Chapter 4: Accounting for Merchandising Businesses

Fundamentals of Merchandising Businesses

Merchandising businesses generate revenue by acquiring products from suppliers and selling those finished goods to customers. Unlike service-based enterprises where revenue is generated purely by providing work or performing tasks, merchandising operations depend on buying and reselling tangible goods.

• Merchandise Inventory: Represents finished goods purchased with the explicit intent of reselling them to customers.

• Perpetual Inventory System: An accounting system where the Merchandise Inventory account is continuously updated in real time as purchases, sales, returns, and allowances take place throughout the accounting period.

Classification of Costs: Product vs. Period Costs

Costs incurred in a merchandising operation are categorized as either product costs or period costs depending on their direct attachment to inventory acquisitions.

• Product Costs (Inventoriable Costs):

  • Consists of all expenditures directly traceable to acquiring merchandise inventory and preparing it for sale.

  • Includes the net purchase price of inventory, freight/transportation-in costs, transit insurance, storage costs, and costs to improve quality prior to sale.

  • These costs are capitalized into the $\text{Merchandise Inventory}$ asset account on the Balance Sheet until the inventory is sold.

• Period Costs (Selling and Administrative Expenses):

  • Costs that cannot be directly traced to specific products or inventory acquisition.

  • Recognized as operating expenses on the Income Statement in the specific accounting period in which they are incurred, regardless of cash payment timing.

  • Includes selling expenses, administrative salaries, executive compensation, office utilities, advertising, office building insurance, interest expenses, and transportation-out.

Classification Breakdown (Problem 4-24A)

• Goods purchased for resale: Product Cost

• Salaries of salespersons: Period Cost

• Advertising costs: Period Cost

• Transportation-out: Period Cost

• Interest on a note payable: Period Cost

• Salary of the company president: Period Cost

• Transportation-in: Product Cost

• Insurance on the office building: Period Cost

• Office supplies: Period Cost

• Costs incurred to improve the quality of goods available for sale: Product Cost

Inventory Allocation and Accounting Mechanics

The total cost of all goods available for sale during an accounting period is allocated between the balance sheet (unsold goods) and the income statement (sold goods).

The Basic Inventory Equation

$\text{Beginning Inventory} + \text{Purchases} = \text{Goods Available for Sale}$

$\text{Goods Available for Sale} - \text{Ending Inventory} = \text{Cost of Goods Sold}$

• Sold Inventory: Transferred out of asset accounts and recognized on the Income Statement as $\text{Cost of Goods Sold}$ (an expense).

• Unsold Inventory: Remains on the Balance Sheet under current assets as $\text{Merchandise Inventory}$ alongside $\text{Cash}$ and $\text{Accounts Receivable}$.

• Core Principle: Inventory is never expensed until the period in which the item is actually sold.

Standard Journal Entries under Perpetual Inventory System

• Purchase of Inventory on Account or Cash:

  • Debit: $\text{Merchandise Inventory}$

  • Credit: $\text{Cash}$ (or $\text{Accounts Payable}$)

• Sale of Inventory on Account or Cash (Requires Two Entries):

  1. Revenue Component:

     • Debit: $\text{Cash}$ (or $\text{Accounts Receivable}$)

     • Credit: $\text{Sales Revenue}$

  2. Cost Component:

     • Debit: $\text{Cost of Goods Sold}$

     • Credit: $\text{Merchandise Inventory}$

Comprehensive Example: Exercise 4-2B

Jason Kidd started a small merchandising business in Year 1 using a perpetual inventory system. The following transactions occurred:

1. Acquired $\$90,000$ cash from the issue of common stock.

2. Purchased inventory for $\$60,000$ cash.

3. Sold inventory costing $\$48,000$ for $\$82,000$ cash.

General Journal Entries

• Event 1:

  • Debit: $\text{Cash}$ $\$90,000$

  • Credit: $\text{Common Stock}$ $\$90,000$
        (To record issuance of common stock)

• Event 2:

  • Debit: $\text{Merchandise Inventory}$ $\$60,000$

  • Credit: $\text{Cash}$ $\$60,000$
        (To record purchase of inventory for cash)

• Event 3a:

  • Debit: $\text{Cash}$ $\$82,000$

  • Credit: $\text{Sales Revenue}$ $\$82,000$
        (To record cash sale of inventory)

• Event 3b:

  • Debit: $\text{Cost of Goods Sold}$ $\$48,000$

  • Credit: $\text{Merchandise Inventory}$ $\$48,000$
        (To record the cost of inventory sold)

T-Account Ledger Balances

• Cash: Debit $\$90,000$ (Stock) - Credit $\$60,000$ (Inventory) + Debit $\$82,000$ (Sales) = Ending Debit Balance of $\$112,000$

• Merchandise Inventory: Debit $\$60,000$ (Purchases) - Credit $\$48,000$ (COGS) = Ending Debit Balance of $\$12,000$

• Common Stock: Ending Credit Balance of $\$90,000$

• Sales Revenue: Ending Credit Balance of $\$82,000$

• Cost of Goods Sold: Ending Debit Balance of $\$48,000$

Multistep Income Statement (Year 1)

\begin{array}{l l} \text{Sales Revenue} & \82,000 \\ \text{Less: Cost of Goods Sold} & (\48,000) \\ \hline \textbf{Gross Profit / Net Income} & \mathbf{\$34,000} \end{array}

Total Assets at End of Period

$\text{Total Assets} = \text{Cash} + \text{Merchandise Inventory} = \$112,000 + \$12,000 = \$124,000$

Special Inventory Transactions for Buyers

When purchasing merchandise, special conditions such as product returns, vendor discounts, and freight terms affect inventory valuation.

Purchase Returns & Allowances

• Purchase Returns: Returning defective, damaged, or undesirable inventory to the vendor.

• Purchase Allowances: Price reductions granted by the vendor if the buyer agrees to keep flawed merchandise.

• Under the perpetual system, returns and allowances directly reduce the $\text{Merchandise Inventory}$ account.

• Transaction Illustration:
  
  

  • Sept 2: RST Corp bought merchandise on account for $\$830$.

    • Debit: $\text{Merchandise Inventory}$ $\$830$

    • Credit: $\text{Accounts Payable}$ $\$830$

  • Sept 8: RST Corp received a credit memorandum of $\$270$ for damaged goods returned.

    • Debit: $\text{Accounts Payable}$ $\$270$

    • Credit: $\text{Merchandise Inventory}$ $\$270$

Purchase Discounts

• A cash discount offered by the seller to encourage prompt payment within a specified discount window.

• Expressed in credit terms such as $2/10, n/30$:

  • $2$: Percentage discount ($2\%$).

  • $10$: Discount period in days (10 days).

  • $n/30$: Net credit period; full payment due within 30 days if discount is not taken.

• Under a perpetual inventory system, cash discounts taken reduce the carrying cost of $\text{Merchandise Inventory}$.

• Transaction Illustration:
  
  

  • BCD Corp purchased $\$100$ of product under terms $2/10, n/30$.

  • If paid within 10 days:
    
    

    • Discount Amount: \100 \times 0.02 = \$2$

    • Cash Paid: $\$100 - \$2 = \$98$

    • Debit: $\text{Accounts Payable}$ $\$100$

    • Credit: $\text{Cash}$ $\$98$

    • Credit: $\text{Merchandise Inventory}$ $\$2$

Freight and Transportation Costs

Freight charges depend on the Free On Board (FOB) terms established between buyer and seller.

• FOB Shipping Point:

  • Responsible Party: Buyer.

  • Ownership Transfer: Title transfers as soon as the goods are delivered to the common carrier (e.g., UPS or FedEx).

  • Account Used: $\text{Merchandise Inventory}$ (Product Cost incurred to bring inventory to place of sale).

• FOB Destination:

  • Responsible Party: Seller.

  • Ownership Transfer: Title transfers only when the buyer physically receives the goods.

  • Account Used: $\text{Transportation-out}$ (Operating Expense / Period Cost to seller).

• Transaction Illustration:

  • QRS Corp purchased merchandise on account for $\$2,700$ with terms net 30 days, FOB Shipping Point. Shipping costs were $\$150$ cash.

  • Journal Entry for Buyer:
    
    

    • Debit: $\text{Merchandise Inventory}$ $\$2,850$ ($\$2,700 + \$150$)

    • Credit: $\text{Accounts Payable}$ $\$2,700$

    • Credit: $\text{Cash}$ $\$150$

Special Sales Transactions for Sellers

Seller accounting reflects revenue reductions when goods are returned, allowances are granted, or prompt settlement discounts are utilized.

Sales Returns & Allowances

• A credit memorandum is issued to a customer who returns goods or receives a price adjustment, reducing their outstanding balance.

• Recording a return requires two separate journal steps under perpetual inventory:

  1. Reverse revenue recognized at selling price.

  2. Restore physical inventory at cost back into asset accounts.

• Transaction Illustration:

  • Sept 1: Whitewater sold $\$500$ of merchandise on account to Rugged (cost $\$400$).

    • Debit: $\text{Accounts Receivable}$ $\$500$

    • Credit: $\text{Sales Revenue}$ $\$500$

    • Debit: $\text{Cost of Goods Sold}$ $\$400$

    • Credit: $\text{Merchandise Inventory}$ $\$400$

  • Sept 5: Rugged returned $\$250$ of merchandise (cost $\$200$). Whitewater issued a credit memo.

    • Debit: $\text{Sales Returns and Allowances}$ $\$250$

    • Credit: $\text{Accounts Receivable}$ $\$250$

    • Debit: $\text{Merchandise Inventory}$ $\$200$

    • Credit: $\text{Cost of Goods Sold}$ $\$200$

Sales Discounts

• Discounts provided to customers for early remittance of credit purchases.

• $\text{Sales Discounts}$ is a contra-revenue account (normal debit balance).

• Transaction Illustration:
  
  

  • JKL Company sold merchandise on account with a list price of $\$5,000$ (cost $\$2,000$) under terms $1/10, n/30$.

    • Initial Sale Entry:
      
      

      • Debit: $\text{Accounts Receivable}$ $\$5,000$

      • Credit: $\text{Sales Revenue}$ $\$5,000$

      • Debit: $\text{Cost of Goods Sold}$ $\$2,000$

      • Credit: $\text{Merchandise Inventory}$ $\$2,000$

    • Collection Scenario A (Within Discount Window):
      
      

      • Discount: \5,000 \times 0.01 = \$50$

      • Cash Collected: $\$4,950$

      • Debit: $\text{Cash}$ $\$4,950$

      • Debit: $\text{Sales Discounts}$ $\$50$

      • Credit: $\text{Accounts Receivable}$ $\$5,000$

    • Collection Scenario B (After Discount Window Expired):
      
      

      • Debit: $\text{Cash}$ $\$5,000$

      • Credit: $\text{Accounts Receivable}$ $\$5,000$

Net Sales Calculation and Financial Reporting

$\text{Net Sales}$ is the key top-line revenue metric reported at the top of the multistep Income Statement.

$\text{Net Sales} = \text{Gross Sales Revenue} - \text{Sales Returns and Allowances} - \text{Sales Discounts}$