Beginner's Guide to Inventory Accounting: What is it and Why to do it?

Accounting and inventory, while both critical components of any business, may seem like two separate tasks, but they are very much linked. Calculating your inventory, or inventory accounting, is a key part of a business’s success. 

While inventory management tracks and controls the movement of inventory, the accounting side deals with the financial information intimately tied to the buying and selling of finished goods. When it comes to inventory accounting, you’ll learn everything you need to know in this guide to inventory accounting. 

What Is Inventory Accounting?

Accounting is the discipline of calculating, processing, and communicating financial information for businesses and individuals. Inventory accounting is a type of accounting that covers the financial operations and responsibilities of the business’s inventory and accurately depicting a company's assets.

As inventory is always changing, the variables associated with its accounting must follow specific methods and procedures to ensure an accurate depiction of a business’s finances. Inventory accounting is an important and often monumental task for any company, as it must cover both sold and unsold products as they come and go from the inventory and bookkeeping records.

How Does Inventory Accounting Work?

Inventory accounting involves using a business' inventory to gain insights into and accurately depicting a business’s financial health. There are many variables that inventory accounting deals with, like the movement of the stock, daily fluctuations in quantity, ageing inventory, and deadstock.

Companies will choose a specific inventory accounting system and method of cost valuation, then will adhere to their guidelines in order to extract and calculate the required financial information from fluctuating expenses and revenue.

Inventory accounting works by tracking inventory costs and recording inventory assets and the overall value of inventory at the beginning and end of an accounting period to determine the metrics of a business.

There are two central inventory accounting systems that your business can choose to use when tracking and recording inventory finances:

Perpetual vs. Periodic Inventory Accounting Systems

The perpetual inventory system records and tracks inventory balances continuously. Updates are made automatically to this system, tracking when products come in and out of the inventory account.

The periodic inventory system tracks inventory by periodically checking the inventory using a physical count to measure the stock and cost of goods sold.

Cost of goods sold (COGS)

Cost of goods sold (COGS) refers to all costs associated with a business’s production process, like the raw materials needed to manufacture those goods and is the value of all inventory goods sold within a given period.

How is Inventory Classified in Accounting?

Inventory is classified as a current asset and will show up as such on the business’s balance sheet.

When recording an inventory item on the balance sheet, these current assets are listed by the price the goods were purchased, not at the price the goods are selling for. Opening and ending inventory balance will need to be recorded on the balance sheet each period.

Learn more about our Excel inventory management template.

Do I have to report inventory?

All businesses must report their inventory to their country’s revenue collection agency. However, the revenue collection agencies do not need to know the specific inventory items, just the costs of goods sold and net income, both of which are calculated using the inventory balance.

Does inventory count as income?

Inventory does not count directly as income on a person’s income statement. However, the inventory’s value is directly linked to the business’s revenue and overall income, so while the stock itself is not income, the value of the inventory is required when determining income.

What Are The Main Inventory Costing Methods?

There are three main methods of inventory valuation that companies can use to account for the value of their stock. To accurately calculate and record the valued inventory each year, businesses must select one of these costing methods and apply it consistently.

Com tax time, for both your business’s needs and to comply with your country’s revenue collection agency, you will need to produce accurate and precise financial statements according to the information gathered from these inventory accounting methods.

Also read: Learn everything you need to know about how to deal with last year's inventory.

FIFO Method

The FIFO method, or the first-in, first-out inventory management technique, tracks the value of goods as they enter and exit the inventory. This method concludes that the stock first purchased for inventory is also the first to be sold, even if it's physically not.

This technique provides businesses with an accurate depiction of the ending inventory and its value. Many companies will opt to use the FIFO inventory method to offload their older stock first, and is most often used by business with perishable inventories.

As a result, the calculations for an inventory’s cost of goods sold will reflect the movement and value of the goods.

FIFO Example

For example, if Mary owns a kitchenware store and uses the FIFO method, she'll need to assign costs to her inventory based on the goods purchased first for her retail business.

If Mary were to buy 50 wine glasses at $12 each, and then order another 50 wine glasses but this time, paying $16 each, she would assign the cost of the first wine glass as resold at $12. Once 50 wine glasses have been sold, the next 50 glasses will be set at the $16 value, no matter what additional inventory was purchased within that time.

LIFO Method

The LIFO method, or last-in, first-out technique, asserts that the last stock added to inventory will be the first sold. At the end of an accounting period, the inventory leftover would be the oldest of the purchased goods.

The disadvantages associated with this costing method outweigh the advantages as this method is typically inaccurate with its inventory value portrayal as it generates prices that fluctuate throughout the year. Many companies would consider this inventory management technique unrealistic, as businesses seek to sell their oldest inventory first, meaning many industries opt to use FIFO over LIFO.

LIFO Example

For example, if Robert runs a jewelry shop and uses the LIFO costing method to manage his inventory, and he buys 100 silver necklaces at $25 per necklace. Later, he chooses to buy another 50 silver necklaces, but this time, the price has gone up to $30 per item.

If Robert uses LIFO to determine the cost of his inventory, the first necklace sold will be priced at $30, even if it came from the previously ordered stock. The first 50 necklaces sold would be assigned the cost of $30, while the following 100 necklaces sold would be priced at $25.

Weighted Average Method

The weighted average method, or average cost method, deals with inventory differently than the FIFO and LIFO methods. This method dictates that the overall value of an inventory is based on the average cost of items purchased and sold within a given accounting period.

If your business industry deals with erratic price fluctuations over a given time, this costing method may not be the best option when evaluating your inventory, as significant price differences will skew the calculations.

Check out these tools for tracking inventory profitability.

Weighted Average Example

For example, if Lisa runs a beauty store and decides to purchase 40 lipsticks at the beginning of the year for $10 each, to sell to customers. Halfway through the year, she decides to order a further 30 at $15, then another 20 lipsticks, at $20 each, at the end of the year. Lisa’s stock now consists of 90 lipsticks, and by the end of the period, she sells 15 of them.

She will need to use the weighted average costing method to determine the cost of units sold. Lisa calculates this number by taking the total inventory purchased in the year, $1250, dividing it by the total number of lipstick units, 90. The average cost of lipstick would then be $13.89, meaning she sold 15 lipsticks at $13.89, for a total of $208.35.

Why Is Inventory Accounting Important?

A key part of running a professional business is ensuring all necessary government and industry-specific laws and regulations are followed. Companies and individuals must produce the appropriate financial statements and income tax returns each year as dictated by their country’s revenue collection agency. Failure to comply with this will result in fines, penalties and possible incarceration.

That means keeping accurate and up-to-date financial records for business management purposes and tax return filing. By following International Financial Reporting Standards (IFRS), a business can determine the appropriate information as required, like corresponding inventory accounting numbers.

Many business owners will use accounting software to help them track and calculate financial information, including inventory management and accounting. Millions of individuals and businesses manage inventory using QuickBooks as a means to simplify this monumental undertaking.

QuickBooks Online offers small businesses inventory tracking software to organise and keep track of inventory quantities, purchase orders, insights, valuation, and more. You can try this popular software free for 30-days.