Mark Farber: Hi, I'm Mark Farber, and this is Accounting Fundamentals.
We're going to shift gears now, and talk a little bit about merchandising operations,
as opposed to service companies.
Service companies are obviously those that sell a service like accounting, or consulting,
bike repairs.
A merchandising operation is a company that buys goods from some place, and then sells
them somewhere else, so it can be a wholesaling company, one that's purchasing goods from
a manufacturer, and selling them to retailers, or it could be a retail company that's purchasing
goods either from a wholesaler or a manufacturer, and then sells it to the end consumer.
The key thing about merchandising companies is that they have all of these goods that
they're buying and selling; stuff that we call inventory.
Inventory is a really important account.
For many companies, it might be one of, if not the largest, asset that they have on their
balance sheet.
It's really important that we understand how we track inventory as opposed to other types
of assets.
Now, inventory is technically anything that a company purchases with the expectation that
they're going to sell it, so it differs from equipment, which is purchased for the purpose
of using in your business, so if a company purchases a computer to use it in the office,
that's equipment, but if a technology company, or a technology reseller purchases a computer
in order to sell it, then that computer is inventory.
There's two broad ways that we keep track of inventory.
One is called the perpetual system, or perpetual inventory, and the other is a periodic system.
We're going to talk about perpetual inventory today.
Now, all inventory, much like assets, either types of assets, is costed out at the cost
that the company pays for it.
When we buy inventory, we account for it at the price that we paid for that inventory,
but it's when we account for it that differs between a perpetual system and a periodic
system.
In a perpetual system, we make adjustments to our inventory account as we buy inventory,
and as we sell it.
We're constantly updating the amount of inventory that the company records in its books, and
that's why we call it a perpetual system.
I have over here four very simple transactions for a company.
On February 3rd, they purchased 1,000 units of whatever it is that they buy and sell at
$6 a unit, the price that they paid.
Then on the 7th, they sold 100 of those units for $10 each.
On February 14th, they sold 20 more units for $12 each, and then February 22nd, they
purchased another 500 units at $6 a unit.
Let's look at how we would record that using a perpetual system.
First of all, on February 7th ... and we'll just start putting them in here ... on February
7th, we have to record the purchase of the inventory, and so we would debit inventory
... debit inventory, and it's 1,000 units at $6 a piece, so $6,000.
Remember we record everything in dollars, not in terms of units.
I'm sorry, it should actually say Feb 3.
And we will credit ... and I'm going to assume these are all done on account, so accounts
payable and accounts receivable are the accounts we're going to use.
So we'll credit accounts payable $6,000.
That now appears in our inventory account.
We've updated it for the purchase.
On the 7th we have a sale, and so Feb 7.
We're going to start by recording the sale of the units same as we always have, so we're
going to debit in this case accounts receivable.
We're assuming it's on credit.
100 units at $10 each is $1,000, so debit accounts receivable $1,000, and we will credit
sales just as we always have, $1,000.
Now, we have to update the inventory, because we've taken 100 units out of inventory.
What we're going to do, is we're going to record the cost of that inventory now.
The cost of those units, remember, was $6 a unit times 100 units, and we're going to
put that into an account.
I'm just going to use the abbreviation here, COGS.
COGS stands for Cost Of Goods Sold, okay?
We're going to debit Cost Of Goods Sold 100 units.
We paid $6 each, so it's $600, and we're going to credit inventory.
I'll just abbreviate it 600.
This two-part transaction says, "We sold the units for $1,000, and we're owed $1,000, and
we took those units out of our inventory, so we're decreasing our inventory, and we're
putting that cost into an account called Cost Of Goods Sold, which is an expense account."
We'll do the same thing on February 14th.
On February 14th, we're going to again, debit accounts receivable.
In this case, 20 units at $12 a unit, so $240, and we're going to credit sales.
Okay, and it's important that you remember that first we have to sell the unit, and then
we take care of the inventory transaction.
A lot of people get confused when they try to put this all together.
First it's a sales transaction, then there's the inventory transaction.
So we have the sales transaction there, and now we're taking 20 units out.
Remember they cost $6 each, so $6 each times 20 units is $120.
We're going to debit Cost Of Goods Sold $120, and we will credit inventory ... write it
out ... $120.
So we've taken $120 out of the company's inventory.
Notice, we keep updating the inventory as we go, and that's the notion of a perpetual
system.
And then finally, on the 22nd of February, I'll try and squeeze it in here, we purchased
another $500 ... sorry, 500 units at $6 each, so we will debit inventory, and 500 units
at $6 each is going to be $3,000.
We will credit accounts payable $3,000.
That's essentially all we do for a perpetual system, so all we've done, is we've added
in over what we've done before.
We've added in this transaction to our sales transactions.
Basically, after we record the sale, we record the transfer of inventory out of inventory,
and into expenses.
In our next video, what we'll do, is we'll take a look at a periodic system, and how
it differs from the perpetual system.