Merchandise Inventory ... accounting for inventory

Merchandise Inventory
Up until this point, we have been studying the accounting cycle for a service business. In general, the accounting procedures of a service business are the simplest to understand. A merchandising business, which is a business that buys goods and resells them at a profit, follows a similar accounting cycle, and uses similar accounting procedures. However, a merchandising business is slightly more complex, as it must account for the cost of the goods that it sells, a cost that does not exist for a service business.

A merchandising business can either operate as a wholesaler or a retailer. A wholesaler is a merchandising business that buys goods from manufacturers and sells to retailers. A retailer is a merchandising business that buys goods from manufacturers or wholesalers, and sells to consumers. In either case, a merchandising business has something that a service business does not – inventory. A merchandising business' inventory includes all the goods (merchandise) that it plans on reselling. Inventory should not be confused with supplies. While supplies include the goods that a business buys to be used within the business, inventory specifically refers to the goods that a business buys to be sold to customers.

Throughout its fiscal period, a merchandising business will have inventory that is available for sale. By the end of this fiscal period, the cost of this inventory that has not been sold will be included on the balance sheet as a current asset, and the cost of the inventory that has been sold will be included on the income statement as an expense, known as cost of goods sold.

Here is a quick example:

Roma Fine Foods, a merchandising business in Toronto, Ontario, has $100,000 of inventory available for sale during its fiscal year. If $37,000 of inventory still remains on hand at the end of the year, then the cost of goods sold for the year amounts to $63,000.
• On the balance sheet, Merchandise Inventory (a current asset) would be valued at $37,000. Merchandise inventory is an asset to the business, as it will bring value in the future.
• On the income statement, Cost of Goods Sold would be valued at $63,000. It is a deduction from sales (similar to an expense) as it is a cost incurred in order to earn the revenue for the period.

There are two systems for accounting for inventory:

• Periodic inventory system

A method of accounting for merchandise inventory, in which the cost of inventory sold is calculated after conducting a physical count of goods remaining at the end of the period. Under this system, the cost of goods sold and the cost of goods remaining are only determined at the end of the period.
Perpetual inventory system – a method of accounting for merchandise inventory, in which the cost of inventory sold, and a record of items remaining in stock are kept up to date on a daily basis. Under this system, the cost of goods sold and the cost of goods remaining are known at any time.
We will learn how to account for inventory under the periodic system first. Later, we will discuss the

• perpetual inventory system.

Looking back at the example above, the cost of goods sold was determined after establishing the cost of inventory that still remained on hand at the end of the period. So, just as the periodic system requires, it is important, at the end of every fiscal period, to conduct a physical count of goods on hand. Doing so will enable you to determine the value of goods that remain on hand at the end of the period (which will represent the inventory on the balance sheet), and the value of goods that have been sold (which will represent the cost of goods sold on the income statement).

The formula to determine cost of goods sold, therefore, is as follows:-
Cost of Goods Sold =
Cost of Beginning Inventory + Cost of Merchandise Purchased – Cost of Ending Inventor

Here is an explanation of the three items that make up this formula.
Cost of Beginning Inventory – last period's ending inventory figure
Cost of Merchandise Purchased – the value of the inventory purchased throughout the period and accumulated in an account called Purchases
Cost of Ending Inventory – determined by conducting a physical count of goods on hand at the end of the period

Let's see an example of the financial statements of a merchandising business. For simplicity, we will use the information for Roma Fine Foods, the above example.

Notice that the Merchandise Inventory account is listed with the current assets. The Merchandise Inventory value represents the cost of inventory that still remains on hand (ending inventory) as of August 31, 20-5, which amounts to $37,000.

Notice that the total cost of goods available for sale amounts to $100,000. This figure is made up of the inventory available at the beginning of the year, plus any purchases of inventory made throughout the year. Since the ending inventory amounts to $37,000, the cost of goods sold is calculated to be $63,000. You will also notice that the cost of goods sold is deducted from sales in order to determine the gross profit figure. Gross profit is the difference between sales and the cost of goods sold. It is the profit from sales before operating expenses are deducted. Therefore, gross profit less operating expenses gives us net income.

Activity 1
1. Calculate the missing figures in the following chart and record your answers .

Activity 2
2. Shown below is a list of some accounts and their balances, as well as an ending inventory figure, for Richard's Clothiers, a merchandising business in Sudbury, Ontario. Complete an income statement for the business, for the year ended November 30, 20-8, using the template provided in the attached Excel file (Activity 2 worksheet). Be sure to format appropriately and use formulas where applicable.