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