How to Journalize Cost of Goods Sold
Accurately record Cost of Goods Sold to reflect true profitability. This guide details essential accounting methods for managing your inventory costs.
Cost of Goods Sold (COGS) represents the direct costs a business incurs to produce or acquire the goods it sells. This figure is subtracted from revenue to determine gross profit. Accurate journalizing of COGS is crucial for reliable financial reporting, ensuring a business’s income statement presents its true performance. Precision in these entries is necessary for compliance and effective financial management, as COGS directly influences taxable income.
Understanding Cost of Goods Sold
COGS encompasses the direct expenses tied to the production or acquisition of goods that a company sells. For manufacturers, these direct costs typically include the raw materials that become part of the finished product, the wages for direct labor involved in production, and manufacturing overhead directly related to the production process, such as factory utilities or equipment depreciation. For merchandisers, COGS primarily consists of the purchase price of the goods from suppliers, along with any freight-in costs incurred to bring the inventory to the business’s location.
COGS is a component in applying the “matching principle” of accounting. This principle dictates that expenses should be recognized in the same accounting period as the revenues they helped generate, ensuring financial statements accurately reflect a company’s performance. The basic formula for calculating COGS is: Beginning Inventory + Purchases – Ending Inventory.
Inventory Accounting Systems
The method a business uses to track its inventory impacts how Cost of Goods Sold is journalized. There are two primary inventory accounting systems: perpetual and periodic.
The perpetual inventory system continuously updates inventory records in real-time with every purchase and sale. This system provides an ongoing balance of inventory on hand and the cost of goods sold, often utilizing technology like point-of-sale (POS) systems and barcode scanners for immediate updates. Conversely, the periodic inventory system does not maintain continuous records of inventory movement. Instead, businesses using this method physically count their inventory at the end of a specific accounting period, such as monthly, quarterly, or annually, to determine the ending inventory balance and then calculate COGS.
Journalizing Cost of Goods Sold Under Perpetual Inventory System
Under the perpetual inventory system, the accounting records are updated immediately with each inventory transaction, providing a continuous tally of inventory and Cost of Goods Sold. When a sale occurs, two journal entries are required to accurately reflect the transaction. The first entry records the revenue generated from the sale: a debit to Cash or Accounts Receivable (depending on whether the sale was for cash or on credit) and a credit to Sales Revenue. This entry captures the selling price of the goods.
Simultaneously, a second entry is made to record the Cost of Goods Sold and the corresponding decrease in inventory. This entry involves a debit to the Cost of Goods Sold expense account and a credit to the Inventory asset account for the cost of the specific goods sold. This ensures that the expense is recognized at the same time the revenue is earned, adhering to the matching principle. If a customer returns goods, the process is reversed: the Inventory account is debited (increased) and the Cost of Goods Sold account is credited (decreased) to reflect the return of the goods to stock. Freight costs incurred on incoming merchandise (freight-in) are added directly to the cost of the Inventory account, increasing its value.
Journalizing Cost of Goods Sold Under Periodic Inventory System
The periodic inventory system differs significantly in its approach to tracking inventory and recognizing Cost of Goods Sold (COGS). Instead of real-time updates, COGS is determined only at the end of an accounting period after a physical count of the remaining inventory. This physical count is crucial for establishing the ending inventory balance.
The calculation of COGS under this system begins with the value of inventory at the start of the period, known as beginning inventory. To this, the net purchases made during the period are added. Net purchases include the cost of new inventory acquired, less any purchase returns and allowances, and purchase discounts received, plus any freight-in costs to bring the goods to the business. This sum represents the goods available for sale during the period. The ending inventory, determined by the physical count, is then subtracted from the goods available for sale to arrive at the Cost of Goods Sold.
At the end of the accounting period, specific closing journal entries are made to adjust the accounts and record COGS. These entries typically involve debiting the Inventory account to reflect the new ending balance, debiting the Cost of Goods Sold account for the calculated amount, crediting the Inventory account for its old beginning balance, and crediting temporary accounts such as Purchases, Purchase Returns and Allowances, Purchase Discounts, and Freight-In to zero them out. This comprehensive entry moves all relevant purchase-related balances into the COGS calculation, ensuring that the expense is properly recorded for the period.