A simple guide to accounting for inventory

As a business owner, managing your inventory isn’t just about keeping track of what’s on your shelves. It’s about making sure your goods and materials are being considered as part of your financial management.  

Inventory accounting helps you understand the value of your goods, so you can make informed decisions and maintain a healthy bottom line.  

In this article, we cover the basics of accounting for inventory, 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. Since they have value, these items need to be accounted for just like any other aspect of your finances.  

In fact, properly accounting for inventory is crucial because it directly impacts your financial statements and profitability. It affects cash flow, financial ratios, tax liabilities, and more.  

It also helps you ensure you have the right products in the right quantities, which reduces carrying costs and prevents stockouts that could lead to lost sales. 

Whether you have an accounts team or are managing your accounting as a sole trader, you need to accurately record your inventory on a regular basis. 

So, what counts as inventory? 

There are 3 main types: 

1. Raw materials: These are the basic materials used in production. 

2. Work-in-Progress (WIP): Goods in various stages of completion in the production process. 

3. Finished goods: Completed products ready for sale. 

You’ll need to account for all of these to effectively manage your stock and get an accurate picture of the value your business holds. 

Is inventory an asset? 

An asset is anything that has the potential to provide future economic benefits to your business. Inventory fits this definition perfectly, as it includes items your company intends to sell in the normal course of business to generate revenue. 

Inventory holds value for your business. It’s listed as a current asset on the balance sheet because it’s expected to be converted into cash or used up within a year.  

When you purchase or produce inventory, it ties up cash until the products are sold. Once sold, inventory is transformed into accounts receivable or cash, contributing to your company’s revenue and profitability. 

It’s important to note that while inventory is an asset, its value can fluctuate. Changes in market demand, technological advancements, or shifts in consumer preferences can impact the value of your inventory. This is why proper inventory accounting and accurate valuation methods are crucial for reflecting the true value of your assets. 

What are the accounting rules for inventory and stock? 

To make sure you’re accounting for inventory properly, you need to stick to certain standards. These help you stay consistent in the ways you manage your finances and ensure you’re getting an accurate picture of the value of your inventory and stock. 

Under UK Generally Accepted Accounting Practice (UK GAAP), these are the key guidelines for the recording and reporting of inventory on financial statements: 

1. Historical cost principle 

This principle dictates that inventory should be recorded at its original cost—the amount paid to acquire or produce the goods. This cost includes all expenses directly associated with bringing the inventory to a location and condition suitable for sale, such as purchase price, transportation costs, handling fees, and other directly attributable costs. 

2. Consistency principle 

This principle requires businesses to consistently apply the same inventory valuation method from one period to another. This ensures comparability in financial statements over time, aiding stakeholders in analysing trends accurately. Any changes in valuation methods should be well-documented and explained in financial disclosures. 

3. Prudence (conservatism) principle 

This principle advises businesses to err on the side of caution when valuing inventory. It suggests that inventory should not be overstated; instead, it should be valued at the lower of its cost or net realisable value. This ensures that inventory is not overstated on the balance sheet, particularly when market conditions change.

4. Lower of Cost or Net Realisable Value (NRV) 

In alignment with the prudence principle is the Lower of Cost or Net Realisable Value (NRV) rule. If the net realisable value of inventory drops below its historical cost, the inventory should be written down to the lower of the 2 values. Net realisable value is the estimated selling price in the ordinary course of business, minus the estimated costs to complete and sell the inventory. 

5. Disclosure requirements 

Under UK GAAP, businesses are required to disclose the accounting policies and methods they use for inventory valuation in their financial statements. 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 for preparing and presenting their financial statements. It provides a framework for financial reporting, covering areas like revenue recognition, measurement of assets and liabilities, and presentation of financial statements.  

Examples of frameworks included in UK GAAP include FRS 102, FRS 105 (for micro-entities) and FRS 101 (reduced disclosure framework).  

Adhering to the UK GAAP principles ensures accurate and transparent financial reporting, providing stakeholders with a clear understanding of your inventory’s value and its impact on your company’s financial health. By following these rules, you’ll maintain compliance with accounting standards and be able to make well-informed financial decisions. 

Main inventory costing methods 

There are several ways to calculate the value of your inventory, each with different implications for financial reporting and tax. Some methods are more beneficial in 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 often aligns with the actual flow of goods and is preferred when prices are rising. It leads to lower taxable income during inflationary periods. 

FIFO example 

Imagine you run a bakery, and you produce and sell batches of cupcakes. You started the month with an inventory of 100 cupcakes that cost you £1 each. As the month progresses, you bake another 100 cupcakes, but this batch cost you £1.20 per cupcake.  

When you use the FIFO method, you assume that the first cupcakes baked (the oldest ones) are 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’s straightforward and is useful when costs are relatively stable. 
 
Weighted average cost example 

In this example, the total cost of all the cupcakes is £220 (£100 for the first batch, £120 for the second). We can use this to 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 be: 

150 cupcakes x £1.10 = £165 

What is opening and closing inventory? 

Under a periodic stock system, you can use opening and closing inventory to account for the value of inventory across periods. Put simply, the closing inventory of one period is the same as the opening inventory at the start of the next. You’re essentially just changing what you’re referring to it as for future calculations. 

In other words, the closing inventory of period 1 is the opening inventory of period 2. 

Here’s how to calculate closing/opening inventory: 

1. Determine the value of your inventory at the start of the current period (this is your opening inventory for period 1). 

2. Add any additional purchases or stock acquired during the period. 

3. Subtract the value of inventory that was sold or used during the period. 

Let’s say you run a clothing store. You started the current period with an opening inventory of £13,000 worth of clothes and materials. Then throughout the period, you made additional purchases totalling £7,000 and sold £12,000 worth of products. 

The formula would be: 

 
Opening inventory (£13,000) + Additional purchases (£7,000) – Sold inventory (£12,000) 

 = £8,000 
 

So, your closing inventory period 1 and opening inventory for period 2 is £8,000. 

By accurately tracking and calculating closing and opening inventory, you can make informed decisions about restocking, pricing, and sales strategies. This allows you to optimise your inventory management and ensure the financial health of your business. 

What is a perpetual stock system? 

As the name suggests, perpetual stock system is one that lets you 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, which can record every inventory transaction—including purchases, sales, returns, and adjustments—as they occur. These transactions are updated in your accounting system immediately, ensuring your inventory records are always accurate and up to date. 

This means you have real-time visibility into inventory levels, which helps you make fast and informed decisions about reordering and pricing, while also identifying potential issues like theft or spoilage. It also helps you to reduce holding costs and minimises the risk of overstocking or understocking.  

Just to note, perpetual stock system requires more resources and tech investment than a periodic one, such as those that use closing and opening inventory. They tend to be better for businesses with a high volume of inventory and that need precise control over their stock levels. 

Final thoughts 

Proper inventory accounting is vital for maintaining a healthy business. It’s a strategic financial practice that affects your bottom line, tax liabilities, and financial reporting accuracy.  

By understanding what inventory is, how to value it, and how to calculate opening and closing inventory, you’ll be able to make informed decisions and find ways to grow your business more effectively. 

FAQs  

Q: What is accounting for inventory? 

A: The process of tracking, valuing, and reporting the goods a business holds for resale or production, ensuring accurate financial records and informed decision-making. 

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 inventory methods from FIFO to LIFO? 

A: You can, but switching inventory methods may have tax implications so consult a financial advisor before making changes.