Best Practices for Inventory Accounting

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Although the basics of inventory control come naturally to many businesses, accurately tracking and recording inventory costs can be a real challenge. Let’s look at some of the best practices when it comes to inventory accounting.

Use the Right Measure

The cost of goods sold (COGS) is the cost of any inventory that is actually sold to customers. COGS includes the procurement cost (what the supplier charges) plus any other costs that the business incurs to sell the inventory. COGs is reported on the income statement alongside sales revenue. If an item’s cost changes while a business holds some inventory of that item, accountants must use a ‘cost flow assumption’ to work out which cost to report – the cost of purchasing the first units, or the cost of the most recently purchased.

Using the wrong cost flow assumption could distort your financial and tax reporting. It could also mean that your accounts do not comply with accounting standards and tax law. The ‘last in, first out’ (LIFO) method assumes that the last goods that are bought are the first to be sold. If COGS has risen, this method will lead to a higher COGS than the other methods, reducing a business’ profit on paper and its tax liability. Some tax authorities permit the use of LIFO, but most do not. Although LIFO may not be permitted for tax purposes, working out COGS using LIFO does provide a more useful estimate of replacement cost.

The ‘first in, first out’ (FIFO) method is the opposite of LIFO and assumes that your business sells the oldest inventory first. FIFO leads to a lower COGS, so your business is taxed on a higher profit. COGS can also be calculated by producing a weighted average cost, which may be a good option if you bought a large volume of inventory at one point in time or if your prices are relatively stable.

Perpetually Value Inventory

Valuing your business’ stock at the start and end of a month can be difficult. Staff often fail to keep up with inventory paperwork, so it can be difficult to use sales or production records to determine how much inventory is in stock. A time-consuming stocktaking procedure is often the only reliable option, but because stock levels are in a constant state of flux, a stocktake to determine actual inventory may become outdated very quickly. By perpetually tracking inventory, online inventory management software makes it easy to keep track of the cost of goods sold. Every transaction updates the cost of goods sold, whether you use the LIFO, FIFO or average landed cost method.

Calculate Then Recost

Working out landed costs is challenging; although your suppliers and customs brokers invoice you promptly, transport providers regularly take several weeks to send you a bill. This creates a practical difficulty for accountants – is it better to estimate costs and risk getting them wrong, or to wait until you have all of the information? A sensible approach is to determine landed costs as soon as possible on the basis of all the available information. This involves using actual supplier and broker charges and an estimate of shipping costs based on previous charges. Inventory management software will typically support purchase order recosting, allowing you to update landed cost when all of the invoices are in.

Pick The Right Tools

Many businesses use Excel spreadsheets to keep track of their inventory and accounts. Although Excel is a powerful business analysis tool, it can be error prone and is time consuming to use. Excel also makes it difficult to perpetually value inventory. Consider picking online inventory management, point of sale and accounting packages that integrate.

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Melanie - Unleashed Software

Article by Melanie Chan in collaboration with our team of Unleashed Software inventory and business specialists. Melanie has been writing about inventory management for the past three years. When not writing about inventory management, you can find her eating her way through Auckland.

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