all permanent (balance sheet)
accounts and the draw account will not appear on the post-closing trial balance because these accounts
have been closed out (balance brought to zero) through the closing entry process.

The objective of the post-closing trial balance is to ensure that debits equal credits of all permanent
(balance sheet) accounts.

Post Test
1. Net revenue will always be greater than gross revenue.
a. True
b. False
2. The Sales Returns and Allowance account (contra revenue account) normally has a debit
balance.
a. True
b. False
3. The Sales Discount account (contra revenue account) would be used to record price discounts
negotiated with your suppliers related to the volume of merchandise purchased from them.
a. True
b. False
4. The Cost of Goods Sold section of the Balance Sheet will normally have a debit balance.
a. True
b. False
5. Opening inventory is always the first line in the Cost of Goods Sold section of the Income
Statement.
 a. True
b. False
6. Freight out is part of the Cost of Goods Sold section.
a. True
b. False
7. Ending inventory is deducted from Cost of Goods Available for Sale in order to arrive at Cost of
Goods Sold.
a. True
b. False
8. Gross Sales less Cost of Goods Sold is equal to net income.
a. True
b. False
9. The perpetual inventory system does not require a physical count of inventory on hand at the
end of the accounting year.
a. True
b. False
10. FOB means “freight on board”.
a. True
b. False

Answers:

1. B - False
2. A - True
3. B - False
4. B - False
5. A - True
6. B - False
7. A - True
8. B - False
9. B - False
10. B - False

Case Study
Practice what you’ve learned in this unit by preparing an income statement for a merchandising
operation.

• Use “ABC Company, Adjusted Trial Balance” to help you with this exercise.
• Using the worksheet for reference, key account balances in the correct location on the income
statement.
• Note: You must complete each entry correctly before you will be able to proceed.
 ABC Company
Adjusted Trial Balance
December 31, 2013
Debit Credit
Cash 2000
Accounts Receivable 2500
Prepaid Rent 500
Prepaid Insurance 2400
Office Supplies 300
Warehouse Supplies 1200
Inventory 4200
Land 100000
Building 150000
Accumulated Amortization - 2500
Building
Equipment 75000
Accumulated Amortization - 1500
Equipment
Accounts Payable 3000
Salary Payable 9500
Mortgage Payable 100000
Bank Loan Payable 15000
Unearned Revenue 3000
Owner Equity 193700
Owner Withdrawal 10000
Sales Revenue 250000
Sales Returns & Allowances 2200
Sales Discounts 1800
Purchases 150000
Purchase Returns & Allowances 3500
Purchase Discounts 1000
Freight In 4000
Rent Expense 12000
Salary Expense 50000
Utility Expense 5000
Insurance Expense 2400
Office Supply Expense 500
Warehouse Supply Expense 1000
Amortization Expense – 1200
Building
Amortization Expense – 2400
Equipment
Total 618700 618700
Note: ending inventory amount: 31500
 Company ABC
Income Statement
For the Year ended December 31, 2013
Revenue
Sales Revenue Fill in the blank
Sales Returns & Allowances Fill in the blank
Sales Discounts Fill in the blank Fill in the blank
Net Sales Fill in the blank

Company ABC
Income Statement
For the Year ended
December 31, 2013
Cost of Goods Sold
Opening inventory Fill in the blank
Purchases Fill in the blank
Purchase Returns & Fill in
Allowances the
blank
Purchase Discounts Fill in Fill in the blank
the
blank
Net Purchases Fill in the blank
Freight In Fill in the blank
Total Purchases Fill in the blank
Cost of Goods Available Fill in the blank
for Sales
Ending Inventory Fill in the blank
Cost of Goods Sold Fill in the
blank
Gross Profit Fill in the
blank

Company ABC
Income Statement
For the Year ended December 31, 2013
Operating Expense
Rent Expense Fill in the blank
Salary Expense Fill in the blank
Utility Expense Fill in the blank
Insurance Expense Fill in the blank
Office Supply Expense Fill in the blank
Warehouse Supply Expense Fill in the blank
Amortization Expense – Building Fill in the blank
 Company ABC
Income Statement
For the Year ended December 31, 2013
Amortization Expense - Fill in the blank Fill in the blank
Equipment

Answer to Case Study

Company ABC
Income Statement
For the Year ended December 31, 2013
Revenue
Sales Revenue 250000
Sales Returns & 2200
Allowances
Sales Discounts 1800 4000
Net Sales 246000

Cost of Goods Sold

Opening inventory 42000
Purchases 150000
Purchase Returns & 3500
Allowances
Purchase Discounts 1000 4500
Net Purchases 145500
Freight In 4000
Total Purchases 149500
Cost of Goods Available for 191500
Sales
Ending Inventory 31500
Cost of Goods Sold 160000
Gross Profit 86000

Operating Expenses
Rent Expense 12000
Salary Expense 50000
Utility Expense 5000
Insurance Expense 2400
Office Supply Expense 500
Warehouse Supply 1000
Expense
Amortization Expense – 1200
Building
Amortization Expense – 2400 74500
Equipment
Net Income 11500

You have completed Merchandising Operations and the Accounting Cycle

Remember to check the timeline before you proceed to the next module to ensure you have completed
any assignments as required. Check with your instructor if you have any questions.