As a business owner, inventory management isn’t just about keeping track of what’s on your shelves. It’s about ensuring that your goods and materials are included in your financial management.
Inventory accounting helps you understand the value of your goods so you can make informed decisions and achieve a healthy bottom line.
In this article, we’ll cover the basics of inventory accounting, including:
What is inventory in accounting?
Inventory refers to the goods and materials your business holds for resale or production. It includes both finished products and raw materials. Because they have value, these items need to be tracked like any other aspect of your finances.
In fact, proper inventory accounting is critical because it directly impacts your financial reports and profitability. It impacts cash flow, financial ratios, tax liabilities and more.
It also helps you ensure you have the right products in the right quantities, reducing inventory costs and preventing stock-outs that could lead to lost sales.
Whether you have an accounting team or manage your accounting as a sole proprietor, you need to accurately record your inventory on a regular basis.
So what counts as inventory?
There are 3 main types:
- Raw material: These are the basic materials used in production.
- In progress (WIP): Goods in various stages of completion of the production process.
- finished goods: Finished products ready for sale.
You need to take all of this into account to effectively manage your inventory and get an accurate picture of your business’s value.
Is inventory an asset?
An asset is anything that has the potential to provide future economic benefits to your company. Inventory fits this definition perfectly because it includes items that your company plans to sell in the normal course of business to generate revenue.
Inventory is valuable to your business. It is listed as a current asset on the balance sheet because it is expected to be converted to cash or used up within a year.
When you purchase or produce inventory, cash is tied up until the products are sold. Once sold, inventory is converted into accounts receivable or cash, contributing to your company’s sales and profitability.
It is important to note that while inventory is an asset, its value can fluctuate. Changes in market demand, technological advances, or changes in consumer preferences may affect the value of your inventory. This is why proper inventory accounting and accurate valuation methods are critical to reflect the true value of your assets.
What accounting rules apply to inventory and inventory?
To ensure that you account for inventory properly, you must adhere to certain standards. These will help you manage your finances consistently and ensure you have an accurate picture of the value of your inventory and stock.
According to United Kingdom Generally Accepted Accounting Principles (UK GAAP), these are the key guidelines for recording and reporting inventory in financial statements:
- Historical cost principle
This principle dictates that inventory should be recorded at its original cost — the amount paid to acquire or produce the goods. These costs include all costs directly associated with bringing inventory to a location and condition suitable for sale, such as: B. Purchase price, transport costs, processing fees and other directly attributable costs.
- Consistency principle
This principle requires companies to use the same inventory valuation method from one period to the next. This ensures the comparability of the annual financial statements over a longer period of time and supports stakeholders in the precise analysis of trends. Any changes in valuation methods should be well documented and explained in financial reports.
- Principle of caution (conservatism).
This principle recommends that companies exercise caution when valuing inventory. It suggests that inventory levels should not be overstated; Instead, it should be valued at the lower of acquisition cost and net realizable value. This ensures that inventory is not overstated on the balance sheet, especially when market conditions change.
- Lower value of acquisition cost or net realizable value (NRV)
In line with the prudence principle, the “lower of acquisition cost or net realizable value” (NRV) rule applies. If the net realizable value of inventories falls below their historical cost, the inventory should be written down to the lower of the two values. Net realizable value is the estimated selling price in the ordinary course of business less the estimated cost of completing and selling the inventory.
- Disclosure requirements
Under UK GAAP, companies are required to disclose in their financial statements the accounting principles and methods they use to value inventory. This transparency ensures that stakeholders understand how inventory values are determined and can assess the impact of different valuation methods.
What is UK GAAP?
UK GAAP is a set of accounting standards, principles and procedures followed by companies in the United Kingdom when preparing and presenting their financial statements. It provides a framework for financial reporting and covers areas such as revenue recognition, valuation of assets and liabilities, and presentation of financial statements.
Examples of frameworks included in UK GAAP are FRS 102, FRS 105 (for micro-enterprises) and FRS 101 (reduced disclosure framework).
Adhering to UK GAAP principles ensures accurate and transparent financial reporting, giving stakeholders a clear understanding of the value of your inventory and its impact on your company’s financial health. By following these rules, you will comply with accounting standards and be able to make informed financial decisions.
Main methods of inventory calculation
There are several ways to calculate the value of your inventory, each with different financial reporting and tax implications. Some methods are more advantageous under different economic conditions, such as when there is a period of inflation or stability.
Here are the most common methods:
First in, first out (FIFO)
FIFO assumes that the oldest items in your inventory are sold first. This method is often based on the actual flow of goods and is preferred when prices rise. This results in lower taxable income during times of inflation.
FIFO example
Imagine you run a bakery and produce and sell cupcakes in large quantities. You started the month with an inventory of 100 cupcakes that cost you £1 each. Over the course of the month you’ll bake another 100 cupcakes, but this batch will cost you £1.20 per cupcake.
When using the FIFO method, you assume that the cupcakes baked first (the oldest ones) will be the first to be sold. So if you sell 150 cupcakes during the month, your cost of goods sold (COGS) calculation would look like this:
(100 cupcakes x £1) + (50 cupcakes x £1.20) = £160
Weighted average cost method
The weighted average cost method calculates the average cost of all units in inventory. It is straightforward and useful when costs are relatively stable.
Weighted average cost example
In this example, the total cost of all cupcakes is £220 (£100 for the first batch, £120 for the second batch). From this we can calculate the average cost of the cupcakes.
Average cost per cupcake = £220 / 200 = £1.10
If you sell 150 cupcakes, your COGS calculation using the weighted average cost method would look like this:
150 cupcakes x £1.10 = £165
What is Opening and Closing Stock?
With a periodic inventory system, you can use opening and closing inventory to determine the value of inventory across multiple periods. To put it simply, the closing stock of one period is the same as the opening stock at the beginning of the next. You’re essentially just changing what you mean for future calculations.
In other words, the closing stock of period 1 is the opening stock of period 2.
How to Calculate Closing/Opening Stock:
- Determine the value of your inventory at the beginning of the current period (this is your opening inventory for Period 1).
- Add any additional purchases or shares acquired during the period.
- Subtract the value of inventory sold or used during the period.
Let’s say you run a clothing store. You started the current period with an opening inventory of clothing and materials worth £13,000. You then made additional purchases totaling £7,000 and sold products worth £12,000 over the period.
The formula would be:
Opening inventory (£13,000) + additional purchases (£7,000) – sold inventory (£12,000)
= £8,000
So your closing stock for period 1 and your opening stock for period 2 are £8,000.
By accurately tracking and calculating closing and opening inventory, you can make informed decisions about replenishment, pricing, and sales strategies. This allows you to optimize your inventory management and ensure the financial health of your business.
What is a perpetual stock system?
As the name suggests, the Perpetual Stock System is a system that allows you to continuously and automatically track the quantity and value of your inventory in real time. To do this, you need technology like barcode scanners and software that can instantly record every inventory transaction – including purchases, sales, returns and adjustments. These transactions are instantly updated in your accounting system, so your inventory records are always accurate and up to date.
This means you have real-time visibility into inventory levels, helping you make quick and informed decisions about reorders and pricing, while identifying potential issues such as theft or spoilage. It also helps you reduce inventory costs and minimize the risk of over- or understocking.
It should only be noted that a system with a perpetual inventory requires more resources and technical investments than a periodic system that uses, for example, closing and opening stocks. They are typically more suitable for companies with high inventory levels that need close control of their inventory levels.
Final thoughts
Proper inventory accounting is critical to maintaining a healthy business. It is a strategic financial practice that impacts your bottom line, your tax liabilities and the accuracy of your financial reporting.
Understanding what inventory is, how it is valued, and how opening and closing inventory is calculated will help you make informed decisions and find ways to grow your business more effectively.
FAQs
Q: What is inventory accounting?
A: The process of tracking, evaluating, and reporting the goods a company holds for resale or production to ensure accurate financial records and informed decisions.
Q: How do I calculate closing inventory?
A: Closing inventory = Opening inventory + Purchases – sold or used inventory
Q: How do I calculate opening inventory?
A: Opening Inventory = Closing Inventory + Purchases – Sold or Used Inventory.
Q: What are the advantages of the weighted average cost method?
A: The weighted average cost method is straightforward and helps smooth out cost fluctuations.
Q: Can I change the inventory method from FIFO to LIFO?
A: While this is possible, changing the inventory method can have tax implications. Therefore, consult a financial advisor before making any changes.
