If you are an accountant working with two companies—one a pure service business, like a consulting firm, and the other a pure merchandising business, like a department store—you’ll notice one glaring difference right away on the balance sheet: inventory. Inventory is goods held for sale during the ordinary course of business. Merchandising businesses work with inventory whereas service companies have no inventory.

Home Depot

Look at this partial (assets only) balance sheet from Home Depot. Merchandise inventories are listed as a current asset because they will turn into cash within a short period of time, and they also represent one of the largest categories of assets ($14.531 billion), second only to the investment in buildings, equipment, and land ($22.77 billion).

See the balance sheet long description here.

Home Depot is a good example of a retail merchandising business. It’s also a corporation and publicly traded, which means we can easily obtain the financial statements. These statements are prepared according to GAAP and audited (by KPMG, LLP). You can look at the full annual report and SEC Form 10-K.

Manufacturing companies have inventory as well; in fact, they have three major categories of inventory: raw materials, work-in-process, and finished goods. Finished goods are sold to distributors (wholesale) and end up on the shelf of your local merchandising company or in the shopping cart of your favorite online retailer. Accounting for manufacturing inventories, because they are moving and changing as they go through the process, is much more complicated than accounting for merchandising inventory, so we’ll stick with the basics for now: buying and selling inventory that is ready for the end user.

The following video provides an overview of the difference between merchandising and service companies and their respective accounting needs.

Next, let’s take a bit of a closer look at how we account for merchandise inventory.

Inventory

On a used car lot, cars are the inventory. Clothing is the inventory in a clothing store. For a real estate developer, inventory is homes waiting to be sold.

At the clothing store, the building would not be considered inventory, even if the owner of the store decided to sell it for some reason (say the owner is selling the entire business or moving to a new location). In addition, any uniform clothing that staff are required to wear would be an asset, not inventory. Only items held for sale during the ordinary course of business are considered inventory.

Let’s take a moment to talk about how inventory is purchased.

Geyer

Let’s say you work as an accountant for a company called Geyer that installs upgraded, vocal interface GPS/Sirius/Mobile–enabled sound systems in just about any vehicle. Shanice, the boss, is running a web promotion for the new Digital XPS-101 and expects to sell about 200 of them. She asks the company’s purchasing agent, Malik, to email Bryan Wholesale, Co., her normal supplier, and order 200 to have on hand. Geyer has a long-standing account with Bryan, so all Malik needs to do is to give the salesperson at Bryan a P.O. (purchase order) number and they will process the order, ship it, and send an invoice. This is what happens:

• You, working in the accounting department, prepare the P.O. and send it to Malik, who in turn emails the sales department at Bryan.
• Malik receives an acknowledgment email and forwards it to you in the accounting department, and a few days later the UPS truck delivers five boxes from Bryan.
• The boxes are opened and there is a packing slip in each one indicating there are 40 boxed sound systems in each larger box.
• Each box is counted and verification made on each packing slip with Malik’s signature (or your company may have a separate receiving dock receipt).
• Malik sends the packing slip to you in accounting so you know the company received everything on the invoice that Bryan Wholesale sent to them.
• Malik stacks the 200 smaller boxes on shelves in the back room so they are ready for the installers and then he steps back and admires his work. What is stacked on the shelves is considered unsold inventory. The shelves are full of assets that will soon turn into cash that will pay the bills and, hopefully, make the company a profit.

The invoice your company received from Bryan contains details of a sale, noting things like the number of units sold, unit price, total price billed, terms of sale, and manner of shipment. As the purchasing agent, Malik may not actually see the invoice, but if he did, it would look something like this:

See the invoice long description here.

For you, the accountant, the invoice has a lot of important data:

• The vendor (a vendor sells things to your company and is associated then with accounts payable, whereas a customer buys things from your company).
• The invoice number (which is an internal number for the vendor) and the date (which is when the payment clock starts ticking, officially).
• Your company (and the shipping address, which might be different if Geyer has several locations but one central billing office).
• Terms of the sale, including:
  • Payment Terms: tells you when the invoice is due and if a discount is offered for early payment
  • Shipping Terms: tells you when the title of the goods passes to the buyer.

Payment Terms

In some industries, credit terms include a cash discount to encourage early payment of an amount due. A cash discount is a deduction from the invoice price that can be taken only if the invoice is paid within a specified time. Sellers call a cash discount a sales discount and buyers call it a purchase discount.

In the case above, the terms 2/10, net 30 means a buyer who pays within 10 days following the invoice date may deduct a discount of 2% of the invoice price. The term 2/10 looks like a fraction, but it’s not. It’s just shorthand. If payment is not made within the discount period, the entire invoice price is due 30 days from the invoice date (net 30 or n 30).

The invoice was dated December 19, so the clock started ticking on the 20th and the 2% discount window closed at the end of business on the 29th (10 days). You could just subtract 19 from 31 to get that date. If the invoice had been dated December 27, the 10-day window would have closed on January 6. (See if you can duplicate that math.)

Companies base discounts on the invoice price of goods. If merchandise is later returned, the returned amount must be deducted from the invoice price before calculating discounts. For example, if the invoice price of goods purchased was $20,000 and the company returned $2,000 of the goods, then the seller calculates the 2% discount on $18,000 ($20,000 original − $2,000 return).

Notice the discount does not apply to shipping charges. To understand why, we need to understand how shipping charges are assessed, so we look at the shipping terms.

Shipping Terms

Shipping terms are used to show who is responsible for paying for shipping and when the title of the goods passes from seller to buyer.

FOB shipping point means “free on board at shipping point.” This is an old-fashioned term that means the seller is free of ownership once the shipping agent takes possession of the goods on behalf of the buyer. In the example above, UPS is an agent of Geyer. When the crew at Bryan Wholesale, Co. put the merchandise into big boxes, it still belonged to Bryan. But, when the UPS driver put the boxes into the truck and shut the door, the XPS-101s became the property of the buyer, Geyer. At that point, Bryan recognized a sale, and, theoretically, Geyer recognized a purchase; however, you, in the accounting department at Geyer, won’t actually record the purchase until the invoice arrives and the goods are accounted for. Usually, since the buyer takes legal title at the shipping point, the buyer incurs all transportation costs after the merchandise has been loaded on a railroad car or truck at the point of shipment. Thus, the buyer is responsible for ultimately paying the freight charges.

UPS and other shippers, however, are usually reluctant to ship items across the country without being paid upfront, so the seller pays the shipper in advance, fronting the money from the buyer. That’s why shipping gets added to the invoice. It’s not part of the sale price—it’s reimbursement to the seller for shipping costs paid on behalf of the buyer. UPS would rather have the seller on the hook to collect the shipping than to get goods to the buyer and have the buyer refuse to pay.

FOB destination means “free on board at destination.” That means the seller holds legal title to the goods until they reach their destination. This isn’t as common as FOB shipping point. Usually, under this scenario, the seller is ultimately responsible for paying the freight charges because the seller still owns the goods all the way to the receiving dock.

All of these concepts are important to know as we calculate the costs of inventory, which we will do in the next section. But first, check your understanding of the definition of inventory.