Accounting in Merchandising Companies

6.2. Analysis of transactions for the second illustration of accounting for inventory

Event No. 1: The effect of $5,000 inventory purchase is increases in both assets (Inventory) and liabilities (Accounts Payable). There is no impact on cash flows because the bookstore made the purchase on account (i.e., will pay later). This is an asset source transaction.

Event No. 2: In Event No. 1 the Inventory account was debited. However, the company returned some goods, which resulted in a reverse operation. In this connection, the company needs to reduce both assets (Inventory) and liabilities (Accounts Payable) by the cost of the goods returned (i.e., $500). There is no impact on cash flows in this transaction. This is an asset use transaction.

Event No. 3a: Dav's Books got a cash discount. A cash discount means that the seller lets the buyer (in our example, the bookstore) pay less in case of a prompt settlement. So, the bookstore will be able to pay the amount due reduced by a 2% discount, that is $4,606 = $4,700 x (100% - 2%) = $4,606, and not the pre-discount amount of $4,700 = $5,000 - $300 of returned goods. This event has the same effect as the goods return in Event No. 2. Both assets (Inventory) and liabilities (Accounts Payable) decrease by the $94 discount ($4,700 - $4,606). There is no impact on the cash flows because no cash is exchanged at this point. This is an asset use transaction.

Event No. 3b: We are familiar with the payment of accounts payable transaction. Cash and Accounts Payable decrease. The accounts payable balance at May 18 was $4,606 ($5,000 - $300 - $94). This transaction results in an operating activity cash outflow because the company paid cash to settle the amount due. This is an asset use transaction.

Event No. 4: The sale of goods is composed of two events which are revenue recognition and expense recognition. The first one acts to increase assets (Accounts Receivable because the company sold on account) and equity (Retained Earnings, by increasing Sales Revenue) by $4,000. The second transaction decreases both equity (Retained Earnings, by increasing Cost of Goods Sold) and assets (Inventory) by $2,000. There is no impact on the cash flows because the bookstore sold goods on account (i.e., the buyer will pay later). Revenue recognition is an asset source transaction and cost of goods sold recognition is an asset use transaction.

Event No. 5: Incurring transportation expense acts to decrease assets (Cash) and equity (Retained Earnings, by increasing Transportation-out) by $400. The cash payment results in an operating activity cash outflow. This represents an asset use transaction.

Events No. 6 (6a & 6b): Getting back some goods sold in Event No.4 has a twofold effect on the bookstore's accounting records. The first one acts to adjust the revenue. Because some goods were returned, it is necessary to reduce Sales Revenue and Accounts Receivable by $500. The second effect is to adjust the expense. Cost of Goods Sold decreases, and Inventory increases by $250. As no cash movement is made in this transaction, there is no impact on cash flows. In this event, the bookstore just makes reverse entries to those from Event No. 4.

Event No. 7: Providing a 2% cash discount to customers has a similar effect on the accounting records as Event No. 6. However, this time the bookstore does not receive any goods back and, therefore, does not have to adjust the expense (Cost of Goods Sold). The bookstore only decreases Accounts Receivable and Sales Revenue by $70 = ($4,000 minus $500 of returned goods) x 2%. There is no impact on cash flows because no cash movements are made in this transaction. This is an asset use transaction.

Event No. 8: The cash collection transaction is already familiar to us. Cash increases and Accounts Receivable decrease. The cash collection results in a cash inflow from operating activities. This is an asset exchange transaction.

6.3. Journal entries for the second illustration of accounting for inventory

Let us see how these transactions look like in the general journal.

Illustration 10: General journal for illustration #2

Event No

Account titles

Debit

Credit

1

Merchandise Inventory

5,000

 

 

    Accounts Payable

 

5,000

2

Accounts Payable

300

 

 

    Merchandise Inventory

 

300

3a

Accounts Payable

94

 

 

    Merchandise Inventory

 

94

3b

Accounts Payable

 4,606

 

 

    Cash

 

 4,606

4a

Accounts Receivable

4,000

 

 

    Sales Revenue

 

4,000

4b

Cost of Goods Sold

2,000

 

 

    Merchandise Inventory

 

2,000

5

Transportation-out

400

 

 

    Cash

 

400

6a

Sales Revenue

500

 

 

    Accounts Receivable

 

500

6b

Merchandise Inventory

250

 

 

    Cost of Goods Sold

 

250

7

Sales Revenue

70

 

 

    Accounts Receivable

 

70

8

Cash

3,430

 

 

    Accounts Receivable

 

3,430

Closing

Sales Revenue

3,430

 

entry

    Cost of Goods Sold

 

1,750

 

    Transportation-out

 

400

 

    Retained Earnings

 

1,280

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