Inventory Accounting in QuickBooks 2017

By Stephen L. Nelson

Fortunately, most of the inventory accounting that goes on in a business gets handled automatically by QuickBooks. When you purchase an inventory item by writing a check or recording an accounts payable bill, for example, QuickBooks automatically adjusts your inventory accounts for both the dollar value of the inventory and the quantity of the items. When you sell an inventory item to a customer, QuickBooks again automatically adjusts the dollar value of your inventory and adjusts the quantity counts of the items you sell.

Basically, all this means is that QuickBooks maintains a perpetual inventory system — an inventory system that lets you know at any time what quantity of items you have in inventory and what value your inventory amounts to. (In the past, smaller firms often used a periodic inventory system, which meant that business owners never really knew with any precision the dollar value of their inventory or the quantity counts for the inventory items that they held.)

Although everything in the preceding paragraph represents good news, several inventory-related headaches do require a bit of accounting magic. Specifically, if your firm carries inventory, you need to know how to deal with obsolete inventory, disposal of obsolete inventory, and inventory shrinkage.

Dealing with obsolete inventory

Obsolete inventory refers to items that you’ve purchased for sale but turn out not to be saleable. Perhaps customers no longer want it. Perhaps you have too much of the inventory item and will never be able to sell everything that you hold.

In either case, you record the fact that your inventory value is actually less than what you purchased it for. And you want to record the fact that, really, the money you spent on the obsolete item is an expense. Suppose that you purchased some $100 item that you now realize is obsolete. How do you record this obsolescence?

Journal Entry 7: Recording an Allowance for Obsolete Inventory
Account Debit Credit
Inventory obsolescence $100
Allowance for obsolete inventory $100

As Journal Entry 7 shows, to record the obsolescence of a $100 inventory item, you first debit an expense account called something like “Inventory obsolescence” for $100. Then you credit a contra-asset account named something like “Allowance for obsolete inventory” for $100.

A contra-asset account gets reported on the balance sheet immediately below the asset account to which it relates. The contra-asset account, with its negative credit balance, reduces the net reported value of the asset account. If the inventory account balance is $3,100, and you have an allowance for an obsolete inventory contra-asset account of $100, the net inventory balance shows as $3,000. In other words, the contra-asset account gets subtracted from the related asset account.

QuickBooks requires you to record Journal Entry 7 yourself, using the Make Journal Entries command.

Disposing of obsolete inventory

When you ultimately do dispose of obsolete inventory, you record a journal entry like this one. This journal entry debits the contra-asset account for $100 and credits inventory for $100. In other words, this journal entry removes the value of the obsolete inventory from both the allowance for obsolete inventory account and the inventory account itself. You record this journal entry when you actually, physically dispose of the inventory — when you pay the junk man to haul away the inventory, for example, or when you toss the inventory into the large Dumpster behind your office or factory.

Journal Entry 8: Recording Disposal of Inventory
Account Debit Credit
Allowance for obsolete inventory $100
Inventory $100

In general, one of the things you should do every year for tax accounting reasons is deal with your obsolete inventory. The tax rules generally state that you can’t write off obsolete inventory unless you actually dispose of it for income purposes. Typically, however, you can write down inventory to its liquidation value. Such a write-down works the same way as a write-down for obsolete inventory. A write-down can be a little tricky if you’ve never done it before, however, so you may want to confer with your tax adviser.

One more really important point about recording disposal of obsolete inventory: Within QuickBooks, you record inventory disposal by adjusting the physical item count of the inventory items. You don’t actually enter a journal entry like the one shown in Journal Entry 8. You adjust the inventory accounts for the obsolete inventory. This adjustment would automatically reduce the inventory account balance. When QuickBooks asks you which account to debit, you specify the allowance for obsolete inventory account.

Dealing with inventory shrinkage

The other chronic inventory headache that many business owners and business managers have to deal with is inventory shrinkage. It’s very likely, sometimes for the most innocent reasons, that your inventory records overstate the quantity counts of items. When this happens, you must adjust your records. Essentially, you want to reduce both the dollar value of your inventory and the quantity counts of your inventory items.

QuickBooks makes this journal entry for you to record this event. This journal entry debits an appropriate expense account — in Journal Entry 9, the expense account is called “Shrinkage expense” — for $100. A journal entry also needs to credit the inventory account for $100.

Journal Entry 9: Recording Inventory Shrinkage
Account Debit Credit
Shrinkage expense $100
Inventory $100

Within QuickBooks, you don’t actually record a formal journal entry like the one shown here. You use something called a physical count worksheet to adjust the quantities of your inventory item counts to whatever they actually are. When you make this adjustment, QuickBooks automatically credits the inventory account balance and adjusts the quantity counts. QuickBooks also requires you to supply the expense account that it should debit for the shrinkage.

In the old days, businesses compared their accounting records with the physical counts of inventory items only once a year. In fact, the annual inventory physical count was a painful ritual that many distributors and retailers went through. These days, most businesses have found that it works much better to stage physical inventory counts throughout the year. This approach, called cycle counting, means that you’re probably comparing your accounting records with physical counts for your most valuable items several times a year.

For your moderately valuable items, you’re probably comparing your inventory accounting records with physical counts once or twice a year. With your least valuable inventory items, you probably compare inventory records with physical counts only irregularly, and you may accept a degree of imprecision. Rather than count screws in some bin, for example, you may weigh the bin and then make an estimate of the screw count.

In any case, you want some system that allows you to compare your accounting records with your physical counts. Inventory shrinkage and inventory obsolescence represent real costs of doing business that won’t get recorded in your accounting records in any other way.