Accounting Unplugged

Cost of Goods Sold and Inventory

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The purpose of an Inventory System in Financial Accounting is to account for resources and to match costs to their related sales as closely as possible.  Management Accounting is more concerned with the details of inventory management but for Financial Accounting, when inventory is purchased or sold, the objective is to satisfy the Matching Principle and to accurately represent the financial position of the entity.

The Matching Principle requires that revenues and their related costs be matched up and posted into the same accounting period.  When Inventory is purchased and before it is sold, there are no revenues to match it to so it cannot be considered a cost until it is sold.

The inventory examples assume that the entity has ownership of products purchased and that they are purchased and manufactured for sale as finished goods.  There are cases where the entity purchasing materials for and accounting for a project are not the owners of the product even as it is in the process of construction or manufacturing.  In these cases, purchases are debited directly to Income Statement Cost accounts.  The key concept is ownership.

There are two systems used to account for Inventory, the Periodic System and the Perpetual System.  Each has its own accounting methods and I’ll demonstrate those methods here.  I will not be explaining Inventory Valuation methods (FIFO, LIFO, Specific Identification etc.)

Periodic Inventory System – Assumes Entity Owns Inventory until Sale:

The first system I’ll demonstrate is the Periodic System.  The Periodic System may work well for companies where changes in sales can be tied closely to changes in inventory purchases. Under this system, as inventory is purchased, it is debited to the Income Statement Account “Purchases” and the Balance Sheet Account “Inventory” is adjusted at the end of the year when the available inventory is counted and valued.  At this time, the balances of the Inventory and Purchase Accounts are transferred to Cost of Goods Sold Account and the value of the Ending Inventory is transferred back from Cost of Goods Sold to Ending Inventory.

Entry for purchases throughout the year.

Account Description Debits Credits
5050 Purchases $10,000
2000 Accounts Payable $10,000

*In the entry above, the credit entry could be cash, I chose Accounts Payable because it will be the most common account used in this situation.

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