How to Account for Inventory

The accounting for inventory involves determining the correct unit counts comprising ending inventory, and then assigning a value to those units. The resulting costs are then used to record an ending inventory value, as well as to calculate the cost of goods sold for the reporting period. These basic inventory accounting activities are expanded upon below.

Determine Ending Unit Counts

A company may use either a periodic inventory system or perpetual inventory system to maintain its inventory records. A periodic system relies upon a physical count to determine the ending inventory balance, while a perpetual system uses constant updates of the inventory records to arrive at the same goal.

Improve Record Accuracy

If a company uses the perpetual inventory system to arrive at ending inventory balances, the accuracy of the transactions is paramount. Accuracy levels can be improved by conducting cycle counts; these are ongoing daily counts of a small portion of the total inventory. Over time, cycle counts can dramatically improve the accuracy of inventory records.

Conduct Physical Counts

If a company uses the periodic inventory system to create ending inventory balances, the physical count must be conducted correctly. This involves the completion of a specific series of activities to improve the odds of counting all inventory items. A key element of these counts is to only use experienced people, such as the warehouse staff. Having the administrative staff conduct physical counts can actually reduce the accuracy of the inventory counts, since they do not have enough knowledge about the nature of the inventory.

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Estimate Ending Inventory

There may be situations where it is not possible to conduct a physical count to arrive at the ending inventory balance. If so, the gross profit method or the retail inventory method can be used to derive an approximate ending balance. It must be emphasized that these methods yield only approximate results, and will likely need to be supplemented by an actual physical count from time to time.

Assign Costs to Inventory

The main role of the accountant on a monthly basis is assigning costs to ending inventory unit counts. The basic concept of cost layering, which involves tracking tranches of inventory costs, involves the first in, first out (FIFO) layering system and the last in, first out (LIFO) system. The specific identification method may also be used. A brief summary of these methods follows:

First in, first out method. This method is an inventory valuation technique where the oldest inventory items purchased or produced are assumed to be sold first. This means that the cost of goods sold is based on the cost of the earliest inventory, while the remaining inventory on hand reflects the most recent purchase costs. FIFO is commonly used during periods of rising prices, as it typically results in a lower cost of goods sold and higher reported profits compared to other methods like LIFO.
Last in, first out method. This method is used to value inventory when the most recently purchased or produced goods are assumed to be sold first. Under LIFO, the cost of goods sold reflects the cost of the latest inventory, while older inventory costs remain on the balance sheet. This method is often used during periods of inflation, as it results in higher a higher cost of goods sold and lower taxable income, but it may also understate the value of ending inventory.
Specific identification method. This method is an inventory valuation technique where the actual cost of each individual item is directly assigned to that specific item when it is sold or remains in inventory. It is typically used for high-value or unique items, such as cars, jewelry, or custom-made products, where tracking each item separately is practical and necessary. By matching the exact cost of the item to its sale, the specific identification method provides highly accurate cost of goods sold and ending inventory values.

Allocate Overhead to Inventory

The typical production facility has a large amount of overhead costs, which must be allocated to the units produced in a reporting period. This is required by the accounting frameworks (such as GAAP and IFRS) to ensure that the full cost of unused units on hand is being recorded within the inventory balance at the end of each reporting period.

Additional Inventory Accounting Issues

The preceding points cover the essential accounting for the valuation of inventory. In addition, it may be necessary to write down the inventory values for obsolete inventory, or for spoilage or scrap, or because the market value of some goods have declined below their cost. There may also be issues with assigning costs to joint and by-product inventory items. We expand upon these additional accounting activities in the following bullet points:

Write down obsolete inventory. There must be a system in place for identifying obsolete inventory and writing down its associated cost.
Review lower of cost or market. The accounting standards mandate that the carrying amount of inventory items be written down to their market values (subject to various limitations) if those market values decline below cost.
Account for spoilage, rework, and scrap. In any manufacturing operation, there will inevitably be certain amounts of inventory spoilage, as well as items that must be scrapped or reworked. There is different accounting for normal spoilage and abnormal spoilage, the sale of spoiled goods, rework, scrap, and related topics.
Account for joint products and by-products. Some production processes have split-off points at which multiple products are created. The accountant must decide upon a standard method for assigning product costs in these situations.
Disclosures. There are a small number of disclosures about inventory that the accountant must include in the financial statements.