Comprehensive Study Notes on Inventories: Merchandising Activities, Systems, and Valuation Methods

Core Accounting Activities of Merchandising Companies

Accounting for merchandising companies ($商業企業$) focuses on three critical areas as defined in the curriculum for Chapters 6 and 8. These areas include the systematic recording of the acquisition of goods, the recording of the sale of goods, and the determination of the cost of goods sold ($銷售成本$). The central objective of these activities is to track the life cycle of a product from its purchase as an asset to its eventual sale as an expense.

The Operating Cycle of a Merchandising Company

The operating cycle ($營業週期$) represents a continuous series of transactions through which a business generates its revenue and subsequent cash receipts from customers. The process follows a specific flow: it begins with the expenditure of Cash to acquire Inventory ($存貨$). The business then engages in the sale of goods on account, which converts inventory into Accounts Receivable ($應收帳款$). Finally, the collection of cash from customers completes the cycle, returning the asset to Cash form. This cycle is the fundamental mechanism of business operations for any merchandising entity.

Inventory as an Asset and an Expense

Products being held for resale are classified and reported as inventory ($存貨$), which is categorized as a current asset ($流動資產$). By definition, current assets are those expected to be consumed or converted into cash within $12$ months. The flow of inventory costs moves from the Statement of Financial Position to the Income Statement. While the goods remain in the possession of the company, they are recorded as assets at their purchase or manufacturing costs. Once the goods are sold, the costs associated with that inventory are transferred and recognized as an expense known as the Cost of Goods Sold ($銷售成本$). This account captures the amount of inventory expensed during a period to help earn revenue. The difference between the total sales revenues and the cost of goods sold results in Gross Profit ($毛利$), which is a vital metric for measuring the profitability of individual sales transactions.

Income Statement Structure for Merchandising Companies

To illustrate the financial reporting of these companies, consider the condensed income statement of Computer City for the year ended 31 December 2010. Revenue from sales is reported at the top, totaling $\$9,000,000$. From this, the Cost of goods sold (amounting to $\$5,400,000$) is subtracted to arrive at a Gross profit of $\$3,600,000$. After deducting further expenses of $\$2,700,000$, the final Profit is calculated as $\$900,000$. This structure emphasizes that gross profit must be sufficient to cover all other operating expenses to result in a net profit.

Two Approaches to Inventory Accounting: Perpetual vs. Periodic Systems

There are two primary systems used to account for merchandise inventories. The first is the Perpetual Inventory System ($永續盤存制$), which keeps a running, continuous record of inventories and the cost of goods sold on a day-to-day basis. Under this system, the inventory amount can be determined at any given point in time. Due to advancements in computerized accounting technology, this approach is now considered easy, cost-effective, and is the method used by most modern companies.

The second approach is the Periodic Inventory System ($定期盤存制$). In this system, no effort is made to keep up-to-date records of inventory or units sold. Instead, the cost of goods sold is computed only periodically by relying solely on physical counts ($庫存盤點$). The inventory and cost of goods sold accounts are typically only updated at the end of the accounting period.

Detailed Transactions under the Perpetual Inventory System

In a perpetual system, specific journal entries are required to reflect the continuous updates to the accounts. When inventory is purchased on account, the entry is: $\text{Dr Inventory xxx}$ $\text{Cr Accounts payable (or Cash) xxx}$

When inventory is sold, two distinct entries must be made. The first recognizes the revenue earned: $\text{Dr Accounts receivable (or Cash) xxx}$ $\text{Cr Sales revenue xxx}$

The second recognizes the expense incurred by converting the asset to an expense: $\text{Dr Cost of goods sold xxx}$ $\text{Cr Inventory xxx}$

As a practical example, on 5 September, Worley Co. purchased $100$ laser lights for $\$30$ per unit on account ($100 \times 30 = \$3,000$). On 10 September, they sold $10$ units for $\$50$ per unit on account. The revenue entry recorded a Debit to Accounts Receivable for $\$500$ ($10 \times 50$) and a Credit to Sales for $\$500$. Simultaneously, the cost entry recorded a Debit to Cost of Goods Sold for $\$300$ ($10 \times 30$) and a Credit to Inventory for $\$300$. Payments are recorded normally, such as a Debit to Accounts Payable and a Credit to Cash when paying suppliers, or a Debit to Cash and a Credit to Accounts Receivable when collecting from customers.

Inventory Shrinkage and Physical Counts

To ensure the accuracy of perpetual records, businesses must perform a physical count of inventory at least once a year. Discrepancies often arise, known as inventory shrinkage ($庫存短缺$), which can be caused by breakage, spoilage, or theft. Reasonable amounts of shrinkage are viewed as a normal cost of business. For instance, if Worley Co. discovers a shortage of $\$2,000$ on 31 December, they record: $\text{Dr Cost of Goods Sold 2,000}$ $\text{Cr Inventory 2,000}$

Detailed Transactions and COGS Calculation in the Periodic System

Under the Periodic Inventory System, transactions differ significantly from the perpetual method. When inventory is purchased, it is recorded to a "Purchases" account rather than the "Inventory" asset account. For example, Worley Co.'s 5 September purchase would be recorded as: $\text{Dr Purchases 3,000}$ $\text{Cr Accounts Payable 3,000}$

When a sale occurs, only the revenue entry is recorded; no entry is made to record the cost of goods sold or to reduce the inventory balance at that time. To find the Cost of Goods Sold at the end of the period, the company must use the following formula: $\text{Beginning Inventory} + \text{Purchases} = \text{Cost of Goods Available for Sale}$ $\text{Cost of Goods Available for Sale} - \text{Ending Inventory (from physical count)} = \text{Cost of Goods Sold}$

Example calculation:

• Inventory (beginning of year): $\$14,000$

• Add: Purchases: $\$130,000$

• Cost of goods available for sale: $\$144,000$

• Less: Inventory (end of year): $\$12,000$

• Cost of goods sold (computed): $\$132,000$

To close these accounts at year-end, entries are made to create the Cost of Goods Sold account, such as: $\text{Dr Cost of Goods Sold 144,000}$ $\text{Cr Inventory (beginning) 14,000}$ $\text{Cr Purchases 130,000}$

Inventory Valuation Methods under IFRS

When identical units of inventory are purchased at different unit costs, companies must choose an inventory valuation method. There are three methods generally accepted under IFRS:

1. Specific Cost Identification

2. Weighted Average Cost ($平均成本法$)

3. First-In, First-Out (FIFO)

The choice of method can significantly affect the reported profit and the value of ending inventory on the Statement of Financial Position.

Specific Cost Identification Method

This method involves the physical tracing of the particular items sold. It is most effective for high-value, low-volume merchandise where units are unique and easy to track, such as automobiles or jewelry. When a unit is sold, its specific acquisition cost is added to the Cost of Goods Sold. Using "The Bike Company" (TBC) as an illustration: if they sell $20$ bikes where $9$ cost $\$91$ and $11$ cost $\$106$, the COGS is calculated as: $(9 \times 91) + (11 \times 106) = \$1,985$. This leaves specific remaining units in the inventory balance.

Weighted Average Cost Method

This method computes a unit cost by dividing the total acquisition cost of all items available for sale by the total number of units available. This calculation must be performed prior to each sale in a perpetual system. The formula for the average cost is: $\frac{\text{Total Cost of Goods Available for Sale}}{\text{Total Number of Units Available for Sale}}$ For TBC, if they have $25$ units with a total cost of $\$2,500$, the average cost is $\$100$ ($2,500 / 25$). If they sell $20$ units, the COGS is $20 \times 100 = \$2,000$. If they then purchase more units at different prices, a new weighted average must be calculated before the next sale.

First-In, First-Out (FIFO) Method

The FIFO method assumes that the first items purchased are the first ones sold. Consequently, the cost of the earliest units acquired is assigned to the Cost of Goods Sold, while the costs of the most recently purchased units remain in ending inventory. This method reflects the flow of costs but does not necessarily match the actual physical flow of goods. For TBC, if the first $10$ units cost $\$91$ and the next $15$ cost $\$106$, a sale of $20$ units would result in a COGS of: $(10 \times 91) + (10 \times 106) = \$1,970$. The ending inventory would then consist of the remaining $5$ units at the more recent price of $\$106$ ($\$530$ total).

Comparative Analysis and Economic Implications

Each valuation method has distinct effects on financial reporting. Specific identification accurately parallels physical flow but can be misleading for identical units. Weighted average assigns all units the same cost, averaging current costs with older ones. FIFO values ending inventory at current costs, but during periods of rising prices, it may overstate profit because the COGS is based on older, lower costs. This increased profit can, in turn, increase the income taxes due.

Comparison of TBC’s Sales Revenue ($\$6,050$) under different methods:

• FIFO: COGS = $\$4,570$; Gross Profit = $\$1,480$; Tax (at 10%) = $\$148$; Profit after tax = $\$1,332$.

• Weighted Average: COGS = $\$4,622$; Gross Profit = $\$1,428$; Tax (at 10%) = $\$142.80$; Profit after tax = $\$1,285.20$.

The Principle of Consistency

The Principle of Consistency ($一貫性原則$) dictates that once a company adopts a particular accounting method, it should follow that method consistently from one year to the next. This allows users of financial statements to make easier comparisons across different periods. While a company may change its accounting principles if there is a justifiable reason, it must generally apply the chosen inventory flow assumption to all sales of that specific merchandise type.