What is inventory accounting?
Inventory accounting is the practice of valuing and reporting on the physical inventory a business holds. It encompasses the day-to-day management of the Accounts Payable, Accounts Receivable and Cost of Goods accounts – and also the periodic reporting that’s essential for insurance, taxes and duties, and valuing a firm for purchase or sale.
Products and components often account for the greatest capital outlay in a business. Because of this, inventory accounting plays a critical role in maintaining the profitability and liquidity of any product-based business.
Benefits of inventory accounting
Inventory accounting helps businesses determine the value of their stock on hand and break down the costs of purchasing, producing, and managing inventory items.
The primary benefits of inventory accounting are:
- It gives you an accurate picture of your margins at the product level, enabling competitive pricing.
- It helps you determine the total value of your business when trying to sell or acquire investors.
- It identifies which products are making you the most money.
- It helps you make smarter decisions around cash flow and purchasing.
- It’s a necessary system for calculating tax obligations.
In short, inventory accounting directly impacts how profitably your business operates.You need it – not just for tax purposes, but to gain visibility across the financial standing of your business and your products.
Inventory accounting and business strategy
Inventory accounting also has a strategic function. Key inventory metrics – including the inventory turnover ratio, supplier lead times, the landed cost of goods sold, and profit margin by SKU – are all used to guide the overall strategy of an effective product business.
A strong grasp of the fundamentals of inventory management is therefore critical for financial professionals within those product-based companies – and for business advisors with manufacturing, wholesale or retail clients.
What is inventory in accounting?
In accounting terms, inventory refers to any stock that is used to produce a finished product intended to be sold.
Inventory in accounting includes (but is not limited to):
- Finished goods
- Raw materials
- Components
- Work-in-progress goods
- Safety stock
Inventory is considered a current asset in accounting because companies usually intend to sell the finished products within a fiscal year.
- Read more: The 23 Types of Inventory You Need to Know About
Inventory accounting key terms and formulas
Before we dive into the details, here’s a quick recap of some of the key terms and inventory accounting formulas you should know.
Beginning inventory
Beginning inventory, also called opening inventory, refers to the total value of a company’s inventory at the start of each accounting period. It is equal to the ending inventory of the previous accounting period.
Beginning inventory can be calculated using the formula:
Cost of Goods Sold + Ending Inventory – Net Purchases = Beginning Inventory
Ending inventory
Ending inventory, also called closing inventory, refers to the total value of a company’s inventory at the end of each accounting period. It is equal to the beginning inventory of the following accounting period.
Ending inventory can be calculated using the formula:
Beginning Inventory + Net Purchases – Cost of Goods Sold = Ending Inventory
Inventory turnover
Inventory turnover, also called the inventory turnover ratio, is a business metric used to calculate the rate at which a company sells, uses, and replaces its inventory. It helps businesses to determine whether they’re carrying the optimal volume of stock relative to how quickly it can be sold.
Inventory turnover ratio can be calculated using the formula:
Cost of Goods Sold / Average Value of Inventory = Inventory Turnover
Cost of goods sold (COGS)
Cost of goods sold refers to the total production and purchasing costs that go into a product sold by a business. It includes direct materials costs, labour costs, and manufacturing costs but does not include indirect expenses, such as marketing costs, distribution costs, and taxes.
COGS is an important metric for understanding the gross profit associated with each product you sell. It provides valuable insights into production costs and is useful for seeing which products provide the most value for a business.
Cost of goods sold can be calculated using the formula:
Beginning Inventory + Net Purchases + Production Costs – Ending Inventory = Cost of Goods Sold
Cost of goods sold example
Let’s put the COGS formula into practice, since this is an especially important part of the inventory accounting process.
Let’s say a company started the year with $10,000 of inventory.
Their purchases added up to $20,000.
At the end of the year, their closing inventory was $5,000.
10,000 Beginning Inventory + 20,000 Net Purchases –5,000 Closing Inventory = 25,000
Their cost of goods sold for that year is $25,000.
Inventory shrinkage
Inventory shrinkage refers to the difference between recorded inventory levels and the actual physical inventory levels in a business. Because any inventory shrinkage counts as a discrepancy in accounting it must be balanced in journal entries with an inventory write-off.
Inventory shrinkage can be calculated using the formula:
(Recorded Inventory Value – Actual Inventory Value) / Recorded Inventory × 100 = Inventory Shrinkage
Inventory write-off
An inventory write-off is a process wherein inventory items are removed from a company’s recorded stock-on-hand list because they are no longer saleable. Inventory write-offs are typically done when goods are stolen, damaged, expired, or made obsolete by a new product or shifts in demand.
How inventory accounting works
Even before it’s sold, inventory holds a value. It is listed as a current asset on the balance sheet. That value can change when products expire, become outdated, get damaged, or when customer demand fluctuates.
Likewise, the cost of producing and selling goods is always changing. This presents a challenge when determining the profitability of goods sold.
Inventory accounting helps you to correctly track the cost of any inventory sold and accurately value any unsold inventory that remains at the end of each accounting period.
Inventory accounting systems
There are two main systems used in inventory accounting: the periodic system and the perpetual system.
- A periodic inventory accounting system is one where inventory records are manually updated after a physical stock count has been performed.
- A perpetual inventory accounting system is one where inventory value, stock levels, and stock movements are continuously recorded and updated in real time.
The perpetual inventory system automatically keeps your inventory records up to date as stock movements occur, so your cost of goods sold (COGS) and inventory accounting will be more accurate throughout the year.
Inventory accounting methods
Inventory accounting methods are the ways in which revenue and expenses are recorded – more specifically,whenthey are recorded.
The two main inventory accounting methods are cash basis accounting and accrual basis accounting. Let’s explore the differences.
- Learn more:Cash Basis vs Accrual Basis Accounting for Inventory
Cash basis accounting for inventory
The cash basis inventory accounting method is where expenses are recorded when cash is spent and income is recorded when cash is received.
This method is beneficial for smaller businesses because it’s simple to use and offers a clear picture of a company’s cash flow at any given time. However, it can result in inaccurate or misleading reporting and is not accepted under the laws of many countries.
Accrual basis accounting for inventory
The accrual basis inventory accounting method, also called traditional accounting, is where income can be recorded before cash is received and expenses are recorded as transactions occur.
This method applies the double-entry accounting principle and provides a more accurate indication of a business’s current financial position.
Accrual basis accounting is compulsory in many countries for businesses of a certain size under theGenerally Accepted Accounting Principles (GAAP). It’s predicted that50% of governmentswill have moved to accrual basis reporting by 2025.
Accounting for stock discrepancies
A reliablestocktaking procedureallows businesses to know its inventory count and value, not only informing decision-makers and driving operations.
It also ensures accurate information is available to accountants, auditors and financial controllers who prepare annual reports, balance sheets and essential statements of earnings.
Identifying discrepancies
A stock take discrepancy occurs if the actual quantity of stock held by a business is different from the quantity shown in its inventory records.
Such differences between actual and mistaken stock counts can present a real problem for businesses, potentially costing the bottom-line in lost sales, build-up of surplus stock, and customer dissatisfaction.
Discrepancies revealed by a company’s stock take software also have a direct effect on how a company values itself and its assets.
Inventory reconciliation
Stocktake discrepancies can occur for a number reasons, including damage, human error, or theft and fraud.
It’s important a company implements a stocktaking procedure whereby it regularly – and especially when a specific discrepancy has been identified – reconciles its inventory, comparing stock counts in its records to the actual amounts of stock held on warehouse shelves.
This will allow the company to work out why there is a difference between the believed and actual stock count, preventing future discrepancies of the same nature, and to make amendments to the records to reflect the accurate figures.
Why reconciliation is important
Accurate inventory records provide for efficient operations and allow accountants to correctly value a company’s inventory property.
Income statements, statements of retained earnings and balance sheets are financial documents essential to a company’s operations, and sometimes even required by law. They can only be prepared properly if inventory is valued accurately.
An example of how reconciliation affects finances:
- If inventory is overstated, the COGS value is lowered.
- If inventory is understated, COGS value is artificially increased.
A mistaken inventory count can make it look as though a company has done more or less business than it actually has, affecting both its current and future overall valuation.
Inventory accounting best practices
Although the basics of inventory control come naturally to many businesses, accurately tracking and recording inventory costs can be a real challenge. Let’s look at some of the best practices when it comes to inventory accounting.
1. Use the right measure
If an item’s cost changes while a business holds some inventory of that item, accountants must use a ‘cost flow assumption’ to work out which cost to report – the cost of purchasing the first units, or the cost of the most recently purchased.
Using the wrong cost flow assumption could distort your financial and tax reporting. It could also mean that your accounts do not comply with accounting standards and tax law.
2. Perpetually value inventory
Valuing your business’ stock at the start and end of a month can be difficult. Staff often fail to keep up with inventory paperwork, so it can be difficult to use sales or production records to determine how much inventory is in stock.
By perpetually tracking inventory, online inventory management software makes it easy to keep track of the cost of goods sold. Every transaction updates the cost of goods sold, whether you use the LIFO, FIFO or average landed cost method.
3. Calculate then recost
Working out landed costs is challenging; although your suppliers and customs brokers invoice you promptly, transport providers regularly take several weeks to send you a bill.
This creates a practical difficulty for accountants – is it better to estimate costs and risk getting them wrong, or to wait until you have all of the information?
A sensible approach is to determine landed costs as soon as possible on the basis of all the available information. This involves using actual supplier and broker charges and an estimate of shipping costs based on previous charges.
4. Pick the right tools
Many businesses use Excel spreadsheets to keep track of their inventory and accounts. Although Excel is a powerful business analysis tool, it can be error prone and is time consuming to use. Excel also makes it difficult to perpetually value inventory.
Consider picking online inventory management, point of sale and accounting packages that integrate.
Examples of inventory in accounting
The term inventory accounting encompasses several inventory bookkeeping strategies. Here are some common examples of inventory in accounting and key considerations for each approach.
Standard inventory accounting
Standard inventory accounting refers to the management and analysis of inventory value and the costs associated with inventory items. It encompasses inventory bookkeeping, inventory valuation, and gross margin determination.
Consignment inventory accounting
Consignment inventory accounting is the collaborative effort between a supplier (the consignor) and a retailer (the consignee) to maintain accurate inventory records for goods on consignment.
Because consignment inventory is owned by the consignor until consignment stock has been sold and payment received, the journal entries are different from standard purchase and sale entries.
- Read more:
Pipeline inventory accounting
Accounting for pipeline inventory, also called in-transit inventory, comes with unique complications due to the sometimes-unclear ownership of in-transit goods. How pipeline inventory is accounted for largely depends on the terms and conditions of the shipping agreement between the shipper and the receiver.
- Read more: In-transit Inventory Guide for Merchants
