Reporting and Analyzing Inventory

What is Merchandise Inventory

Merchandise Inventory was defined as the cost of the goods on hand as of the date the inventory was taken. The valuation of the inventory taken is based on its cost. Keep in mind that merchandise inventory represents only those assets that were acquired exclusively for the purpose of resale in the normal course of business.The taking of an inventory of supplies on the other hand was for the purpose of converting an asset on the books to an expense to the extent those supplies had been used up.

Types of Inventory Systems

The Periodic System

There are basically two inventory systems used in accounting: the periodic and the perpetual inventory systems. So far we have discussed only the former. When the PERIODIC INVENTORY SYSTEM is used, only the income from sales is recorded when sales are made. No entries are made in either the merchandise inventory or the purchases account to recognize the cost of the particular items sold.Periodically (at least once, a year, usually at the end of the accounting period), a physical inventory is taken to determine the cost of the ending inventory. A comparison between the cost of goods available for sale (beginning merchandise inventory plus net purchases) and the ending merchandise inventory enabled the accountant to determine the cost of goods sold.
Most businesses use the periodic inventory system, especially if the goods sold consist of large quantities of diverse products.

The Perpetual Inventory System

With the PERPETUAL INVENTORY SYSTEM, accounting records that continuously disclose the amount of inventory are maintained. A separate subsidiary ledger is maintained that contains separate accounts for each type of inventory item. Increases in the specific inventory item are directly to the specific account and corresponding decreases due to sales or returns are credited directly to the specific account. Thus the balance in the individual subsidiary ledger account at any moment in time represents the actual amount of that particular product on hand. Since this method is time-consuming and expensive to maintain, it is primarily used by those organizations that sell relatively small numbers of items with high unit cost, such as automobile dealerships. While perpetual inventory system may be used for the sale of automobiles, the parts department of the dealership will use a periodic inventory system.

To use the perpetual inventory system, the actual cost of the goods assigned to the various accounts in the subsidiary inventory ledger must be known. While the periodic system segregated cost and revenue items related to merchandise purchased into specific accounts, such as purchases returns and allowances, purchases discounts, and freight on purchases, this is not done under the perpetual system. The cost assigned to the various inventory accounts under the perpetual system is composed of the purchase price and all costs incurred in acquiring such merchandise, less savings from discounts and any subsequent authorized purchased returns. The most significant difference in using the perpetual system is the activity that takes place in the merchandise inventory account, which replaces the merchandise purchases account used in the periodic system.

See Example Exercise 1