Merchandise Inventory Notes

Merchandise Inventory Notes

Overview of Merchandise Inventory

  • Chapter Focus: Accounting for inventory, especially in a perpetual system.

Recording a Sale

  • Two journal entries required:
  • Record the sale.
  • Record the reduction of inventory.
  • Example Entry:
  • Date: June 21
    • Debit: Accounts Receivable $5,000
    • Credit: Sales Revenue $5,000
    • Explanation: Sale on account.
  • Date: June 21
    • Debit: Cost of Goods Sold $3,500
    • Credit: Merchandise Inventory $3,500
    • Explanation: Record the cost of goods sold.

Inventory Accounting Principles

  • **Key Principles: **
  1. Consistency Principle
  2. Disclosure Principle
  3. Materiality Concept
  4. Accounting Conservatism

1. Consistency Principle

  • Ensures businesses use the same accounting methods over time for comparability.
  • Changes in accounting methods must be disclosed in the financial statement notes to inform stakeholders.

2. Disclosure Principle

  • Companies must report sufficient information for external users to make informed decisions.
  • Information reported must be relevant and faithfully represented.
  • Example: Green Mountain Coffee Roasters, Inc. reported descriptive notes in their financials.

3. Materiality Concept

  • Follow accounting practices strictly for significant items.
  • What is considered significant? Items likely to influence decisions, e.g., numbers are often rounded for large corporations.
  • Items below $1,000,000 are typically deemed immaterial.

4. Accounting Conservatism

  • Report less favorable outcomes when presented with two or more options.
  • Key Goals:
  • Do not overstate assets or net income.
  • Anticipate potential losses (not gains).
  • Choose expenses over assets if there's uncertainty.

Inventory Costs Under a Perpetual Inventory System

  • Counting inventory at the period's end while also calculating cost of goods sold based on sold units.
  • Example Calculation:
  • Each unit costs $350.
  • Ending Inventory = 4 units x $350 = $1,400
  • COGS = 14 units x $350 = $4,900.

Inventory Costing Methods

  • Four GAAP-acceptable methods:
  1. Specific Identification
  2. First-in, First-out (FIFO)
  3. Last-in, First-out (LIFO)
  4. Weighted-Average
Specific Identification Method
  • Used for inventory where specific costs can be tracked (e.g., real estate, unique artwork).
FIFO Method
  • Assigns the cost of the oldest inventory first when sold.
  • Results in lower COGS and higher net income when costs are increasing.
LIFO Method
  • Assigns the newest inventory costs when sold.
  • Results in higher COGS and lower net income when costs are rising.
Weighted-Average Method
  • Averages the cost of inventory after each purchase to determine the cost of goods sold.
  • Example Formula: Avg Cost per Unit = Total Inventory $$ / Units on Hand.

Effects on Financial Statements

  • The choice of inventory method affects financial results:
  • In periods of rising inventory costs, FIFO shows the highest gross profit; LIFO shows the highest COGS.
  • In periods of declining inventory costs, the opposite is true.

Lower-of-Cost-or-Market Rule

  • Inventory must be reported at the lower of its cost or market value.
  • Example: If inventory costs $2 million but market value is only $1.2 million, report it at $1.2 million.

Merchandiser's Financial Statements

Types of Income Statements

  1. Single-Step: All revenues and expenses are listed together; no subtotals.
  2. Multi-Step: Highlights significant segments, including gross profit and operating income.

Multi-Step Example

  • Total Revenues: $920,000
  • Total Expenses: $818,580
  • Net Income: $101,420

Inventory Turnover

  • The turnover ratio measures how quickly inventory is sold. Formula:
  • Inventory Turnover = Cost of Goods Sold / Average Merchandise Inventory.

Days' Sales in Inventory

  • Measures how long inventory is held. Important for items with expiration dates.

Inventory Errors

  • Incorrect inventory impacts financial statements significantly:
  • Overstated Ending Inventory: $5,000
  • Gross profit increased; cost of goods sold undervalued.
  • Correct errors to reflect actual performance.