Inventory, also called merchandise inventory, is the company’s investment in products that it plans to sell to customers. It is an asset recorded on the balance sheet along with other current assets. Manufacturers make their own inventory, while retailers and other businesses buy their inventory from suppliers.
Under U.S. Generally Accepted Accounting Principles, companies usually record inventory at the lower of cost or market value. This means that they record inventory at its original cost unless its market value is lower than cost.
To determine the cost of inventory, companies must use a cost flow assumption. The four most common techniques for computing the cost of inventory are:
- First-in first out (FIFO),
- Last-in first out (LIFO),
- Weighted Average (also known as Moving average), and
- Specific identification.
To keep track of inventory costs, companies use either periodic or perpetual inventory systems. In a periodic inventory system, a company physically counts its inventory at the end of each year. To compute cost of goods sold, it uses the following formula:
Cost of goods sold = beginning inventory + purchases – ending inventory
(Note that the beginning inventory would be the same as the ending inventory last year.)
In a perpetual inventory system, a company continuously keeps track of the balance of all of its inventory activity. Every sale of every item is recorded, so that the company has a record of how many goods are in stock at any given time. Cost of goods sold is calculated based on the actual number of units that the company recorded as sold during the period.
To record a purchase of inventory, debit the account “inventory.” If you’re purchasing on credit, then credit the account “accounts payable.” Otherwise, if you’re paying for it now, credit the account “cash.” Here’s an example of purchasing inventory on credit for $1,000: