Money Matters

A simple guide to accounting for inventory

Learn the basics of inventory accounting and get a better understanding of your financial position.  

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. 

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So, what counts as inventory? 

There are 3 main types: 

  1. Raw materials: These are the basic materials used in production. 
  1. Work-in-Progress (WIP): Goods in various stages of completion in the production process. 
  1. Finished goods: Completed products ready for sale. 

You’ll need to account for all of these to 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 South African Generally Accepted Accounting Practice (SA 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. 

  1. 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. 

  1. 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. 

  1. Impairment and Reversal of Impairment 

SA GAAP introduces the concept of impairment and reversal of impairment for inventory valuation. If the net realisable value of inventory drops below its historical cost, and this decline is not temporary, the inventory should be written down to the lower value. If the value of inventory recovers, the upward revaluation is recognised up to the historical cost. 

  1. Disclosure requirements 

Under SA 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. 

Adhering to the SA 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 R20 each. As the month progresses, you bake another 100 cupcakes, but this batch cost you R24 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 R20) + (50 cupcakes x R24) = R3,200 

Last in, first out (LIFO) 

LIFO assumes that the newest items in inventory are sold first. While it may reflect the physical movement of goods less accurately, this method is also useful during periods of inflation as it can lower taxable income. 

LIFO example 

Let’s continue with the bakery example. You still have the same number of cupcakes with the same costs, but LIFO assumes that the most recently baked cupcakes are the first to be sold.  

Using the same numbers, your COGS calculation with LIFO would be: 

(100 cupcakes x R24) + (50 cupcakes x R20) = R3,400 

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 R4,400 (R2,000 for the first batch, R2,400 for the second). We can use this to calculate the average cost of the cupcakes. 

Average cost per cupcake = R4,400 / 200 = R22 

If you sell 150 cupcakes, your COGS calculation using the weighted average cost method would be: 

150 cupcakes x R22 = R3,300 

What is opening inventory? 

Opening inventory is the value of your inventory at the beginning of a period. By calculating this accurately, you’ll have a benchmark to measure your business’s growth or decline during the accounting period. 

Here’s how to calculate opening inventory: 

  1. Determine the closing inventory value from the previous accounting period. This is the value of your inventory at the end of the previous period (see next section). 
  1. Review any additional purchases made or new stock acquired before the start of the current period. 
  1. Subtract the value of any sales or usage of inventory that occurred before the start of the current period. 

Let’s imagine you run a clothing store. At the end of the previous accounting period, your closing inventory value was R200,000. Just before the start of the current period, you made additional purchases totalling R100,000. However, you also sold a small portion of your inventory from the previous period, valued at R40,000. 

The opening inventory formula would be: 

Closing inventory (R200,000) + Additional purchases (R100,000) – Sold inventory (R40,000)  

= R260,000 

What is closing inventory? 

Closing inventory is the value of your inventory at the end of an accounting period. It reveals the worth of the products that remain unsold or unused. Calculating closing inventory accurately helps you determine your business’ profitability and the value of the inventory you’ll carry over to the next period. 

Here’s how to calculate closing inventory: 

  1. Determine the value of your inventory at the start of the period (opening inventory). 
  1. Add any additional purchases or stock acquired. 
  1. Subtract the value of inventory that was sold or used during the period. 

Let’s continue with our clothing store example. Throughout the accounting period, you made additional purchases totalling R140,000. You also sold inventory worth R240,000. The opening inventory value was R260,000. 

The closing inventory formula would be: 

Opening inventory (R260,000) + Additional purchases (R140,000) – Sold inventory (R240,000) 

 = R160,000 

By accurately tracking and calculating opening and closing 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. 

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. 

Get a fast and accurate view of your stock

Use the inventory management features of Sage Accounting Plus

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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.