Accounting for a Merchandising Business

What makes a merchandising business different?

A service business (a tutor, a salon) sells work. A merchandising business (a shop, a wholesaler) sells goods it bought ready-made. So it needs extra accounts.

• Merchandise inventory: goods on the shelf waiting to be sold. It is a current asset.
• Purchases (periodic system): the cost of goods bought to resell.
• Purchase returns and allowances, purchase discounts: they reduce purchases.
• Freight-in (transport in): cost of bringing goods to the shop. It adds to the cost of the goods.
• Sales, sales returns and allowances, sales discounts: sales minus the last two = net sales.
• Cost of goods sold (COGS): what the sold goods cost the business.

Gross profit = net sales − COGS. It must pay for rent, wages and other operating expenses.

Perpetual and periodic inventory systems

Perpetual system: the Inventory account changes with every purchase and every sale. A barcode scanner at the till does this. You always know the stock and COGS.

Periodic system: purchases go to a Purchases account. Inventory is updated only after a physical count at the end of the period. COGS is worked out then.

Journal entries side by side (buy 5,000 on credit, then sell goods costing 3,000 for 4,500 cash)

Physical count and safety of stock

Even with a perpetual system, count the stock at least once a year, usually after closing hours or when the shop is shut. The difference between book stock and counted stock is shrinkage (theft, damage, errors). Protect stock with locked stores, separate people for buying, receiving and recording, regular surprise counts, and CCTV.

Net purchases, net sales and cost of goods sold

Net purchases = purchases − purchase returns − purchase discounts + freight-in.

Net sales = sales − sales returns − sales discounts.

COGS = opening inventory + net purchases − closing inventory. The middle total (opening + net purchases) is called goods available for sale.

Discount terms

"2/10, n/30" means: take 2% off if you pay within 10 days; otherwise pay the full amount within 30 days. A buyer records the 2% as a purchase discount; the seller records it as a sales discount.

Freight terms

FOB shipping point: the buyer owns the goods once they leave the seller, so the buyer pays freight. FOB destination: the seller owns them until they arrive, so the seller pays (freight-out is a selling expense).

Sales tax

Sales tax (GST, VAT, HST) collected from customers is not the shop's income. It is a liability owed to the government. Example: sale 1,000 + 13% tax: Dr Cash 1,130 / Cr Sales 1,000 / Cr Sales Tax Payable 130. Tax paid on purchases can often be claimed back (input tax credit), so it is recorded as a receivable or offset.

The accounting cycle: statements, adjusting and closing entries

The cycle is the same as for a service business: journalise → post to ledger → trial balance → adjustments → financial statements → closing entries. The extras are about stock.

1. Adjust inventory: in a perpetual system, record shrinkage (Dr COGS / Cr Inventory). In a periodic system, the count gives the closing inventory figure.
2. Multi-step income statement: net sales → − COGS → gross profit → − operating expenses (selling and administrative) → operating income → ± other items → net income.
3. Classified balance sheet: current assets (cash, receivables, merchandise inventory, prepaid items), long-term assets, current liabilities (payables, sales tax payable), long-term liabilities, owner's equity.
4. Closing entries: close Sales and other credit-balance temporary accounts to Income Summary; close COGS (or Purchases, returns, discounts, freight-in in a periodic system) and expenses to Income Summary; close Income Summary and Drawings to Capital.

Why year-end matters: a wrong closing stock moves profit. If closing stock is overstated by 1,000, COGS is 1,000 too low and profit is 1,000 too high; next year it reverses.

Rules and choices (GAAP / IFRS): record stock at cost, or at net realisable value if lower (conservatism). Cost can be found with FIFO or weighted average (some countries also allow specific identification). Use the same method every year (consistency). A single-step income statement is an allowed alternative to the multi-step one.

Inventory turnover = COGS ÷ average inventory. A higher number means stock sells fast; a low one means goods sit on shelves. Accounting software keeps the perpetual record, prints stock reports and flags low stock.

Try it: a mini shop on paper

Pick 5 items at home (say 5 pens bought at 10 each). "Sell" 3 to a family member at 15 each. Write the entries both ways: perpetual (two entries per sale) and periodic (count the 2 pens left at the end). Check that both give COGS = 30 and gross profit = 15. Then try the sliders in the last 3D step.

Key formulas and definitions

• Net sales = Sales − Sales returns − Sales discounts
• Net purchases = Purchases − Purchase returns − Purchase discounts + Freight-in
• Goods available for sale = Opening inventory + Net purchases
• COGS = Goods available for sale − Closing inventory
• Gross profit = Net sales − COGS
• Net income = Gross profit − Operating expenses (± other items)
• Gross margin % = Gross profit ÷ Net sales × 100
• Inventory turnover = COGS ÷ Average inventory

Worked examples

Common mistakes

• Adding purchase returns or discounts to purchases. They reduce purchases; only freight-in is added.
• In a perpetual system, recording only the sale and forgetting the second entry (Dr COGS / Cr Inventory).
• Treating sales tax collected as income. It is a liability owed to the government.
• Thinking a higher closing stock raises COGS. It lowers COGS and raises gross profit.