Inventory management is one of the important areas to run and manage your business effectively. Knowing how much inventory you have at your business premises and what level should be maintained mitigates the risk of an out-of-stock situation. So, there is a need to account for inventories properly via recording journal entries of purchasing, processing, and selling.
Learning about different accounting entries is necessary to balance the financial figures to keep track of business inventories. To record journal entries for inventories, you must have a basic understanding of the double-entry methods. In this article, we shall explain how to record journal entries for inventories under different scenarios.
How to record a journal entry for inventory?
Inventory transactions are journalized to keep track of inventory movements. Various kinds of journal entries are made to record the inventory transactions based on the type of circumstance. For example, entries are made to record purchases, sales, and spoilage/obsolescence, etc.
Further, two inventory accounting systems record the journal entries for inventories, i.e., periodic and perpetual. The periodic inventory system is better for those businesses that maintain less inventory. On the other hand, a perpetual inventory system is a much-detailed way of recording the transaction and is suitable for higher inventory levels businesses.
Inventory Cycle
The inventory cycle is comprised of three following stages.
- Ordering stage of inventory
- The production stage of inventory
- Transfer to finished goods
In the first stage, inventory is ordered to meet the demand of business operations. The inventory purchased is then processed (known as Work in progress) to produce finished goods. The last stage involves the packaging and delivery of finished goods to customers. The inventory cycle is usually calculated by estimating the number of days.
For instance, it may take a week to order the goods, 3 days may be used to process raw material, and two days may be required to pack finished goods and deliver to customers. The combined figure of these days constitutes an inventory cycle.
Accounting for Inventory
Purchase of inventory
We shall debit the raw material and credit either cash or accounts payable to record the inventory purchases. If we have paid our suppliers in cash, the cash account is credited to show that cash has been used to finance raw material inventory.
Now, if you haven’t paid your suppliers immediately and agreed to terms that payment will be made after a few days, we shall credit Accounts payable instead of cash.
Further, the following entry will be passed if your business deals in merchandise to buy finished goods and resell them to the customer by adding profit margin.
| Particulars | Debit | Credit |
| Inventory Account (Finished goods) | XXX | |
| Cash/Accounts Payable | XXX |
It depends on the nature of the business whether to record inventory as raw material or merchandise inventory. However, if the business model is processing and sale, the material purchase is recorded. On the other hand, finished goods are purchased and recorded if the business model is based on trading (buy and sales).
Indirect production cost
The conversion of raw inventory into finished goods may result in incurring production-related expenses. For example, rent, utility, and supplies are necessary for the manufacturing process, and these expenses are charged as production overheads that are ultimately allocated to inventory. The entry for the recording of indirect production costs is as follows:
| Particulars | Debit | Credit |
| Production overheads | XXX | |
| Cash\Accounts payable | XXX |
Indirect labour cost
There are some other expenses such as salaries of staff managing the materials. These costs are also allocated to overheads and become part of inventory ultimately by charging those overheads to work in the process. The journal entry to record these costs is as follows:
| Particulars | Debit | Credit |
| Production Overheads | XXX | |
| Wages | XXX |
Transfer of Raw material to work in process
The raw materials purchased are used in the production process. This phenomenon is shown in journal entries by debiting Work in process and crediting raw material. The following journal entry is passed.
| Particulars | Debit | Credit |
| Work in progress | XXX | |
| Raw materials | XXX |
Recording of obsolete inventory
The production process may sometimes result in spoilage or obsolete inventory. So, it’s important to know how to record such obsolescence. To record this spoilage, the overhead account is debited by crediting it against Work in progress. The entry is:
| Particulars | Debit | Credit |
| Overhead Account | XXX | |
| Work in progress | XXX |
Transfer of Raw material to finished goods
Once the production is completed, the completed units are transferred out to finished goods. The entry is passed by debiting finished goods inventory and crediting the Work in the process account.
| Particulars | Debit | Credit |
| Finished Goods Inventory Account | XXX | |
| Work in process Account | XXX |
Sale of finished goods
The finished goods can be sold to the market after packaging. A cost of goods sold account is created upon its sale that tells us what the cost of goods sold was. The entry to record this cost of goods sold is as:
| Particulars | Debit | Credit |
| Costs of goods sold | XXX | |
| Finished goods inventory | XXX |
A separate entry for sale is also made by crediting sales and debiting accounts receivables.
| Particulars | Debit | Credit |
| Accounts receivable | XXX | |
| Sale | XXX |
Now you know how to record a journal entry for inventory purchased and how the inventory processing is recorded. At every stage to keep an up-to-date record for your business.
Different accounting entries are made to show the inventory figures for different types of business (merchandise business journal entries for inventory are different from other business types).
Example
Suppose a company HLK .ltd has purchased merchandise inventory costing $50,000 on credit on 1st January 2021. HLK. ltd has agreed to pay the suppliers after three weeks, i.e., on 21st January 2021.
Here are the journal entries for this transaction:
1st January 2021
(Purchase of inventory on credit)
| Particulars | Debit | Credit |
| Merchandise inventory | 50,000 | |
| Accounts Payable | 50,000 |
(Payment to the supplier)
21st January 2021
| Particulars | Debit | Credit |
| Accounts Payables | 50,000 | |
| Cash | 50,000 |
Conclusion
Inventory management is one of the essential aspects of business management. It’s the fact that a large amount of the working capital is allocated for the inventory. So, it means that holding inventory for the business costs money. Hence, business needs to minimize the cost of holding inventory without going out of stock.
Further, the inventory cycle of the business contains three stages that include ordering, production, and finalization of the finished goods. In general, a lower period of inventory is more desirable from a profitability perspective. However, the operational perspective supports the availability of stock in significant quantity. Hence, the business needs to balance between operational and profitability perspectives.
In addition to this, there can be different journal entries for recording inventory. For instance, if inventory is purchased, there can be different entries depending on the business model. Like if inventory is purchased for further processing, it’s debited in the raw mater account and transferred to the working in process account. And once production is completed, it’s transferred to the finished goods account.
On the other hand, the purchase of trading goods is directly posted in the chart of account for finished goods.
Frequently asked questions
What is double entry for the purchase of finished goods and impact the accounting record?
Following double entry is posted for the purchase of finished goods.
| Particulars | Debit | Credit |
| Finished goods | XXX | |
| Accounts payable/cash | XXX |
The debit impact of the transaction is a recording of the finished goods in the accounting record, and it remains in the books until sold to the customers. On the other hand, the credit impact of the transaction is a recording of liability or outflow of the cash from the business.
Enlist different types of costs incurred on inventory?
Cost of inventory includes the following,
- Ordering cost – the cost of placing an order to purchase inventory.
- Holding cost – the cost of holding inventory like the cost of warehousing.
- Stock out cost – the cost of not being able to meet the customer’s order.
What is the audit risk associated with inventory?
Overstatement of inventory is the prime audit risk associated with the inventory. It means the inventory balance may be overstated in the business leading to overstated assets and overstated profitability.