Principles of Accounting

Chapter 5
Inventory and
Merchandising
Operations
 Learning Objectives

•Understand the nature of inventory and retailing operations

•Record inventory-related transactions
•Understand and apply different inventory cost assumptions
service comp = not have investting
manifactoring 1 raw materals 2 senior 3 fnsh products
merchansing comp

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Contrasting a Service Company with a
Merchandiser

Merchandisers have two accounts that service entities don’t

need:
• Cost of goods sold on the income statement
• Inventory on the balance sheet
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Inventory and Cost of Goods Sold When
Inventory Cost Is Constant

Assume a retailer has in

stock 3 shirts that cost
$30 each. The store
sells 2 of the shirts for
$50 each.

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Understand the nature of inventory
and retailing operations
The cost of inventory sold shifts from asset to expense when
the seller delivers goods to the buyer.

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Understand the nature of inventory
and retailing operations
Inventory Cost Flow in a Merchandising Company

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Understand the nature of inventory
and retailing operations
• Sales Price vs. Cost of Inventory
– Sales revenue is based on the sale price of inventory sold
– Cost of goods sold is based on the cost of inventory sold

Cost of goods sold (income statement) = Number of units of inventory sold × Cost per unit of inventory

– Inventory on the balance sheet is based on the cost of

inventory still on hand

Inventory (balance sheet)= Number of units of inventory on hand × Cost per unit of inventory

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Sale Price vs. Cost of Inventory
Number of Units of Inventory
– Determined from accounting records
– Evidenced by physical count at year-end
– Consigned goods:
 Do not include those held for another company
 Include those out on consignment
– In transit goods treatment depends on shipping terms

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Inventory Systems

• Information on inventories is very important for

merchandising companies, as most of their activities base
on inventories. In accounting for inventories, these
companies have two options:
1.Periodic inventory system
2.Perpetual inventory system

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 Inventory Systems
Periodic Inventory System:
• Periodic inventory system is used by the companies with
inexpensive inventories and manual accounting systems.
• In periodic inventory system, there is no record for Cost of
Goods Sold (COGS) until the end of accounting period
• The formula that is used to calculate COGS is:
COGS = Beginning Inventory + Purchases – Ending Inventory

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 Inventory Systems
Perpetual Inventory System:
• Perpetual inventory system has widespread use

• Companies continuously update the inventory account

whenever a transaction occurs
• The purchases of inventories are directly debited to inventory
account, while the cost of inventories are credited when they
are sold.
• Companies may have accurate information on inventories
they have anytime they need.

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Periodic Inventory- Perpetual Inventory
System System
Periodic Inventory System
• Used for inexpensive goods
• Does not keep a running record of all goods bought, sold, and
on hand
• Inventory counted at least once a year
Perpetual Inventory System
• Used for all types of goods
• Keeps a running record of all goods bought, sold, and on hand
• Inventory counted at least once a year

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Accounting for Purchase Transactıons
in a Perpetual Inventory System
• The cycle of a merchandising company begins with the
purchase of merchandise inventory.
• They normally record purchases when they receive the goods
from the seller.
• Business documents provide written evidence of the
transaction.
• An invoice is a seller’s request for payment from a purchaser.
Invoices are also called bills

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Purchase of Merchandising Inventory on Cash
Example: On April 1, Anatolian Company purchased 500 units of drinking
glasses from Best Glass Company in Eskişehir to sell in its showroom in Izmir.
Price of a glass is 6.00 $ Suppose Anatolian Company receives the goods on
April 1, and makes payment on that date.

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Fright in (Transportation Cost)
Example:On April 2, Anatolian Company paid a 200 $ freight charge for an
April 1st purchase with FOB shipping point.

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Purchase of Merchandising Inventory on Account
Example: Assume that on April 3, instead of paying cash, Anatolian Company
purchased 500 units of tea glasses from First Glass Company in Antalya to
sell in its showroom in Izmir on account. Price of a glass is 5.00 $

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 Purchase Returns and Allowances

• Purchase returns exist when sellers allow purchasers to return

merchandise that is defective, damaged, or under-performing.

• When the purchaser returned the goods to the seller for credit if the sale
was made on credit, or for a cash refund if the purchase was for cash.

• The purchaser may prefer keeping the unsatisfactory merchandise if the

seller is willing to grant an allowance (deduction) from the purchase price.

• This transaction is known as a purchase allowance.

• In these cases, cost of the merchandise to the buyer decreases.

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Purchase Returns
Example: On April 3, when Anatolian Company received the glasses, the
quality checks detected 50 glasses with scratches on them. Therefore, on April
7, Anatolian Company returned these 50 glasses and demanded refunding.

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Purchase Allowances
Example: On April 7, Anatolian Company realized that there were 20 more
glasses with a different design, next to the scratched ones. However, these
different designed glasses are kept in the warehouse, because First Glass
offered to reduce the price to 1.00 from 5.00 $ per glass. The cost of inventory
and the liability to First Glass have both declined by 80 $ [20 glasses x (5.00 –
1.00)].

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 Purchase Discount
• A purchase discount is a discount that businesses offer to purchasers as
an incentive for early payment.
• The cash discount is related to the timing of payment.
• If the buyer pays the invoice price within a certain number of days before
the maturity, a predetermined rate of discount is applied on invoice amount
by mentioning credit terms.
• Such a discount or credit terms is shown as %/d1. n/d2, where
%= discount rate
d1 = number of days discount can be applied
n = net payment
d2 = maturity
• For example, “2/10, n/30” means a 2% discount if paid within 10 day;
otherwise, the full amount is due in 30 days.

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Purchase Discount
• Example: Suppose that credit terms of Purchase of Inventory on April 3 from
First Glass Company is 3/10; n/30. Let’s assume that Anatolian Company
made payment on April 13.
• The first step is to determine the ending balance of “Accounts Payable” to use
as the basis for cash discount if the payment is made within the discount
period. T-Accounts for Merchandise Inventory and Accounts Payable on April
13 are represented below:

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 Purchase Discount

• The debt amount of Anatolian Company to First Glass Company is 2,170 $

(2,500 – 250 – 80).
• Accounts payable is credited by 2,500 $ for the purchase but purchase
returns and purchase allowances decrease the payable by debit entries of
250 $ and 80 $, respectively.
• At the end, Accounts Payable has 2,170 $ credit balance.
• Anatolian Company makes payment in discount period, therefore Anatolian
Company will pay 3% less.
• The cash discount amount is 65.10 $ (2,170 x 3%), and Anatolian
Company pays 2,104.90 $ (2,170 – 65.10)

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 Purchase Discount
• When Anatolian Company pays on April 13, which is within the discount
period, the cash payment entry would be:

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 Purchase Discount
• Alternative Situation: If Anatolian Company pays on due date, which is not
within the discount period, the cash payment entry would be:

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 Cost of Inventory Purchased

• Knowing the net cost of inventory allows a business to determine the actual
cost of the merchandise purchased. Net cost of inventory is calculated as
follows:

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 Accounting for Sales Transactıons
in a Perpetual Inventory System
• The amount a business earns from selling merchandise inventory is
called Sales Revenue.
• Two entries are required to record sale transactions:
1. The first entry is necessary to record the earned sales revenue: The
seller increases (debits) Cash (or Accounts Receivable, if a credit sale),
and also increases (credits) Sales Revenue for the invoice price of the
goods.
2. The second entry records the expense side of the sales event (the cost
of the merchandise sold): The seller increases (debits) Cost of Goods
Sold, and also decreases (credits) Merchandise Inventory for the cost of
those goods.

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Sale of Merchandising Inventory on Cash
Example: Suppose that Anatolian Company sold 100 units of drinking glasses
to a customer for cash On April 18. Sales price of a glass is 7.00 $.
Anatolian Company records this cash sales of 700 $ by debiting Cash and
crediting Sales Revenue as follows:

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Sale of Merchandising Inventory on Cash
• Anatolian Company sold goods. Therefore, a second journal entry must also
be made to decrease the Merchandise Inventory balance. Suppose these
goods cost Anatolian Company 600 $ .
• Under the perpetual inventory system, the cost of merchandise sold and the
reduction in merchandise inventory should also be recorded.
• The second journal entry will transfer the 600 $ from the Merchandise
Inventory account to the Cost of goods sold account, as follows:

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Sale of Merchandising Inventory on Account
• Example: Suppose that Anatolian Company sold another 100 units of
drinking glasses to another customer on credit on April 20. But sales price of
a glass is 8.00 $.
• Anatolian Company records this credit sales of 800 $ by debiting Accounts
Receivable and crediting Sales Revenue as follows:

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Sale of Merchandising Inventory on Account
• The second journal entry will transfer the 600 $ from the Merchandise
Inventory account to the Cost of Goods Sold account, as follows:

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Transportation for The Sold of
Merchandise Inventory
• In FOB shipping point type of transportations, the seller is responsible from
the goods only up to the shipment point, these agreements are freight-in
agreements from the buyer’s perspective.
• For the seller,since the transportation cost (freight) is not under the seller’s
responsibility, these agreements are called freight-out.
• If the seller pays the transportation cost on behalf of the buyer, the amount
is debited to accounts receivable and credited to cash account
• if the shipment terms are FOB destination, the seller is responsible from the
inventories until the final destination and transportation cost is paid by the
seller.
• This is a freight-in agreement for the seller. In these kinds of sales
transactions, seller records the amount paid for transportation as delivery
expense, which is a kind of marketing expense.
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Transportation for The Sold of
Merchandise Inventory
Example: Suppose that on April 21 Anatolian Company paid 50 $ to the
transportation company for the sold items for April 20 sales. FOB destination
point.

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 Sales Returns and Allowances
• Sales returns and allowances decrease the net amount of revenue earned
on sales. When goods are returned from the buyer, this can be accepted as
a partial cancellation of the sales.
• Therefore, receivables should be decreased to the extent sales are
cancelled.
• On the other hand, return of sold goods is recorded under an account
called “Sales Returns & Allowances”.
• This contra-sales revenue account is reported below the “Sales Revenue”
in income statement to calculate “Net Sales”.
• Under the perpetual inventory system, another entry should also be
prepared to present the increase in inventories and decrease
in/cancellation of COGS as a result of the return.

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 Sales Returns
• Example: On April 25, half of the 100 units of drinking glasses sold on credit
on April 20 is returned.
• Return of 50 glasses will cause decreases in both revenues and receivables by
400 $ (8.00 $ x 50 glasses). The accounting entries are prepared as follows:

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 Sales Returns
• On the other hand, COGS is reversed and inventories are increased by 300 $
(6.00 x 50 glasses).

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 Sales Allowances
• Example: On April 26, Anatolian Company grants 50 $ sales allowance to
the customer for goods damaged in transit.

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 Sales Discounts
• As a means of encouraging the buyer to pay before the end of the credit
period, the seller may offer the customer a cash discount—called by the
seller a sales discount.
• Example: Anatolian Company received payment from the customer on April
30. This collection is related to April 20 sales. Suppose that credit terms are
2/10; n/30.
• When the customer makes payment within the discount period, on April 30,
Anatolian Company will record the receipt of cash and decrease Accounts
Receivable for 350 $, as follows:

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 Sales Discounts
• Sales discount is based on the invoice price less returns and allowances.
Considering the returns and other allowances provided by Anatolian
Company, the balance of Accounts Receivable item should be determined at
first.

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Net Sales Revenue
Gross Profit

• Net sales revenue, cost of goods sold, and gross profit are key elements
of profitability. Net sales revenue is calculated as Sales Revenue less
Sales Returns and Allowances and Sales Discounts.

• Net sales revenue of Anatolian Company = 1,500 – (450 + 7) = 1,043 $

• Gross profit of Anatolian Company = 1,043 – 900 = 143 $
sales reveanue
(-) sales returns&allowances
(-) sales Discounts
-----------------------------------
Net sales
(-) cofgs
------------------------
gross proffit
17.04

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Inventory Costing Methods
• Businesses must have a way to determine the value of merchandise
inventory on hand and also the value sold (cost of goods sold).
• For this reason, first they have to choose an accounting system and then a
cost flow system for their inventories.
• Choosing an inventory accounting system is fundamental for calculating the
value of inventory on hand and the cost of goods sold.
• There are two basic inventory accounting systems: “Perpetual Inventory
System” and “Periodic Inventory System”.
 Perpetual Inventory System is an inventory system of tracking and
recording inventory and cost of goods sold on a continual basis.
 Periodic Inventory System is a system of determining the quantity of
inventory on hand only periodically.

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Inventory Costing Methods

• Specific Identification Method

• Average Cost Method
• First-In, First-Out (FIFO) Method
• Last-In, First-Out (LIFO) Method

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 Specific Identification Method

• The specific identification method uses the specific cost of each inventory
unit to determine ending inventory and cost of goods sold.
• Specific identification requires that companies keep records of the original
cost of each individual inventory item.
• In the specific identification method, the company knows exactly which item
was sold and exactly what the item cost.
• The specific identification method is impractical unless each unit can be
identified accurately.
• This costing method is best for businesses that sell unique, easily identified
inventory items, such as jeweler (a specific diamond earring), an automobile
dealer (each automobile has a unique serial number)

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 Specific Identification Method
Example: Auk-Mart Inc. uses Specific Identification Method for inventory costing
under perpetual inventory system.
May 15th sale of 2,000 units are from the May 10th purchase; and May 25th sale
of 4,000 units from May 5th purchase.
Calculation of Auk-Mart Inc.’s “Cost of Goods Sold” and “Ending Inventory” by
using Specific-Identification Method is as follows:

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 Average Cost Method
• The average cost method allocates the cost of goods available
for sale on the basis of the weighted average unit cost incurred.
• The average cost method assumes that goods are similar in
nature. When the average cost method is used in a perpetual
inventory system, the business computes a new weighted
average cost per unit after each purchase.
• This unit cost is then used to determine the cost of each sale
until another purchase is made and a new average is
computed.
• Ending inventory and cost of goods sold are then based on the
same average cost per unit.

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 Average Cost Method
• Example: Auk-Mart Inc. uses Average Cost Method of inventory costing
under perpetual inventory method, calculation of “Cost of Goods Sold” and
“Cost of Ending Inventory” are as follows:
• The company uses perpetual inventory system
• Cost of Goods Sold for May 15: If the company uses average cost method,
firstly we have to calculate the average unit cost at the date of sale. It is
simply calculated by dividing total cost of inventories by number of units
available for sale.

Average Cost per Unit= 51,200 TL / 10,000 units= 5.12 TL

Cost of Goods Sold = 2,000 units X 5.12 TL = 10,240 TL

cost of good on hand = 8000 unitzX 5,12= 40.960
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 Average Cost Method
• Cost of Goods Sold for May 25: In order to calculate cost, of goods sold for
May 25 sale, we will follow exactly the same steps. First, we calculate the
average unit cost of inventories on hand and multiply this amount with the
number of units sold. However, we have to be careful while we are calculating
the total cost of inventory available for sale.

As of May 25, we have 10,000 units available for sale, 8,000 units of this amount are
inventory left from the sale of May 15, and 2,000 of this amount are from the
purchase of May 20.

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 Average Cost Method

• While we are calculating the total cost of 8,000 units which are left from the
sale of May 15 we have to use the average unit cost already calculated as of
May 15 which is 5.12 TL

Average Unit Cost = 51,760 TL /10,000 units = 5.176 TL

Cost of Goods Sold = 4,000 units X 5.176 TL = 20,704 TL

cost of goods on hand =6000 units X5,176tl=31.056

Total Cost of Goods Sold for May= 10,240 TL + 20.704 TL = 30,944 TL

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 Average Cost Method
• Cost of Ending Inventory:In order to calculate the cost of ending inventory,
we take into consideration the cost of inventory left on hand from the sale of
May 25 using the average unit cost for that date and the other inventory
purchased during the period

AC/UNT42.056/ 8000= 5,25772

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 First- In First- Out (FIFO) Method

• The First-In, First-Out (FIFO) method assumes that the earliest goods
purchased are the first to be sold.
• The cost of goods sold is based on the oldest purchases – that is, the first
units to come in are assumed to be the first units to go out of the warehouse
(sold).
• FIFO costing is consistent with the physical movement of inventory (for most
companies).
• Companies sell their oldest inventory first.

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 First- In First- Out Method
• Example: Assume that Auk-Mart Inc. uses First-in-First Out (FIFO) method
of inventory costing under perpetual inventory method
• 2,000 units are sold on May 15. While we are calculating cost of goods sold
for this date, we assume the company makes this sale from inventories
purchased on May 5 since that is the very first purchase made in May.
• So cost of goods sold for May 15 sale is calculated as 10,000 TL

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 Last- In First- Out (LIFO) Method

• Last-in, First-out (LIFO) is just the opposite of FIFO.

• Under the last-in, first-out (LIFO) method, ending inventory comes from the
oldest costs (beginning inventory and earliest purchases) of the period.
• The cost of goods sold is based on the most recent purchases (new costs) –
that is, the last units in are assumed to be the first units out of the
warehouse (sold).
• This method is forbidden for being misleading especially in hyperinflationary
economies.

in tukry we dont use it because of high infation

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 Last- In First- Out Method
• Example: Assume that Auk-Mart Inc. uses Last-in-First Out (LIFO) method of
inventory costing under perpetual inventory method
• 2,000 units are sold on May 15, under LIFO we assume Company makes this
sale from inventories purchased on May 10 since that is the last purchase
made before the sale.
• The cost of goods sold for May 15 is calculated as 10,400 TL.
• Company also sold 4,000 units on May 25

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