How Is Inventory Accounted for in Accrual Accounting?

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Tracking inventory is important for any retail company.
Tracking inventory is important for any retail company. (Image: Rolling office inventory cardboard image by TekinT from <a href='http://www.fotolia.com'>Fotolia.com</a>)

For any retail business, keeping track of inventory—when it is sold, how much it cost, and how much revenue was generated by it—is important. There are a number of methods that accountants use to track inventory expenses and revenue, and as long as they don't violate any laws, they are all valid. While multiple companies in the same industry may use the same method to increase the comparability for the sake of the investors, it is not uncommon to see a wide variety of practices in use.

Accrual Accounting

Because it allows organizations to keep track of data in a far more accurate manner, in addition to the inherent illegality of using cash accounting, most businesses the world over use accrual accounting. Under this method, revenue generated by selling merchandise is recorded in equity when the merchandise changes hands. This is not affected by whether or not it is immediately paid for, simply that the merchandise has been delivered. In addition, the cost of that inventory is removed from assets as an expense, matching the expense with the revenue it generated.

Weighted Average

The most common type of inventory accounting in use today is the weighted average system. Under the weighted average system, the recorded price of the cost of goods sold is the average of however many different prices inventory was purchased for, weighted by how much of each stock was purchased. As an example, the weighted average of three equal stocks of $10, $20 and $30 inventory would be $20, as it's the average (because each inventory stock was the same amount).

LIFO

Last In First Out, or LIFO, accounting is the second primary type of inventory accounting. In LIFO, the cost of goods is equal to the cost of the goods purchased most recently. As that is used up, older stock is accounted for. For instance, if 15 units of stock cost $10, followed by five units of stock at $20, selling 10 units of stock would cost a total of $150, or five times 20 plus five times 10.

FIFO

First In First Out, or FIFO accounting is the third primary type of inventory accounting. In FIFO, the cost of goods is equal to the cost of the goods purchased first. As that is used up, more recent purchases are accounted for. As an example, if 15 units of stock cost $10 dollars, followed by five units of stock at $20, selling 10 units of stock would cost a total of $100, or 10 times $10.

Cash Accounting

Cash accounting is not used to track the purchase and sale of inventory due primarily to the same reason that cash accounting is illegal in many countries for business transactions. Because transactions are recorded only when money—and not the merchandise—changes hands, cash accounting does not accurately reflect the present status of the company and makes it easy to lose track of inventory.

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References

  • "Financial Accounting (7th Edition)"; Walter T. Harrison and Charles T. Horngren; 2008
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