Inventory Accounting: Definition, How It Works, Advantages

Inventory Accounting

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What Is Inventory Accounting?

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, so they need to be accurately valued in order for the company to have a precise valuation.

Key Takeaways

  • Inventory accounting determines the specific value of assets at certain stages in their development and production.
  • This accounting method ensures an accurate representation of the value of all assets, company-wide.
  • Careful examination by a company of these values could lead to increased profit margins at each stage of the product.

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.

How Inventory Accounting Works

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 A company which is manufacturing or selling an outdated item might see a decrease in the value of its inventory.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.

Advantages of Inventory Accounting

The main advantage of inventory accounting is to have an accurate representation of the company's financial health. However, there are some additional advantages to keeping track of the value of items through their respective production stages. Namely, inventory accounting allows businesses to assess where they may be able to increase profit margins on a product at a particular place in that product's cycle.

This can be seen most prominently in products that require exceptional time or expense in secondary stages of production. Items such as pharmaceuticals, machinery, and technology are three products that require large amounts of expense after their initial designing. By evaluating the value of the product at a certain stage⁠—such as clinical trials or transportation of the product⁠—a company can adjust the variables at that stage to keep the product value the same while increasing their profit margins by decreasing expenses.

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