What is inventory accounting?
Inventory accounting is the process of tracking inventory, assigning value to it, and recording it in the company's financial statements throughout its lifecycle – from purchase to sale.
Inventory accounting allows a business to understand the true cost of its goods, helping it make informed pricing decisions. It also supports effective cash flow management by making sure that capital is not unnecessarily trapped in surplus stock.
A primary purpose of inventory accounting is to ensure that financial statements accurately reflect the value of inventory – as a current asset on the balance sheet and, when sold, as the cost of goods sold (COGS) on the income statement. Because inventory values can change due to factors such as damage, shrinkage, decline in market value, or obsolescence, inventory accounting helps prevent companies from overstating or understating their assets and profitability in financial reports.
Types of inventory
Inventory generally falls under three main categories:
- Raw materials: These are the basic components that go into manufacturing goods. For example, steel for making nuts and bolts
- Work in progress: These include partially finished goods that are not yet ready to be sold, such as furniture that is yet to be assembled
- Finished goods: These are goods that are ready to be sold, such as completed and assembled furniture or nuts and bolts that are ready to be shipped
When dealing with various types of stock, inventory accounting teams may sometimes create sub-categories to simplify tracking. Common sub-categories include:
- In-transit inventory, or inventory that has left the supplier but is yet to reach the buyer
- Anticipation inventory, or surplus stock kept in anticipation of a future increase in demand
- Buffer inventory, or extra stock for absorbing unexpected fluctuations in demand or supply
- Obsolete inventory, or stock that is no longer selling
Why inventory accounting matters
Effective inventory accounting has numerous benefits, from informed decision-making to reliable financial reporting:
Accurate pricing strategies
Businesses can use inventory accounting to set competitive prices based on actual data rather than guesswork.
Improved cash flow management
Inventory accounting ensures companies avoid overstocking and the additional storage costs associated with it, thereby improving cash flow management. At the same time, it helps prevent stock-outs that can lead to lost sales and empowers businesses to focus on their best-selling products. By achieving inventory balance, businesses can optimise revenue generation and cash flow.
Reliable financial reporting
Inventory accounting is essential for ensuring that balance sheets and income statements reflect the true value of inventory and accurate profit margins, respectively. Accurate financial reporting not only offers stakeholders a true picture of a company's financial health but is a regulatory requirement as well. Depending on the jurisdiction, inventory accounting must comply with applicable standards such as the International Financial Reporting Standards (IFRS), the Singapore Financial Reporting Standards (SFRS) that is aligned with the IFRS, and the US Generally Accepted Accounting Principles (GAAP¹).
Tax compliance
Calculation of COGS is an important component of inventory accounting. And COGS directly impacts taxable income. Accurate inventory accounting helps businesses make correct tax reporting and avoid fines, penalties, or action from tax authorities.
Enhanced decision-making
Inventory accounting data and insights support informed decision-making in procurement, production, and sales. They help businesses plan stock replenishment, improve demand forecasting, and schedule production more effectively. As a result, companies gain greater agility to respond to market changes and capitalise on emerging opportunities.
How inventory accounting works
Inventory accounting comprises three core functions – tracking, valuation, and record-keeping. Each has its own methodologies, which are explained below:
Inventory tracking
There are two methods used to track inventory – the periodic and perpetual systems.
Periodic inventory system
A periodic inventory system updates inventory records at regular intervals, say every month or quarter. A physical count is conducted and based on the results, cost of goods sold is calculated using the formula:
Beginning inventory + purchases - ending inventory = cost of goods sold
Here, beginning inventory is stock value at the beginning of the accounting period, purchases refers to the value of all purchases made during that period, ending inventory is stock value at the end of the accounting period, and cost of goods sold is the direct cost of buying or manufacturing inventory that a company sells. After calculation, cost of goods sold is recorded as an expense on the income statement.
The periodic inventory system is simple and inexpensive. However, its drawback is that it does not provide day-to-day inventory positions.
Perpetual inventory system
In contrast, in a perpetual inventory system, inventory is updated every time an item is purchased or sold. The cost of goods sold is, therefore, calculated in actual time, giving businesses real-time visibility into inventory position without the need for a physical count. However, the perpetual system requires the use of inventory management software.
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Inventory valuation
Besides inventory tracking, inventory valuation is another key component of the inventory accounting process. It determines the value of inventory and is also used to calculate the cost of goods sold. There are 4 inventory valuation methods:
First in first out (FIFO)
The most widely used method, it works on the assumption that items produced or purchased the earliest are sold first. First in first out (FIFO) is widely regarded as the most intuitive inventory valuation method as it most closely reflects the actual cost of inventory.
This method usually results in a lower COGS and higher gross income because the oldest inventory is usually cheaper than newer stock, which may have been subject to a rise in material prices and other costs. One disadvantage of this method is that a higher gross income can lead to a higher taxable income amount.
Last in first out (LIFO)
Under the last in first out (LIFO) method, the newest inventory is sold first. Based on the assumption that new inventory is more expensive than older stock, the LIFO method results in a higher COGS and lower gross income. It is useful for keeping taxable income low during periods of high inflation. However, the advantage is temporary. When the remaining lower-cost inventory is eventually sold, the company will report a lower COGS and higher gross income, leading to a higher tax bill.
Weighted average cost (WAC)
The weighted average cost (WAC) method calculates average inventory cost by dividing the total cost of goods available for sale by the total number of units available for sale. Also known as cost averaging, it is particularly useful for businesses that sell large quantities of identical items. It is simple to implement and smooths out the effects of price fluctuations by averaging inventory costs, resulting in more stable COGS and gross profit across accounting periods. However, this is also its main drawback. Because it averages costs, the WAC method can obscure the true impact of changing prices on inventory.
Specific identification
This method tracks each item of inventory from purchase to sale and assigns cost individually instead of grouping them together on the basis of time or cost. It is especially useful for businesses selling high-value, one-of-a-kind commodities. Specific identification results in the most accurate COGS figure but also requires detailed record-keeping.
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Absorption costing vs variable costing in inventory accounting
Before applying an inventory valuation method to calculate cost of goods sold, businesses must first determine the production cost of each inventory item. This is done using either absorption costing or variable costing.
Absorption costing assigns all manufacturing costs, fixed and variable, to each unit of inventory. It is also called full costing. In contrast, variable costing – also called direct costing – only assigns variable manufacturing costs to each unit.
Absorption costing includes costs such as direct materials, direct labour, and fixed overheads while variable costing doesn't account for fixed overheads.
A primary difference between the two methods is that absorption costing is required for external financial reporting under IFRS whereas variable costing is used primarily for internal decision-making and is not permitted for preparing financial statements.
How journal entries are made in inventory accounting
After tracking and valuation, the third step in inventory accounting is recording, which involves making journal entries for each inventory transaction using the double-entry system.
Here's how journal entries are recording at various stages of the inventory lifecycle:
- Purchase: The inventory is recorded as a debit in the inventory account and a credit in the cash account (or accounts payable, if bought on credit)
- Sale: This requires 2 entries. First, revenue from the sale is recorded as a debit in the cash account (or accounts receivable) and a credit in revenue. Next, the item's cost is recorded as a debit in cost of goods sold and a credit in inventory
- Return: If a customer returns an item, it is recorded as a debit in sales returns and a credit in accounts receivable, followed by a debit in inventory and a credit in COGS
- Adjustment: When inventory is updated, that also requires a journal entry. For example, if inventory has shrunk and is now at a lower level than what the company records show, it must be recorded as a credit in inventory and a debit in inventory shrinkage expense or COGS. Similarly, for an inventory write-off (due to stock losing value or becoming unsellable), it is recorded as a credit in inventory and a debit in inventory write-off
Inventory accounting best practices
- Select the inventory valuation method that aligns with your inventory type, industry standards, and other business needs. Once selected, apply this method across all accounting periods to ensure uniformity and consistency in your financial statements
- Conduct regular physical counts of your inventory even if you use inventory accounting software. Manual counting can back up your digital records and catch inventory shrinkages your automated system may have missed. Physical counting also allows you to perform rolling counts of specific stock sub-sets – for example, weekly counts for fast moving items or monthly counts for low-value stock
- Track key performance metrics, such as inventory turnover ratio (COGS / average inventory) and days inventory outstanding ([average inventory / COGS] x 365). A high inventory turnover ratio usually signals strong sales and effective inventory management while a low ratio is indicative of slow sales or surplus stock. Similarly, the lower a company's days inventory outstanding, the faster it is converting stocks into sales
Get the Aspire advantage
Yet another way to optimise inventory accounting is by leveraging digital tools and automation that improve data accuracy, have real-time tracking and reconciliation capabilities, and offer accounting integrations to sync records across systems and close books faster.
Aspire offers a range of products, including expense management tools, multi-currency business accounts, and corporate cards, to help businesses improve visibility and control over cash flows related to inventory purchases and supplier payments. These capabilities support real-time expense tracking, align inventory-related transactions with accounting records, and help reduce manual bookkeeping errors.
Conclusion
Effective inventory accounting plays a critical role in how a business assigns value to stock and manages it while ensuring that its financial statements reflect the true worth of its assets. By selecting appropriate inventory tracking and valuation methods, adhering to relevant accounting standards, and leveraging technology to streamline processes, businesses can turn inventory data into a powerful driver of strategic decision-making and business performance.
FAQs
What are the types of inventory?
Inventory can be broadly classified into raw materials, works in progress, and finished goods.
What are the 4 methods of inventory valuation?
The 4 valuation methods for calculating cost of goods sold are:
- First in first out (FIFO), which assumes that the oldest inventory is sold first
- Last in first out (LIFO), which assumes that newest stock is sold first
- Weighted average cost (WAC), which assigns the same average cost to all stock items
- Specific identification, which assigns actual cost to each unit of inventory
How is inventory shown on a balance sheet?
Inventory is classified as a current asset on a balance sheet and is typically placed in the upper section, right after cash and accounts receivable.
Which is better, FIFO or LIFO?
The answer depends on a business' inventory type and other unique needs. First in first out (FIFO) suits businesses that need to sell their oldest inventory first (example, perishables, smartphones, healthcare products). Meanwhile, businesses looking to keep taxable income low during periods of high inflation may opt for LIFO, which results in a higher cost of goods sold and lower gross income that lowers the tax burden.
What is a journal entry for inventory?
Businesses are required to make journal entries for each inventory-related transaction – such as purchase, sale, and return – in the relevant assets, expense, and liabilities accounts using the double-entry accounting method.
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