What Is Merchandise Inventory in Accounting?

Merchandise inventory is a fundamental concept in accounting for businesses that acquire and sell physical goods. It represents a significant asset on a company’s financial statements, influencing its financial health and profitability. Understanding merchandise inventory is central to assessing a business’s operational efficiency.

What is Merchandise Inventory

Merchandise inventory refers to goods a business purchases with the intention of reselling them to customers. Unlike manufacturing inventory, which includes raw materials, work-in-process, and finished goods produced by the company, merchandise inventory consists of finished goods acquired from another entity, such as a wholesaler or manufacturer, to be sold in their existing condition. For instance, a retail clothing store’s merchandise inventory is the apparel it buys from suppliers to sell to shoppers. An electronics retailer holds merchandise inventory in the form of electronics acquired for resale.

This type of inventory is classified as a current asset on a company’s balance sheet, meaning it is expected to be converted into cash or sold within one year or one operating cycle. The value of merchandise inventory encompasses the purchase price paid to suppliers and any additional costs incurred to bring the goods to their current location and condition, such as transportation and insurance. Accurate identification and valuation of merchandise inventory are important for financial reporting, as they directly impact a company’s reported assets.

Inventory Valuation Methods

Assigning a cost to merchandise inventory is a necessary step for accounting purposes, particularly for determining the Cost of Goods Sold (COGS) and the value of ending inventory. The choice of inventory valuation method can significantly impact a company’s financial statements, including reported net income and asset values. Generally Accepted Accounting Principles (GAAP) in the United States permit several methods, while International Financial Reporting Standards (IFRS) have different allowances.

One common method is First-In, First-Out (FIFO), which assumes that the first goods purchased are the first ones sold. Under FIFO, the cost of the oldest inventory items is matched against sales revenue, and remaining inventory reflects the cost of the most recently acquired items. For example, if a bookstore buys 100 copies of a book at $10 each, then another 100 copies at $12 each, and subsequently sells 150 books, FIFO would assume the first 100 sold cost $10 each and the next 50 sold cost $12 each.

Another method is Last-In, First-Out (LIFO), which assumes that the last goods purchased are the first ones sold. This means the cost of the most recent inventory items is expensed as COGS, leaving the cost of older inventory on the balance sheet. For instance, using the previous bookstore example, if 150 books were sold under LIFO, the assumption would be that the 100 books costing $12 each were sold first, followed by 50 books costing $10 each. While LIFO is permitted under U.S. GAAP, it is generally prohibited under IFRS due to concerns about it not accurately reflecting the physical flow of goods or current inventory values.

A third approach is the Weighted-Average Method, which calculates an average cost for all goods available for sale during a period. This average unit cost is then applied to both the units sold (COGS) and the units remaining in inventory. This method can smooth out price fluctuations, providing a more consistent cost valuation. For example, if the bookstore had 200 books available for sale with a total cost of $2,200, the weighted average cost per book would be $11. This average would then be used to cost the 150 books sold and the 50 books remaining. The selection of any of these methods can lead to different reported gross profits and ending inventory values.

Recording Inventory Transactions

Merchandise inventory is tracked and recorded within a company’s accounting system using one of two primary methods: the perpetual inventory system or the periodic inventory system. The perpetual inventory system continuously updates inventory records with each purchase and sale transaction. This system provides real-time information on inventory levels and the Cost of Goods Sold. For instance, when a customer buys an item, the system automatically reduces the inventory count and records the cost of that specific item as COGS.

In contrast, the periodic inventory system updates inventory records only at specific intervals, typically at the end of an accounting period. Under this system, a physical count of the inventory is required to determine the ending inventory balance and to calculate the Cost of Goods Sold. This method is often simpler and more cost-effective for smaller businesses. For example, a small boutique might count its remaining items at the end of each month or quarter to update its inventory figures.

When merchandise is sold, its cost is moved from the inventory asset account to the Cost of Goods Sold account, which is an expense on the income statement. This process adheres to the matching principle, ensuring that the expense of the goods is recognized in the same period as the revenue generated from their sale, allowing for the calculation of gross profit. Accurate recording of inventory transactions is important for reliable financial reporting.