How to record inventory purchases

Inventory is what the business buys or makes in order to sell. business.gov.au splits it by stage: raw materials, work in progress and finished goods. A retailer's shelf stock and a manufacturer's raw materials are both inventory.

Things the business buys to use rather than sell are not. Cleaning products for the shop, a new shelving unit or the delivery van are costs or assets of the business, recorded the way any other purchase is.

Not while it's still on the shelf. Stock bought to sell still belongs to the business until a customer buys it, so its cost is held as an asset and becomes an expense, cost of goods sold, as the items sell. business.gov.au's glossary counts inventory among the things a business owns, and its balance sheet guidance lists inventory with cash among current assets: things that can be turned into cash within a year.

Charging stock straight to an expense, with nothing done about what's left over, puts costs in the wrong month. Here is a gift shop's first month, in which it bought stock costing 6,500.00 and sold stock costing 4,200.00:

The first column makes this month look worse than it was and next month better, when stock costing 2,300.00 sells with no cost set against it. Holding unsold stock as an asset matches each item's cost to the month it sells in. Books that record stock purchases to an expense account reach the same answer by bringing the stock still on hand into the accounts at the end of the period.

Stock isn't a capital purchase either. business.gov.au describes a capital cost as a substantial one-off purchase of items such as plant, equipment, buildings or land, and lists equipment, tools and furniture among a balance sheet's fixed assets. Stock is bought to be sold and replaced, again and again.

business.gov.au describes two ways of tracking stock. A periodic system relies on counting stock and updating the records by hand. A perpetual system has software or a point-of-sale system update the records with every purchase and sale. The bookkeeping entries tend to follow the same split.

Under periodic tracking, how the counted stock is valued and brought into the accounts is a question for your accountant. Under either system, the sale itself is recorded separately, as income.

Both: like every entry in double-entry bookkeeping, it has a debit and a credit of the same amount. The debit goes to inventory, or to purchases with periodic tracking. The credit depends on how the stock was paid for. business.gov.au's glossary describes a debit as the left-hand entry that represents an asset or expense, and double-entry bookkeeping as recording each transaction in 2 accounts.

• Bought on a supplier account: credit accounts payable. Until the bill is paid, the supplier is a creditor, someone the business owes money to.
• Paid on the spot from the business bank account: credit the bank.
• Paid with a business credit card: credit the credit card account, which is cleared when the card itself is paid.
• Paid as a deposit before the goods arrive: the money has gone, but there is no stock yet. Ask your accountant which account should hold a deposit until the goods and the bill arrive.

A homewares shop orders a batch of lamps on a supplier account. A few arrive damaged and go back, some are sold, and the bill is paid less the credit.

The inventory account and the stock record now show the same value: the lamps still on the shelf, at what they cost. The payment touched only accounts payable and the bank, because the purchase was recorded when the bill came in.

Inventory is the stock you hold at a point in time; purchases are the stock you bought over a period. Inventory is a balance, read from the stock records or the balance sheet on a date. Purchases are a total, added up from supplier bills for a month, a quarter or a year.

With periodic tracking the two meet in one calculation. Take returns to suppliers off purchases to get net purchases. Beginning inventory plus net purchases is the cost of all the stock the business had available to sell in the period. Take off the stock still on hand at the end, and what remains is the cost of the stock that was sold.

The result is only as good as the two counts: an error in either one moves cost of goods sold by the same amount. Our guide to calculating cost of goods sold goes further into the method.

A purchase order isn't an entry in the books; it records what you asked for. The entry comes from the supplier's bill, once you have checked it against the order and against what actually arrived.

1. Check the delivery against the order: items, quantities and condition.
2. Check the bill against both, including the price agreed. business.gov.au suggests a written supplier contract that covers price, payment terms and delivery terms, which gives you something to check against.
3. Enter the bill, and update the stock record with the quantities received.
4. If goods arrive without a bill, or a bill arrives without the goods, note it. Near a period end, which period the purchase belongs to is a question for your accountant.

If your books use cash accounting, business.gov.au explains that a bill isn't recorded until it is paid. The stock record still needs updating when the goods arrive, so quantities stay right in the meantime.

• Goods returned: record the supplier's credit note against accounts payable and the account the purchase went to, and take the units out of the stock record.
• Freight and other costs of getting stock in: whether these are added to the cost of the stock or recorded as a separate cost is a question for your accountant.
• Supplier discounts: a discount shown on the bill usually means the purchase is recorded at the price charged. A discount for paying early is less clear-cut, so ask your accountant how to record it.

Here is the difference the freight choice makes on one bill. A deli buys 60 tins of olive oil at 15.00 each and is charged 60.00 freight on the delivery:

The supplier is owed the same either way. What changes is when the freight reaches the profit and loss statement: straight away as its own cost, or a tin at a time inside cost of goods sold as the tins sell. Settle the treatment once with your accountant and apply it to every stock bill, so the figures compare from month to month.

Returns follow the credit note. If part of a delivery goes back, the credit note covers those units and the stock record drops by the same number. If the supplier swaps faulty items instead of crediting them, the value doesn't change: record the units going back and the replacements arriving, so the record shows both movements. A credit note that arrives after the bill is paid leaves the supplier owing you, and it stays in accounts payable until it is used against a later bill or refunded.

A stock card, or the item's record in your inventory system, is where each purchase meets the quantities. When an item's buying price changes, the card needs costs as well as units. Like the second freight option above, this card records each tin at the supplier's price.

From 25 August the card holds tins bought at two prices. When the next tins sell, it needs a rule for which cost goes out with them, such as the oldest cost first or an average of everything on hand. Which costing method your books use is a question for your accountant; the bookkeeping job is to apply the same one every time.

Start with the cost of what you expect to sell, add the stock you want left at the end of the month, and take off what you hold at the start: the answer is how much stock to buy. business.gov.au describes a budget as a listing of planned revenue and expenditure for a period, and its cash flow guidance says forecasting customers' needs and buying stock at the right price and time frees up cash and shelf space.

October's purchases run ahead of its sales because the shop is building stock for its busiest months. December's are low because the plan is to sell down after the season. Plan each month-end stock figure at or above your reorder points, since business.gov.au describes a reorder point as the smallest amount of an item you want in stock before you order more.

Put the purchases into your cash flow forecast in the months the bills fall due under the supplier's terms, not the months the goods arrive. Then compare each month's actual purchases with the budget, and find out why before placing more orders in a month that is already well over.

Each of these leaves the books and the shelves telling different stories:

• Recording the payment as a second purchase. Spot it: the supplier's bill still shows as unpaid after you've paid it, and the inventory account is higher than the stock record. Fix it: reverse the second entry and apply the payment to the bill.
• Entering the quantity ordered rather than the quantity delivered. Spot it: the stock record is ahead of the shelf straight after a delivery, or the docket and the bill disagree. Fix it: correct the units to what arrived, and ask the supplier for the missing goods or a credit note.
• Entering the bill at the price on the purchase order when the supplier charged a different price. Spot it: the supplier's statement and accounts payable disagree, and the unit cost on the stock card differs from the bill. Fix it: correct the bill to the price charged, and raise any price you didn't agree to with the supplier.

business.gov.au suggests listing every product you stock with its name or code, description, quantity, supplier, and cost and selling price, and capturing every sale and return. A stock record kept that way can be compared with the inventory account at any time, and with the shelves at the next stocktake.

Keep supplier bills, credit notes and delivery records. Stock-related expense records appear on business.gov.au's list of records to keep, and the usual period is 5 years.