Inventory Accounting – Free Guide for Accountants & Advisors
Welcome to the Unleashed Inventory Accounting Guide – a free series covering practical inventory management and inventory accounting methods.
What is inventory accounting?
Inventory accounting is the practice of valuing and reporting on the physical inventory a business holds. It’s a critical role, with products and components often accounting for the greatest capital outlay in a business.
Inventory accounting involves both the day-to-day management of the Accounts Payable, Accounts Receivable and Cost of Goods accounts – but also the periodic reporting that’s so important for things like taking out the right levels of insurance, paying taxes and duties, and even valuing a firm for purchase or sale.
Inventory accounting and business strategy
Inventory accounting also has a strategic function. Key inventory metrics – including the inventory turnover ratio, supplier lead times, the landed cost of goods sold, and profit margin by SKU – are all used to guide the overall strategy of an effective product business.
A strong grasp of the fundamentals of inventory management is therefore critical for financial professionals within those product-based companies – and for business advisors with manufacturing, wholesale or retail clients.
- Learn more: What are the types of inventory cost?
Inventory costing methods explained
Here we look at the Lifo, Fifo and Weighted Average Cost methods – and the pros and cons of each
In inventory accounting we need to choose a method of costing our inventory.
With the Lifo method not accepted under the Generally Accepted Accounting Practices (GAAP) or the International Financial Reporting Standards (IFRS), we’re left to choose between the Fifo and Weighted Average methods.
In this video we look at the pros and cons of each in terms of accuracy, margin reporting and the admin time required.
Accounting for stock discrepancies
A reliable stocktaking procedure allows businesses to know its inventory count and value, not only informing decision-makers and driving operations.
It also ensures accurate information is available to accountants, auditors and financial controllers who prepare annual reports, balance sheets and essential statements of earnings.
A stock take discrepancy occurs if the actual quantity of stock held by a business is different from the quantity shown in its inventory records.
Such differences between actual and mistaken stock counts can present a real problem for businesses, potentially costing the bottom-line in lost sales, build-up of surplus stock, and customer dissatisfaction.
Discrepancies revealed by a company’s stock taking procedure also have a direct effect on how a company values itself and its assets.
Stocktake discrepancies can occur for a number reasons, including damage, human error, or theft and fraud.
It’s important a company implements a stocktaking procedure whereby it regularly – and especially when a specific discrepancy has been identified – reconciles its inventory, comparing stock counts in its records to the actual amounts of stock held on warehouse shelves.
This will allow the company to work out why there is a difference between the believed and actual stock count, preventing future discrepancies of the same nature, and to make amendments to the records to reflect the accurate figures.
Why reconciliation is important
Accurate inventory records provide for efficient operations and allow accountants to correctly value a company’s inventory property.
Income statements, statements of retained earnings and balance sheets are financial documents essential to a company’s operations, and sometimes even required by law. They can only be prepared properly if inventory is valued accurately.
An example of how reconciliation affects finances:
- If inventory is overstated, the COGS value is lowered.
- If inventory is understated, COGS value is artificially increased.
A mistaken inventory count can make it look as though a company has done more or less business than it actually has, affecting both its current and future overall valuation.
Inventory accounting best practices
Although the basics of inventory control come naturally to many businesses, accurately tracking and recording inventory costs can be a real challenge. Let’s look at some of the best practices when it comes to inventory accounting.
1. Use the right measure
If an item’s cost changes while a business holds some inventory of that item, accountants must use a ‘cost flow assumption’ to work out which cost to report – the cost of purchasing the first units, or the cost of the most recently purchased.
Using the wrong cost flow assumption could distort your financial and tax reporting. It could also mean that your accounts do not comply with accounting standards and tax law.
2. Perpetually value inventory
Valuing your business’ stock at the start and end of a month can be difficult. Staff often fail to keep up with inventory paperwork, so it can be difficult to use sales or production records to determine how much inventory is in stock.
By perpetually tracking inventory, online inventory management software makes it easy to keep track of the cost of goods sold. Every transaction updates the cost of goods sold, whether you use the LIFO, FIFO or average landed cost method.
3. Calculate then recost
Working out landed costs is challenging; although your suppliers and customs brokers invoice you promptly, transport providers regularly take several weeks to send you a bill.
This creates a practical difficulty for accountants – is it better to estimate costs and risk getting them wrong, or to wait until you have all of the information?
A sensible approach is to determine landed costs as soon as possible on the basis of all the available information. This involves using actual supplier and broker charges and an estimate of shipping costs based on previous charges.
4. Pick the right tools
Many businesses use Excel spreadsheets to keep track of their inventory and accounts. Although Excel is a powerful business analysis tool, it can be error prone and is time consuming to use. Excel also makes it difficult to perpetually value inventory.
Consider picking online inventory management, point of sale and accounting packages that integrate.