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Sales of Merchandise Inventory: Perpetual Method

Since every merchant sells inventory, it is imperative to know the costs of that inventory. Every sale will affect four accounts. Which ones? Well, imagine you've sold some of your inventory. What have you done? Let's analyze this!

• You earned revenue, so there will be a sales account that will increase (i.e., will be credited).
• You received either cash or an IOU, which creates a receivable, so either cash or accounts receivable will be affected (debited).
• You sold stuff, meaning you used your inventory to generate revenue, so the inventory account must decrease (be credited) since it is no longer available for sale.
• And, since you used it to generate revenue, the "stuff" becomes an expense known as cost of goods sold (COGS, also known as cost of merchandise sold), so the expense increases (is debited).

The journal entry for a sale will be as follows:

One Important Note

The rules of GAAP will not allow the sales revenue account to be changed, so in order to reflect what was really sold, we must create contra accounts that will indicate any reductions in the original sales.

We know that many of our customers will take advantage of any discounts that we offer, just as we take advantage of any discounts that are offered to us. These discounts will reduce what we really collect, so why don't we just change the sales to show that? Well, management wants to know how these discounts affect the bottom line. If everyone takes the discount, then management needs to know that—perhaps they will eliminate the discount or change the discount terms in order to increase profits. Management cannot do that if there is not a way to itemize this reduction in sales. So, there is a sales discount account that indicates how much the company did not receive due to the use of discounts.

What About Returns?

Well, once again, management wants to know how many returns there were, because this may be indicative of problems within the company. If there are a lot of returns, someone better be looking for answers, because the management will have lots of questions! Were the returns due to shoddy merchandise? The company may want to change its vendor to protect its image of quality. Were the returns due to errors in the warehouse, with poor performance by the packing department? The company may need to look at its labor force, develop some training sessions, or create a method to track stocking performances. Were the returns due to problems with shipping? Perhaps the company needs to revisit the quality controls of its shipping department or its transportation company. Another contra account called sales returns is created to provide information concerning this reduction in sales.

What About Allowances?

Sometimes allowances are combined with the returns account, but often another contra account is set up to identify losses due to allowances. Often, allowances occur when the customer is sent the wrong item, such as a short-sleeve t-shirt instead of a long-sleeve t-shirt. Many times, the customer will accept the item if the cost is discounted due to the error. Sometimes there was a mistake in the order or the process. Perhaps the customer wanted Penn State blue t-shirts, but received Tarheel blue t-shirts. If the t-shirt says Penn State on it, the seller cannot send it to North Carolina. However, the customer might be willing to take the t-shirt at a lower cost because it could still be sold (just not at the same price as a Penn State blue)! The company may want to know why allowances had to be made. It could put forth a claim against its supplier due to the mix-up, or perhaps if the mix-up were made in house, the company could look at its employees to find out what happened. There may be a third contra account named sales allowances to indicate items that reduced the actual amount of revenue collected.

Remember: $\text{net sales}=\text{sales}-\text{(sales discounts})-\text{(sales returns})-\text{(sales allowances})$.

Note: In this course, we combine sales returns and allowances into one ledger account.

Example

A merchandiser uses the perpetual inventory method when recording inventory transactions. It had the following transactions in the month of March related to selling merchandise and collecting cash from customers:

1. On March 1, the corporation sold merchandise for $1,500. The merchandise cost $900. The corporation immediately collected cash.
2. On March 2, the corporation sold merchandise on account for $3,000. The merchandise cost $1,800. Terms for the sale were 2/10, n/30.
3. On March 3, the corporation sold merchandise on account for $4,500. The merchandise cost $2,700. Terms for the sale were 2/10, n/30.
4. On March 9, the corporation collected payment from the March 2nd sale, less a 2% discount.
5. On March 15, the corporation collected payment from March 3. The customer did not make the payment prior to the end of the discount period.
6. On March 20, the corporation sold merchandise on account for $4,500. The merchandise cost $2,700. Terms for the sale were 2/10, n/30.
7. On March 25, the customer returned merchandise from the March 20th sale for $1,500, with a cost of goods sold of $900.
8. On March 30, the corporation granted one of its customers a $100 sales allowance for goods damaged in transit.