Tracking inventory is never easy, and with Amazon changing the rules recently, let’s take a minute to ensure we understand how inventory should be recorded in your books. We’ll start quite simply with the definition of inventory. From an accounting perspective, it is an asset and will show up on your balance sheet, just like your bank accounts. In fact, I tell our clients that inventory is cash they can’t spend. The nice thing about inventory is that if you have invested wisely, you will be able to sell it for a significant return, while your bank accounts grow very slowly with interest rates so low.

How to Account for Inventory Down Payments

Things get a little tricky when you start to spend money on down payments for products that you have not yet received. In a simplified accounting system, we would record that transaction as inventory because that is what we are buying. However, recording it before you have the product in hand can skew your balances in your inventory account and your Cost of Goods Sold (COGS). If you make a down payment and the product will be received in a future month, you are going to create some confusion in your numbers.

Best Practice Tip: A better process would be to record that down payment in a prepaid account (also an asset type account on your balance sheet). That way, the down payment will not be confused with inventory on hand.

How to Account for Inventory Prepayments

Once you pay the balance on your inventory purchase, it may still be several weeks before you receive it. Most often we see this situation when a product is being shipped by boat from China and the typical time in transit is 60 days. The same situation occurs as mentioned with the prepayment of inventory. Payments have been made for the inventory, but you do not have the product in hand. Trying to ensure that the dollars paid equal the cost of the products on hand is confusing if you include the prepayments and total payments for items in transit.

Best Practice Tip: The best practice in this case is to record both the prepayment and the balances paid to an Inventory in Transit account once the products have shipped. This too is a balance sheet account. You must monitor your items in the prepaid account and do a journal entry to move them into the Inventory in Transit account. Typically paying the final balance on the purchase order is your cue to make this journal entry.

When Your Product Becomes Inventory

The day the items arrive and are accepted into your possession, either your warehouse or directly at Amazon, is the day they are properly considered Inventory. At this point you could physically count your inventory or get the physical counts from Amazon reports and compare them to your financial books.

Best Practice Tip: For our clients, we look at these counts at month end and do a journal entry to ensure that the prepayments and Inventory in Transit items are cleared and properly recorded in the inventory account.

If your inventory balances or your Cost of Goods Sold balances never seem to make sense, then you may be recording your inventory too soon before you actually have possession of it. Thinking through your payment process and your shipping times (transit) will help you understand how the actual movement of the product should be recorded as it makes its journey to you and how the dollars need to be recorded at each step in the process.

Using COGS to Match Your Costs to Your Revenue

Another issue I see when I review books for potential clients is when their accountant books inventory based on counts for the last day of the month. However, their revenue is recognized when it is received from Amazon. These periods typically do not coincide. You will have sales dollars recorded based on payout dates, but the COGS are recorded based on the calendar date. The reason we record COGS is to match the costs to the revenue. If the dates don’t coincide, that immediately creates an issue.

Best Practice Tip: A best practice that everyone should follow if they are tracking inventory is to do a “true up” at least every quarter. Many clients will record their COGS monthly throughout the year and do an adjustment at year end for tax purposes. This can lead to some serious disappointment and can cause you to “act” on your numbers when they are not accurate. Lost inventory, refunds, damaged product that should be written off and several other factors impact your inventory quantities. Since inventory is like cash, and it really is important to your business success, make sure you compare physical counts to financial costs at least quarterly.

It’s worth the effort to monitor all the moving parts of this process and get it “dialed in.” If you cannot understand your COGS, then your gross margin will not be reliable and that is one of the primary metrics you should be monitoring. At Bookskeep, inventory is a priority to ensure we give our clients accurate data each month.