The major objectives of accounting for inventories are the matching of appropriate costs against revenues in order to arrive at the proper determination of periodic income, and the accurate representation of inventories on hand as assets of the reporting entity as of the date of the statement of financial position.

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Under any system of accounting, financial statements should be fully articulated (i.e., the statement of financial position and income statement are linked together mechanically).

And, to achieve the goal, accounts would need to record every single event—related to inventory, in this case—along the inventory cycle: raw material received, raw material moved to the line of production, finished goods moved to the finished good warehouse, obsolescence, stolen, and finished goods sold out or moved to other warehouses.

So here we go with journal entries…

 

Raw Material Inventory

1. Receiving the raw material – When any raw material is received means the raw material inventory is increased too. So, after counting and matching the quantity with the purchase order, you would record “Receipt of Goods” entries, as follows:

[Debit]. Inventory—Raw Materials  = xxx
[Credit]. Accounts Payable = xxx

(Note: xxx is amount of actual quantity received. You can replace the ‘accounts payable’ with ‘cash’ if it is a cash transaction).

 

2. Moving raw materials to the line of production – When any raw materials going out of the warehouse—usually to the line of production, means the raw material is decreased. On the other hand, it shifted the raw materials to a new form of inventory which will be located in the line of production, called “WIP—Work In Process Inventory”. So for this event, you would make the following record:

[Debit]. WIP—Work In Process Inventory = xxx
[Credit]. Inventory—Raw Materials = xxx

 

3. Adjusting raw material inventory – Some materials maybe damaged/obsolete, some maybe loss (stolen) time-by-time. Such risks are inevitable. Referring to the conservatism principle, you would need to make a reserve for such risks.  Reserving in this case means you are charging cost in advance. So to prepare it, you would need to make reserve account, or you may want to create some for more details report and easier way to drill down in the future. Here are journal entries you would need to make:

For obsolete raw materials:
[Debit]. Cost of Goods Sold = xxx
[Credit]. Obsolescence Raw Material Reserve = xxx

For stolen raw materials:
[Debit]. Cost of Goods Sold = xxx
[Credit]. Stolen Raw Material Reserve = xxx

OR; create a single reserve:
[Debit]. Cost of Goods Sold = xxx
[Credit]. Raw Material Reserve = xxx

 

So, when actual obsolescence or loss (because of it is stolen) is occurred, you would make an adjustment entry as follows:

[Debit]. Raw Material Reserve = xxx
[Credit]. Raw Material Inventory = xxx

The same case could be happened to the WIP—Work In Process Inventory. And, the same steps are required to reflect those in the book, except that you need to replace the “Raw Material” with “WIP—Work In Process”.

In any manufacturing process, wastes are inevitable. And, you would need to reflect the loss in the book by making the following journal entry in the current period:

[Debit]. Cost of goods sold = xxx
[Credit]. WIP—Work In Process Inventory = xxx

 

Finished Goods Inventory

1. Finished Goods Inventory Received – Finished goods inventories could be come from inside the company—line of production (when it is a manufacturing company), or from outside of the company—finished good purchased (when it is a retail/trading company). Wherever it comes from, finished goods inventory is increased and need to be reflected in the book. So, you would make the following entries:

Finished Goods come from line of production:

[Debit]. Finished Goods Inventory = xxx
[Credit]. WIP—Work In Process Inventory = xxx

Finished Goods come from outside of the company (purchased finished goods):

[Debit]. Finished Goods Inventory = xxx
[Credit]. Accounts Payable = xxx

(Note: xxx is amount of actual quantity received. You can replace the ‘accounts payable’ with ‘cash’ if it is a cash transaction).

 

2. Finished Goods Shipped Out – There are two possibilities of reason for shipping out the finished goods inventory: sold or moved to other warehouse location. Either it is shipped out to customers (sold) or moved to other warehouse location, it will definitely decrease the finished goods inventory and should be reflected on the book. So, here are journal entries you need to make:

Finished good sold:

[Debit]. Accounts Receivable = xxxx
[Credit]. Sales = xxx
[Credit]. Sales Tax Payable = x
(Note: This is to record the sales and sales tax. ‘xxxx’ is amount of the sales plus sales tax, ‘xxx’ is amount of the sales only, ‘x’ is amount of the sales tax)

AND;

[Debit]. Cost of Goods Sold = xxx
[Credit]. Finished Goods Inventory = xxx

(Note: This is to record the finished goods decrease. ‘xxx is amount of the cost)

 

3. Finished Goods Inventory Adjustment – Finished goods inventory could become obsolete or stolen, and to anticipate the risk, you would need to reserve it. To do that, you would need to make the following entry:

[Debit]. Cost of Goods Sold = xxx
[Credit]. Finished Goods Reserve = xxx

So, when actual obsolescence or loss (because of it is stolen) is occurred, you would make an adjustment entry as follows:

[Debit]. Finished Goods Reserve = xxx
[Credit]. Finished Goods Inventory = xxx

As what you do on the raw material inventory, you may want to separate the ‘obsolescence’ with ‘stolen’ too for easier control and analyses in the future time.

 

Physical Count Inventory Adjustment

The accounting for inventories is done under either a periodic or a perpetual system. In a periodic inventory system, the inventory quantity is determined periodically by a physical count. The quantity so determined is then priced in accordance with the cost method used. Cost of goods sold is computed by adding beginning inventory and net purchases (or cost of goods manufactured) and subtracting ending inventory.

Alternatively, a perpetual inventory system keeps a running total of the quantity (and possibly the cost) of inventory on hand by recording all sales and purchases as they occur. When inventory is purchased, the inventory account (rather than purchases) is debited. When inventory is sold, the cost of goods sold and reduction of inventory are recorded.

Periodic physical counts are necessary, however—at least to satisfy the tax regulations (tax regulations require that a physical inventory be taken, at least annually). Most likely, you will find variances—actual quantity vs. recorded quantity. And, you would need to make both perfectly matched, means you would need to adjust your record—either up or down.

The following entries assume that there are increases in inventory balances:

[Debit]. Raw materials inventory = xxx
[Debit]. Work-in-process inventory = xxx
[Debit]. Finished goods inventory = xxx
[Credit]. Cost of goods sold = xxx

(Note: If there are decreases in the inventory balances, then the debits and credits are reversed.)

 

Specific Inventory Adjustment Entries

As I have described it in the preface of this post: first, the COGS and other costs in the Income Statement should be tightly linked with the ‘on hand’ inventory balance on the Balance Sheet which should represent the real value of the actual asset. However, for some reasons, sometime, you may find values of the inventory you’ve recorded become higher compare to the market price. To achieve the goal, you would need to make the following adjustment entry:

[Debit]. Loss on Inventory Valuation = xxx
[Credit]. Raw Materials Inventory = xxx
[Credit]. WIP—Work In Process Inventory = xxx
[Credit]. Finished Goods Inventory = xxx