Merchandise Inventory, Inventory Costing, Cash & Internal Controls, and Receivables: Principles of Accounting Study Guide

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Merchandise Inventory

Purchase of Merchandise Inventory

Merchandise inventory transactions involve recording purchases, returns, allowances, discounts, and freight costs. Accurate accounting ensures proper valuation and reporting of inventory.

Purchase Returns and Allowances: When merchandise is returned or an allowance is granted, the buyer reduces both Accounts Payable and Merchandise Inventory. Journal Entry: Debit Accounts Payable; Credit Merchandise Inventory.
Purchase Discounts: Vendors may offer discounts for early payment (e.g., 2/10, n/30). Example: $1,000 purchase with 2% discount: $1,000 x 2% = $20 discount; payment = $980. Journal Entry: Debit Accounts Payable $1,000; Credit Cash $980; Credit Merchandise Inventory $20.
Net Cost of Inventory Purchased: Net cost considers purchase price, returns, discounts, and freight-in. Formula: Example: $1,000 purchase, $65 returns, $20 discounts, $80 freight-in: Net cost = $995.

Sale of Merchandise Inventory

Sales of merchandise require recording both revenue and the cost of goods sold under a perpetual inventory system.

Compound Journal Entry for Sales: 1. Record sale: Debit Accounts Receivable or Cash; Credit Sales Revenue. 2. Record cost: Debit Cost of Goods Sold; Credit Merchandise Inventory.
Sales Returns and Allowances: When merchandise is returned, two entries are made if goods are resalable: 1. Debit Sales Returns and Allowances; Credit Accounts Receivable. 2. Debit Merchandise Inventory; Credit Cost of Goods Sold.
Sales Discounts: Sellers offer discounts for early payment. Example: $5,000 sale, 1% discount: $5,000 x 1% = $50; cash received = $4,950. Journal Entry: Debit Cash $4,950; Debit Sales Discounts $50; Credit Accounts Receivable $5,000.
Gross Profit Calculation: Step 1: Net Sales Revenue = Sales Revenue - Sales Returns and Allowances - Sales Discounts Step 2: Gross Profit = Net Sales Revenue - Cost of Goods Sold Example: Net Sales Revenue = $4,950; COGS = $2,000; Gross Profit = $2,950.

Credit Terms, Freight Costs, and Shrinkage

Understanding credit terms, freight costs, and inventory shrinkage is essential for accurate inventory accounting.

Credit Terms: Specify payment timing and discounts (e.g., 2/10, n/30 means 2% discount if paid within 10 days, full payment due in 30 days).
Freight Costs: FOB Shipping Point: Buyer pays freight; Debit Merchandise Inventory. FOB Destination: Seller pays freight; Debit Delivery Expense.
Inventory Shrinkage: Losses due to theft, damage, or errors. Formula: Example: $5,000 book inventory, $4,700 physical inventory; shrinkage = $300. Journal Entry: Debit Cost of Goods Sold $300; Credit Merchandise Inventory $300.

Inventory Costing

Key Accounting Principles

Inventory accounting is governed by several principles to ensure accurate and fair reporting.

Materiality: Small amounts may be treated simply if they do not affect decisions.
Matching Principle: Expenses are recorded in the same period as related revenues (e.g., COGS when merchandise is sold).
Conservatism: Choose options that do not overstate assets or income (e.g., lower-of-cost-or-market).
Disclosure: Important information must be disclosed to users.

Weighted Average Cost Method

The weighted average method assigns an average cost to each unit of inventory.

Weighted Average Cost Per Unit: Formula: Example: $80,554 total cost, 514 units: $80,554 \div 514 = $156.72 per unit.
COGS and Ending Inventory: COGS = UnitsSold x AverageCost Ending Inventory = UnitsRemaining x AverageCost Example: 338 units sold, 176 units remaining, $156.72 average cost: COGS = $52,971.36; Ending Inventory = $27,582.72.
Gross Profit: Example: $82,810 sales revenue, $52,971.36 COGS; Gross Profit = $29,838.64.

FIFO Method

FIFO (First In, First Out) assumes the oldest inventory is sold first.

COGS Calculation: COGS is based on the cost of the oldest inventory layers. Example: 338 units sold: 34 units at $145, 60 at $152, 244 at $156; Total COGS = $52,114.
Ending Inventory: Remaining units are valued at the most recent costs. Example: 12 units at $156, 164 at $162; Ending Inventory = $28,440.
Gross Profit: Example: $82,810 sales revenue, $52,114 COGS; Gross Profit = $30,696.

Lower-of-Cost-or-Market Rule

Inventory is reported at the lower of historical cost or market value, following the conservatism principle.

Application: Example: Historical cost = $5,000; Market value = $4,300; Inventory reported = $4,300.

Inventory Errors

Errors in ending inventory affect COGS and gross profit.

COGS Formula:
Effects of Errors: Inventory too high: COGS too low, Gross Profit too high. Inventory too low: COGS too high, Gross Profit too low.

Cash and Internal Controls

Bank Reconciliation

Bank reconciliation matches the company's cash records with the bank statement, identifying necessary adjustments.

Bank-Side Adjustments: Add deposits in transit; subtract outstanding checks.
Book-Side Adjustments: Add bank collections and interest; subtract service charges, NSF checks, and errors.
Adjusted Cash Balance: Both bank and book sides must reconcile to the same amount. Example: Adjusted balance = $7,357.

Journal Entries for Reconciliation Items

Some reconciliation items require journal entries, while others do not.

Requires Entry: Bank collections, service charges, NSF checks.
No Entry: Deposits in transit, outstanding checks, bank errors.
Example: Bank collection of A/R: Debit Cash; Credit Accounts Receivable. Service charge: Debit Expense; Credit Cash.

Petty Cash

Petty cash is used for minor expenses, managed under the imprest system.

Imprest System: Cash remaining plus receipts equals the petty cash fund. Formula:
Examples: Stamps, office supplies, small meals.

Cash Overage/Shortage

Cash Short and Over account records discrepancies between expected and actual cash.

Shortage: Debit Cash Short and Over.
Overage: Credit Cash Short and Over.
Example: Petty cash fund $100, receipts $72, actual cash $25; expected cash $28; shortage $3. Journal Entry: Debit Expenses $72; Debit Cash Short and Over $3; Credit Cash $75.

Receivables and Notes Receivable

Allowance for Bad Debts

The allowance method estimates uncollectible accounts, ensuring receivables are not overstated.

Allowance for Bad Debts: Contra-asset account with a credit balance; reduces Accounts Receivable.
Bad Debts Expense: Expense account; recorded in the same period as sales.
Net Accounts Receivable Formula:

Percent-of-Sales Method

This method estimates bad debts expense as a percentage of net credit sales.

Formula:
Example: $80,000 sales, 3% estimated uncollectible: $2,400 expense.
Journal Entry: Debit Bad Debts Expense; Credit Allowance for Bad Debts.

Write-Off and Recovery of Uncollectible Accounts

When an account is deemed uncollectible, it is written off; if later collected, it is reinstated and cash is received.

Write-Off: Debit Allowance for Bad Debts; Credit Accounts Receivable.
Recovery: 1. Reinstate: Debit Accounts Receivable; Credit Allowance for Bad Debts. 2. Collect: Debit Cash; Credit Accounts Receivable.

Aging Schedule Method

The aging method estimates uncollectibles based on the age of receivables.

Calculation: Multiply each age category by its estimated uncollectible percentage; sum for total allowance.
Bad Debts Expense: Target allowance minus existing credit balance (add if existing balance is debit).
Example Table:

Age	A/R Balance	Uncollectible %	Estimated Uncollectible
Current	$10,000	2%	$200
1–30 days	$5,000	5%	$250
31–60 days	$3,000	10%	$300
Over 60 days	$2,000	20%	$400
Total			$1,150

Journal Entry: Debit Bad Debts Expense; Credit Allowance for Bad Debts.

Net Accounts Receivable Calculation

Net accounts receivable is the amount expected to be collected.

Formula:
Example: A/R $20,000; Allowance $1,500; Net A/R = $18,500.

Notes Receivable: Maturity and Interest

Notes receivable earn interest and have a specific maturity date.

Maturity Date: Count days from the day after issuance; include the final day.
Interest Calculation: Formula: For a 360-day year: Example: $6,000 principal, 12%, 30 days: $6,000 \times 12\% \times \frac{30}{360} = $60.
Collection at Maturity: Steps: 1. Record issuance; 2. Accrue interest; 3. Record collection. Example: $6,000 note, $60 accrued interest, $300 remaining interest; total cash received = $6,360.

Additional info:

All journal entries and formulas are based on the perpetual inventory system and standard accounting practices.
Examples are simplified for clarity and exam preparation.