6 Merchandising and Inventory

Merchandising transactions

A merchandising business earns revenue by buying goods and reselling them to customers. Unlike a service business, it reports Merchandise inventory as an asset until the goods are sold; once sold, their cost becomes Cost of goods sold (COGS), an expense. Gross profit is the difference between net sales and COGS.

Recording purchases and sales

In a perpetual system, a purchase of goods is recorded by debiting Merchandise Inventory and crediting Cash or Accounts Payable. In a periodic system, the debit is to Purchases instead; the credit is still to Cash or Accounts Payable.

A sale is recorded by debiting Cash or Accounts Receivable and crediting Sales Revenue. A perpetual system also records the cost of the goods sold with a separate entry: debit COGS and credit Merchandise Inventory. A periodic system determines the cost entry at period-end rather than recording it with each sale.

Sales Returns and Allowances and Sales Discounts reduce gross sales. Purchase returns, allowances, and discounts reduce the cost of purchases. Costs directly related to acquiring goods, such as freight-in, are generally included in inventory cost.

Net sales and gross profit

Net sales are calculated by subtracting sales returns and allowances and sales discounts from sales revenue:

Gross profit is net sales less COGS:

These measures connect the revenue from goods sold with the cost assigned to those goods.

Perpetual and periodic inventory systems

A Perpetual system updates inventory records as purchases and sales happen, providing a running book balance and recording COGS with each sale. A physical count is still necessary to identify discrepancies such as theft, damage, or recording errors. A shortage found during the count is adjusted, often by debiting COGS and crediting Inventory.

A Periodic system records purchases in temporary purchase accounts but does not update the inventory balance or record COGS for each sale. At period-end, a physical count establishes ending inventory, and COGS is calculated from beginning inventory, net purchases, and goods available for sale:

Net purchases reflect purchase returns, allowances, and discounts, and typically include freight-in.

Assigning costs to goods

When identical goods are purchased at different prices, a business needs a consistent way to assign their costs between COGS and ending inventory. These Cost-flow assumptions do not have to match the physical order in which goods leave the store.

Consider a store with $10$ units costing $\$10$ each that buys another $10$ units at $\$12$ each, then sells $12$ units. The goods available cost $\$220$, and $8$ units remain. The methods assign costs as follows:

• Specific identification: Assigns each item's actual cost to the item sold. It suits distinct, high-value goods such as cars or custom equipment.

• FIFO (first-in, first-out): Assigns the oldest costs to COGS first. In this example, COGS is $10 \times \$10 + 2 \times \$12 = \$124$, and the remaining inventory cost is $\$96$.

• LIFO (last-in, first-out): Assigns the newest costs to COGS first. Here, COGS is $10 \times \$12 + 2 \times \$10 = \$140$, and the remaining inventory cost is $\$80$.

• Weighted average: Uses an average cost per unit. Here, the average is $\$220 \div 20 = \$11$ per unit; COGS is $12 \times \$11 = \$132$, and the remaining inventory cost is $\$88$.

When purchase costs are rising, LIFO generally produces higher COGS and lower ending inventory than FIFO. When costs are falling, the relationship generally reverses. Weighted-average cost smooths price changes. Under perpetual accounting, the average is typically recalculated after each purchase; under periodic accounting, it is calculated for the period.

Inventory valuation and reporting effects

The cost-flow method assigns costs to goods sold and goods remaining; the inventory valuation rule determines whether recorded inventory cost must be written down. These are related but distinct steps.

Under U.S. GAAP, inventory measured by methods other than LIFO or the retail inventory method—such as FIFO or average cost—is generally reported at the lower of cost and Net realizable value (NRV). NRV is the estimated selling price in the ordinary course of business less reasonably predictable completion, disposal, and transportation costs. If NRV falls below cost, the difference is recognized as a loss. LIFO- and retail-method inventory follow a different lower-of-cost-or-market measurement rule, so the NRV rule should not be applied indiscriminately to those methods.

Ending inventory affects both the balance sheet and the income statement. If ending inventory is overstated, COGS is understated and income is overstated. If ending inventory is understated, COGS is overstated and income is understated.