In this article we’ll explore how Inventory transactions appear on the income statement and balance sheet. Inventory accounting for small business owners can be confusing at first, but with a few examples it may become clear.
Background on Inventory Accounting
To start understanding inventory transactions it’s helpful to begin with a solid understanding of some accounting fundamentals. Please review the following:
- The Income Statement
- The Balance Sheet
- Accrual Accounting vs. Cash Accounting
Inventory on the Financial Statements of a Business
The inventory that you hold is an asset to the company. As such businesses take pains to count and value inventory and record it as an Asset on the Balance Sheet. A company may have many inventory subaccounts and/or classes. These may simply be used to track inventory for different categories of products, they may also be used to track work-in-progress inventory or different warehouse locations.
||Work In Progress
Inventory Accounting in Manufacturing
Manufacturing businesses have the most complicated inventory accounting. They must keep track of three types of inventories:
1. Raw materials inventory
2. Work in progress inventory
3. Finished goods inventory
Each finished product may be made up of many different components. Components may be grouped together into assemblies and sub-assemblies, each of which is assigned a tracking number. Interchangeable parts may be ordered from different suppliers, further complicating the tracking of assemblies and subassemblies. Different materials may have different units of measure – meters of sheet metal, numbers of printed circuit boards, kilograms of paint, etc.. The cherry on top of this inventory complexity is tracking different batches or lots of inventory items – which can be important for food manufacturing or painting. All this has to be tracked in the accounting of inventory.
As inventory progresses from raw materials through to finished goods, it must be re-valued to factor in the additional value your team has put into it.
It is very important that even small manufacturing businesses understand and implement inventory management solutions early on. Small business ERPs and inventory management SaaS products do exist and while they may not be an exact fit for your business, they’ll certainly help.
Inventory Valuation Rules in Accounting
When we remove items from inventory, we must account for their value somehow. But what value should be used?
- Last in First Out (LIFO) – under the LIFO rule, the value of an item removed from inventory is the value of the last unit purchased for that item. If I just purchased 10 tablets from my supplier for $100 each, then I sold one, I reduce inventory value by $100. It doesn’t matter if my supplier used to charge me $80 each. I could have purchased my first tablet for $60 3 years ago, and I’ll only record the $60 inventory reduction when I sell my last one.
- First in First Out (FIFO) – under the FIFO rule, the first item purchased in a category sets the value I record. I my above example, I record the $60 first.
- Average value – under this rule, the value of any given item in inventory is the sum of the inventory purchases divided by the number of items.
Note that accounting software such as Quickbooks Online often uses the Average Value rule for inventory valuation. Inventory heavy businesses who want to use a different inventory accounting rule, or who need to see the value of their inventory under different rules, should invest in an inventory management software that integrates with Quickbooks Online.
Note also that the Canada Revenue Agency requires businesses to file taxes based on the FIFO rule. Businesses are free to maintain their accounting records using other inventory valuation methods.
Does Inventory Go on The Income Statement?
The value of inventory you hold does NOT appear on the income statement. However, certain expense transactions that relate to inventory do appear on the Income Statement. If this sounds confusing, just remember: when we remove items from inventory, we should record this as an expense.
- If inventory items are sold, then their value is recorded in the Cost of Goods Sold (COGS) expense account on the income statement. The inventory asset account on the balance sheet is reduced by the same amount.
- If inventory is lost, damaged or stolen, this is generally termed ‘shrinkage’. When inventory is ‘written off’ in this way, we record an expense on the income statement.
Buying inventory does NOT impact the income statement. When buying inventory, we record the transaction in the Inventory Account (an Asset account on the Balance Sheet). The other side of this transaction is usually Accounts Payable to a supplier (a Liability account on the Balance Sheet), but could hit a bank account or credit card account.
Inventory Accountants in Canada
It is exceedingly rare to find a public practice accountant in Canada that has expertise dealing with inventory, other than year-end filings. Entreflow is a Vancouver based Accounting Firm with Accountants in Toronto as well, and we deal with high-growth small businesses across Canada. We have extensive experience cleaning up messes in inventory accounting and implementing new inventory management SaaS solutions and small business cloud ERP. Please contact us for help.