Merchandising Accounting: Inventory & Financials

Merchandising Activities

• Merchandising firm accounting entails issues for clothing retailers and grocery stores.
• Financial statements for merchandising firms differ from service firms, so there are unique considerations.
• Evaluation of the performance of merchandising firms requires the utilization of financial information.
• Managing inventory, goods purchased for resale, is critical.
• Retail chains must acquire and sell hundreds of items quickly at competitive prices for success.
• Inventory is a relatively liquid asset in most merchandising firms, sold within days or weeks.
• Inventory usually appears near the top of the balance sheet, immediately below accounts receivable.

Operating Cycle of a Merchandising Company

• The series of transactions through which a business generates revenue and related cash receipts from customers make up the operating cycle.
• The sequence of transactions repeats itself continuously.
• Operating cycle consists of merchandise purchases, merchandise sales, and collection of receivables.
• Some collected cash is used to purchase more merchandise and the cycle restarts.
• A key factor for merchandising firms is to determine when revenue should be in its income statement.
• Revenue represents the financial measure of the goods provided.
• Reporting revenue is recognized when it has been earned.
• The company has performed all functions included in the agreement with the customer to earn revenue.
• All transaction costs are known or reasonably estimated to earn revenue.
• Revenue is recognized at the point of sale.

Comparing Activities

• Most merchandising firms acquire inventories in a ready-to-sell condition from other business organizations.
• Manufacturers produce their own inventories, unlike merchandisers.
• General Motors, IBM, and Boeing Aircraft are manufacturers, not merchandisers.
• Manufacturers have longer, more complex operating cycle than merchandising companies
• Examples and chapter illustrations are limited to companies purchasing inventory in ready-to-sell condition.
• The basic concepts also apply to manufacturers.

Retailers and wholesalers

• Merchandising firms include both retailers and wholesalers.
• Retailers sell merchandise directly to the public.
• Retailers range in size from large chains like Walmart and The Gap to smaller businesses such as gas stations and convenience stores.
• There are more businesses engaged in retail sales than any other economic activity.
• Wholesalers buy large quantities of merchandise from different manufacturers and then resell merchandise to retailers.
• Wholesalers do not sell to the public, they are less well-known than retailers.
• The discussed concepts apply equally to retailers and wholesalers.

Income Statement of a Merchandising Company

• A merchandising firm's income statement differs from that of a service entity.
• Sales is the total revenue generated by selling merchandise.
• Costs transfer from the balance sheet to the income statement as items are sold from inventory
• Cost of goods sold is subtracted sales to arrive at gross profit.
• Other expenses such as wages, advertising, and depreciation subtracted from gross profit to arrive at net income
• There is net income only if gross profit is more than the sum of other expenses.

Computer City Example Income Statement

• $900,000 in sales represent the selling price of merchandise sold to customers.
• Criteria for revenue recognition have been met
• Selling merchandise introduces cost of doing business - the cost to acquire the inventory sold
• Costs are removed or transferred to the income statement to offset sales revenue as items transfer from inventory
• $540,000 cost subtracted from sales revenue referred to as the cost of goods sold.
• The cost of goods sold is an expense and is shown individually from other expenses.
• The business earns Net Income only if its gross profit exceeds other expenses.

Accounting System Requirements

• Control accounts are used to prepare financial statements
• Statements summarize the financial position of a business and the results of its operations.
• While general ledger accounts are a useful tool, they don't provide the detailed info necessary to effectively manage most business enterprises.
• Subsidiary ledgers show detailed information.

Subsidiary Ledgers

• They contain specific information about general ledger control accounts
• Merchandising businesses maintain accounts receivable and accounts payable ledgers.
• If there are 500 credit customers, there are 500 individual customer accounts, making a total equal to the general ledger
• The ledger contains separate inventory accounts for every item that they sell.
• Maintaining records would involve a lot of work in a manual accounting system.
• Subsidiary ledger and general ledger accounts are posted automatically in computerized systems.
• Transactions are recorded in the control accounts and the specific account information.

Approaches to Accounting for Merchandise Inventories

• Perpetual and periodic inventory systems are the two common approaches.
• Today the growing use of tech has made the perpetual approach both easy and cost-effective.
• Periodic approach is more often used by small businesses with manual accounting systems.
• Accounting for inventory is related to accounting for prepaid expenses.
• Inventory is initially reported as an asset in the balance sheet as it is purchased
• It becomes an expense as the goods are then sold.
• Inventory costs flow from the balance sheet to the income statement in both systems.

Perpetual Inventory System

• Transaction costs involving sales are recorded immediately as they occur.
• The accounting records are maintained up-to-date.
• Purchases of goods are recorded in the Inventory account, an asset account.
• There are two journal entries necessary when merchandise is sold.
• One entry recognizes revenue earned.
• Second entry recognizes the related cost of goods sold.
• A perpetual inventory system uses an inventory subsidiary ledger that is always up to date.
• The ledger provides info about the items that the business purchases or sells.
• Cost, amount sold, and quantities are some of the items tracked.

Merchandise Purchases

• Purchases of items are recorded at cost.

Merchandise Sales

• Revenue earned in a sales transaction is equal to the sales price x number of units sold
• The matching principle dictates should be matched with all of the costs and expenses.

Ledger Postings

• Sales transactions are posted in Computer City’s general ledger
• The first entry for Accounts Receivable is posted for the RJ Travel Agency account
• The reduction in inventory (second entry) is posted to the Regent 21-Inch Monitor’s ledger.
• Reducing both Accounts Payable and Cash is a related entry.

Collection

• The reduction in Accounts Receivable is posted to the RJ Travel Agency account
• Completing the operating cycle results in gross profit.

Physical Inventory Taking

• The key aspect of perpetual inventory is that the Inventory account is constantly updated for all purchases and merchandise sales
• Management uses the inventory to determine if a physical count relates to the amount in the inventory subsidiary ledger.
• Inventory shrinkage refers to unrecorded inventory decreases (breakage, theft, etc).
• Corporations take a physical inventory and it is usually done near year-end.
• Per-unit inventory ledger costs establish total inventory cost
• Control accounts and the accounts in the ledger then adjusted with actual count dollar amounts.

Shrinkage Example

• At year-end, Computer City has an inventory cost of $72,200.
• The on-hand amount is $70,000, and the proper entry would be to increase the debit of cost of goods sold and reduce inventory credit for $2,200.
• Computer City adjusts subsidiary ledger accounts to reflect physical count. Shrinkage amounts are normally debited to Cost of Goods Sold.

International Info on Inventory

• Inventory valuation standards differ between IFRS and GAAP
• GAAP doesn't allow reversals of inventory write-downs, but international standards do when criteria are met.
• Depending on the financial statements, whether prepared under GAAP or IFRs a firm could differ when the inventory values are balanced.

Closing Entries in Perpetual Inventory System

• Merchandising businesses with perpetual inventory systems mirror service-type businesses.
• The sales account is a revenue account that closes into the income summary with other revenue accounts.
• The COGS account is closed into the income summary the same way.

Periodic Inventory Systems

• It provides an accounting alternative to perpetual inventory systems.
• It makes no effort to keep up-to-date records of unsold product.
• Instead these amounts are determined usually at fiscal year end.