As with all businesses, a manufacturing company uses a sequence of events known as an accounting cycle to prepare financial statements. Being a manufacturer brings some specific requirements, notably the need to use the accrual method in most cases, and the need to find a system to value inventory.
The accounting cycle is the complete process of events that turns the company’s transactions during an accounting period into a final set of financial statements. The statements cover the expenses and revenues during the period, plus the remaining assets and liabilities at the end of the period. The precise details of the accounting cycle can be defined in different ways, but the general principles are: record transactions; total and verify transactions; make adjustments for accrual method purposes; verify the adjusted totals; prepare the financial statements; and close temporary accounts.
There are two main elements to the recording process. First, the business makes a record of each transaction — whether purchase, sale, loan or repayment — when it takes place. Second, the business totals these transactions into ledger accounts. Each of these accounts covers a specific category of activity such as revenue, expenses, accounts payable, accounts receivable, cash on hand or capital.
Because a manufacturer carries an inventory, it will normally be required to use the accrual rather than cash method when preparing accounts for tax purposes. Accrual means recording transactions at the time money becomes owed, even if this isn’t when it’s paid. For example, a sale on credit to a customer is listed when the goods are delivered, not when the customer finally pays. To reflect this method, the accountants must make adjusting entries to the ledgers. This means adding entries that don’t show up in the record of transactions, which is done by referring to documents such as invoices rather than cash records. Normally such adjustments involve adding money to the revenue or expenses total, but in cases of prepayment — such as paying rent in advance that covers a time beyond the accounting period — there may be subtractions instead.
When tracking inventory — both when matching costs to expenses, and in valuing the company’s assets at the end of the accounting period — a company must place a value on each item. This can cause confusion if the company has multiple units of an item, but bought some of them at different prices. The solution is to use one of two consistent methods of valuation. One is First in First Out by which, for accounting purposes, each sold unit is treated as if it were the unit in stock the longest, and valued appropriately. The contrasting Last in First Out (LIFO) means treating each sold unit as if it were the most recently added. The system a company chooses may be restricted by accounting standards, for example, those that apply if it’s a publicly traded company.