How to Record Inventory Transactions for Accounting

Inventory represents the goods a business holds for sale, including raw materials, work-in-progress, and finished products. It is a current asset on a company’s balance sheet because these items are typically expected to be converted into cash within a year. Accurately recording inventory is fundamental for a business’s financial health and for informed decision-making.

Proper inventory accounting directly influences a company’s financial statements. It affects the calculation of the Cost of Goods Sold (COGS) on the income statement, which in turn impacts reported profit. The value of inventory also appears as an asset on the balance sheet, reflecting the company’s financial position. Without precise inventory recording, financial reports can be misleading, affecting assessments of profitability, asset valuation, and tax obligations.

Inventory Systems: Perpetual and Periodic

Businesses primarily use one of two systems to track inventory: perpetual or periodic. Each system has distinct methods for updating inventory records and determining the Cost of Goods Sold. The choice of system impacts the frequency and detail of inventory information available.

A perpetual inventory system continuously updates records with every purchase and sale in real-time. It uses technology like point-of-sale (POS) terminals, scanners, and specialized software. When goods are purchased, the inventory account increases; when sold, it decreases, and Cost of Goods Sold is recorded simultaneously. This provides an up-to-the-minute view of inventory levels and costs.

In contrast, a periodic inventory system does not maintain a continuous record. Inventory levels and Cost of Goods Sold are determined through physical counts at specific intervals, such as monthly or annually. Purchases are recorded in a purchases account, and sales revenue is recorded, but there is no immediate update to inventory or COGS for each sale. Cost of Goods Sold is calculated at the end of the period using a formula: beginning inventory plus purchases, minus ending inventory from the physical count.

Even with a perpetual system, physical counts are still necessary periodically to verify record accuracy and account for discrepancies like theft, damage, or errors. Perpetual systems offer continuous, real-time data, while periodic systems provide a snapshot at specific points in time.

Inventory Costing Methods

The monetary value assigned to inventory and Cost of Goods Sold is determined by specific costing methods. These methods assume a particular flow of costs, impacting a company’s reported financial performance and tax liabilities.

The First-In, First-Out (FIFO) method assumes the first goods purchased are the first ones sold. Cost of Goods Sold reflects the cost of the oldest inventory, while ending inventory is valued at the cost of the most recently purchased items. This method often aligns with the physical flow of goods, especially for perishable items. During periods of rising prices, FIFO generally results in a lower Cost of Goods Sold and a higher reported net income, which can lead to higher tax obligations.

The Last-In, First-Out (LIFO) method assumes the last goods purchased are the first ones sold. Under LIFO, Cost of Goods Sold reflects the cost of the most recent inventory acquisitions, and ending inventory is valued based on the cost of the oldest items still on hand. In an inflationary environment, LIFO typically results in a higher Cost of Goods Sold and a lower reported net income, which can reduce taxable income. LIFO is generally not permitted under International Financial Reporting Standards (IFRS), though it is allowed under U.S. Generally Accepted Accounting Principles (GAAP).

The weighted-average cost method calculates an average cost for all goods available for sale during a period. This average cost is then applied to both Cost of Goods Sold and ending inventory. To determine the weighted-average cost, the total cost of all units available for sale is divided by the total number of units available. This method smooths out price fluctuations, providing a more moderate impact on reported income compared to FIFO or LIFO.

Recording Daily Inventory Transactions

Recording daily inventory transactions involves making specific journal entries that reflect the movement and cost of goods. The exact entries depend on the inventory system used, whether perpetual or periodic. These entries ensure that financial records accurately reflect a business’s inventory position and profitability.

When a business purchases inventory, the transaction increases the Inventory account. If on credit, Accounts Payable is credited. For example, a $1,000 inventory purchase on credit debits Inventory for $1,000 and credits Accounts Payable for $1,000. If with cash, the Cash account is credited.

For sales transactions under a perpetual inventory system, two journal entries are required. The first records revenue by debiting Accounts Receivable or Cash and crediting Sales Revenue. The second simultaneously records Cost of Goods Sold and reduces Inventory by debiting Cost of Goods Sold and crediting Inventory. For example, if goods costing $600 are sold for $1,000 on credit, debit Accounts Receivable for $1,000, credit Sales Revenue for $1,000, then debit Cost of Goods Sold for $600, and credit Inventory for $600. Under a periodic system, only the sales revenue entry is made at the time of sale; Cost of Goods Sold is determined later through a physical count.

When inventory is returned to a supplier, it’s a purchase return. The journal entry involves debiting Accounts Payable or Cash (if a refund is received) and crediting a Purchase Returns and Allowances account or Inventory. For example, returning $100 of inventory previously purchased on credit debits Accounts Payable for $100 and credits Inventory for $100.

Sales returns occur when customers return goods. Under a perpetual system, two entries are made: one to reduce sales revenue and another to adjust inventory and Cost of Goods Sold. The first entry debits a Sales Returns and Allowances account (a contra-revenue account) and credits Accounts Receivable or Cash. The second entry debits Inventory and credits Cost of Goods Sold. For example, if goods sold for $100 (costing $60) are returned, debit Sales Returns and Allowances for $100, credit Accounts Receivable for $100, then debit Inventory for $60, and credit Cost of Goods Sold for $60.

Physical Inventory and Adjustments

Conducting a physical inventory count involves verifying the quantity and condition of items held in stock. This process confirms inventory record accuracy, identifies discrepancies, and accounts for losses. Even businesses using perpetual inventory systems perform physical counts to align digital records with actual stock levels.

Physical counts help identify “shrinkage,” which refers to inventory loss not attributed to sales, such as theft, damage, or spoilage. They also allow businesses to identify obsolete or slow-moving items, informing decisions about promotions or write-offs.

The process generally involves establishing clear cut-off procedures to ensure that transactions are recorded in the correct accounting period. Teams then systematically count all items, documenting quantities and conditions. Technology like barcode scanners can help improve accuracy and efficiency during this process.

After a physical count, adjustments are often necessary to reconcile the accounting records with the actual physical inventory. For a periodic inventory system, the physical count is the basis for determining the ending inventory balance and calculating the Cost of Goods Sold for the period. This involves closing entries that establish the new ending inventory figure and expense the cost of goods sold.

Under a perpetual inventory system, adjustments are made for discrepancies between book records and the physical count. If the physical count reveals less inventory than records show (due to shrinkage or errors), a journal entry reduces the Inventory account. This involves debiting an account like Cost of Goods Sold or Inventory Shrinkage Expense and crediting Inventory. For example, if a perpetual system shows $10,000 of inventory but a physical count reveals only $9,800, debit Cost of Goods Sold (or Inventory Shrinkage) for $200 and credit Inventory for $200.