CHAPTER 6

MERCHANDISING INVENTORIES

The series of transactions through which a business generates its revenue and its cash receipts from
customers is called the operating cycle.

Retailers and Wholesalers: Merchandising companies include both retailers and wholesalers.

A retailer is a business that sells merchandise directly to the public. Retailers may be large or small; they
vary in size from national store chains to small neighborhood businesses.

Wholesalers buy large quantities of merchandise from several different manufacturers and then resell
this merchandise to many different retailers. Because wholesalers do not sell directly to the public, even
the largest wholesalers are not well known to most consumers.

A COMPARISON OF INCOME STATEMENTS USED BY A SERVICE COMPANY AND A MERCHANDISING

COMPANY
ACCOUNTING SYSTEM REQUIREMENTS FOR MERCHANDISING COMPANIES

We recorded economic events using only general ledger accounts. These accounts, often referred to as
control accounts, are used to prepare financial statements that summarize the financial position of a
business and the results of its operations.

Subsidiary ledgers contain information about specific control accounts in the company’s general ledger.
Merchandising companies always maintain accounts receivable and accounts payable subsidiary ledgers.

Inventory subsidiary ledger contains information about each and every item purchased and sold
separately.

TWO APPROACHES USED IN ACCOUNTING FOR MERCHANDISE INVENTORIES

(1) A perpetual inventory system, or (2) a periodic inventory system. In the past, both systems
were in widespread use. Today, however, the growing use of computerized accounting systems
has made the perpetual approach easy and cost-effective to implement. Thus, the periodic
approach is used primarily by very small businesses with manual accounting systems.

NOTE: Accounting for inventory is similar to accounting for the prepaid expenses. As inventory is
purchased, it is initially reported as an asset in the balance sheet. As it is sold to customers, this asset is
converted to an expense, specifically, the cost of goods sold.

Both perpetual and periodic inventory systems account for the flow of inventory costs from the balance
sheet to the income statement.

Perpetual Inventory Systems

In a perpetual inventory system, all transactions involving costs of merchandise are recorded
immediately as they occur.
The system draws its name from the fact that the accounting records are kept perpetually up-to-date.
Purchases of merchandise are recorded by debiting an asset account entitled Inventory. When
merchandise is sold, two entries are necessary: one to recognize the revenue earned and the second to
recognize the related cost of goods sold. This second entry also reduces the balance of the Inventory
account to reflect the sale of some of the company’s inventory. A perpetual inventory system uses an
inventory subsidiary ledger. This ledger provides company personnel with up-to-date information about
each type of product that the company buys and sells, including the per-unit cost and the number of
units purchased, sold, and currently on hand.
TAKING A PHYSICAL INVENTORY
When a physical inventory is taken, management uses the inventory ledger to determine on a product-
by-product basis whether a physical count of the inventory on hand corresponds to the amount
indicated in the inventory subsidiary ledger. Over time normal inventory shrinkage may cause some
discrepancies between the quantities of merchandise shown in the inventory records and the quantities
actually on hand. Inventory shrinkage refers to unrecorded decreases in inventory resulting from such
factors as breakage, spoilage, employee theft, and shoplifting. In order to ensure the accuracy of their
perpetual inventory records, most corporations are required to take a complete physical count of the
merchandise on hand at least once a year. This procedure is called taking a physical inventory, and it
usually is performed near year-end. Once the quantity of merchandise on hand has been determined by
a physical count, the per-unit costs in the inventory ledger accounts are used to determine the total cost
of the inventory. The Inventory control account and the accounts in the inventory subsidiary ledger then
are adjusted to the quantities and dollar amounts indicated by the physical inventory.
Periodic Inventory Systems
A periodic inventory system is an alternative to a perpetual inventory system. In a periodic inventory
system, no effort is made to keep up-to-date records of either the inventory or the cost of goods sold.
Instead, these amounts are determined only periodically—usually at the end of each year.
Computing the Cost of Goods Sold The year-end inventory is determined by taking a complete physical
count of the merchandise on hand. Once the ending inventory is known, the cost of goods sold for the
entire year can be determined by a short computation.

Recording Inventory and the Cost of Goods Sold:

In a periodic system, the ending inventory and the cost of goods sold are recorded during the company’s
year-end closing procedures (The term closing procedures refers to the end-ofperiod adjusting and
closing entries.
SUMMARY OF THE JOURNAL ENTRIES MADE IN PERPETUAL AND PERIODIC INVENTORY STYLE
FACTORS INFLUENCING CHOICE OF INVENTORY SYSTEM

Transactions Relating to Purchases

CREDIT TERMS AND CASH DISCOUNTS
Manufacturers and wholesalers normally sell their products to merchandisers on account. The credit
terms are stated in the seller’s bill, or invoice.
One common example of credit terms is “net 30 days,” or “n/30,” meaning full payment is due in 30
days. Another common form of credit terms is “10 eom,” meaning payment is due 10 days after the end
of the month in which the purchase occurred.
Perhaps the most common credit terms offered by manufacturers and wholesalers are 2/10, n/30. This
expression is read “2, 10, net 30,” and means that full payment is due in 30 days, but that the buyer may
take a 2 percent discount if payment is made within 10 days. The period during which the discount is
available is termed the discount period. Because the discount provides an incentive for the customer to
make an early cash payment, it is called a cash discount. Buyers, however, often refer to these discounts
as purchase discounts, while sellers frequently call them sales discounts.
Purchase recorded at net cost
The net cost —that is, the invoice price minus any available discount.
Recording the loss of a cash discount

 Purchase Discounts Lost is an expense account.

 Thus the lost purchase discount is basically a finance charge, similar to interest expense. In an
income statement, finance charges usually are classified as non-operating expenses.
Recording Purchases at Gross Invoice Price
Gross (total) invoice price. If payment is made within the discount period, these companies must record
the amount of the purchase discount taken.
Purchases recorded at gross price

Buyer records discounts taken

 Purchase Discounts Taken is treated as a reduction in the cost of goods sold.

 A shortcoming of the gross price method as compared to the net cost method for valuing
inventory is that it does not direct management’s attention to discounts lost. Instead, these
discounts are buried in the costs assigned to inventory.
RETURNS OF UNSATISFACTORY MERCHANDISE
Return is based on recorded acquisition cost
TRANSPORTATION COSTS ON PURCHASES
Transportation costs relating to the acquisition of inventory, or any other asset, are not expenses of the
current period; rather, these charges are part of the cost of the asset being acquired.
Often, many different products arrive in a single shipment. In such cases, it may be impractical for the
purchaser to determine the amount of the total transportation cost applicable to each product. For this
reason, many companies follow the convenient policy of debiting all transportation costs on inbound
shipments of merchandise to an account entitled Transportation-i.
Transactions Relating to Sales
The term net sales means total sales revenue minus sales returns and allowances and minus sales
discount.

SALES RETURNS AND ALLOWANCES

Most merchandising companies allow customers to obtain a refund by returning any merchandise
considered to be unsatisfactory. If the merchandise has only minor defects, customers sometimes agree
to keep the merchandise if an allowance (reduction) is made in the sales price.
A sales return reverses recorded revenue . . .

And the recorded cost of goods sold

 This entry is based on the cost of the returned merchandise to the seller, not on its sales price.
(This entry is not necessary when a sales allowance is granted to a customer who keeps the
merchandise.)
 SALES DISCOUNTS
Sales are recorded at the gross sales price

Seller records discounts taken by customers

 Sales Discounts is another contra-revenue account.

Contra-revenue accounts have much in common with expense accounts; both are deducted from gross
revenue in determining net income, and both have debit balances. Thus contrarevenue accounts (Sales
Returns and Allowances and Sales Discounts) are closed to the Income Summary account in the same
manner as expense accounts.
DELIVERY EXPENSES
If the seller incurs any costs in delivering merchandise to the customer, these costs are debited to an
expense account entitled Delivery Expense. In an income statement, delivery expense is classified as a
regular operating expense, not as part of the cost of goods sold.
ACCOUNTING FOR SALES TAXES
Sales tax recorded at time of sale

GROSS PROFIT
Gross profit = Sales revenue - Cost of goods sold
Gross profit margin = Gross profit / Sales revenue