Lesson 27: Introduction to Merchandise Inventory
In this lesson, we will talk about the difference between service and
merchandise companies, and the accounting steps related to their operations. We
will give examples of the business types and learn how to record merchandising
operations on the income statement.
Merchandise inventory is an asset that we need to understand how to identify,
report and collect. There is a good bit of material that
we have to cover on this topic but for the purpose of this lesson we will talk
about the two types of operations and how they differ when it comes to
financial accounting.
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As you can see from
the steps depicted above, service companies perform a service, while a
merchandising company buys and sells inventory. These two types of businesses
differ in the main fact that a merchandising company has inventory.
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Both types of companies need to report the collection of accounts receivable and
cash,
but they have very different methods when it comes to
reporting on financial statements.
The definition of merchandising operations is much different for a services
company than for a standard merchandising company.
Service companies sell their skills or expertise in
the form of a service, instead of a physical item. For example, consulting,
fitness coaching, public accounting and attorneys are all examples of service
businesses.
They perform a service in exchange for payment;
essentially the service is their product. Services businesses do not have to
report inventory, because they are not selling tangible items.
In contrast to service companies, merchandising companies carry physical
inventory of products. Think of big box retailers such as Home Depot and
Wal-Mart, as they carry inventory that is sold to customers.
They need to be able to
record and quantify the inventory on their balance sheet. They record the
inventory as the lower figure between cost and net realizable value (NRV).
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Net realizable value is calculated by deducting any amortization,
depreciation and impairment from
the cost of the inventory. Impairment often means that
the merchandise becomes obsolete and is worth a lower amount.
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For example, if the company has 500 units at $6 a piece, they would have a cost
of $3,000 for their total inventory. If a portion of the inventory becomes
obsolete and the total inventory is only worth $1,900, the company would need
to report the lower NRV of $1,900 on the balance sheet.
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This ensures that
the assets are stated conservatively based on the value of the inventory.
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Merchandising companies have an extra step when compared to services businesses
as they have to record the cost of inventory on the income statement.
On the income statement, the company first lists the net sales, and then
subtracts the cost of goods sold, to come up with the gross profit figure.
Let's take a look at the sample income statement above, and I will describe
what each of these terms means.
The sales revenue also known as net sales is the total amount of sales that
the company made during the accounting period.
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Merchandise businesses need to sell their inventory and
record the cost of goods sold,
which is the costs incurred to obtain the product or goods for sale to
the consumer.
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Finally, the gross profit is calculated by subtracting the cost of goods sold
from the net sales. This figure is also known as the fatty profit, because it
represents what is left over after the goods are sold.
Expenses are then deducted from
the gross profit to come up with the final figure of operating income.
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In the next lesson, we will be diving deeper into merchandising concepts,
as we cover the differences between perpetual and periodic inventory.