Accounting for Merchandise Inventory: Transactions, Financial Statements, and Shipping Terms

This chapter focuses specifically on the analysis and recording of transactions related to merchandise inventory, utilizing the JPS business as a primary example.

Transaction Description: JPS purchased merchandise inventory for $14,000$ cash.
Inventory Increase: When a business purchases inventory, the asset account "Merchandise Inventory" increases.
Journal Entry:
- Debit Merchandise Inventory: $14,000$
- Credit Cash: $14,000$
Posting to the General Ledger (T-Accounts):
- Merchandise Inventory T-account: A debit entry of $14,000$ is posted to the left side.
- Cash T-account: A credit entry of $14,000$ is posted to the right side.

Terminology: In accounting, the word "recognized" is used interchangeably with the word "recorded."
Transaction Description: JPS recognized sales revenue from selling inventory for $12,000$ cash.
Revenue Recognition: Since cash was received as a result of the sale, the asset account "Cash" increases and the equity account "Sales Revenue" increases.
Journal Entry (Part A):
- Debit Cash: $12,000$
- Credit Sales Revenue: $12,000$
Posting to the General Ledger (T-Accounts):
- Cash T-account: A debit entry of $12,000$ is posted to representing the inflow of cash.
- Sales Revenue T-account: A credit entry of $12,000$ is posted to record the earnings.

Concept: Retailers typically sell merchandise for a price higher than the original purchase cost. For financial reporting, the cost of the inventory actually sold must be removed from the inventory account and recorded as an expense.
Transaction Description: JPS recognized $8,000$ of Cost of Goods Sold (COGS).
Analytical Breakdown: While the inventory was sold for $12,000$ (Event 3a), JPS had originally paid only $8,000$ for that specific inventory.
The Nature of COGS: Cost of Goods Sold is an expense account. To record or increase an expense, the account must be debited.
Journal Entry (Part B):
- Debit Cost of Goods Sold: $8,000$
- Credit Merchandise Inventory: $8,000$
Posting to the General Ledger (T-Accounts):
- Cost of Goods Sold T-account: A debit entry of $8,000$ is posted on the left side.
- Merchandise Inventory T-account: A credit entry of $8,000$ is posted to show the reduction in inventory on hand.

Data for financial statements is derived from the Trial Balance, which in turn reflects the balances in the General Ledger (T-accounts).

Structure Change: Unlike service businesses, merchandising firms include a specific deduction for the cost of items sold.
Gross Margin Calculation:
- Sales Revenue: $12,000$
- Less: Cost of Goods Sold: $(8,000)$
- Gross Margin (or Gross Profit): $4,000$ ( $12,000 - 8,000 = 4,000$ )
Operating Expenses: Selling and Administrative expenses are deducted from the Gross Margin.
- Selling and Administrative Expense: $1,000$
Net Income Calculation:
- $4,000 \text{ (Gross Margin)} - 1,000 \text{ (Operating Expenses)} = 3,000$
Profitability Assessment: The business is profitable because Sales Revenue ( $12,000$ ) exceeds Total Expenses ( $9,000$ , comprising $8,000$ COGS and $1,000$ Selling/Admin).

Asset Section Adjustments: Merchandising businesses include "Merchandise Inventory" as a current asset.
Account Balances:
- Cash Balance: $6,500$ (per general ledger).
- Merchandise Inventory Balance: $6,000$ ( $14,000 \text{ original debit} - 8,000 \text{ credit from sale} = 6,000$ ).
- Land: $5,500$ .
- Total Assets: $6,500 + 6,000 + 5,500 = 18,000$ .
Liabilities and Equity:
- Accounts Payable: $0$ .
- Common Stock: $15,000$ .
- Retained Earnings: $3,000$ ( $\text{Beginning Balance } 0 + \text{Net Income } 3,000 - \text{Dividends } 0 = 3,000$ ).
- Total Liabilities and Stockholders' Equity: $0 + 15,000 + 3,000 = 18,000$ .
Accounting Equation: Total Assets ( $18,000$ ) = Total Liabilities + Stockholders' Equity ( $18,000$ ).

When goods are purchased, transportation costs are often incurred. The party responsible for these costs and the timing of the ownership transfer depends on the "shipping terms."
FOB (Free On Board): The acronym used to denote shipping terms.

Ownership Transfer: The buyer acquires legal ownership of the goods as soon as the seller delivers them to the shipper/carrier.
Responsibility: Because the buyer owns the goods while they are in transit, the buyer is responsible for the transportation costs.
Accounting Treatment: Transportation costs are treated as part of the cost of the inventory.
Buyer's Journal Entry:
- Debit Merchandise Inventory (for the cost of transportation)
- Credit Cash (or Accounts Payable if not paid in cash)

Ownership Transfer: The buyer does not own the inventory until the goods actually reach the buyer's location (the destination).
Responsibility: The seller typically owns the goods during transit in this scenario.
Accounting Treatment: The buyer does not record shipping costs for goods purchased under FOB Destination terms because the buyer does not own the inventory while it is being transported.

A multistep income statement provides more detailed information than a single-step statement by distinguishing between operating and non-operating activities.

Gross Margin Section:
- Sales Revenue: $24,750$
- Less: Cost of Goods Sold: $(12,000)$
- Gross Margin: $12,750$
Operating Income Section: Deducts expenses related to the primary day-to-day operations of the business.
- Selling and Administrative Expenses: $5,000$
- Transportation Out: $450$
- Operating Income Calculation: $12,750 \text{ (Gross Margin)} - 5,000 - 450 = 7,300$
Non-Operating Items Section: Items that do not relate to the daily primary operation of the business.
- Interest Expense: An expense that must be subtracted ( $360$ ).
- Gain on Sale of Land: A profit from an incidental transaction, which is added ( $700$ ).
Final Net Income Calculation:
- Operating Income: $7,300$
- Less: Interest Expense: $(360)$
- Add: Gain on Sale of Land: $700$
- Net Income: $7,640$