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

Accounting and inventory may seem like two separate yet critical components of any business, but they are linked. Accounting for inventory by calculating inventory in accounting terms is a specific and single part of a business’s success. 

Whereas 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 the type of accounting that covers these financial operations and responsibilities of the business’s inventory, accurately depicting the assets of the company.

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. It must cover both sold and unsold products as they come and go from the inventory and the bookkeeping records.

How Does Inventory Accounting Work?

Inventory accounting involves accurately depicting a business’s financial health as determined by its inventory. There are many variables that inventory accounting deals with, from the movement of the stock, daily fluctuations in quantity, ageing inventory and deadstock, and so on.

Companies will need to choose a specific inventory accounting system and method of cost valuation and 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 the perpetual system, tracking when a product comes into or leaves the inventory account. In contrast, the periodic inventory system tracks inventory by periodically checking the inventory with a physical count to measure the stock and cost of goods sold.

Cost of goods sold (COGS)

The cost of goods sold, also known as COGS, refers to all costs associated with a business’s production process, such as the raw materials needed to manufacture those goods. It is the value of all inventory goods sold within a given period.

How is Inventory Classified in Accounting?

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 inventory balance and ending inventory balance will need to be recorded on the balance sheet each period.

Do I have to report inventory?

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

Does inventory count as income?

Inventory as an entity does not count directly as income on a person’s income statement. Nonetheless, the inventory’s value is directly linked to the business’s revenue and overall income. Therefore, the stock itself is not income, but the value of the inventory is required for determining income.

What Are The Main Inventory Costing Methods?

There are three main methods of inventory valuation that companies can choose to 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 stick with it.

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

FIFO Method

The FIFO method, known as 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 stock to be sold, even if it is 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. As a result, the calculations for an inventory’s cost of goods sold will reflect the movement and value of the goods. This inventory accounting method is one most often used by businesses, especially ones with perishable inventories.

FIFO Example

Suppose Mary owns a kitchenware store and follows the FIFO accounting method of inventory costing. She will need to assign costs to her inventory based on the goods purchased first for her retail business.

For example, 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 are sold, the next 50 glasses are set at the $16 value, no matter the additional inventory 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 purchased goods.

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

LIFO Example

Say Robert runs a jewelry shop and uses the LIFO costing method to manage his inventory. Suppose 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. Following the last-in, first-out method, the first 50 necklaces 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 utterly different from 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 throughout a given time, then 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

Suppose Lisa runs a beauty store and decides to purchase lipstick to sell to customers. She opts to buy 40 lipsticks at the beginning of the year for $10 each. Halfway through the year, she decides to order a further 30 at $15, and then another 20 lipsticks at $20 each at the end of the year. Lisa’s stock 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, so she, therefore, sold 15 lipsticks at $13.89, for a total of $208.35.

Why Is Inventory Accounting Important?

Part of running a professional business ensures all government and industry-specific laws and regulations are followed as necessary. 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 will result in fines and penalties and possible incarceration.

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

Many business owners look to accounting software to help them track and calculate financial information- this also includes 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! Try this popular software as a free trial today!