Accounting for Inventory (in a Merchandising Business)

In this video you’ll find out what
Inventory means and how to account for it
in a Merchandising Business. [Music] Hey there I’m James
you’re watching Accounting Stuff and in today’s video
we’re going to tackle a topic that I get asked about all the time… Inventory. Not gonna lie
this is a big one. So I’m putting together
a whole Inventory Mini-Series to make sure that
we’ve covered all the bases. This is video number one
and I’ll be uploading the rest of the playlist over the next few weeks. So hit subscribe
if you’d like to see those. Today I want to focus on
Inventory in a Merchandising Business. Specifically how Inventory
in the Balance Sheet interacts with the Cost of Goods Sold
and Revenue accounts in the Income Statement. This can be a bit confusing
so I recommend you watch this video all the way through to the end
so you get the complete picture. There are two main types of business
that hold Inventory Manufacturing Businesses
and Merchandising Businesses. Manufacturing Businesses buy
raw materials which they make into finished goods
that they then sell to earn revenue. Whereas Merchandising Businesses
do things slightly differently. They buy goods that they resell
to earn revenue. Okay so with that in mind
what is Inventory? Well in a Manufacturing Business
Inventory is the raw materials work in progress and finished goods
held by a business that it intends to sell to earn revenue. However in a Merchandising Business
Inventory is the goods held by the business. So you see the definition for Inventory
in a Merchandising Business is a bit simpler. Manufacturing Businesses hold
three different types of Inventory. Raw materials
work in progress and finished goods
whereas Merchandising Businesses only have one type of Inventory
Goods. For a good to be treated as Inventory
a Merchandising Business must hold on to it and it must plan to sell it in the future
in order to earn revenue. This future economic benefit is the
characteristic that makes Inventory an Asset. Actually Inventory is normally
thought of as a Current Asset because most businesses intend
to turn their Inventory into Cash within one year. But more than that soon… Let’s imagine that you own
a Merchandising Business. You buy your Inventory from a supplier
and then you sell this Inventory on to your end customer. Sell what? Hats! Actually since I’m in Canada
and winter’s just around the corner let’s do Toques instead. So you run a Merchandising Business
that sells Toques. You buy your Toques from
your local manufacturer at $4 a Toque which you pay for in cash. Then you sell these Toques on to
your end customers at $7 a Toque. Your customers pay you ‘On Account’. How do you account for this? Well for each Toque that you sell
there are two transactions to consider. Transaction 1 takes place when
you buy the Toque from your supplier and Transaction 2 happens when
you sell that Toque on to your end customer. To record these transactions
you’ll need to create some journal entries. So what’s the journal entry
for Transaction 1? You’ve bought a Toque
from your supplier for 4 dollars so you need to debit your Inventory account
to increase it by $4. You debit Inventory
because Inventory is a type of Asset. The A in DEALER
which makes it a normal debit account. So debits increase it and credits decrease it. If you haven’t heard of DEALER before
it’s a handy acronym that you can use to identify debit and credit accounts. I’ve made a video explaining
what it is in more detail which you can find up up here. Ok now where does the other side of
this journal entry go? You’ve bought something so you have
two options… You could credit cash
or you could credit accounts payable. In this example you paid
for the Toque in cash so you credit your cash account
to decrease it by four dollars. Cash is another kind of Asset. The A in DEALER which makes it
a normal debit account. So you credit cash to decrease it. Great so here’s your completed
journal entry for Transaction 1. Debit Inventory by four dollars
and credit cash by four dollars. But how does this journal entry
affect your books? Well we can find out how
using T-Accounts. T-Accounts help us visualize
the impact of transactions on your general ledger. This journal entry affects
two T-Accounts Cash and Inventory. These are both Assets which
are held in your business’s Balance Sheet. In T-Accounts debits always
go on the left and credits always go in the right. So you debit the left hand side
of your Inventory T-Account by four dollars and
credit the right hand side of your Cash T-Account by four dollars. Okay
I’m afraid that was the easy part in Transaction 2 things
become a little more complicated. We need two journal entries
to record this transaction. Oh and if you find it hard
to remember all of this I’ve put together a one-page
cheat sheet that summarizes all of the key areas in this video. You can help support this channel
by buying it on my website there should be a link to it up here. In Transaction 2 you need to
recognize your revenue and record your cost of goods sold. To recognize your revenue
you need to credit your revenue account by seven dollars to increase it
in your Income Statement. Revenue is the R in DEALER
a normal credit account so credits increase it
and debits decrease it. But where does the other side go? Well you’ve sold something
so that means you need to debit cash or accounts receivable. In this example the customer
paid you ‘On Account’ that’s like an IOU. They haven’t actually
paid you the money yet. That means you need to
debit accounts receivable to recognize that you’re owed 7 dollars. Whoa hold on to your horses! We’ve got one more journal entry to do. You need to release the cost of goods sold
from your Balance Sheet to your Income Statement. Here’s what I mean by that… In Transaction 1 you took up four dollars
of Inventory in your Balance Sheet. This is your cost of goods. When you sell the Toque
to your customer you will need to release this cost of goods
from your Balance Sheet to your Income Statement. But how do you do that? Well you credit your Inventory account
by four dollars to decrease it in your Balance Sheet
and you debit your cost of goods sold account by four dollars
to increase it in your Income Statement. Cost of goods sold is a type of Expense. The E in DEALER. A normal debit account. So debits increase it
and credits decrease it. Nice one! So we’ve worked out both of your
Transaction 2 journal entries. But how do these affect your books? We’re going to need more T-Accounts. Three more because as well as
affecting cash and inventory these entries hit accounts receivable
in your Balance Sheet along with revenue and cost of goods sold
in your Income Statement. To recognize your revenue you
debited accounts receivable by $7 and credited revenue by $7
and to release your inventory or your cost of goods sold
from your Balance Sheet you credited inventory by $4
and debited cost of goods sold by $4. What’s nice about T-Accounts
is that we can easily see the impact of these
transactions on your books. You’re left with negative cash of four dollars
an increase of seven dollars in accounts receivable
and a net movement of nil in your inventory account. You’ve also earned
seven dollars of revenue and incurred four dollars of cost of goods sold. These five T-Accounts
make up a small section of your business’s books
which in turn are used to build Financial Statements like
your Balance Sheet and your Income Statement. The Balance Sheet gives you
a snapshot of your assets liabilities and equity
at a single point in time. Whereas the Income Statement
summarizes your revenues and expenses over a period of time. So now let’s recap what went down
a few moments ago but this time with the
whole picture laid out in front of us. In Transaction 1 you bought a Toque
from your supplier. You converted four dollars of cash
in your Balance Sheet into another type of Asset. Inventory. At this point you’re down
four dollars in cash and you’re holding
four dollars of inventory in your Balance Sheet. Then in Transaction 2
you sold the Toque on to a customer. This transaction impacted
both your Balance Sheet and your Income Statement
because you released this inventory from your Balance Sheet to
cost of goods sold in your Income Statement.
And at the same time you recognized the 7 dollars of revenue
in your Income Statement and increased your accounts receivable
in the Balance Sheet by 7 dollars as well. That leaves you with
negative 4 dollars of cash and 7 dollars of accounts receivable
in your Balance Sheet. In your Income Statement
you’ve earned a gross profit of $3. I realize that we just covered
a lot in this video but like I mentioned
all of the key parts are summarized in the Cheat Sheet which
you can find here. I’ll be releasing the rest of the
Inventory playlist very soon so make sure you subscribe. I’m watching you! I’m not actually watching you… Any questions let me know down below
in the comments as usual and I’ll see ya.

41 thoughts on “Accounting for Inventory (in a Merchandising Business)

  1. Hey there, it's been a while! I'll link to the playlist in the description once I've released the rest of the Inventory Mini-Series. Here are the timestamps for those who'd like to jump ahead…

    00:55 – Manufacturing vs Merchandising Businesses
    01:23 – Inventory in a Manufacturing Business
    01:36 – Inventory in a Merchandising Business
    02:12 – Why Inventory is an Asset
    02:29 – Inventory Worked Example – Question
    03:22 – Inventory Worked Example – Solution
    08:41 – Recap

  2. I'm very happy you posted! We just finished the chapters on merchandising businesses and inventory management, but this is a great review for me and I will refer struggling classmates to this!

  3. I like your videos. Can you please explain how bad debts work and provision for doubtful debts thanks.


  5. You are the sole reason I am passing my financial accounting class. Also, your cheat sheets are GOLD. Thank you!

  6. Please keep making video like this.. love to watch it! I can't find any other intersting accounting channel

  7. Would like to hear your opinion about how difficult is to learn accounting principles of another country. Just in general how hard can it be?

  8. Hello James,

    I hope you are doing well!
    I'd just like to thank you for your videos!
    I've worked in the Financial/Accounting department (in the last one since last year) for 8 years, and I'm an accounting student trying to become an accountant.
    I'm from Brazil and I speak Portuguese, but I've been trying to learn English and with your videos I could merge the two things, practicing my English and learning vocabulary about Accounting.
    Just thank you!
    Your videos were great and very explanatory, congratulations!

  9. what is the difference between the contract based revenue recognition approach and the earnings based approach? studying for my final and need help sos they're so similar

  10. Love to see you again man! Also, could you do a video explaining Depreciation and the methods?

  11. You’re a life saver! We’re covering this in my accounting class and I didn’t understand it! Thank you so so much! Don’t stop uploading! All us undergrad students thank you!

  12. Dude! That's just what I needed now keep them coming looking forward to your help need your help understanding this stuff I gotta have a ferm grasp of this to bad you cant join me and my friends

  13. And I know theres more to come but when you get a chance I'm struggling with understanding the discounting math so exp 2/10 net 30 I know it means 30 days to pay but the 2% discount is different than normal way and how to journalize it

  14. Pls make a journal entry of whole transaction in merchandising inventory specially frieght in where ir go? And the discount how to crack it..thanks.

  15. Could you go over LIFO, FIFO, and weighted average examples. Been struggling. Thanks

  16. You are such an accounting genius. Your class is very effective. Thanks man👍

  17. I am a sophomore majoring in accounting and I was really struggling but your videos have helped me sooo much. Will you be doing videos and selling templates of tips for financial statements such as the income statement etc.?

  18. I have a hard time understanding the equity section. I hope you can post a video about it soon.

  19. Hi Jamess im one your biggest fan pls follow me back in twitter @andrewandal1 so i can ask you some questions about accounting

  20. Thank you for making this requested video! I really appreciate your time and effort you put into it

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