The Process of Accounting Treatment for Raw Materials Inventory

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 expenditures 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 expenditure in the Profit and Loss Statement (explained thoroughly in the chapter on financial statements), as part of an item entitled “Raw materials expenditures”.

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 expenditure, even though it has already been registered in the Flour Purchase ledger account (as an expenditure 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).

Registration of Inventory in the Raw Materials Inventory Ledger

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 Inventory ledger account named Raw Materials Inventory (in certain cases, the inventory is really in the raw materials warehouse).

Registration in the Inventory ledger accounts is as follows:

Flour Purchase Ledger Account

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.

Raw Materials Inventory Ledger Account

Figurative Explanation in Recording Transactions in a Ledger Account

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.

Ledger Accounts – Inventory 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.

Flour Purchase Ledger Account

Raw Materials Inventory 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. Additional examples are given in the following page.