Inventory is accounted for as an asset, which means it will show up on a company’s balance sheet. An increase in inventory is recorded as a debit while a credit signifies a reduction in the inventory account. When it comes to retail or distribution, inventory involves the purchase of goods for sale to customers. In a manufacturing company, inventory refers to the raw materials used to manufacture a good.
Inventory is classified as a current asset, since the company expects to use or sell the goods within a one year period. Inventory may be the most valuable asset a company has, depending on the nature of the company’s business activities. A company must report inventory at the cost it paid to purchase it as opposed to the selling price of the goods, as explained by the Accounting Coach website. When a company has too much inventory, it may incur additional storage and insurance charges. However, when a company has insufficient inventory it may lose revenue and credibility with customers. Companies may use a perpetual or periodic system for recording inventory.
A company that uses the perpetual system updates the inventory balance with each sale. A perpetual system is more complex and expensive in comparison to a periodic system. Using a perpetual system offers greater protection from fraud and allows the managers of the business to have greater control over inventory. In the perpetual system, a company debits the inventory account as opposed to the purchases account to indicate the purchase of inventory. Companies that employ a perpetual system may have a computerized system to record every transaction at the moment it occurs.
In a periodic system, a company updates its inventory balance on an annual basis. Companies that use the periodic system may record its inventory balance more than once a year, at the discretion of the company’s owners and managers. When a company uses the periodic system, a debit to the purchases account indicates the company has bought inventory. A company may physically count inventory at the end of the year to determine the ending inventory balance, which becomes the beginning inventory balance for the following year.
Cost of Goods Sold
Cost of goods sold is tied to a company’s inventory because it indicates the price a company paid to sell goods to its customers, according to the Accounting Coach. Cost of goods sold represents the price paid to a company’s supplier plus the costs of providing the goods to the company’s customers. Advertising and shipping expenses represent aspects of a company’s cost of goods sold. Say, for example, a company paid $25 for a clock, $5 for shipping and $10 for advertising. The company records a $40 debit into the inventory account. A $40 credit is recorded in cash or accounts payable if the company purchased the clock on credit. When the clock is sold, the company debits cost of goods sold for $40 and records a $40 credit for revenue to indicate the sale of the clock. A company's cost of goods sold is reported on the income statement.