Inventory Accounting: What It Is, How It Works, and Why It Matters

Inventory accounting is essential for any business that buys or sells goods. It helps you track the value of what you have in stock and understand how it affects your income and expenses. Whether you’re a small business owner, a shop manager, or part of a finance team, learning how inventory accounting works can make a big difference in how you manage your money, stock, and reports.

I’ll break down the basics of inventory accounting, including what it is, how it works, the main systems and methods used, and why it matters to your business

What Is Inventory Accounting?

Inventory accounting is the process of tracking and recording the value of the items a business has in stock. It shows how much your inventory is worth at the start and end of a period, as well as the cost of selling the items during that time.

This helps businesses know their true costs, calculate profit, file accurate tax reports, and keep their financial records in order.

How Inventory Accounting Works

Inventory accounting works by tracking how much your inventory is worth over time. It records the value of the stock you have at the beginning and end of each accounting period, and the cost of the products you sold in between.

Businesses use this information to understand how their inventory affects profits and expenses. It also helps them stay accurate with their bookkeeping and tax reporting.

To do this, companies choose:

• An inventory system (how often inventory is tracked)
• A costing method (how the value of inventory is calculated)

Once these are set, the business uses them to:

• Record inventory when it’s bought and sold
• Track stock movement (what comes in and what goes out)
• Calculate the cost of goods sold (COGS)
  
• Show inventory value on financial statements

The goal is to give a clear picture of what inventory is worth, what has been sold, and how that impacts the business’s income.

Main Inventory Accounting Systems

There are two main systems used in inventory accounting: perpetual and periodic. Each system helps track the value and movement of inventory in different ways.

Perpetual Inventory System

The perpetual system updates inventory records in real-time. Every time a product is bought or sold, the system adjusts the inventory balance automatically. This gives a constant view of current stock levels and inventory value.

This system is useful for businesses that use inventory software or sell products regularly, like retail stores or e-commerce shops.

Periodic Inventory System

The periodic system checks inventory at set times, such as monthly, quarterly, or yearly. A physical count is done, and records are updated based on what’s found. The cost of goods sold (COGS) is then calculated at the end of the period.

This method works well for smaller businesses or those with fewer sales, where real-time tracking isn’t needed.

Both systems help businesses manage stock and report inventory accurately—it just depends on how often you want to track and update your numbers.

Inventory Costing Methods (with Examples)

When tracking inventory, businesses need a way to calculate how much their stock is worth. This is where inventory costing methods come in. These methods help assign a cost to the products you sell and the inventory you still have on hand.

There are three common inventory costing methods: FIFO, LIFO, and Weighted Average. Each method works differently, and the one you choose affects how you report inventory and profit.

FIFO (First-In, First-Out)

FIFO assumes the first items you buy are the first ones you sell. This means older inventory is recorded as sold before newer stock.

Example:
You buy 50 mugs at $5 each. Later, you buy another 50 mugs at $7 each.
If you sell 50 mugs using FIFO, they are recorded as sold at $5 each.

FIFO is useful for products that expire or lose value over time, like food or beauty products.

LIFO (Last-In, First-Out)

LIFO assumes the last items you buy are the first ones you sell. Newer inventory is recorded as sold before older stock.

Example:
You buy 100 shirts at $10 each, then buy 50 more at $12 each.
If you sell 50 shirts using LIFO, they are recorded as sold at $12 each.

LIFO may reduce reported profits when prices are rising, but it’s not allowed in some countries due to tax rules.

Weighted Average

This method takes the average cost of all items in inventory and applies it to each unit sold.

Example:
You buy 30 pens at $1, then 20 more at $2. The total cost is $70 for 50 pens.
$70 ÷ 50 = $1.40 per pen.
If you sell 10 pens, the cost is recorded as $14.

This method is simple and works well when product prices change often.

Choosing a method depends on your product type, pricing, and how you want to report inventory and profit. Once selected, it should be used consistently for clear and accurate reporting.

 Inventory on the Balance Sheet

In accounting, inventory is listed as a current asset on your company’s balance sheet. This shows the value of items your business owns and plans to sell.

Inventory is recorded at the purchase price, not the selling price. This means you list what it cost to buy the items, not what customers pay for them.

At the end of each accounting period, you need to record:

• Opening inventory – the value of stock at the start of the period
• Closing inventory – the value of stock left at the end

These numbers help calculate your cost of goods sold (COGS) and give a clear picture of how much inventory is affecting your business’s profit and financial position.

Keeping inventory records up to date helps ensure that your balance sheet reflects what your business truly owns and what it’s worth.

Reporting Inventory for Tax and Compliance

All businesses must report their inventory as part of their yearly tax filings. This helps tax agencies calculate your cost of goods sold (COGS) and net income. You don’t need to list every item, just the total inventory value.

Even though inventory is not counted as income, it affects your income calculation. The value of your opening and closing inventory helps figure out how much you spent and how much you earned.

Accurate inventory records are important to:

• File correct tax returns
• Meet government rules
• Avoid fines and penalties

Using inventory accounting helps you stay compliant, prepare financial reports, and keep your business records clear and organized.

Why Inventory Accounting Is Important

Inventory accounting is a key part of running a business. It helps you understand the value of your stock, track your spending, and calculate your profit.

Accurate inventory records make it easier to:

• File tax returns correctly
• Create reliable financial statements
• Make smart decisions about buying and selling
• Avoid overstocking or running out of products

Inventory accounting also helps you stay in line with local tax laws and industry rules. If your records are wrong or incomplete, you could face fines, delays, or other penalties.

Using the right system and method keeps your inventory numbers clear, your reports accurate, and your business running smoothly.

Tools to Simplify Inventory Accounting

Keeping track of inventory can take time, especially as your business grows. The good news is, some tools make inventory accounting easier.

Many businesses use accounting software to help record inventory, calculate costs, and update reports automatically. These tools reduce errors, save time, and keep your records organized.

For example, ArmPOS helps you:

• Track inventory levels in real time
• Record purchases and sales
• Calculate the cost of goods sold
• Create financial reports with inventory data

Using software means you don’t have to do everything by hand. It’s a simple way to stay on top of your stock and keep your accounting accurate.