How to Record Inventory in Accounting

Inventory represents goods a business holds for sale, along with raw materials and work-in-progress. Accurately recording inventory is fundamental for any entity dealing with physical products. It serves as a significant asset on the balance sheet, reflecting the value of goods available for future sales. Proper inventory management directly impacts the income statement through the Cost of Goods Sold (COGS), which is the expense associated with items sold. Meticulous accounting for inventory is essential for reliable financial reporting and informed business decisions.

Inventory Tracking Systems

Businesses primarily use two systems to track inventory: the perpetual and the periodic inventory system. These systems dictate how inventory levels and the cost of goods sold are recorded.

The perpetual inventory system continuously updates records for every purchase and sale. This system provides real-time information on inventory quantity, cost, and cost of goods sold. When inventory is purchased, the Inventory asset account is debited, and Cash or Accounts Payable is credited.

Upon a sale, two entries are made under the perpetual system: one for sales revenue and another for the cost of goods sold. For instance, if goods costing $100 are sold for $150 on account, Accounts Receivable is debited for $150 and Sales Revenue is credited for $150. Simultaneously, Cost of Goods Sold is debited for $100 and Inventory is credited for $100, reflecting the reduction in inventory and the corresponding expense.

Conversely, the periodic inventory system does not maintain a continuous record. It relies on a physical count at specific intervals, typically at the end of an accounting period, to determine ending inventory and cost of goods sold. Purchases are initially recorded in a temporary “Purchases” account, not directly in the Inventory asset account.

When inventory is purchased under the periodic system, the Purchases account is debited, and Cash or Accounts Payable is credited. For example, a $500 purchase involves a debit to Purchases and a credit to Cash or Accounts Payable. When goods are sold, only the sales revenue is recorded; the cost of goods sold is calculated at the end of the period using a formula involving beginning inventory, net purchases, and ending inventory.

Methods for Valuing Inventory

Assigning a cost to inventory and goods sold requires specific costing methods. These methods assume which units of inventory are sold first, regardless of actual physical movement. The chosen method significantly impacts the reported value of ending inventory and the Cost of Goods Sold.

The First-In, First-Out (FIFO) method assumes the first units purchased are the first ones sold. The cost of the oldest inventory items is expensed as Cost of Goods Sold, while ending inventory is valued using the costs of the most recently purchased items. For example, if a business buys 10 units at $5, then 10 units at $6, and sells 12 units, FIFO assigns $50 (10 units x $5) plus $12 (2 units x $6) to Cost of Goods Sold. The remaining 8 units are valued at $6 each in ending inventory.

The Last-In, First-Out (LIFO) method assumes the last units purchased are the first ones sold. The cost of the most recently acquired items is matched against sales revenue as Cost of Goods Sold. Ending inventory is composed of the costs of the oldest inventory units. While permissible under U.S. Generally Accepted Accounting Principles (GAAP), LIFO is not allowed under International Financial Reporting Standards (IFRS).

Using the previous example, if a business bought 10 units at $5 and 10 units at $6, then sold 12 units, LIFO assigns $60 (10 units x $6) plus $10 (2 units x $5) to Cost of Goods Sold. This leaves the remaining 8 units valued at $5 each in ending inventory. This method typically results in a higher Cost of Goods Sold and lower taxable income during periods of rising costs.

The Weighted-Average method calculates an average cost for all inventory available for sale. This average cost is then applied to both the Cost of Goods Sold and the ending inventory. To determine the average, the total cost of goods available for sale (beginning inventory cost plus purchases) is divided by the total number of units available. For instance, if 20 units were available for sale at a total cost of $110 (10 @ $5 + 10 @ $6), the average cost per unit would be $5.50 ($110 / 20 units). If 12 units were sold, COGS would be $66 (12 units x $5.50), and ending inventory would be $44 (8 units x $5.50).

Recording Common Inventory Transactions

Purchases

Under a perpetual inventory system, if inventory is purchased for $1,000 on account, the entry is a debit to Inventory for $1,000 and a credit to Accounts Payable for $1,000. If freight costs of $50 are incurred, the Inventory account is debited for $50 and Cash is credited for $50, as freight-in is a cost of acquiring the inventory.

Under a periodic system, the purchase would be debited to a Purchases account for $1,000, and Accounts Payable credited for $1,000. Freight-in would be debited to a Freight-In account for $50 and Cash credited for $50.

Sales

If goods costing $600 are sold for $900 on account, a perpetual system requires two entries. First, Accounts Receivable is debited for $900 and Sales Revenue is credited for $900. Second, Cost of Goods Sold is debited for $600 and Inventory is credited for $600, reflecting the outflow of inventory.

Under a periodic system, only the revenue entry is made at the time of sale: Accounts Receivable debited for $900 and Sales Revenue credited for $900. The cost of goods sold is determined later through a period-end calculation.

Returns

When a business returns inventory it previously purchased, or receives an allowance for damaged goods, the entry reverses the original purchase. If a $100 purchase return occurs under a perpetual system, Accounts Payable is debited for $100 and Inventory is credited for $100, reducing both the liability and the asset. Under a periodic system, Accounts Payable is debited for $100, and a Purchase Returns and Allowances account is credited for $100.

If a customer returns goods previously purchased, or is granted an allowance, the business must record this event. For a $150 sales return (costing $80) under a perpetual system, Sales Returns and Allowances is debited for $150 and Accounts Receivable is credited for $150. An additional entry debits Inventory for $80 and credits Cost of Goods Sold for $80, restoring the inventory and reducing the expense. Under a periodic system, only the revenue reversal occurs: Sales Returns and Allowances is debited for $150 and Accounts Receivable is credited for $150.

Maintaining Accurate Inventory Records

Ensuring accurate inventory records requires ongoing practices and adjustments. Even with perpetual inventory systems, physical verification is necessary to confirm recorded balances align with actual quantities. This process helps identify discrepancies from theft, damage, errors, or spoilage.

Physical inventory counts involve systematically counting all inventory items at a specific point in time. Businesses typically perform these counts at least once a year. Any differences found between the physical count and the recorded balance necessitate an adjustment.

If a physical count reveals actual inventory is less than the recorded amount, an adjustment decreases the inventory asset. For example, if records show $50,000 in inventory but the physical count reveals only $49,000, an entry debits Cost of Goods Sold for $1,000 and credits Inventory for $1,000. This increases the expense and reduces the asset to reflect the actual quantity.

Beyond quantity verification, inventory valuation requires adherence to principles like Lower of Cost or Market (LCM) or Net Realizable Value (NRV). This principle mandates inventory be reported on the balance sheet at the lower of its historical cost or its current market value. This ensures assets are not overstated if their value has declined due to obsolescence, damage, or falling prices.

If the market value or net realizable value falls below historical cost, a write-down adjustment is necessary. For instance, if inventory costing $10,000 now has a market value of $8,000, a loss of $2,000 must be recognized. The journal entry debits Loss on Inventory Write-Down for $2,000 and credits Inventory for $2,000. Obsolete or significantly damaged items, no longer having salable value, require a write-off by debiting a loss account and crediting the Inventory account.