Inventory, What Counts as Inventory, How it is Accounted for and How that Affects Financial Reports
What is Inventory?
The term inventory has different meanings to different people. The word inventory has a different meaning in the UK and the USA. In American English and the context of accounting, the term inventory refers to the materials and goods that are held by a business for the main purpose of re-sale.
In British English, the term inventory refers to a compiled list for formal use such as the contents of a house for rent or even the details of an estate for probate. Another term that is closely related to the word inventory in stock but in both American and UK contexts, it is used in stock exchange jargon to refer to shares (Samanta, 2015).
Inventory refers to materials that are in store waiting to be processed or undergoing processing. The organization’s balance sheet consists of a lot of inventories such as finished goods sub-assemblies, components and raw materials. A lot of organizations do not like inventories because they represent capital that is held in investments that are not generating any returns.
Inventories in-store incur storage costs and are susceptible to obsolescence and spoilage. Various methods have been developed over the last decade to help reduce inventory levels and enhance efficiency at the production facilities. Some of these include the just-in-time (JIT) technique, Kanban, flexible and lean manufacturing (Samanta, 2015).
Despite management’s dislike for inventories, they have a positive impact on production as they ensure steady supply and ready availability of materials for production. Large inventories reduce the frequency of replenishments hence reducing ordering costs resulting in economies of scale for the companies.
Work-in-progress (WIP) inventories reduce variability effects of production rates in factories thus protecting against process failures. The finished goods inventories help in ensuring smooth customer service or service interruptions. Other types of inventories include spare parts that are used for maintenance purposes as well as extra volumes to achieve economies of scale.
The definition of the term inventory changes with the sector within which it is being used. The commonly used definition of inventory is all items, materials, merchandise and goods that are held by a business organization for sale to generate profits (Tanoy, 2020). For newspaper vendors who transport newspapers for sale, it is the newspapers that are treated as inventory but the vehicle is considered as an asset.
How do we categorize inventory according to the sector?
Manufacturing industry
It refers to the finished product, the raw materials that are used in the production as the semi-finished goods in the factory or warehouse.
Service Industry
In a service industry, there are no tangible items hence inventory in this context refers to the steps involved before a sale is made. It could be rooms for accommodation in a hotel or even information for a consultancy firm.
Inventory in general terms can be defined as an asset that is either tangible or intangible.
Different Types of Inventories
Raw materials
They consist of all items that undergo processing to make the final product. Raw materials exist only in the context of manufacturing. The trading industry does not involve manufacturing or processing hence there are no raw materials.
Work in progress
This refers to the raw materials that are in the production pipeline but have not been completed or approved as final or finished goods.
Finished goods inventory
Refers to the end products that are ready to be presented in the market for sale. They also refer to those goods that have passed through all the processes of production as well as quality checks.
What Counts as Inventory?
The main items that count as inventory in a firm’s financial accounting terms include finished goods, semi-finished goods and raw materials.
What are the Different Types of Inventory?
Raw materials
Also called inputs, raw materials refers to all items that undergo processing to make up an end product. The inputs used by a producer can be sourced from external sources or from within the company in the form of a by-product.
Work-in-progress inventories
This refers to those raw materials that are in the process of undergoing conversion into the finished product but haven’t been approved as finished goods. After being processed into the final product, they must undergo quality checks to qualify as finished goods ready for sale or use.
Finished Goods
These are end products of a manufacturing process that are ready for sale in the market. Finished goods are characterized as “finished” after they have undergone quality checks.
MRO Inventory
These to Maintenance, Repairing and Operating Supplies. This type of inventory is mainly found in manufacturing set-ups. MRO inventories are not taken as inventories in the accounting books but they play a critical role in the day to day operations of a company. They are normally used for repairs, maintenance, and running of machinery, tools and others that are used in the manufacturing process. Examples of MRO items include screws, gloves, uniforms, bolts and lubricants.
Buffer Inventories
Buffer inventories are safety stocks that are meant to cushion a manufacturer or seller against stock-outs. Buffer stocks items t t are stored in a factory, store or warehouse to cater for any unexpected shocks such as a spike in demand, labour strikes, catastrophes, natural disasters, pandemics or even delays in transport (Tanoy, 2020).
Cycle Inventory
Cycle inventory refers to those items that are ordered regularly in large quantities or lot sizes. They are those inventories that are used directly in the manufacturing process or are part of some regular process.
Decoupling Inventory
Decoupling inventory are used in production lines whereby the production process is undertaken by several machines. In this manufacturing set-up, the output of one machine becomes the input of another machine hence the decoupling process works best when all the machines operate in tandem.
A failure of any single machine can adversely impact the whole process hence the need for decoupling inventory. If one machine breaks down, the decoupling inventory is proceeded by a substitute machine to avoid derailing the production process (Tanoy, 2020).
Transit Inventory
This refers to goods in transit or items that are being transported from one destination to another. An example of transit inventory is raw materials that are being transported to the factory by road or finished goods being ferried to the store by a lorry.
How is Inventory Accounted for?
The accounting for inventories is done by determining the correct stock counts that constitute the ending stocks. These units are then assigned values after which the resultant costs are used for recording the financial value of the ending inventory and computing the costs of sales for the accounting period (Accounting Tools, 2021).
How do we determine the ending inventory counts?
Two main methods are commonly used in maintaining inventory records. These are the perpetual inventory system and the periodic inventory system. The periodic inventory system uses physical count in determining the ending stock balances. In using the periodic system, the physical stock count must be done accurately and correctly by ensuring the completion of prerequisite activities to ensure that all items are counted (Accounting Tools, 2021).
A perpetual system on the other hand updates the stocks constantly in an attempt to determine the ending stock balances. In situations where a company uses a perpetual inventory system, it is important to ensure the accuracy of the stock records by ensuring that every transaction is correctly captured.
However, it should be noted that it is not always convenient or possible to conduct physical stocktaking hence estimation of the end stocks is done by use of the retail inventory method or the gross profit method.
How do accountants assign Costs to Inventory?
Assigning costs to the ending inventory units is one of the major roles of accountants. One of the best techniques that are used for inventory costing is the first-in-first-out (FIFO) whereby cost layering is undertaken by tracking layers of stock costs.
Another method for assigning inventory costs is the last-in-first-out (LIFO) method whereby the first inventories are issued first while new ones enter the store (Accounting Tools, 2021).
Weighted average cost (WAC) is another method of inventory valuation. This method is based on the average cost of all inventories that are acquired within a certain period. This valuation method is suitable for businesses that do not have much variation in their stocks (Intuit QuickBooks, 2021).
Another method that is used for assigning inventory costs is the standard costs that allocate predetermined costs to all products as opposed to basing them on historical costs.
costs are also allocated to inventories that are produced within a certain reporting period.
What comprises accounting for the valuation of inventory?
There are several issues of accounting that pertain to various types of inventories. These include writing down the financial values for obsolete stock, scrap, spoilage or decline in stock value below their original costs. These points can be explained as below:
- Writing down obsolete stocks- this requires the presence of a system for identifying obsolete items and writing down their associated costs.
- Reviewing market costs- the accounting standards require firms to write their inventories to their real market values while observing certain limitations if the market values drop below the inventory costs.
- Accounting for spoilage, scrap and rework- This principle is observed in the manufacturing sector whereby certain items get spoiled, become scrap or are reworked thus impacting their values. These occurrences have their accounting whereby the spoiled, reworked and scrapped items are accounted for differently.
- Joint products accounting- this refers to accounting for multiple products that have split-off points in the course of their production or processing. The accountant must have a technique in place for assigning costs to these products at split-off points.
How do Inventory Valuations Affect Financial Reporting?
Correct inventory valuation is vital when accounting for inventories that enter the financial reports. If stocks are not accurately accounted for they can bring discrepancies in financial statements such as income statements, balance sheets and statements of retained earnings (Melanie, 2018).
The recorded amount in accounting for inventories represents the total quantities and value of inputs, finished goods and work-in-progress inventories that are owned by a business.
In each accounting cycle, the expenses incurred must be in line with the revenues generated to help determine a firm’s net income. In accounting for inventories, the cost of goods sold (COGS) must be subtracted from the sales revenues earned. This is accomplished by adding inventory purchases to the beginning inventory.
What are Inventory Discrepancies?
Inventory discrepancies are defined as the differences between the inventories that are captured in the records and what is available in stock. Variations in the cost of goods sold can directly impact the financial statements, especially the income statement where the cost of goods is deducted from the sales to arrive at the gross profit. Overstated inventories inflate the gross profits whereas understating will negatively impact the gross profits.
What is Inventory Overstatement?
This happens when stock records indicate higher inventories held than they are in physical count. These discrepancies can be caused by fraud, error, theft, damage and incorrect physical count. When stocks are overstated, they lower the COGS as this means higher closing stock hence causing overstatement of the current and total assets as well as retained earnings (Melaine, 2018).
What is Understatement in Inventories?
Understating inventory leads to increased COGS and less inventory on hand than the actual stocks held. Understatement can be caused by failure to reconcile the movement of finished goods and raw materials from one place to another. It can also be caused by administrative errors such as in receipting.
How do we correct Inventory Discrepancies?
To avoid overstatements and understatements, inventory adjustments or reconciliations are used to correct the discrepancies (Melanie, 2018).
When companies misrepresent their inventories, the mistakes are carried forward to the next accounting cycle because the closing stocks for one year are the opening stocks for the next. Adjustment entries are made in stock journals to correct the mistake. For overstated stocks, the adjustment entry will involve the addition of the omitted items whereas the understated stock will need the removal of the surplus item.
References
Samanta, P. (2015) Introduction to Inventory Management. Researchgate Publication https://doi.org/10.13140/RG.2.2.14914.99522
Tanoy (2020) What is Inventory? Definition, Types & Examples. Zoho Corporation Pvt. https://www.zoho.com/inventory/guides/inventory-definition-meaning-types.html
Accounting Tools (2021)Accounting for Inventory. Accounting Tools. https://www.accountingtools.com/articles/accounting-for-inventory.html
Intuit Quickbooks (2021) Comparing Different Inventory Valuation Methods: FIFO, LIFO, and WAC. https://www.tradegecko.com/inventory-management/inventory-valuation-methods
Melanie (2018) Accounting for Inventory: The Impact of Inventory Discrepancies on Financial Reporting. https://www.unleashedsoftware.com/blog/accounting-inventory-impact- inventory-discrepancies-financial-reporting