Accounting Treatments for Different Kinds of Inventory

Inventory registration accounts follows the production process from the delivery of raw materials through their transformation into finished products that are ready for sale.

Types of Inventory in a Firm:

Inventory is usually sorted into three groups:

1. Inventory of raw materials – materials from which the company prepares (manufactures) the products that it sells.
2. Inventory of products being processed – products that are still in the manufacturing process.
3. Inventory of finished products – products ready for sale that are waiting for a customer.

The following discussion refers only to inventory groups 1 and 3. Inventory of products being processed is usually negligible, and is usually included in the inventory of finished products. Most firms physically count their inventory once a year, usually at the end of the year. Large firms usually continuously monitor and register inventory movements.

Inventory of Raw Materials

Background:

For reasons of simplicity, reference will be made to a bakery named the Victor Bakery, whose only raw material is flour. The bakery prepares its financial statements at the end of the year. The bookkeeper registers all purchases of flour in the Flour Purchase ledger account, which is an expense ledger account. At the end of the year, when the financial statements are prepared, the bakery has no flour left. The sum of its flour purchases during the year (as listed in the Flour Purchase ledger account) is presented as expense in the Profit and Loss Statement as part of an item entitled “Raw materials expenses”. If, however, the bakery has 100 kg of flour left at the end of the year (as physically counted), this balance of flour is an asset, not an expense, even though it has already been registered in the Flour Purchase ledger account (as an expense ledger account). Theoretically, the bakery can sell the balance of this flour, or return it to the supplier, and receive its value in cash.

If the balance of flour is returned to the supplier, the registration in the ledger accounts would be as follows (assuming that the value of the flour remains $100):

The value of 100 kg of flour ($100) is deducted (credited) from the Flour Purchase Ledger Account.
A debit of this sum is registered in the Flour Supplier Ledger Account (returning the flour to the supplier generates a debt to the bakery on the part of the supplier, as if the supplier were a customer who had been sold 100 kg of flour on credit).

Flour Purchase Ledger Account

Flour Supplier Ledger Account

Registration of Inventory in the Raw Materials Inventory Ledger Account

In practice, the flour is obviously not returned to the supplier, nor is it sold. What happens is that the flour is transferred to a “virtual warehouse”, represented by a ledger account named Raw Materials Inventory (in certain cases, the inventory is really in the raw materials warehouse). Registration in the ledger accounts is as follows:

The expenditure registered for the purchase of flour inventory is subtracted from the Flour Purchase Ledger Account (the balance of purchases declines by $100), while the flour inventory, which is represented as if it were located in the (virtual) warehouse, constitutes part of the firm’s purchases.

An Explanation from a Different Perspective (Figurative):

Assume that the company is like a family, and every ledger account in it is a family member. The children do business with each other. In the above example, 100 kg of flour move from child A (the Flour Purchase Ledger Account) to child B (the Raw Materials Inventory Ledger Account). The flour moves from one person to another, but it remains in the family, and is part of its assets. At the end of the year, the balance remaining in the Flour Purchase Ledger Account is transferred to the Profit and Loss Statement, and the ledger account is left with a balance of 0. The ledger account is “empty” at the beginning of a new year, and registration of flour purchases for the next year begins.

Flour Purchase Ledger Account

Raw Materials Inventory Ledger Account

Return Transfer from the Raw Materials Inventory Ledger Account to the Flour

Purchase Ledger Account

Immediately following preparation of the financial statements, the flour inventory is returned from the virtual warehouse. Receiving is registered in the Flour Purchase Ledger Account, and giving is registered in the Raw Materials Inventory Ledger Account. The virtual warehouse is left with no inventory.

The remaining flour inventory from the preceding year is now registered as expenditure for the New Year in the Flour Purchase Ledger Account.

Although the term “transfer” is used for flour instead of buying and selling, the monetary value of the flour is registered in the ledger accounts as if a transaction at full price had taken place with an external party, as is the case in bookkeeping for any internal transaction in a company. Everything is registered in monetary value as if a transaction had taken place between two parties sharing a business relationship.

Raw Materials Inventory Ledger Account

Inventory of finished products

Background:

Expenses for manufacturing products

A number of expense elements play a role in the manufacturing of finished products. The main ones are as follows:

Raw materials – the expense is registered in the Raw Materials Purchase Ledger Accounts. A separate ledger account is kept for each type of raw material. The bakery in the example uses only flour. Other (real) bakeries also use yeast and salt, resulting in three ledger accounts:

(1) Flour purchases; (2) Yeast purchases; (3) Salt purchases.

Work of production employees – the expense is registered in the Salaries – Production Ledger Account.

1. Wear and Tear – wear and tear is the deterioration of equipment, machinery, and buildings as a result of frequent usage. The substance and calculation of wear and tear, also called “Depreciation”, will be discussed more thoroughly later.

2. Miscellaneous manufacturing expenses – in addition to the three elements listed above, which are the most significant, there are other expenses, such as electricity, shipping, user fees for forklifts, etc. These are grouped together under the heading of Miscellaneous Manufacturing expenses.