Inventory stock is a business asset and the ending balance of inventory is reported on the company balance sheet under current assets. When looking at a company’s current assets, special attention should be given to inventory which consists of the merchandise a business owns but has yet to sell. For many types of business, the inventory shown on the balance sheet is one of the important items to analyse because it gives an insight into what is fundamentally happening to the business.
While not an income statement account, any change in inventory, however, is a factor in the calculation of the Cost of Goods Sold (COGS) and this component is reported on a company’s income statement. Increases in inventory are subtracted from a company’s purchases of goods while a decrease in inventory is added to a company’s purchase of goods to calculate COGS.
A change in inventory stock can be shown as an adjustment to the COGS, or income statements may show the calculation of COGS as (Beginning inventory + Net purchases) – Ending inventory stock.
Why is this important?
The inventory figure on the balance sheet presents an interesting conundrum because although it represents an asset, there are many risks of carrying too much inventory on the balance sheet. As inventory increases, it has a greater chance of manifesting in losses that reduce both the return on equity and on assets. Three risks of inventory loss include:
- Spoilage that occurs when a product goes bad and is unsaleable. This is a serious concern for those businesses that produce, manufacture, distribute and assemble perishable goods. When spoilage occurs, the estimated value of the spoiled inventory stock must be deducted from the company’s balance sheet.
- Shrinkage is the term used when referring to inventory that is stolen, shoplifted or misappropriated. The greater the inventory amount that a business has on the balance sheet, the greater the risk it could be stolen. Therefore inventory-heavy businesses companies with significant public access, such as large retailers, are going increasingly high-tech to implement sophisticated risk mitigation processes.
- Obsolesce is a loss that occurs when too much inventory remains on the balance sheet and there is a risk of this inventory stock becoming damaged, outdated or obsolete. Meaning it also becomes unsaleable or the price must be reduced to clear the stock. When inventory stock does become obsolete, businesses must reduce the value of that inventor on the balance sheet by entering it as a write-down on the income statement.
Weighted average inventory costing
The weighted average inventory method can be used to achieve a balance sheet estimate of inventory stock. It values a company’s inventory stock by applying the average cost of on-hand inventory to each item of stock. This means that the COGS and on-hand inventory is treated comparatively the same when it comes to determining value.
A key reason companies choose weighted average costing over other accounting methods is because it drastically simplifies cost calculations and record keeping.
Accounting for inventory
Companies must choose a method to track inventory and the two ways to account for inventory are the perpetual and periodic inventory systems. Perpetual systems always require accounting records to show the amount of inventory on hand and the account balance must be adjusted each time inventory stock is added or sold.
In a periodic system, sales are recorded as they occur, and the inventory account is only updated following a physical inventory count and the COGS is determined.
Regardless of what inventory accounting method a business uses, it is good practice to perform a physical stocktake at least once annually.