Assignment on Inventory

Introduction

Inventory usually includes goods that are being made (in the process of being produced) and goods that are finished and ready for sale. So far, we have talked about businesses that provide services. However, there are other types of businesses one of which is a merchandising company. Merchandising companies create a supply of goods that are delivered to customers. This supply is called inventory.

Inventory

Inventory is a current asset on a company’s balance sheet. Inventory includes goods for resale, raw materials, spare parts, etc.

Merchandise inventory is goods that are held for resale by a merchandising company.

Inventory for resale is accounted for in the Merchandise Inventory account. This is an asset account shown in the assets section of the balance sheet.

Inventory costs. Product and period costs

All costs related to acquiring goods and making them ready for sale are accumulated in the Merchandise Inventory account. Such costs are associated with products and often called product costs.

Product costs are costs required to produce inventory and make it ready for sale. Such costs are directly associated with inventory production.

Product costs are expensed in the period of inventory sale regardless of when the goods were purchased or produced by the company.

There are a few types of expenditures that cannot be directly traced to a specific product. Such costs include (but not limited to) advertising, administrative salaries, insurance, etc. Such costs are called selling and administrative expenses.

Selling and administrative expenses are expenses of selling and administrative nature that are not directly traceable to a specific product. Examples are advertising, administrative salaries and insurance, among others.

Because selling and administrative expenditures are expensed in the period in which they are incurred, they are labeled period costs.

Period costs are costs associated with a specific period and not a specific product. Period costs include selling and administrative expenses.

Cost of goods available for sale and cost of goods sold

Total inventory cost for a given accounting period is calculated by adding the beginning inventory account balance to the amount of inventory acquired during the period. The result of adding these two numbers is called cost of goods available for sale.

Cost of goods available for sale is the cost of goods acquired during a period plus the cost of goods on hand at the beginning of the period. This cost represents all inventories available for sale during the period.

The cost of goods available for sale is allocated between the Merchandise Inventory account and an expense account called Cost of Goods Sold. At a period end, inventory that has not been sold during the period is shown as an asset on the balance sheet (Merchandise Inventory) and inventory that has been sold is shown as an expense on the income statement (Cost of Goods Sold).

Cost of goods sold (COGS) is the difference between the cost of goods available for sale and the cost of goods on hand at period end. This cost represents the cost of goods sold by the company during the period.

Gross margin is the difference between the sales revenue (i.e., revenue generated from sales) and the cost of goods sold. Gross margin shows what profit the company made after cost of goods sold, but before any other expenses (selling and administrative, etc.).

Operating income is the difference between the gross margin and selling and administrative expenses.

 Perpetual and periodic inventory systems

There are two inventory accounting systems – perpetual and periodic.

Perpetual inventory system means that the inventory account is adjusted perpetually. The inventory account is affected each time inventory is sold or purchased.

Periodic inventory system adjusts the inventory account only at the end of an accounting period. Purchases and sales do not affect the inventory account during the accounting period, but do affect at the period end.

Although both systems have different approaches to inventory accounting, they provide the same results. The amount of cost of goods sold and the amount of sales will be the same regardless which method the company applies.

 Illustration #1 of accounting for inventory (period 1)

In our example, we will follow the rules of the perpetual inventory system. Under the perpetual inventory system sales and purchases of inventory are recorded directly to the Merchandise Inventory account when they take place. The accounting events below refer to a book store called Dav’s Books that was opened in 20X6 fiscal year:

1. The owner contributed $3,000 of inventory and $9,000 cash to the business.
2. $4,000 cash was paid to purchase additional inventory.
3. $200 cash was paid for the inventory transportation (see Event No. 2) from the vendor to the bookstore.
4. Inventory that cost $2,000 was sold for $5,500 cash.
5. Transportation expenses of $300 to deliver sold goods (see Event No. 4) were incurred and paid with cash.
6. $400 of selling expenses were incurred and paid with cash.

 Analysis of capital contribution transaction

Event No. 1. The owner made a combined capital contribution that consisted of cash and inventory. Cash ($9,000), Inventory ($3,000), and Contributed Capital (totally, $12,000) increase. This is an asset source transaction:

Illustration : Effect of capital contribution

Analysis of inventory acquisition transaction

Event No. 2. The Merchandise Inventory account increased when the inventory purchase was made for $4,000 cash. Inventory increases and Cash decreases. This is an asset exchange transaction:

Illustration : Effect of inventory acquisition

 Analysis of transportation-in costs

Event No. 3. Recall that all expenses incurred to deliver goods and make them ready for sale are treated as part of inventory costs and recorded in the Merchandise Inventory account. So, the transportation costs related to the delivery of inventory from the vendor to the bookstore are recorded in the Merchandise Inventory account. This transportation expense is called transportation-in.

Transportation-in expenditures are cost incurred to delivery inventory from the vendor (supplier) to the company. Transportation-in costs are treated as part of the inventory costs (product costs).

The transaction acts to increase Merchandise Inventory and to decrease cash. This is an asset exchange transaction:

Illustration: Effect of transportation-in costs

 Analysis of the inventory sale transaction

Event No. 4.This event is composed of two parts. The first one (4a in the table below) is recognition of sales revenue. Cash and Retained Earnings increase by $5,500. Transaction 4a is an asset source transaction. The second part (4b) is designed to record the cost of goods sold. Remember that goods are expensed only at the point of sale (under perpetual system). Accordingly, $2,000 should be removed from the Merchandise Inventory account and placed to the expense account called Cost of Goods Sold. Transaction 4b is an asset use transaction.

Illustration : Effects of inventory sale

Analysis of transportation-out expenses

Event No. 5. The cash payment made by the bookstore to deliver goods to the customer is called transportation-out:

Transportation-out expenditures are expenses incurred to deliver products from the company to the customer. Transportation-out expenditures are treated as period costs and expensed in the period of incurrence.

The company records transportation-out expenditures as an operating expense. This is an asset use transaction:

Illustration: Effect of transportation-out expenses

 Analysis of selling expenses transaction

Event No. 6. The $400 cash payment for selling expense has the same effect as operating expenses do. Cash and Retained Earnings decrease. This is an asset use transaction:

Illustration : Effect of selling expenses

Journal entries and T-accounts for illustration #1 of accounting for inventory

Let us prepare the general journal and post all transactions to T-accounts.

Illustration :General journal for illustration #1

Note the last entry that is called a closing journal entry. We zeroed the nominal accounts (revenue and expense accounts) for use in the next accounting period. The closing entry is combined because we include both revenue and expense accounts into it.

Illustration: Summary of T-accounts for illustration #1

Illustration #2 of accounting for inventory (period 2)

Let us go on with the illustration and expand Dav’s Books operations to the next (20X7) accounting period. The following transactions took place:

1. On May 14, the company purchased $5,000 of goods (inventory) on account. The seller delivered the goods at their expense.
2. Some goods delivered to Dav’s Books were damaged; thus, Dav’s Books returned $300 of them to the seller (May 16).
3. On September 18, the company made cash payment on the balance of the accounts payable. In addition, the bookstore would receive a 2% cash discount from the seller if Dav’s Books made the payment in two weeks. As the payment was made within two weeks, Dav’s Books took advantage of the 2% discount.
4. On June 12, the company sold goods costing $2,000 for $4,000 on account.
5. Dav’s Books incurred $400 of transportation expenses to deliver the goods to the customers. The expense was paid in cash on June 12.
6. Due to an error in filling out the purchase order in Event No. 6 and respectively shipping some goods not ordered, the customers sent back and the bookstore accepted a return of $500 of goods. The cost of the goods was $250.
7. On June 15, the company provided the buyer with a 2% cash discount if the buyer pays within two weeks. The buyer met the requirement (buyer paid within two weeks).
8. On September 12, the company collected the balance due on accounts receivable.

Effects of transaction for illustration #2 of accounting for inventory

Let us look at each of the transactions, record them in the general journal, transfer the data to T-accounts, and prepare the financial statements. All effects of the transactions on the accounting equation are shown in the table below.

Illustration : Effects of 20X7 events of the accounting equation

 Analysis of transactions for illustration #2 of accounting for inventory

Event No. 1. The effect of $5,000 inventory purchase is increases in both assets (Inventory) and liabilities (Accounts Payable). This is an asset source transaction.

Event No. 2. In Event No. 1 the Inventory account was debited. However, the company returned some goods, which resulted in a reverse operation. In this connection, the company needs to reduce both assets (Inventory) and liabilities (Accounts Payable) by the cost of the goods returned. This is an asset use transaction.

Event No. 3a. Dav’s Books got a cash discount. A cash discount means that the seller lets the buyer (in our example, the bookstore) pay less in case of a prompt settlement. So, the bookstore will have a right to pay the amount due reduced by a 2% discount, that is $4,606 ($4,700 x [100% – 2%] = $4,606), and not the initial amount ($5,000 minus $300 of returned goods = $4,700). This event the same effect as the goods return in Event No. 2. Both assets (Inventory) and liabilities (Accounts Payable) decrease by the $94 discount ($4,700-$4,606). This is an asset use transaction.

Event No. 3b. We are familiar with the payment of accounts payable transaction. Cash and Accounts Payable decrease. The accounts payable balance at May 18 was $4,606 ($5,000 – $300 – $94). This is an asset use transaction.

Event No. 4. Sale of the goods is composed of two events which are revenue recognition and expense recognition. The first one acts to increase assets (Accounts Receivable because the company sold on account) and equity (Sales Revenue) by $4,000. The second transaction decreases both equity (Retained Earnings, by increasing Cost of Goods Sold) and assets (Inventory) by the amount of $2,000. Revenue recognition is an asset source transaction and cost of goods sold recognition is an asset use transaction.

Event No. 5. Incurring transportation expense acts to decrease assets (Cash) and equity (Retained Earnings, by increasing Transportation-out) by $400. This represents an asset use transaction.

Event No. 6a & 6b. Getting back some goods sold in Event No.4 has a twofold effect on the company’s accounting records. The first one acts to adjust the revenue recognition. Because some goods were returned, it is necessary to reduce Sales Revenue and Accounts Receivable by $500. The second effect is to adjust the expense recognition. Cost of Goods Sold decreases, and Inventory increases. In this event, the company just makes reverse entries to those from Event No. 4.

Event No. 7. Providing a 2% cash discount to customers has a similar effect on the accounting records as Event No. 6. However, this time the bookstore does not receive any goods back, and, therefore, does not have to adjust expense part of the transaction (Cost of Goods Sold). Therefore, the company only decreases Accounts Receivable and Sales Revenue by $70 ([$4,000 minus $500 of returned goods] x 2%). This is an asset use transaction.

Event No. 8. Collection of cash from accounts receivable is already familiar to us. Cash increases and Accounts Receivable decrease. This is an asset exchange transaction.

Journal entries for illustration #2 of accounting for inventory

Let us see how these transactions look like in the general journal.

Illustration: General journal for illustration #2

T-accounts of transactions for illustration #2 of accounting for inventory

It is time to transfer the amounts to T-accounts.

Illustration: T-accounts of transaction for illustration #2

Financial statements for illustration #2 of accounting for inventory

Finally, financial statements prepared for 20X6 and 20X7 are shown below.

Illustration : Financial statements for Dav’s books for 20X6 and 20X7

Multiple-step and single-step income statements

Note a new format of the Income Statement. This format matches particular revenues with respective expenses. For example, Net Sales and Cost of Goods Sold provide information on the difference between the selling price and the cost of goods sold. Such format of the income statement is used to prepare information for financial analysis. Income statements of such kind are called multiple-step income statements.

Multiple-step income statement shows numerous steps in determining a net income (or net loss). Each step provides a different measure of a company’s results of operations.

In contrast, a single-step income statement that we had been dealing with before only includes information on total revenues and total expenses.

Single-step income statement shows only one step in determining a net income (or net loss).

Comparison of the periodic and perpetual inventory systems

One important aspect about the periodic inventory system should be mentioned. The periodic inventory system is known to be used more frequently than the perpetual one. The reason is simple. It is easier to make a few period-end adjusting entries than to adjust accounting records every time a sale or purchase is made (for example, grocery store sales are very frequent). Under the periodic system the cost of goods sold is determined at the end of the period. Purchases or sales of inventory do not affect the inventory account during the period. When goods are purchased, the cost is recorded in the Purchases (Inventory Purchases) account. When goods are sold, a reduction in the Inventory account does not take place. Transportation-outs, purchase returns, and allowances are recorded in separate accounts. The cost of goods sold is calculated by subtracting the amount of ending inventory from the total costs of goods available for sale (see the table below). The ending inventory is determined by performing a period end physical count.

The Schedule of Cost of Goods Sold helps in performing the computations:

Illustration: Schedule of cost of goods sold

However, there is one weak point about the periodic system. The point relates to lost, damaged, or stolen merchandise. Because the periodic system determines the cost of goods sold and the ending inventory at the end of the period, it is impossible, during the period, to figure out whether there were any goods stolen, damaged, or lost. It is rather difficult even at the period end because all the goods not available at hand are considered sold.

At the same time, it is quite easy to figure out the damaged, lost, or stolen goods if a company employs the perpetual system. Simple comparison of the physically counted merchandise on hand at the end of the period and the book balance of the Merchandise Inventory account will do the job. If there is a difference between the two, then some goods were damaged, stolen, or lost. In such a case an adjusting entry is needed to record the goods not available any more. The adjusting entry acts to decrease assets and equity. The equity is decreased by increasing an expense account called Inventory Loss (or sometimes directly to Cost of Goods Sold). The assets are decreased by reducing the inventory account.

For example, let us assume a company applies the perpetual inventory system and has the book balance of the Merchandise Inventory account of $1,500. The physical count at the end of the period showed that only $1,300 of goods was on hand. The inventory loss of $200 ($1,500 – $1,300) should be recorded as follows:

Illustration: Effect of recording inventory loss in the horizontal model

The entry in the general journal looks like this:

Illustration: Journal entry to record the inventory loss