Accounting for stock
Stock can be an essential part of a business. We look at how to value stock and report it in the accounts.
Accounting for stock or inventory accounting is an essential part of a business if you buy and sell goods. It values the unsold stock at the end of an accounting period.
This involves recording inventory items, valuing them, and then reporting this information in financial statements. There are several methods that can be used to calculate the inventory value, and the choice of method may have a significant impact on the reported profitability of a company.
As a result, inventory accounting is a complex and vital area of accounting that requires careful planning and analysis.
The UK uses a Financial Reporting Standard (FRS102). Under this standard, there are two stock valuation methods FIFO and average cost AVCO). We will show examples of the two ways. A third method, LIFO, can be used in limited circumstances.
Stock on the Balance Sheet
Inventory is one of the most important assets on a company’s balance sheet. Inventory refers to the stock of goods that a company has on hand, including raw materials, finished products, and even work in progress. Because inventory is a vital part of a company’s operations, it is essential to understand where it appears on the balance sheet.
Inventory is typically classified as a current asset, meaning it is expected to be converted to cash within one year.
Accounting for Stock Transactions
When accounting for stock, several different transactions might take place with stock:
- You purchase new stock, so you increase the stock value.
- You sell stock and transfer it to the cost of sales on the profit and loss account, also known as the income statement.
- Stock write-off – If the stock is no longer valid, it might need to be written off by a journal.
- Stock adjustment – If the physical quantity is different from the quantity in the records, an adjustment is required
The easiest way to complete stock transactions is in accounting software. However, not all accounting software packages include a stock account, so check before you choose one. Two good accounting software packages that account for stock are Xero and Quickbooks.
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An example of accounting for stock transactions is:
We are looking at a computer retail business that buys and sells computers and parts. The product that we will follow with all the examples is a laptop.
At the beginning of the year, a business holds a stock of 6 laptops. It purchases a further 15 and sells 17. At the year-end, the stock held is 4. The value for the remaining 4 will show in the current assets. If the laptops are all purchased for 250.00, the stock record will look like this:
Date | Description | Purchases QTY | Value | Sales QTY | Value | Closing Stock Qty | Value |
1 Jan | Opening Stock | 6 | 1500.00 | ||||
3 Jan | 3 | 750.00 | 3 | 750.00 | |||
10 Jan | 10 @ 260 | 2500.00 | 13 | 3250.00 | |||
15 Jan | 10 | 2500.00 | 3 | 750.00 | |||
17 Jan | 5 @ 625 | 1250.00 | 8 | 2000.00 | |||
22 Jan | Closing Stock | 4 | 1000.00 | 4 | 1000.00 |
The opening balance of stock was 6 laptops @ 250.00 = 1500.00. The closing stock was 4 @ 250.00 = 1000.00. These will be the figures posted on the balance sheet.
We will use the above example in the LIFO, AVCO, and FIFO, which have different purchase costs. It will demonstrate how they are all calculated.
Stock Valuation Methods or Inventory Accounting Method
We will look at the following stock valuation methods that are used to find the closing stock value: First In, First Out (FIFO), the average cost (AVCO) and Last in, First Out (LIFO).
What is FIFO?
The First in, First Out method assumes that the first item purchased is the first item sold (oldest product). This is because the prices of goods purchased may change constantly, and you must consider the changes.
We will look at this in more detail by using the laptop example above but changing the cost price. The opening stock is purchased at 250.00 each. The other 2 purchases are 260.00 and 265.00.
Date | Description | Purchases QTY | Value | Sales QTY | Value | Closing Stock Qty | Value |
1 Jan | Opening Stock | 6 | 1500.00 | ||||
3 Jan | 3 | 750.00 | 3 | 750.00 | |||
10 Jan | 10 @ 260 | 2600.00 | 13 | 3350.00 | |||
15 Jan | 3 | 750.00 | |||||
7 | 1820.00 | 3 | 780.00 | ||||
17 Jan | 5 @ 265 | 1325 | 8 | 2105.00 | |||
22 Jan | 3 | 780.00 | |||||
1 | 265.00 | ||||||
22 Jan | Closing Stock | 4 | 1060.00 |
The sales on each date now have different values. The first value is the oldest stock, and the second value is the most recent purchase. The closing stock is 4 @ 265.00 = 1060.00
What is AVCO?
AVCO is the average cost method.
Using the example of keyboards above, it will look like this. Our example presumes that the average cost of the stock brought forward is £250.
Date | Description | Purchases QTY | Value | Sales QTY | Value | Closing Stock Qty | Value | Average Value |
1 Jan | Opening Stock | 6 | 1500.00 | |||||
3 Jan | 3 | 750.00 | 3 | 750.00 | ||||
10 Jan | 10 @ 260 | 2600.00 | 13 | 3350.00 | 257.692 | |||
15 Jan | 10 | 2576.92 | 3 | 773.08 | ||||
17 Jan | 5 @ 265 | 1325.00 | 8 | 2098.08 | 262.26 | |||
22 Jan | 4 | 1049.04 | 4 | 1049.04 |
After the first purchase, although the goods were purchased at 260.00, the average price was 257.692.
After the second purchase, the average price is adjusted again at 262.26.
The difference between the FIFO and AVCO in this example is 10.96, but if the cost were much higher, it would affect the stock value much more.
What is LIFO?
LIFO stands for Last in, First out. Although it is not used much in the UK, it is worth knowing about. Again, we will use the above example.
Date | Description | Purchases QTY | Value | Sales QTY | Value | Closing Stock Qty | Value |
1 Jan | Opening Stock | 6 | 1500.00 | ||||
3 Jan | 3 | 750.00 | 3 | 750.00 | |||
10 Jan | 10 | 2600.00 | 13 | 3350.00 | |||
15 Jan | 10 | 2600.00 | 3 | 750.00 | |||
17 Jan | 5 | 1325.00 | 8 | 2105.00 | |||
22 Jan | 4 | 1060.00 | 4 | 1045.00 |
The final stock is made up of the following: 3 units @ 250.00 and 1 unit @ 265.00 = 1045.00
As you can see from all 3 methods, the stock is calculated using different figures.
Should I use FIFO, AVCO or LIFO?
As we looked at in the beginning, when accounting for stock, most businesses use either the first-in, first-out method or average cost. The most popular method is first in, first out. If unsure which method is best for your business, speak to your accountant. Once the company has a method, they must stick to using the same process.
Inventory Management
inventory management is keeping track of inventory levels and restocking as needed. This process can be manual or automated, but it is essential for businesses that rely on inventory to keep their operations running smoothly. Inventory management systems help businesses to track inventory levels, set reorder points, and generate reports.
The information is then used to decide when to order more inventory and how much to order. Inventory management is critical to supply chain management and can significantly impact a business’s bottom line.
Inventory Accounting – Stock Check
Part of the year-end process is to complete a stock check; this will be done on the last day of the accounting period. It will ensure that the figures in the accounts are the same as the actual quantity held. You can complete a stock check in various ways, including physically counting the stock or using a scanner to record each item.
If the physical stock levels differ from the accounts’ figures, the stock adjustment is created. Stock levels might differ for several reasons, including theft, accounting error and disposal of old stock.
Cost of Goods Sold on the Profit and Loss Report
The cost of goods sold (COGS) is important in accounting and business.
It represents the cost of the inventory sold during a period and can be used to calculate the gross profit. Businesses use a journal entry to transfer the cost of goods sold from the balance sheet to the profit and loss account.
If the business uses accounting software, the cost of goods sold is automatically adjusted when a sales invoice is issued, and the goods are listed on the invoice.
This entry includes the cost of the inventory that was sold, as well as any associated expenses, such as shipping. The journal entry is then posted to the profit and loss account, which can be used to calculate the gross profit. By understanding how to transfer COGS from the balance sheet to the profit and loss account, businesses can more accurately track their financial performance.
Once the gross profit is calculated, the general and administrative expenses are deducted to calculate the net profit.
Accounting for Stock – Summary
When accounting for stock, most businesses use the first-in, first-out (FIFO) or average cost method. The FIFO method assumes that the first item purchased is the first item sold (oldest product). The AVCO method uses the average cost of the stock brought forward. The LIFO method assumes that the last item purchased is the first to be sold (newest product).
The most popular method is the FIFO. If unsure which method is best for your business, speak to your accountant. Once the company has a method, it must stick to using the same process.
- Stock is listed in the balance sheet as a current asset.
- Three main methods for calculating the cost are LIFO, AVCO and FIFO.
- The easiest way to account for the stock is by using accounting software.
- When sold, the stock is transferred to the COGS on the Profit and Loss Report.
- Complete a stock take at a period end and make any adjustments necessary.
For further reading on accounting for stock or inventory accounting, see our articles on the balance sheet and manual stock control.