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.