Even though using bookkeeping software will help with the daily use of accounting functions for a small business, it’s still important to have an understanding of the basic functions of accounting. Before learning about inventory and cost of goods sold, it’s important to first have an understanding of debits and credits.
The Relationship of Inventory and Cost of Goods Sold
Inventory and cost of goods sold or cost of sale, are both general ledger (GL) accounts. The main difference between the two is that inventory is an asset and cost of goods sold is used to figure gross profit. Since inventory is an asset, it’s reported on the balance sheet. Since the cost of goods sold is a GL that’s used to figure gross profit, it’s reported on the income statement. As it increases, gross profit decreases.
The Sales Invoice, Inventory and Cost of Goods Sold
When a sales invoice is written that affects the inventory account, the cost of sales GL account is generally used as a reciprocal account. A reciprocal account means that it acts like an opposite. If a sales invoice is written, and a credit is posted to reduce inventory, a debit is automatically posted for the same amount to increase the cost of sales.
To illustrate how a sales invoice would post to the sales journal, let’s assume that an item was sold for $100.00, with an inventory cost of $60.00. The customer paid cash and there’s a 6% sales tax. If accounting software is used to generate a sale invoice, the posting of all appropriate GL accounts is generally automatic.
- Cash $106.00 debit (increase)
- Sale Tax $6.00 credit (liability increase)
- Sales $100.00 credit (income increase)
- Cost of Goods Sold $60.00 debit (increase)
- Inventory $60.00 credit (asset decrease)
The Purchase Journal and Inventory
When inventory is purchased on open credit terms, it is posted to the purchase journal. Cost of sale is not affected because it only relates to income generated from a sale. If inventory is paid for when purchased, it is generally posted through the check register. To illustrate how inventory is posted using the purchase journal, we’ll assume that $1,000 worth of inventory is purchased and a 5% bulk discount was received on the purchase.
- Inventory $1,000 debit (asset increase)
- Accounts Payable $950 credit (liability increase)
- Discounts $50 credit (income increase)
At the end of each month, the general ledger totals are transferred to the financial statements. Cost of goods sold is deducted from sales and reported as gross profit. The inventory balance is reported as an asset on the balance sheet.