How Does Accounting Change With Merchandise Inventory?

When a business begins to sell physical goods, its accounting practices undergo a notable shift. This involves new complexities for tracking, valuing, and reporting assets held for resale. The introduction of merchandise inventory requires adjustments to how a company records purchases, sales, and the associated costs, moving beyond the simpler accounting for service-based operations. These changes ensure accurate financial reporting that reflects profitability.

Defining Merchandise Inventory

Merchandise inventory refers to goods a business acquires for resale to customers. This includes finished products ready for sale, such as items on retail shelves or in a warehouse. Merchandise inventory is a current asset on a company’s balance sheet, expected to be sold and converted into cash within one year.

Its value includes the price paid to suppliers and any additional costs to bring them to their current location and condition, such as transportation and insurance. This distinguishes it from other assets like equipment, held for long-term use, or supplies, consumed in operations. Its primary purpose is to generate revenue through sales.

Fundamental Accounting Impact

Merchandise inventory alters a company’s financial statements. On the Balance Sheet, merchandise inventory appears as a current asset, reflecting the value of unsold goods. It is usually listed below cash and accounts receivable, signifying its liquidity.

Merchandise inventory directly impacts the Income Statement through Cost of Goods Sold (COGS). COGS represents the direct costs of goods sold during an accounting period, including the price paid for merchandise and expenses like inbound freight. When merchandise is sold, its cost is transferred from the inventory asset account to the COGS expense account.

COGS calculation directly affects gross profit, determined by subtracting COGS from sales revenue. A higher COGS reduces gross profit, while a lower COGS enhances it, influencing profitability and taxable income. For tax purposes, COGS is a deductible expense, allowing businesses to reduce their taxable income.

Inventory Tracking Systems

Businesses use two systems to track merchandise inventory: Perpetual and Periodic. They differ in how frequently they update records and determine Cost of Goods Sold, impacting real-time visibility and financial reporting.

The Perpetual Inventory System continuously updates inventory records with each purchase and sale, providing real-time information on balances and costs. It often utilizes point-of-sale (POS) systems and computer databases for automated tracking. Even with continuous updates, physical counts are still conducted periodically to reconcile records and account for issues like theft or damage.

In contrast, the Periodic Inventory System does not continuously track inventory movements. Balances and Cost of Goods Sold are determined only at the end of an accounting period, typically through a physical count. When goods are purchased, they are recorded in a temporary “Purchases” account, rather than directly to the Merchandise Inventory account. The Cost of Goods Sold is calculated at the end of the period using a formula that includes beginning inventory, net purchases, and ending inventory from the physical count. This system is less expensive to maintain but offers less control and real-time insight into inventory.

Inventory Costing Methods

When identical items are purchased at different costs, businesses use an inventory costing method to assign values to Cost of Goods Sold and ending inventory. The three common methods are First-In, First-Out (FIFO), Last-In, First-Out (LIFO), and Weighted-Average. Each makes a different assumption about the flow of goods and can impact reported financial figures, particularly during periods of changing prices.

The First-In, First-Out (FIFO) method assumes the first goods purchased are the first ones sold. Under FIFO, the oldest costs are assigned to the Cost of Goods Sold, and the most recent costs remain in the ending inventory. This method often results in a higher net income and higher taxable income during inflationary periods because it matches lower, older costs against current revenues. FIFO aligns with the physical flow of goods for many businesses, especially those dealing with perishable items or products with a short shelf life.

The Last-In, First-Out (LIFO) method assumes the most recently purchased goods are the first ones sold. Consequently, LIFO assigns the most recent costs to the Cost of Goods Sold, leaving the older costs in ending inventory. During periods of rising prices, LIFO results in a higher Cost of Goods Sold and a lower reported net income, which can lead to lower taxable income. While permitted under U.S. Generally Accepted Accounting Principles (GAAP), LIFO is prohibited under International Financial Reporting Standards (IFRS).

The Weighted-Average method calculates the average cost of all inventory units available for sale. This average cost is then applied to both the Cost of Goods Sold and the ending inventory. This method smooths out price fluctuations, providing intermediate values for COGS and inventory compared to FIFO and LIFO. The weighted-average method is used when individual inventory units are indistinguishable, such as with grains or liquids.

Recording Key Inventory Transactions

Recording merchandise inventory transactions involves specific journal entries that reflect the movement and valuation of goods. These entries depend on the chosen inventory system (perpetual or periodic) and costing method (FIFO, LIFO, or weighted-average).

For purchases under a perpetual inventory system, the Merchandise Inventory account is debited to increase the asset, and Cash or Accounts Payable is credited. For example, if a business buys $1,000 worth of goods on credit, the entry would be a debit to Merchandise Inventory for $1,000 and a credit to Accounts Payable for $1,000. If the purchase includes shipping costs, such as $50 for freight-in, this cost is also added to the Merchandise Inventory account, increasing its value.

When sales occur under a perpetual system, two journal entries are required. The first entry records the revenue generated: Cash or Accounts Receivable is debited for the sales price, and Sales Revenue is credited. For instance, selling goods for $1,500 on account would involve a debit to Accounts Receivable for $1,500 and a credit to Sales Revenue for $1,500.

The second entry simultaneously recognizes Cost of Goods Sold and reduces the inventory asset. This involves a debit to Cost of Goods Sold and a credit to Merchandise Inventory for the cost of the items sold, determined by the chosen costing method (FIFO, LIFO, or weighted-average). If the cost of those goods was $800, the entry would be a debit to Cost of Goods Sold for $800 and a credit to Merchandise Inventory for $800.

Purchase returns and allowances reduce the cost of inventory and the amount owed or paid. If a business returns $100 worth of merchandise purchased on credit before paying, Accounts Payable is debited for $100, and Merchandise Inventory is credited for $100. If the return occurs after payment, Cash is debited and Merchandise Inventory is credited. Similarly, sales returns require two entries to reverse the original sale. The first entry reduces revenue and the customer’s balance: Sales Returns and Allowances (a contra-revenue account) is debited, and Cash or Accounts Receivable is credited for the sales price. The second entry increases inventory and reduces Cost of Goods Sold: Merchandise Inventory is debited, and Cost of Goods Sold is credited for the cost of the returned goods.