6.1 Account for Inventory

Inventory is merchandise held by companies for the purpose of being sold to customers. Inventory is a current asset account on the balance sheet. 

For companies in the manufacturing sector, production costs such as direct labor and factory overhead are included within the inventory account. However, for illustrative purposes in this course, we will focus on inventory accounting for a non-manufacturing company, whereby:

• Inventory is increased when the company purchases merchandise.
• Inventory is decreased when the company sells goods to customers.

An inventory roll shows the movement in inventory within a given period as:

Beginning Inventory + Net Purchases – Cost of Goods Sold = Ending Inventory

Cost of Inventory

The cost principle requires that inventory be recorded at the invoice price, which is the amount paid to acquire inventory plus all costs incurred to bring the inventory to saleable conditions including:

• Purchase price (i.e., invoice price)
• Freight-in
• Insurance while in transit
• Any costs paid to get the inventory ready to sell (i.e., production costs including direct labor costs)

The following items need to be subtracted from the cost of inventory:

• Returns
• Allowances
• Discounts

All other costs (e.g., advertising, sales commission, etc.) are operating expenses and are not included in the cost of inventory. This is an important concept because in increasing net income, companies might be incentivized to capitalize ineligible costs as inventory.

The value of inventory affects two financial statement accounts:

1. Inventory, reported as a current asset on the balance sheet, and
2. Cost of goods sold (cost of sales), reported as an expense on the income statement.

Cost of Goods Sold

The cost of the inventory sold transfers costs out of the inventory account on the balance sheet to the cost of sales (or cost of goods sold) account on the income statement when the seller delivers the goods to the buyer (i.e., when the related revenue is recognized; this is the matching principle, which was covered in a previous unit).

(Harrison et al., 2018, p. 236)

Cost of Inventory vs. Sale Price

The cost of inventory is not necessarily the same as its selling price. In most cases, both are different since a business would ideally sell its inventory for profit. Cost of inventory is the amount paid to acquire the inventory, whereas the sale price is the amount the inventory is sold for. This concept is important as it impacts different accounts on the financial statements:

• Inventory (Balance Sheet) =  Number of Inventory Units on Hand  ×  Cost per Unit of Inventory
• Cost of Goods Sold (Income Statement) =  Number of Inventory Units Sold  ×  Cost per Unit of Inventory Sold
• Sales Revenue (Income Statement) =  Number of Inventory Units Sold  ×  Sale Price per Unit Sold

Gross profit is the excess of sales revenue over cost of goods sold.

Gross Profit = Sales Revenue – Cost of Goods Sold
(Income Statement)

It is called gross profit because operating expenses have not yet been subtracted.

Note: gross profit is only a subtotal on the income statement. It is not an account.

Number of Units of Inventory

The number of inventory units on hand is determined from the accounting records, backed up by a physical count of the goods at period-end. Note:

• Consigned goods are always reported in the accounting records of the company that owns them, regardless of where they are physically being held for sale.
• Companies include inventory in transit from suppliers or to customers depending on who has legal title at period-end (i.e., based on shipping terms).

Understanding Shipping Terms

Shipping terms, otherwise known as FOB (free on board) terms, indicate who owns the goods at a particular time.

Inventory Accounting Systems

There are two main types of inventory accounting systems:

1. Perpetual system, and
2. Periodic system.
   
   

(Harrison et al., 2018, p. 239)

For this course, we will focus mainly on the perpetual inventory system as this is the system used by most businesses nowadays.

When a company makes a purchase of inventory, a journal entry is needed in the perpetual system:

When a company makes a sale, two journal entries are immediately recorded in the perpetual system:

1. Record the sale at selling price:

2. Record the cost of goods sold at cost value:

Let’s take a look at an example:

Assume that XYC Inc.’s beginning inventory balance on January 1 is $100K, and its net purchases of inventory on January 16th is $560K on account. XYC Inc. makes a net credit sale of $900K on January 31 and the cost of inventory for this sale is $540K.

What journal entries would you post to record these transactions?

© Course Author(s) and University of Waterloo

Sales Discounts

Sometimes, especially in business-to-business (B2B) sales when the transaction is taking place between two businesses for large orders, a discount is offered if the invoice is paid within a short time frame. There is common nomenclature used to represent these discounts, shown below:

Credit terms of 2/10, n/30 (read as: “two ten, net thirty”) means:

• The customer can deduct 2% from the invoice amount if cash payment is received within 10 days of the date of sales.
• Otherwise, the full invoice amount is due within a max. of 30 days.