What Is Inventory Accounting and How Does It Work?

Inventory accounting is the systematic process of valuing and recording a company’s goods held for sale. This area of accounting ensures businesses accurately track the costs associated with acquiring or producing their inventory. It is important for businesses to maintain financial health, make informed decisions, control costs, and manage cash flow. Proper inventory accounting influences financial statements, profitability, regulatory compliance, and transparent financial reporting.

Understanding Inventory Accounting Fundamentals

Inventory refers to goods a company holds for sale, including raw materials, work-in-progress, and finished goods. It is a current asset on a company’s balance sheet, reflecting the value of goods available for sale. On the income statement, inventory is a component of the Cost of Goods Sold (COGS), which is the direct cost of producing goods sold.

The relationship between inventory and COGS is: Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold. Beginning inventory is goods on hand at the start of a period, purchases are new inventory costs acquired, and ending inventory is the value of goods remaining. Accurately calculating COGS directly affects a company’s gross profit and net income. Misstated inventory values can lead to inaccurate profitability representation.

Common Inventory Costing Methods

Businesses use different costing methods to determine the value of inventory and the Cost of Goods Sold. These methods are assumptions about which inventory items are sold first. The choice of method can significantly impact reported profits and asset values, especially during periods of changing costs.

The First-In, First-Out (FIFO) method assumes that the first goods purchased or produced are the first ones sold. This approach aligns with the natural flow of many businesses, particularly those dealing with perishable goods or items with expiration dates. Under FIFO, the oldest costs are matched against current revenues to determine COGS, leaving the most recent costs in ending inventory. During periods of rising costs, FIFO generally results in a lower Cost of Goods Sold, leading to higher reported net income and inventory value. Conversely, during periods of falling costs, FIFO results in a higher COGS and lower reported net income.

The Last-In, First-Out (LIFO) method assumes that the most recently purchased or produced goods are the first ones sold. This method is not permitted under International Financial Reporting Standards (IFRS) due to concerns about potential distortions in financial reporting and outdated inventory valuations. However, it is allowed under U.S. Generally Accepted Accounting Principles (GAAP). In an environment of rising costs, LIFO results in a higher Cost of Goods Sold, leading to a lower reported net income and potentially lower tax liabilities. During periods of falling costs, LIFO results in a lower COGS and higher reported net income.

The Weighted-Average method calculates the average cost of all available inventory for sale. This average cost is then applied to both the Cost of Goods Sold and the ending inventory. This method smooths out price fluctuations, as it does not assume a specific flow of goods. It is suitable for businesses with large quantities of identical items.

To calculate the weighted-average cost per unit, the total cost of goods available for sale is divided by the total number of units available. This average cost is then multiplied by the number of units sold to determine COGS and by the number of units remaining to determine ending inventory.

Valuing Inventory on Financial Statements

Businesses must value inventory on their financial statements, considering its current market worth. Accounting principles emphasize conservatism, meaning assets should not be overstated and potential losses recognized promptly. This leads to rules like the Lower of Cost or Net Realizable Value (LCNRV).

The Lower of Cost or Net Realizable Value (LCNRV) rule requires inventory to be reported at the lower of its historical cost or its net realizable value. Net realizable value (NRV) is the estimated selling price minus any costs to complete, dispose of, and transport the inventory. This rule ensures that if inventory value declines below its original cost, the loss is recognized.

Inventory may need to be written down if its market value falls below its cost due to obsolescence, damage, or a decline in market demand. For example, if a product becomes outdated, its selling price may drop significantly, necessitating a write-down. This adjustment prevents the overstatement of assets on the balance sheet.

An inventory write-down impacts both the balance sheet and the income statement. On the balance sheet, inventory value is reduced, decreasing total assets. On the income statement, the write-down is typically treated as an expense, often increasing the Cost of Goods Sold or recognized as a separate loss. This reduces net income and retained earnings.

Inventory Tracking Systems

Businesses use two main systems to track inventory: perpetual and periodic. Each system has different implications for how inventory records are maintained and updated. The choice depends on the business’s size, inventory volume and value, and need for real-time information.

A perpetual inventory system continuously updates inventory records with every purchase and sale. This system provides real-time data on inventory levels, Cost of Goods Sold, and available stock. It relies on technology such as point-of-sale (POS) systems, barcode scanners, and integrated software that automatically records transactions.

Advantages include greater accuracy, real-time insights, and immediate COGS calculation. This allows timely reordering, reduced stockouts, and close monitoring of product profitability. It is beneficial for companies with high-value items or those requiring constant stock visibility.

In contrast, a periodic inventory system updates records only at the end of an accounting period. This system requires a physical count to determine ending inventory balance and calculate Cost of Goods Sold. Purchases are recorded in a separate account throughout the period.

The periodic system is simpler and more cost-effective, suitable for small businesses or those with low-value, high-volume items where continuous tracking is not practical. However, it does not provide real-time inventory information, and COGS is only determined after the physical count, meaning data is not current between counting periods.