Published in: Accounting

Is Merchandise Inventory an Asset?

Author Joy Sunday Zaleng

Published on: October 14, 2022

Effective inventory management is essential for the business success of wholesalers, retailers, and distributors. Oftentimes, these companies have considerable amounts of money invested in a stock that is intended for sale to customers.

For many companies, this merchandise inventory is known as the inventory of goods for sale, which is valuable to them. For example, automobile dealers may have millions of dollars tied in vehicle inventory. The ability of a business to manage its inventory properly can have an immense impact on its profitability, competitiveness, customer satisfaction, and most importantly, its survival.

So, is merchandise inventory an asset? Before looking at whether a merchandise inventory is an asset, it is critical to decipher what the term implies in accounting. This article also explains the merchandise inventory formula and its journal entries.

Retailers, wholesalers, and distributors are typically the only businesses with merchandise inventory. Although manufacturers produce inventory, they do not purchase and resell it. Therefore, the inventory of manufacturers is not considered merchandise inventory.

For some business types, this can be the single largest asset on the balance sheet. If these goods are sold during an accounting period, their cost will be charged to the cost of goods sold and it then appears as an expense in the income statement in the period when the sale took place. If the sale of these goods does not take place during an accounting period, their cost will be recorded as a current asset and will appear on the balance sheet until the time they are sold.

If there is a decrease in the market value of merchandise inventory below its recorded cost, then it is required for one to record the cost down to its market value and charge the difference to expense, under the lower cost or market rule.

Therefore, merchandise inventory is so called because wholesalers, retailers, and distributors generate revenue by buying the goods from manufacturers as well as other suppliers and then, marketing and selling them to customers, that is merchandising. Merchandise inventory, therefore, is the manifestation of the value of the goods that a retailer or other reseller intends to sell to customers. This includes the goods a company holds in all locations, including storage facilities, warehouses, and retail stores.

See also: Balance Sheet Substantiation

A company buys or creates assets in order to increase its value or benefit its operations. Having said this, assets can be considered as anything that can generate cash flow in the future regardless of whether it is a tangible or intangible asset.

Merchandise inventory impacts a company’s assets, accounts payable, profit, and expenses as these are all important measures of a business’s financial health. With this, it is important to accurately account for merchandise inventory.

The value of merchandise inventory includes the price paid to suppliers and associated costs such as transportation and insurance. The reason why it is listed on the balance sheet as an asset is a fact that businesses spend money on it and it has economic value. Also, inventory turnover represents one of the primary sources of revenue generation as well as subsequent earnings for the company and its shareholders.

A balance sheet is essentially a business’s statement of financial position at a certain date and time and alongside assets, it includes liabilities and the total worth also known as the net worth of the company. So investors make use of information from the balance sheet such as the merchandise inventory to assess a company’s value and financial stability.

Inventory is something that one will incorporate for future use in business operations. This definition covers those items that have been bought for resale, for example, skirts for a clothing store. It also covers parts one has on hand that will go into the items manufactured such as wood and screws for a furniture-manufacturing business.

It is critical for a business to keep track of merchandise inventory as it is a part of loss prevention. The act of reducing inventory loss can include increasing the company’s security, surveillance, sales floor supervision, and regular inventory of the company merchandise by an independent inventory company. Increasing the security of a company in order to reduce the loss of inventory has to do with the supervision of inventory from when it is acquired to when it leaves the store in a sale.

When the inventory leaves the store, every movement of the merchandise is accounted for and a company can minimize losses and may be able to identify and eliminate the source of losses when they occur.

Another thing to note is that checking the quantity of merchandise upon arrival is a critical step in ensuring that no inventory was lost or forgotten in shipment.

There are tools used to keep track of merchandise inventory such as sales records, inventory software, and inventory devices. To make sure that there is an accurate assessment of merchandise inventory that is independent of the people charged with managing it, a company might hire an external company that provides professional inventory services.

In cases where an outside inventory service assesses a business’s inventory, it usually implies traveling to the location where the inventory is stored and counting the inventory in person. Sometimes, this is carried out by hand with a paper ledger to keep a record of amounts. However, it is most frequently carried out using a computer system and devices that scan merchandise tags to keep a record of inventory. This is where inventory management comes in.

It is important to note that processing a high amount of inventory for a long time is usually bad for a business because of the challenges it presents. These challenges include storage costs, spoilage costs, and the threat of obsolescence. Possessing too little amount of inventory is also disadvantageous as a company may run the risk of market share erosion as well as losing profit from potential sales. This is why inventory management is usually emphasized as it helps in minimizing inventory costs because goods and received only when needed.

See also: Unearned Revenue is What Type of Account?

Merchandise inventory valuation

1. First-in, first-out (FIFO)
2. Last-in, first-out (LIFO)
3. Weighted average

First-in, first-out (FIFO)

The FIFO method is based on the fact that the cost of goods sold is based on the earliest purchased materials. On the other hand, the carrying cost of the remaining inventory is based on the cost of the latest purchased materials.

Last-in, first-out (LIFO)

The LIFO method states that the valuation of the cost of goods sold takes place using the cost of the latest purchased materials while the value of the remaining inventory is based on the earliest purchased materials.

Weighted average

The weighted average method requires the valuation of both inventory and cost of goods sold based on the average cost of all materials that were purchased during the period.

The management of companies or businesses, analysts, and investors can make use of a company’s inventory turnover to determine the number of times it sells its products over a certain period of time. Inventory turnover can be an indication of whether a company has too much or too little inventory on hand.

Merchandise inventory formula

The formula for calculating merchandise inventory value is:

Merchandise inventory value = Inventory cost of each unit * unsold inventory amount

After calculating the merchandise inventory value, the next thing is to calculate the cost of goods sold. The formula is represented as:

COGS = (Beginning inventory + Purchased inventory value) – Merchandise inventory value

The cost of goods sold is then used to calculate the profit as represented below:

Profit = Total sales – COGS

As previously stated, merchandise inventory is the cost of goods at hand that is available for sale at any given time. It is a current asset with a normal debit balance which means that debit will increase while credit will decrease. Also, inventory information is needed in order for management to determine the cost of goods sold in any accounting period. With this, it is required for the management to know the cost of goods on hand at the beginning of the accounting period, the net cost of purchase during the accounting period, and the cost of goods on hand at the end of the accounting period.

Because the ending inventory for one period is the beginning period for the next, the management already has knowledge of the beginning inventory. Companies record purchases, purchase discounts, purchase returns and allowances, and transportation throughout the period. There is always a need for management to determine only the cost of the ending inventory at the end of the period in order to calculate the value of the cost of goods sold. Note that the cost of goods sold is the inventory cost to the seller of the goods that are sold to customers. It is an expense item with a normal debit balance.

It is required for accountants to have accurate figures of merchandise inventory in order to calculate the cost of goods sold. They make use of two basic methods for determining the amount of merchandise inventory which are the perpetual inventory procedure and the periodic inventory procedure.

When discussing inventory, there is a need to clarify whether one is referring to the physical goods on hand or the merchandise inventory account, which financially represents the physical goods on hand. The difference between the perpetual and the periodic inventory procedures is the frequency at which the merchandise inventory account is updated in order to reflect the goods that are physically on hand.

Under the perpetual inventory procedure, there is a continuous updating of the merchandise inventory account to reflect the items that are on hand. Also, there will be a need for the company to record the merchandise purchased in the inventory account or the merchandise inventory account. Under the periodic method, on the other hand, the business waits for the end of the accounting period before counting everything.

In other words, the accounts will usually be updated when the company performs the physical count of the remaining merchandise inventory on hand. Also, the business will not record the merchandise purchased directly into the inventory account, the figures will rather be recorded into a temporary account such s the purchases account.

Example

To have a better understanding of how the value of merchandise inventory and cost of goods sold is calculated, the following example should be considered:

A footwear merchandiser had ten units of beginning inventory that is worth $1,000, he purchased 50 units of shoes from a supplier at $100 per pair, he sold 40 pairs and each pair was sold at $200, and at the end of the accounting cycle, he had 20 pairs left. In order to arrive at the value of merchandise inventory, the amount of unsold inventory should be multiplied by the cost of each unit.

Using the formula earlier stated:

Merchandise inventory value = Inventory cost of each unit * unsold inventory amount

Merchandise value = 100 x 20 = $2000

The value of merchandise inventory is usually considered the same as the ending inventory, it will then be entered into the balance sheet.

Now, the cost of goods sold, the direct cost of the production of merchandise inventory for sale, will be calculated using the formula:

COGS = (Beginning inventory + Purchased inventory value) – Merchandise inventory value

Applying this formula to the shoe retailer example, the result would be as follows:

COGS = [1000 + (50 x 100)] – 2000 = $4000

The profit can now be calculated using the cost of goods sold as follows:

Profit = Total sales – COGS

Profit = (40 x 200) – 4000 = $4000

See also: Is Prepaid Expense an Asset?

Merchandise inventory journal entry

Merchandise inventory is an asset account. If a retailer purchases additional volumes of a product that is in short supply, the cost of the shipment will be recorded in the merchandise inventory account and until the retailer sells the goods, it will not be treated as an expense. When the sale of these goods takes place, their cost will be deducted from the merchandise inventory account and added to the cost of goods sold expenses for the period. This has a direct impact on the company’s gross profit for the accounting period because the gross profit is calculated by subtracting the cost of goods sold from net sales.

In essence, merchandise inventory accounts for all the products that a retailer has acquired with the intention of resale. Typically, these goods are in transit from the merchandise suppliers, in storage facilities, on display stores, or probably in consignment in other locations. Since merchandise inventory includes physical goods and these goods are easily convertible into cash, it is recorded as a current asset.

When an accountant organizes the balance sheet for the accounting period, any inventory left over is recorded as merchandise on hand, listing it as an asset and recording it as an asset, and recording it as a debit to accounts payable. If the retailer purchases a merchandise inventory, it will be recorded as a debit to the inventory account and credit to the accounts payable.

As stated before, a company can use either the perpetual inventory system or the periodic inventory system to make journal entries for merchandise inventory. The company that uses the former will make a journal entry for merchandise purchased differently from the company that uses the latter.

Under the perpetual inventory system

Merchandise may be purchased either on credit or in cash.

Merchandise purchased on credit

Under the perpetual inventory system, the business or company can make a journal entry for merchandise purchased on credit by debiting the merchandise inventory account and crediting the accounts payable.

In this journal entry, there is an increase in the total assets on the balance sheet due to the increase in the merchandise inventory while there is an increase in the total liabilities by the same amount as the company is obligated to settle the accounts payable by making payments to the supplier in the future.

Merchandise purchased in cash

If the company makes the merchandise purchase in cash, the journal entry can be made by debiting the merchandise entry and crediting the cash account due to the cash outflow from the purchase date under this inventory system.

It is seen that there is a slight difference between this journal entry from that of the merchandise purchased on credit. While merchandise purchased on credit impacts that it brings about an increase in both the total assets and total liabilities, merchandise purchased on cash does not have any impact on the total liabilities on the balance sheet. This is because the journal entry for merchandise purchased on cash will bring about an increase in the asset (merchandise inventory) on one side while it will bring about a decrease on another asset (cash) thereby resulting in zero impact as the increase and decrease in the value of the two assets net off each other.

Under the periodic inventory system

Under the periodic inventory system, journal entries can be made for merchandise purchased on credit and merchandise purchased in cash also.

Merchandise purchased on credit

Under this system, the journal entry for merchandise purchased on credit can be made by debiting the purchases account and crediting the accounts payable.

The purchases account is a temporary account for the merchandise purchased and its usual balance is on the debit side. At the end of the period when there is a need for the company to update the ending merchandise inventory balance in order to calculate the cost of goods sold during the period, the purchases account will be cleared.

Merchandise purchased in cash

In a situation whereby the merchandise is purchased in cash, the business can make the journal entry for the merchandise purchased by crediting the cash account instead, and not the accounts payable this time around.

Example

On the 1st of September, a merchandising company purchases merchandise worth $20,000 on credit from one of its suppliers. On the 25th of that same month, it made a cash payment of $20,000 to the supplier in order to settle the credit purchase.

Using the perpetual inventory system, the company’s journal entry for the $20,000 merchandise purchased on credit will be as follows:

As of September 1st, there will be an increase in both the total assets and total liabilities on the balance sheet by $20,000.

As of September 25th, a cash payment of $20,000 has been made to clear off the credit purchase. The journal entry will be made by debiting $20,000 into the accounts payable to remove it from the balance sheet as follows:

This journal entry is for the settlement of the credit purchase amount that the company made on the 1st of September, therefore, both assets and liabilities will decrease by $20,000.

2) Using the periodic inventory system, the journal entry for merchandise purchased on credit, September 1st, will be as follows:

$20,000 is recorded in the purchase account in this journal entry because using the periodic inventory system, the company will only update the merchandise inventory account when it performs the physical count of the actual inventory.

The journal entry on the 25th of September for the settlement of the $20,000 credit will be as follows: