For a business that sells a product, inventory is tracked using accounting software. Depending on accounting specifics, the inventory can be tracked in one of two ways. As a result, adjustments for ending inventory can vary at the end of the year. Some business have other adjustments that must be made for ending inventory due to the use of discounts, returns and allowances accounts.
Perpetual Inventory System vs. Periodic Inventory System
Depending on how your accounting software is set up, your inventory tracking system can be perpetual or periodic. With a perpetual system, changes to the inventory amount are made in real-time. For example, if you enter in a sales invoice for 15 items in your inventory, the system automatically reduces your inventory amount by 15. With a periodic inventory, the inventory amount remains at the year’s starting amount until you update it.
Regardless of your type of inventory system, a physical count of the inventory should be done at the year’s end. Due to shrinkage, such as employee theft or loss, you may not have the amount of inventory on hand you think you do. A physical count lets you know exactly how much inventory the business has at the time of the count. You cannot make any ending inventory adjustments until you do the count.
Inventory Quantity Adjustment
If you are using the perpetual inventory system and your physical count shows the same number on hand, you do not have to make an adjustment. However, if the number on hand differs from what your accounting system shows, you must make a quantity adjustment. The exact process for entering the adjustment varies by accounting software. Generally you can make a “new quantity” adjustment.
Cost of Goods Sold Adjustment
When you make an adjustment to the inventory quantity, you must also make a corresponding adjustment to the cost of goods sold account. To calculate this, you need to know the price paid for the inventory units you are adjusting. For example, if the unit price is $6 and you are adjusting by only six, units the cost is $36. The exact process for entering the adjustment varies by accounting software. Generally you can make a “new value” adjustment.
Less Common Adjustments
If you are using a purchase returns and allowance account or a purchase discounts account, you need to close these at year's end. You only have these accounts in a periodic inventory system. The entries you have in each of these accounts is a credit, which you close by debiting the accounts and issuing a corresponding credit to the inventory account at year's end. A similar adjustment must be made if you are using a sales returns and allowance account or a sales discounts account. These accounts can be in either inventory system. Instead of having a credit in these accounts, you have a debit. Close out the year-end account with a credit to these accounts and a debit to inventory.