Accounting: The Language of Business (Part 28)

With greater extensibility and programmability, bitcoin can evolve to enable transformations in how all forms of property are secured and exchanged, how voting and governance function, including spilling into the automation of commercial law, audit, and accounting.

Jeremy Allaire

Accounting for a Merchandising Businesses

(Part B)

by

Charles Lamson

Financial Statements for a Merchandising Business

In the next couple posts, we illustrate the financial statements for NetSolutions after it becomes a retailer of computer hardware and software. During 2023, we assume that Chris Clark implemented a second phase of NetSolutions business plan. Accordingly, Chris notified clients that beginning July 1, 2024, NetSolutions would be terminating its consulting services. Instead, it would become a personalized retailer.

Netsolutions' business strategy is to focus on offering personalized service to individuals and small businesses who are upgrading or purchasing new computer systems. Netsolutions' personal service before the sale will include no-obligation, on-site assessment of the customer's computer needs. By providing tailor-made solutions, personalized service, and follow-up, Chris feels that NetSolutions can compete effectively against larger retailers, such as Best Buy or Office Depot.

Multiple-Step Income Statement

The 2025 income statement for NetSolutions is shown in Exhibit 1. This form of income statement, called a multiple-step income statement, contains several sections, subsections, and subtotals.

EXHIBIT 1 Multi-Step Income Statement

Sales is the total amount charged customers for merchandise sold, including cash sales and sales on account. Both sales returns and allowances and sales discounts are subtracted in arriving at net sales.

Sales returns and allowances are granted by the seller to customers for damaged or defective merchandise. For example, rather than have a buyer return merchandise, a seller may offer a $500 allowance to the customer as compensation for damaged merchandise. Sales returns and allowances are recorded when the merchandise is returned or when the allowance is granted by the seller.

Sales discounts are granted by the seller to customers for early payment of amounts owed. For example, a seller may offer a customer a 2% discount on a sale of $10,000 if the customer pays within 10 days. If the customer pays within the 10-day period, the seller receives cash of $9,800 and the buyer receives a discount of $200 ($10,000 x 2%). Sales discounts are recorded when the customer pays the bill.

Net sales is determined by subtracting sales returns and allowances and sales discounts from sales. Rather than reporting the sales, sales returns and allowances, and sales discounts as shown in Exhibit 1, many companies report only net sales.

Cost of merchandise sold is the cost of the merchandise sold to customers. To illustrate the determination of the cost of merchandise sold, assume that NetSolutions purchased $340,000 of merchandise during the last half of 2024. If the inventory at December 31, 2024, the end of the year, is $59,700, the cost of the merchandise during 2024 is $280,300, as shown below.

As we discussed in the preceding paragraphs, sellers may offer customers sales discounts for early payment of their bills. Such discounts are referred to as purchases discounts by the buyer. Purchase discounts reduce the cost of merchandise. A buyer may return merchandise to the seller (a purchase return), or the buyer may receive a reduction in the initial price at which the merchandise was purchased (a purchase allowance). Like purchase discounts, purchases returns and allowances reduce the cost of merchandise purchased during a period. In addition, transportation costs paid by the buyer for merchandise also increase the cost of merchandise purchased.

To continue the illustration, assume that during 2025 NetSolutions purchased additional merchandise of $521,980. It received credit for purchases returns and allowances of $9,100, took purchases discounts of $2,525, and paid transportation costs of $17,400. The purchases returns and allowances and the purchases discounts are deducted from the total purchases to yield the net purchases. The transportation costs, termed transportation in, are added to the net purchases to yield the cost of merchandise purchased of $527,755, as shown below.

The ending inventory of NetSolutions on December 31, 2024, $59,700, becomes the beginning inventory for 2025. The beginning inventory is added to the cost of merchandise purchased to yield merchandise available for sale. The ending inventory, which is assumed to be $62,150 , is then subtracted from the merchandise available for sale to yield the cost of merchandise sold of $525,305, as shown in Exhibit 2.

EXHIBIT 2 Cost of Merchandise Sold

The cost of merchandise sold was determined by deducting the merchandise on hand at the end of the period from the merchandise available for sale during the period. The merchandise on hand at the end of the period is determined by taking a physical count of inventory on hand. This method of determining the cost of merchandise sold and the amount of merchandise on hand is called the periodic method of accounting for merchandise inventory. Under the periodic method, the inventory records do not show the amount available for sale or the amount sold during the period. In contrast, under the perpetual method of accounting for merchandise inventory, each purchase and sale of merchandise is recorded in the inventory and the cost of merchandise sold accounts. As a result, the amount of merchandise available for sale and the amount sold are continuously (perpetually) disclosed in the inventory records.

Most large retailers and many small merchandising businesses use computerized perpetual inventory systems. Such systems normally use bar codes. An optical scanner reads the bar code to record merchandise purchased and sold. Merchandise businesses using a perpetual inventory system report the cost of merchandise sold as a single line on the income statement, as shown in Exhibit 1 for NetSolutions. Merchandise businesses using the periodic inventory method report the cost of merchandise sold by using the format shown in Exhibit 2. Because of its wide use, we will use the perpetual inventory method throughout the next several posts.

Gross profit is determined by subtracting the cost of merchandise sold from net sales. Exhibit 1 shows that NetSolutions reported gross profit of $182,950 in 2025. Operating income, sometimes called income from operations, is determined by subtracting operating expenses from gross profit. Most merchandising businesses classify operating expenses as either selling expenses or administrative expenses. Expenses that are incurred directly in the selling of merchandise are selling expenses. They include such expenses as salesperson salaries, store supplies used, depreciation of store equipment, and advertising. Expenses incurred in the administration or general operations of the business are administrative expenses or general expenses. Examples of these expenses are office salaries, depreciation of office equipment, and office supplies used. Credit card expertise is also normally classified as an administrative expense. Although selling and administrative expenses may be reported separately, many companies report operating expenses as a single item.

Other income and expense is reported on NetSolutions' income statement in Exhibit 1. Revenue from sources other than the primary operating activity of a business is classified as other income. In a merchandising business, these items include income from interest, rent, and gains resulting from the sale of fixed assets.

Expenses that cannot be traced directly to operations are identified as other expense. Interest expense that results from financing activities and losses incurred in the disposal of fixed assets are examples of these items.

Other income and other expense are offset against each other on the income statement, as shown in Exhibit 1. If the total of other income exceeds the total of other expense, the difference is added to income from operations to determine net income. If the reverse is true, the difference is subtracted from income from operations. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 232-236*

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