Inventory and Merchandizing Operations: Financial Accounting Study Notes

Inventory and Merchandizing Operations

Introduction

This section covers the accounting principles and procedures related to inventory and merchandising operations, including the nature of inventory, recording inventory transactions, inventory costing methods, and the evaluation of inventory management using financial ratios.

Nature of Inventory and Retailing Operations

Inventory in Financial Accounting

• Inventory refers to goods held for resale (merchandisers) or for use in production (manufacturers).

• When inventory is sold, its cost shifts from an asset (Inventory) to an expense (Cost of Goods Sold) on the income statement.

• For manufacturers, inventory includes raw materials, work in progress (WIP), and finished goods.

Recording Inventory-Related Transactions

Journal Entries for Inventory Transactions

• Purchasing inventory increases the Inventory account (asset) and increases Accounts Payable (liability) if bought on credit.

• Selling inventory increases Sales (revenue) and Accounts Receivable (if on credit), while Cost of Goods Sold (expense) is recorded and Inventory is decreased.

Example Journal Entries:

Date	Accounts and Explanation	Debit	Credit
5/10	Purchased inventory on account (3 shirts at $30 each)	90,000	90,000
9/10	Sold inventory on account (2 shirts at $50 each)	100,000	100,000
9/10	Recorded cost of goods sold	?	?

Inventory Systems

	Perpetual	Periodic
Usage	All types of goods	Inexpensive goods
Tracking	Keeps a running total of all goods bought, sold, and on hand	Does not keep a running total; inventory counted at least once a year

Inventory Costing Methods

Overview

• Inventory costing methods determine how costs are assigned to inventory and cost of goods sold.

• Main methods: Specific Unit, First-In, First-Out (FIFO), Last-In, First-Out (LIFO), Average Cost.

Specific Unit Method

• Used for unique, high-value items (e.g., automobiles, jewelry).

• Inventory recorded at the specific cost of each unit.

• Not practical for homogeneous goods.

First-In, First-Out (FIFO)

• Assumes oldest inventory items are sold first.

• Ending inventory consists of most recent purchase costs.

• Favored by IFRS.

Example:

Beg balance	10 units @ $10 = $100
Purchases	25 units @ $14 = $350 25 units @ $18 = $450
Cost of goods sold (40 units)	10 @ $10 = $100 25 @ $14 = $350 5 @ $18 = $90
Ending Balance	20 units @ $18 = $360

Last-In, First-Out (LIFO)

• Assumes most recent inventory items are sold first.

• Oldest costs remain in ending inventory.

• Not allowed under IFRS.

Example:

Beg balance	10 units @ $10 = $100
Purchases	25 units @ $14 = $350 25 units @ $18 = $450
Cost of goods sold (40 units)	25 @ $18 = $450 15 @ $14 = $210
Ending Balance	10 units @ $10 = $100 10 units @ $14 = $140

Average Cost Method

• Calculates a weighted average cost per unit for all inventory available for sale.

• Cost of goods sold and ending inventory are based on this average cost.

Formulas:

• Average cost per unit: $\frac{\text{Cost of goods available}}{\text{Number of units available}}$

• Cost of goods sold: $\text{Number of units sold} \times \text{Average cost per unit}$

• Ending inventory: $\text{Number of units on hand} \times \text{Average cost per unit}$

Example:

Beg balance	10 units @ $10 = $100
Purchases	25 units @ $14 = $350 25 units @ $18 = $450
Cost of goods sold (40 units @ $15)	$600
Ending Balance	20 units @ $15 = $300

Impact of Inventory Methods on Financial Statements

Increasing Inventory Prices

	Cost of Goods Sold	Ending Inventory
FIFO	Lowest (older, less expensive costs)	Highest (recent, more expensive costs)
LIFO	Highest (recent, more expensive costs)	Lowest (older, less expensive costs)

Decreasing Inventory Prices

	Cost of Goods Sold	Ending Inventory
FIFO	Highest (older, more expensive costs)	Lowest (recent, less expensive costs)
LIFO	Lowest (recent, less expensive costs)	Highest (older, more expensive costs)

Additional info: LIFO is often used for tax purposes in the US, as it can reduce taxable income when prices are rising.

Principles Related to Inventories

Comparability Principle

• Businesses should use the same accounting methods year-to-year to allow for meaningful comparisons.

• Changes in methods are allowed but must be disclosed, including the effect on net income.

Net Realizable Value (NRV)

• NRV is the estimated selling price in the ordinary course of business, less costs of completion and sale.

• Inventory is reported at the lower of cost or NRV. If NRV is lower, inventory is written down.

Manufacturing Companies and Inventory

Types of Inventory

• Raw materials: Direct materials used in production.

• Work in progress (WIP): Unfinished products; includes direct materials, direct labor, and manufacturing overhead.

• Finished goods: Completed products ready for sale.

Allocation of Manufacturing Overheads

• Overheads are allocated based on normal capacity (average expected production under normal circumstances).

• If actual production exceeds normal, overhead is allocated based on actual production.

• If actual production is less than normal, overhead is allocated based on normal capacity, and the difference is expensed.

Example Table:

Situation	Actual Production	IPO Allocation per Unit
Normal	5,000	2,400
Overproduction	6,000	2,000
Underproduction	4,000	2,400 (difference expensed)

Evaluating Inventory Management

Gross Profit Percentage

• Measures a company's ability to cover operating costs and earn a profit.

• Formula: $\text{Gross Profit Percentage} = \frac{\text{Revenue} - \text{Cost of Goods Sold}}{\text{Revenue}} \times 100\%$

Inventory Turnover

• Indicates how efficiently inventory is managed and sold.

• Formula: $\text{Inventory Turnover} = \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}$

• Where Average Inventory = $(\text{Beginning Inventory} + \text{Ending Inventory}) / 2$