Hult International Business School - London

Accounting for Managers

Handout 9 – Merchants & Inventory

Fall 2023

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Who Is a Merchant ?
Intermediary who buys goods from suppliers and sells them to final consumers
(ex. Tesco, eBay); or to other intermediaries (ex. wholesalers).
1. Merchants buy goods, mark them up and sell them at a profit (hopefully).
2. Gross Profit is the difference between the price goods were sold at vs. the price
at which they were bought at.
3. The gross profit must be large enough to cover operating expenses incurred in
running the business, thus justify the existence of the business.

Numerical Example: ($s in millions)

Sales Revenues 124.6
Cost of Merchandise Sold 108.0
Gross Profit 16.6

Operating Expenses 7.5

Net Income 9.1

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Merchant / Inventory Accounting
In order to account for Merchant’s operations, we need to
understand accounting for Inventory.
Inventory ...
• Is a current asset bought/held exclusively for (re)sale.
• As opposed to other assets that are usually used by the business.
• Is recorded on the B/S at the cost incurred to:
1. Acquire it, and
2. Prepare it for sale (shipping, handling, insurance, etc.);
• these are called “inventoriable costs”.

Debit Inventory $ XYZ

Credit Cash, A/P $ XYZ

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Inventory Costs Example
($s)
A ski shop is preparing for its annual winter
Invoice for 50 pairs of skis 24,500 ski sale.
Shipping costs of skis 450 Which of these costs are inventoriable
Wages of store manager 1,600 costs that can be debited to the
Wages of workers preparing skis Inventory account ?
for sale 980 • Costs recorded in Inventory are highlighted.
Store insurance policy cost 460 • Costs incurred to acquire inventory;
Cost of ski sale flyers 230 • Costs incurred to get the inventory ready for
Total 28,220 sale;
• Other costs are operating expenses that are
Total Inventory Cost 25,930 to be recorded during the accounting period
(period expenses).
Total Operating Expenses 2,290

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Classification of Costs … Matters
As shown on the previous slide ... costs can either be classified
as:
Inventoriable Costs Period Expenses
As a result will end up on the As a result will end up on the
Balance Sheet. Income Statement.
• (they are capitalized). • (they are expensed).

Balance Sheet Income Statement

($s in thousands) ($s in thousands)
Cash 12.0 Sales Revenues 124.6
A/R 26.6 Cost of Merchandise Sold 108.0
Inventory 25.9 Gross Profit 16.6
Operating Expenses 2.3
Total Current Assets 64.5
Net Income 14.3

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Inventory Recording & Credit Terms
Terms of sale will indicate when the legal title to the inventory asset passes from
the seller to the buyer. At this time ...
• Buyer needs to record the purchase;
• Seller needs to record the sale;
Terms of sale are usually stated on the Invoice (if sold on account), Example ...
Due in 45 days from the day of the invoice
n45
(net of returns and allowances).

Due in 45 days from the day of the invoice

1/10, n45 (net of returns and allowances).
1% discount can be taken if paid within 10 days.

FOB "Free On Board" (as of destination) ...

Destination Freight paid by seller.

FOB "Free On Board" (as of shipping point) ...

Shipping Point Freight paid by buyer.

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Shipping Point & Destination
FOB meaning depends on the perspective.
Looking from the perspective of the Merchant ... In case of a:
• Purchase: “FOB shipping point” means merchant pays the freight;
• Sale: “FOB shipping point” means customer pays the freight;

Producer Merchant Customer

• Purchase: “FOB Destination” means producer pays the freight;

• Sale: “FOB destination” means merchant pays the freight;
Image source: PowerPoint image library.
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FOB Destination
When should the wholesaler record the sale of skis and the ski shop record the
purchase of skis ? FOB destination means that freight is paid for by the
point of shipment. Legal title passes when the goods arrive on July 5th.

Wholesaler Ski Shop

July 1: July 1: Ski shop

Warehouse orders 50 pairs of
processes the skis.
order and loads
it on a truck.
July 5: Delivery
July 1: Delivery received.
shipped.

Image source: PowerPoint image library.

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FOB Shipping Point
When should the wholesaler record the sale of skis and the ski shop record the
purchase of skis ? FOB shipping point means that freight is paid for by the
recipient. Legal title passes when the goods are shipped on July 1th.

Wholesaler Ski Shop

July 1: July 1: Ski shop

Warehouse orders 50 pairs of
processes the skis.
order and loads
it on a truck.
July 5: Delivery
July 1: Delivery received.
shipped.

Image source: PowerPoint image library.

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How To Record Shipping Costs
In case of FOB Shipping Point recipient pays for shipping costs.
These are inventoriable (since they are part of getting the inventory) and need to
be recorded on the Balance Sheet.
In case of our ski shop the entry is as follows (and the wholesaler records nothing):
Debit Inventory 450
Credit Cash, A/P 450

In case of FOB Destination point of shipment pays for shipping costs.

These are not inventoriable (since they are part of the sales effort and not part of
getting the inventory).
They need to be recorded as a delivery expense on the Income Statement in the
accounting period.
In case of our wholesaler the entry is as follows (and the wholesaler records nothing):
Debit Delivery Expense 450
Credit Cash, A/P 450

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Accounting For Inventory Sales
Two things happen when a merchant sells an inventory item:
Shareholder's
Assets = Liabilities +
Equity

1. Revenue +240 = + +240

2. Expense -180 = + -180
1. Revenue is earned.
• Assets go up (Cash or A/R);
• Equity goes up (in the Sales Revenue account);
2. Expense is incurred.
• Assets go down (Inventory);
• Equity goes down (in the Cost of Goods Sold account - COGS);
Debit Cash, A/R 240
1
Credit Sales Revenue 240

Debit COGS 180

2
Credit Inventory 180

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Gross Profit
The difference between Sales Revenues and GOGS is called
Gross Profit.
Shareholder's
Assets = Liabilities +
Equity

1. Revenue +240 = + +240

2. Expense -180 = + -180
Gross Profit 60 60

• Gross profit is the major determinant of businesses’ overall profitability.

• Expressed as a % ratio (Gross Margin = Gross Profit / Sales Revenues),
it is one of the most important tools in the analysis of financial
statements.

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Income Statement (P/L) – Single Step
A single step Income
Income Statement (Single Step)
statement presents: ($s in thousands)
• All revenue items
combined together; Revenues:
• All expense items Sales Revenues 124.6
combined together; Other (one off) Revenues 1.4
Total Revenues 126.0
In one single step Net
Income is Expenses:
Cost of Merchandise Sold (COGS) 88.8
calculated. Selling Expenses 14.2
• This is less than ideal Marketing Expenses 12.1
way to present Genaral & Admin Expenses 7.7
company’s performance Other Expenses 1.1
Total Expenses 123.9
since it does not present
HOW the profit was Net Income 2.1
earned.
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Income Statement (P/L) – Multi Step
Income Statement (Multi Step)
This is the standard way ($s in thousands)
of presenting Income
Sales Revenues 124.6
Statement. Cost of Merchandise Sold (COGS) 88.8
• Revenue and Expense Gross Profit 35.8
items are segmented
into various categories; Operating Expenses:
Selling Expenses 14.2
Net Income is calculated Marketing Expenses 12.1
in a series of steps. Genaral & Admin Expenses 7.7
Total Operating Expenses 34.0
• This is a better way to
present company’s Income From Operations 1.8
performance since it
presents HOW the profit Other Income & Expenses:
was earned, by separating Other (one off) Revenues 1.4
Other Expenses 1.1
operational and non
operational items. Net Income 2.1
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Sales Returns & Allowances (I)
There always exists a possibility that once goods have been delivered to a
customer, he/she changes his/her mind. Two common outcomes are:
Sales Return Allowance

Item is returned in Customer (if not

total or partially. entirely happy with the
product) negotiates a
discount for it.

Image source: PowerPoint image library.

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Sales Returns & Allowances (II)
In either case there is an impact (a reduction) on Sales Revenues.
In both cases, a contra account is used called Sales Returns and
Allowances.
• Sales Revenue account has a normal Credit balance.
• Sales Returns and Allowances account has a normal Debit balance.
• The difference between the two account balances is the Net Sales Revenue
(actual value of Sales Revenue).
• Net Sales Revenue is not an account, rather it represents the actual
value items were sold for and is shown on the Income Statement.
Income Statement (Multi Step)
($s in thousands)

Revenues:
Sales Revenues 124.6
Sales Returns & Allowances 12.5
Net Sales Revenue 112.1

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Accounting For Sales Returns
Two things happen when a merchant sells an inventory item:
1. Revenue is earned and current asset increased.
2. Expense is incurred and inventory reduced.
March Debit Cash, A/R 125
1st Credit Sales Revenue 125

March Debit COGS 89

1st Credit Inventory 89

Two things happen when an inventory item is returned:

1. Revenue and current asset are reduced.
2. Expense is reduced and good are returned to inventory, (they will be sold
again).
March Debit Sales, Returns & Allowances 12.5
5th Credit Cash, A/R 12.5

March Debit Inventory 8.9

5th Credit COGS 8.9

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Accounting For Allowance
Two things happen when a merchant sells an inventory item:
1. Revenue is earned and current asset increased.
2. Expense is incurred and inventory reduced.
March Debit Cash, A/R 125
1st Credit Sales Revenue 125

March Debit COGS 89

1st Credit Inventory 89

One thing happens when an allowance is granted since no

inventory items are returned:
1. Revenue and current asset are reduced (by whatever % amount agreed).

March Debit Sales, Returns & Allowances 12.5

5th Credit Cash, A/R 12.5

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Credit Terms
Credit terms apply to sales made on account.
Due in 45 days from the day of the invoice
1/10, n45 (net of returns and allowances).
1% discoint can be taken if paid within 10 days.

In the example above, a customer gets a sales discount (a reduction in sales

price) of 1% if he/she pays within 10 days.
These discounts are not period expenses, and are treated in the same way as
Sales Returns & Allowances. They are recorded in a contra account called
Sales Discounts.
• Sales Revenue account has a normal Credit balance.
• Sales Returns and Allowances account has a normal Debit balance.
• Sales Discounts account has a normal Debit balance.
• The difference between the three account balances is the Net Sales
Revenue (actual value of Sales Revenue).

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Accounting for Credit Terms – Purchase
If a $125 purchase was made on credit terms 1/10, n45, a $1.25 discount would
apply if invoice paid within 10 days.
Purchase

Producer Merchant Customer

• Inventory is debited and A/P is credited to record inventory purchase.

March Debit Inventory 125
1st Credit A/P 125

• A/P is debited and Inventory as well as Cash is credited to record payment for
inventory.
Debit A/P 125
March
Credit Inventory 1.25
5th
Credit Cash 123.75

Image source: PowerPoint image library.

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Accounting for Credit Terms – Sale
If a $125 sale was made on credit terms 1/10, n45, a $1.25 discount would
apply if invoice paid within 10 days.
Sale

Producer Merchant Customer

• A/R is debited and Sales Revenue is credited to record a sale.

March Debit A/R 125
1st Credit Sales Revenue 125

• Cash as well as Sales Discount are debited and A/R is credited to record the
receipt of payment.
Debit Cash 123.75
March
Debit Sales Discount 1.25
5th
Credit A/R 125

Image source: PowerPoint image library.

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Credit Card Sales
There are (obvious) benefits to allowing customers to pay for purchases using a
credit card. For their services, credit card companies charge a fee (anywhere
from 2% to 5%).

After depositing credit card receipts with the bank, the retailer / business will
receive (few days later) in cash the Invoice price less than the fee %.
These discounts are not period expenses, and are treated in the same way as
Sales Returns & Allowances. They are recorded in a contra account called
Credit Card Discounts.
• Sales Revenue account has a normal Credit balance.
• Sales Returns and Allowances account has a normal Debit balance.
• Sales Discounts account has a normal Debit balance.
• Credit Card Discounts account has a normal Debit balance.
• The difference between the four account balances is the Net Sales Revenue
(actual value of Sales Revenue).
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Income Statement & Discounts
Net Sales Revenue is not an account, rather it represents the actual value items
were sold for and is shown on the Income Statement.
• Sales Revenue account has a normal Credit balance.
Contra Accounts:
• Sales Returns and Allowances account has a normal Debit balance.
• Sales Discounts account has a normal Debit balance.
• Credit Card Discounts account has a normal Debit balance.
The difference between the four account balances is the Net Sales Revenue
(actual value of Sales Revenue).
Income Statement (Multi Step)
($s in thousands)

Revenues:
Sales Revenues 124.6
Sales Returns & Allowances 12.5
Sales Discounts 1.25
Net Sales Revenue 110.9
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Full Income Statement (I)
Full Income statement with a Sales Income Statement (Multi Step)
($s in thousands)
Returns item is shown.
Revenues:
Now various ratios can be calculated Sales Revenues 124.6
to help analyze performance. Sales Returns & Allowances 12.5
Sales Discounts 1.25
• Gross Margin = Net Sales Revenue 110.9
Gross Profit/Net Sales = 28%; Cost of Merchandise Sold (COGS) 79.9
Gross Profit 31.0
• Operating Income Margin =
Operating Expenses:
EBIT/Net Sales = -2.7% Selling Expenses 14.2
• Net Income Margin = Marketing Expenses 12.1
Genaral & Admin Expenses 7.7
Net Income / Net Sales = -2.4% Total Operating Expenses 34.0

Income From Operations (EBIT) -3.0

Other Income & Expenses:

Other (one off) Revenues 1.4
Other Expenses 1.1

Net Income/(Net Loss) -2.7

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Accounting for Sales (VAT) Tax
In most jurisdictions, merchants/retailers are responsible for collecting
the sales tax / VAT tax from the buyer at the point of sale of goods or
services.

This tax is later passed on to tax authorities, i.e. a liability account called
Sales Tax Payable / VAT Tax Payable is credited.

A $200 sales revenue in a 20% VAT jurisdiction would be recorded as

shown below.
Debit Cash, A/R 240
Credit VAT Tax Payable 40
Credit Sales Revenue 200

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Appendix

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Full Income Statement (II)
Full Income statement with a Income Statement (Multi Step)
($s in thousands)
Allowance item is shown.
Revenues:
Now various ration can be calculated Sales Revenues 124.6
to help analyze performance. Sales Returns & Allowances 12.5
Sales Discounts 1.25
• Gross Margin = Net Sales Revenue 110.9
Gross Profit / Net Sales = 19.9%; Cost of Merchandise Sold (COGS) 88.8
Gross Profit 22.1
• Operating Income Margin =
Operating Expenses:
EBIT / Net Sales = -10.8% Selling Expenses 14.2
• Net Income Margin = Marketing Expenses
Genaral & Admin Expenses
12.1
7.7
Net Income / Net Sales = -10.6% Total Operating Expenses 34.0

Income From Operations (EBIT) -12.0

Other Income & Expenses:

Other (one off) Revenues 1.4
Other Expenses 1.1

Net Income/(Net Loss) -11.7

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