Chapter Three
Accounting for Merchandising Businesses
3.1 Introduction to Merchandising Operations
1. Types of Businesses: Service vs. Merchandising
Service Businesses:
Provide intangible services.
No inventory is held.
Revenue comes from service fees.
Example: Legal firms, salons, consulting agencies.
Merchandising Businesses:
Buy and resell tangible goods for profit.
Maintain an inventory of goods for sale.
Revenue comes from sales of merchandise.
Example: Supermarkets, electronics stores, clothing retailers.
Retailers vs. Wholesalers:
Retailers sell directly to consumers (e.g., Walmart).
Wholesalers sell to other businesses (e.g., Metro Cash & Carry).
2. Key Differences in Accounting
Service businesses do not have inventory or cost of goods sold (COGS).
Merchandising businesses require:
o Inventory tracking.
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o COGS calculation.
o Use of Sales, Purchases, Inventory, and Freight accounts.
Journal Entry Comparison:
Assume that service business earned Br 5000
Service:
Cash Dr. 5,000
Service Revenue Cr. 5,000
Merchandising: Earned birr 5000 from the sale of goods initially
purchased at birr 3000
Cash Dr. 5,000
Sales Revenue Cr. 5,000
Cost of Goods Sold Dr. 3,000
Inventory Cr. 3,000
Gross Profit=Sales- CGS=Br.5000-Br. 3000= Br 2000
3.2 Inventory and Cost of Goods Sold (COGS)
1. Types of Inventory Systems
a. Perpetual Inventory System
Continuously updates inventory and COGS.
Provides real-time information.
Requires computerized systems or point-of-sale (POS) systems.
Example:
Purchased inventory on account at Br.10,000
Inventory Dr. 10,000
Accounts Payable Cr. 10,000
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Sold goods (Cost: 6,000; Sales: 9,000):
Cash Dr. 9,000
Sales Revenue Cr. 9,000
Cost of Goods Sold Dr. 6,000
Inventory Cr. 6,000
b. Periodic Inventory System
Updates inventory and COGS at the end of the period.
Requires physical inventory counts.
Example:
Purchase:
Purchases Dr. 10,000
Accounts Payable Cr. 10,000
COGS Calculation (at period end):
COGS = Beginning Inventory + Purchases - Ending Inventory
2. Recording Inventory Transactions
A. Freight Costs:
FOB Shipping Point (Buyer pays freight/Transportation cost):
Assume that buyer pays Br. 500 for transportation charge.
Inventory Dr. 500
Cash Cr. 500
FOB Destination (Seller pays freight/Transportation cost):
Freight-out Expense Dr. 500
Cash Cr. 500
B. Purchase Returns and Allowances:
Return of defective inventory:
Accounts Payable Dr. 200
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Inventory Cr. 200
C. Sales Returns and Allowances: Contra sales Account
Customer returns goods of having sales value of Br.150 which was
initially purchased at Br.90.
Sales Returns & Allowances Dr. 150
Cash Cr. 150
Inventory Dr. 90
Cost of Goods Sold Cr. 90
3. Calculating Cost of Goods Sold
COGS Formula (Periodic System):
COGS = Beginning Inventory + Net Purchases - Ending Inventory
Where:
Net Purchases = Purchases + Freight-in - Purchase Returns
3.3 Inventory Valuation Methods
1. Specific Identification
Tracks actual cost of each unique item sold.
Used for high-value, low-volume items (e.g., vehicles, antiques).
Example:
Sold a machine purchased for $25,000:
COGS = $25,000
2. FIFO (First-In, First-Out)
Assumes oldest inventory is sold first.
Ending inventory consists of the most recent purchases.
Results in lower COGS and higher net income during inflation.
Example: Purchases:
January1/2024: 100 units @ $10 = $1,000
January 20/2024: 100 units @ $12 = $1,200
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Total Units 200 Units Br. 2200
Sold 150 units:
COGS = (100 x $10) + (50 x $12) = $1,600
Ending Inventory = 50 x $12 = $600
3. LIFO (Last-In, First-Out)
Assumes newest inventory is sold first.
Ending inventory consists of older costs.
Results in higher COGS and lower net income during inflation.
Not permitted under IFRS.
Example: Using same data:
COGS = (100 x $12) + (50 x $10) = $1,700
Ending Inventory = 50 x $10 = $500
4. Weighted Average Cost
Assigns average cost to all units.
Example:
Total units = 200 (100 @ $10 + 100 @ $12)
Total cost = $2,200
Average cost/unit = $11
Sold 150 units:
COGS = 150 x $11 = $1,650
Ending Inventory = 50 x $11 = $550
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Summary Comparison of Inventory Methods
Method COGS Ending Effect on Common Usage
(Inflation) Inventory Profit
FIFO Lower Higher Higher International use
(IFRS)
LIFO Higher Lower Lower U.S. only (GAAP)
Weighted Moderate Moderate Moderate Bulk items,
Average frequent
purchases
Specific Actual cost Actual cost Actual cost Unique, expensive
Identification items