Chapter 8: Merchandise Inventory

In this chapter you will learn about how merchandise inventory affects businesses, how it is controlled, accounted for, and reported in financial statements.
 

What is merchandise inventory?

Merchandise inventory is a resource. It consists of the products merchandising companies buy from suppliers and sell to customers. For example, The Gap buys shirts, blouses, slacks, socks and many other products from numerous other companies. The Gap displays these products in its stores and sells them to customers, hopefully at higher prices than The Gap paid for them. Through this process of buying and selling products, The Gap's management increases The Gap's resources over time.

In terms of the accounting equation, merchandise inventory is a current asset as shown below. The numbers in parentheses refer to the chapters in which the accounts are discussed.
 
 

Resources

=

Sources of Resources

Assets

=

Liabilities

+

Stockholders' Equity

Current Assets 
  Cash and cash equivalents (6) 
  Accounts receivable (7) 
  Allowance for uncollectible accounts (7) 
  Merchandise inventory (8)

 

 

 

 Revenues 
  Sales (7) 
  Sales returns and allowances (7) 
Operating Expenses 
  Bank service expense (6) 
  Uncollectible accounts expense (7) 
Other Revenues & Expenses 
  Interest revenue (6) 
  Interest expense (6)

Merchandising: an overview

Merchandising companies attempt to increase their resources through the continuous process of buying products and selling them to customers at higher prices. Because owners have rights to any increases in resources brought about by management activities, as the companies' resources increase so do the rights of owners (stockholders' equity). A simplified view of how merchandising inventory affects merchandising companies can be seen in four major steps: (1) the purchase of merchandise from suppliers, (2) the sale of merchandise to customers, (3) the collection of cash from customers, and (4) the payment of cash to suppliers.

Step 1: the merchandising company purchases merchandise on credit from suppliers. Although merchandise may be purchased for cash, this example considers credit purchases only. As a result of buying merchandise on credit, the merchandising company's resources (assets) increase. Since assets increase with debits, the purchase of merchandise inventory is shown below as a debit to assets (Step 1: Merchandise inventory). Since the sources of the merchandise inventory were companies who sold the products to the merchandising company on credit, the merchandising company's liabilities also increase as a result of the merchandise purchase. Since liabilities increase with credits, the increase in liabilities is shown below as a credit to liabilities (Step 1: Accounts payable). As you remember from previous chapters, the accounts payable account is used to record the dollar amount owed to suppliers for services or products purchased from them but not paid for yet. In total, the result of merchandising step 1 is an increase in assets (merchandise inventory) and an equal increase in liabilities (accounts payable).
 

Total
Resources

=

Sources of
Borrowed
Resources

+

Sources of
Owner Invested
Resources

+

Sources of
Management Generated
Resources

Assets

=

Liabilities

+

Stockholders' Equity

Step 1: Merchandise inventory

 

 

 

Step 1:
Accounts
payable

 

 

 

 

 

 


 

 

 

 

 

 

 

Revenues

 

 

 

 

 

 

 

 

 

 

 


 

 

 

 

 

 

 

Expenses

 

 

 

 

 

 

 

 

 

 

 

Step 2: the merchandising company sells merchandise on credit to customers. Although merchandise may be sold for cash, this example considers credit sales only. As a result of selling merchandise on credit, two things happen simultaneously to the merchandising company's resources (assets). Resources decrease as the products (merchandise inventory) flow out of the company to customers. Resources also increase as resources (accounts receivable) flow into the company. Because managers want to know about both of these two effects, sales of products to customers are separated into two parts: the flow of merchandise inventory to customers and the flow of accounts receivable to the company. These two effects will be discussed as steps 2A and 2B.
 

Step 2A: the flow of merchandise to customers. As the merchandising company sells its products to customers, the company's resources (assets) decrease because some of its merchandise goes out of the company. Since assets decrease with credits, the sale of merchandise inventory is shown below as a credit to assets (Step 2A: Merchandise inventory). Since the reason for the merchandise inventory flowing out of the company was management's action of selling it to customers, the "using up" of the merchandise by management results in an expense. In this case, the expense is called the cost of goods sold. Since owners are responsible for managers' actions, the cost of goods sold, like all expenses, decreases stockholders' equity. Since stockholders' equity decreases with debits, the decrease in stockholders' equity is shown below as a debit to stockholders' equity (Step 2A: Cost of goods sold). In total, the result of merchandising step 2A is a decrease in assets (merchandise inventory) and an equal decrease in stockholders' equity (through an increase in the cost of goods sold "expense").
 

Total
Resources

=

Sources of
Borrowed
Resources

+

Sources of
Owner Invested
Resources

+

Sources of
Management Generated
Resources

Assets

=

Liabilities

+

Stockholders' Equity

Step 1: Merchandise inventory

Step 2A: Merchandise inventory

 

 

Step 1:
Accounts
payable

 

 

 

 

 

 


 

 

 

 

 

 

 

Revenues

 

 

 

 

 

 

 

 

 

 

 


 

 

 

 

 

 

 

Expenses

 

 

 

 

 

 

 

 

 

Step 2A:
Cost of goods sold

 

Step 2B: the flow of promises (accounts receivable) from customers. When customers buy products from the merchandising company on credit, they promise to pay the company by some specific date in the future. As a result, the merchandising company's resources (assets) increase because it has more promises (accounts receivable) than it had before the sale. Since assets increase with debits, the increase in accounts receivable is shown below as a debit to assets (Step 2B: Accounts receivable). Since the reason for the accounts receivable flowing into the company was management's action of selling products to customers, the increase in accounts receivable by management results in a revenue. In this case, the revenue is called sales. Since owners are responsible for managers' actions, the sales, like all revenues, increase stockholders' equity. Since stockholders' equity increases with credits, the increase in stockholders' equity is shown below as a credit to stockholders' equity (Step 2B: Sales). In total, the result of merchandising step 2B is an increase in assets (accounts receivable) and an equal increase in stockholders' equity (through an increase in sales revenue).
 

Total
Resources

=

Sources of
Borrowed
Resources

+

Sources of
Owner Invested
Resources

+

Sources of
Management Generated
Resources

Assets

=

Liabilities

+

Stockholders' Equity

Step 1: Merchandise inventory

Step 2B:
Accounts receivable

Step 2A: Merchandise inventory

 

 

Step 1:
Accounts
payable

 

 

 

 

 

 


 

 

 

 

 

 

 

Revenues

 

 

 

 

 

 

 

 

 

 

Step 2B:
Sales


 

 

 

 

 

 

 

Expenses

 

 

 

 

 

 

 

 

 

Step 2A:
Cost of goods sold

 

It is important to note the stockholders' equity effects of step 2, the sale of merchandise to customers on credit, appear in two separate accounts. The decrease in stockholders' equity, as resources flow out of the company to customers, is shown through an increase in the cost of goods sold expense. The increase in stockholders' equity, as resources flow into the company from customers, is shown as an increase in sales revenue. These two separate stockholders' equity accounts, cost of goods sold and sales, are used because managers and others are interested in both the flow of resources to customers and the flow or resources to the company.
 

Step 3: the collection of cash from customers. When customers pay for the products they purchased on credit, the merchandising company's resources (assets) change from accounts receivable to cash. As a result, the company's cash increases and its accounts receivable decrease by the same dollar amount. Since assets increase with debits, the increase in cash is shown below as a debit to assets (Step 3: Cash). Since assets decrease with credits, the decrease in accounts receivable is shown below as a credit to assets (Step 3: Accounts receivable).
 

Total
Resources

=

Sources of
Borrowed
Resources

+

Sources of
Owner Invested
Resources

+

Sources of
Management Generated
Resources

Assets

=

Liabilities

+

Stockholders' Equity

Step 1: Merchandise inventory

Step 2B:
Accounts receivable

Step 3:
Cash

Step 2A: Merchandise inventory

Step 3:
Accounts receivable

 

 

Step 1:
Accounts
payable

 

 

 

 

 

 


 

 

 

 

 

 

 

Revenues

 

 

 

 

 

 

 

 

 

 

Step 2B:
Sales


 

 

 

 

 

 

 

Expenses

 

 

 

 

 

 

 

 

 

Step 2A:
Cost of goods sold

 

Step 4: the payment of cash to suppliers. When a company pays for the products it purchased on credit, the merchandising company's resources (assets) decrease as the cash flows out of the company. Since the cash was paid to a creditor, the merchandising company's liabilities also decrease. Since assets decrease with credits, the decrease in cash is shown below as a credit to assets (Step 4: Cash). Since liabilities decrease with debits, the decrease in liabilities is shown below as a debit (Step 4: Accounts payable).
 

Total
Resources

=

Sources of
Borrowed
Resources

+

Sources of
Owner Invested
Resources

+

Sources of
Management Generated
Resources

Assets

=

Liabilities

+

Stockholders' Equity

Step 1: Merchandise inventory

Step 2B:
Accounts receivable

Step 3:
Cash

Step 2A: Merchandise inventory

Step 3:
Accounts receivable

Step 4:
Cash

 

Step 4:
Accounts payable

Step 1:
Accounts
payable

 

 

 

 

 

 


 

 

 

 

 

 

 

Revenues

 

 

 

 

 

 

 

 

 

 

Step 2B:
Sales


 

 

 

 

 

 

 

Expenses

 

 

 

 

 

 

 

 

 

Step 2A:
Cost of goods sold

 

The four steps discussed above illustrate the effects of merchandise inventory flowing in and out of a company. Through this process of buying and selling products, merchandising companies attempt to increase their resources over time. If more resources (cash and accounts receivable) are received from customers than has to be paid to suppliers, the merchandising company's resources will increase. This increase in resources will increase stockholders' equity because revenues (sales) will be greater than expenses (cost of goods sold). In other words, the increase in resources will increase stockholders' equity through net income. Remember, net income is calculated as the difference between revenues and expenses. Once again, owners are interested in managers generating net income because net income results in increased resources to which owners have a right.

 

 

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