Description
Review the available materials for the chapters covered this week, including the lecture, reading, publisher materials, demonstration problems and exercises at the end of the chapters. After reviewing these materials and attempting the assignment for the week, what challenges did you face? Do you have any questions on the material? Participate in follow up discussion by helping your classmates and sharing your tips for understanding materials, when possible.Merchandising and Inventory Accounting
Introduction
Companies are typically classified as being service companies, merchandising companies, or manufacturing companies. Service companies provide a service rather than selling a tangible product. Examples of service companies include electricians, accounting firms, and hair salons. Merchandising and manufacturing companies, however, sell tangible goods as their primary course of business. Merchandising companies that sell to consumers are called retailers, and companies that sell to retailers are called wholesalers. The difference between merchandising companies and manufacturing companies is that merchandising companies buy their products to sell, whereas manufacturing companies purchase raw materials that they convert into a product to sell. Department stores such as Wal-Mart, K-Mart, and Target are merchandising companies. Many manufacturing companies such as Sony, General Foods, and Cuisinart sell their products to merchandisers to be sold ultimately to the consumer. This module explores the challenges that arise in accounting for merchandising companies.
Merchandising Operations and Inventory
Accounting for merchandising companies requires careful tracking of inventory. This includes keeping track of the value of the products purchased, merchandise sold, and inventory on hand. For merchandising companies, inventories are assets that are held for sale in the ordinary course of business. Inventory is frequently the largest current asset of a merchandising company (Kieso, Weygandt, & Warfield, 2009). When inventory is purchased, it is considered a current asset. When it is sold, the cost of that inventory must be matched against the revenue in the period of the sale, in accordance with the matching principle. The expense of inventory is called the cost of goods sold.
To calculate the cost of goods sold, the beginning value of inventory is added to the cost of goods purchased during the period. The cost of goods available for sale represents the cost of all merchandise that could have been sold during the period, which is equal to the cost of goods sold plus the ending value of inventory. The cost of goods sold is shown as an expense item on the income statement, and the ending inventory is shown as a current asset on the balance sheet. Most companies control their inventory through point-of-sale (POS) systems and, therefore, can keep a current, perpetual track of inventory on hand and current account of cost of goods sold. Under a perpetual inventory system, the value of inventory and the cost of goods sold are always up to date in the accounting system as each sale transaction is recorded. When sales of merchandise are recorded, the sale is recorded at the selling price by debiting accounts receivable or cash and crediting sales revenue. At the same time, in a perpetual inventory system, the cost of the merchandise sold is transferred from the inventory account to the cost of goods sold account by debiting cost of goods sold and crediting merchandise inventory for the original cost of the inventory. Inherently, the gross profit on a sale is reflected in the income statement, since that is where the sales revenue and the cost of goods sold are both accounted for.
Inventory Valuation
The challenge in recording sales transactions for both merchandising and manufacturing companies is assessing the cost of the specific inventory sold. Some types of inventory are unique by nature and, therefore, can be tracked via the specific identification method. Cars, for example, are generally tracked individually and based on precise features and a unique vehicle identification number. Under the specific identification method, costs associated with each specific unit of inventory can be transferred from the merchandise inventory to cost of goods sold at the time of sale. However, most merchandise is not easily identifiable because many inventory items are homogenous, or similar, to the point that tracking inventory items individually is difficult, if not impossible. The specific identification method valuing inventory is an actual cost flow method.
Since most merchandising companies purchase similar products in bulk, it becomes difficult to determine the specific cost of an individual unit sold. In addition, the cost of acquiring merchandise usually fluctuates, necessitating the use of cost flow assumptions to track the cost of goods sold. For merchandise that is not tracked individually, the accountant must make a cost flow assumption to determine which costs to attach to the units sold and which costs to attach to the units remaining in inventory.
Four different inventory cost methods are used to allocate the cost of goods available for sale to the units remaining in inventory and to the units sold. These methods, which are all acceptable under Generally Accepted Accounting Principles, are first-in first-out (FIFO), last-in-first-out (LIFO), weighted-average cost, and specific identification. Specific identification is an actual cost flow method, while FIFO, LIFO, and weighted-average costing are cost flow assumptions. The chosen cost flow assumption need not match the physical flow of inventory.
Lower-of-Cost-or-Market Value
Ending inventory should be valued based on the lower-of-cost-or-market basis (LCM basis), also known as the replacement cost. This practice can have a major effect on the statements of companies facing declining costs. Damaged, obsolete, and out-of-season inventory should also be written down to their current estimated net realizable value if below cost. The LCM adjustment increases cost of goods sold, decreases income, and decreases reported inventory in the year of the write-down.
Analyzing Inventory
The inventory turnover ratio (cost of goods sold divided by average inventory) measures the efficiency of inventory management. It reflects how many times average inventory was produced and sold during the period. Analysts and creditors watch this ratio because a sudden decline may mean a company is facing an unexpected drop in demand for its products or it is becoming careless in its production management.
Conclusion
The accountant is required to exercise judgment in choosing inventory methods. It is imperative that the accountant understand the implications for the business when selecting an inventory method and also comprehend the intricacies of applying that method to purchase and sales transactions. Accounting for a merchandising company is much more complex than accounting for a service entity due to the valuation of inventory and calculation of cost of goods sold. The cost of goods sold figure is considered a critical indicator for financial analysts, as is the gross profit margin. Understanding the methods used to calculate the cost of goods sold and gross profit will yield a greater understanding of the financial statements as a whole and lead to a more accurate analysis of a business from the standpoint of an investor or creditor.
References
Kieso, D., Weygandt, J., & Warfield, T. (2009). Intermediate accounting (3rd ed.) Hoboken, NJ: John Wiley and Sons, Inc.
© 2013. Grand Canyon University. All Rights Reserved.
Merchandising and Inventory Accounting
Introduction
Companies are typically classified as being service companies, merchandising companies, or manufacturing companies. Service companies provide a service rather than selling a tangible product. Examples of service companies include electricians, accounting firms, and hair salons. Merchandising and manufacturing companies, however, sell tangible goods as their primary course of business. Merchandising companies that sell to consumers are called retailers, and companies that sell to retailers are called wholesalers. The difference between merchandising companies and manufacturing companies is that merchandising companies buy their products to sell, whereas manufacturing companies purchase raw materials that they convert into a product to sell. Department stores such as Wal-Mart, K-Mart, and Target are merchandising companies. Many manufacturing companies such as Sony, General Foods, and Cuisinart sell their products to merchandisers to be sold ultimately to the consumer. This module explores the challenges that arise in accounting for merchandising companies.
Merchandising Operations and Inventory
Accounting for merchandising companies requires careful tracking of inventory. This includes keeping track of the value of the products purchased, merchandise sold, and inventory on hand. For merchandising companies, inventories are assets that are held for sale in the ordinary course of business. Inventory is frequently the largest current asset of a merchandising company (Kieso, Weygandt, & Warfield, 2009). When inventory is purchased, it is considered a current asset. When it is sold, the cost of that inventory must be matched against the revenue in the period of the sale, in accordance with the matching principle. The expense of inventory is called the cost of goods sold.
To calculate the cost of goods sold, the beginning value of inventory is added to the cost of goods purchased during the period. The cost of goods available for sale represents the cost of all merchandise that could have been sold during the period, which is equal to the cost of goods sold plus the ending value of inventory. The cost of goods sold is shown as an expense item on the income statement, and the ending inventory is shown as a current asset on the balance sheet. Most companies control their inventory through point-of-sale (POS) systems and, therefore, can keep a current, perpetual track of inventory on hand and current account of cost of goods sold. Under a perpetual inventory system, the value of inventory and the cost of goods sold are always up to date in the accounting system as each sale transaction is recorded. When sales of merchandise are recorded, the sale is recorded at the selling price by debiting accounts receivable or cash and crediting sales revenue. At the same time, in a perpetual inventory system, the cost of the merchandise sold is transferred from the inventory account to the cost of goods sold account by debiting cost of goods sold and crediting merchandise inventory for the original cost of the inventory. Inherently, the gross profit on a sale is reflected in the income statement, since that is where the sales revenue and the cost of goods sold are both accounted for.
Inventory Valuation
The challenge in recording sales transactions for both merchandising and manufacturing companies is assessing the cost of the specific inventory sold. Some types of inventory are unique by nature and, therefore, can be tracked via the specific identification method. Cars, for example, are generally tracked individually and based on precise features and a unique vehicle identification number. Under the specific identification method, costs associated with each specific unit of inventory can be transferred from the merchandise inventory to cost of goods sold at the time of sale. However, most merchandise is not easily identifiable because many inventory items are homogenous, or similar, to the point that tracking inventory items individually is difficult, if not impossible. The specific identification method valuing inventory is an actual cost flow method.
Since most merchandising companies purchase similar products in bulk, it becomes difficult to determine the specific cost of an individual unit sold. In addition, the cost of acquiring merchandise usually fluctuates, necessitating the use of cost flow assumptions to track the cost of goods sold. For merchandise that is not tracked individually, the accountant must make a cost flow assumption to determine which costs to attach to the units sold and which costs to attach to the units remaining in inventory.
Four different inventory cost methods are used to allocate the cost of goods available for sale to the units remaining in inventory and to the units sold. These methods, which are all acceptable under Generally Accepted Accounting Principles, are first-in first-out (FIFO), last-in-first-out (LIFO), weighted-average cost, and specific identification. Specific identification is an actual cost flow method, while FIFO, LIFO, and weighted-average costing are cost flow assumptions. The chosen cost flow assumption need not match the physical flow of inventory.
Lower-of-Cost-or-Market Value
Ending inventory should be valued based on the lower-of-cost-or-market basis (LCM basis), also known as the replacement cost. This practice can have a major effect on the statements of companies facing declining costs. Damaged, obsolete, and out-of-season inventory should also be written down to their current estimated net realizable value if below cost. The LCM adjustment increases cost of goods sold, decreases income, and decreases reported inventory in the year of the write-down.
Analyzing Inventory
The inventory turnover ratio (cost of goods sold divided by average inventory) measures the efficiency of inventory management. It reflects how many times average inventory was produced and sold during the period. Analysts and creditors watch this ratio because a sudden decline may mean a company is facing an unexpected drop in demand for its products or it is becoming careless in its production management.
Conclusion
The accountant is required to exercise judgment in choosing inventory methods. It is imperative that the accountant understand the implications for the business when selecting an inventory method and also comprehend the intricacies of applying that method to purchase and sales transactions. Accounting for a merchandising company is much more complex than accounting for a service entity due to the valuation of inventory and calculation of cost of goods sold. The cost of goods sold figure is considered a critical indicator for financial analysts, as is the gross profit margin. Understanding the methods used to calculate the cost of goods sold and gross profit will yield a greater understanding of the financial statements as a whole and lead to a more accurate analysis of a business from the standpoint of an investor or creditor.
References
Kieso, D., Weygandt, J., & Warfield, T. (2009). Intermediate accounting (3rd ed.) Hoboken, NJ: John Wiley and Sons, Inc.
© 2013. Grand Canyon University. All Rights Reserved.
