Addis Ababa University, College of Business and Economics, Department of Accounting & Finance

FUNDAMENTALS OF ACCOUNTING-I
CHAPTER - 3
Accounting for a Merchandising Enterprise

3.1 Introduction
1. Definition:
Merchandising enterprise: refers to a business organization, which buys finished products and
resells them to its customers for profit.
Assets held for resale in the normal course of business of a merchandising enterprise are called
merchandise inventory.

2. Types of Vendors
o Wholesaler – buys/imports and distributes/sells to retailers
o Retailer – buys from wholesaler and sells directly to consumers.

3. Characteristics – The following points distinguish a merchandising enterprise from other types
of businesses:
 Difference between merchandising and service enterprises
o A merchandising enterprise sells finished products rather than services and revenues
from sells of finished goods are called sales.
o A merchandising business has two types of major expenses - cost of goods sold which
represent expired cost of merchandise sold and operating expenses which represent all
other expenses necessary to run the business.
o In a merchandising business net income is calculated after two steps: first gross profit
is determined to be the difference between sales and cost of goods sold and then net
income is determined by deducting operating expenses from gross profit.
o A merchandising business uses relatively more types of accounts including sales and
purchase related ones (discussed in subsequent sections).
 Difference between merchandising and manufacturing enterprises
o A merchandising enterprise does not manufacture products rather buy them from
manufacturers or other merchandisers.

4. Major activities
o Buying and selling merchandise inventory
5. Accounting
o Though there are some basic differences between merchandising enterprise and the other
types of businesses, accounting cycle is equally applicable to any kind of business. Like
in the other organizations, the following are applied in accounting for financial affairs of
a merchandising business:
 Double entry accounting and the rules of debts and credits
 Use of various types and classes of accounts
 Use of journals and ledgers
 Preparation of financial statements
 And others
o Accounting for a merchandising business is usually divided into two broad categories –
Accounting for Purchases and Accounting for Sales which are covered in the following
sections.

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 Addis Ababa University, College of Business and Economics, Department of Accounting & Finance
3.2 Accounting for Purchases

1. Purchasing Procedures – The purchasing of merchandise inventory in a merchandising

business may involve the following procedures
 Issuance of purchase requisition – a business form usually prepared by the storekeeper
requesting the purchasing department of a business for purchase of certain types and
quantities of inventory items not available in store.
 Issuance of purchase order – a business form issued by the purchase department
requesting vendors to supply the business with certain types and quantities of inventory on
a specified date and at an agreed upon price. This form usually contains information such as
the type and quantity of inventory ordered, price, and terms of payment and transportation.
 Preparation of receiving report – a business form usually prepared by the storekeeper
evidencing the types, amounts and conditions of inventory received from vendors.
 Recording purchase – keeping record of purchases which is done by the accounts
department of a business. Journal entries are prepared after checking the consistency of
information contained in three basic purchase source documents: purchase order, receiving
report and purchase invoice.
 Settlement of invoices – this refers to making cash payments for inventories purchased and
is done after checking the accuracy and validity of the invoice to be settled.

2. Recording Purchases – Purchases of merchandise inventory are recorded and accumulated in a

general ledger account called Purchases. Purchases is an income statement account to be closed
at the end of each accounting period to the Income Summary or to Cost of Goods Sold account.
It has a debit normal balance. The following entries are needed to record purchases of
merchandise inventory:
Purchases xx
Accounts Payable/Cash xx
Example 3-1
On May 2, 2004, DNN Grocery purchased $65,000 of merchandise from EBG Distributors.
20% of the purchases are on cash and the remaining on credit.

Required: Record the above transactions for:

a) DNN b) EBG

3. Deductions from Purchases – refer to reductions in the cost of purchases as a result of such
transactions as early payment of purchase invoices, returns of damaged or defective goods and/or
price reduction received from sellers for minor defects on goods purchased.

i) Purchase Discounts – When goods are sold on credit, sellers usually offer price reduction called
Cash Discounts to encourage buyers to pay invoices early. Such price reductions are identified
by the purchaser as Purchase Discounts and recorded as a credit to Purchase Discounts account,
while the seller identifies them as Sales Discounts and records them as a debit to Sales
Discounts account. Purchase discounts and sales discounts are contra accounts reported as
deductions from purchases and sales, respectively.

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 Addis Ababa University, College of Business and Economics, Department of Accounting & Finance
 Agreements between the buyer and the seller concerning such issues as to when to make
payment for the goods, who will pay for transportation, who owns goods in transit, etc are
collectively called sales/purchase terms. Credit terms, part of the sales terms, refer to
arrangements between the buyer and the seller as to when to pay for purchases on credit. The
credit terms indicate
 Credit period – the time period within which the invoice for credit purchase is due. For
example, net 30 days (usually written as n/30) means that the amount is due 30 days from
the date of invoice. Other terms include n/45 and n/eom (net due by the end of the month
in which the purchase was made).
 Discount rate and period – Discount rate represents cash discount expressed in
percentage of the invoice amount. Discount period is time period, shorter than the credit
period, within which the invoice must be entirely or partly paid to get the stated discount.
For example, 2/10 indicates that the buyer can get 2% discount if it settles the invoice
within 10 days from the date of the invoice. Discounts are applicable to only amount of
invoice paid within the discount period and on invoice amount net of returns and
allowances (discussed below).
The buyer for invoices paid within the discount period makes the following entry:
Accounts Payable xx
Purchase Discount xx
Cash xx
Example 3-2
On May 1, 2004, DNN Grocery purchased $24,000 of merchandise from EBG Distributors,
terms 2/10, n/30. DNN paid the invoice in full on May 11, 2004.
Required: Record the above transactions for
a) DNN b) EBG

ii) Trade Discounts – refer to reduction from list prices of goods. They help sellers to adjust list
prices without changing price catalogs and/or charge different prices to different customers
based on the quantity of goods bought. For example, sellers do not charge the same price for
small and large quantity purchases. In our country, trade discounts are commonly identified
as Big Discounts and are used to reduce selling prices of goods so as to attract buyers
especially during holiday weeks. Trade discounts are used to determine the actual invoice
price of goods and do not appear in the accounting records.

Example 3-3
On May 4, 2004, Merewa Music Shop purchased 100 tape recorders from Sky Electronics, terms
2/10, n/30. The tape recorders are listed at $400 each subject to 30% trade discount. Merewa paid for
60 of the tape recorders on May 15, 2004.
Required: Record the above transactions for
a) Merewa b) Sky

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 Addis Ababa University, College of Business and Economics, Department of Accounting & Finance
iii) Purchase Returns and Allowances – When goods purchased are damaged or found to be
defective or with the wrong color and size, the buyer may take any of the following actions
depending mainly upon the extent of the damage or defect:
 Return the goods and get credit (reduction in amount payable to the seller) or refund for
the value of the returned goods resulting in Purchase Returns to the buyer and Sales
Returns to the seller.
 Keep the goods but ask for price adjustment which when approved by the seller results in
Purchase Allowances for the buyer and Sales Allowances for the seller.

Returns and allowances are recorded by the purchaser as credit to Purchases Returns and
Allowances - a contra purchases account while the seller records them as a debit to contra
sales account called Sales Returns and Allowances. The purchaser issues a document called
debit memo to request credit for returns and allowances and the seller issues a credit memo
to notify its acceptance of the buyer’s request for credit.
The following entry is made by the buyer when it receives credit memo from the seller for
returns and allowances:
Accounts Payable/Cash xx
Purchase Returns and Allowances xx

Gross purchases – (purchase discounts + purchase returns & allowances) = Net purchases

Example 3-4
On May 1, 2004, DNN Grocery purchased $54,000 of merchandise from EBG Distributors,
terms 2/10, n/EOM. On May 5, 2004 DNN discovered and returned $10,000 of defective
goods and on the same date received credit memo from EBG acknowledging the returns.
DNN settled the outstanding balance in full on May 11, 2004.
Required: Record the above transactions for
a) DNN b) EBG

iv) Shipment Terms – are usually parts of credit terms specifying the party responsible for
paying transportation costs and transfer of ownership of goods sold/bought. There are two
common shipment terms:
 FOB (Free On Board) Shipping Point – This means that ownership of the goods passes
from the seller to the buyer at shipping point or right after the goods leave the store of the
seller. Under this term the buyer owns the goods in transit and will cover all freight costs.

 FOB Destination – This means that ownership of the goods will not pass from the seller to
the buyer until the goods reach their destination i.e. the buyer’s location or store. Under this
term the seller owns the goods in transit and covers all freight costs.

Transportation costs are recorded by the buyer as a debit to an account called Freight or
Transportation In as shown below.

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 Addis Ababa University, College of Business and Economics, Department of Accounting & Finance
By the end of an accounting period, the balance of this account is added to the purchases
account to determine total cost of purchases during a given period.
Freight-in xx
Cash xx
The seller, if responsible to cover for transportation costs, records transportation costs paid as
operating expenses by debiting an expense account called Delivery Expense or
Transportation/Freight Out as follows.

Freight-Out/Delivery Expense xx
Cash xx

Example 3-5
On May 1, 2004, DNN Grocery purchased $60,000 of merchandise from EBG Distributors,
terms 2/10, n/eom, FOB Shipping point and paid $2,000 for transportation. DNN settled the
invoice in full on May 11, 2004.
Required: Record the above transactions for
a) DNN b) EBG

In some cases, the seller may pay for transportation costs on behalf of the buyer under FOB
Shipping point terms. In such cases, the seller will add the mount paid to the invoice price
and record it as a debit to Accounts Receivable increasing the mount due from the buyer. The
buyer, in its part will record the amount as a credit to the Accounts Payable account
increasing the amount payable to the seller and as a debit to freight-in account. Prepaid
transportation costs are not subject to discount.

Example 3-6
On June 1, 2004, DNN Grocery purchased $32,000 of merchandise from EBG Distributors,
terms 2/10, n/45, and FOB shipping point. EBG paid $500 cash for transportation and added
it to the invoice. DNN settled the invoice in full on June 11, 2004.
Required: Record the above transactions for
a) DNN b) EBG

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 Addis Ababa University, College of Business and Economics, Department of Accounting & Finance
3.3 Accounting for Sales
1. Selling Procedures – The selling process may involve the following procedures
 Approving purchase orders – usually done by the credit department of a business, this
step involves making sure that incoming purchase orders are valid and the information
related to price and product type match with the currently available price policy and types
of product. Besides, if the buyer is requesting for credit, this procedure aims at making sure
that such buyer worth giving credit. When a purchase order is approved it will be converted
into a sales order.
 Inventory dispatch order – a form prepared by the sales department ordering the store to
ship certain inventory items to a buyer whose purchase order is approved.
 Issuance of sales invoice – done by the accounts section in consultation with the sales
department and the store, contains the terms related to payment, transportation and related
issues. Is prepared based on information contained on customer purchase order, inventory
dispatch order and sales order.
 Recording sales – keeping record of sales which is done by the accounts department of a
business. Journal entries are prepared after checking the consistency of information
contained in three basic sales source documents: sales order, inventory dispatch order and
sales invoice.
 Collection of invoices – this refers to collection of cash from customers for inventories sold
to them.
2. Recording Sales – Sales of merchandise inventory are recorded and accumulated in a general
ledger account called Sales. This is an income statement account to be closed at the end of each
accounting period to Income Summary. As a revenue account, it has a credit normal balance. The
following entries are needed to record sales of merchandise inventory:
Accounts Receivable/Cash xx
Sales xx
Example 3-7
On June 1, 2004, DNN Grocery sold $32,000 of merchandise to Nanu Snack. 30% of the
sales are on cash and the remaining on credit, terms 2/10, n/30. The credit is settled on June
11,2004 in full.
Required: Record the above transactions for:
a) DNN b) Nanu

3. Deductions from Sales – refer to reductions from the total sales arising from such transactions
as early settlement of invoice by customers, returns of damaged or defective goods and/or price
reduction offered for minor defects of goods sold to customers.

i) Sales Discounts – Refer to discounts taken by customers who settle their accounts within the
discount period. Sales discounts are recorded as a debit to the Sales Discounts, contra sales
account whose balance is reported on the income statement as a deduction from the related
sales.
The following entry is made by the seller to record invoices settled within the discount period:
Cash xx
Sales Discount xx
Accounts Receivable xx
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 Addis Ababa University, College of Business and Economics, Department of Accounting & Finance
Example 3-8
On June 11, 2004, DNN Grocery received cash from Nanu Snack in full settlement for the
credit sales made on June 1, 2004 in example 3-7 above.
Required: Record the above transactions for
a) DNN b) Nanu

ii) Trade Discounts – refer to reduction from list prices of goods which are used to adjust list
prices without changing price catalogs and/or charge different prices to different customers
based on the quantity of goods bought. Trade discounts are used to determine the actual
invoice price of goods and do not appear in the accounting records.

Example 3-9
On March 5, 2004, DNN Grocery sold $40,000 of merchandise subject to 20% trade discount to AAT
Room, terms 2/10, n/30. AAT Room settled the invoice in full on March 15, 2004.
Required: Record the above transactions for
a) DNN b) AAT

iii) Sales Returns and Allowances - arise when credit is given to customers returning unsatisfactory
goods and/or requesting for price adjustment for such goods.
Returns and allowances are recorded as a debit to the Sales Returns and Allowances, a contra sales
account whose balance will be reported on the income statement as a deduction from the related sales.
The ff entry is made to record issuance of credit memo to customers for returns and allowances:

Sales Returns and Allowance xx

Accounts Receivable/Cash xx

Gross sales – (sales discounts + sales returns and allowances) = Net sales
Example 3-10
On March 15, 2004, DNN Grocery sold $40,000 of merchandise to AAT Room, terms 2/15, n/30. On
March 17, 2004, AAT returned $5,000 of defective goods and DNN issued credit memo for the
returned goods. AAT settled the invoice in full on March 30, 2004.
Required: Record the above transactions for
a) DNN b) AAT

iv) Shipment Terms – determine ownership of goods in transit and the party responsible for
payment of transportation costs. Two shipment terms:
 FOB Shipping Point – buyer owns goods in transit and pays for transportation costs.
 FOB Destination – seller owns goods in transit and pays for transportation costs, and
records them as follows.

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 Addis Ababa University, College of Business and Economics, Department of Accounting & Finance
Freight-Out/Delivery Expenses xx
Cash xx
Example 3-11
On May 1, 2004, DNN Grocery sold $30,000 of merchandise to AX Hotels, terms 2/10, n/30,
FOB Destination and paid $2,000 cash for transportation. On May 11, 2004, AX settled its
invoice in full.
Required: Record the above transactions for
a) DNN b) AX

V) Sales Tax (Value Added Tax) – refers to a tax levied on buyers of certain goods and
services. The seller is responsible by law to collect sales tax from its customers and regularly
submit them to the tax authority. Until remitted, sales taxes are recorded by the seller as liability
as follows:
Accounts Receivable/Cash xx
Sales Tax Payable xx
Sales xx
 Sales taxes are calculated on invoice prices less returns and allowances. However, sales
discounts are not exempted from sales taxes. The transportation company has to collect
taxes on transportation services it sell to its customers.

Example 3-12
On June 21, 2004, DNN Grocery sold $80,000 of merchandise subject to a 2% sales tax and
10% trade discount to AX Hotels, terms 2/10, n/30, FOB Shipping Point. DNN paid $2,000
cash for transportation and added it to the invoice. On Jan. 23, 2004, AX returned defective
goods with an invoice price of $10,000, excluding sales tax. On Jan. 31, 2004 AX settled its
invoice in full.

Required: Record the above transactions for

a. DNN b. AX

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 Addis Ababa University, College of Business and Economics, Department of Accounting & Finance

3.4 Financial Reporting for Merchandising Firms

I) Financial Statements
A. Income Statement -Two forms:
i) Single-step
o Has two sections only: total revenues and total expenses
o No details of net sales, cost of goods sold, operating expenses, etc
o Net income is computed in a single step by deducting total expenses from total revenues
o Revenues
 Net sales  Other income
 Rent income
o Expenses
 Cost of goods sold  Selling expenses
 Administrative expenses  Other expense
o Net income = total revenues – total expenses

ii) Multiple-step
o Shows in detail net sales, cost of goods sold, operating expenses and other items
o You have to go several steps to compute net income
o Has several sections, subsections, totals and intermediate balances, including the following
o Gross profit section
Gross sales xx
Less: Sales discounts xx
Sales returns and allowances xx (xx)
Net sales xx
Cost of goods sold:
Beginning Merchandise Inventory xx
Add: Net Purchases
Gross Purchases xx
Less: Purchase Discounts xx
Returns and Allowances xx (xx) xx
Merchandise Available for Sale xx
Less: Ending Merchandise Inventory (xx)
Cost of Goods Sold (xx)
Gross profit xx

o Operating expenses section

 Selling expenses which comprise all expenses incurred in connection with
selling activities including sales salary expenses, delivery expenses,
advertising expenses, store supplies expenses, depreciation on store
equipment, etc.
 Administrative expenses, which comprise all expenses incurred in
connection with administration or general operations including office salary
expenses, utility expenses, office supplies expenses, depreciation on office
equipment, etc.

o Other income and expenses section

 Rent income, interest income, gain from disposal of plant assets, etc
 Interest expenses, loss from disposal of plant assets, etc

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 Addis Ababa University, College of Business and Economics, Department of Accounting & Finance
B. Capital Statement (Statement of Owners Equity)
C. Balance Sheet ( Report and Account Forms), and
D. Statement of Cash Flows (Cash Inflows and Outflows)

II) Adjusting Entries

 Make adjustment for all accrued and deferred items
 Adjustment of merchandise inventory
o to remove beginning inventory (which is assumed to be sold)
Income summary xx
Merchandise inventory xx
o To record ending inventory (known by physical count)
Merchandise inventory xx
Income summary xx

III) Closing Entries

 Close all revenue and contra purchase accounts to Income Summary account
Sales xx
Rent Income xx
Purchases Discount xx
Purchases Returns and Allowances xx
Income Summary xx
 Close all purchases, expenses and contra sales accounts to Income Summary account
Income Summary xx
Purchases xx
Freight-in xx
Sales Discounts xx
Sales Returns and Allowances xx
Salary Expense xx
Rent Expense xx
Miscellaneous Expenses xx
 Close debit or credit balance of Income Summary to capital account
Income Summary (credit balance) xx
AA, Capital xx
 Close drawing account to capital account
AA, Capital xx
AA, Drawing xx

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 Addis Ababa University, College of Business and Economics, Department of Accounting & Finance
Example 3-13
The unadjusted trial balance for XYZ Grocery on December 31, 2003 is presented below:

XYZ Grocery
Trial Balance
As of December 31, 2003
Account Title Debit Credit
Cash........................................................…………………. 87,400
Notes Receivable.......................................……………….. 30,200
Accounts Receivable..................................………………. 74,150
Merchandise Inventory....................................................... 60,000
Office Supplies.................................................................... 2,200
Prepaid Insurance………………………………………… 4,400
Store Equipment.................................................................. 38,100
Accumulated Depreciation-Store Equipment...................... 2,600
Office Equipment.......................................... ……………. 26,400
Accumulated Depreciation-Office Equipment.................... 2,400
Accounts Payable................................................................ 12,000
Sales Tax Payable………………………………………… 2,700
Unearned Rent..................................................................... 24,000
Long-term Notes Payable.................................................... 25,000
Kebede, Capital................................................................... 125,000
Kebede, Drawing................................................................. 14,700
Sales..................................................................................... 700,000
Sales Returns & Allowances............................................... 8,000
Sales Discounts…………………………………………… 7,000
Purchases……..…………………………………………... 420,000
Purchase Returns & Allowances…………………………. 9,100
Purchase Discounts………………………………………. 4,900
Transportation-In…………………………………………. 15,000
Sales Salaries Expense…………………………………… 25,400
Advertising Expense……………………………………… 14,300
Miscellaneous Selling Expense…………………………... 8,200
Office Salaries Expense………………………………….. 44,000
Rent Expense…………………………………………….. 18,000
Miscellaneous Administrative……………………………. 7,700
Interest Expense………………………………………….. 2,550 .
907,700 907,700

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 Addis Ababa University, College of Business and Economics, Department of Accounting & Finance
 Additional Information:
a) Merchandise Inventory as of December 31, 2003................................ $70,000
b) Interest accrued on long-term notes payable on December 31, 2003... 320
c) Office Supplies as of December 31, 2003............................................ 1,300
d) Insurance expired during 2003.............................................................. 1,200
e) Depreciation during 2003 on:-
Store equipment............................................................................. 3,200
Office equipment………………………………………………... 2,580
f) Salaries accrued on December 31, 2003
Sales Salaries……………………………………………………. 900
Office Salaries…………………………………………………… 1,400

g) Rent Income Earned during 2003…………………………………….. 3,000

Required:
i) Prepare worksheet for XYZ Grocery for the year ended December 31, 2003. Key each
adjusting entry by the letter corresponding to the data given.
ii) Prepare the following financial statement
a) The multiple-step income statement
b) The single-step income statement
c) The report form balance sheet
iii) Journalize the necessary adjusting entries
iv) Journalize closing entries
v) Prepare post-closing trial balance

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