What Is Inventory Accounting?
An inventory accounting method is an approach to calculating the total value of the inventory that is owned by a business at a particular time duration. It is calculated in such a way that the total cost incurred in buying the inventory and getting it ready it can be directly made available for sale in the market. This is crucial in accounting since the balance sheet and income statement are immediately impacted. You have five effective ways for inventory accounting that are specific identification. The weighted average, first out, last in first out, and retail inventory methods are widely used by e-commerce businesses. Inventory accounting methods also include the raw materials and finished goods that a company owns or sells to customers.
Calculating the exact inventory value is a challenging task for many financial businesses. Have a look at the basic formula used to determine the cost of goods sold in an accounting period:
|Beginning inventory + Purchases – Ending inventory = Cost of goods sold|
In this post, we’re going to learn about various inventory accounting methods that you can use for your financial reporting.
Inventory Accounting Methods
1. Specific Identification Method
This is one of the most popular and widely used accounting inventory methods that allows you to keep track of each item in inventory and assign costs individually rather than grouping items together. You can separately track each item in inventory and charges apply to the cost of goods sold. Data tracking can be time-consuming as it is only used for very high-cost such as automobiles as it is not a suitable approach in most other situations. Also, it is useful when a company can mark, track, and identify each item in its inventory.
2. First In, First Out Method
If you have large numbers with identical items, specific identification may not be suitable. In this case, using First In First Out can be worth it. This accounting method supposes to sell an item from the oldest batch but it is only accurate when the prices of goods fluctuate. This option is great when you’re looking for an accurate inventory representation and want to reap the benefits of the same item at varying prices. This inventory accounting method conforms to the actual inventory movement. This is the main reason why it is highly preferable by businesses.
3. Last In, First Out Method
In the Last in First out method, you’re assuming that items that are bought last are sold first, which means that the items still available in the stock are the oldest ones. This approach is restricted under International Financial Reporting Standards. Therefore it does not follow the natural inventory flow as other accounting methods do. We all know that prices fluctuate with time. Assuming that the recently bought units are the first ones having lower operating earnings, and fewer income taxes paid.
4. Weighted Average Method
If you have products whose prices rarely change, then you can surely use the Weighted Average Costing method as it uses a pool of costs for a particular unit. All your purchases are added to the pool of cost where the cost is divided by all units that you have made from your end. You’ll only have one inventory layer when you’re working with the Weighted Average Costing method. The cost of inventory purchases is associated with the existing cost of deriving a new weighted average cost. One of the benefits of using this method is that it allows you to easily track as compared to specific costing. Also, it doesn’t even compensate for differing margins across SKUs.
5. Retail Inventory Method
Lastly, the retail method is used for financial reporting. It provides the ending inventory balance sheet for a store by measuring the inventory cost relative to the goods bought. Also allows you to identify the expenses you made to recognize this period and ensure that all your inventory is consistent and up to the mark.
The main advantage of using this method is that you can easily calculate the cost of goods and work efficiently even if you have weak inventory cost tracking. The main cost might not be accurate because the prices fluctuate at times if you have products with diverse markups.
After reading this post, you must have figured out which inventory management system is suitable for you when it comes to financial reporting. Make sure to invest a significant amount of time in choosing a suitable approach that suits your requirements. Choosing the wrong ones might come up with new challenges and weaken your sales. So choose the one that helps to overcome your challenges and strengthen your sales to shift different kinds of stock.
Vishal Shah works in a software development company TatvaSoft.com