Inventory Accounting

What it is

Inventory accounting is the area of accounting that assigns value to a company’s stock of goods and records changes in those values. Inventory typically exists in three stages:
* Raw materials
* Work in progress (WIP)
* Finished goods ready for sale

Accurate inventory accounting treats these items as assets and ensures the balance sheet and income statement reflect their correct values.

Why inventory values change

Inventory values can fluctuate for many reasons, including:
* Depreciation, deterioration, or obsolescence
* Changing customer tastes or demand
* Supply constraints or surpluses
* Additional costs incurred in later production stages (e.g., clinical trials, transport)

Accounting must capture these changes so assets and cost of goods sold (COGS) are correctly reported.

How it works

Accounting standards (e.g., GAAP and IFRS) require consistent methods to value inventory to prevent profit or asset inflation or understatement. Because profit = revenue − costs, misstating inventory affects COGS and therefore reported profit:

• Understating inventory cost can overstate profit.
• Overstating inventory value can overstate assets and company valuation.

Companies must select and consistently apply an inventory valuation method and adjust inventory for write-downs when value declines.

Common valuation methods

• First-In, First-Out (FIFO): Assumes the earliest purchased or produced items are sold first. Ending inventory consists of the most recently acquired items.
• Last-In, First-Out (LIFO): Assumes the latest acquired items are sold first. (LIFO is permitted under GAAP in some jurisdictions but not under IFRS.)
• Average Cost (Weighted Average): Assigns an average cost to inventory based on total cost of goods available for sale divided by units available.

Each method affects COGS, ending inventory valuation, and tax/financial reporting differently; selection depends on business circumstances and applicable accounting standards.

Advantages of inventory accounting

• Provides a clearer picture of a company’s financial health by valuing assets appropriately.
• Helps management identify stages in the production cycle where costs can be reduced to improve margins.
• Supports better pricing, purchasing, and production decisions by tracking cost changes across stages.

Key takeaways

• Inventory accounting values goods at raw, in-progress, and finished stages and records changes that affect assets and profit.
• Changes in inventory value arise from wear, obsolescence, demand shifts, and additional production costs.
• Consistent valuation methods (FIFO, LIFO, average cost) and compliance with accounting standards ensure reliable financial reporting and help management optimize margins.