Question

discuss the accounting-for-inventory transactions of merchandising companies, the two formats of preparing the income statement, and how to evaluate the profitability of a merchandising company. We will also discuss how companies determine the year-end inventory value and cost of goods sold using one of the cost-flow assumptions. Finally, examine  the impact of choosing a certain cost-flow assumption on the tax liability and other financial statement numbers of a company.

Let's begin with this question: How is the income statement of a merchandising company different from that of a service company?

Answer 1

The Income statement for Merchandising Company with 2 types of Inventory system:

Perpetual Inventory - Here the Inventory is updated with each sale, so that Cost of Goods sold is calculated every time. The Gross Profit is calculated a follows: Sales(net of sales Return) - Cost of Goods Sold

Merchandising Company means a Company which does not produce any item but purchases & sells items.Under Perpetual Inventory, Cost of Goods sold is updated with every time a sale takes place, no calculation is required Cost of Goods sold can be straightway taken from the Trail balance. This system is prevalent with Companies doing business in high value items.

Periodic Inventory - Here the Companies do not update the Inventory with each & every transaction but takes the Inventory value at the end of a period, say every month end usually. Here the physical balance of the item is counted and valued as per the Company's valuation Method and taken as Closing Inventory value, The assumption here is that any reduction in the Inventory is taken as item sold. The Purchase value & Net change in Inventory value is the Cost of Goods sold

Cost Flow assumptions - It is the manner of taking out the Inventory & calculating the Cost of Goods sold like FIFO, LIFO. average cost method. Lets say a Company follows FIFO cost method, when a sale takes place of a item category, it is assumed the first item purchased of that category and in this method the Closing value of the Inventory will be higher as Cost of Goods will be lower and Net Income will be higher & thus a higher tax liability.

So in US, the the method which is generally accepted is LIFO, which values where the Net Income is lower as it assumes the purchase made last is sold first and thus a lower Tax liability for the Company and same method also needs to be followed for financial statements as a rule called LIFO conformity rule to dissuade Companies to follow different method for reporting for Investors, creditors.

The Income statement of a Merchandising Company is different from that of a Service Company - For a service Company there is no impact of Inventory, as this Company sells not items but services such as a legal consultant Company, a freight forwarder Company. For calculating the Gross Profit the cost of service is deducted from Service Revenue with mo Inventory adjustment.