A Beginner's Guide to Inventory Accounting - Instream Media

A Beginner’s Guide to Inventory Accounting

The first type of inventory transaction you’d make would involve buying raw materials inventory, or the materials you use to make your products. You’ll have to have a basic understanding of the inventory cycle and double-entry accounting methods to make the proper entries. If your business manufactures products instead of offering services, you’ll need to keep accounting records of your inventory transactions.

Various kinds of journal entries are made to record the inventory transactions based on the type of circumstance. For example, entries are made to record purchases, sales, and spoilage/obsolescence, etc. There are two methods or systems to account for inventory including the perpetual system and periodic system. Likewise, the company uses one of the two systems to make journal entry for inventory purchase. When a company sells its finished goods, it must record the transaction in its journal entries. This is done to keep track of the inventory and to ensure that the company is accurately reporting its income and expenses.

Bookkeeping Entries for Inventory Transactions

In this journal entry, there is no purchase account and the amount of purchase directly goes to the inventory account by adding to the inventory balances. This way the company can view the inventory balances after posting the purchase journal entry (or at any time). In the journal entry of inventory purchase, the difference between the perpetual system and periodic system is on the debit side. Under the perpetual system, the amount of inventory purchase is posted to the inventory account while, under the periodic system, it is posted to the purchase account instead.

  • Inventory shortage occurs when there are fewer items on hand than your records indicate, and/or you have not charged enough to the operating account through cost of goods sold.
  • Unlike IAS 2, US GAAP does not allow asset retirement obligation costs incurred as a consequence of the production of inventory in a particular period to be a part of the cost of inventory.
  • Although it’s not nearly as simple as a single equation, this step essentially has an acquirer subtracting the fair value of the assets acquired and liabilities assumed from the amount it paid for the acquiree.

Both returns and allowances reduce the buyer’s debt to the seller (accounts payable) and decrease the cost of the goods purchased (inventory). However, in accounting, we have to differentiate between purchases as explained above and other purchases such as those involving the procurement of a fixed assets (e.g. factory machine or building). Such purchases are capitalized in the statement of financial position of the entity (i.e. recognized as assets of the entity) rather than being expensed in the income statement. If you only sold a single item, inventory accounting would be simple, but it’s likely that you have multiple items in inventory and need to account for each of those items separately. While this is not difficult, you can quickly run into complications when inventory costs vary. Inventory transactions are journalized to keep track of inventory movements.

Mergers & Acquisitions: It Takes a Village

A chart of accounts lists each account type, and the entries you need to take to either increase or decrease each account. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. For businesses to succeed, it is important for them to understand the differences between inventory and COGS. Knowing the differences can help businesses make decisions such as when to purchase inventory and when to record COGS.

Mary Girsch-Bock is the expert on accounting software and payroll software for The Ascent. Weighted average is best used in a manufacturing environment where inventory is frequently intermingled, and difficult to track separately. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. The Perpetual Method is preferred because it’s easier to understand and follow, mainly because the simple Purchase method doesn’t require a lot of explanation.

Perpetual inventory system

A debit entry is made to one account, and a credit entry is made to another. Comparing inventory and fixed assets reveals different characteristics and implications for businesses. Fixed assets are long-term assets that are used to generate revenue and are recorded at their net book value. Inventory, on the other hand, is a current asset and can be converted into cash within one business year.

Guide to inventory

An additional problem with the calculation is that it assumes an accurate inventory count at the end of each reporting period. If there was no physical count, or if the record keeping for a perpetual inventory system is not accurate, then the inputs used for the monthly procedure for outstanding checks calculation of inventory purchases are not necessarily correct. Inventory devaluation reduces (C) the Inventory object code for the devaluation of goods not sold over time and increases (D) the Cost of Goods Sold object code in the sales operating account.

Create a Free Account and Ask Any Financial Question

Finally, the last step in the acquisition method discussed in ASC 805 outlines how the acquiring company must calculate any goodwill created by the transaction. Although it’s not nearly as simple as a single equation, this step essentially has an acquirer subtracting the fair value of the assets acquired and liabilities assumed from the amount it paid for the acquiree. As you might’ve guessed, the acquisition date is critical for several reasons.

It causes assets (inventory) and liabilities (accounts payable) to increase. The Purchase Method is a popular accounting technique that’s used to record purchases and sales of inventory. If a company sells some of its inventory for cash but records the sale as one made on credit, then it will be overstating expenses and understating revenues. This simplifies inventory accounting while providing better insight into business operations.

Inventory Account Under the Perpetual Inventory System

Conversely, when there are many interchangeable items, cost formulas – first-in, first-out (FIFO) or weighted-average cost – may be used. Techniques for measuring the cost of inventories, such as the standard cost method or the retail method, may be used for convenience if the results approximate cost. Under the perpetual inventory system, the cost of inventory items purchased are recorded directly into the account Inventory. This calculation does not work well for the manufacturing sector, since the cost of goods sold can be comprised of items other than merchandise, such as direct labor. These other components of the cost of goods make it more difficult to discern the amount of inventory purchases. The debit impact of the transaction is a recording of the finished goods in the accounting record, and it remains in the books until sold to the customers.

For example, COGS is used to calculate net income, while inventory does not directly affect it. Additionally, inventory is typically valued when it is purchased, while COGS is only valued when the goods are sold. Lastly, inventory is an asset that can be used in the future, while COGS is an expense that is only used in the present. The costs necessary to bring the inventory to its present location – e.g. transport costs incurred between manufacturing sites are capitalized.

If you buy $100 in raw materials to manufacture your product, you would debit your raw materials inventory and credit your accounts payable. Once that $100 of raw material is moved to the work-in-process phase, the work-in-process inventory account is debited and the raw material inventory account is credited. Inventory purchases are recorded on the operating account with an Inventory object code, and sales are recorded on the operating account with the appropriate sales object code. A cost-of-goods-sold transaction is used to transfer the cost of goods sold to the operating account. When it comes to recording obsolete inventory, businesses must account for the cost of items that are no longer usable. This can be done through a journal entry that records the write-off of the value of the inventory.

Like IAS 2, US GAAP companies using FIFO or the weighted-average cost formula measure inventories at the lower of cost and NRV. Unlike IAS 2, US GAAP companies using either LIFO or the retail method compare the items’ cost to their market value, rather than NRV. So, any purchase of equipment or office supplies should never be posted into the purchase account. Otherwise, there will be a misstatement in the calculation of the cost of goods sold at the end of the period.

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