Assets whose purpose is for sale to customers are inventory. In a grocery store, food is inventory. Books and magazines are inventory. Cash registers are not inventory.
A developer builds a tract of homes and puts them up for sale. Are those buildings fixed assets or inventory?
Answer: inventory because their purpose is for sale to customers.
For people live in those homes, they are fixed assets. Even though a homeowner may hope to sell it sometime down the road, he’s using the asset, not just holding it for sale.
Inventory accounting shows up in two places in the financial statements. It is a current asset in the Balance Sheet. It is also a part of Cost of Goods Sold in the Income Statement.
Few software packages handle the Cost of Goods Sold accounting properly. While in theory Cost of Goods Sold should show Beginning Inventory, Purchases, and Ending Inventory, we lump them all into just one account.
This is where you may want to consult your particular accounting program’s limitations, to see if you need to do this, too.
At the end of the year each company should physically count its inventory. The accountant should price this merchandise at cost and then adjust the books to the inventory that is actually on hand. Both GAAP and IRS rules require a physical count once a year.
But how do you count for inventory in the meantime?
One method is the percent of sales method. First, you should code all inventory purchases to Inventory (the Balance Sheet account). Next, figure your average markup. This can be based on the ratio of Cost of Goods Sold to Sales in previous years. Then at the end of the period (usually a month or a quarter) make an adjusting entry to credit this amount out of inventory and debit it into Cost of Goods Sold.
Assume markup of 20%. August Sales were $10,000.
Cost of Goods Sold should be $8,000.
Don’t try to be too exact with these estimates. They are, after all, estimates. Use rounding. Don’t imply accuracy that is not there and is not possible to achieve. Note that this is why a physical count is so important. That should be calculated to the last penny!
How do you cost inventory?
So the clerks have gone all around the plant and you now have a whole bunch of count sheets. The amounts of each item should be multiplied by how much these items cost to get your cost. But how can you know? What if the prices were different at different times of the year? Which prices should you use?
First, you’ve got to have records of how much units were bought at what prices. Next, you have several options: First in First Out (FIFO), Average, and Last in First Out (LIFO). As the names imply, you go through your lists, crossing out items as sold until you get to the number of units that match your count. Those are the prices you use to cost the items on your count sheets.