Businesses that have inventory on hand must account for inventory losses at the end of an accounting period. Inventory losses are due to such things as theft, obsolete merchandise and broken or damaged goods. Businesses are required to take an on-hand physical inventory count of all merchandise at least once a year and then make an adjustment to inventory based on the loss discovered.
Companies with inventory use one of two common methods to account for that inventory: the periodic method or the perpetual method. The periodic method records all inventories into one account, where they remain until a physical inventory count is taken. When this occurs, the inventory account is credited for the difference. The perpetual method is a computerized method that records all inventories when they are purchased, and as they are sold the inventory gets credited out of the account immediately.
Companies use different types of methods to account for the sale of inventory. One is first in, first out, or FIFO. This means the first inventory purchased is the first inventory sold. Last in, first out is a, or LIFO, is another method. This method states the last inventory purchased is the first sold. Other companies use a method called weighted average, which measures the sale of goods based on their average cost.
When a company takes a physical inventory count at the end of a period, it may discover obsolete or out-of-date merchandise. When this happens, the difference in cost needs to be recorded on the books to keep the inventory account as accurate as possible. If a company has 100 items recorded on the books for $10 each, but it figures the items are really worth only $6 each, an adjusting entry needs to be made. In this case, an entry of $400 would be debited to the Cost of Goods Sold account and $400 would be credited to the Inventory account. This reduces the cost of inventory shown in the bookkeeping records.
Often, a company accepts returns that are damaged goods. These goods are sometimes returned to the manufacturer, but not always. If they are not returned to the manufacturer, the company must write off the damaged goods so they are not part of the inventory count. To do this, the journal entry would be a debit to Cost of Goods Sold and a credit to Inventory.
No matter how good a company's internal controls are, theft is bound to occur. The difference between what the inventory is supposed to be and what it is calculated at is usually because of theft by employees and customers. The inventory account needs to be adjusted because of this. When theft is discovered during a physical inventory count, the business must debit the Cost of Goods Sold account and credit the Inventory account.