Accounting for Merchandising Company Inventory

By Kenneth Boyd, Lita Epstein, Mark P. Holtzman, Frimette Kass-Shraibman, Maire Loughran, Vijay S. Sampath, John A. Tracy, Tage C. Tracy, Jill Gilbert Welytok

Accounting for merchandise inventory is generally easier than accounting for manufacturing inventory. That’s because a merchandising company, such as a retail store, has only one class of inventory to keep track of: goods the business purchases from various manufacturers for resale.

Here’s an example of the basic flow of inventory for a retailer: A linen sales associate at a major department store tells the manager that a certain style of linen is in low supply. The manager follows the store’s purchasing process, and the store receives a shipment of linens from its vendor.

This transaction is a purchase (cost), but it’s not an expense until the department store sells the linens. So the business records the entire shipment of linens on the balance sheet as an addition to both inventory and accounts payable. Accounts payable is used instead of cash because the department store has payment terms with this vendor and money has yet to change hands during this transaction.

Say that in August, the store sells linens to customers for $150 that cost the company $75 to purchase from the vendor. Sales revenue increases by $150, cost of goods sold increases by $75, and inventory decreases by $75. Matching the expense to revenue, the effect to net income is $150 sales – $75 cost of goods sold = $75 profit on sale.

Pretty basic stuff. The company buys inventory and sells it. Next, you consider how retail shops normally track inventory. Two major types of inventory systems exist: perpetual and periodic.

Perpetual system

Most larger retailers have electronic cash registers (ECRs) that scan the bar code of each product and record the sale into the system, along with an increase to cash. If the business also uses a point-of-sale system, which means transactions at the register automatically update all accounting records, the inventory count is updated constantly, perpetually, as the ECR records the item sold.

This means that the cost of the item sold is taken out of the asset inventory account and moved to cost of goods sold (COGS).

With point-of-sale systems, transactions taking place at the cash register update all inventory, COGS, and sales information throughout the system in real time as the transactions occur.

Suppose you go into a national chain retailer and buy a birthday card for a friend. As you check out, the point-of-sale software updates the greeting card department records showing that one less birthday card is available for sale. The software also updates COGS showing the cost for the card and revenue to reflect the retail price (what you just paid) for the birthday card.

Even if a company uses a point-of-sale system, taking a physical inventory at year-end (or periodically) is still important to verify that the perpetual system is working correctly. Taking a physical inventory is also the best way to identify breakage and theft issues. If the inventory accounting records differ from the inventory items counted, the company may need to adjust the dollar amount of inventory on the books.

Periodic system

With a periodic system, the physical inventory is taken periodically, and the resulting figure is used to adjust the balance sheet “inventory asset” account. This is the same inventory count and adjustment process you see with the perpetual system. However, the perpetual system updates inventory constantly, whereas the periodic system doesn’t.

Retail shops using periodic inventory usually take inventory at their particular year-end. However, inventory could be taken more often, such as quarterly or at the end of every heavy sales season (such as Valentine’s Day, Mother’s Day, and the December holidays).

Keep in mind this formula for calculating ending inventory:

Ending inventory = Beginning inventory + Purchases – Cost of goods sold

Here’s how the periodic system works:

  • The business takes ending inventory, coming up with a dollar amount for all unsold inventory, as of the last day of the accounting period. Say ending inventory is $1,000.

  • Next, the company’s accounting department subtracts ending inventory totals from the sum of beginning inventory ($2,000) and purchases made during the period ($1,500).

  • Finally, the accounting department plugs the three inventory items into the previous formula to calculate cost of goods sold (COGS).

The formula looks like this:

$1,000 = $2,000 + $1,500 – $2,500

Using the periodic system, COGS can be determined with accuracy only after the physical inventory is taken. When companies prepare financial statements and a physical inventory isn’t taken, they use an estimate. That estimate is based on the previous formula.

Specifically, a business uses the beginning and ending inventory amounts, along with purchases during the period. Because inventory may be a large part of a firm’s total assets, a physical inventory count is highly recommended.

Don’t include consignment goods in inventory. With a consignment arrangement, the merchandiser (consignee) is acting as a middleman between the owner of the goods (consignor) and the customer. The merchandiser doesn’t have title to the goods.

If the consigned item is sold, the sales proceeds are transferred to the owner. For providing the consignment as a service, the merchandiser receives a fee or a percentage of the sales proceeds from the owner.