CHAPTER THREE

ACCOUNTING FOR A MERCHANDISING ENTERPRISE

Merchandising Operations
Merchandise enterprise acquires merchandise for resale to customers. It is the selling of
merchandise, instead of a service, that makes the activities of merchandising enterprises differs
from the activities of service enterprise. Merchandising companies that purchase and sell directly
to consumers are called retailers. Merchandising companies that sell to retailers are known as
wholesalers. The primary source of revenues for merchandising companies is referred to as
sales revenue or sales. When the merchandise is sold the revenue is reported as sales (sales
revenue) and its cost which is recognized as expense is divided into two categories 1) cost of
merchandise sold (cost of goods sold), which is subtracted from sales to arrive at gross profit. 2)
Operating expenses- are expenses incurred in the process of earning

Operating Cycles

The operating cycle of a merchandising company ordinarily is longer than that of a service
company. The purchase of merchandise inventory and its eventual sale lengthen the cycle. The
operations of a merchandising business involve the purchase of merchandise for sale (purchasing
activity), the sale and distribution of the products to customers (sales activity), and the receipt of
cash from customers (collection activity).Note that the added asset account for a merchandising
company is the Inventory account. Companies report inventory as a current asset on the balance
sheet.

Flow of Costs

The flow of costs for a merchandising company is as follows: Beginning inventory plus the cost
of goods purchased is the cost of goods available for sale. As goods are sold, they are assigned to
cost of goods sold. Those goods that are not sold by the end of the accounting period represent
ending inventory. Companies use one of two systems to account for inventory: a perpetual
inventory system or a periodic inventory system.

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Merchandise Inventory Systems
There are two main systems for accounting merchandise held for sale.
1. Perpetual Inventory System: is a system in which each purchase and sales of merchandise
is recorded in an inventory account. Under a perpetual inventory system, inventory
shrinkage, lost or stolen goods are more readily determined because the total record for a
period should be compared to the physical count at the end of the period.
In a perpetual inventory system, companies keep detailed records of the cost of each inventory
purchase and sale. These records continuously—perpetually—show the inventory that should be
on hand for every item. For example, a Ford dealership has separate inventory records for each
automobile, truck, and van on its lot and showroom floor. Similarly, a Kroger grocery store uses
bar codes and optical scanners to keep a daily running record of every box of cereal and every jar
of jelly that it buys and sells. Under a perpetual inventory system, a company determines the cost
of goods sold each time a sale occurs. A perpetual inventory system provides better control over
inventories than a periodic system. Since the inventory records show the quantities that should be
on hand, the company can count the goods at any time to see whether the amount of goods
actually on hand agrees with the inventory records. If shortages are uncovered, the company can
investigate immediately.

E.g. if the inventory records for computer King co. indicates Br 63,950 as ending
inventory(unsold) at the end of the period and the actual physical count indicate Br 62,150, the
inventory shrinkage is Br 1,800(63,950-62,150). Since no system of procedures and safeguards
can totally eliminate it, it is often considered a normal cost of operations.
Dec. 31, Cost of merchandise sold -------------------- 1,800
Merchandise inventory -------------------------------- 1,800
If the amount of the shrinkage is abnormally large it may be disclosed separately on the income
statement by debiting “loss from merchandise inventory shrinkage.” In the case of perpetual
inventory system reorder decision are more accurately made because exact inventory levels are
known constantly.
2. Periodic Inventory System: Is a system in which at the end of the accounting period the
inventory balance determined through physical count. The physical inventory is used to
determine the cost of merchandise on hand at the end of the period and the cost of
merchandise sold during the period.

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In a periodic inventory system, companies do not keep detailed inventory records of the goods on
hand throughout the period. Instead, they determine the cost of goods sold only at the end of the
accounting period—that is, periodically.

To determine the cost of goods sold under a periodic inventory system, the following steps are
necessary:

1. Determine the cost of goods on hand at the beginning of the accounting period.

2. Add to it the cost of goods purchased.

3. Subtract the cost of goods on hand at the end of the accounting period.

Accounting for Purchase

Companies purchase inventory using cash or credit (on account). They normally record
purchases when they receive the goods from the seller. Business documents provide written
evidence of the transaction. A canceled check or a cash register receipt, for example, indicates
the items purchased and amounts paid for each cash purchase. Companies record cash purchases
by an increase in Inventory and a decrease in Cash. A purchase invoice should support each
credit purchase. This invoice indicates the total purchase price and other relevant information.
Thus a merchandising enterprise can accumulate in the purchase account the cost of all
merchandise purchased for resale during the accounting period.
For example Ato Tona (the buyer) uses as a purchase invoice the sales invoice prepared by
Shashe Audio Supply, Inc. (the seller) to purchase supplies on account for Br 3,800. Ato Tona
makes the following journal entry to record its purchase from Shashe Audio Supply. The entry
increases (debits) Inventory and increases (credits)
Accounts Payable.
E.g. Jan 3 inventory----------------------- 3,800
Account payable --------------------------3,800
Not all purchases are debited to Inventory, however. Companies record purchases of assets
acquired for use and not for resale, such as supplies, equipment, and similar items, as increases to
specific asset accounts rather than to Inventory. For example, to record the purchase of materials
used to make shelf signs or for cash register receipt paper, merchandising enterprise would
increase Supplies.

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Freight Costs
The sales agreement should indicate who—the seller or the buyer—is to pay for transporting the
goods to the buyer’s place of business. When a common carrier such as a railroad, trucking
company, or airline transports the goods, the carrier prepares a freight bill in accord with the
sales agreement.
Freight terms are expressed as either FOB shipping point or FOB destination. The letters FOB
mean free on board. Thus, FOB shipping point means that the seller places the goods free on
board the carrier, and the buyer pays the freight costs. Conversely, FOB destination means that
the seller places the goods free on board to the buyer’s place of business, and the seller pays the
freight.
Freight costs incurred by the buyer
When the buyer incurs the transportation costs, these costs are considered part of the cost of
purchasing inventory. Therefore, the buyer debits (increases) the account Inventory. For
example, if upon delivery of the goods on May 6, Ato Tona (the buyer) pays XYZ Freight
Company Br 150 for freight charges, the entry on At Tona is:
May 6 Inventory …………………..150
Cash…………………… 150
(To record payment of freight on goods purchased)
Thus, any freight costs incurred by the buyer are part of the cost of merchandise purchased. The
reason: Inventory cost should include any freight charges necessary to deliver the goods to the
buyer.
Freight costs incurred by the seller
In contrast, freight costs incurred by the seller on outgoing merchandise are an operating expense
to the seller. These costs increase an expense account titled Freight-out or Delivery Expense. If
the freight terms on the invoice had required Shashe Audio Supply (the seller) to pay the freight
charges, the entry by Shashe Audio Supply would be:
May 4 Freight-out (or Delivery Expense) ……………..150
Cash .....................................................…...150
(To record payment of freight on goods sold)
When the seller pays the freight charges, it will usually establish a higher invoice price for the
goods to cover the shipping expense.

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Purchase Returns and Allowances
A purchaser may be dissatisfied with the merchandise received because the goods are damaged
or defective, of inferior quality, or do not meet the purchaser’s specifications. In such cases, the
purchaser may return the goods to the seller for credit if the sale was made on credit or for a cash
refund if the purchase was for cash. This transaction is known as a purchase return.
Alternatively, the purchaser may choose to keep the merchandise if the seller is willing to grant
an allowance (deduction) from the purchase price. This transaction is known as a purchase
allowance. When merchandise is returned (purchase return) or a price adjustment is required
(purchase allowance), the buyer usually sends the seller a debit memorandum i.e. a document
issued by purchaser to inform a supplier (seller) that a debit has been made to the suppliers
account on the purchaser’s books. The buyer may use a copy of the debit memorandum as the
basis for recording and the original send to the seller. When a buyer returns merchandise or has
been granted an allowance prior to paying the invoice, the amount of the debit-memo is deducted
before discount is computed.
Assume that on May 8 Ato Tona returned goods costing Br300 to Shashe Audio Supply. The
following entry by Ato Tona for the returned merchandise decreases (debits) Accounts Payable
and decreases (credits) Inventory.
May 8 Accounts Payable …………………..300
Inventory …………………………..300
(To record return of goods purchased from Shashe Audio Supply)
N.B. purchase discount and purchase return and allowance are contra (offsetting) accounts to
purchase account b/c it is subtracted from purchase on the income statement.
Purchase Discounts
The credit terms of a purchase on account may permit the buyer to claim a cash discount for
prompt payment. The buyer calls this cash discount a purchase discount.
This incentive offers advantages to both parties: The purchaser saves money, and the seller
shortens the operating cycle by more quickly converting the accounts receivable into cash.
Credit terms specify the amount of the cash discount and time period in which it is offered. They
also indicate the time period in which the purchaser is expected to pay the full invoice price. For
instance some of credit term written in the following form
2/10, n/30, which is read “two-ten, net thirty- This means that the buyer may take a 2% cash
discount on the invoice price less (“net of”) any returns or allowances, if payment is made

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 within 10 days of the invoice date (the discount period). Otherwise, the invoice price, less
any returns or allowances, is due 30 days from the invoice date.
1/10 EOM (end of month) means that a 1% discount is available if the invoice is paid within
the first 10 days of the next month.
When the seller elects not to offer a cash discount for prompt payment, credit terms will
specify only the maximum time period for paying the balance due. For example, the invoice
may state the time period as n/30, n/60, or n/10 EOM. This means, respectively, that the
buyer must pay the net amount in 30 days, 60 days, or within the first 10 days of the next
month.
When the buyer pays an invoice within the discount period, the amount of the discount decreases
Inventory. Why? Because companies record inventory at cost and, by paying within the discount
period, the merchandiser has reduced that cost.

To illustrate assume Ato Tona pays the balance due of Br3, 500 (gross invoice price of $3,800
less purchase returns and allowances of $300) on May 14, the last May 4 day of the discount
period. The cash discount is Br70 (Br3, 500 *2%), and Ato Tona pays Br3, 430 (Br3, 500
*2=Br70). The entry Ato Tona makes to record its May 14 payment decreases (debits) Accounts
Payable by the amount of the gross invoice price, reduces (credits) Inventory by the Br70
discount, and reduces (credits) Cash by the net amount owed.
May 14 Accounts Payable ………………………..3,500
Cash ………………………………………..3,430
Inventory ……………………………………...70
(To record payment within discount period)
If Ato Tona failed to take the discount, and instead made full payment of Br3, 500 on June 3, it
would debit Accounts Payable and credit Cash for Br3, 500 each.
June 3 Accounts Payable ………………….3, 500
Cash ……………………………..3,500
(To record payment with no discount taken)
N.B. Most businesses design their accounting systems so that all available discounts are taken.
Even if the buyer has to borrow to make the payment within a discount period, it is normally to
the buyers’ advantage to do so.

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Accounting for Sales
Companies record sales revenues, like service revenues, when earned, in compliance with the
revenue recognition principle. Typically, companies earn sales revenues when the goods transfer
from the seller to the buyer. At this point, the sales transaction is complete and the sales price
established.
Sales may be made on credit or for cash. A business document should support every sales
transaction, to provide written evidence of the sale. Cash register tapes provide evidence of cash
sales. A sales invoice, provides support for a credit sale. The original copy of the invoice goes to
the customer, and the seller keeps a copy for use in recording the sale. The invoice shows the
date of sale, customer name, total sales price, and other relevant information.
The seller makes two entries for each sale. The first entry records the sale: The seller increases
(debits) Cash (or Accounts Receivable, if a credit sale), and also increases (credits) Sales
Revenue. The second entry records the cost of the merchandise sold: The seller increases (debits)
Cost of Goods Sold, and also decreases (credits) Inventory for the cost of those goods. As a
result, the Inventory account will show at all times the amount of inventory that should be on
hand.
To illustrate a credit sales transaction, Shashe Audio Supply records its May 4 sale of Br 3,800 to
Ato Tona as follows (assume the merchandise cost Shashe Audio Supply Br 2,400).
May 4 Accounts Receivable …………………..3,800
Sales Revenue ………………………..3,800
(To record credit sale to Ato Tona per invoice)
4 Cost of Goods Sold …………………………2,400
Inventory ……………………………………2,400
(To record cost of merchandise sold on invoice to Ato Tona)

Sales Discount
Like a purchase discount, a sales discount is based on the invoice price less returns and
allowances, if any. The seller increases (debits) the Sales Discounts account for discounts that
are taken. They are recorded by debiting the sales discounts account and are considered to be a
reduction in the amount initially recorded in sales.
For example, Shashe Audio Supply makes the following entry to record the cash receipt on May
14 from Ato Tona within the discount period.

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May 14 cash--------------------------------3,430
Sales discount --------------------- 70
A/R ------------------------------------------3,500
(To record collection within 2/10, n/30 discount period from Ato Tona)
Like Sales Returns and Allowances, Sales Discounts is a contra-revenue account to Sales
Revenue. Its normal balance is a debit.

Sales Return and Allowance

We now look at the “reverse” of purchase returns and allowances, which the seller records as
sales returns and allowances. These are transactions where the seller either accepts goods back
from the buyer (a return) or grants a reduction in the purchase price (an allowance) so the buyer
will keep the goods. If the return or allowance is for sale on account, the seller usually gives the
buyer a credit memorandum. This memo shows the amount for which the buyer is to be
credited and the reason therefore.
For instance Shashe Audio Supply’s entries to record credit for returned goods involve (1) an
increase (debit) in Sales Returns and Allowances (a contra account to Sales Revenue) and a
decrease (credit) in Accounts Receivable at the Br 300 selling price, and (2) an increase (debit)
in Inventory (assume a Br 140 cost) and a decrease (credit) in Cost of Goods Sold, as shown
below (assuming that the goods were not defective).
May 8 Sales Returns and Allowances ……………………….300
Accounts Receivable ……………………………300
(To record credit granted to Sauk Stereo for returned goods)
8 Inventory ……………………………………140
Cost of Goods Sold ………………………………………..140

Sales Taxes
Sales tax is a tax levied to customer. The liability for sales tax is ordinarily incurred at the time
the sale is made regardless of the terms of the sale. At the time of a cash sale, the seller collects
the sales tax. When a sale is made on account, the buyer is charged for the tax. The seller credits
the sales account for only the amount of the sale, and credits the tax to sales tax payable. E.g.
sales of Br 100 on account, subjects to a tax of 4% could be recorded

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Aug. 12 Account Receivable ----------------------------- 104
Sales ------------------------------------------------------------ 100
Sales tax payable ---------------------------------------------- 4
N.B. periodically, the appropriate amount of sales tax is paid to the taxing unit, and sales tax
payable is debited.

Trade Discounts
Wholesalers are businesses that sell merchandise to other businesses rather than to the general
public. Many wholesalers publish catalogs. Rather than updating their catalogs frequently,
wholesalers often publish price updates, which may involve large discounts from the list prices
in their catalogs. In addition, wholesalers may offer special discounts to certain classes of buyers,
such as government agencies or businesses that order large quantities. Such discounts are called
trade discounts.
Sellers and buyers do not normally record the list prices of merchandise and the related trade
discounts in their accounts. For example, assume that J Company purchased 600 units of
merchandises from B Company terms 3/10, n/30. The merchandise has a list price of Br 50 per
unit with the trade discount of 10%. Assuming the buyer has paid within the discount period, the
purchase and the sale transaction in both the buyer’s and the seller’s books would be recorded as
follows.
List price (600 units *Br 50)……………….Br 30,000
Trade discount (10%* Br 30,000)…………… (6,000)
Balance after the 10% trade discount…………24,000
The buyer’s book
At the time of purchases:
Merchandise inventory………24,000
Account payable……..24, 000
At the time of payment:
Account payable………..24,000
Cash………………..23,280
Purchase discount……..720

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The seller’s book
At the time of sale:
Account receivable………..24,000
Sales………………..24,000
At the time of receipts:
Cash………………23,280
Sales discount………..720
Account receivables…..24,000

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 Recording merchandise transactions under the perpetual inventory system
Each merchandising transaction affects a buyer and a seller. The following illustration for S
company (Seller) and B Company (Buyer) show how the same transactions would be recorded
by both the seller and the buyer.
July 1. S Company sold merchandise on account to B Co. Br 7,500, terms FOB shipping point,
n/45. The cost of the merchandise sold was Br 4,500
July 2. B Co. paid transportation charges of Br 150 on July 1 purchase from S Company.
July 5. S Company sold merchandise on account to B Co., Br 5,000, terms FOB destination,
n/30. The cost of the merchandise sold was Br 3,500.
July 7. S Company paid transportation costs of Br 250 for delivery of merchandise sold to
B Co. on July 5.
July 13. S Company issued B Co. a credit memorandum for merchandise returned Br 1,000. The
merchandise had been purchased by B Co. on account on July 5. The cost of the
merchandise returned was Br 700.
July 15. S Company received payment from B Co. for purchase of July 5.
July 18. S Company sold merchandise on account to B Co., Br 12,000, terms FOB shipping
point, 2/10, n/eom. Scully Company prepaid transportation costs of Br 500, which were
added to the invoice. The cost of the merchandise sold was Br 7,200.
July 28. S Company received payment from B Co. for purchase of July 18, less discount (2%
*Br 12,000).
S Company B Company
Accounts Receivable—B Co. ………7,500 Merchandise Inventory 7,500
Sales…………………………………7,500 Ac. Payable……………….7,500
Cost of Merchandise Sold ………4,500
Merchandise Inventory …………4,500
2 Merchandise Inventory …..150
No entry Cash …………………….150
5 Accounts Receivable…………….. 5,000 Merchandise Inventory ……5,000
Sales ……………………………….5,000 Accounts Payable……………. 5,000
Cost of Merchandise Sold ………….3,500
Merchandise Inventory ……………..3,500
7 Delivery Expense ……………………250 No entry

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 Cash ……………………………….250
13 Sales Returns and Allowances ……..1,000 Accounts Payable…………... 1,000
Accounts Receivable……………….. 1,000 Merchandise Inventory ……..1,000
Merchandise Inventory ………………700
Cost of Merchandise Sold …………..700
15 Cash …………………………………4,000 Accounts Payable………. 4,000
Accounts Receivable.……………….4,000 Cash ………………………4,000
18 Accounts Receivable………………. 12,000 Merchandise Inventory …….12,500
Sales …………………………….12,000 Accounts Payable………… 12,500
Accounts Receivable…………………. 500
Cash ……………………………….500
Cost of Merchandise Sold ……………..7,200
Merchandise Inventory …………..,7,200
28 Cash …………………………………..12,260 Accounts Payable………... 12,500
Sales Discounts …………………………..240 Merchandise Inventory ……...240
Accounts Receivable………………… 12,500 Cash ………………………12,260

Financial Statements for Merchandising Enterprise

The basic financial statements for a merchandise enterprise, including the income statement,
statement of owner’s equity (retained earnings for corp.) and balance sheet, are similar to those
of a service enterprise. The basic difference between the financial statements of a merchandise
enterprise and a service enterprise include the cost of merchandise sold section of the income
statement, and the inclusion of merchandise inventory on the balance sheet as a current asset.
Income Statement
The income statements classifies accounts in to such categories as gross profit on sales, income
from operations, income before taxes, and net income.
The amount of detail presented in the various sections varies from company to company.
E.g. instead of reporting gross sales, sales return and allowance and sales discounts, some
company just report net sales.
Revenue from sales: the total of all changes to customers for merchandising sold both for cash
and on account, is reported in this section. Sales return & allowance and sales discounts are
deducted from the gross amount to yield net sales.

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Cost of merchandise sold: the determination of merchandise sold is beginning merchandise
inventory plus net purchase during the period minus ending merchandise inventory (inventory on
hand at the end of the period).

Gross profit: the excess of the net revenue from sales over the cost of merchandise sold is called
gross profit, gross profit on sales or gross margin. It is called gross b/c operating expense must
be deducted from it.
A company’s gross profit may also be expressed as a percentage by dividing the amount of gross
profit by the net sales.
E.g. assume the net sales amounts to Br 460,000 and the cost of goods sold, amounts to Br
316,000, and then the gross profit rate is 31.3%(144,000/460,000). The gross profit rate tells
how many cents of each sale dollar go to gross profit. Gross profit represents the merchandise
profit of a co. It is not a measure of the overall profitability of a company; b/c operating
expenses have not been deducted. But comparisons of current gross profit rate with past periods
& with gross profit rate of competitors provide information about the effectiveness of company’s
purchasing function and the soundness of its pricing policies.
Operating expenses: - are the expenses incurred in the process of earning sales revenue. These
expenses are similar in merchandising and service companies. It includes salaries and wages of
the sales force, depreciation of store equipment and store supplies, advertising, office salaries,
depreciation of office equipment, and office supplies used, rent expenses, insurance expenses
and taxes expenses.
Income from operation: the excess of gross profit over total operating expenses is called
income from operations or operating income. The amount of the income from operation and its
relationship to capital investment and to net sales is important factors in judging the efficiency of
management and the degree of profitability of an enterprise. If operating expenses are greater
than the gross profit, the excess is called loss from operation.
Other income: revenue from sources other than the principal activity of a business is classified
as other income, or non-operating income (I.e. revenues that result from secondary or auxiliary
operations and gains that are unrelated to the company’s operation).
For a merchandise company these sections includes
- Interest revenue from notes receivable and marketable securities
- Dividends revenue from investment in capital stock
- Rent revenue from subleasing the portion of the store
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 - Gain from the sales of properties, plant and equipment
Other expenses: - expenses that cannot associate definitely with operations are identified other
expense or non-operating expense.
E.g. - interest expense that result from financing activities (interest on N/P, and loans payable)
- Casualty losses from recurring causes such as accidents.
- Loss from the sale or abandonment of property, plant and equipment
- Loss from strikes by employees and suppliers
The two categories of non-operating items are offset against each other on the income statement.
If the total of other income exceeds the total of other expenses, the difference is added to income
from operations.
Net income: the final figure on the income statement is labeled net income (net loss). It is the net
increase (or net decrease) in owner’s equity as a result of profit making activities.
Shashe Audio Supply
Income statement/statement of profit or loss
For the year ended December 31,2014
Sales revenues
Sales revenue Br 480,000
Less: Sales return and allowance Br 12,000
Sales discounts 8,000 20,000
Net sales 460,000
Cost of goods sold 316,000
Gross profit 144,000
Operating expenses
Salaries and wages expense 64,000
Utilities expense 17,000
Advertising expense 16,000
Depreciation expense 8,000
Freight-out 7,000
Insurance expense 2,000
Total operating expense 114,000
Income from operations 30,000
Other income and expense
Interest revenue 3,000
Gains on sale of equipment 600
Causality loss from vandalism (200) 3,400
Interest expense 1,800
Net income Br 31,600

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 Retained Earnings Statement
The retained earnings statement summarizes the changes, which have occurred in the retained
earnings account during the fiscal period. It serves as a connecting link b/n the income statement
and the balance sheet.

Shashe audio supply.inc

Retained Earning
For the Year Ended Dec.31, 2014
Retained earnings, Jan 1, 2014 -------------------------- $53,800
Net income for the year ----------------------- $31,600
Less dividends ----------------------------- 18,000
Increase in retained earnings----------------------- 13,600
Retained earnings, Dec.31, 1990 ----------------------- $66,400

The combined statement emphasizes net income as the connecting link b/n the income statement
and the retained earnings portion of owner’s equity and thus, helps the readers understanding. A
criticism of the combined statement is that the net income figure is buried in the body of the
statement.
Classified Statement of Financial Position
The traditional arrangement of assets on the left-hand side of the balance sheet, with liability and
owner’s equity on the right-hand side is referred to as the account form. If the three sections are
arranged in a down word sequence, it is referred as report form.
Shashe audio supply, inc
Statement of financial position
For the year ended December 31, 2014
Assets
Property, plant and equipment
Equipment Br 80,000
Less acc. Depreciation 24,000 56,000
Current assets
Prepaid insurance 1,800
Inventory 40,000
Account receivable 16,100
Cash 9,500 67,400
Total Br 123, 400

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 Liabilities
Account payable 20,400
Salaries and wage payable 5,000
Total liabilities 25,400
Owner’s equity
Share capital ordinary 65,000
Add retained earnings 33,000
Total equity 93,000
Total liabilities and equity Br 123,400

Adjusting Entries
A merchandising company generally has the same types of adjusting entries as a service
company. However, a merchandiser using a perpetual system will require one additional
adjustment to make the records agree with the actual inventory on hand. Here’s why: At the end
of each period, for control purposes, a merchandising company that uses a perpetual system will
take a physical count of its goods on hand. The company’s unadjusted balance in Inventory
usually does not agree with the actual amount of inventory on hand. The perpetual inventory
records may be incorrect due to recording errors, theft, or waste. For this reason, the difference is
often called inventory shrinkage or inventory shortage. Thus, the company needs to adjust the
perpetual records to make the recorded inventory amount agree with the inventory on hand. This
involves adjusting Inventory and Cost of Goods Sold.
For example, suppose that PW Audio Supply has an unadjusted balance of $40,500 in Inventory.
Through a physical count, PW Audio Supply determines that its actual merchandise inventory at
year-end is $40,000. The company would make an adjusting entry as follows.
Cost of Goods Sold …………………500
Inventory ………………………500
(To adjust inventory to physical count or inventory shrinkage)
After the adjusting entry has been recorded, the accounting records agree with the actual physical
inventory at the end of the period. Since no system of procedures and safeguards can totally
eliminate it, inventory shrinkage is often considered a normal cost of operations. If the amount of
the shrinkage is abnormally large, it may be disclosed separately on the income statement. In
such cases, the shrinkage may be recorded in a separate account, such as Loss from Merchandise
Inventory Shrinkage.

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Accounting for Deferrals and Accruals
1. Accounting for Deferrals
A deferral is a delay of the recognition of an expense already paid or of revenue
already received.
Deferred expenses expected to benefit a short period of time are listed on the balance sheet
among the current assets, where they are called Prepaid Expenses. Long-term prepayments that
can be charged to the operations of several years are presented on t he balance sheet in a section
called Deferred Charges.
Deferred revenues may be listed on the balance sheet as a current liability, where they are called
Unearned Revenues or revenues received in advance. If a long period of time is involved, they
are presented on the balance sheet in a section called Deferred Credits.
Adjustments for Deferrals:
a) Adjusting Entries for Prepaid Expenses (Deferrals)
Prepaid expenses are the costs of goods and services that have been purchased but not used at the
end of the accounting period. The portion of the asset that has been used during the period
has become an expense; the remainder will not become an expense until sometime in the future.
Prepaid expenses include such items as prepaid insurance, prepaid rent, prepaid advertising,
prepaid interest, and various hinds of supplies.
Insurance premiums or other services or supplies that are used may be debited to asset
accounts when purchased, even though all or a part of them are expected to be
consumed during the accounting period. The amount actually used is then determined at the end
of the period and the accounts adjusted accordingly.
E.g. 1 Assume that the office supplies account of Noble Trading Company has a balance
of Birr 8,181 at December 31, 2008, the end of the year. This amount represents the cost of
office supplies on hand at the beginning of the year and the office supplies purchased during the
year. If the physical inventory at the end of the year indicated office supplies on hand totaling
Birr 2,550, the cost of the office supplies used during the year is Birr 5,635 (Birr 8,185-birr
2550). The adjusting entry to record the Birr 5,635 decrease of the asset and the
corresponding increase in expense is as follows.
Adjusting Entry
Dec. 31 Office supplies expense.......................... 5,635
Office supplies .......................................... 5,635

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E.g.2. Assume that the prepaid insurance account for noble trading has a balance of Birr 16,750
at December 31, 2008. This amount represents the unexpired insurance at the beginning of the
year plus the total of premiums on policies purchased during the year. Assume further that Birr
10,435 of insurance premiums have expired during the year, leaving Birr 6,315 of
unexpired premiums (Birr 16,750-Birr 6,315). The adjusting entry to record the Birr 10,435
decrease of the asset and the corresponding increase in expense is as follows:
Adjusting Entry

Dec. 31 Insurance expense ......................... 10,435

Prepaid Insurance................................ 10,435
b) Adjusting Entries for Unearned Revenues (Deferrals)
Revenue received during a particular period may be only partly earned by the end of the
period. Items of revenue that are received in advance represent a liability that may be termed
unearned revenue. The portion of the liability that is charged during the period through
delivery of goods or services has been earned; the remainder will be earned in the future. For
example, magazine publishers usually receive in advance payment for subscriptions covering
periods ranging from a few months to a number of years. At the end of the accounting period,
that portion of the receipts which is related to future periods has not been earned and should,
therefore, appear in the balance sheet as a liability.
By accepting advance payment of a good or service, a business commits itself to furnish the
good or the service at some future time. At the end of the accounting period, if some portion
of the good or the service has been furnished, past of the revenue has been earned. The
earned portion appears in the income statement. The unearned portion represents a liability of the
business to furnish the good or the service in a future period and is reported in the balance sheet
as a liability
When revenue is received in advance, it may be credited to a liability account.
Assume that on October 1, 2008 Noble Trading Company rents a portion of a building that
has been leasing for a period of one year, receiving Birr 10,000 in payment for the
entire rental. Assume also that the transaction was originally recorded by a debit to cash
and a credit to the liability account Unearned Rent. On December 31, 2008, the end of the fiscal
period, one fourth of the amount has been earned and three fourths of the amount remains a
liability. The entry to record the revenue and reduce the liability appears as follows:

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Adjusting entry
Dec. 31 Unearned Rent ........................ 2,500
Rent Income ........................... 2,500

Adjustments for Accruals:

a) Adjusting Entries for Accrued Liabilities (Accrued Expenses)
Some expenses accrue from day to day but are usually recorded only when they are
paid.
Examples are salaries paid to employees and interest paid on notes payable. The amounts of such
accrued but unpaid items at the end of the fiscal period are both an expense and a
liability. It is for this reason that such accruals are called accrued liabilities or accrued
expenses.
Assume that on December 31, 2008, the end of the fiscal year, the sales salaries
expense account for Noble Trading Company has a debit balance of Birr 68, 250 and the
office salaries expense account has a debit balance of Birr 29,860. For this particular fiscal
period, the records of the business show that the accruals for sales salaries and office salaries are
Birr 8,850 and Birr 4,450, respectively at the end of the year. The entry to record to additional
expense and liability is as follows:
Adjusting Entry
Dec.31 Sales salaries expense ......................... 8,850
Office salaries expense ......................... 4,450
Salaries payable ........................... 13,300

b) Adjusting Entries for Accrued Assets (Accrued Revenues)

All assets belonging to the business at the end of an accounting period and all revenues
earned during the period should be recorded in the ledger. But during a fiscal period it is
common to record some types of revenue only as the cash is received; consequently, at the end of
the period there may be items of revenue that have not been recorded. In such cases, the amount
of the accrued revenue must be recorded by debiting an asset account and crediting a
revenue account. Because of the dual nature of such accruals, they are called accrued
assets or accrued revenues

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 To illustrate the adjusting entry for an accrued asset assume that on December 31,2008, the end
of the fiscal year Noble Trading Company has an interest -bearing note assume further that
the interest earned but not collected as of December 31, 2008 is Birr 4,980. The entry to record
this increase in the amount of interest due (receivable) on the note and the revenue earned is a
follows:
Adjusting entry
Dec. 31 Interest Receivable ................................. 4,990
Interest Income ............................ 4,990

Worksheet
Shashe audio supply.inc
work sheet
for the year ended December 31, 2014
Trial balance Adjustments Adjusted TB income statement statement of
financial position

Accounts Dr Cr Dr Cr Dr Cr Dr Cr Dr Cr
cash 9,500 9,500 9,500

account receivable 16,100 16,100 16,100

Inventory 40,500 (a) 500 40,000 40,000

prepaid insurance 3,800 (b) 2,000 1,800 1,800

Equipment 80,000 80,000 80,000

Acc.Depreciation 16,000 (c) 8,000 24,000 24,000
equipment
Account payable 20,400 20,400 20,400

Share capital- 50,000 50,000 50,000

ordinary
Retained earnings 33,000 33,000

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Dividends 15,000 15,000 15,000
sales revenue 480,000 480,000 480,000
sales return and 12,000 12,000 12,000
allowances
sales discounts 8,000 8,000 8,000

cost of goods sold 315,500 (a) 360,000 360,000

500
freight-out 7,000 7,000 7,000

advertising expense 16,000 16,000 16,000

salaries and wage 59,000 (d)5,000 64,000 64,000

expense
utilities expense 17,000 17,000 17,000

Totals 599,400 599,400

insurance expense (b)2,00 2,000 2,000
0
depreciation expense (c)8,000 8,000 8,000
salaries and wages (d) 5,000 5,000 5,000
payable
Totals 15,500 15,500 612,400 612,400 450,000 480,000 162,500 132,500
net income 30,000 30,000
480,000 480,000 162,500 162,500
Closing Entries
The closing entries for a merchandising business are similar to those for a service business. The
first entry closes the temporary accounts with credit balances, such as Sales, to the income
summary account. The second entry closes the temporary accounts with debit balances, including
Sales Returns and Allowances, Sales Discounts, and Cost of Merchandise Sold, to the income
summary account. The third entry closes the balance of the income summary account to the
owner’s capital account. The fourth entry closes the owner’s drawing account to the owner’s
capital account.

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After the closing entries have been prepared and posted to the accounts, a post closing trial
balance may be prepared to verify the debit-credit equality. The only accounts that should appear
on the post-closing trial balance are the asset, contra asset, liability, and owner’s capital accounts
with balances. These are the same accounts that appear on the end-of-period balance sheet.

Recording merchandise transactions under the periodic inventory system

Using the periodic inventory system, purchases of inventory are recorded in a purchases account
rather than in a merchandise inventory account. No attempt is made to keep a detailed record of
the amount of inventory on hand at any given time. Instead, at the end of the period, a physical
count of merchandise inventory is taken.

Determining Cost of Goods Sold Under a Periodic System

Determining cost of goods sold is different when a periodic inventory system is used rather than
a perpetual system. As you have seen, a company using a perpetual system makes an entry to

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record cost of goods sold and to reduce inventory each time a sale is made. A company using a
periodic system does not determine cost of goods sold until the end of the period. At the end of
the period the company performs a count to determine the ending balance of inventory. It then
calculates cost of goods sold by subtracting ending inventory from the goods available for sale.
The cost of merchandise sold during a period is reported in a separate section in the income
statement.
Assume that X co. began its business operations on Jan 3, 1989, and purchased $340,000 of
merchandise during the year. If the inventory at the end of the year is $ 59,700 (periodic system).
The cost of merchandise sold during the period can be calculated as:
Cost of merchandise sold:
Purchase --------------------------------------------------------- 340,000
Less merchandise inventory Dec. 31, 1989-------------------- 59,700
Cost of merchandise sold --------------------------------------- 280,300
If the co. continues its operation for the next year 1990, it has beginning inventory.
E.g. assume that the company purchases additional merchandise of $521,980, receives credit for
purchases return and allowance of $9,100 takes purchases discounts of $2,525 and pays
transportation costs of $17,400. At the end of the year, the ending inventory is assumed to be
$62,150 is on hand. The cost of merchandise sold can be found as:

Mer. Inventory Jan 1, 1990(beginning Inventory) ------------------------ $59,700

Purchases----------------------------------------- $521,980
Less purchase return and allowance -------$9,100
Purchase discounts------------------------- 2,525 11,625
Net purchase ------------------------------------- 510,355
Add transportation in -------------------------------- 17,400
Cost of merchandise purchased --------------------------------------------------527,755
Merchandise available for sale------------------------------------------------ $ 587,455
Less merchandise inventory Dec. 31, 1990 (ending inventory) ------------- 62,150

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Cost of merchandise sold ----------------------------------------------- $525,305
Recording Merchandise Transactions
In a periodic inventory system, companies record revenues from the sale of merchandise when
sales are made, just as in a perpetual system. Unlike the perpetual system, however, companies
do not attempt on the date of sale to record the cost of the merchandise sold. Instead, they take a
physical inventory count at the end of the period to determine (1) the cost of the merchandise
then on hand and (2) the cost of the goods sold during the period. And, under a periodic system,
companies record purchases of merchandise in the Purchases account rather than the Inventory
account. Also, in a periodic system, purchase returns and allowances, purchase discounts, and
freight costs on purchases are recorded in separate accounts.
June 5. Purchased Br 30,000 of merchandise on account, terms 2/10, n/30.
June 8. Returned merchandise purchased on account on June 5, Br 500.
June 15. Paid for purchase of June 5, less return of Br 500 and discount of Br 590 [(Br 30,000-
500) *2%].
June 18. Sold merchandise on account, Br 12,500, 1/10, n/30. The cost of the merchandise sold
was Br 9,000.
June 21. Received merchandise returned on account, Br 4,000. The cost of the merchandise
returned was Br 2,800.
June 22. Purchased merchandise, Br 15,000, terms FOB shipping point, 2/15, n/30, with prepaid
transportation charges of Br 750 added to the invoice.
June 28. Received Br 8,415 as payment on account from June 18 sale less return of June 21 and
less discount of Br 85 [(Br 12,500 –Br 4,000) *1%].
June 29. Received Br 19,600 from cash sales. The cost of the merchandise sold was Br 13,800.
Periodic Inventory System perpetual Inventory System
5 Purchases ………………….30,000 Merchandise Inventory …………30,000
Accounts Payable …………..30,000 Accounts Payable …………………30,000
8 Accounts Payable ………………500 Accounts Payable ……………….500
Purchases Returns and Allowances 500 Merchandise Inventory …………….500
15 Accounts Payable ……………..29,500 Accounts Payable …………….29,500
Cash …………………………28,910 Cash ………………………….28,910
Purchases Discounts ……………590 Merchandise Inventory ……….590
18 Accounts Receivable …………12,500 Accounts Receivable ………….12,500
Sales ……………………….12,500 Sales …………………….12,500

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 Cost of Merchandise Sold ……..9,000
Merchandise Inventory ……..9,000
21 Sales Returns and Allowances…... 4,000 Sales Returns and Allowances...4,000
Accounts Receivable …………….4,000 Accounts Receivable …………….….4,000
Merchandise Inventory …………..2,800
Cost of Merchandise Sold …..2,800
22 Purchases …………….15,000 Merchandise Inventory ………15,750
Transportation In ………..750 Accounts Payable ………..15,750
Accounts Payable ……….15,750
28 Cash ……………………..8,415 Cash ……………………….8,415
Sales Discounts ……………..85 Sales Discounts ……………….85
Accounts Receivable …….8,500 Accounts Receivable ……8,500
29 Cash …………………….19,600 Cash ……………………….19,600
Sales ………………….19,600 Sales …………………19,600
Cost of Merchandise Sold ……13,800
Merchandise Inventory …….13,800

Adjusting process under the periodic inventory

The adjusting process is the same under the periodic and perpetual inventory systems except for
the inventory shrinkage adjustment. Under both the periodic and perpetual inventory systems the
ending merchandise inventory is determined by a physical count.
Under the perpetual inventory system the ending inventory physical count is then compared to
the amounts in the inventory ledger and the amount of inventory shrinkage is determined. This
inventory shrinkage is recorded as a debit to Cost of Merchandise Sold and a credit to
Merchandise Inventory.
Under the periodic inventory system, a separate inventory ledger is not maintained during the
year. Instead, purchases of inventory are recorded in the purchases account.
As a result, the inventory shrinkage cannot be directly determined, but is included indirectly in
the cost of merchandise sold computation
.A primary disadvantage of the periodic inventory system is that the amount of inventory
shrinkage is not separately determined.
Closing entries under periodic inventory system

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The closing entries differ in the periodic inventory system in that there is no cost of merchandise
sold account to be closed to Income Summary. Instead, the purchases, purchases discounts,
purchases returns and allowances, and transportation in accounts are closed to Income Summary.
In addition, the merchandise inventory account is adjusted to the physical inventory count
through the closing process.

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Reversing Entries
In order to reduce routine transactions and to simplify the analysis and recording of subsequent
transactions related to adjusting entries in the following year, an optional procedure called
reversing entries might be used. A reversing entry is the exact reverse of the adjusting entry; the
debit and credits are merely reversed.
Reversing Entries for Accrued Liabilities
If there has been an adjusting entry for accrued salaries at the end of the year, however the first
payments of salaries in the following year will include such year-end accrual. In the absence of
reversing entry it will be necessary, to debit salaries payable for the amount owed for the earlier
year and salary expenses for the portion of expense for the later year.
To illustrate, assume the following facts for an enterprise that pays salaries weekly and ends its
fiscal year on Dec. 31.
1) Salaries are paid on Friday for the five-day week ending on Friday
2) The balance in salary expense as of Friday, Dec.27 is $62,500
3) Salaries accrued for Monday and Tuesday (Dec.30& Dec.31), total $500
4) Salaries paid on Friday, Jan 3,of the following year total $1,250
The adjusting entry to record the accrued salary expense and salaries payable (for Monday&
Tuesday) is:
Dec. 31 Salary expense-------------------------------- 500
Salary payable --------------------------------------------- 500
After the adjusting entry has been posted, salary expenses will have a debit balance of
$63,000(62,500 + 500) & salary payable will have a credit balance of $500. After the closing
process is completed, salary expense is in balance (zero balance) for entries of the following
year, but salaries payable continues to have credit balance of $500.
On Jan. 3, of the New Year, the accountant must be forced to divide the debit entry of the
payment of the salary (payroll) as a debit of $500 to salary payable and a debit of $750 to salary
expense by referring the adjusting entries in the journal or ledger. The need to refer to earlier
entries and to divide the debit between two accounts can be avoided by recording reversing
entries as of the first day of the following fiscal period.
Jan. 1, Salaries payable -------------------------500
Salary expense ------------------------------------- 500

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The effect of the reversing entry is to transfer the $500 liability from salaries payable to the
credit side of salary expense. The real nature of the $500 balance is unchanged; it remains a
liability. When the payroll is paid on Jan. 3, salary expense will be debited and cash will be
credited for $1,250 (the entire amount of the weekly salaries). After the entry is posted, salary
expense will have a debit balance of $750, which is the amount of expense incurred for jan.1-3.
Reversing Entries for Accrued Assets
Some revenue may not be recorded until cash is received. During this year-end adjustment is
necessary to record the revenue accrued.
To illustrate, assume that an enterprise has a note receivable on which $6,000 of interest is due
every six months. If $4000 of interest income has been earned (accrued) on Dec. 31, the end of
the year, the adjusting entry would be as follows:
Dec. 31 Interest receivable --------------------------- 4,000
Interest income ------------------------------------------ 4,000
In order to avoid crediting two accounts at the time of receipt (interest receivable for 4,000 &
interest income for 2,000) and referring the earlier entries, reversing entry may be used.
Jan. 1 Interest income -------------------------------- 4,000
Interest receivable ------------------------------------------------ 4,000
The effect of the reversing entry is to transfer the $4,000 asset from interest receivable to the
debit side of interest income. The real nature of the $4,000 balance is unchanged; it remains an
asset. When the $6,000of interest is received on March 1 of the following year, interest income
will have a balance of $2,000 which is the amount of income realized for the period Jan. 1-
Mar.1.
Mar.1 Cash ----------------------------------- 6,000
Interest income ------------------------------------ 6,000

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