Inventory accounting is the body of accounting that deals with valuing and accounting for changes in inventoried assets. A company's inventory typically involves goods in three stages of production: raw goods, in-progress goods, and finished goods that are ready for sale. Inventory accounting will assign values to the items in each of these three processes and record them as company assets. Assets are goods that will likely be of future value to the company. Assets need to be accurately valued so the company can be accurately valued.

Inventory items at any of the three production stages can change in value. Changes in value can occur for a number of reasons including depreciation, deterioration, obsolescence, change in customer taste, increased demand, decreased market supply, and so on. An accurate inventory accounting system will keep track of these changes to inventory goods at all three production stages and adjust company asset values and the costs associated with the inventory accordingly.

Breakin Down Inventory Accounting

GAAP requires inventory to be properly accounted for according to a very particular set of standards, to limit the potential of overstating profit by understating inventory value. Profit is revenue minus costs. Revenue is generated by selling inventory. If the inventory value (or cost) is understated, then the profit associated with the sale of the inventory may be overstated. That can potentially inflate the company's valuation.

The other item the GAAP rules guard against is the potential for a company to overstate its value by overstating the value of inventory. Since inventory is an asset, it affects the overall value of the company. A company which is manufacturing or selling an outdated item might see a decrease in the value of its inventory. Unless this is accurately captured in the company financials, the value of the company's assets and thus the company itself might be inflated.