Inventory refers to the goods and materials a business holds for the purpose of resale or production. It includes raw materials, work-in-progress items, and finished products. Inventory is a key asset in a company’s balance sheet, as it represents the stock that will generate future revenue. Efficient inventory management ensures that there is enough stock to meet customer demand without overstocking, which ties up capital and increases holding costs.
The accounting treatment of inventory involves its recognition, measurement, and subsequent valuation.
- Recognition:
Inventory is recognized as an asset on the balance sheet when it meets specific criteria. Generally, inventory is recognized when it is held for sale in the ordinary course of business or in the process of production for such sale.
- Measurement:
Inventory is initially measured at its cost, which includes all costs directly related to bringing the inventory to its present location and condition. This includes purchase or production costs, freight, handling, and any other directly attributable costs.
- Cost Flow Assumptions:
GAAP allows for different cost flow assumptions to assign costs to inventory items. The most commonly used methods are First-In, First-Out (FIFO), Last-In, First-Out (LIFO), and Weighted Average Cost. The chosen method should reflect the flow of goods and the economic circumstances of the entity.
- Lower of Cost or Net Realizable Value (LCNRV):
Inventory is evaluated for potential obsolescence, damage, or decline in value. If the net realizable value (estimated selling price less selling costs) of an inventory item is lower than its cost, the inventory is written down to its LCNRV. This prudence concept ensures that inventory is not carried at an amount higher than its recoverable value.
- Disclosure:
GAAP requires disclosure of significant accounting policies related to inventory, including the cost flow assumptions used and any valuation adjustments made. Additionally, information about the carrying amount of inventory, inventory turnover, and any constraints or restrictions on the sale or use of inventory may be disclosed.
Example of Accounting Treatment of Inventory:
| Stage of Inventory | Accounting Entry | Example |
| Purchase of Inventory | Dr: Inventory Account Cr: Accounts Payable/Cash Account |
Purchased raw materials for ₹50,000: Inventory Account Dr ₹50,000 To Accounts Payable ₹50,000 |
| Inventory Used in Production | Dr: Cost of Goods Sold (COGS) Account Cr: Inventory Account |
Raw materials used in production worth ₹20,000: COGS Account Dr ₹20,000 To Inventory Account ₹20,000 |
| Sale of Finished Goods | Dr: Accounts Receivable/Cash Account Cr: Sales Revenue Account Dr: COGS Account Cr: Inventory Account |
Sold finished goods for ₹80,000 (cost ₹40,000): Accounts Receivable Dr ₹80,000 To Sales Revenue ₹80,000 COGS Account Dr ₹40,000 To Inventory Account ₹40,000 |
| Inventory Valuation at Year-End | Adjustment Entry: Adjust the Inventory Account to reflect the lower of cost or market value | Inventory valued at ₹30,000 at year-end (original cost ₹35,000): Inventory Account Dr ₹5,000 To Inventory Valuation Reserve ₹5,000 |