Last reviewed: July 2026.
Inventory accounting links physical quantities to the general ledger and cost of sales. Errors in purchases, cut-off, cost formulas or net realisable value can overstate both profit and current assets.
This guide explains the main journal entries under perpetual and periodic systems, the costs included in inventory, sales and returns, production overhead, NRV write-downs and practical controls.
Inventory and the accounting system
Inventory includes assets held for sale, work in progress and materials or supplies consumed in production or service delivery. The accounting system must capture quantities, unit costs, locations, ownership and condition. The financial statements then measure inventory at the lower of cost and net realisable value.
Businesses may use a perpetual system, which updates inventory and cost of sales continuously, or a periodic system, which determines cost of sales after a physical count and closing valuation. The same IAS 2 measurement principles apply, but the journal flow and timing differ.
Purchases and directly attributable costs
Under a perpetual system, purchases of goods for resale are debited to inventory. Freight-in, import duties and non-refundable taxes that bring inventory to its present location and condition are included in cost. Trade discounts, rebates and similar items reduce cost.
Abnormal waste, most storage costs not necessary in production, general administration and selling costs are expensed. Clear coding is important because automatically posting every supplier invoice to inventory can overstate assets and delay expenses.
Sales and cost of sales entries
When inventory is sold under a perpetual system, two entries are usually recorded: debit cash or receivables and credit revenue for the sale; then debit cost of sales and credit inventory for the carrying amount of the goods. The revenue amount and inventory cost are different measurements.
Under a periodic system, purchases are accumulated separately during the period. Cost of sales is calculated using opening inventory plus net purchases and production costs, less closing inventory. The closing inventory adjustment places the counted and valued amount in the statement of financial position.
Returns, discounts and damaged goods
Purchase returns reduce inventory or purchases and the supplier liability. Sales returns reverse revenue and the customer balance; if returned goods are saleable, inventory and cost of sales are also reversed at the original carrying amount. Damaged goods are assessed for write-down or disposal rather than automatically restored to full cost.
Settlement discounts and variable consideration require consistent treatment with the applicable revenue and inventory policies. The system should retain links between the original transaction, credit note, quantity movement and valuation change.
Cost formulas and production overhead
Specific identification is used for inventory items that are not ordinarily interchangeable. FIFO or weighted average is used for ordinarily interchangeable items. The selected formula should be applied consistently to inventories with a similar nature and use.
For manufactured inventory, cost includes direct materials, direct labour and a systematic allocation of fixed and variable production overhead. Fixed overhead is allocated using normal capacity; unallocated overhead caused by low production is expensed rather than hidden in inventory.
Write-down to net realisable value
Net realisable value is the estimated selling price in the ordinary course of business less estimated completion and selling costs. If NRV falls below cost, inventory is written down and an expense is recognised. Reviews are normally item by item or by appropriate groups of similar items.
If circumstances improve, a previous write-down may be reversed, but only up to the original write-down. The reversal reduces the inventory expense in the period. Supporting evidence should include ageing, sales after period end, obsolescence reports and forecast selling costs.
Worked journal example
A retailer buys goods for 40,000 and pays freight of 2,000. It sells part of the goods for 35,000; their carrying cost is 24,000. Under a perpetual system, inventory is debited 42,000. The sale debits receivables 35,000 and credits revenue 35,000, while cost of sales is debited 24,000 and inventory credited 24,000.
At year end the remaining inventory has cost 18,000 but NRV of 15,500. The entity debits inventory write-down expense 2,500 and credits inventory or an allowance 2,500. The closing carrying amount is 15,500.
Inventory controls and reconciliation
Strong controls include approved item masters, restricted changes to standard costs, three-way matching, sequential goods-received notes, controlled stock issues, cycle counts and independent investigation of differences. Slow-moving and obsolete items should be reviewed before the reporting date.
The inventory subledger should reconcile to the general ledger. Quantity differences, negative inventory, unusual margins and manual journals should be investigated. Cut-off testing confirms that purchases, sales, goods in transit and consignment inventory are recorded in the correct period and by the correct owner.
Practical review checklist
- Confirm ownership, location and condition of inventory.
- Use approved item codes and consistent cost formulas.
- Include only qualifying purchase and conversion costs.
- Record sales and cost of sales in the correct period.
- Process returns and credit notes against original transactions.
- Test inventory at the lower of cost and NRV.
- Reconcile physical counts, subledger and general ledger.
- Investigate cut-off, ageing, negative stock and manual journals.
Related Accounting Support guides
Authoritative references
This educational guide explains general accounting principles. Apply the reporting framework, law and market rules relevant to the entity and jurisdiction.