Recording inventory
In order to prepare a statement of
comprehensive income it is necessary to be able to calculate gross profit. This
is done by comparing the sale proceeds from the sale of items of inventory to
the cost of those items. This is an application of the accruals concept
(matching principle).
In order to calculate gross profit it is
necessary to record opening inventory, purchases and closing inventory.
There are two main methods of recording
inventory.
Each method uses a ledger account for
inventory but these have different roles.
A question on year-end adjustments for
inventories will normally require you to use the periodic inventory method but
the perpetual inventory system is examinable in its own right.
Periodic inventory method (period-end method): accounting procedures
This system is based on the use of two ledger
accounts:
- Purchases account which is used to record all purchases during the year; and
- Inventory account which is used to record the value of inventory at the beginning/end of the financial year.
It operates as follows:
Year 1
A business starts on 1 January Year 1. This
business has no opening inventory.
All inventory purchased in the year to 31
December Year 1 is recorded in the purchases account.
Illustration: Purchases through the year
Debit Credit
Purchases X
Cash or liabilities X
At the end of the year a trial balance is
extracted. One of the balances in the trial balance is the purchases figure for
the year.
This is transferred to cost of sales clearing the
purchases account to zero.
Illustration:
Year end transfer to cost of sales
Debit Credit
Cost
of sales X
Purchases
X
At the end of the year cost of sales must be calculated.
Purchases are not thesame as cost of sales because the company still holds some
of the items that it purchased.
The number of items of inventory still held is
established through an inventory count. This involves the staff of the business
counting every item of inventory and making a record of this. The inventory is
then valued (usually at cost). This figure is the closing inventory.
It is recognised as an asset on the statement of
financial position and as a credit entry on the statement of comprehensive
income (where it reduces the cost of sales expense).
Illustration: Closing inventory double entry
Debit Credit
Inventory (statement of financial position) X
Cost of sales (Statement of comprehensive income) X
The exact location of the credit entry might
be to one of several accounts but ultimately it always achieves the same
purpose, that is, to set reduce cost of sales. Thus it might be a credit to a
statement of comprehensive income inventory account (which is later transferred
to a cost of sales account or it might be a credit to the cost of sales
account.
At the end of year 1 the purchases and the
credit entry for closing inventory form part of the profit for the period. The
debit entry for closing inventory is carried down into year 2 as an asset.
Year 2
The closing inventory in year 1 becomes the
opening inventory in year 2
All inventory purchased in the year to 31
December Year 2 is recorded in the purchases account.
At the end of the year a trial balance is
extracted. One of the balances in the trial balance is the purchases figure for
the year. Another of the balances is the opening inventory which has been there
since the start of the year.
The purchases together with the opening
inventory are what the business could have sold in the period. These are both
transferred to the cost of sales.
Illustration: Year end transfer to cost of sales
Debit Credit
Cost of sales X
Purchases X
Cost of sales
X
Inventory (statement of financial position) X
Note that this is the transfer of the opening inventory to cost of
sales)
At the end of the financial year, the closing
inventory is physically counted and valued. The closing inventory double entry
is then processed.
Illustration: Closing inventory double entry
Debit Credit
Inventory (statement of financial position) X
Cost of sales (Statement of comprehensive income) X
In summary
Opening inventory in the trial balance (a
debit balance) and purchases (a debit balance) are both transferred to cost of
sales.
This clears both accounts.
- Closing inventory is recognised in the inventory account as an asset (a debit balance) and the other side of the entry is a credit to cost of sales.
- Cost of sales comprises purchase in the period adjusted for movements in inventory level from the start to the end of the period.
Illustration: Cost of sales
Year 1 Year 2
Rs. Rs.
Opening inventory (a debit) - X
Purchases (a debit) X X
X X
Closing inventory (a credit) (X) (X)
Cost of sales X X
Remember the following:
In a period-end system of accounting for inventory, the double
entries are between the inventory account and the statement of comprehensive income.
- The cost of opening inventory is included in the cost of sales. It is an expense, and expenses are a debit entry. So debit the statement of comprehensive income (and credit the inventory account) with the cost of the opening inventory.
- The cost of closing inventory is included in the statement of financial position as an asset, so there must be a debit balance for the closing inventory. So debit Inventory (and credit Statement of comprehensive income) with the valuation of the closing inventory.
Perpetual inventory method: accounting procedures
A single account is used to record all
inventory movements. The account is used to record purchases in the period and
inventory is brought down on the account at each year-end. The account is also
used to record all issues out of inventory.
These issues constitute the cost of sales.
When the perpetual inventory method is used,
a record is kept of all receipts of items into inventory (at cost) and all
issues of inventory to cost of sales.
Each issue of inventory is given a cost, and
the cost of the items issued is either the actual cost of the inventory (if it
is practicable to establish the actual cost) or a cost obtained using a
valuation method.
Each receipt and issue of inventory is
recorded in the inventory account. This means that a purchases account becomes
unnecessary, because all purchases are recorded in the inventory account.
All transactions involving the receipt or
issue of inventory must be recorded, and at any time, the balance on the
inventory account should be the value of inventory currently held.
Furthermore, all transactions involving any kind of
adjustment to the cost of inventory must be recorded in the inventory account.
Read Also:UNEARNED Income and ACCRUED Income
Summary of journal entries under each system
 |
Summary of journal entries under each system |
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