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What is inventory accounting and why is it important?

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Last editedMay 20222 min read

Inventory accounting, or inventory management, plays an important role in business operations. In fact, it can make a significant difference both to business compliance and profits.

In this post we’ll define inventory accounting, explain how it works and discuss some of the main advantages of effective inventory management.

What is inventory accounting?

Inventory accounting is the sector of accounting that handles valuing and recording changes in inventory. Inventory usually includes goods in various stages of production, from raw goods to finalized goods ready for the shelves.

Inventory accounting will allocate a value to items at each process stage and then document them as company assets. Assets can have a big impact on the future value of a business, so noting asset values accurately is crucial.

However, this is easier said than done as the designated value of inventory items can change in value over time. This happens due to depreciation, damage to goods, market changes, increases/decreases to demand, changing trends etc. A good inventory accounting system will be able to account for these changes and adjust company asset values and the relevant costs involved in the inventory accordingly.

How inventory accounting works

In the U.S., public companies must follow GAAP. This acronym stands for “generally accepted accounting principles”, which is a set of principles laid out by the Financial Accounting Standards Board (FASB).

GAAP requires businesses to record inventory accurately and enforces a rigorous set of standards in order to achieve this. It prohibits businesses from both understating and overstating the value of their inventory, since doing so can lead to a company having an inflated valuation. Understating the value of inventory can make it seem as if profits are higher than they actually are (as profit is revenue minus costs, and inventory contributes to costs), meaning that a company could end up with a falsely high valuation. In a similar vein, inventory is an asset, and as a result, overstating the value of inventory can give the impression that a company has greater assets than it really does.

Say, for instance, a company produces and sells an item that is steadily losing value but the inventory accounting doesn’t accurately record this value decrease, this can result in an inflated company valuation.

Advantages of inventory accounting

  • Provides a precise representation of the finances of a business

  • Makes it easier for business to see opportunities to grow profit margins

The principal advantage to inventory accounting is that it leads to a more precise and authoritative representation of a business’s financial picture. However, there are some additional perks to accurately noting item value through production. Specifically, inventory accounting means businesses can better gauge where they are able to increase profit margins.

This can be seen most clearly in businesses that manufacture products which require a great deal of time and expense during production. Such items include pharmaceuticals, technology and machinery. Through assessing the value of products while in certain production stages — e.g. during the clinical trial stage — a business can then alter the variables at that stage in order to keep the product value stable, while still increasing their profit margins. This would involve essentially decreasing expenses. 

Inventory accounting: summary

On the whole, inventory accounting assesses the precise value of assets at different stages of their manufacturing and production. It helps to guarantee an accurate representation of the value of all assets, which is reflected in the value of the company. Close assessment of the values ascertained in inventory accounting can help businesses to increase profit margins.

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