written by | May 13, 2022

What is Inventory Accounting? A Comprehensive Guide

The inventory of a business includes all its goods available for sale to customers during the business process. Inventory is considered a current asset as they typically are sold within a year or during the operating cycle of a business. Additionally, inventories are the most valuable asset for retailers in general.

Accounting for inventory is the method of recording and tracking inventory costs. Costs for inventory refer to the total cost necessary to purchase goods. It includes the actual transportation expenses, product costs, etc. A proper inventory accounting system allows companies to show their net earnings precisely. 

To do this, accountants should use proper methods to measure the inventor. Inaccurate numbers or values for inventory could make a company appear more successful than it is. It may further make a company appear more profitable on its accounts.

Did You Know?

The three kinds of inventory comprise working-in-progress, raw materials and complete products. There are 3 ways to value inventory. These are:

  • First-in, first-out technique.
  • Last-in, first-out technique.
  • Weighted average method.

What is Inventory Definition Accounting?

Inventory refers to the items your business can offer for sale or storage. The inventory of your small business includes the following:

  • Raw materials are required to create finished products.
  • Products that are part of the manufacturing process.
  • Complete products.

Small business inventory is a type of asset. A property is something that provides value to your company. Keep track of inventory as an asset in the current position on your balance report. Current assets are those that you can convert into cash within a year.

You must record the proceeds in your earnings statement if you sell your inventory. Also, you must calculate the cost of the goods you sell (COGS) and then record the amount on your earnings statement. COGS refers to the amount it takes to make your products. It may include buying inventory, transforming raw materials into goods you sell, etc. 

Also Read: Different Inventory Valuation Methods: What Are They?

Inventory for Manufacturers

Manufacturers generally have three categories of inventory, which reflect different stages of the manufacturing process.

  1. Raw materials: The compulsory items for the manufacturing companies to make products.
  2. Work in process: Half-ready goods.
  3. Final goods: Products that are ready for sale to buyers.

The categories may differ between manufacturers. For instance, the finished product of a seller could be a buyer's raw materials. Likewise, although many manufacturers deal with the work in process, it isn't required for companies with shorter production cycles. 

Also, if you’ll be starting a business shortly, we suggest you give it some thought before jumping indirectly. For example, write your business plan and analyse a few more techniques to be fail-safe.

Inventory Accounting Method is Available to Retailers

For companies that do not have an established production system, It is not mandatory to categorise inventory. This is typically the case for retailers, distributors, or wholesalers who purchase finished products to sell to other parties at a premium cost. 

The inventory that is made up entirely of goods that have been finished is known as merchandise.

The primary difference between inventory for merchandise and manufacturing inventory is that the merchandise inventory has already gone through manufacturing before it reaches the retailer or merchant while manufacturing inventory needs more processing.

Merchants can deal with assembly or even delivery or small-scale packaging. These tasks don't come under 'manufacturing'.

What is the Value of Inventory?

Inventory valuation is a method of accounting that companies use to determine the worth of inventory stocks that are not sold as they prepare their annual financial reports. Inventory stocks are an asset to an organisation. To be recorded in the balance account, it must be valued financially. This number can help you determine the ratio of your inventory turnover. In turn, it assists you in planning your purchases.

What is the Significance of Inventory Valuation?

Recognising the unsold items is just one aspect of the valuation of inventory. It is also necessary to estimate the rate you will divide by the number to get an end-to-end value. You might have paid various rates for these products throughout the year. Hence, you must select a method to calculate an average price.

What are the Contents of Inventory Accounting?

The most important elements of inventory accounting include:

Costs of Inventory for Retailers

The direct cost of inventory for retailers comprises purchasing the item besides the expenses compulsory to make the product that is ready to sell, including shipping and sales taxes. Gross profit is the difference between the price of a sale and the price of a product. Keeping the lower price of the product sold compared to the selling price is an old indicator of the strength of a business.

Costs of Manufacturing Inventory

For any business that manufactures its products, the direct costs are counted as direct materials costs. It includes raw manufacturing overhead, materials and direct labour costs such as salaries of staff members responsible for manufacturing the product. 

Manufacturing overheads refer to costs incurred during production. However, they directly relate to direct material and labour. Examples of manufacturing overhead are salaries for factory managers and the materials needed to maintain machinery and electrical power for machines.

What Are the Objectives of Inventory Valuation?

Inventory is the term used to describe products intended for sale or items that are not sold. Manufacturing comprises raw material, intermediate and finished products. Inventory valuation is carried out at the end of each financial year to determine the value of the products sold and the value of unsold inventory.

This is vital since excessive or insufficient inventory can affect the profitability and production of a company.

Consider Your Gross Income

With inventory, you can calculate your exact gross profit or the surplus of sales more than the cost of the goods sold. To calculate the gross profit or any other profits from trading, the value of goods sold is then matched to the revenues for the period of accounting.

Cost of the goods that are sold: Opening stocks x purchases Closing stock

The equation above indicates how the inventory value can affect the expenses and, consequently, your gross profits. For instance, if the inventory at the end of the year is undervalued, this will increase the year's profit and decrease profits in subsequent years.

Find the Liquidity Position

The stock that is closed is reported as an asset that is in the current position. The final stock's value in the Sheet of Balancing will identify your company's financial position. Incorrect or overvalued stock can provide an inaccurate position of capital and the entire financial situation.

Methods to Evaluate the Inventory

The valuing of inventory is contingent on how the company manages the inventory over time. An organisation must evaluate inventories at cost. Since inventory is always replenished and sold, and its cost is always shifting, the company should make an expense flow estimation that it is likely to often use.

Specific Identification

With this technique, every product in the inventory will be monitored from the moment it's stocked until it is eventually sold. It is generally employed for huge items that are easily identifiable and feature a wide range of functions and prices connected with these options.

The most important requirement for this approach is to track every product individually using RFID tags, the date of receipt, stamped or serial number. Although this method brings an extremely high level of precision to the estimation of inventory, it can only be used for valuable, scarce products for which distinction is required.

Also Read: Everything You Need to Know about Inventory Costing Methods

First-In & First-Out (FIFO)

First-in, first-out is a valuation technique in which the assets acquired or produced are first used, disposed of, or sold off.

Businesses highly use this method of valuing business inventory. Unfortunately, this method doesn't accurately represent expenses in cases of sudden price spikes. 

Last-In, First-Out (LIFO)

In this method, we assume the inventory with the latest value is the first one with the highest selling chances, leaving behind the older inventory. There are scarce sales of the old inventory, so very few businesses use this method to value inventory. Businesses face significant losses due to that.

Conclusion

The concept of valuation of inventory may seem complicated initially. But once we break it down into smaller pieces and explain each method, it becomes a lot easier. 

This is precisely what we set out to achieve in this piece. Whether you're an established business owner or an aspiring business owner, you must be aware of the importance of inventory valuation since inventory is an integral component in the category of assets on your balance statement. 

Understanding the importance of inventory valuation will allow you to meet your growth goals for your business and get the most out of the current market conditions. 

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FAQs

Q: What is an inventory accounting entry?

Ans:

An inventory accounting entry is a record in one's accounting ledger that assists in tracking inventory transactions.

Q: What are various types of inventory accounting?

Ans:

There are mainly two types of inventory accounting systems:

  • Periodic system
  • Perpetual system

Q: What is inventory accounting standard 2?

Ans:

Accounting Standard 2 deals with the inventories' accounting treatment by the business entities. AS2 offers details regarding the items that make an inventory and numerous costs related to such an inventory.

Q: How can I understand inventory meaning in accounting?

Ans:

The term "inventory" refers to listing or counting items. In accounting, inventory is a current asset covering all stock in all production stages.

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