INVENTORY & COST OF GOODS SOLD

Main ideas, concepts, and lessons

• Inventory exists in both manufacturing and merchandising businesses, but the definition differs:
  • Manufacturing businesses: hold raw materials, work in progress, and finished goods.
  • Merchandising businesses: hold goods they purchased with the intention to resell.
• Inventory is an Asset because it provides future economic benefit (the business plans to sell it later).
• Inventory is typically a Current Asset because it is usually converted to cash within about one year.
• Inventory connects the Balance Sheet and the Income Statement:
  • On the Balance Sheet, inventory is tracked as an asset.
  • On the Income Statement, inventory costs appear when goods are sold as Cost of Goods Sold (COGS), which then offsets sales revenue.
• A merchandising sale uses a two-step process:
  1. Buying inventory initially records it in Inventory (Balance Sheet).
  2. Selling inventory later “releases” its cost into COGS (Income Statement) while also recognizing Revenue.

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Methodology / instructions (journal entry workflow)

Setup example (Toques merchandising)

• Buy toques from a supplier for $4 each (paid in cash).
• Sell to customers for $7 each.
• Customers pay on account (the business records Accounts Receivable instead of receiving cash immediately).

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Transaction 1: Purchase inventory for $4 (cash purchase)

Journal entry

• Debit Inventory — $4
• Credit Cash — $4

Accounting logic (what changes)

• This increases an asset (Inventory) and decreases another asset (Cash)—both on the Balance Sheet.

T-account impacts

• Inventory (Asset): debit left by $4
• Cash (Asset): credit right by $4

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Transaction 2: Sell the toque for $7 on account

This requires two journal entries.

Entry A: Recognize revenue from the sale ($7)

• Debit Accounts Receivable — $7 (customer owes you)
• Credit Revenue — $7

What this does

• Increases the asset Accounts Receivable on the Balance Sheet
• Increases Revenue on the Income Statement

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Entry B: Transfer the cost of the sold item from Inventory to COGS

Since the toque’s cost was $4, you “release” that cost from the Balance Sheet to the Income Statement:

• Credit Inventory — $4
• Debit Cost of Goods Sold — $4

What this does

• Decreases the asset Inventory on the Balance Sheet
• Increases the expense Cost of Goods Sold on the Income Statement

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Combined results after both transaction steps (as shown)

Balance Sheet movements (net)

• Cash: - $4 (cash outflow from Transaction 1)
• Accounts Receivable: + $7 (on-account sale from Transaction 2)
• Inventory: net 0 (bought $4, then credited $4 when sold)

Income Statement movements

• Revenue: + $7
• COGS: - $4
• Gross profit: $3 (= $7 − $4)

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How the example ties together (big picture recap)

• Transaction 1 converts cash into inventory.
• Transaction 2 affects:
  • Balance Sheet: recognizes Accounts Receivable and removes sold inventory via the COGS transfer
  • Income Statement: recognizes Revenue and records the matching COGS

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Speakers / sources featured

• James — presenter (channel: Accounting Stuff)