Merchandise Inventory: Principles, Costing Methods, and Financial Statement Effects

Merchandise Inventory: Principles and Controls

Inventory Principles

Merchandise inventory refers to goods held for resale by a business. Proper accounting principles ensure inventory is classified and reported fairly, supporting decision-making by investors and creditors.

• Consistency Principle: Use the same accounting methods and procedures from period to period, allowing for comparability. Any justified change must be disclosed.

• Disclosure Principle: Provide enough relevant information for outsiders to make informed decisions. State the inventory costing method in financial statement notes.

• Materiality Concept: Information is material if it could influence a user’s decision, depending on the company’s size and the item’s nature.

• Conservatism: Exercise caution when uncertainty requires judgment. Do not anticipate uncertain gains; provide for probable losses.

Inventory controls include authorizing purchases, tracking receipts, recording damaged inventory, performing physical counts, and updating sales records. These controls protect both the goods and the reliability of accounting records.

Perpetual Inventory System

Constant Unit Cost Example

Under a perpetual inventory system, inventory records are updated as purchases and sales occur. Unsold inventory remains an asset; sold inventory becomes an expense (Cost of Goods Sold).

• Ending Inventory: $\text{Units on hand} \times \text{Unit cost}$

• Cost of Goods Sold (COGS): $\text{Units sold} \times \text{Unit cost}$

Example: If all units cost $350, and 4 units remain, ending inventory is $1,400. COGS for 14 units sold is $4,900.

Variable Unit Cost Example

When unit costs change, the allocation of costs to COGS and ending inventory depends on the chosen costing method.

• Cost available: $(2 \times 350) + (4 \times 360) + (12 \times 380) = 6,700$

• Four basic inventory costing methods: Specific Identification, FIFO, LIFO, Weighted-Average

Inventory Costing Methods

Specific Identification

This method matches each sold item with its actual acquisition cost. It is suitable for unique, identifiable items.

• COGS: Sum of actual costs of units sold

• Ending Inventory: Sum of actual costs of units remaining

FIFO (First-In, First-Out)

FIFO assigns the oldest available costs to COGS first. The remaining inventory contains the most recent costs.

• COGS: Oldest costs assigned to units sold

• Ending Inventory: Newest costs assigned to units remaining

Journal Entries under FIFO

• Purchases: Debit Merchandise Inventory, Credit Accounts Payable

• Sales: Debit Accounts Receivable, Credit Sales Revenue

• COGS: Debit Cost of Goods Sold, Credit Merchandise Inventory

LIFO (Last-In, First-Out)

LIFO assigns the newest available costs to COGS first. Older costs remain in ending inventory.

• COGS: Newest costs assigned to units sold

• Ending Inventory: Oldest costs assigned to units remaining

Journal Entries under LIFO

• Same structure as FIFO, but COGS and Inventory amounts differ due to cost assignment

Weighted-Average Cost

Recalculate the weighted-average unit cost after each purchase. Each sale uses the average then in effect.

• Weighted-average unit cost: $\text{Current total cost available} \div \text{Current units available}$

Journal Entries under Weighted-Average

• COGS and Inventory entries use the moving-average cost for each sale

Financial Statement Effects of Costing Methods

Income Statement Comparison

Different inventory costing methods affect COGS and gross profit, but not sales revenue.

• FIFO: Lowest COGS, highest gross profit (when costs rise)

• LIFO: Highest COGS, lowest gross profit (when costs rise)

• Weighted-average: Middle values

• Specific identification: Varies with actual units sold

Lower-of-Cost-or-Market Rule (LCM)

LCM compares historical inventory cost with market (replacement cost) and reports the lower amount. If market is below cost, inventory is written down; if market is equal or above cost, no upward adjustment is made.

• Write-down: Debit COGS, Credit Merchandise Inventory for the difference

Inventory Errors and Their Effects

Current Period Errors

Errors in ending inventory affect COGS, gross profit, and net income. Overstated ending inventory understates COGS and overstates profit; understated ending inventory overstates COGS and understates profit.

Errors Carrying into Next Period

An error in ending inventory in one period becomes an error in beginning inventory in the next period, affecting COGS and profit in both periods. The combined effect over two periods offsets, but each period’s statements are incorrect.

Summary Table of Inventory Errors

Inventory Turnover and Days in Inventory

Inventory Turnover

Inventory turnover measures how rapidly a company sells inventory. It is calculated as:

• Average Inventory: $(\text{Beginning Inventory} + \text{Ending Inventory}) \div 2$

• Inventory Turnover: $\text{Cost of Goods Sold} \div \text{Average Inventory}$

A higher turnover suggests faster sales; a lower turnover can indicate excess inventory or slow sales.

Days’ Sales in Inventory

This ratio estimates the average number of days inventory is held before sale:

• Days’ Sales in Inventory: $365 \div \text{Inventory Turnover}$

Lower days indicate faster inventory movement; higher days suggest inventory stays longer and ties up funds.

Periodic Inventory System

Periodic System Calculations

Under a periodic system, inventory is updated at period end. Purchases accumulate separately, and a physical count determines ending inventory and COGS.

• COGS: $\text{Beginning Inventory} + \text{Net Purchases} - \text{Ending Inventory}$

Costing methods (FIFO, LIFO, Weighted-Average) are applied at period end, and results may differ from perpetual system calculations.

Account Reference and Journal Entry Reasoning

Each account has a normal balance (debit or credit) and increases or decreases accordingly. Merchandise Inventory is a current asset with a normal debit balance; COGS is an expense with a normal debit balance.

• Purchases: Debit Purchases, Credit Accounts Payable

• Sales: Debit Accounts Receivable, Credit Sales Revenue

• COGS: Debit Cost of Goods Sold, Credit Merchandise Inventory

Key Takeaways

• Inventory costing methods affect COGS and ending inventory, not sales revenue.

• Errors in inventory balances affect COGS, gross profit, and net income.

• Turnover and days in inventory are important performance metrics.

• Periodic and perpetual systems differ in timing and calculation of inventory balances.