Accounting Unplugged


Cost of Goods Sold and Inventory

Posted in 6. Operations by Erin Lawlor on the September 7th, 2008

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The purpose of an Inventory System in Financial Accounting is to account for resources and to match costs to their related sales as closely as possible. Management Accounting is more concerned with the details of inventory management but for Financial Accounting, when inventory is purchased or sold, the objective is to satisfy the Matching Principle and to accurately represent the financial position of the entity.

The Matching Principle requires that revenues and their related costs be matched up and posted into the same accounting period. When Inventory is purchased and before it is sold, there are no revenues to match it to so it cannot be considered a cost until it is sold.

The inventory examples assume that the entity has ownership of products purchased and that they are purchased and manufactured for sale as finished goods. There are cases where the entity purchasing materials for and accounting for a project are not the owners of the product even as it is in the process of construction or manufacturing. In these cases, purchases are debited directly to Income Statement Cost accounts. The key concept is ownership.

There are two systems used to account for Inventory, the Periodic System and the Perpetual System. Each has its own accounting methods and I’ll demonstrate those methods here. I will not be explaining Inventory Valuation methods (FIFO, LIFO, Specific Identification etc.)

Periodic Inventory System - Assumes Entity Owns Inventory until Sale:

The first system I’ll demonstrate is the Periodic System. The Periodic System may work well for companies where changes in sales can be tied closely to changes in inventory purchases. Under this system, as inventory is purchased, it is debited to the Income Statement Account “Purchases” and the Balance Sheet Account “Inventory” is adjusted at the end of the year when the available inventory is counted and valued. At this time, the balances of the Inventory and Purchase Accounts are transferred to Cost of Goods Sold Account and the value of the Ending Inventory is transferred back from Cost of Goods Sold to Ending Inventory.

Entry for purchases throughout the year.

Account Description Debits Credits
5050 Purchases $10,000
2000 Accounts Payable $10,000

*In the entry above, the credit entry could be cash, I chose Accounts Payable because it will be the most common account used in this situation.

At the end of the year, inventory is counted and valued and adjusting entries are made to the Balance Sheet and Income Statement Accounts.

This entry assumes prior entries and the following account balances at the end of the year: Beginning Inventory of $5,000, Purchases of $60,000 and Ending Inventory of $6,000.

Entry to transfer balances to Cost of Goods Sold and adjust the Inventory Account to equal the ending balance valuation.

Account Description Debits Credits
5000 Cost of Goods Sold $65,000
1375 Inventory $5,000
5050 Purchases $60,000
1375 Inventory $6,000
5000 Cost of Goods Sold $6,000

When working with accounts like Inventory under the Periodic Inventory system, I prefer to remove the entire account balance and make the adjusting entry equal to the new ending balance. This strategy makes future auditing of the account more clear.

Freight-In is considered a direct cost of inventory because all costs that are directly related to the acquisition and preparation for sale of inventory are considered part of its direct cost. Freight-In is not included in the adjusting entries, it is maintained in a separate account. Freight-In is an Income Statement Cost Account.

Companies using the Periodic Inventory System provide more detail for Cost of Goods Sold on the Income Statement and expand the entry to include the Cost of Goods Sold calculation/statement.

The format for the Cost of Goods Sold Statement is:

  • + Beginning Inventory
  • + Net Purchases (Inventory Purchases - Returns)
  • + Freight “In” Charges
  • - Ending Inventory
  • ————————–
  • Cost of Goods Sold

Perpetual Inventory System - Assumes Entity Owns Inventory until Sale:

The next system is the Perpetual Inventory System. Using this system, inventory purchases are debited to a Balance Sheet Inventory account rather than an Income Statement Purchase account and they are transferred to the Cost of Goods Sold account at the time of sale.

Under the perpetual system, products that are purchased as finished goods are accounted for in one inventory account but products that will be manufactured use three inventory accounts, raw materials, work in progress and finished goods.

For the purposes of this entry, I will use one Cost of Goods Accounts (5000), three Inventory Accounts (in the 1300 range) and one Revenue Account (4000 - Sales). The Account Numbers are not important to the concept, they are used here to provide easy identification. The important concept is the difference between Cost of Goods which is an Income Statement Item and Inventory which is a Balance Sheet Item.

In the case of retail, where products are purchased as finished goods and then resold, products are owned by the seller until sold. An example of the initial cost entry is:

Account Description Debits Credits
1375 Inventory $1,500
2000 Accounts Payable $1,500

There are two entries to make when Products (Inventory) are sold:

Record the Sale:

Account Description Debits Credits
1200 Accounts Receivable $3,000
4000 Sales $3,000

And then transfer the Cost of the products that were sold from Inventory to Cost of Goods:

Account Description Debits Credits
5000 Cost of Goods Sold $1,500
1375 Inventory $1,500

In the case of Value Added or Manufacturing, all costs related to purchasing materials and preparing them for sale are included in their value. When a company purchases Raw Materials well in advance a Raw Materials Inventory Account is used. In cases where the company is manufacturing or constructing a product for sale but only purchases inventory as it is required, the Raw Materials Inventory Account is skipped and the Purchases are debited directly into the Work in Progress Inventory Account.

Purchase of Raw Materials In Advance:

Account Description Debits Credits
1300 Inventory - Raw Materials $500
2000 Accounts Payable $500

To Record the purchase of Raw Materials that will be put to immediate use:

Account Description Debits Credits
1325 Inventory - Work in Progress (Materials) $500
2000 Accounts Payable $500

Or, to transfer the cost of the Raw Materials that are in the process of Manufacturing to Work in Progress.

Account Description Debits Credits
1325 Inventory - Work in Progress (Materials) $500
1300 Inventory - Raw Materials $500

To Record Direct Labor:

Account Description Debits Credits
1325 Inventory - Work in Progress (Labor) $500
2000 Operating Account $500

To Transfer the Cost of the Value Added or Manufactured Goods that are completed to Finished Goods:

Account Description Debits Credits
1375 Inventory - Finished Goods $1,500
1325 Inventory - Work in Progress $1,500

* Credit entries are “Source of Funds/Value” entries and for these examples they are either cash - Operating (Bank) Account, a delay in cash - Accounts Payable OR they are Transfers of Values. For cash or cash delays, I selected the accounts that would be the most commonly used for each. Payroll is usually posted when it is paid and Purchases are often made on account.

Sales/Revenue Entries

There are two entries to make when Products (Inventory) are sold:

Record the Sale:

Account Description Debits Credits
1200 Accounts Receivable $3,000
4000 Sales $3,000

And then transfer the Cost of the products that were sold from Inventory to Cost of Goods:

Account Description Debits Credits
5000 Cost of Goods Sold $1,500
1375 Inventory $1,500

Cost of Goods Sold, Services - No Inventory:

In the case of Services, there is no product for ownership transfer so, an example of the the initial cost entry is simple:

Account Description Debits Credits
5000 Cost of Goods (Labor) $1,000
1000 Operating Account $1,000

The entry for the sale of services is as simple as the entry for its cost:

Account Description Debits Credits
1200 Accounts Receivable $2,000
4000 Sales $2,000

Cost of Goods Sold: No Inventory Accounting, Assumes Entity does not Own Inventory:

The Cost entries are simply made directly to the Income Statement Cost Accounts.

Account Description Debits Credits
5000 Labor Costs $5,000
5100 Equipment Costs $5,000
5200 Materials Costs $20,000
5300 Subcontract Costs $60,000
1000 Operating Account $5,000
2000 Accounts Payable $85,000

The Revenue entries for this Cost of Goods Sold case will be the same as the Revenue Entry above for Services. However, if the manufacturing or construction of the product extends over several accounting periods, there are additional entries that may have to be made to adjust a portion of the Revenue Entry into a either an “Under-Billings” Asset account or an “Over-Billings” Liability account in order to satisfy the Revenue Principle. I will address those adjustments in the next post.

© 2008 - 2010 Erin Lawlor

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**disclaimer: All information posted on this blog is from my own experience and training. The guidelines I present are general and in my experience, standard practice. I do not write with authority from any Accounting Standards Boards.

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