What Kind of Account Is Inventory in Accounting?

Inventory represents the goods and materials a business holds for sale or for use in producing items for sale. Businesses carefully manage their inventory to ensure they have sufficient stock to meet customer demand without holding excess quantities that tie up capital.

Understanding Inventory as a Current Asset

Inventory is classified as an asset because it provides a future economic benefit to the company, meaning it can be sold to generate revenue. More specifically, inventory is considered a current asset. Current assets are those expected to be converted into cash, sold, or consumed within one year or within the company’s normal operating cycle, whichever is longer.

The expectation of converting inventory to cash within a short timeframe distinguishes it from non-current assets, such as property, plant, and equipment, which are held for long-term use. While inventory is less liquid than cash or marketable securities, it is still considered readily convertible compared to fixed assets. Inventory’s value directly contributes to a company’s total assets within the accounting equation (Assets = Liabilities + Equity).

For businesses, inventory is one of the largest components of current assets. Its proper classification and valuation are necessary for accurately representing a company’s financial health. An incorrect inventory balance can lead to misstatements of assets and owner’s equity on the balance sheet.

Categorizing Inventory by Business Type

The specific form inventory takes varies significantly depending on the nature of the business. Businesses categorize their inventory to reflect its stage in the production or sales cycle.

For retailers and wholesalers, inventory primarily consists of finished goods purchased for resale, often referred to as merchandise inventory.

Manufacturing companies have several distinct categories of inventory. Raw materials are the basic inputs used in the production process, such as lumber for furniture or fabric for clothing. Work-in-process (WIP) inventory includes goods that have begun the manufacturing process but are not yet complete, representing partially finished products. Finished goods are the completed products ready for sale to customers.

Methods for Valuing Inventory

Inventory is recorded at its cost, which includes all expenditures necessary to bring the item to its current condition and location. This cost can encompass the purchase price, freight, and other directly attributable costs. Assigning a cost to items sold and items remaining in inventory can become complex, especially when identical items are purchased at different prices over time.

To address this, businesses use inventory costing methods such as First-In, First-Out (FIFO), Last-In, First-Out (LIFO), and Weighted-Average Cost. The FIFO method assumes that the first goods purchased are the first ones sold, meaning the oldest costs are expensed as Cost of Goods Sold, and the most recent costs remain in ending inventory. Conversely, LIFO assumes that the last goods purchased are the first ones sold, so the most recent costs are expensed, and older costs remain in inventory. The Weighted-Average Cost method calculates an average cost for all available units and applies that average to both the units sold and the units remaining in inventory.

The choice of method can significantly impact the reported value of inventory on the balance sheet and the Cost of Goods Sold on the income statement. In an inflationary environment, for instance, FIFO generally results in a lower Cost of Goods Sold and a higher ending inventory value compared to LIFO, which results in a higher Cost of Goods Sold and a lower inventory value. Inventory valuation also follows the Lower of Cost or Market (LCM) rule. This rule requires that inventory be reported at the lower of its historical cost or its current market value, preventing inventory from being overstated on the balance sheet if its value declines.

How Inventory Appears on Financial Statements

Inventory is prominently displayed on a company’s balance sheet, where it is listed as a current asset. The value presented on the balance sheet represents the cost of unsold inventory at the end of an accounting period.

Beyond the balance sheet, inventory also directly impacts the income statement through the Cost of Goods Sold (COGS). When inventory items are sold, their cost is transferred from the inventory account on the balance sheet to the COGS account on the income statement. This transfer directly affects a company’s gross profit, which is calculated as sales revenue minus COGS, and subsequently impacts net income.

The flow of inventory costs from the balance sheet to the income statement illustrates the inventory cycle: goods are purchased (increasing inventory), held, and then their cost is expensed as COGS when they are sold. An increase in inventory during a period means less cost is expensed as COGS, while a decrease means more cost is recognized.