Merchandising Company Financial Statements: A Worked Example
Merchandising company financial statements report on a business that buys and resells goods. The multiple-step income statement subtracts cost of goods sold (COGS) from net sales to show gross profit, then subtracts operating expenses, adds other revenues and gains, and subtracts other expenses, losses, and income tax to reach net income. Net income updates retained earnings, and the classified balance sheet reports merchandise inventory as a current asset.
A merchandiser, such as a retailer or wholesaler, buys finished goods and resells them without changing them. Unlike a business that provides only services, a merchandiser reports merchandise inventory and cost of goods sold. A business that provides services and also sells goods may report both service revenue and merchandising accounts. Start from adjusted account balances, and prepare the statements in order, because each one feeds the next. A complete reporting package also includes a statement of cash flows and notes.
Watch Professor Farhat explain
Merchandising Accounting: Purchases, Discounts & FOB Explained
This clip (4:51 to 7:46) introduces net sales, cost of goods sold, and gross profit. The worked statements below build on those ideas. Want the full lesson on purchases, discounts, and FOB shipping terms? Watch the complete video on YouTube.
In What Order Do You Prepare Merchandising Company Financial Statements?
Use balances after adjusting entries and before closing entries. Otherwise, you may omit earned revenue or expired costs, or find that temporary accounts have already been reset. The preparation order matters because each statement supplies a number for the next.
| Report | Question answered | Amount carried forward |
|---|---|---|
| Income statement | What profit was earned during the period? | Net income |
| Retained earnings statement | How did accumulated earnings change? | Ending retained earnings |
| Balance sheet | What is the financial position at the date? | Assets = liabilities + equity |
The income statement and retained earnings statement cover a period. The balance sheet reports a date. The SEC’s guide to financial statements explains these complementary perspectives. For a service-company comparison, see preparing financial statements from adjusted balances.
Merchandising Income Statement Example (Multiple-Step Format)
Hypothetical example. Harbor Retail Inc. has the following adjusted amounts for the year ended December 31, 20X7. All amounts are dollars. Assume no other income-statement items and use the stated $4,500 tax expense; no tax-rate calculation is required.
| Income statement item | Amount |
|---|---|
| Sales revenue | $250,000 |
| Less: sales discounts | (4,000) |
| Less: sales returns and allowances | (6,000) |
| Net sales | 240,000 |
| Cost of goods sold | (150,000) |
| Gross profit | 90,000 |
| Selling expenses | (30,000) |
| Administrative expenses | (40,000) |
| Income from operations | 20,000 |
| Interest revenue | 1,000 |
| Interest expense | (3,000) |
| Income before income taxes | 18,000 |
| Income tax expense | (4,500) |
| Net income | $13,500 |
Net sales versus gross profit
Sales discounts and sales returns and allowances are contra revenue accounts: they reduce sales revenue. Net sales is $250,000 − $4,000 − $6,000 = $240,000. Deduct COGS of $150,000 to obtain $90,000 gross profit. Unsold inventory remains an asset on the balance sheet. Under a periodic system, ending inventory is subtracted inside the COGS calculation (shown below), so never subtract it again after gross profit.
Gross profit versus operating income
Selling expenses support sales activities, such as advertising and sales staff compensation. Administrative expenses support general management. Deduct both from gross profit to get $20,000 of operating income, which the statement labels income from operations. The two terms mean the same thing. For this retailer, interest revenue and interest expense appear outside operations. After those items and income taxes, net income is $13,500.
Account classification depends on use. Depreciation on office equipment is an administrative expense in this teaching case; depreciation on sales equipment could be a selling expense. Follow the facts rather than classifying every depreciation charge identically.
How Do You Calculate Cost of Goods Sold?
Where did Harbor’s $150,000 of COGS come from? It depends on the inventory system.
Under a perpetual inventory system, purchases increase Merchandise Inventory. Each sale records revenue and transfers the cost of the goods sold from Merchandise Inventory to COGS, so COGS is recorded throughout the period. Purchase discounts, purchase returns, and freight-in are recorded directly in Merchandise Inventory. Year-end adjustments may still be needed for shrinkage or other differences identified by a physical count.
Under a periodic inventory system, the company records purchases in a separate Purchases account and works out COGS at year-end after a physical count. Here is how Harbor’s COGS would look under a periodic system, using these hypothetical amounts.
| Cost of goods sold item | Amount |
|---|---|
| Beginning merchandise inventory | $30,000 |
| Purchases | 160,000 |
| Less: purchase discounts | (3,000) |
| Less: purchase returns and allowances | (5,000) |
| Net purchases | 152,000 |
| Add: freight-in | 3,000 |
| Cost of goods purchased | 155,000 |
| Cost of goods available for sale | 185,000 |
| Less: ending merchandise inventory | (35,000) |
| Cost of goods sold | $150,000 |
Cost of goods available for sale is beginning inventory plus cost of goods purchased: $30,000 + $155,000 = $185,000. Freight-in, the shipping cost paid to bring goods in, is part of inventory cost. Freight-out, the shipping cost to deliver goods to customers, is a selling expense instead. The $35,000 ending inventory is the same amount reported as a current asset on the balance sheet below.
Multiple-Step vs. Single-Step Income Statement
The statement above is a multiple-step income statement: it shows subtotals such as gross profit and income from operations on the way to net income. A single-step income statement lists all revenues together and all expenses together, then subtracts once. Both formats give the same net income.
| Income statement item | Amount |
|---|---|
| Revenues | |
| Net sales | $240,000 |
| Interest revenue | 1,000 |
| Total revenues | 241,000 |
| Expenses | |
| Cost of goods sold | 150,000 |
| Selling expenses | 30,000 |
| Administrative expenses | 40,000 |
| Interest expense | 3,000 |
| Total expenses before income tax | 223,000 |
| Income before income taxes | 18,000 |
| Income tax expense | (4,500) |
| Net income | $13,500 |
Income tax is often shown on its own line even in a single-step format, as it is here. The multiple-step format is especially useful for merchandisers because gross profit shows how well the company prices and buys its goods.
How Does Net Income Flow Into Retained Earnings?
Harbor began with retained earnings of $22,000 and declared and paid $3,500 of dividends during the year, so no dividends payable appears on the balance sheet. Assume no other retained earnings changes. The statement uses the same period heading as the income statement.
| Retained earnings item | Amount |
|---|---|
| Beginning retained earnings | $22,000 |
| Add: net income | 13,500 |
| Less: dividends | (3,500) |
| Ending retained earnings | $32,000 |
Dividends reduce retained earnings, not net income. Retained earnings also differs from cash: it is accumulated earnings retained in equity, not a separate cash fund. Preparing this reconciliation does not itself post the closing entries.
What Does a Merchandiser’s Classified Balance Sheet Look Like?
The balance sheet is dated December 31, 20X7. Assume a normal operating cycle under one year, current receivables and prepayments, a note due within the next year, bonds due five years later, and that the full year’s income tax is still unpaid at year-end. The receivables allowance is the applicable adjusted estimate for this simplified case.
| Balance sheet classification | Amount |
|---|---|
| Current assets | |
| Cash | $15,000 |
| Accounts receivable, $28,000 less $2,000 allowance | 26,000 |
| Merchandise inventory | 35,000 |
| Prepaid insurance | 4,000 |
| Total current assets | 80,000 |
| Equipment, $70,000 less $18,000 accumulated depreciation | 52,000 |
| Total assets | $132,000 |
| Current liabilities | |
| Accounts payable | $18,000 |
| Notes payable | 10,000 |
| Income taxes payable | 4,500 |
| Other accrued liabilities | 7,500 |
| Total current liabilities | 40,000 |
| Long-term bonds payable | 20,000 |
| Total liabilities | 60,000 |
| Common stock | 40,000 |
| Ending retained earnings | 32,000 |
| Total stockholders’ equity | 72,000 |
| Total liabilities and equity | $132,000 |
The check is $132,000 = $60,000 + $72,000. The allowance reduces receivables; accumulated depreciation reduces equipment to its carrying amount. Neither is a liability. A classified balance sheet separates current and noncurrent groups; an unclassified balance sheet omits those subgroup totals. Follow the format requested in your assignment.
What Do These Statements Tell You? Three Quick Ratios
Gross profit rate: gross profit divided by net sales. For Harbor, $90,000 ÷ $240,000 = 37.5%. About 37.5 cents of every sales dollar is left after covering the cost of the goods sold.
Profit margin: net income divided by net sales. For Harbor, $13,500 ÷ $240,000 = about 5.6%.
Current ratio: current assets divided by current liabilities. For Harbor, $80,000 ÷ $40,000 = 2.0, so current assets cover current liabilities twice.
Common mistakes
- Using gross sales to calculate gross profit: deduct the sales reductions first.
- Using beginning retained earnings: the balance sheet needs $32,000, after the year’s profit and dividends.
- Deducting accumulated depreciation as this year’s expense: distinguish the cumulative contra asset from depreciation expense.
- Trying to close the Merchandise Inventory account: inventory is a permanent (balance sheet) account, so its ending balance carries into next year. See closing entries for a merchandising company for the accounts that do close.
Exam Tip: How This Shows Up on the CPA Exam
The CPA exam’s FAR section blueprint includes preparing a single-step or multiple-step income statement and a classified balance sheet from a trial balance and supporting documents. Expect task-based simulations, where you are given balances and must place each amount on the correct line.
Three habits save points:
- Subtract sales discounts and sales returns and allowances before you compute gross profit.
- Tie ending retained earnings from the retained earnings statement to the balance sheet before moving on.
- Confirm that assets equal liabilities plus equity. If they do not, look first for a contra account (an account that reduces a related account, such as the allowance or accumulated depreciation) placed on the wrong side.
Merchandising Company Financial Statements: Interactive Exercise
Check your understanding of contra revenue, inventory classification, gross profit, interest expense, retained earnings, and periodic cost of goods sold (COGS) in this six-question exercise. Then apply these concepts in the calculation questions below.
Review the questions, answers, and explanations
- Which account is a contra revenue account? Sales discounts reduce sales revenue to arrive at net sales. Freight-in is part of inventory cost, and merchandise inventory is an asset.
- Where is ending merchandise inventory reported? Ending merchandise inventory is reported as a current asset on the balance sheet. Only the cost of goods already sold becomes COGS.
- What does gross profit equal? Gross profit equals net sales minus cost of goods sold. Operating expenses are deducted afterward to determine income from operations.
- For a retailer, which item appears outside income from operations? Interest relates to financing, not the retailer’s main buying and selling activity, so it appears after income from operations.
- Beginning retained earnings is $22,000, net income is $13,500, and dividends are $3,500. What is ending retained earnings? $22,000 + $13,500 − $3,500 = $32,000. Dividends reduce retained earnings.
- Under a periodic inventory system, how is cost of goods sold calculated? Cost of goods available for sale is beginning inventory plus cost of goods purchased. Subtract what is still on hand to find what was sold.
Does the complete financial reporting package include more? Yes. It includes additional statements and disclosures, including cash flows.
Three practice questions with explained answers
1. Sales are $90,000, discounts $1,500, and returns $2,500. What are net sales?
Answer: $86,000. Both contra revenue balances reduce sales: $90,000 − $1,500 − $2,500.
2. If COGS is $54,000 and operating expenses are $20,000, what are gross profit and operating income?
Answer: Using the $86,000 net sales above, gross profit is $32,000 and operating income is $12,000. Operating expenses are deducted after gross profit.
3. Beginning retained earnings is $17,000, net income is $12,000, and dividends are $4,000. What balance goes into equity?
Answer: $25,000. Add profit and subtract distributions: $17,000 + $12,000 − $4,000.
Key Takeaways
- A merchandiser buys and resells goods, so its statements include merchandise inventory and cost of goods sold.
- Net sales equals sales revenue minus sales discounts and sales returns and allowances.
- Gross profit equals net sales minus cost of goods sold. Operating expenses come after gross profit.
- Prepare the statements in order: income statement, then retained earnings statement, then balance sheet.
- Ending retained earnings from the retained earnings statement goes into the equity section of the balance sheet.
- Ending merchandise inventory is a current asset carried into the next period. Under a periodic system, year-end entries replace the beginning inventory balance with the ending inventory balance; inventory is not left at zero like a temporary account.
Frequently asked questions
Is merchandise inventory the same as cost of goods sold?
No. Inventory represents goods still held for sale; COGS is the cost assigned to goods already sold.
Does every corporation have to report earnings per share?
No. U.S. GAAP earnings-per-share requirements generally apply to entities with publicly traded common stock or potential common stock and entities filing to issue them. This introductory example omits earnings per share. See FASB ASC 260 for scope and presentation requirements.
Are these three statements a complete reporting package?
No. This lesson demonstrates their connection. Cash-flow information, broader equity changes, notes, and other applicable requirements must also be considered in actual reporting.
What is the difference between a merchandising company and a service company?
A business that provides only services generally has no merchandise inventory or merchandise cost of goods sold, although it may report costs of providing services. A merchandiser buys goods for resale and reports net sales, cost of goods sold, and gross profit. A business that provides services and also sells goods may report both types of activity.
What is the difference between perpetual and periodic inventory?
A perpetual system updates inventory for purchases and records both the revenue and cost of goods sold when goods are sold. A periodic system records purchases in a separate account and calculates cost of goods sold at the end of the period using a physical count of ending inventory. Both systems use physical counts to verify inventory quantities.
Is freight-in part of cost of goods sold?
Yes, indirectly. Freight-in is added to the cost of inventory, so it becomes part of cost of goods sold when the goods are sold. Freight-out, the cost of delivering goods to customers, is a selling expense.
How do you calculate the gross profit rate?
Divide gross profit by net sales. In this example, $90,000 ÷ $240,000 = 37.5%.
About the Author
Mansour Farhat, CPA, CIA, DBA, teaches accounting and CPA exam topics through Farhat Lectures and the Farhat Lectures YouTube channel. Read more about Professor Farhat.
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