What Is Inventory Accounting?
Let me explain inventory accounting to you—it's the part of accounting that handles valuing and tracking changes in a company's inventoried assets. Your company's inventory usually includes goods in three production stages: raw goods, in-progress goods, and finished goods ready for sale. Inventory accounting assigns values to items in each of these stages and records them as company assets. Since assets are goods that will likely provide future value to your company, they must be accurately valued for a precise overall company 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.
How Inventory Changes Affect Accounting
Inventory items at any of the three production stages can change in value, and these changes happen for reasons like depreciation, deterioration, obsolescence, shifts in customer taste, increased demand, decreased market supply, and more. An accurate inventory accounting system tracks these changes across all three stages and adjusts your company’s asset values and associated inventory costs accordingly.
How Inventory Accounting Works
GAAP requires you to account for inventory according to a specific set of standards to limit the risk of overstating profit by understating inventory value. Profit is revenue minus costs, and revenue comes from selling inventory. If you understate the inventory value or cost, the profit from that sale might be overstated, which can inflate your company's overall valuation.
GAAP rules also protect against overstating your company's value by inflating inventory values. Inventory is an asset, so it impacts your company's total value. If you're manufacturing or selling an outdated item, its inventory value might decrease. Unless you accurately capture this in your financials, your company's assets—and thus the company itself—might appear inflated.
Advantages of Inventory Accounting
The primary advantage of inventory accounting is getting an accurate picture of your company's financial health. But there are more benefits to tracking item values through their production stages. Specifically, it lets you assess where you can boost profit margins on a product at particular points in its cycle.
This is especially clear in products that demand significant time or expense in later production stages. Think of items like pharmaceuticals, machinery, and technology, which incur high costs after initial design. By evaluating the product's value at a specific stage—such as clinical trials or transportation—you can adjust variables there to maintain the product value while cutting expenses and increasing your profit margins.
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