Lesson 5: Accounting for Merchandising Operations

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. An example of a merchandising Income Statement appears in Illustration 5-11 on page 198. You’ll note that in addition to the operating expenses, there is something called Cost of Goods Sold. Cost of Goods Sold is the cost of the inventory that was sold, and is often the major cost of a merchandising company. The cost of inventory that was not sold would appear as the balance of the inventory account on the Balance Sheet.

Learning Objectives

A productive approach to Chapter 5 is as follows:

  1. Learn the account names, locations, and how the journal entries work;

  2. Get a fundamental understanding of the Income Statement;

  3. Study the closing entries for a merchandising company;

  4. Consider how the Accounting system measures both costs and revenues in support of the Income Statement, and the Inventory balance on the Balance Sheet.

Merchandising Accounts and Journal Entries

There are two general methodologies for merchandising accounting:

  1. The periodic inventory system;
  2. The perpetual inventory system.

Chapter 5 concentrates on the perpetual system. The "perpetual" refers to the fact that every purchase of inventory is debited to the Inventory account; likewise, every sale of inventory 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 cost of inventory on hand.

Accounts Used in the Perpetual Inventory Method

In the perpetual inventory system, you'll find a new account in the assets section (Merchandise Inventory) and several new accounts in owner's equity that are used for recording sales, subtractions from sales, and cost of goods sold.

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Journal Entries for the Perpetual Inventory Method

As suggested above, the Perpetual method makes use of the Inventory account when Inventory is purchased sold. Here is a summary of the typical journal entries:

  1. When inventory is purchased, a debit is made to the Inventory account and a credit made to Cash or Accounts Payable. Inventory is a current asset.

    Example: Jones purchases $5,000 of Inventory on account, with terms of 2/10, n/30. The journal entry would be:

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  2. 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. The entry is:

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  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 considered a type of expense account, and 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:

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  4. Depending upon prevailing interest rates, merchandisers may offer a discount if their customer pays early. Such discounts are expressed something like this: "2/10, n/30", which means that if the customer pays within 10 days, the customer can deduct 2% of the amount of their invoice. Suppose Jones pays off the supplier for the inventory purchased in transaction 1 above. Keep in mind that he originally purchased $5,000 of inventory, but that he immediately returned $500 to the supplier. He currently owes $4500. If he pays within 10 days, he can deduct 2% of the invoice amount. Two percent of $4500 is $90, and he can satisfy the invoice by paying $4410. Here is the journal entry:

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    Notice that, by paying early, we can reduce the cost of inventory by $90.
  5. Similarly, we can offer terms to our customers. Looking back at transaction 3, if Jones offers terms of 2/10, n/30 on a sale of $1300, the customer can deduct $26, and Jones will receive a check for $1274 to satisfy the bill:

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  6. If freight charges are paid on incoming merchandise, such charges are just added to the inventory cost.  For example, if freight of $80 is paid for delivery of inventory to us, the entry is:

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    Freight charges are considered an additional cost of inventory from the buyer's point of view. Note that from the seller's point of view, freight charges are considered a selling expense (Freight Out).
  7. If a customer returns goods to us, such goods are considered a Sales Return. For example, if a customer returns goods for which $100 was paid, the following entry would be made:

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    Note: if the goods that are returned to us are unsaleable due to damage or malfunction, no further entry is necessary. However, if the returned items can be resold, they must be put back in the Inventory account (at our cost), as follows:

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    You might think of this situation as an "unsale" of the goods; both the Sale is reversed (by the debit to Sales Returns and Allowances) and the cost of the sold inventory is moved from Cost of Goods Sold back into the Inventory account. A convenient summary of these merchandising transactions appears on page 194 in Illustration 5-5.

The Merchandising Income Statement

As mentioned earlier, the Merchandising Income Statement is illustrated on page 198 in Illustration 5-11. The general format of this statement is as follows:

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This is the format for a multiple step income statement. There are two main calculations (the steps), as follows:

  1. Net Sales - Cost of Goods Sold = Gross Profit

  2. Gross Profit - Expenses = Net Income

For simplicity, I've omitted the Other Revenues and Gains, and the Other Expenses and Losses.

Your text also illustrates a single step income statement, in which Cost of Goods Sold is simply presented as an ordinary expense. This form of statement appears on page 199 in Illustration 5-12.

Closing Entries for Merchandising

Going back to the T-accounts for the Perpetual Inventory method, the closing entries would be journalized as follows:

Sales   XXX  
  Income Summary   XXX


Income Summary   XXX  
  Sales Discounts   XXX
  Sales Ret. & All.   XXX
  Cost of Goods Sold   XXX
  All Expenses...   XXX


Income Summary   XXX  
  Capital   XXX


Capital   XXX  
  Drawing   XXX

An example of the closing entries appears on pages 193-194.

Assignment, Lesson 5

Write out the answers to the following Questions, Exercises, and Problems on pages 210-226.

Q 1,2,4,6,7,8,9
Q 11,12,13,15
BE 5-1, BE 5-3, BE 5-4
E5-1, 5-2, 5-6, 5-7
P5-2A...see solution

Hints and Check Figures for Chapter 5

Q5 Cost of Goods Sold is determined at the moment of sale.
Q15 Tricky question:  Gross Profit is $39,000
Q16 Operating Expenses = $330,000
BE5-3a.  Seller's viewpoint. Debit Accounts Receivable $800,000, credit Sales $800,000; then debit COGS $620,000 and credit Merchandise Inventory $620,000.
BE5-4a..  Buyer's viewpoint. Deebit Merchandise Inventory for $800,000 and credit Accounts Payable for $800,000.
P5-2A c. Net Sales = $12,650; Cost of Goods Sold = $8,800; Gross Profit = $3,850.   Check your journal entries here.

Web Assignment

Consider the situation in which a person invests money for retirement.  How much would you hope to earn in a bank account, mutual fund, or in the stock market?  Would 6% be satisfactory to you?  Turning to the nature of merchandising businesses, what sort of return do you think they make?  There are a couple of interesting measures that you might consider:

1.  Gross Profit Percentage = Gross Profit divided by Net Sales
2.  Net Income as a Percent of Net Sales = Net Income divided by Net Sales

Choose two merchandising companies and then go to their web sites or home pages, and see if you can locate the income statement.  Calculate the Gross Profit Percentage and the Net Income as a Percent of Net Sales.  On the home page, look for something like "About Us", "Investor Relations" or "Annual Reports."    You might even be able to find enough detail in the "Financial Highlights" section.

Two other items:  unlike your textbook, most companies do not calculate the gross profit in the income statement, so grab your calculator before logging in.  Also, you may find that Cost of Goods Sold is called "Cost of Sales" and may be combined with other costs.  This is ok; just make an approximate calculation.  Here are some possibilities for your search:


Self Quiz

Chapter 5 Quiz

If you have questions regarding this lesson, please email me at the following address:

Revised: December 2004