Journal entry for inventory & cost of goods sold

Inventory is a crucial component of the financial structure for retailers, distributors, and manufacturers alike, representing a key current asset on a company’s balance sheet. It encompasses not only finished goods awaiting sale in the case of retailers, but also raw materials and work-in-process for manufacturers, all of which contribute to the production of final products.

This assortment of goods is not merely a physical presence within a company’s premises; it is a financial representation of investments that are tied up until the products are sold. The value of inventory is recorded and reported on the balance sheet at its cost, which includes the expenses incurred in acquiring or producing the goods, such as purchase costs, manufacturing costs, and transportation costs.

As products are sold to customers, the corresponding cost of those goods is removed from the inventory on the balance sheet. This transaction is then reflected in the company’s income statement under the category known as the cost of goods sold (COGS). The cost of goods sold is a critical metric, representing the direct costs associated with the production or purchase of the goods that a company sells during a specific period.

The cost of goods sold is a significant line item on the income statement and is often the largest expense reported by companies, particularly those in manufacturing and retail industries. Its prominence is due to its direct link to the core operations of a business, as it captures the expenses directly tied to the production or procurement of the products being sold. In essence, the cost of goods sold is the amount a company spent to produce or acquire the goods that were actually sold during the reporting period.

By subtracting the cost of goods sold from the total sales revenue, a company arrives at its gross profit. This figure represents the amount of money left over after accounting for the direct costs of producing or purchasing goods, providing a fundamental measure of a company’s profitability and efficiency in its core operations.

Journal entry for inventory cost of goods sold

In accounting, when inventory is sold, the cost of those goods needs to be recorded through a journal entry. Let’s go through the journal entry for the cost of goods sold:

Assuming a scenario where a company sells $10,000 worth of goods from its inventory with a cost of goods sold of $6,000:

The journal entry:

1. Debit (Increase) Cost of Goods Sold (Expense):
   • Debit the Cost of Goods Sold account to recognize the expense associated with the sale.

   Date       Account                    Debit      Credit
   MM/DD/YY    Cost of Goods Sold                     $6,000
   
   

2. Credit (Decrease) Inventory (Asset):
   • Credit the Inventory account to reduce the asset on the balance sheet since these goods are no longer available for sale.

   Date       Account                    Debit      Credit
   MM/DD/YY    Inventory                             $6,000
   
   

This journal entry accurately reflects the cost of goods sold and the corresponding reduction in inventory. The Cost of Goods Sold account on the income statement increases by the amount of the expense, while the Inventory account on the balance sheet decreases by the same amount, reflecting the actual cost of the goods that were sold during the specified period.

How Inventory and Cost of Goods Sold link to Financial Statements?

Inventory and Cost of Goods Sold (COGS) are critical elements in the preparation of financial statements, specifically the income statement and the balance sheet. Here’s how these components are linked to these financial statements:

1. Balance Sheet:
   • Inventory (Asset): The value of the inventory is reported as a current asset on the balance sheet. It includes the cost of raw materials, work-in-progress, and finished goods. The balance sheet provides a snapshot of a company’s financial position at a specific point in time, and inventory is part of the total assets.

   Assets
   -------------------------------------
   Current Assets:
       - Cash
       - Accounts Receivable
       - Inventory
       - Other Current Assets
   
   

2. Income Statement:
   • Cost of Goods Sold (Expense): When inventory is sold, the cost associated with those goods is recognized as the Cost of Goods Sold on the income statement. The income statement summarizes a company’s revenues and expenses over a specific period, resulting in the net income or loss.

   Revenue
   - Cost of Goods Sold
   -------------------------------------
   Gross Profit
   - Operating Expenses
   - Other Income and Expenses
   -------------------------------------
   Net Income (or Loss)
   
   

   The Cost of Goods Sold is subtracted from the total revenue to calculate the gross profit. Gross profit represents the amount remaining after accounting for the direct costs of producing or acquiring the goods sold.
3. Statement of Retained Earnings (if applicable):
   • If the company prepares a statement of retained earnings, the net income from the income statement contributes to changes in retained earnings. This statement shows how the company’s retained earnings have changed over a specific period.

   Beginning Retained Earnings
   + Net Income
   - Dividends
   -------------------------------------
   Ending Retained Earnings
   
   

   Net income, which includes the Cost of Goods Sold, contributes to the increase in retained earnings unless dividends are paid out.

In summary, the link between inventory, Cost of Goods Sold, and the financial statements is evident in the balance sheet, where inventory is reported as an asset, and in the income statement, where the Cost of Goods Sold is a key expense affecting the calculation of gross profit and, subsequently, net income. These financial statements provide a comprehensive view of a company’s financial health and performance.