Inventory Accounting

Thankfully, most of the inventory accounting that goes on in a business gets handled automatically by QuickBooks. For example, when you purchase an inventory item by writing a check or recording an accounts payable bill, QuickBooks automatically adjusts your inventory accounts both for the dollar value of the inventory and the quantity of the items. When you sell an inventory item to a customer, QuickBooks again automatically adjusts the dollar value of your inventory and adjusts the quantity counts of the items you sell.

Basically, all this means is that QuickBooks maintains a perpetual inventory system—an inventory system that lets you know at any time what quantity of items you have in inventory and what value your inventory amounts to. (In the past, smaller firms often used a periodic inventory system, which meant that business owners never really knew with any precision the dollar value of their inventory or the quantity counts for the inventory items that they held.)

Although everything in the preceding paragraph represents good news, several inventory-related headaches do require a bit of accounting magic. Specifically, if your firm carries inventory, you need to know how to deal with obsolete inventory, disposal of obsolete inventory, and inventory shrinkage. I discuss all three accounting gambits in the following paragraphs.

Dealing with Obsolete Inventory

Obsolete inventory refers to items that you've purchased for sale but turn out not to be saleable. Perhaps customers no longer want it. Perhaps you have too much of the inventory item and will never be able to sell everything that you hold.

In either case, you record the fact that your inventory value is actually less than what you purchased it for. And you want to record the fact that, really, the money you spent on the obsolete item is an expense. For example, suppose that you purchased some $100 item that you now realize is obsolete. How do you record this obsolescence? Table 1 shows the conventional approach.

Account	Debit	Credit
Inventory obsolescence	1,00
Allowance for obsolete inventory		1,00

Table 1 - Journal Entry 7: Recording an Allowance for Obsolete Inventory

As Journal Entry 7 shows, to record the obsolescence of a $100 inventory item, you first debit an expense account called something like "inventory obsolescence" for $100. Then you credit a contra-asset account named something like "allowance for obsolete inventory" for $100. As I mention in the discussion of accounts receivable, a contra-asset account gets reported on the balance sheet immediately beneath the asset account to which it relates. The contra-asset account, with its negative credit balance, reduces the net reported value of the asset account. For example, if the inventory account balance was $3,100 and you had an allowance for an obsolete inventory contra-asset account of $100, the net inventory balance shows as $3,000. In other words, the contra-asset account gets subtracted from the related asset account.

Remember

QuickBooks requires you to record Journal Entry 7 yourself using the Make Journal Entries command.

When you ultimately do dispose of obsolete inventory, you record a journal entry like the one shown in Table 2. This journal entry debits the contra-asset account for $100 and credits inventory for $100. In other words, this journal entry removes the value of the obsolete inventory both from the allowance for obsolete inventory account and from the inventory account itself. You record this journal entry when you actually physically dispose of the inventory. This may be, for example, when you pay the junk man to haul away the inventory or when you toss the inventory out into the large Dumpster behind your office or factory.

Account	Debit	Credit
Allowance for obsolete inventory	1,00
Inventory		1,00

Table 2 - Journal Entry 8: Recording Disposal of Inventory

Why not just credit the asset account?

If you're really getting into this double-entry bookkeeping, you may wonder why you don't just credit the inventory account in the case of something like obsolete inventory. Wouldn't that save you time and trouble? Well, yes and no.

Simply crediting the inventory account does make sense. Such an approach saves you the task of having to set up a goofy contra-asset account. However, accountants have concluded over the centuries that it makes sense to keep a record of your obsolete inventory as long as you own it. There are a bunch of different reasons for this, but one reason is that you want to know what inventory you need to get rid of or dispose of.

It's not necessary to set up some sort of separate system for keeping track of obsolete inventory. By using the contra-asset account, you can continue to store information about your inventory in the accounting system without making the balance sheet information and income statement information incorrect.

This logic applies to other contra-asset accounts, too. For example, I describe how to set up a contra-asset account for uncollectible accounts receivable. The business about wanting to have some record of your uncollectible accounts receivable—perhaps so you know you don't want to deal with those customers again—means that you may as well keep this information in the accounting system. A contra-asset account allows you to do so and at the same time not have the presence of uncollectible receivables overstate your accounts receivable balance.

Tip

In general, one of the things you should do every year for tax accounting reasons is deal with your obsolete inventory. The tax rules generally state that you can't write off obsolete inventory unless you actually dispose of it for income purposes. You can, however, typically write down inventory to its liquidation value. Such a write-down works the same way as a write-down for obsolete inventory. A write-down can be a little tricky if you've never done it before, however, so you may want to confer with your tax advisor.

One more really important point about recording disposal of obsolete inventory: Within QuickBooks, you record inventory disposal by adjusting the physical item count of the inventory items. So even though I won't go down that path here, you should know that you don't actually enter a journal entry like the one shown in Journal Entry 8. You adjust the inventory accounts for the obsolete inventory. This adjustment would automatically reduce the inventory account balance. When QuickBooks asks you which account to debit, you specify the allowance for obsolete inventory account.

Dealing with Inventory Shrinkage

The other chronic inventory headache that many business owners and business managers have to deal with is inventory shrinkage. It's very likely, sometimes for the most innocent reasons, that your inventory records overstate the quantity counts of items. When this happens, you must adjust your records. Essentially, you want to reduce both the dollar value of your inventory and the quantity counts of your inventory items.

Table 3 shows the journal entry that QuickBooks makes for you to record this event. This journal entry debits an appropriate expense account—in Journal Entry 9, I call the expense account shrinkage expense — for $100. A journal entry also needs to credit the inventory account for $100.

Account	Debit	Credit
Shrinkage expense	1,00
Inventory		1,00

Table 3 - Journal Entry 9: Recording Inventory Shrinkage

Within QuickBooks, as I mentioned, you don't actually record a formal journal entry like the one shown here. You use something called a physical count worksheet to adjust the quantities of your inventory item counts to whatever they actually are. When you make this adjustment, QuickBooks automatically credits the inventory account balance and adjusts the quantity counts. QuickBooks also requires you to supply the expense account that it should debit for the shrinkage.

Tip

In the old days (by the "old days," I mean a few decades ago), businesses compared their accounting records with the physical counts of inventory items only once a year. In fact, the annual inventory physical count was a painful ritual that many distributors and retailers went through. These days, I think, most businesses have found that it works much better to stage physical inventory counts throughout the year. This approach, called cycle counting, means that you're probably comparing your accounting records with physical counts for your most valuable items several times a year. For your moderately valuable items, you're probably comparing your inventory accounting records with physical counts once or twice a year. With your least valuable inventory items, you probably only irregularly compare inventory records with physical counts, and you may accept a degree of imprecision. For example, rather than counting screws in some bin, you may weigh the bin and then make an estimate of the screw count. In any case, you want some system that allows you to compare your accounting records to your physical counts. Inventory shrinkage and inventory obsolescence represent real costs of doing business that won't get recorded in your accounting records in any other way.

Recording Accounts Payable Transactions

Within QuickBooks, you have the option of either working with or without an accounts payable account. If you want to, you can record expenses when you write checks. This means that in order to have a complete list of all your expenses, you must have recorded checks that pay all your expenses. This approach works fine—and, in fact, is the approach that I've always used in my businesses.

QuickBooks also supports a more precise approach of recording expenses. By answering a few questions during the QuickBooks setup process, you can set up an accounts payable account, which is just an account that tracks the amounts that you owe your vendors and other suppliers.

Recording a Bill

When you use an accounts payable account, you enter the bills that you get from vendors when you receive them.

Table 1 shows the way this transaction is recorded. Journal Entry 5 automatically debits office supplies expense for $1,000 and credits accounts payable for $1,000. This is the journal entry that would be recorded by QuickBooks if you purchased $1,000 of office supplies and then entered that bill into the QuickBooks system.

Account	Debit	Credit
Office supplies	1,000
Accounts payable		1,000

Table 1 - Journal Entry 5: Recording a Credit Purchase

Paying a Bill

When you later pay that bill, QuickBooks records Journal Entry 6, shown in Table 2. In Journal Entry 6, QuickBooks debits accounts payable for $1,000 and credits cash for $1,000. The net effect on accounts payable combining both the purchase and the payment is zero. That makes sense, right? The approach shown in Journal Entries 5 and 6 counts the amount that you owe some vendor or supplier as a liability, accounts payable, only while you owe the money.

Account	Debit	Credit
Accounts payable	1,000
Cash		1,000

Table 2 - Journal Entry 6: Recording the Payment to Vendor

When you record Journal Entry 6 in QuickBooks, you must supply the name of the account that gets debited. QuickBooks obviously knows which account to credit—the accounts payable account. However, QuickBooks also has to know the expense or asset account to debit.

QuickBooks does need to know which cash account to credit when you pay an accounts payable amount. You identify this when you write the check to pay the bill.

Some other Accounts Payable Pointers

Let me make a couple of additional points about Journal Entries 5 and 6:

• The accounts payable method is more accurate. The accounts payable method, which is what Journal Entries 5 and 6 show, is the best way to record your bills. The accounts payable method means that you record expenses when the expenses actually occur. As you may have already figured out, the accounts payable method is really the mirror image of the accounts receivable approach. The big benefit of the accounts payable method, as you may intuit, is that it keeps track of the amounts that you owe vendors and suppliers and it recognizes expenses as they occur rather than when you pay them (which may be some time later).

• Not every debit is for an expense. Journal Entry 5 shows the debit going to an office supplies expense account. Many of the accounts payable that you record are amounts owed for expenses. However, not every accounts payable transaction stems from incurring some expense. You may also need to record the purchase of an asset—such as a piece of equipment. In this case, the debit goes not to an expense account but to an asset account. Other than this minor change, however, the transaction works in the same way.

  Tip

  Can you guess how an expense or fixed asset purchase gets recorded if you don't use an accounts payable account? In the case where you paid $1,000 for office supplies, QuickBooks debits office supplies expense for $1,000 and credits cash for $1,000 when you write a $1,000 check. As part of writing the check, you identify which expense account to debit.

  If you're purchasing a $1,000 piece of equipment, the journal entry looks and works in roughly the same way. When you record the purchase, QuickBooks debits the asset account for $1,000 and credits cash for $1,000. Again, this transaction gets recorded when you write the check to pay for the asset.