Adjusting stock, often referred to as inventory adjustment, is the process of updating a company's inventory records to reflect its actual physical inventory, account for changes in value, or correct discrepancies. This essential accounting procedure ensures that financial statements accurately represent the value of goods available for sale and the cost of goods sold.
Why Are Stock Adjustments Necessary?
Stock adjustments are critical for maintaining accurate financial records and operational efficiency. They address various situations where recorded inventory doesn't match the reality:
- Physical Discrepancies: Differences between physical counts and system records due to errors, theft (shrinkage), or damage.
- Valuation Changes: Writing down the value of obsolete, damaged, or slow-moving inventory to its net realizable value.
- Accounting Period End: To align inventory records with a physical count at the close of an accounting period.
- Returns: Handling customer returns that re-enter inventory.
- Spoilage or Breakage: Removing items that are no longer sellable.
The Process of Adjusting Stock
Adjusting stock involves a systematic approach to identify discrepancies and formally update inventory records.
1. Gather Initial Information
Begin by determining the beginning inventory for the accounting period you are calculating. This initial figure serves as the baseline for all subsequent inventory movements. Understanding your starting point is crucial for tracking changes accurately.
2. Calculate the Cost of Goods Sold (COGS)
Calculating the cost of goods sold (COGS) is a fundamental step. This figure represents the direct costs attributable to the production of the goods sold by a company during a period. While COGS itself doesn't directly adjust stock, it's a critical component in understanding the flow of inventory and its impact on profitability, especially when determining ending inventory in a periodic system.
3. Evaluate Inventory
A thorough evaluation of inventory involves comparing your recorded stock levels with the actual physical quantity on hand. This often includes:
- Physical Counts: Manually counting all inventory items to get an accurate physical tally.
- Cycle Counts: Counting a small subset of inventory regularly, rather than a full annual count.
- Damage Assessment: Identifying items that are damaged, obsolete, or otherwise unsellable.
This evaluation step is where discrepancies between records and reality are identified.
4. Identify Discrepancies: Understated vs. Overstated Inventory
Once evaluated, inventory records might reveal two primary types of errors that necessitate adjustments:
- Understated Inventory: This occurs when the physical count is higher than the recorded inventory, or when items were removed from records but are still physically present. This could be due to unrecorded purchases, missed returns, or data entry errors.
- Impact: If left uncorrected, an understatement leads to an overstatement of COGS and an understatement of assets and net income.
- Overstated Inventory: This happens when the physical count is lower than the recorded inventory. Common causes include shrinkage (theft), damage, spoilage, unrecorded sales, or errors in recording incoming stock.
- Impact: An overstatement inflates assets and net income, while understating COGS.
5. Make the Formal Adjustment
After identifying discrepancies, formal adjustments are made in the accounting system. This typically involves journal entries that affect the Inventory Asset Account and an Inventory Adjustment Account (often tied to COGS or a separate expense account).
| Adjustment Type | Debit Account | Credit Account | Description |
|---|---|---|---|
| Overstated Inventory (e.g., shrinkage, damage, obsolescence) | Cost of Goods Sold or Inventory Shrinkage Expense | Inventory | Decreases the asset value of inventory to reflect the actual quantity or value. Increases expenses, reducing net income. This ensures the inventory asset is not inflated. |
| Understated Inventory (e.g., finding unrecorded stock) | Inventory | Cost of Goods Sold or Inventory Adjustment Revenue | Increases the asset value of inventory to reflect found items. Decreases expenses (or increases revenue), increasing net income. This corrects the previous undervaluation of the inventory asset. |
For example, if a physical count reveals $1,000 less inventory than recorded due to shrinkage, the adjustment would be to debit Cost of Goods Sold (or Inventory Shrinkage Expense) for $1,000 and credit Inventory for $1,000. This brings the inventory asset account down to its accurate value and correctly expenses the lost stock.
Practical Tips for Effective Stock Adjustment
- Regular Physical Counts: Implement a robust system for periodic or cycle counts to catch discrepancies early.
- Inventory Management System (IMS): Utilize an IMS or Enterprise Resource Planning (ERP) system to automate tracking and reduce manual errors. Learn more about inventory management.
- Reconciliation: Regularly reconcile physical counts with perpetual inventory records.
- Employee Training: Train staff on proper inventory handling, receiving, and dispatching procedures to minimize errors.
- Security Measures: Implement security protocols to prevent theft and damage, which are major causes of overstated inventory.
- FIFO/LIFO/Weighted Average: Consistently apply your chosen inventory valuation method (e.g., FIFO, LIFO, or Weighted Average) to ensure accurate cost calculations for adjustments.
By diligently following these steps, businesses can achieve accurate inventory records, leading to more reliable financial reporting and better operational decision-making.
