Accounting for Inventory Transactions and Profitability Evaluation in Merchandising Companies

QUESTION
discuss the accounting-for-inventory transactions of merchandising companies, the two formats of preparing the income statement, and how to evaluate the profitability of a merchandising company. We will also discuss how companies determine the year-end inventory value and cost of goods sold using one of the cost-flow assumptions. Finally, we will examine the impact of choosing a certain cost-flow assumption on the tax liability and other financial statement numbers of a company.
Let’s begin with this question: How is the income statement of a merchandising company different from that of a service company?

ANSWER
1. Income Statement Differences between Merchandising and Service Companies
The income statement of a service company and a merchandising company differs in terms of the amount of reported revenues and the presentation of cost of goods sold and gross profit. In a service company, the revenue section of the income statement looks simple. Revenues are reported when services performed, not when cash is received. The statement shows the total revenues generated by the company during the reporting period. It does not record any revenues for future services that have been paid in advance. The unearned revenue is recorded in the balance sheet as a liability. In contrast, a merchandising company uses a more complex revenue recognition principle. The income statement should show the sales revenue for the period and the gross profit of the company. Sales revenue represents the actual invoiced sales to customers, not the purchase revenue as recognized in the company’s books. However, as for services, revenue is recognized when goods are delivered to the buyers, not when the cash is received. The cost of goods sold is the expenses that a merchandising company has paid to produce the goods that have been sold during the reporting period. The calculation of cost of goods sold is not necessary in a service company’s income statement. Besides, it is also different from the expense of purchase that has been paid during the period. This is because the cost of goods sold should be recorded as expenses in the same period as sales which have been generated from the sold goods. Unlike in a merchandising company, the statement will only show the net sales after deducing the cost of goods sold. It does not show the total revenues from goods purchased by the company. However, the revenue section will show total revenues overall, including for any future services that have been paid in advance. In contrast to a service company, the income statement of a merchandising company should also present the cost of goods sold and gross profit. The cost of goods sold is the expenses that a merchandising company has paid to produce the goods that have been sold during the reporting period. The calculation of cost of goods sold is not necessary in a service company’s income statement.
1.1. Revenue Recognition in Merchandising Companies
The title to the inventory passed from the seller to Revcon Inc. at the shipping point. The goods will be shipped FOB (Free On Board) shipping point. When the inventory arrives at Revcon Inc.’s location, the prepaid freight will be reclassified to the income statement and Revcon Inc. will record the delivery costs as a part of the cost of the goods sold.
Illustration 1: Revcon Inc. ordered an inventory costing $4,000 on 11/20/X1 and received the inventory on 12/3/X1. The seller paid for the shipping cost of $200.35.
Revenue is earned when the seller transfers the promised goods or services to the customer, regardless of when the customer pays for the product. In a merchandising company, revenue is earned through the sale of merchandise. Revenue from the sale of inventory is recorded in the income statement when title to the goods passes from the seller to the buyer. Goods can be sold under different contractual terms. If the seller explicitly agrees to pay for the transportation of the inventory to the buyer, then the seller has title to the goods until the inventory reaches the buyer. If the merchandise is shipped FOB (Free On Board) shipping point, then the title to the goods passes to the buyer at the shipping point. In this case, the seller will record the sales revenue and the inventory will be reduced when the goods have been loaded onto the shipping vehicle. The buyer is responsible for the transportation costs and the seller will not record additional costs associated with delivering the inventory to the buyer. If the merchandise is shipped FOB destination, then the title to the goods passes to the buyer when the goods reach the buyer’s place of business. In this case, the seller will record the sales revenue and reduce the inventory when the merchandise has been delivered to the customer’s location. The seller is responsible for the additional costs of shipping the merchandise to the buyer, and therefore the seller will record the costs associated with the transportation as freight-out expenses on the income statement. On the contrary, if the seller agrees to pay for the additional transportation costs, then the buyer will not take title to the goods until the merchandise is delivered. If the merchandise is shipped FOB destination, then the revenue from the sales transaction and the related cost in the amount of the prepaid freight will be recorded as a deferred cost on the balance sheet. The seller will record the freight cost as a part of the cost of the goods sold when the inventory is delivered to the customer’s location. As a result, the merchandise appears in the inventory and the seller consumes the freight cost, at which point the deferred cost of the prepaid freight will be reclassified from the balance sheet to the income statement.
Revenue from sales transactions
1.2. Cost of Goods Sold Calculation in Merchandising Companies
The cost of goods sold calculation in the income statement in merchandising companies is a primary difference from the income statement in service companies. In service companies, there is no requirement for tracking the inventory and the cost of goods sold. Instead, the cost of goods sold in merchandising companies is like the direct labor and manufacturing overhead in manufacturing companies: it is associated with the inventory that has been sold. In another word, cost of goods sold represents the expense of the goods that have been sold during the period. The calculation of cost of goods sold is shown as follows: begin with the beginning inventory, add the purchase, and then subtract the ending inventory. The beginning and the ending inventory are also reported in the balance sheet at the end of the year. However, the income statement is only for each period. When the goods are sold, the cost of those goods will be transferred from inventory to the cost of goods sold. From the formula of calculating the cost of goods sold, it is understood that cost of goods sold usually involves three accounts: the inventory, the purchase, and the cost of goods sold itself which is shown in the income statement. Since the merchandise inventory in the balance sheet has to be measured at the end of the month every time, the cost of goods sold should be periodically calculated and matching with the actual cost of the goods which are in the inventory. You could see how important the time and the effort of keeping track of the inventory, buying and selling the goods are to the manager. All these activities will be reflected in the income statement and the balance sheet that provide useful information for decision making, performance evaluation, and comparison with similar companies. According to the document, there are two formats of preparing the income statement in merchandising companies, which are single-step income statement and multiple-step income statement. The single-step income statement is simple and uses only one step to calculate the net income. On the other hand, the multiple-step income statement provides more detailed information for the users, like the gross profit and the total operational expenses. And it also provides a subcategory for each kind of operational expense.
1.3. Gross Profit Calculation in Merchandising Companies
The formula to calculate gross profit is: Gross Profit = Net Sales – Cost of Goods Sold (COGS). It is important to note that COGS is the cost of inventory at the beginning of the accounting period, plus the cost of purchases during the accounting period, minus the cost of inventory at the end of the accounting period. Inventories usually involve various cost factors due to inflation or other price level changes. So, the management has to choose a cost flow assumption from different inventory valuation methods. There are three most widely used inventory valuation methods under a perpetual inventory system, which are: First-In, First-Out (FIFO); Last-In, First-Out (LIFO) and Weighted Average Cost. These methods will lead to different allocation of cost of goods sold between consecutive accounting periods and therefore it will lead to different figures of gross profit and eventually different tax liability. On the other hand, under a periodic inventory system, the cost of goods sold and the ending inventory are physically counted and then costed at the end of the accounting period. The value of closing inventory is calculated by: closing inventory = opening inventory + purchase – closing inventory. As a conclusion, the main difference between gross profit margin, operating profit margin and net profit margin is the deduction used in the formula of each margin. Gross profit margin deducts cost of goods sold from net sales, while operating profit margin deducts the total operating expenses from gross profit; and net profit margin deducts all the other expenses (e.g. interest, taxation) from the operating profit. It is important to make an overall efficiency comparison on different profit margins of a particular company, by comparing with the margins growth over different accounting periods and by comparing the margins with the average company margins in the same industry.
2. Two Formats of Preparing the Income Statement
2.1. Single-Step Income Statement Format
2.2. Multiple-Step Income Statement Format
3. Evaluating the Profitability of a Merchandising Company
3.1. Gross Profit Margin Analysis
3.2. Operating Profit Margin Analysis
3.3. Net Profit Margin Analysis
4. Determining Year-End Inventory Value in Merchandising Companies
4.1. Perpetual Inventory System
4.2. Periodic Inventory System
5. Cost of Goods Sold Calculation using Cost-Flow Assumptions
5.1. First-In, First-Out (FIFO) Method
5.2. Last-In, First-Out (LIFO) Method
5.3. Weighted Average Cost Method
6. Impact of Cost-Flow Assumptions on Tax Liability and Financial Statements
6.1. Tax Implications of Different Cost-Flow Assumptions
6.2. Effect on Inventory Valuation
6.3. Impact on Profitability Measures