What is Inventory?
Inventory is an asset account composed of items a company is planning to sell to customers. In financial accounting, we deal primarily with merchandising companies. A merchandiser is a company that purchases products from other companies to sell to customers. There are two major types of merchandisers: wholesalers and retailers. Wholesalers are middlemen. They purchase products from manufacturers and then sell them to retailers. Retailers sell products to the end users, either individual consumers or businesses who will use the product.
Perpetual and Periodic Inventory Systems
Every business that deals with inventory must decide how it will track its inventory. Large retailers and even some small retailers have computer systems which track inventory coming into the business and each item as it is sold. This is called a perpetual inventory system. According to Merriam-Webster, perpetual means “happening all the time or very often.” When a company using perpetual inventory, like Target, gets products shipped to them, all products are scanned into the computer system to let the system know how many units of each product the store has. When items are purchased, the computer system not only records the sale of the product (the revenue), it also records the decrease in inventory. When you purchase a roll of paper towels, the checkout system tells the store there is one less roll of paper towels in inventory.
What if the business doesn’t have a computerized inventory system? It would be very difficult to manually record how many of each item the company has at all times. These businesses use a periodic inventory system. The company tracks the dollar value of purchases and then counts what is left over at the end of the year. If the business knows what it had at the beginning of the year and how much it purchased, this tells the business how much product it could have sold. We call this goods available for sale. When we subtract how much we have left, called ending inventory, from goods available for sale, we can calculate how much we sold. We call this cost of goods sold.
Beginning Inventory + Purchases = Goods Available for Sale – Ending Inventory = Cost of Goods Sold
We call this a periodic system because we only know the exact balances in inventory at the end of each period, usually the end of the year. The business must do an inventory count and do an entry to adjust the inventory account to the proper dollar value. The offset account for this adjusting entry is cost of goods sold.
Does a perpetual inventory system negate the need for a physical count? Absolutely not! All businesses must count inventory at least once a year. There are many reasons why physical inventory would not match the computer records. Theft, damaged goods and cashier error can all cause inventory errors. I worked for a number of retailers in high school and college and each of them did inventory counts multiple times a year to look for inventory errors.
Journal Entries: Purchasing Inventory
We stated earlier that under the perpetual system, changes in inventory are always recorded. Therefore, if inventory levels are changing, either because inventory is increasing or decreasing, we must include the Inventory account in the journal entry. Let’s look at some examples.
Example #1 – Perpetual Inventory
On July 17, ABC company purchases $1200 worth of inventory on account. Record the journal entry for this company, which uses a perpetual inventory system.
Break down this statement. What is happening here? ABC is purchasing inventory, which means it is acquiring or getting inventory. Therefore, the balance in inventory is going up. What is the company exchanging for this inventory? Because the transaction is on account, ABC is not paying for the inventory today. Instead, the company is promising to pay for the inventory in the future. The account we use for that promise is accounts payable. Here is the journal entry:
Notice we used the inventory account in the journal entry because the company uses the perpetual inventory system. How would this entry be different if we used the periodic system?
Example #2 – Periodic Inventory
On July 17, ABC company purchases $1200 worth of inventory on account. Record the journal entry for this company, which uses a periodic inventory system.
Remember the formula we used to calculate cost of goods sold under the periodic inventory system:
Beginning Inventory + Purchases = Goods Available for Sale – Ending Inventory = Cost of Goods Sold
In order to do this calculation, we must keep purchases separate from inventory. Therefore, we need an account to place those purchases in. We will use an account called Purchases (not very creative, is it?). That is the only difference in the journal entry.
At the end of the year, we will close out the purchases account to update the balance in inventory after a physical count has been completed. We will discuss that process at the end of this discussion.
Journal Entries: Selling Inventory
In a perpetual inventory system, we must always include inventory in our journal entries when the balance in the account is changing. When we sell inventory to generate revenue, the balance in the inventory account is decreasing. Therefore, we need to add that information to the entry. Let’s look at an example.
Example #3 – Perpetual Inventory
On August 2, ABC company, which uses a perpetual inventory system, sells $1,000 worth of inventory to KLI, LLC on account. The inventory cost ABC $600.
Break down the transaction. What is happening here? ABC sold stuff to another company on account. The stuff ABC sold was purchased for $600. Therefore, ABC has a $1,000 sale and the cost of that sale is $600. First record the sale, then record the inventory adjustment. Here is the journal entry:
Because the company uses a perpetual inventory system, we not only have to record the sale, we also have to record the change in inventory. Now let’s look at the transaction under a periodic inventory system.
Example #4 – Periodic Inventory
On August 2, ABC company, which uses a periodic inventory system, sells $1,000 worth of inventory to KLI, LLC on account. The inventory cost ABC $600.
When using a periodic inventory system, the company only updates the inventory balances periodically or occasionally. That means that we are not tracking inventory with every journal entry. Inventory is only updated at the end of the period (quarterly or annually). Since we are not constantly tracking the inventory balances, we do not include the change in inventory in our journal entry.
Under periodic inventory, the sales transaction looks just like those we have done previously for service based companies. All we need to do is record the revenue.
That’s it. Record the revenue and you are done.
When working with inventory, it is important to keep the difference between perpetual and periodic straight in your mind.
Under perpetual inventory, we are constantly updating the balance in inventory. Anytime the quantity or value of inventory changes, it must be recorded to the Inventory account. This includes purchasing inventory, selling inventory and transactions related to returns and purchase discounts.
Under periodic inventory, we are only updating the balance in inventory periodically. Therefore, the only time you should use the Inventory account is when doing the adjusting entry to close out the Purchases account. When purchasing or selling inventory, do not use the inventory account. For purchases, use the Purchases account. When selling inventory, only record the sale. Inventory is not part of the transaction.
Introduction to Periodic and Perpetual Inventory
Sales Entries: Periodic and Perpetual Methods
Purchasing Inventory: Periodic and Perpetual Journal Entries
A bond is a liability companies use when a large amount of cash is needed. Rather than go to a bank or other lender, a company will issue bonds and sell them to the public. By selling bonds on the open market, the company has more control over the terms of the liability, such as interest rate and duration. Market forces still play a part. For example, if the interest rate offered by the company is too low, the public may not be interested in buying the bonds. If the market believes that the company may not pay back the bonds, the market will demand a higher interest rate.
Bonds can be traded, similar to publically traded stocks. It is not uncommon for a bond to have multiple owners before it matures because bonds typically have long maturity periods. According to the Securities Industry and Financial Markets Association, the average maturity of a corporate bond issued in December 2013 was 15 years. Typically, bonds are issued in denominations of $1,000, $5,000 or $10,000. The company determines the total amount of cash it needs to raise with the issuance. Bond certificates are printed and sold to an investment firm, also called an underwriter. The underwriter then sells the bonds to the public. Bonds are subject to the same changes in market value that stocks experience. The market value of a bond relates to the interest rate the bond is paying compared to the rate people can get on other similar investments. The market value can also fluctuate based on the market’s perception of the company’s ability to repay the bond.
A bond certificate will contain the face value of the bond. Face value is the amount that will be received at maturity. This is also called par value. It will also have the stated interest rate and the maturity date. The maturity date is the date the bonds will be repaid unless the company has the option and elects to repay them early.
The face value of a bond is not repaid until the maturity date of the bond unless the company that issues the bond chooses to repay the bond sooner. Only interest payments are made during the life of the bond. At maturity, the bond holder or buyer will receive the face value of the bond.
When a company issues bonds, it must record the amount of cash received and the corresponding liability. Recording the liability is the easiest part because the liability is always equal to the face value of the bond. To determine how much cash will be received, we need to know if the bond will sell for par value.
A bond will sell for par value if the stated interest rate is equal to the market rate. If that is the case, the company will receive cash equal to the face value of the bond.
Hill and Valley, Inc. issues $400,000 worth of 10-year, semiannual, 8% bonds on December 1. The market rate at the time of issuance is also 8%. Record a journal entry for the issuance of the bonds.
Since the stated interest rate and the market rate are the same, these bonds will be sold at face value. The journal entry for a par value bond, like this one, is fairly simple. The accounts will be Cash, to record the increase in cash, and the liability will be called Bonds Payable. The amount of the entry is the face value of the bond.
When the market rate is not the same as the stated or contract rate, the bond payable and cash will not be the same. If the market rate is higher than the stated rate, that means people are not willing to pay as much for the bonds. Either there is risk associated with the company or there are better investments elsewhere. In order to entice the public to buy the bonds, the company must offer a discount on the bonds. The company will receive less cash than face value. The difference between the face value of the bond and the cash received is called the bond discount or discount on bonds payable.
Hill and Valley, Inc. issues $400,000 worth of 10-year, semiannual, 8% bonds on December 1. The market rate at the time of issuance is 10%; therefore, the bonds will only bring $350,152. Record the journal entry for the issuance of the bonds.
In this case, the market rate is higher than the stated rate which means that the bonds will sell for less than face value.If the public can get 10% elsewhere, why would they pay full price to only receive 8%? They wouldn’t. So while the bond will pay $400,000 at the end of the 10-year term, the bond is only worth $350,152 right now (we will discuss how you calculate that number later in the material).
The difference between the amount of cash received and the liability is called Discount on Bonds Payable. This is a contra-liability, linked to Bonds Payable. Since Discount on Bonds Payable is a contra-liability, the normal balance is a debit. This makes sense because we need something to add to Cash on the debit side to balance out the $400,000 Bond Payable.
When a company offers a bond at a higher interest rate than the market expects, the public is willing to pay more for the bonds. This causes more cash to come in than the amount of the liability. In cases like this, we say that the bond sells for a premium.
Why would a company offer a bond at a premium? This can occur when the company offers a slightly higher interest rate than the market rate or when the company is so stable that it is almost certain that the creditors will be repaid. In today’s record low interest rate environment, the public is willing to spend a bit more money up front to get a better interest rate.
When a bond sells for a premium, the amount of cash generated from the sale is higher than the liability. In order to balance the journal entry, we create an account called Premium on Bonds Payable. This is an additional liability that attaches to Bonds Payable, just like a contra-account would. However, because the normal balance in Premium on Bonds Payable is a credit balance, it is not considered a contra-liability.
Hill and Valley, Inc. issues $400,000 worth of 10-year, semiannual, 8% bonds on December 1. The market rate at the time of issuance is 6%; therefore, the bonds will bring $459,512. Record the journal entry for the issuance of the bonds.
Because more cash is generated from the sale than the amount of the outstanding liability, the bonds are selling at a premium. The company will receive $459,512 in Cash but the Bond Payable is only $400,000. The amount of the premium is $59,512 (we will discuss how to calculate the premium later in the material). Cash is increasing, the Bond Payable is increasing and the Premium on Bonds Payable is increasing.
Recording Interest Payments
Most bonds pay interest on a recurring basis, typically annually or semiannually. Bonds that do not pay interest, called zero coupon bonds, are heavily discounted because the current value of a bond is based on the combined value of the interest and principal payment to be received. Since there are no interest payments, buyers look for a return on investment when they purchase the bonds. In order to get that return on investment, the bonds are heavily discounted.
Recording the interest payment on a bond is similar to the calculation used in other types of debt, except when there is a discount or premium. When there is a discount or premium, that amount must be divided up amongst all the interest payments; this is called amortization. On the date the bond matures, the amount of the discount or premium must be fully amortized, meaning that the balance in those accounts must be zero. Each time interest payment is made, a portion of the discount or premium must be included in the entry.
Recording Interest for Par (Face) Value Bonds
The cash payment for interest is calculated based on the principal balance of the bond, the face rate of the bond and the amount of time each interest payment covers. Many times you will see this referred to as:
Since the outstanding principal of a bond is not paid until maturity, the interest payment is always the same.
Hill and Valley, Inc. issues $400,000 worth of 10-year, semiannual, 8% bonds on December 31. The market rate at the time of issuance is also 8%. Record a journal entry for the first interest payment on June 30.
Because this bond was issued at par value, the interest calculation is simple. Just use I = PRT. In this case, principal is $400,000. The interest rate is 8%. Time should be expressed as a fraction of months covered by the payment over the number of months in the year. Since these are semiannual interest payments, each payment is for six months’ worth of interest. You can also look at it from the perspective that there are two payments each year, so therefore, we need to cut the annual interest rate in half.
No matter how we look at it, the time portion of the calculation is the same. Now let’s plug the information into the formula and calculate the cash payment.
Now, we must write the journal entry. The company is going to pay the interest on June 30, so we know that cash is one of the accounts. Interest is a cost of the bond, therefore it is an expense. Interest expense is the other account. Cash is decreasing and the expense is increasing.
Adjusting for interest accrued but not paid
When working with par value bonds the calculation and resulting journal entry are fairly simple. There is one catch, though. What if the bond was issued on December 1, rather than December 31?
The matching principle states that we must match revenue and expenses. Because the bond was issued on December 1, there is one month of interest that must be accrued at the end of the year. We must do an adjusting entry to record the one month worth of interest expense. Because the interest will not be paid until June 1, this also creates a payable: Interest Payable.
Hill and Valley, Inc. issues $400,000 worth of 10-year, semiannual, 8% bonds on December 1, 2013. The market rate at the time of issuance is also 8%. Record all entries related to the first interest payment on June 1, 2014
This question is a bit more open-ended than the last, because there are actually two different ways we could handle this. Both involve an adjusting entry and the entry for the payment, but one method requires a reversing entry. If the reversing entry is not done, the entry for the June 1 payment is a bit more complicated. We will run through both versions.
The cash payment on June 1 is still $16,000 because we are still discussing a $400,000, 8% semiannual bond.
The only difference is the timing of the interest expense. One month if interest falls into 2013; five months fall into 2014. The first thing we need to do is figure out the monthly interest. Because this is a six-month payment, we can divide $16,000 by six. For simplicity, we will round to the nearest whole dollar. The monthly interest is $2,667.
If the bonds were repaid on December 31, 2013, the company would be required to repay the bonds plus $2,667 in interest. To ensure the financial statements are complete and accurately reflect all activity, the company must record the $2,667 in Interest Expense. The amount will not be paid until June 1, 2014 so we will record the amount as a liability. It is due to the bondholders, which is why it is a liability.
This entry will be done whether you do the reversing entry or not. The purpose of a reversing entry is to undo an adjusting entry. Why would you undo an adjusting entry? In order to make someone’s job easier! Let’s look at this example without the reversing entry.
On June 30, we need to record the payment of $16,000 to the bondholders. Fairly simple, right? We record cash decreasing by $16,000. We also record $16,000 of interest expense — or do we? Wait, the interest expense is not $16,000 because $2,667 of interest expense was recorded on December 31. The interest expense from January 1 to June 1 is $13,333. So what about the other $2,667 needed to balance the entry? That is in Interest Payable. We need to debit the liability to show that it has been paid off.
Using reversing entries with interest payable
Now if you are the bookkeeper, are you going to remember to record the decrease in the payable? Most likely, the bookkeeper will record the entire $16,000 to interest expense which will require someone to do an adjusting entry later on to fix the error. How can we make the bookkeeper’s life easier? Use a reversing entry!
After the December 31 entry has been completed, we can do a second entry dated January 1 to undo the adjustment. Notice that the adjusting entry is done in the new year. To undo the entry, debit the payable and credit the expense.
How does this solve our problem? Well, I’m sure you can see that the reversing entry clears the payable, bring the balance to zero. What will the entry do to our expense? The expense now has a $2,667 credit balance. On June 1, the bookkeeper records the entry to record interest expense and the payment of the interest.
Let’s look at the T-account for Interest Expense.
By completing the reversing entry, we simplify the entry on June 1! Either method is fine as long as we are consistent.
Recording Interest on a Discounted Bond
With a discounted bond, there are three items that need to be handled when we do the entry for interest payments.
- Calculate how much cash will be paid. The amount of cash required is the same for all bonds with the same face rate and denomination. A $400,000, semiannual 8% bond will require the same amount of cash for the interest payment whether it is sold at par, a discount or a premium. Only the interest expense is affected by the discount or premium.
- Calculate the amount of amortized bond discount. Over the life of the bond, we must amortize or phase out the bond discount. The discount is phased out by using a straight-line approach, similar to amortization for intangible assets.
- Compute the interest expense. The interest expense for a discounted bond is equal to the cash needed for payment plus the amount of amortized bond discount.
Interest expense = Cash + reduction in bond discount
Let’s look at an example to help solidify this concept.
Hill and Valley, Inc. issues $400,000 worth of 10-year, semiannual, 8% bonds on December 31. The market rate at the time of issuance is 10%; therefore, the bonds will only bring $350,152. Record the journal entry for the first interest payment on June 30 assuming the company uses straight-line amortization.
A $400,000 bond that brings $350,152 in cash was discounted $49,848.
First, we will figure out the cash payment. This is an 8% bond where the interest is paid twice a year. Interest is calculated off the face value of the bond. Remember PRT!
This discount must be amortized over the life of the bond. Since it is a 10-year bond with semiannual payments, there are 20 interest payments over the life of the bond. We can take $49,848 divided by 20 payments or $2,492.40. This is the amount of amortization each time an interest payment is made.
Finally, we need to calculate the interest expense. Essentially, the interest expense is pulled into the journal entry. We stated earlier that interest expense is the amount of cash plus the amount the bond discount is reduced.
The three accounts are Cash, Discount on Bonds Payable and Interest Expense. Cash is decreasing so we credit the account. The normal balance in Discount on Bonds Payable is a debit (contra liability), so to reduce the account we will credit the account. Interest Expense is an expense account, so we debit the account. Now we have all the information we need to construct the journal entry.
Notice that the Interest Expense is just plugged into the entry. You cannot calculate the interest expense in a conventional way by multiplying by a percentage rate. Even if you were to look at the market rate, that would not help. The interest at the market rate would be $20,000 ($400,000 * 10% * 6/12). This is actually why companies are willing to sell bonds at a discount. The interest at market rate would be higher than the interest expense at a lower face rate plus the amortized discount.
Recording Interest on a Premium Bond
When a company sells a bond at a premium, the purchasers pay more than face value for the bonds. The premium helps to offset some of the cost of the bonds, lowering the interest expense of the bonds. The amount of cash required for all 8% bonds is the same.
The method for dealing with a bond premium is exactly the same as a bond discount.
- Calculate the amount of cash required using PRT.
- Calculate the amount of bond premium to amortize.
- Compute the interest expense. In this case, the bond premium will reduce the interest expense.
Why does the premium reduce interest expense? The amount of cash is based on the face rate of the bond. Because the bond purchasers paid extra for the bond, the company more money than the face value of the bond. That additional cash helps to offset the amount the company pays in effective interest. A portion of each cash payment is a return of the premium to the purchasers. This lowers the interest expense to the company.
Let’s run through some numbers.
Hill and Valley, Inc. issues $400,000 worth of 10-year, semiannual, 8% bonds on December 31. The market rate at the time of issuance is 6%; therefore, the bonds will bring $459,512. Record the journal entry for the first interest payment on June 30 assuming the company uses straight-line amortization.
If bonds with a face value of $400,000 bring $459,512 in cash, there is a premium on the bonds. The premium is $59,512.
Step 1 is to calculate the amount of cash required. We have a $400,000, 8% semiannual bond.
For each interest payment, Cash will decrease or be credited $16,000.
Step 2 is to calculate the amount of bond premium to be amortized. Since the company uses straight-line amortization, we will record the same amount of amortization each time interest is paid. On a 10-year semiannual bond, there will be 20 payments.
$59,512 / 20 = $2,975.60
Each time an interest payment is recorded, we will amortize $2,975.60 of premium. The normal balance in Premium on Bonds Payable is a credit. Therefore, in order to amortize or reduce the amount of the account, we must debit the account.
The last step is to compute the amount of interest expense. Interest expense is $16,000 less the amount of the amortized premium. When bond purchasers pay a premium it is as though they are offsetting some of the interest. For each payment made, $2,975.60 of the premium is returned to the purchasers which lowers the amount of interest expense for the company. The amount of interest expense is $13,024.40.
We have all the information we need to write the entry.
When working with bonds, remember that a par value bond sells for face value. If the market interest rate is higher than the face rate, the bond will sell for less than face value. The bond will be discounted. If the market interest rate is lower than the face rate, the bond will sell for more than face value. The bond will be sold for a premium.
Discounts and premiums do not affect the amount of cash paid for interest. These items do affect the amount of interest expense recorded by the company. Discounts and premiums must be amortized over the life of the bond, each time an interest payment is made. By the time the bond matures, the discount or premium should have a zero balance. A discount increases the amount of interest expense recorded by the company. A premium reduces interest expense.
Introduction to Bonds
Journal Entries for Bond Issuance
Journal entries are probably the most important part of any financial accounting class. They are the language of accounting.
This is a journal entry. It describes a transaction. The entry above tells us that on January 17, the company purchased land worth $100,000 and a building worth $225,000. The company put down $125,000 cash and took out a note with the bank for $200,000. Once you understand how journal entries are constructed, you will be able to read and write them yourself.
Debits and Credits
Debits and credits are the heart of the journal entry because they tell us if we are acquiring something or giving something up. Depending on the type of account, it will increase or decrease when it is debited or credited.
Remember the accounting equation? Assets = Liabilities + Equity. Just as we need to keep the accounting equation in balance, we must keep our debits and credit in balance. Each journal entry must contain equal debits and credits. Notice the entry above: $325,000 in debits and $325,000 in credits. In order for that to occur, each journal entry must have at least two accounts. You can never have a one line journal entry because it would not balance.
In accounting, we frequently refer to the normal balance in the account. The normal balance is a positive balance or what would need to be done to increase the balance.
Because the accounting equation tells us that assets must equal liabilities and equity, it makes sense that the normal balance for assets is a debit and the normal balance for liabilities and equity is a credit. Remember that normal balance means positive or increasing balance. What do you do to decrease the balance of an asset? If a debit increases the balance, than a credit to the account would decrease the balance. As we saw in the example entry above when we wanted to decrease cash, we credited the account.
What about revenue and expenses? Why is revenue’s normal balance a credit while expense’s is a debit? First, let’s discuss the relation these two accounts have to equity. Retained Earnings is a major component of equity. What causes retained earnings to increase? Profit. What causes profit to increase? Revenue. If revenue increases equity, then it should act the same way that equity does. Therefore, revenue has a credit balance. Since expenses decrease profit and equity, it makes sense that the normal balance is a debit.
If you still are not sure, put revenue or expenses in a journal entry with cash. Most people who study accounting quickly learn how cash behaves in most situations. If you know how cash will behave, you can figure out the other account. When a company does work and gets paid, cash increases so we debit cash. The other account, revenue, would be the credit. When a company pays for its rent, cash decreases so we credit Cash. To balance the entry, we debit Rent Expense.
Steps for Completing Journal Entries
- Read the transaction to get a feel for what is happening. Do you understand what happened? Try to put it into your own words.
- Identify the accounts you will put in your journal entry. Identify the type of account for each account used.
- For each account, determine if the balance is increasing or decreasing. Then determine if that increase or decrease is a debit or credit.
- Determine the amount that each account is changing.
On January 4, Lisa decides to start a bookkeeping business and invests $10,000 cash and $5,000 worth of computer equipment in exchange for stock in the company.
- The company received cash and computer equipment in exchange for stock.
- Cash (asset), Computer Equipment (asset) and Common Stock (equity).
- Cash – increasing, debit. Computer Equipment – increasing, debit. Common Stock – Increasing, credit.
- Cash – $10,000. Computer Equipment – $5,000. Common Stock – $15,000
This may seem like a lot of steps but when you are first learning how to do journal entries, it really helps to go through each of the steps as you write the entry. You don’t need to write out the answers to each of the steps as I did above, but you should do it mentally as you figure out the entry. I have had many students who will put the abbreviation for the account type next to the account name.
If you are going to do that, I recommend using Eq for equity and Ex for expense.
When learning to do journal entries, take your time and go through the steps. Make sure to learn the accounts and what type each account is. You may want to make flash cards with the name of the account on one side and the type of account on the other. You should also learn when to use a particular account, for example, when to use Unearned Revenue instead of Revenue or Prepaid Insurance rather than Insurance Expense.
This may seem difficult at first, but if you learn the terminology and practice, you will get better at it. For most students, a lightbulb goes off in their minds somewhere in the first six weeks of the course; everything clicks and they no longer need to use the steps above. Until you have your lightbulb moment, make sure to use the steps outlined above.