Explain what financial statement inventory costs are capital

Explain what financial statement inventory costs are capitalized to and why. Explain when inventory costs are incurred as an expense. What account is used to classify inventory costs as an expense?

Solution

Merchandise inventory is reported as a current asset on the balance sheet. The effects of merchandise inventory on the income statement is shown as the cost of goods sold, which is usually the largest expense of merchandising companies. A company\'s ending inventory must be reported accurately. An error on the reported invenotry will cause errors on the income statement as well as balance sheet. Further, the closing invenotry of currrent year becomes next year\'s opening inventory, it can have impact on next year\'s income statement and financial statement as well. It is also important to have an accurate count and valuation of the closing inventory.

In perpetual inventory system, merchandise inventory and cost of goods sold are updated continuously on each sale and purchase transaction. Some other transactions may also require an update to inventory account for example, sale/purchase return, purchase discounts etc. Purchases are directly debited to inventory account whereas for each sale two journal entries are made: one to record sale value of inventory and other to record cost of goods sold. Purchases account is not used in perpetual inventory system.

In periodic inventory system, merchandise inventory and cost of goods sold are not updated continuously. Instead purchases are recorded in Purchases account and each sale transaction is recorded via a single journal entry. Thus cost of goods sold account does not exist during the accounting period. It is determined at the end of accounting period via a closing entry..