Understanding The Basics of Inventory Accounting (A Guide For Small Business)

The goal of any business is to make a profit…usually, as much as possible. To do that, you have to generate revenue. And to do that, you have to move some inventory.

This post will help you understand how your inventory accounting impacts your business so you can track it correctly and have an accurate picture of your company’s financial health. So if you’re in the business of selling things (even if you’re in a strictly service-based business with no “inventory” at all), read on.

Inventory Accounting

Because your inventory has value, it needs to be reflected in your accounting. As you keep track of your assets and liabilities to determine the financial health of your business, don’t fail to overlook how much inventory on hand can have an impact on your numbers.

Inventory accounting is the aspect of your overall accounting process that focuses on the ever-changing values of the physical goods you have on hand that make running your company possible. Investopedia has a good article defining inventory accounting that breaks inventory down into 3 stages of production.

1. Raw goods – your stockpile of materials needed to make widgets
2. In-progress goods – widgets in various stages of completion
3. Finished goods – widgets ready for sale

They go on to explain how at any given time, the value of your inventory in any of those 3 categories can fluctuate. This is based on several factors.

• Deterioration
• Obsolescence
• Customer preferences
• Supply
• Market prices

And values can change quickly. You may have a large supply of something that the world ordinarily considers unimportant (e.g. fidget spinners—once the fad was over, the price markdown wasn’t far behind.). 

The takeaway is that you should be aware of possible changes in inventory value whenever it is influenced by any of those factors (and many more) so that you always have a reliable picture of what your company is worth. 

Accounting for inventory and understanding how it can reveal various risks associated with your business (shrinkage, spoilage, obsolescence) is an important part of running a successful company.

Is Cost of Goods Sold An Asset?

We just mentioned that raw materials used in making things are a category of inventory you might have. Sometimes people are confused about where to record the value of those materials on their balance sheet. And that’s understandable. Is it an asset or an expense?

Inventory on hand has value. Therefore it is considered an asset of your company. It gets reflected as such on your balance sheet.

However, using raw materials to create other products that you then sell to your customers is considered a Cost of Goods Sold (COGS), which is considered an expense. Once you sell a finished product to your customer, what was once an asset becomes a COGS expense.

For further reading, take a look at a couple of articles that will help you understand COGS even better.

• “Cost of Goods Sold” by Accountingtools.com
• And this post we wrote a while back, “When Does Inventory Cost Become An Expense?”

Cost of Goods Sold Journal Entry

So how do you record the Cost of Goods Sold as a journal entry? The folks at accountingtools.com have a helpful checklist. They break it down into 7 steps:

1. Beginning Inventory Balance – Start with an accurate inventory valuation at the beginning of the period in question.
2. Add Inventory Purchase Costs – As the period goes on, record any additional inventory you purchase as those invoices come in. Be sure to either enter them into a single account for all purchases or in the appropriate inventory categories if you have them broken down that way.
3. Add Overhead Costs – Be sure to include expenses related to transporting, storing, moving, and managing your inventory.
4. Do a Physical Count – At the end of the period, physically count and record all of your on-hand inventory. Your company may regularly use some sort of perpetual inventory system that tracks your inventory numbers in real time as they move in and out of your business. If so, simply record the most up-to-date numbers at the end of the recording period you’re working on.
5. Calculate the Cost of Ending Inventory –  This step can be complicated. You’ll want to have your accountant double-check things here because there are several ways to do this.
   1. FIFO – (First In, First Out) This is probably the most common method of inventory management since it prevents inventory items from “aging” too much before they are used. The easiest way to picture it is to imagine a restaurant. If they purchase milk, for example, they want to use the oldest gallon on hand before the one they just purchased since it runs the risk of spoiling soon.
      
      Because costs are calculated based on the value of older items (which may have been purchased at a cheaper price, thanks to inflation) COGS using FIFO may be lower than current costs.
      
   2. LIFO – (Last In, First Out) Imagine, in this situation, a retail store shelf where employees replenish items by placing new stock in front of unsold products. When customers come along, they pick the item at the front and move on. If the shelf is restocked often enough, the oldest item in the back might not be sold for a very long time.
      
      LIFO has been banned under the International Financial Reporting Standards (IFRS) but is still allowed in the U.S. under our Generally Accepted Accounting Principles (GAAP) rules. IFRS did away with it to prevent companies from potentially distorting their profitability…understating the value of their inventory to keep taxable income low.
      
   3. Weighted Average – With this method, owners take an average of the oldest and newest units of inventory to arrive at a figure that best represents the entire lot. This is usually helpful when it may be difficult to separate individual units or accurately apply FIFO or LIFO.
      
6. Determine COGS – Use the beginning inventory value and subtract the cost of your ending inventory. This is your COGS. If you use several inventory accounts, simply combine all of those beginning inventory values before subtracting ending costs.
   
7. Record COGS as a Journal Entry

Inventory On The Balance Sheet

Since inventory is an asset, it should be listed at the top of your balance sheet along with other current assets. It’s not as liquid as cash, but more easily sold than long-term assets like land or commercial property. 

We Know Accounting For Inventory

Accounting for inventory and understanding how it can reveal various risks associated with your business (shrinkage, spoilage, obsolescence) is an important part of running a successful company. We’ve been doing this for a long time and would love to help make it easier for you.To find out how our team of accounting experts can simplify your inventory accounting (and lots of other aspects of running a business), schedule a call today!

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