Accounting for inventory (stock) is a task that many businesses will face. Businesses who buy and sell goods rather than services will either have to buy in goods to sell on at a profit, or buy in materials to manufacture their own goods, again to sell on.
Large retailer’s inventory
Some businesses may wait until they receive an order for goods from a customer before manufacturing goods.
However, many large retailers and manufacturers will constantly buy in goods/materials to ensure that they always have a flow of goods available to sell at any time. In this scenario, it will lead to a business having stock on hand at the end of the day/week/month etc. For us to then give a true and fair view of the business‘ trading position, we need to first value that stock but then also account for it in the accounting records.
There are different ways in which we can value stock, however IAS 2 states that stock must be valued at the lower of cost (what was paid for it) and net realisable value (what we can sell it for). In most cases a business would hope that the cost would be lower than the net realisable value, otherwise they would be selling goods on for less than they had paid for them, resulting in a loss.
The matching concept
Once valued we must then account for this in the business’ records. When the business first bought the goods, these will have been accounted for as ‘purchases’ in the accounting records. However, some of these goods are now sat unsold as ‘stock’ (in a warehouse or on a shop floor for example). The matching concept tells us that we must match income and expenses together, therefore we need to carry this stock forward to the period in which the goods will be sold. This will ensure the income received from the sale can be matched against the cost of buying the goods in the first place.
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The cost of sales calculation
The way that inventory is accounted for is therefore to credit the profit and loss account during the cost of sales calculation. The cost of sales calculation is: opening stock + purchases – closing stock. We can see here that we are reducing the ‘cost of sales’ figure by taking off the ‘closing stock’ figure. You can also see that within this calculation we add on any opening stock, so when we move onto the next accounting period, the stock taken off originally is then added back in. As stated before, this therefore matches the value of the stock into the period where it will be sold and when the income is received.
Recording inventory as assets
The other entry we need to make for stock is to record it as an asset on the balance sheet. The stock is an asset because the business owns that stock – they have bought and paid for it but have not yet sold it, so this will also need to also be recorded in the financial statements. For this to be entered correctly as an asset we would debit the closing stock value to a stock account on the balance sheet.
We can see that by performing these functions relating to stock, we have credited the profit and loss account and debited the balance sheet. We have equal debits and credit and so the inventory journal balances as we have followed the double entry principle. A large manufacturing business may benefit from life cycle costing, which you can read more about here.