Accounting for Merchandising

Transactions

BBA Honors/Emphasis
Kathmandu University School of
Management
 The Nature of Inventory
• There are two types of inventory held by
businesses: finished inventory, held by retailers and
wholesalers, and materials inventory, held by
manufacturers.
• There are three types of inventory costs borne by
manufacturers: direct materials, direct labor, and
manufacturing overhead.
• There are three distinct forms of inventory for a
manufacturer: raw materials, work in process, and
finished goods.
 Inventory of Wholesalers
and Retailers
 Purchased in finished form
 Resold without transformation
 Classified as “Merchandise
Inventory” on balance sheet

LO1
 Gap, Inc.
Consolidated Balance Sheets
[Partial]
January 30, January 30,
ASSETS (in millions) 2022 2021
CURRENT ASSETS:
Cash and cash equivalents More $ 1,561 $ 2,348
Short term investments than
100 255
Merchandise inventory 40% of 1,620 1,477
Other 645 614
current
TOTAL CURRENT ASSETS 3,926 4,664
assets
Inventory of Manufacturers
Costs Included in Inventory

Direct Direct Manufacturing

Materials Labor Overhead
 Direct Material and Direct Labor
Costs (VC)
Direct Material Costs: The cost of the ingredients
used in making a product. E.g. cost of plastic, fabric
and rubber for making shoes.

Direct Labor Costs: The amounts paid to workers to

manufacture the product. E.g. hourly wage paid to
an assembly line worker
 Manufacturing Overhead
Costs
• Depreciation on equipment used in the production
process
• Property taxes on the production facility
• Rent on the factory building
• Salaries of maintenance personnel
• Salaries of manufacturing managers
• Salaries of the materials management staff
• Salaries of the quality control staff
• Utilities for the factory
• Wages of building janitorial staff
Three Forms of Inventory
The inventory of a manufacturer takes three distinct forms:
Direct materials or raw materials enter a production
process

Work-in-process or Work-in-progress: Some of the

materials have entered the process and some labor costs
have been incurred but the product is not finished.

Finished goods are a manufacturer’s inventory that is

complete and ready for sale.
Inventory of Manufacturers
Costs Included in Inventory Balance Sheet Classifications

Direct Raw
materials materials

Manufacture
Direct Work in
products
labor process

Manufacturing
overhead Finished
goods
Types of businesses and
inventory cost
 IBM
Consolidated Balance Sheets
[Partial]
ASSETS (in millions) 2021
Current assets:
Inventories: at December 31
Finished goods $ 432
Work in process and Raw Materials 2,018
Total $ 2,450
Condensed Income Statement
for a Merchandiser
Net sales $100,000
Cost of goods sold 60,000
Gross profit $ 40,000
Selling and administrative expenses
29,300
Net income before tax $ 10,700
Income tax expense 4,280
Net income $ 6,420

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 Contra-Sales Accounts
Sales Sales Discounts

normal normal
credit debit
balance balance

Sales Returns Sales Allowances

normal normal
debit debit
balance balance
 Sales Discount Returns and
Allowances
Sales Discount: Discount given to customer for
the early payment of their account.

Sales return: Allow the customer to return

merchandise within a stipulated period of time.

Allowance: Customer may be given an allowance

for spoiled or damaged merchandise

Note: Sales return and allowance and Sales discount

is deducted from Sales revenue to get Net sales.
Credit Terms and Sales Discounts
n/30 Payment due 30 days from invoice

1/10, n/30 Deduct 1% of invoice amount if

paid within 10 days; otherwise full
invoice amount is due in 30 days

2/10, n/30 Deduct 2% of invoice amount if

paid within 10 days; otherwise full invoice
amount is due in 30 days
The Cost of Goods Sold Model
The Cost of Goods Sold Model
Beginning Purchases of
inventory + merchandise

= Goods Available
for Sale

Less: Ending inventory

=
Cost
of goods
sold
 The Cost of Goods Sold Model
Beginning inventory $
15,000
+ Cost of goods purchased 63,000
= Cost of goods available for sale 78,000
– Ending inventory (18,000)
= Cost of goods sold $ 60,000
“Pool” of goods An increase in ending
available to sell inventory means more
during the period was bought than sold
Perpetual Inventory Systems

Inventory records are updated

after each purchase or sale

 Point-of-sale terminals have improved the

ability of mass merchandisers to maintain
perpetual systems
 Periodic Inventory Systems
Inventory records are updated
periodically based on physical
inventory counts

 Reduces record keeping but also decreases the

ability to track theft, breakage, etc., and prepare
interim financial statements
 Cost of Goods Purchased
 Cost of inventory purchased (invoice price):
Less:
Purchase returns and
allowances
Purchase discounts

Plus:
Transportation-in
Cost of goods purchased
The company purchased $65,000 of
merchandise during the period. Two
amounts are deducted from purchases
to arrive at net purchases: purchase
returns and allowances of $1,800 and
purchase discounts of $3,700. The cost
of $3,500 incurred by Daisy’s to ship the
goods to its place of business is called
transportation-in, or freight-in.
Cost of goods purchased
Assume that Daisy’s buys shoes on account from Nike at a cost of $4,000. The
journal entry to record the purchase is as follows:

Suppose that Daisy’s returns $850 of merchandise to Nike for credit on Daisy’s
account. The return decreases both liabilities and purchases. Note that because
a return reduces purchases, it has the effect of reducing expenses and
increasing net income and stockholders’ equity.
Recording Purchase Returns

Accounts Payable 850

To Purchase Returns and Allowances 850

(To record inventory returned to supplier)

Assume a purchase of merchandise on March 13 for
$500, with credit terms of 1/10, n/30.

If the company does not pay within the discount period,
the accountant simply makes an entry to record the
payment of $500 cash and the reduction of accounts
payable. However, assume that the company does pay its
account on March 23, within the discount period.
Recording Purchase Discounts
Accounts Payable 500
Cash 495
Purchase Discounts 5
($ 500 × 1% = $5 discount)

To record payment within discount period to

supplier who offers 1% purchase discount.
Example: For each of the following transactions of Buckeye
Corporation, prepare the appropriate journal entry. (All
purchases on credit are made with terms of 1/10, n/30, and
Buckeye uses the periodic system of inventory.)

July 3: Purchased merchandise on credit from Wildcat

Corp. for $3,500.

July 6: Purchased merchandise on credit from

Cyclone Company for $7,000.

July 12: Paid amount owed to Wildcat Corp.

August 5: Paid amount owed to Cyclone Company.

Answer:

Journal July 3 Purchases .............................................. 3,500

Entry Accounts Payable ............................. 3,500
Analysis To record purchases of merchandise on credit.
Balance Sheet Income Statement
STOCKHOLDERS’ NET
ASSETS = LIABILITIES + EQUITY REVENUES – EXPENSES = INCOME
Accounts Payable 3,500 (3,500) Purchases 3,500 (3,500)

Journal July 6 Purchases .............................................. 7,000

Entry Accounts Payable ............................. 7,000
Analysis To record the purchase of merchandise on credit.
Balance Sheet Income Statement
STOCKHOLDERS’ NET
ASSETS = LIABILITIES + EQUITY REVENUES – EXPENSES = INCOME
Accounts Payable 7,000 (7,000) Purchases 7,000 (7,000)
Journal July 12 Accounts Payable ................................... 3,500
Entry Cash.................................................. 3,465
Analysis Purchase Discounts .......................... 35
To record payment on account:
$3,500 – 0.01($3,500) = $3,465.
Balance Sheet Income Statement
STOCKHOLDERS’ NET
ASSETS = LIABILITIES + EQUITY REVENUES – EXPENSES = INCOME
Cash (3,465) Accounts 35 Purchase 35
Payable (3,500) Discounts* (35)
*The Purchase Discounts account has increased. It is shown as a decrease because it is a contra -purchases account and causes expenses
to decrease.

Journal Aug. 5 Accounts Payable ................................... 7,000

Entry Cash.................................................. 7,000
Analysis To record payment on account.
Balance Sheet Income Statement
STOCKHOLDERS’ NET
ASSETS = LIABILITIES + EQUITY REVENUES – EXPENSES = INCOME
Cash (7,000) Accounts
Payable (7,000)
 FOB Destination Point

Title passes at destination

 No sale or purchase until inventory reaches its

destination
 Seller responsible for inventory while in transit
 FOB Shipping Point
 Both sale and purchase recorded upon shipment
 Buyer responsible for inventory while in transit

Title passes when shipped

 Recording Shipping Costs

Transportation-In 300
Cash 300

To record shipping costs on inventory purchased

Assume that on December 28, 2014, Nike ships running shoes to
Daisy’s Running Depot. The trucking company delivers the
merchandise to Daisy’s on January 2, 2015. Daisy’s fiscal year end
is December 31. The effect of shipping terms on purchases and sales
can be summarized as follows:
Analysis of Profitability

Of
particular
interest Gross
to current and Profit %
potential
investors

LO4
Daisy’s Profitability
Net sales $100,000
Cost of goods sold 60,000
Gross profit $ 40,000
Gross profit ratio = 40%

Gross Profit Ratio = Gross Profit

Net Sales
(How many cents on every $ of sales are left over
after covering the cost of the product)
 Inventory Valuation and
Income Measurement
Value
Value
expensed
assigned to When Sold =
as cost of
inventory
goods sold
on balance
on income
sheet
statement

LO5
 Inventory Costs Included
 Any freight costs incurred by buyer
 Cost of insurance for inventory in transit
 Cost of storing inventory before selling
 Excise and sales taxes
During the first month of operations, ABC Company
incurred the following costs in ordering and receiving
merchandise for resale. No inventory was sold.
 List price, $100, 200 units purchased
 Volume discount, 10% off list price
 Paid freight costs, $56
 Insurance cost while goods were in transit, $32
 Long-distance phone charge to place orders, $4.35
 Purchasing department salary, $1,000
 Supplies used to label goods at retail price, $9.75
 Interest paid to supplier, $46
Required:
What amount do you recommend the company record as
merchandise inventory on its balance sheet? Explain your
answer.
For any items not to be included in inventory, indicate their
appropriate treatment in the financial statements.
Answer:

List price: $100 × 200 units $20,000

Less: 10% volume discount (2,000)
Freight costs 56
Insurance for goods in transit 32
Total cost $18,088

Under the cost principle, all of these costs are necessary to put
the inventory into a position where it can be sold.

Other classifications:
The phone charges and purchasing department salary would
both be difficult to match directly with the sale of any
particular product and therefore should be treated as operating
expenses of the period. The labeling supplies are immaterial in
amount and should also be reported as operating expenses. The
interest paid to suppliers is a financing cost and would be
reported as interest expense on the income statement.
Inventory Costing Methods
Four costing methods available:

Specific Weighted
Identification Average

First-in, First-out Last-in, First-out

(FIFO) (LIFO)
Detailed Costing Method Example
Beginning inventory, Jan. 1: 500 units (unit cost $10)
Inventory purchases:
Date Units Unit Cost
1/20 300 $ 11
4/8 400 12
9/5 200 13
12/12 100 14
Total purchases 1,000 units
Ending inventory, Dec. 31: 600 units

Calculate the Cost of Goods Sold and Ending

Inventory under each cost
Specific Identification Method

Step 1: Identify the specific units in

inventory at the end of the
year and their costs.
Specific Identification Method
Units in ending inventory:
Date purchased Units Cost Total Cost
1/20 100 $11 $ 1,100
4/8 300 12 3,600
9/5 200 13 2,600
Ending inventory 600 $ 7,300

Units × Cost = Total cost

Specific Identification Method
Step 2: Identify the units sold and
calculate the cost of goods
sold.
Specific Identification Method
Date purchased Units Cost Total Cost
Beg. inventory 500 $10 $5,000
1/20 200 11 2,200
4/8 100 12 1,200
12/12 100 14 1,400
Cost of goods sold 900 $9,800

Units × Cost = Total cost

Weighted Average Method

Step 1: Calculate the cost of goods

available for sale.
Weighted Average Method
Date purchased Units Cost Total cost
Beg. inventory 500 $10 $ 5,000
1/20 300 11 3,300
4/8 400 12 4,800
9/5 200 13 2,600
12/12 100 14 1,400
Cost of goods
available for sale 1,500 $17,100
Weighted Average Method
Step 2: Divide the cost of goods available for sale
by the total units to determine the weighted average
cost per unit.
Weighted Average Method
Cost of Goods Available for Sale
Units Available for Sale

$17,100
= $11.40/unit
1,500
Weighted Average Method
Step 3: Calculate ending inventory and cost of goods
sold by multiplying the weighted average cost per unit by the
number of units in ending inventory and the number of units
sold.

Average
Cost × # of
Units
Weighted Average Method
ALLOCATE TO
Ending Cost of
Inventory Goods
Sold
Units on hand 600
Units sold 900
Weighted average cost $11.40 $ 11.40
×

Total cost of goods

available of $17,100 allocated: $6,840 $10,260
 First-in, First-out
(FIFO) Method

Step 1: Assign the cost of the beginning

inventory to cost of goods sold.
First-in, First-out (FIFO) Method
ALLOCATE TO
Ending Cost of
Units Cost Inventory Goods Sold
1/1 500 $10 $5,000
1/20 300 $11
4/8 400 $12
9/5 200 $13
12/12 100 $14
First-in, First-out (FIFO) Method
Step 2: Continue to work forward until you
assign the total number of units sold
during the period to cost of goods sold.
Allocate the remaining costs to ending
inventory.
First-in, First-out (FIFO) Method
ALLOCATE TO
Sold Unsold Ending Cost of
Units Units Cost Inventory Goods Sold
1/1 500 $10 $5,000
1/20 300 $11 3,300
4/8 100 300 $12 $3,600 1,200
9/5 200 $13 2,600
12/12 100 $14 1,400
TOTALS $7,600 $9,500
Last-in, First-out (LIFO) Method

Step 1: Assign the cost of the last units

purchased to cost of goods sold.
Last-in, First-out (LIFO) Method
ALLOCATE TO
Ending Cost of
Units Cost Inventory Goods Sold
1/1 500 $10
1/20 300 $11
4/8 400 $12
9/5 200 $13
12/12 100 $14 $1,400
Last-in, First-out (LIFO) Method
Step 2: Work backwards until you assign the
total number of units sold during the
period to cost of goods sold (allocate
the remaining costs to ending inventory).
Last-in, First-out (LIFO) Method
ALLOCATE TO
Unsold Ending Cost of
Units Units Cost Inventory Goods Sold
1/1 500 $10 $5,000
1/20 200 100 $11 1,100 $ 2,200
4/8 400 $12 4,800
9/5 200 $13 2,600
12/12 100 $14 1,400
TOTALS 900 600 $6,100 $11,000
 Comparison of Costing
Methods
Cost of Goods
Ending Goods Available
Inventory Sold for Sale
Specific
Identification $7,300 $ 9,800 $17,100
Weighted
Average 6,840 10,260 17,100
FIFO 7,600 9,500 17,100
LIFO 6,100 11,000 17,100
LO
 Comparison of Costing Methods

In periods of rising prices: Weighted

Average FIFO LIFO

Highest cost of goods sold?

Lowest cost of goods sold? X
Highest gross profit? X
Lowest net income? X
Lowest income taxes? X
X
 Selecting an Inventory
Costing Method
The choice of an inventory method will
impact cost of goods sold and thus net
income. A company should choose the
method that results in the most accurate
measure of net income for the period.
Income Statements for the
Inventory Costing Methods
 LIFO Issues
 LIFO liquidation
• Liquidation can result in high gross
profit (and large tax bill)
 LIFO conformity rule
• If used for tax, LIFO must also be used
for books
 LIFO reserve
• Difference between inventory value
stated at FIFO and value stated at LIFO
 An Example of LIFO Liquidation
 Walmart uses the LIFO method of inventory accounting for its domestic
stores. Over a four year period, for example, it might purchase one million
units of a specific product in each of the first three years. However, due to
rising prices, the per unit cost of its inventory is $10 in year one, $12 in
year two, $14 in year three. The product is sold for a price of $50 a piece
over the three year period. However, Walmart only sells 500,000 units of
the product in each of the first three years, leaving 1.5 million units on
hand. Since it assumes that demand won't increase, it only purchases
500,000 units of inventory in year four, for a per-unit cost of $15. If it
continues to sell the product for $50, this strategy is beneficial in that it
reduces its tax burden.

 However, demand for the product unexpectedly goes up and Walmart

immediately sells all 500,000 units of the product in year four for total
sales of $25,000,000, total COGS of $7,500,000 and a gross profit of
$17,500,000. Consumer demand continues to increase, and Walmart is
forced to liquidate its older inventory, selling an additional 500,000 units
from year three, for revenues of $25,000,000 but total COGS of
$7,000,000, meaning that its gross profit for the inventory sold from year
three is $18,000,000. The combined gross profit is $500,000 higher than if
the company had purchased all of its inventory for a cost of $15,
increasing its tax burden.
 International Inventory
Valuation Methods
 Acceptable methods of costing inventory in the
United States may not be acceptable in other
countries
• LIFO is generally accepted in the United States
• IASB (international standards) prohibit the use
of LIFO by companies that follow international
standards
 It is uncertain whether LIFO will survive as an
acceptable inventory valuation method
 Inventory Error
Inventory errors arise for a variety of
reasons. If ending inventory is overstated,
cost of goods sold will be understated and
thus net income for the period overstated.
The opposite effects will occur when
ending inventory is understated.
Reasons for Inventory Errors
 Mathematical mistakes
 Physical inventory counting errors
 Cutoff problems – in-transit
 Goods on consignment
 Effect of Inventory Errors on
the Income Statement, 2014
Reported Corrected Effect
Sales $1,000 $1,000
Beginning inventory $ 200 $ 200
Add: Purchases 700 700
Goods available for sale $ 900 $ 900
Less: Ending inventory 300 250 $50 OS
Cost of goods sold $ 600 $ 650 50
US
Gross margin $ 400 $ 350 50
OS
Operating expenses 100 100
Net income
OS = overstatement
$ 300 $ 250 50
US = understatement
OS
 Effect of Inventory Errors on the
Income Statement, 2015
Reported Corrected
Effect
Sales $1,500 $1,500
Beginning inventory $ 300 $ 250 $50
OS
Add: Purchases 1,100 1,100
Goods available for sale $1,400 $1,350 50 OS
Less: Ending inventory 350 350
Cost of goods sold $1,050 $1,000 50
OS
Gross margin $ 450 $ 500 50
OSUS
=
overstatement
Operating
US = expenses 120 120
Inventory Turnover Ratio
Cost of Goods Sold
Average Inventory

The number of times per period inventory is

turned over (i.e., sold)

LO1
Number of Days’ Sales in
Inventory
Number of Days in the Period
Inventory Turnover Ratio

The average number of days inventory

is on hand before its sold
 Statement of Cash Flows
Cash Flows from Operating Activities:
Net income xxx
Increase in inventory –
Decrease in inventory +
Increase in accounts payable +
Decrease in accounts payable –

Indirect
Method

LO1
 Appendix
Accounting Tools:
Inventory Costing Methods with the Use of
a Perpetual Inventory System
 FIFO Costing with a
Perpetual System

li e d at
a pp
F IFO a le
o f s
time

Same FIFO inventory total under periodic

and perpetual systems
 LIFO Costing with a
Perpetual System

l i e d at
a pp
LIFO a le
o f s
time

Different LIFO inventory total under periodic and

perpetual systems because of pricing gap
Moving Average with a
Perpetual System

e ra ge
te d av e a c h
e ig h f or
w e d
New comput
o st is
c s e
c ha
pur
Different inventory total under weighted average
(periodic) and moving average (perpetual)
End of Chapter 6