Accounting in Merchandising Companies

Cost of goods available for sale, cost of goods sold (COGS), gross margin, inventory; selling and administrative expenses; multi-step income statement and single-step income statement.

1. Definition of inventory
We have talked about businesses that provide services. However, there are other types of businesses and one of them is a merchandising company. Merchandising companies create a supply of goods that are delivered to customers. This supply is called inventory:

Inventory is a current asset on a company's balance sheet. Inventory includes goods for resale, raw materials, spare parts, etc.

Inventory usually includes goods that are being made (in the process of being produced) and goods that are finished and ready for sale.

Merchandise inventory is goods that are held for resale by a merchandising company.

Inventory for resale is accounted for in the Merchandise Inventory account. This is an asset account shown in the assets section of the balance sheet.

2. Inventory costs. Product and period costs

All costs related to acquiring goods and making them ready for sale are accumulated in the Merchandise Inventory account. Such costs are associated with products and often called product costs:

Product costs are costs required to produce inventory and make it ready for sale. Such costs are directly associated with the inventory production.

Product costs are expensed in the period when inventory is sold regardless of when the inventory was purchased or produced by a company. There are a few types of expenditures that cannot be directly traced to a specific product. Such costs include (but are not limited to) advertising, administrative salaries, insurance, etc. Such costs are called selling and administrative expenses:

Selling and administrative expenses are expenses of selling and administrative nature that are not directly traceable to a specific product. Examples are advertising, administrative salaries and insurance, among others.

Because selling and administrative expenditures are expensed in the period in which they are incurred, they are labeled period costs:

Period costs are costs associated with a specific period and not a specific product. Period costs include selling and administrative expenses.

3. Cost of goods available for sale and cost of goods sold

The total inventory cost for a given accounting period is calculated by adding the beginning inventory account balance to the amount of inventory acquired during the period. The result of adding these two numbers is called a cost of goods available for sale:

Cost of goods available for sale is the cost of goods acquired during a period plus the cost of goods on hand at the beginning of the period. This cost represents all inventories available for sale during the period.

The cost of goods available for sale is allocated between the Merchandise Inventory account and an expense account called Cost of Goods Sold. At a period end, inventory that was not sold during the period is shown as an asset on the balance sheet (Merchandise Inventory) and inventory that was sold is shown as an expense on the income statement (Cost of Goods Sold).

Cost of goods sold (COGS) is the difference between the cost of goods available for sale and the cost of goods on hand at a period end. This cost represents the cost of goods sold by the company during the period. Gross margin is the difference between the sales revenue (i.e., revenue generated from sales) and the cost of goods sold. Gross margin shows what profit the company made after the cost of goods sold, but before any other expenses (selling and administrative, etc.). Operating income is the difference between the gross margin and selling and administrative expenses

4. Perpetual and periodic inventory systems

There are two inventory accounting systems - perpetual and periodic:

Perpetual inventory system means that the Inventory account is adjusted perpetually. The Inventory account is affected each time inventory is sold or purchased. Periodic inventory system only adjusts the Inventory account at the end of an accounting period. Purchases and sales do not affect the Inventory account during the accounting period, but do affect at the period end.

Although both systems have different approaches to inventory accounting, they are to provide the same results. The cost of goods sold amount and the sales amount should be the same regardless which system a company applies.

5. First illustration of accounting for inventory (period 1)

In our example, we will follow the rules of the perpetual inventory system. Under the perpetual inventory system sales and purchases of inventory are recorded directly to the Merchandise Inventory account when they take place. The accounting events below refer to a bookstore business called Dav's Books that was opened in 20X6: 1. The owner contributed $3,000 of inventory and $9,000 cash to the business. 2. $4,000 cash was paid to purchase additional inventory. 3. $200 cash was paid for the inventory transportation (see Event No. 2) from the vendor to the bookstore. 4. Inventory that cost $2,000 was sold for $5,500 cash. 5. Transportation expenses of $300 to deliver the sold goods (see Event No. 4) were incurred and paid with cash. 6. $400 of selling expenses were incurred and paid with cash.

5.1. Analysis of capital contribution transaction

Event No. 1: The owner made a combined capital contribution that consisted of cash and inventory. Cash ($9,000), Inventory ($3,000), and Contributed Capital (totally, $12,000) increase. This is an asset source transaction: Illustration 1: Effect of capital contribution Balance Sheet Cash + Inv. = Cont. Cap. + Ret. Earn. Income Statement Rev. - Exp. = Net Inc.

Event No.

Cash Flows

Event No. Beg. 1 End. Cash + $ 0 +

Balance Sheet Inv. $ 0 = = Cont. Cap. $ 0 + + Ret. Earn. $ 0 n/a 0

Income Statement Rev. - Exp. = Net Inc.

Cash Flows

$ 0 - $ 0 = $ 0 n/a 0 n/a 0 = = n/a 0 9,000 FA

9,000 + 3,000 = 12,000 + 9,000 + 3,000 = 12,000 +

5.2. Analysis of inventory acquisition transaction

Event No. 2: The Merchandise Inventory account increased when the $4,000 inventory purchase was made. Inventory increased and cash decreased. This is an asset exchange transaction: Illustration 2: Effect of inventory acquisition Balance Sheet Event No. Beg. 2 End. Cash 9,000 + Inv. = Cont. Cap. + Ret. Earn. 0 n/a 0 Rev. - Exp. = 0 n/a 0 0 n/a 0 = = = Net Inc. 0 n/a 0 (4,000) OA Income Statement Cash Flows

+ 3,000 = 12,000 + n/a +

(4,000) + 4,000 = 5,000

+ 7,000 = 12,000 +

5.3. Analysis of transportation-in costs

Event No. 3: Recall that all expenses incurred to deliver goods and make them ready for sale are treated as part of inventory costs and recorded in the Merchandise Inventory account. So, the transportation costs related to the delivery of inventory from the vendor to the bookstore are recorded in the Merchandise Inventory account. This transportation expense is called transportation-in:

Transportation-in expenditures are costs incurred to deliver inventory from a vendor (supplier) to a company. Transportation-in costs are treated as part of the inventory costs (product costs).

The transaction acts to increase merchandise inventory and to decrease cash. This is an asset exchange transaction: Illustration 3: Effect of transportation-in costs

Balance Sheet Event No. Beg. 3 End. Cash + Inv. = Cont. Cap. + Ret. Earn. 0 n/a 0

Income Statement Rev. - Exp. = 0 n/a 0 0 n/a 0 = = = Net Cash Flows Inc. 0 n/a 0 (200) OA

5,000 + 7,000 = 12,000 + (200) + 200 = n/a +

4,800 + 7,200 = 12,000 +

5.4. Analysis of inventory sale transaction

Event No. 4: This event is composed of two parts. The first one (4a in the table below) is the recognition of sales revenue. Cash and Retained Earnings increase by $5,500. Transaction 4a is an asset source transaction. The second part (4b) is designed to record the cost of goods sold. Remember that goods are only expensed at the point of sale (under the perpetual system). Accordingly, $2,000 should be removed from the Merchandise Inventory account and placed to the expense account called Cost of Goods Sold. Transaction 4b is an asset use transaction. Illustration 4: Effects of inventory sale Balance Sheet Cash 4,800 5,500 n/a + + + Inv. 7,200 n/a = Cont. Cap. + Ret. Earn. 0 5,500 Income Statement Rev. 0 Exp. 0 n/a = = = Net Inc. 0 5,500 5,500 OA Cash Flows

Event No. Beg. 4a 4b End.

= 12,000 + = n/a n/a +

5,500 n/a

+ (2,000) = 5,200

+ (2,000) 3,500

- (2,000) = (2,000) 3,500

10,300 +

= 12,000 +

5,500 - (2,000) =

5.5. Analysis of transportation-out expenses

Event No. 5: The cash expenditure made by the bookstore to deliver goods to the customer is called transportation-out:

Transportation-out expenditures are expenses incurred to deliver products from a company to a customer. Transportation-out expenditures are treated as period costs and expensed in the period of incurrence.

The company records transportation-out expenditures as an operating expense. This is an asset use transaction: Illustration 5: Effect of transportation-out expenses

Balance Sheet Event No. Cash + Inv. = Cont. Cap. + Ret. Earn.

Income Statement Cash Rev. Exp. = Net Inc. Flows

Beg. 10,300 + 5,200 = 12,000 + 3,500 5,500 - (2,000) = 3,500 5 (300) + n/a = n/a + (300) n/a - (300) = (300) (300) OA

End. 10,000 + 5,200 = 12,000 + 3,200 5,500 - (2,300) = 3,200

5.6. Analysis of selling expenses transaction

Event No. 6: The $400 cash payment for selling expense has the same effect as operating expenses do. Cash and Retained Earnings decrease. This is an asset use transaction: Illustration 6: Effect of selling expenses Balance Sheet Event No. Cash + Inv. = Cont. Cap. + Ret. Earn. Rev. Exp. = Net Inc. Income Statement Cash Flows

Beg. 10,000 + 5,200 = 12,000 + 3,200 5,500 - (2,300) = 3,200 6 End. (400) + n/a = n/a + (400) n/a - (400) = (400) (400) OA

9,600 + 5,200 = 12,000 + 2,800 5,500 - (2,700) = 2,800

5.7. Journal entries and T-accounts for the first illustration of accounting for inventory
Let us prepare the general journal and post all transactions to T-accounts: Illustration 7: General journal for illustration #1 Event No 1 Account titles Cash Merchandise Inventory Contributed Capital 2 Merchandise Inventory Cash 3 Merchandise Inventory (Transportationin) 200 4,000 4,000 Debit 9,000 3,000 12,000 Credit

Event No

Account titles Cash

Debit

Credit 200

4a

Cash Sales Revenue

5,500 5,500 2,000 2,000 300 300 400 400 5,500 2,000 300 400 2,800

4b

Cost of Goods Sold Merchandise Inventory

Transportation-out Cash

Selling Expenses Cash

Closing entry

Sales Revenue Cost of Goods Sold Transportation-out Selling Expense Retained Earnings

Note the last entry that is called a closing journal entry. We zeroed the nominal accounts (revenue and expense accounts) for use in the next accounting period. The closing entry is combined because we include both revenue and expense accounts into it. Illustration 8: Summary of T-accounts for illustration #1 Assets Cash (1) 9,000 (4a) 5,500 (2) 4,000 (3) (5) (6) Bal. 9,600 200 300 400 Retained Earnings (cl.) 2,800 Bal. 2,800 Merchandise Inventory (1) 3,000 (2) 4,000 (3) 200 (4b) 2,000 Sales Revenue (cl.) 5,500 (4a) 5,500 Bal. 0 0 = Liabilities + Equity Contributed Capital (1) 12,000 Bal. 12,000

Bal. 5,200

Cost of Goods Sold (4b) 2,000 Bal. 0 (cl.) 2,000

Transportation-out (5) 300 Bal. 0 (cl.) 300

Selling Expense (6) 400 Bal. Totals Assets 14,800 = Liabilities 0 + Equity 14,800 0 (cl.) 400

6. Second illustration of accounting for inventory (period 2)

Let us go on with the illustration and expand Dav's Books operations to the next (20X7) accounting period. The following transactions took place: 1. On May 14, the company purchased $5,000 of goods (inventory) on account. The seller delivered the goods at their expense. 2. Some goods delivered to Dav's Books were damaged. Thus, Dav's Books returned $300 of them to the seller (May 16). 3. On May 18, the company made a cash payment to settle the full balance due to the vendor from Event No. 1. The vendor provided a 2% cash discount to the bookstore because Dav's Books made the payment with two weeks after the purchase. 4. On June 12, the company sold goods costing $2,000 for $4,000 on account. 5. Dav's Books incurred $400 of transportation expenses to deliver the goods to the customer from Event No. 4. The expense was paid in cash on June 12. 6. Due to an error in filling out the purchase order in Event No. 6 and respectively shipping some goods not ordered, the customer sent back, and the bookstore accepted, some goods with the selling price of $500. The original cost of the goods was $250. 7. On June 15, the bookstore informed the customer from Event No. 4 that the customer would received a 2% cash discount if the payment was made within two weeks after the purchase. 8. On June 16, the customer from Even No. 4 paid the balance due for the goods delivered by the bookstore.

6.1. Effects of transactions for the second illustration of accounting for inventory
Let us review these transactions, record them in the general journal, transfer the data to T-accounts, and prepare the financial statements. The effects of these transactions on the accounting equation are shown in the table below: Illustration 9: Effects of 20X7 events of the accounting equation Assets Cash Beginning Balances 1) Inventory purchase 2) Goods return 3a) Cash discount on goods 3b) Cash payment 4a) Revenue recognition 4b) COGS recognition 5) Transp.-out expense 6a) Revenue adjustment 6b) COGS adjustment 7) Cash discount provided 8) Cash collection Ending Balances + 3,430 $8,024 + $8,056 + + 250 (70) (3,430) $ 0 = $ 0 + $12,000 + $4,080 (400) (500) (2,000) (4,606) + 4,000 $9,600 + Invent. $5,200 + 5,000 (300) (94) + Accts Rec. $ 0 = = Liab. Accts Pay. $ 0 + + Cap. $12,000 Equity Contr. + Ret. Earn. $2,800

+ 5,000 (300) (94) (4,606) + 4,000 (2,000) (400) (500) + 250 (70)

6.2. Analysis of transactions for the second illustration of accounting for inventory
Event No. 1: The effect of $5,000 inventory purchase is increases in both assets (Inventory) and liabilities (Accounts Payable). There is no impact on cash flows because the bookstore made the purchase on account (i.e., will pay later). This is an asset source transaction. Event No. 2: In Event No. 1 the Inventory account was debited. However, the company returned some goods, which resulted in a reverse operation. In this connection, the company needs to reduce both assets (Inventory) and liabilities (Accounts Payable) by the cost of the goods returned (i.e., $500). There is no impact on cash flows in this transaction. This is an asset use transaction.

Event No. 3a: Dav's Books got a cash discount. A cash discount means that the seller lets the buyer (in our example, the bookstore) pay less in case of a prompt settlement. So, the bookstore will be able to pay the amount due reduced by a 2% discount, that is $4,606 = $4,700 x (100% - 2%) = $4,606, and not the pre-discount amount of $4,700 = $5,000 - $300 of returned goods. This event has the same effect as the goods return in Event No. 2. Both assets (Inventory) and liabilities (Accounts Payable) decrease by the $94 discount ($4,700 - $4,606). There is no impact on the cash flows because no cash is exchanged at this point. This is an asset use transaction. Event No. 3b: We are familiar with the payment of accounts payable transaction. Cash and Accounts Payable decrease. The accounts payable balance at May 18 was $4,606 ($5,000 - $300 - $94). This transaction results in an operating activity cash outflow because the company paid cash to settle the amount due. This is an asset use transaction. Event No. 4: The sale of goods is composed of two events which are revenue recognition and expense recognition. The first one acts to increase assets (Accounts Receivable because the company sold on account) and equity (Retained Earnings, by increasing Sales Revenue) by $4,000. The second transaction decreases both equity (Retained Earnings, by increasing Cost of Goods Sold) and assets (Inventory) by $2,000. There is no impact on the cash flows because the bookstore sold goods on account (i.e., the buyer will pay later). Revenue recognition is an asset source transaction and cost of goods sold recognition is an asset use transaction. Event No. 5: Incurring transportation expense acts to decrease assets (Cash) and equity (Retained Earnings, by increasing Transportation-out) by $400. The cash payment results in an operating activity cash outflow. This represents an asset use transaction. Events No. 6 (6a & 6b): Getting back some goods sold in Event No.4 has a twofold effect on the bookstore's accounting records. The first one acts to adjust the revenue. Because some goods were returned, it is necessary to reduce Sales Revenue and Accounts Receivable by $500. The second effect is to adjust the expense. Cost of Goods Sold decreases, and Inventory increases by $250. As no cash movement is made in this transaction, there is no impact on cash flows. In this event, the bookstore just makes reverse entries to those from Event No. 4. Event No. 7: Providing a 2% cash discount to customers has a similar effect on the accounting records as Event No. 6. However, this time the bookstore does not receive any goods back and, therefore, does not have to adjust the expense (Cost of Goods Sold). The bookstore only decreases Accounts Receivable and Sales Revenue by $70 = ($4,000 minus $500 of returned goods) x 2%. There is no impact on cash flows because no cash movements are made in this transaction. This is an asset use transaction. Event No. 8: The cash collection transaction is already familiar to us. Cash increases and Accounts Receivable decrease. The cash collection results in a cash inflow from operating activities. This is an asset exchange transaction.

6.3. Journal entries for the second illustration of accounting for inventory
Let us see how these transactions look like in the general journal. Illustration 10: General journal for illustration #2 Event No 1 Account titles Merchandise Inventory Accounts Payable 2 Accounts Payable Merchandise Inventory 3a Accounts Payable Merchandise Inventory 3b Accounts Payable Cash 4a Accounts Receivable Sales Revenue 4b Cost of Goods Sold Merchandise Inventory 5 Transportation-out Cash 6a Sales Revenue Accounts Receivable 6b Merchandise Inventory Cost of Goods Sold 7 Sales Revenue Accounts Receivable 8 Cash Accounts Receivable Closing entry Sales Revenue Cost of Goods Sold Transportation-out Retained Earnings 3,430 1,750 400 1,280 3,430 3,430 70 70 250 250 500 500 400 400 2,000 2,000 4,000 4,000 4,606 4,606 94 94 300 300 Debit 5,000 5,000 Credit

6.4. T-accounts of transactions for the second illustration of accounting for inventory
It is time to transfer the amounts to T-accounts: Illustration 11: T-accounts of transaction for illustration #2 Assets Cash Beg. 9,600 (8) 3,430 (5) 400 (2) (3a) (3b) 4,606 Bal. 8,024 94 = Liabilities Accounts Payable Beg. 0 + Equity Contributed Capital Beg.12,000 Bal. 12,000

300 (1) 5,000

(3b) 4,606 Bal. 0 Retained Earnings Beg. 2,800 (cl.) 1,280 300 94 Bal. 4,080

Merchandise Inventory Beg. 5,200 (1) (6b) 5,000 (2) 250 (3a)

(4b) 2,000 Bal. 8,056 Sales Revenue Beg. (6a) Accounts Receivable Beg. 0 (7) 70 (7) 70 0

500 (4a) 4,000

(cl.) 3,430 Bal. 0

(4a) 4,000 (6a) 500 (8) 3,430 Bal. 0

Cost of Goods Sold Beg. 0 250 (cl.) 1,750 Bal. 0

(4b) 2,000 (6b)

Transportation-out

Beg. (5) Bal.

0 400 (cl.) 400 0

Totals Assets 16,080 = Liabilities 0 + Equity 16,080

6.5. Financial statements for the second illustration of accounting for inventory
Finally, financial statements prepared for 20X6 and 20X7 are shown below. Illustration 12: Financial statements for Dav's books for 20X6 and 20X7 Dav's Books Income Statement For the Period Ended 20X6 and 20X7 For the Period Ended 20X6 Net Sales Cost of Goods Sold Gross Margin Less: Operating Expense Transportation-out Selling Expense Operating Income Non-Operating Items Net Income (300) (400) $2,800 0 $2,800 (400) 0 $1,280 0 $1,280 $5,500 (2,000) $3,500 For the Period Ended 20X7 $3,430 (1,750) $1,680

Dav's Books Balance Sheet Periods Ended 20X6 and 20X7 Period Ended 20X6 Assets Cash Accounts Receivable Merchandise Inventory $9,600 0 5,200 $8,024 0 8,056 Period Ended 20X7

Dav's Books Balance Sheet Periods Ended 20X6 and 20X7 Period Ended 20X6 Total Assets $14,800 Period Ended 20X7 $16,080

Liabilities Accounts Payable Total Liabilities

$ 0 $ 0

$ 0 $ 0

Equity Contributed Capital Retained Earnings Total Equity $12,000 2,800 $14,800 $12,000 4,080 $16,008

Total Liabilities and Equity

$14,800

$16,080

Dav's Books Statement of Changes in Equity Periods Ended 20X6 and 20X7 Period Ended 20X6 Beginning Contributed Capital Plus: Capital Acquisition Ending Contributed Capital $ 0 12,000 $12,000 Period Ended 20X7 $12,000 0 $12,000

Beginning Retained Earnings Plus: Net Income Less: Distributions Ending Retained Earnings

$ 0 2,800 0 $2,800

$2,800 1,280 0 $4,080

Total Equity

$14,800

$16,080

Dav's Books Statement of Cash Flows For Periods Ended 20X6 and 20X7 For Period Cash Flows from Operating Activities Cash Receipts from Sales Revenue Cash Payments for Expenses Net Cash Flow from Operating Activities $5,500 (4,900) $600 $3,430 (5,006) (1,576) For Period Ended 20X6 Ended 20X7

Net Cash Flow from Investing Activities

$ 0

$ 0

Cash Flows from Financing Activities Cash Receipts from Capital Contribution Net Cash Flows from Financing Activities $9,000 $9,000 $ 0 $ 0

Net Change in Cash Plus: Beginning Cash Balance Ending Cash Balance

$9,600 0 $9,600

(1,576) 9,600 $8,024

You can determine what is included in the cash flow amounts by reviewing transaction explanations provided earlier and noting what type of cash flows (operating, financing, or investing) they represent.

6.6. Multiple-step and single-step income statements

Note a new format of the income statement. This format matches revenues with respective expenses. For example, the net sales and the cost of goods sold provide information about the difference between the sales amount and the cost of goods sold. Such format of the income statement is used to prepare

information for financial analysis. Income statements of such kind are called multiple-step income statements:

Multiple-step income statement shows numerous steps in determining the net income (or net loss). Each step provides a different measure of a company's results of operations.

In contrast, a single-step income statement that we used in other tutorials only includes information on total revenues and total expenses:

Single-step income statement shows only one step in determining the net income (or net loss).

7. Comparison of the periodic and perpetual inventory systems

The periodic inventory system is known to be used more frequently than the perpetual one. The reason is simple. It is easier to make a few period-end adjusting entries than to adjust accounting records every time a sale or purchase is made (for example, grocery store sales are very frequent). Under the periodic system the cost of goods sold is determined at the end of the period. Purchases or sales of inventory do not affect the inventory account during the period. When goods are purchased, the cost is recorded in the Purchases (Inventory Purchases) account. When goods are sold, a reduction in the Inventory account does not take place. Transportation-out expenditures, purchase returns, and allowances are recorded in separate accounts. The cost of goods sold is calculated by subtracting the amount of ending inventory from the total cost of goods available for sale (see the table below). The ending inventory is determined by performing a period end physical count. The schedule of cost of goods sold helps in performing these computations: Illustration 13: Schedule of cost of goods sold Beginning Inventory Plus: Purchases Plus: Transportation-in Less: Purchase Returns and Allowances Less: Purchase Discounts Cost of Goods Available for Sale Less: Ending Inventory Cost of Goods Sold However, there is one weak point about the periodic system which relates to lost, damaged, or stolen merchandise. Because the periodic system determines the cost of goods sold and the ending inventory at the end of the period, it is impossible, during the period, to figure out whether there were any goods

stolen, damaged, or lost. It is rather difficult even at the period end because all goods not available at hand are considered sold. At the same time, it is quite easy to figure out damaged, lost, or stolen goods if a company employs the perpetual system. A simple comparison of the physically counted merchandise on hand at the end of the period and the book balance of the Merchandise Inventory account will do the job. If there is a difference between the two, then some goods were damaged, stolen, or lost. In such a case an adjusting entry is needed to record the goods not available any more. The adjusting entry acts to decrease assets and equity. The equity is decreased by increasing an expense account called Inventory Loss (or sometimes directly increasing the Cost of Goods Sold account). The assets are decreased by reducing the Inventory account. For example, let us assume a company applies the perpetual inventory system and has the book balance of the Merchandise Inventory account of $1,500. The physical count at the end of the period showed that only $1,300 of goods was on hand. The inventory loss of $200 ($1,500 - $1,300) should be recorded as follows: Illustration 14: Effect of recording inventory loss in the horizontal model Assets (200) = = Liabilities n/a + Equity + (200) Rev. - Exp. n/a = Net Inc. (200) Cash Flow n/a

- (200) =

The entry in the general journal looks like this: Illustration 15: Journal entry to record the inventory loss Event No 1 Account titles Inventory Loss (Cost of Goods Sold) Inventory Debit 200 200 Credit

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