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

Inventory refers to the raw materials used by a company to produce goods, unfinished work-in-process (WIP) goods, and finished goods available for sale. The term inventory accounting encompasses several inventory bookkeeping strategies. Here are some common examples of inventory in accounting and key considerations for each approach. Consider picking online inventory management, point of sale and accounting packages that integrate. A business must document its inventory transactions by publishing inventory accounting journal entries in the accounting ledger.

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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. Inventory accounting involves accurately depicting a business’s financial health as determined by its inventory.

Inventory accounting and business strategy

RFID tags attached to inventory items transmit data to a reader, enabling automatic identification and tracking without the need for manual scanning. This technology enhances inventory accuracy, reduces labor costs, and adjusting entries can significantly speed up processes like receiving, picking, and shipping. The Weighted Average Cost method calculates the cost of inventory based on the average cost of all items available for sale during the period.

Financial Statement Presentation Example

  1. Inventory accounting helps you figure out how much inventory you have, what it cost you, and what it’s worth to your business.
  2. Finding the method that best suits your business can go a long way toward making the process easier.
  3. The sole purpose of these current assets is to sell them to customers for a profit, but just because an asset is for sale doesn’t mean that it’s considered inventory.

Inventory accounting software like Xero can help you track what’s selling and what’s not. A company’s cost of inventory is related to the company’s cost of goods sold that is reported on the company’s income statement. Manufacturers, however, must include all the of the production costs and any other cost like packaging that is necessary to make the inventory ready for sale.

Inventory Accounting: A Comprehensive Guide

The basic concept of cost layering, which involves tracking tranches of inventory costs, involves the first in, first out (FIFO) layering system and the last in, first out (LIFO) system. A different approach is the assignment of a standard cost to each inventory item, rather than a historical cost. There are two central inventory accounting systems that your business can choose to use when tracking and recording inventory finances. One way to track the performance of a business is the speed of its inventory turnover.

IAS 2 — Inventories

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. Opening inventory balance and ending inventory balance will need to be recorded on the balance sheet each period. 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. So any unsold inventory becomes an asset that must first be valued, and then included in the financial statement for the financial period.

Time Value of Money

The periodic inventory system is simple and only requires an inventory spreadsheet to keep track of sales and goods remaining in stock. Basically, a count is performed periodically throughout the year to see what was sold and what was left. Although this is a very simple way to keep track of merchandise, it has many downsides. For instance, a sandwich shop’s delivery truck is not considered inventory because it has nothing to do with the primary business of making and selling sandwiches. To a car dealership, on the other hand, this truck would be considered inventory because they are in the business of selling vehicles.

In fiscal 2022, P&G had materials and supplies (raw materials) of approximately $2.2 billion, work in process of $856 million, and finished goods of $3.9 billion. Finished goods inventory is inventory that has been completely built and is ready for immediate sale. Regardless of the inventory cost method mentioned above, finished goods inventory consists of the raw material cost, direct labor, and an allocation of overhead.

But it can lose its value fast if it gets old, out of date, damaged, or the market price for that type of product drops. Since the costs of the items purchased or produced are likely to change (especially with inflation), companies must elect a cost flow assumption for valuing its inventory and its cost of goods sold. Inventory valuation is determined by attaching a specific value to the products that remain in inventory at the end of the accounting period.

To accurately calculate and record the valued inventory each year, businesses must select one of these costing methods and stick with it. 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. 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. The main advantage of inventory accounting is to have an accurate representation of the company’s financial health.

Analysts must account for this difference when analyzing companies that use different inventory systems. There is an interplay between the inventory account and the cost of goods sold in the income statement — this is discussed in more detail below. Say Robert runs a jewelry shop and uses the LIFO costing method to manage his inventory. Later, he chooses to buy another 50 silver necklaces, but this time, the price has gone up to $30 per item. Nonetheless, the inventory’s value is directly linked to the business’s revenue and overall income. When it comes to the end of a business’ accounting period, it is somewhat unlikely that the business has sold the entirety of its inventory.

Physical counting for all the products is also a very time-consuming job that requires manual labour. Due to these reasons, many companies do not perform a physical count of their inventory frequently. Perpetual Inventory system is most commonly used by businesses such as retailers with multiple outlets etc. With the Perpetual inventory system, all your product’s stock levels are updated automatically whenever a product is received or delivered to the customer.

Collaborating with suppliers can lead to better pricing, timely deliveries, and improved inventory availability. Clear communication, data sharing, and mutually beneficial agreements can help businesses maintain optimal inventory levels and minimize supply chain disruptions. This comprehensive guide will provide you with a deep understanding of inventory accounting, its methods, and its impact on profit and taxation. One alternative is to record your inventory as an asset when you buy it, and only record the cost (along with the income) when you sell it.

It is often deemed the most illiquid of all current assets and, thus, it is excluded from the numerator in the quick ratio calculation. In accounting, inventory is considered a current asset because a company typically plans to sell the finished products within a year. Accounting is the discipline of calculating, processing and communicating financial information of businesses and individuals. Inventory accounting is the type of accounting that covers these financial operations and responsibilities of the business’ inventory, accurately depicting the assets of the company. With the perpetual inventory system, your product stock levels are always updated whenever a product is received or fulfilled to the customer.

For items that are interchangeable, IAS 2 allows the FIFO or weighted average cost formulas. [IAS 2.25] The LIFO formula, which had been allowed prior to the 2003 revision of IAS 2, is no longer allowed. Another advanced strategy is the use of demand forecasting tools that leverage historical sales data, market trends, and predictive analytics to anticipate customer demand.

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