Fundamentals of Accounting II

INTRODUCTION
This is the second part of your Basic Accounting subject. It is very important to have a complete coverage
and mastery of your Fundamentals of Accounting subject. This is a pre-requisite subject before you can
proceed to the higher accounting subjects in your college. This part covers the following topics:
1. Accounting for Merchandising Business (Continuation of Accounting I)
2. Statement of Financial Position
3. Statement of Comprehensive Income
4. Statement of Changes in Owner’s Equity
5. Cash Flow Statement
6. Analysis and Interpretation of Financial Statements 1
7. Analysis and Interpretation of Financial Statements 2
8. Accounting Books – Journal and Ledger
9. Basic Documents and Transactions Related to Bank Deposits
10. Basic Reconciliation Statement
11. Income and Business Taxation
12. Accounting Practice Set
This accounting subject is substantially about financial statement analysis, so it is expected that you have a
critical mindset as to analyzing something. In the first part, we are to explore different types of Financial
Statements. This was already discussed in your FABM I. There are two lessons that is under the higher
accounting subject, the Basic Bank Reconciliation under Financial Accounting I and Income and Business
Taxation under Taxation subject.
Prior to the end of semester, you are required to accomplish “Accounting Practice Set”. This accounting set
is an application of your knowledge in FABM I and II, so it is better for you to aim mastery in every lesson.
To be able to do that, knowing the concepts is very helpful.

Goodluck future CPA’s, Businessmen, Managers, and someone of your dream!

Prepared by: Mr. Risaldy A. Alegria

Subject Teacher

Warning: DO NOT upload or photocopy, or reproduce by any means this handout.

 Fundamentals of Accounting II

Chapter I
Accounting for Merchandising
Part I

For the past lessons in FABM I, the service entity is the subject of every lesson, none of them sells product,
instead they provide a service for profit. An entity that resells products at profit is the Merchandising
Business. Typically, they buy products from a Manufacturing Company and resell it for a profit.
Merchandising Business is almost everywhere. In fact, many of our personal transactions are with
merchandising business such as grocery stores, hardware, department stores and the most common, sari-
sari stores.
The same accounting process also applies to a merchandising business. The accounting rules and concepts
remain the same regardless of the types of businesses. However, there are some transactions that are unique
to a merchandising business primarily because of its operating cycle. (Accounting, by: J, Salogagcol)
The operating cycle of the merchandising business is:

Cash

Collections Purchases

Accounts Merchandise
Receivable Inventory
Sales
Basically, the accounting cycle of a merchandising business starts from cash which is used to purchase
Merchandise Inventory, secondly sell it to cash customers and collect the payment immediately. What is
illustrated above is the transaction from a credit customer. Credit customer means a customer who doesn’t
pay his account immediately that is why his account is stored in the Accounts Receivable account and
eventually collect it. The accounting cycle is a repetitive sequence.
Accounts used in a Merchandising Business
Other accounts used in a merchandising business are different from a service type business. It will be
helpful to use specific revenue and expense account relating to entity’s merchandise.
Merchandise Inventory is differentiated from other assets. Remember that Merchandise inventory is an item
held for “sale”. When an asset acquired is held for use in “operation” it is not included in the merchandise
inventory account.

REVENUES EXPENSES

*Purchases
*Sales
*Sales returns and *Freight-in
*Purchase returns and
allowances
*Sales discounts Allowances
*Purchase discounts

You should remember these accounts and its normal balance in order to help you in proper recording of
merchandising transactions.
Sales
The “Sales” or “Sales revenue” account is used to record and accumulate the sales price of merchandise
sold. In Filipino, the sales means “napagbentahan”. Sales is different from net income which is the benefits
obtained from the operation. Sales revenue increases Owner’s Equity account so the normal balance is
credit.

Warning: DO NOT upload or photocopy, or reproduce by any means this handout.

 Fundamentals of Accounting II
There are two ways of recording sales. First is we debit the same amount credited to cash if a customer is a
cash customer or the one who pays rightly after the sale. The second way is debiting the same amount to
Account Receivable account if the customer is a credit customer.
Cash Sale
On March 1,2020, Future CPA Company sold merchandise worth 50,000 to a cash customer.
Debit Credit
March 1 Cash 50,000
Sales 50,000
To record cash sales.

Credit Sales
On March 1,2020, Future CPA Company sold merchandise worth 50,000 on account.
Debit Credit
March 1 Accounts receivable 50,000
Sales 50,000
To record credit sales.

Sales return and allowances

In a merchandising business, it is not avoidable that some customers may return their previously bought
merchandise. This is called “Sales return”, a contra revenue account. Another event in a sales transaction
is that when a customer discovers that some of its bought merchandise is defective. As a compensation, the
customer is usually given a reduction in the amount owed or as a cash refund to the customer. This is called
as “Sales allowance”. In practice, sales return and sales allowance is recorded in a single account “Sales
return and allowances”. Since this is a contra revenue account, it has a normal debit balance.

Example #1: A cash customer has returned goods worth 10,000.

Debit Credit
March 1 Sales return and allowances 10,000
Cash 10,000
To record sales return and allowances.

Example #2: A credit customer has returned goods worth 10,000.

Debit Credit
March 1 Sales return and allowances 10,000
Accounts receivable 10,000
To record sales return and allowances.

See the difference between transactions from a cash customer and credit customer. The credit entry for a
cash customer is the account “Cash” while the credit entry for a credit customer is the account “Account
receivable”.

Discounts
Discount is very common to a business, but in a merchandising business, there are two types of discount.
The first one is what we call “Trade Discount”. This is sometimes referred to as “Quantity Discount” or
“Volume Discount”. Trade discount is a reduction in sales price given to customers to encourage them to
buy the entity’s merchandise. An example of this is the discount given by department stores ranging from
20% to a high of 70% especially during holiday seasons. Trade discount is not recorded or journalized
in the books. The effect of this discount is, when you deduct trade discount to the sales you arrive at its
“Invoice price” or the actual amount that you are obliged to pay.

Example #1: The list price of a merchandise is 20,000. Assume that an entity gives a 40% trade discount.
Determine the invoice price.
Alternative formula:
List price: 20,000 List price: 20,000
Trade discount x 40% x 60% (100% - 40%)
8,000 Invoice price 12,000

Warning: DO NOT upload or photocopy, or reproduce by any means this handout.

 Fundamentals of Accounting II
20,000 – 8,000 = 12,000

The 12,000 becomes the invoice price. Remember that the 8,000-trade discount is not recorded in the books.
There are times that trade discount is in various discount rates. Refer to the example below:

Example #2
An entity has a merchandise with a list price of 50,000 subjects to a trade discount 20%; 10%. Compute the
invoice price.
Using the alternative formula, the invoice price is computed as following:

List price: 50,000

Multiply x 80%
Amount after the 1st trade discount of 20%: 40,000
Multiply x 90%
Invoice price after the 2nd trade discount 36,000

The entity shall record the sales in the amount of 36,000 and not as 50,000 because the trade discount
is not recorded in the books.

Another discount that an entity may offer to its customer is the “Sales discount”. This is also called as “Cash
discount”. This is a kind of discount given to a credit customer. This is given to customers in order to
encourage them to pay immediately or for prompt payment. Usually, the customers are given a certain
period to settle their account (Credit period), and when customers are able to pay within the given period,
they will they will be entitled to a Sales discount or cash discount. This period is termed as “discount
period”.

Example: Assume an entity sells 50,000 worth of merchandise on account with credit terms 2/10, N/30.
2/10 is what we call the “discount period” and the N/30 is the “credit period. The credit term means that
the customers shall pay its account within 30 days but when able to pay within 10 days, their account will
be decreased by 2% cash discount.

Journal entry: (at the merchandiser’s standpoint)

Initial Entry: Debit Credit

Accounts receivable 50,000
Sales 50,000
To record sales on account with credit term 2/10; N/30

Assume that the customer has settled its account within 10 days.

Debit Credit
Cash 49,000
Sales discount 1,000
Accounts Receivable 50,000
To record the collection within a discount period.

Assume that the customer has settled its account beyond the discount period.

Debit Credit
Cash 50,000
Accounts Receivable 50,000
To record the collection beyond the discount period.
Sales discount and sales return and allowances are deducted from the Sales to arrive at “Net Sales”.

Purchases
The Purchases account is used to record the cost of merchandise acquired for resale. It has a normal debit
balance since it is an expense account. In every purchase of merchandise, Purchases account is debited
while the credit is either Cash or Account payable account.

Warning: DO NOT upload or photocopy, or reproduce by any means this handout.

 Fundamentals of Accounting II

Example #1
An entity purchased merchandise costing 100,000 using cash.
The entry to record the purchase transaction is:
Debit Credit
Purchases 100,000
Cash 100,000
To record cash purchase of merchandise.

Example #2
An entity purchased merchandise costing 100,000 on account.
Debit Credit
Purchases 100,000
Accounts payable 100,000
To record purchase of merchandise on account.

Bear in mind that we only use purchases and similar expenses account when merchandise for resale
to customers is involved.

Freight-in
It is normal for an entity to incur expenses in order to bring the merchandise to its saleable condition. All
cost incurred to bring the merchandise to its saleable condition must be capitalized or recorded as part of
the cost of merchandise purchased. Freight-in is the account used to record the transportation cost of the
merchandise purchased. Since it is said that it is included as part of the cost of the merchandise purchased,
it has a normal debit balance.

Example:
To record the payment of transportation cost of 2,000, the journal entry would be:
Debit Credit
Freight-in 2,000
Cash 2,000
To record incurred transportation cost.

The credit can be a cash or account payable when the entity has not yet paid the transportation cost.
Remember we are under the accrual basis of accounting. So, upon the incurrence of the expenses, we should
record it regardless of the actual cash disbursements.

Purchase Returns and Allowances

This account is counterpart account of Sales return and allowances. It is used to record the amount of
merchandise purchased returned to a supplier or reduction of the amount purchased because of defective
goods. It has a normal credit balance because it reduces the balance of Purchases account. Observe the
similarity of the following account.

SELLER BUYER

1.Sales 1.Purchases

2.Sales return and 2.Purchase return

allowances and allowances

3.Sales discount 3.Purchase

discount

Example: To record the return of goods to a supplier costing 5,000 would be:
#1 Cash purchase
Debit Credit
Cash 5,000
Purchase return and allowances 5,000
To record the purchase return.

Warning: DO NOT upload or photocopy, or reproduce by any means this handout.

 Fundamentals of Accounting II
#2 Purchase on account
Debit Credit
Accounts payable 5,000
Purchase return and allowances 5,000
To record the purchase return on account.
The Purchase return and allowances is a deduction from the Purchases account.

Purchase Discount
Purchase discount is like a mirror image of a Sales discount account. The sales discount to a seller is a
purchase discount to a buyer. It has a normal credit balance because it serves as a deduction from the
Purchases. This is only given to a credit customer to encourage them for a prompt payment.

Example: The entity buys merchandise on account for 50,000 with credit terms 3/10, N/30.
The journal entry to record the purchase would be:

Debit Credit
Purchases 50,000
Accounts payable 50,000
To record the purchase of merchandise on account.

Assume that an entity was able to settle its account within the discount period. The journal entry
would be:

Debit Credit
Accounts payable 50,000
Cash 48,500
Purchase discount 1,500
To record the payment within the discount period.

Assume that an entity fails to settle the account within the discount period. The journal entry would
be:

Debit Credit
Accounts payable 50,000
Cash 50,000
To record the payment of accounts payable.

The Purchase return and allowances and Purchase discount are deducted from the Purchases to
arrive at the Net Purchases.

Freight-out
This is another term for a transportation cost. This is the cost of transportation incurred by a seller in
transporting the goods to the buyer. This is a selling expense account. Since it is an expense account, it has
a normal debit balance.

Example:
The seller incurred 5,000 transportation cost in delivering the goods to the buyer. The journal entry of the
seller would be:

Debit Credit
Freight-out 5,000
Cash 5,000
To record payment of delivery cost.

Sometimes, the freight out is paid by the buyer under the freight collect term. In this case, the credit must
be accounts payable. We will discuss other selling and purchasing terms in the succeeding sections.

End of Part I

Warning: DO NOT upload or photocopy, or reproduce by any means this handout.

 Fundamentals of Accounting II

Part II
Financial Statements of a Merchandiser

Financial statements of a Merchandiser business are similar to that of a service entity. But there are other
things that make it different from that of a service entity such as the Income Statement preparation.

Income Statement
Service Business Merchandising Business

Service Revenue P200,000 Sales 500,000

Less: Cost of Sales 250,000
Less: Expenses 130,000 Gross Profit 250,000
Net Profit P70,000 Less: Operating Expenses 50,000
Net Profit P200,000

The first line begins with “revenues”. Service revenue is for a service entity while “Sales” or “Sales revenue
is the account for a Merchandiser business. It is very important to state the correct classification of revenue
to let the users of financial statement know the type of business that the entity is primarily engaged in.

In the expenses section, the difference between the two types of business is the manner by which the
expenses are presented. In a service type of business, there is no classification of expenses but in the
merchandising business it is required to make a distinction between “Cost of Sales” and “Operating
expenses.

Cost of sales or Cost of goods sold is the cost of the merchandise sold while the operating expenses include
the general, administrative, and selling expenses incurred during the period. In other words, all expenses
other than Cost of sales are included in the operating expenses.

2 types of Income Statement (as to manner of presenting expenses)

1. Single step income statement – presentation of expenses as a single amount. Particularly used by a
service type of business.
2. Multi-step income statement – expenses are presented in numerous subsections and intermediate
summary figures. Particularly used by a Merchandising business.

Net Profit
Net profit or sometimes referred to as Net income. It is the difference between the total revenues and all the
expenses incurred during a period. This is closed to the Capital or Equity account at the end of the period.

Cost of Sales/Cost of Goods Sold

Cost of sales is the cost of the merchandise sold. In determining the cost of goods sold, there are two systems
of accounting for inventory- the Periodic and Perpetual Inventory System.

Periodic Inventory System

This is system of accounting inventory we have used from the previous discussions. The features of this
inventory system are:
1. It does not keep track of records of the movement of inventory.
2. Purchases are debited to the Purchases account.
3. The cost of sales is not recorded at the time of sale.
4. The cost of ending inventory is determined at the end of the period by physical counting.
5. The cost of goods sold is determined by preparing Statement of cost of goods sold using this format:

Statement of Cost of Goods Sold

Beginning inventory Pxxxx

Add: Purchases xxxx
Freight-in xxxx
Less: Purchase discount xxxx
Purchase return xxxx
Goods available for sale xxxx
Less: Ending inventory xxxx
Cost of Sales Pxxxx

Warning: DO NOT upload or photocopy, or reproduce by any means this handout.

 Fundamentals of Accounting II

Remember that under the Periodic inventory system, there must be a physical inventory count to be
conducted at the end of the year. And for the auditing purposes, physical count is conducted.

Example problem:
Kaya mo to Merchandising Company provided you the following information:

Purchases P200,000
Purchase returns 12,000
Purchase discounts 8,000
January 1, 2019, Inventory 270,000
Transportation costs paid
in bringing the goods to the customers 2,500
Transportation costs paid in purchasing
merchandise for resale. 3,000
Goods on hand at the end of the year
based on physical count 100,000

Task: Compute the cost of sales.

Solution:
Beginning inventory 270,000
Add: Purchases 200,000
Freight-in 3,000
Less: Purchase returns (12,000)
Purchase discounts (8,000)
Goods available for sale 453,000
Less: Ending inventory (100,000)
Cost of Sales P353,000

Observe that the cost of transporting the goods to the customers is not included because this is treated
as a “selling expense”.

Perpetual Inventory System

The unique feature of this inventory system is “a running balance of inventory is maintained”. While
the Periodic system uses the Purchases account in every purchase transaction, the Perpetual inventory
system uses the “Inventory” account for purchases of merchandise. In every sale transaction, the cost of
sales is immediately recorded. The sales returns and allowances and sales discount are credited to inventory
account.

Example:
An entity purchased 100,000 merchandise.
Debit Credit
Inventory 100,000
Cash 100,000
To record purchase of merchandise.

Assume that the same entity sold goods worth 50,000 which has a mark-up of 60% on cost.

Debit Credit
Cash 25,000
Sales 25,000
To record cash sales.

Cost of sales 31,250

Inventory 31,250
To record cost of sales.

Warning: DO NOT upload or photocopy, or reproduce by any means this handout.

 Fundamentals of Accounting II

Cost of sales:

Price 50,000
Divide by 1.6
Cost of sales 31,250

Observe the difference of way of recording the purchase and sales transaction under the Perpetual inventory
system from Periodic system. Through this journal entry, inventory and the cost of sales at any given point
in time are always accessible from the entity’s records. So, there is no need to prepare statement of cost of
sales because the cost of sales is rightly determined after every sales transaction.

Freight terms and payment terms

There are different types of agreements. In these freight agreements, it is determined who must be the one
to pay the freight cost.

Who must pay the freight? Answer: As a rule, the owner of the merchandise must be the one to shoulder
the freight.

When we say “the owner of the merchandise”, it is not clear who really the owner is under the purchase or
sale transaction. So, it is better to refer to the following:

1. FOB Destination – the ownership of the goods is still under the seller until the same is already
delivered to the premises of the buyer. Following the principle of this term, since the seller is the
owner of the merchandise, then the latter shall be the one to shoulder the freight.

2. FOB Shipping point – the goods ownership is already passed to the buyer while in transit or the
time it is put in the shipping point. So, whatever happens to the goods will be under the concern of
the buyer. Under this term, the buyer is the one obliged to shoulder the freight cost.

3. Freight prepaid – the freight is actually paid by the seller but it does not mean that he is the one
obliged to pay. It depends to whether the term is FOB Destination or Shipping point.

4. Freight collect – the freight is actually paid by the buyer but it does not mean that he is the one
obliged to shoulder the freight. Still, it depends to whether the term is FOB Destination or Shipping
point.

These terms are sometimes complemented such as:

1. FOB Destination, Freight collect – the goods are still owned by the seller while in transit and
therefore he should pay for the freight. The freight payment term is Freight collect which means
the buyer will pay the freight. The seller should decrease his receivable from the buyer, and in
the same process, the buyer should decrease his payable to the seller.

2. FOB Destination, Freight Prepaid – the goods are still owned by the seller while in transit
and therefore he should pay the freight. The freight payment term is Freight prepaid which
means the seller will pay the freight. There is no accounting problem here.

3. FOB Shipping point, Freight collect – the goods are already owned by the buyer on transit
and therefore he should pay the freight. The freight term is Freight collect which means the
buyer will pay the freight. There is no accounting problem here.

4. FOB Shipping point, Freight prepaid – the goods are already owned by the buyer on transit
and therefore he should pay the freight. The freight term is Freight prepaid which means the
seller will pay the freight. The buyer should increase his payable and in the same process, the
seller should increase his receivable.

Below are the examples for FOB Destination, freight collect and FOB Shipping point, Freight prepaid.
Example:
1. FOB Destination, Freight collect
BILIB AKO SA INYO Company purchased merchandise worth 50,000 on account. The related
freight cost is 1,000.

Warning: DO NOT upload or photocopy, or reproduce by any means this handout.

 Fundamentals of Accounting II

Journal entry:
Buyer Seller

Initial Entry: Initial Entry:

Debit Credit Debit Credit
Purchases 50,000 Accounts receivable 50,000
Accounts payable 50,000 Sales 50,000

Accounts payable 1,000 Freight-in 1,000

Cash 1,000 Accounts receivable 1,000
Upon collection:
Upon payment:

Accounts payable 49,000

Cash 49,000
Cash 49,000
Accounts receivable 49,000

2. FOB Shipping point, Freight prepaid

KAKAYANIN PARA SA PANGARAP Company purchased merchandise worth 50,000 on
account. The related freight cost is 1,000.

Buyer Seller

Initial Entry: Initial Entry:

Debit Credit Debit Credit
Purchases 50,000 Accounts receivable 50,000
Accounts payable 50,000 Sales 50,000

Freight-in 1,000 Accounts receivable 1,000

Accounts payable 1,000 Cash 1,000

Upon payment: Upon collection:

Cash 51,000
Accounts payable 51,000
Accounts receivable 51,000
Cash 51,000

Prepared by: Mr. Risaldy A. Alegria

-End of Chapter one-
Sources:
1. Accounting by: Jekell Salogagcol,
2. Fundamentals of Accounting Volume 1
by Franklin T. Agamata, MBA, FICB, CPA
Alfred Lindon F. Berbano, MBA, CPA
Tommy B. Buado, MICB, RCA, CPA

Warning: DO NOT upload or photocopy, or reproduce by any means this handout.

 Fundamentals of Accounting II

-End of Chapter One-

Warning: DO NOT upload or photocopy, or reproduce by any means this handout.