Accounting for inventories can be complicated with specific rules for debits and credits affecting various accounts. Fortunately, computerized accounting systems help in this process, minimizing errors while automatically performing many tasks. The rules for inventory accounting in the United States are governed by the Generally Accepted Accounting Principles, also known as GAAP.
A firm needs to have at least one account for inventory -- an asset account with a regular debit balance. Manufacturing firms may have more than one inventory account, such as Work-in-Process Inventory and Finished Goods Inventory. Some firms also use a Purchase account (debit account) to recognize inventory purchases. Manufacturing and merchandising businesses may use accounts named Cost of Goods Sold or Cost of Goods Manufactured. As with any debit account, all of these accounts are increased by debits and decreased by credits.
Increases in Inventory
Increases in inventory are often due to purchases. The journal entry to increase inventory is a debit to Inventory and a credit to Cash. If a business uses the purchase account, then the entry is to debit the Purchase account and credit Cash. At the end of a period, the Purchase account is zeroed out with the balance moving into Inventory. Increases could also be due to sales returns and in that situation, the journal entry involving inventory is to debit Inventory and credit Cost of Goods Sold. Often, a separate inventory account for returned goods is used -- apart from the regular inventory.
Decreases in Inventory
An inventory decreases with sales. The entry involving inventory is to debit/increase Cost of Goods Sold and to credit/decrease Inventory. Instead of making this journal entry, some firms calculate the cost of goods sold based on inventory count at period-end. Note that discounts on sales don't affect inventory accounts -- any discount is recognized as part of sales/cash or sales/accounts receivable accounts only.
Inventory accounts can be adjusted for losses or for corrections after a physical inventory count. Accountants may decrease the value of inventory for obsolescence, for instance. The journal entry to decrease inventory balance is to credit Inventory and debit an expense, such as Loss for Decline in Market Value account. Adjustments to increase inventory involve a debit to Inventory and a credit to an account that relates to the reason for the adjustment. For example, the credit could go toward accounts payable or cash, if the adjustment relates to purchases not recognized in the books.