What is Inventory Accounting?

Inventory accounting is the process of keeping track of movements of stock in and out of a company. It covers both the logistics of stock management and the related financial accounting. In a financial context, most countries have specific rules about how inventory accounting should be carried out and listed in company accounts.

In principle, inventory accounting simply means keeping records of how much stock a company has and its total value. In practice, this can be more complicated as most companies have multiple product lines in multiple warehouses. There is also the potential for confusion and complexity where a manufacturing company takes multiple steps to produce an end product. For example, with a car, parts such as the engine, chassis and windscreen can exist either as unused parts or in the form of a completed but unsold car. The company may also have other parts, such as stereo systems, which may be added later on to a "completed" car to fulfill a custom order.

One issue that is particularly important with inventory accounting is that the price of buying components or stock may change over time. For example, a company may at one stage have 100 shipping boxes that cost $0.10 (USD) and another 100 shipping boxes that cost $0.12 as they were bought after a price rise by the supplier. Assuming these boxes are identical, there will be potential confusion when the boxes are used and sent out to a customer and the company has to deduct the value of the boxes from its inventory total.

There are two main approaches to this problem. One is known as First In First Out, or FIFO. This works on the basis that each unit shipped from inventory is assumed to be the earliest one that entered the inventory. In the example above, it would be a box that cost the company $0.10.

The main alternative system is Last In First Out, or LIFO. This works on the basis that each unit shipped from inventory is assumed to be the last one that entered the inventory. In the example above, it would be a box that cost the company $0.12. It's important to note that which box is actually physically shipped out does not matter in accounting terms.

In the example given, a company using LIFO would deduct more money for each box it shipped, leaving the paper value of its inventory lower. This will be the situation in most cases because of the effects of inflation. In many cases, the paper value of a company's inventory will count towards its income in financial accounts and thus affect the company's tax liabilities. Many US firms use the LIFO system as a result, lowering their tax payments. Some countries require that companies use FIFO, both to increase tax revenues and to allow easier comparison between different companies.