Inventory accounting records, values, and reports your companyโs inventory. More than that, itโs the best support tool for your tax obligations and financial statements.
Why inventory accounting matters
Inventory covers allย goods youย buy, make, or sell, includingย raw materials and finished inventory items. Inventory accounting is how you measure your businessโs inventory value. It covers the entire inventory accounting process from purchase to sale.
In simpler terms, inventory accounting answers three very important questions for your business:
- How much inventory do we have now (i.e. inventory levels and stock levels)?
- What are our inventory costs and actual cost per unit?
- What can our inventory sales generate in revenue?
Because inventory is both an asset and an expense, good inventory accounting will help you make better, more informed business decisions.
Is inventory an asset or expense?
Inventory is an asset while you hold it. At this stage, it appears on the balance sheet as your company’s inventory. But inventory becomes an expense when goods sold leave your shelves. That expense is cost of goods sold (COGS), sometimes also called goods sold cost.
Trading stock changes can change taxable income. A lower closing value can lower taxable income.
How do you record inventory in accounting?
You will record inventory the same way across different accounting periods, which protects your accounting records at large. Most businesses use one of two inventory accounting systems:
- Record purchases as an asset, then expense on sale.
- Expense purchases, then adjust for beginning inventory and closing stock.
Both approaches involve tracking the movement of stock, so you still need to record transactions for returns and write-offs. Also note that a stocktake validates inventory records by matching physical inventory to inventory readings and counts.
Still unsure? An easy cost of goods sold formula is:
COGS = Beginning inventory + Net purchases โ Ending inventory
Periodic inventory system or perpetual inventory system?
In terms of inventory accounting systems, youโll usually follow one of these models in the table below.
| Inventory accounting system | What it tracks | Best for |
|---|---|---|
| Periodic system | Update stock after stocktakes | Low volume |
| Perpetual system | Update stock after each sale | High volume |
Put more simply, periodic systems find issues later while perpetual systems make sure you have better inventory control.
How do you value stock in accounts?
The value of you stock really depends on your method for inventory valuation. Pick one main inventory valuation method and stay consistent.
For tax, trading stock can be valued at cost, market selling value, or replacement value. For financial statements, some of the most popular inventory accounting methods include FIFO and weighted average cost.
These are the main inventory accounting methods used out there in the real business world:
- Specific identification.
- First in, first out (FIFO).
- Weighted average cost method (AVCO).
If you realise that one system isnโt working for you, bear in mind that changing methods mid-year can cause some not-inconsequential accounting issues. For instance, it can distort your actual inventory value.
1) AVCO (weighted average cost method)
As the name suggests, this method averages the price of your purchased inventory. For each item type you bought, you simply find the average price across the period.
By multiplying the average price of a product line by the quantity of items sold, you’ll have the value of your inventory.
However, this method becomes rather inexact, particularly when prices change significantly. Your actual inventory value might, in fact, be above or below this result.
By using the AVCO method of inventory accounting, you can miss out on valuable data relating to specific profit margins and how the price of your inventory changed over time.
2)ย FIFO (first in, first out method)
The first in, first out method assumes older stock will sell first, which is why it works when thereโs real stock rotation. Under FIFO, older costs flow into the cost of goods sold, whereas newer costs stay in ending inventory.
FIFO can give you better oversight of batch-level margins, while also helping with dated or perishable stock. But it relies on better data capture, which is where inventory management software can help.
How do you choose the right inventory accounting method?
The right inventory accounting method for your business should fit your normal operations. In other words, start with how you physically move stock. For example, you might use:
- Specific identification for high-value, unique items.
- FIFO for dated, perishable or regulated stock.
- Weighted average cost for high-volume, similar goods.
Then test the outcome by asking a few questions: Does it explain profit movements? Does it match sales patterns and buying cycles? Does it cut out unnecessary costs and write-offs?
What inventory accounting helps you do
Inventory accounting plays a very important role in inventory management, as it provides better signals for managing inventory. Just a few of the benefits of inventory accounting include:
- Fewer missed sales opportunities from stockouts.
- Less revenue loss from too much inventory.
- Better pricing using actual cost and COGS.
- More consumer confidence and better service.
- Improves the customer experience with fewer stockouts.
- Fewer unnecessary costs related to storage.
Track the ratios monthly and compare them to inventory trends and sales patterns. Also be mindful of problems like having too much stock that ties up your companyโs cash flow, as well as having too little stock, which can hurt customer confidence.
If youโre stocking in-demand inventory, review lead times weekly as even the smallest shifts can cause missed sales opportunities.
When to use an inventory accounting specialist
Use an inventory accounting specialist when thereโs too much complexity in your system, which is very common in the manufacturing and wholesale industries. No matter how you operate, a few big red flags are:
- High inventory value swings each period.
- Complex production costs and direct materials costs.
- Heavy distribution costs across sites.
- Repeated write-offs and unexplained variances.
Get it right, and youโll be sailing smoothly. And if youโre having problems, donโt be afraid to reach out to the experts straight away.
