What Is An Accounting Period?

An accounting period is a period of time such as the 12 months of January 1 through December 31, or the month of June, or the three months of July 1 through September 30. It is the period for which financial statements are prepared. For example, the income statement and the cash flow statement report the amounts occurring during the accounting period, and the balance sheet reports the amounts of assets and liabilties as of the final moment of the accounting period.

While companies are required to prepare financial statements for each annual accounting period, most companies also prepare financial statements for each monthly accounting period. This monthly feedback can be valuable for the company's management but only if it reflects:

• accrual accounting


• the matching principle


• adjusting entries

For instance, if a company prepares monthly financial statements, there needs to be adjusting entries as of the last day of every month to:

• accrue expenses and liabilities that occurred but have not yet been recorded. Examples include maintenance, repairs, wages of hourly paid employees, utilities used, property taxes, interest, etc.


• record the depreciation for the 30 days of the month.


• adjust prepaid expenses for the amounts that have expired and to defer the expenses that have not expired as of the end of the month.

Popular accounting software will allow you to specify any period of time and the financial statements will be generated for that period. For example, you could specify a 7-day period. However, if you have not entered adjusting entries as of the last day of that short accounting period, I believe that the financial statements will be more misleading than helpful. 

What Is An Account Payable?

An account payable is an obligation to a supplier or vendor for goods or services that were provided in advance of payment.

To illustrate an account payable let's assume that Joe's Plumbing Service provides XCorp with repair services on August 29 and agrees to bill XCorp. On August 31 XCorp receives an invoice from Joe's for $900. The invoice states that the $900 is due within 30 days. After reviewing and approving the invoice, XCorp enters Joe's invoice into its accounting records with a credit to Accounts Payable and debit to Repairs and Maintenance Expense.

Until the invoice from Joe's Plumbing Service is paid, Joe's invoice serves as the supporting document for XCorp's accounts payable and also as a supporting document for Joe's accounts receivable. 

What Is A Promissory Note?

A promissory note is a written promise to pay an amount of money by a specified date (or on demand). The promissory note could involve a loan from a bank, a loan from a relative, a replacement for an account payable, etc.

The written amount of money is referred to as the face amount. The face amount will be recorded in the promisor's (borrower's) general ledger with a credit to the liability account Notes Payable or Loans Payable. The promisee (lender) will record the face amount with a debit to its asset account Notes Receivable.

If the promissory note specifies a fair interest rate, it is used to accrue interest expense and interest payable on the books of the borrower. The lender will accrue interest revenue or income and interest receivable.

If the promissory note does not specify interest, it should be assumed that the face amount includes some interest. The estimated future amount of interest should be recorded by the borrower in the contra accountDiscount on Notes Payable. The lender should record the same amount in a contra account Discount on Notes Receivable. The discount is then amortized over the life of the note to Interest Expense (borrower) and Interest Revenue (lender). (source)

What Is Net?

In accounting, net usually refers to the combination of positive and negative amounts. For example, the amount ofnet sales is the combination of the amount of gross sales (a positive amount) and some negative amounts such as sales returns, sales allowances, and sales discounts. Hence, if gross sales are 990 and sales returns are 10, sales allowances are 5, and sales discounts 20, the net sales are 955 (990 minus 35).

Here are some additional examples of net:

• net realizable value. The amount to be received in the ordinary course of business minus the costs of completion and disposal.


• net property, plant and equipment. The recorded costs of the tangible noncurrent assets used in the business minus the related accumulated depreciation.


• accounts receivable, net. The recorded amount of accounts receivable minus the allowance for doubtful accounts.


• net cash provided by operating activities. The combination of the cash inflows and the cash outflows from a company's operations (activities outside of its investing and financing activities).


• loss on disposal, net of tax. An accounting loss on the sale of a business segment minus the income taxes that were saved (avoided, sheltered) because the loss was also deductible on the company's income tax return.


• net income. Revenues and gains minus expenses and losses.             (source)

What Is Inventory?

I think of inventory as a company's goods on hand, which is often a significant current asset. Inventory serves as a buffer between a company's sales of goods and its production or purchase of goods. Companies strive to find the proper amount of inventory to avoid lost sales, disruptions in production, high holding costs, etc.

Manufacturers usually have the following categories of inventories: raw materials, work-in-process, finished goods, and manufacturing supplies. The amounts of these categories are usually listed in the notes to its balance sheet.

A company's cost of inventory is related to the company's cost of goods sold that is reported on the company's income statement.

Since the costs of the items purchased or produced are likely to likely to change, companies must elect a cost flow assumption for valuing its inventory and its cost of goods sold. In the U.S. the common cost flow assumptions are FIFO, LIFO, and average.

Sometimes a company's inventory of goods is referred to as its stock of goods, which is held in its stockroom or warehouse. [source] 

What Are The Ways To Value Inventory?

Generally, the balance sheet of a U.S. company must value inventory at cost. In other words, a company's inventory is not reported at the sales value. (An exception occurs when a company's inventory consists of readily salable commodities that have quoted market prices.)

Since the costs of products may change during an accounting year, a company must select a cost flow assumption that it will use consistently. For instance, should the oldest cost be removed from inventory when an item is sold? If so, the company will select the cost flow assumption known as first-in, first out (FIFO). In the U.S. an alternative is to remove the period's most recent cost when an item is sold. This is known as last-in, first-out (LIFO). Another option is to use an average method such as the weighted-average method or the moving-average method. Both the LIFO method and the average methods will result in different values depending on whether a company uses the perpetual method or the periodic method. Still another option is to use the specific identification method.

The LIFO cost flow assumption can be achieved by tracking the units in inventory or by using price indexes. When price indexes are used, it is referred to as dollar-value LIFO. (Retailers often use a technique called dollar-value retail LIFO.)

The accountants' concept of conservatism can result in some inventories being valued at less than cost. Hence, an additional method for valuing inventory is the lower of cost or market. For example, if the replacement cost of a company's inventory has declined to an amount that is less than cost, the company may be required to reduce its inventory cost. The amount of the that adjustment will also reduce the current period's net income.

A company's inventory must be measured and reviewed very carefully as it is an important amount for determining a company's financial position and profitability.

Why And How Do You Adjust The Inventory Account In The Periodic Method?

At the end of an accounting period (month, year, etc.) the inventory account is adjusted so that the balance sheet will report the cost (or lower) of the goods actually owned by the company.

When an adjusting entry is used, the related income statement account will be a cost of goods sold account. An example of such an account is Inventory Change or Inventory (Increase) Decrease.

To illustrate the inventory adjustment, let's assume that the cost of a company's actual inventory at the end of the year is $40,000. However, its general ledger asset account Inventory has a debit balance of $35,000. The company's inventory adjusting entry will 1) debit Inventory for $5,000 and 2) credit Inventory Change for $5,000. [You can think of the $5,000 credit balance in this income statement account as a reduction of the company's debit balance in its Purchases account. In other words, not all of the purchases should be matched with the period's sales since we know that the inventory has increased by $5,000.]

Next, let's assume that another company's cost of its actual ending inventory is $62,000. However, its inventory account has a debit balance of $70,000. This will require an adjusting entry to 1) credit Inventory for $8,000 and 2) debit Inventory Change for $8,000. The $8,000 debit in this income statement account will be an addition to the cost of the goods purchased. In other words, not only was it necessary to match the cost of purchases with sales, it was also necessary to match the additional $8,000 of cost that was removed from inventory.

Textbooks often change the balance in the account Inventory (under the periodic method) through closing entries. (One closing entry removes the amount of beginning inventory and one closing entry records the cost of the ending inventory. ) We believe that an adjusting entry is more logical and efficient, especially when monthly and year-to-date financial statements are prepared using accounting software. [source]

Inventory and Cost of Goods Sold [Part 6]

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Methods of Estimating Inventory

There are two methods for estimating ending inventory:

1. Gross Profit Method
2. Retail Method

1. Gross Profit Method. The gross profit method for estimating inventory uses the information contained in the top portion of a merchandiser's multiple-step income statement:

Let's assume that we need to estimate the cost of inventory on hand on June 30, 2012. From the 2011 income statement shown above we can see that the company's gross profit is 20% of the sales and that the cost of goods sold is 80% of the sales. If those percentages are reasonable for the current year, we can use those percentages to help us estimate the cost of the inventory on hand as of June 30, 2012.

While an algebraic equation could be constructed to determine the estimated amount of ending inventory, we prefer to simply use the income statement format. We prepare a partial income statement for the period beginning after the date when inventory was last physically counted, and ending with the date for which we need the estimated inventory cost. In this case, the income statement will go from January 1, 2012 until June 30, 2012.

Some of the numbers that we need are easily obtained from sales records, customers, suppliers, earlier financial statements, etc. For example, sales for the first half of the year 2012 are taken from the company's records. The beginning inventory amount is the ending inventory reported on the December 31, 2011 balance sheet. The purchases information for the first half of 2012 is available from the company's records or its suppliers. The amounts that we have available are written in italics in the following partial income statement:

We will fill in the rest of the statement with the answers to the following calculations. The amounts in italics come from the statement above. The bold amount is the answer or result of the calculation.

This can also be calculated as 80% x Sales of $56,000 = $44,800.

Inserting this information into the income statement yields the following:

As you can see, the ending inventory amount is not yet shown. We compute this amount by subtracting cost of goods sold from the cost of goods available:

Below is the completed partial income statement with the estimated amount of ending inventory at $26,200. (Note: It is always a good idea to recheck the math on the income statement to be certain you computed the amounts correctly.)

2. Retail Method. The retail method can be used by retailers who have their merchandise records in both cost and retail selling prices. A very simple illustration for using the retail method to estimate inventory is shown here:

As you can see, the cost amounts are arranged into one column. The retail amounts are listed in a separate column. The Goods Available amounts are used to compute the cost-to-retail ratio. In this case the cost of goods available of $80,000 is divided by the retail amount of goods available ($100,000). This results in a cost-to-retail ratio, or cost ratio, of 80%.

To arrive at the estimated ending inventory at cost, we multiply the estimated ending inventory at retail ($10,000) times the cost ratio of 80% to arrive at $8,000. 

Additional Information and Resources

Because the material covered here is considered an introduction to this topic, many complexities have been omitted. You should always consult with an accounting professional for assistance with your own specific circumstances.

Inventory and Cost of Goods Sold [Part 5]

Specific Identification

In addition to the six cost flow assumptions presented in Parts 1 - 4, businesses have another option: expense to the cost of goods sold the specific cost of the specific item sold. For example, Gold Dealer, Inc. has an inventory of gold and each nugget has an identification number and the cost of the nugget. When Gold Dealer sells a nugget, it can expense to the cost of goods sold the exact cost of the specific nugget sold. The cost of the other nuggets will remain in inventory. (Alternatively, Gold Dealer could use one of the other six cost flow assumptions described in Parts 1 - 4.)

LIFO Benefits Without Tracking Units

In Part 1 and Part 2 you saw that during the periods of increasing costs, LIFO will result in less profits. In the U.S. this can mean less income taxes paid by the company. Most companies view lower taxes as a significant benefit. However, the process of tracking costs and then assigning those costs to the units sold and the units on hand could be too expensive for the amount of income tax savings. To gain the benefit of LIFO without the tracking of costs, there is a method known as dollar value LIFO. This topic is discussed in intermediate accounting textbooks. The Internal Revenue Service also allows companies to use dollar value LIFO by applying price indexes. (You should seek the advice of an accounting and/or tax professional to assess the cost and benefit of these techniques.)

Inventory Management

Over the past few decades sophisticated companies have made great strides in reducing their levels of inventory. Rather than carry large inventories, they ask their suppliers to deliver goods "just in time." Suppliers and merchandisers have learned to coordinate their purchases and sales so that orders and shipments occur automatically.

A company will realize significant benefits if it can keep its inventory levels down without losing sales or production (if the company is a manufacturer). For example, Dell Computers has greatly reduced its inventory in relationship to its sales. Since computer components have been dropping in costs as new technologies emerge, it benefits Dell to keep only a very small inventory of components on hand. It would be a financial hardship if Dell had a large quantity of parts that became obsolete or decreased in value.

Financial Ratios

Keeping track of inventory is important. There are two common financial ratios for monitoring inventory levels: (1) the Inventory Turnover Ratio, and (2) the Days' Sales in Inventory. (These are discussed and illustrated in the Explanation of Financial Ratios.)

Estimating Ending Inventory

It is very time-consuming for a company to physically count the merchandise units in its inventory. In fact, it is not unusual for companies to shut down their operations near the end of their accounting year just to perform inventory counts. The company may assign one set of employees to count and tag the items and another set to verify the counts. If a company has outside auditors, they will be there to observe the process. (Even if the company's computers keep track of inventory, accountants require that the computer records be verified by actually counting the goods.)

If a company counts its inventory only once per year it must estimate its inventory at the end of each month in order to prepare meaningful monthly financial statements. In fact, a company may need to estimate its inventory for other reasons as well. For example, if a company suffers a loss due to a disaster such as a tornado or a fire, it will need to file a claim for the approximate cost of the inventory that was lost. (An insurance adjuster will also compute this amount independently so that the company is not paid too much or too little for its loss.)
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Inventory and Cost of Goods Sold [Part 4]

B1. Perpetual FIFO

Under the perpetual system the Inventory account is constantly (or perpetually) changing. When a retailer purchases merchandise, the retailer debits its Inventory account for the cost; when the retailer sells the merchandise to its customers its Inventory account is credited and its Cost of Goods Sold account is debited for the cost of the goods sold. Rather than staying dormant as it does with the periodic method, the Inventory account balance is continuously updated.

Under the perpetual system, two transactions are recorded when merchandise is sold: (1) the sales amount is debited to Accounts Receivable or Cash and is credited to Sales, and (2) the cost of the merchandise sold is debited to Cost of Goods Sold and is credited to Inventory. (Note: Under the periodic system the second entry is not made.)

With perpetual FIFO, the first (or oldest) costs are the first moved from the Inventory account and debited to the Cost of Goods Sold account. The end result under perpetual FIFO is the same as under periodic FIFO. In other words, the first costs are the same whether you move the cost out of inventory with each sale (perpetual) or whether you wait until the year is over (periodic).

B2. Perpetual LIFO

Under the perpetual system the Inventory account is constantly (or perpetually) changing. When a retailer purchases merchandise, the retailer debits its Inventory account for the cost of the merchandise. When the retailer sells the merchandise to its customers, the retailer credits its Inventory account for the cost of the goods that were sold and debits its Cost of Goods Sold account for their cost. Rather than staying dormant as it does with the periodic method, the Inventory account balance is continuously updated.

Under the perpetual system, two transactions are recorded at the time that the merchandise is sold: (1) the sales amount is debited to Accounts Receivable or Cash and is credited to Sales, and (2) the cost of the merchandise sold is debited to Cost of Goods Sold and is credited to Inventory. (Note: Under the periodic system the second entry is not made.)

With perpetual LIFO, the last costs available at the time of the sale are the first to be removed from the Inventory account and debited to the Cost of Goods Sold account. Since this is the perpetual system we cannot wait until the end of the year to determine the last cost—an entry must be recorded at the time of the sale in order to reduce the Inventory account and to increase the Cost of Goods Sold account.

If costs continue to rise throughout the entire year, perpetual LIFO will yield a lower cost of goods sold and a higher net income than periodic LIFO. Generally this means that periodic LIFO will result in less income taxes thanperpetual LIFO. (If you wish to minimize the amount paid in income taxes during periods of inflation, you should discuss LIFO with your tax adviser.)

Once again we'll use our example for the Corner Shelf Bookstore:

Let's assume that after Corner Shelf makes its second purchase in June 2011, Corner Shelf sells one book. This means the last cost at the time of the sale was $89. Under perpetual LIFO the following entry must be made at the time of the sale: $89 will be credited to Inventory and $89 will be debited to Cost of Goods Sold. If that was the only book sold during the year, at the end of the year the Cost of Goods Sold account will have a balance of $89 and the cost in the Inventory account will be $351 ($85 + $87 + $89 + $90).

If the bookstore sells the textbook for $110, its gross profit under perpetual LIFO will be $21 ($110 - $89). Note that this is different than the gross profit of $20 under periodic LIFO.

B3. Perpetual Average

Under the perpetual system the Inventory account is constantly (or perpetually) changing. When a retailer purchases merchandise, the costs are debited to its Inventory account; when the retailer sells the merchandise to its customers the Inventory account is credited and the Cost of Goods Sold account is debited for the cost of the goods sold. Rather than staying dormant as it does with the periodic method, the Inventory account balance under the perpetual average is changing whenever a purchase or sale occurs.

Under the perpetual system, two sets of entries are made whenever merchandise is sold: (1) the sales amount is debited to Accounts Receivable or Cash and is credited to Sales, and (2) the cost of the merchandise sold is debited to Cost of Goods Sold and is credited to Inventory. (Note: Under the periodic system the second entry is not made.)

Under the perpetual system, "average" means the average cost of the items in inventory as of the date of the sale. This average cost is multiplied by the number of units sold and is removed from the Inventory account and debited to the Cost of Goods Sold account. We use the average as of the time of the sale because this is aperpetual method. (Note: Under the periodic system we wait until the year is over before computing the average cost.)

Let's use the same example again for the Corner Shelf Bookstore:

Let's assume that after Corner Shelf makes its second purchase, Corner Shelf sells one book. This means the average cost at the time of the sale was $87.50 ([$85 + $87 + $89 + $89] ÷ 4]). Because this is a perpetual average, a journal entry must be made at the time of the sale for $87.50. The $87.50 (the average cost at the time of the sale) is credited to Inventory and is debited to Cost of Goods Sold. After the sale of one unit, three units remain in inventory and the balance in the Inventory account will be $262.50 (3 books at an average cost of $87.50).

After Corner Shelf makes its third purchase, the average cost per unit will change to $88.125 ([$262.50 + $90] ÷ 4). As you can see, the average cost moved from $87.50 to $88.125—this is why the perpetual average method is sometimes referred to as the moving average method. The Inventory balance is $352.50 (4 books with an average cost of $88.125 each).

Comparison of Cost Flow Assumptions

Below is a recap of the varying amounts for the cost of goods sold, gross profit, and ending inventory that were calculated above.

The example assumes that costs were continually increasing. The results would be different if costs were decreasing or increasing at a slower rate. Consult with your tax advisor concerning the election of cost flow assumption.
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Inventory and Cost of Goods Sold [Part 3]

A2. Periodic LIFO

"Periodic" means that the Inventory account is not updated during the accounting period. Instead, the cost of merchandise purchased from suppliers is debited to an account called Purchases. At the end of the accounting year the Inventory account is adjusted to equal the cost of the merchandise that is unsold. The other costs of goods will be reported on the income statement as the cost of goods sold.

"LIFO" is an acronym for Last In, First Out. Under the LIFO cost flow assumption, the last (or recent) costs are the first ones to leave inventory and become the cost of goods sold on the income statement. The first (or oldest) costs will be reported as inventory on the balance sheet.

Remember that the costs can flow differently than the goods. In other words, if Corner Shelf Bookstore uses LIFO, the owner may sell the oldest (first) book to a customer, but can report the cost of goods sold of $90 (the last cost).

It's important to note that under LIFO periodic (not LIFO perpetual) we wait until the entire year is over before assigning the costs. Then we flow the year's last costs first, even if those goods arrived after the last sale of the year. For example, assume the last sale of the year at the Corner Shelf Bookstore occurred on December 27. Also assume that the store's last purchase of the year arrived on December 31. Under LIFO periodic, the cost of the book purchased on December 31 is sent to the cost of goods sold first, even though it's physically impossible for that book to be the one sold on December 27. (This reinforces our previous statement that the flow of costs does not have to correspond with the physical flow of units.)

Let's illustrate periodic LIFO by using the data for the Corner Shelf Bookstore:

As before we need to account for the total goods available for sale: 5 books at a cost of $440. Under periodic LIFO we assign the last cost of $90 to the one book that was sold. (If two books were sold, $90 would be assigned to the first book and $89 to the second book.) The remaining $350 ($440 - $90) is assigned to inventory. The $350 of inventory cost consists of $85 + $87 + $89 + $89. The $90 assigned to the book that was sold is permanently gone from inventory.

If the bookstore sold the textbook for $110, its gross profit under periodic LIFO will be $20 ($110 - $90). If the costs of textbooks continue to increase, LIFO will always result in the least amount of profit. (The reason is that the last costs will always be higher than the first costs. Higher costs result in less profits and usually lower income taxes.)

A3. Periodic Average

Under "periodic" the Inventory account is not updated and purchases of merchandise are recorded in an account called Purchases. Under this cost flow assumption an average cost is calculated using the total goods available for sale (cost from the beginning inventory plus the costs of all subsequent purchases made during the entire year). In other words, the periodic average cost is calculated after the year is over—after all the purchases of the year have occurred. This average cost is then applied to the units sold during the year as well as to the units in inventory at the end of the year.

As you can see, our facts remain the same-there are 5 books available for sale for the year 2011 and the cost of the goods available is $440. The weighted average cost of the books is $88 ($440 of cost of goods available ÷ 5 books available) and it is used for both the cost of goods sold and for the cost of the books in inventory.

Since the bookstore sold only one book, the cost of goods sold is $88 (1 x $88). The four books still on hand are reported at $352 (4 x $88) of cost in the Inventory account. The total of the cost of goods sold plus the cost of the inventory should equal the total cost of goods available ($88 + $352 = $440).

If Corner Shelf Bookstore sells the textbook for $110, its gross profit under the periodic average method will be $22 ($110 - $88). This gross profit is between the $25 computed under periodic FIFO and the $20 computed under periodic LIFO.
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