If your business carries stock for sale, it’s good to understand the basics of inventory costing and the value in your financial accounts.
There are two ways of recording inventory value – perpetual or periodic. This article focuses on the periodic system – we’ll cover the perpetual system in the next OTM Bookkeepers Melbourne blog.
Inventory costing and stock management directly affect your business’s profitability. How much stock you hold impacts your profit or loss at the end of the financial year.
Periodic Inventory Method
The periodic method of accounting for inventory value relies on taking a physical count of stock on hand at specific intervals, for example, monthly, quarterly or annually. This system updates your financial accounts on the date of the stocktake, which means your financial reports only reflect the correct value periodically (not all the time, as is the case with a perpetual inventory system).
With periodic inventory, the purchase of stock is allocated to a cost of sales (COS) expense account. Sales of stock are allocated to a sales (or income) account, and there is no immediate impact on the inventory asset account.
The inventory asset account is the one that reflects the value of the stock on hand. When a stocktake is performed, the balance in the COS purchases account is transferred to the inventory asset account via a journal entry, correcting the value of the stock on hand and the cost of sales.
This system is useful for small operations that don’t hold a lot of stock, where stocktake is a relatively simple affair and where precise financial value of stock in between stocktake dates is not essential.
Periodic inventory is prone to errors and is not appropriate for large or complex inventory – for that, you’ll need to use the perpetual system and specialised stock management software.
How to Value the Stock
There are different accounting methods for stock; some are more appropriate for different types of businesses.
You can use the first-in-first-out method, an average cost per item, specific pricing per item, or a last-in-first-out method.
Whichever valuation method is chosen, stick to it! The method chosen affects the inventory value in your accounts, so it’s essential to be consistent for the accuracy of your reports. Not sure which system you’re using? Talk to us, and we’ll match you with one of our Xero certified advisors who can analyse your inventory costs and systems.
Factors affecting the inventory value include the item cost, inbound freight, customs duties, packaging and, if buying from overseas, the foreign exchange rate.
The ATO allows for simplified trading stock rules in some circumstances – if you’re eligible, you don’t need to perform a physical stocktake; instead, you provide an estimate of stock value at the end of the financial year. You can use this rule if the value of your trading stock changes by $5,000 or less and your turnover is less than $10 million.
When using the periodic system, you’ll need to regularly record adjustments for damaged, obsolescent, or missing stock – monthly, quarterly or annually, depending on the size of the inventory and frequency of adjusting events.
Maintaining the System
If you hold stock, then you need to account for it correctly. For example, we’ve often seen new client files that have started recording the value of the stock but never adjusted the value at stocktake, so the inventory value in the financial reports is inaccurate.
You’ll need to perform a stocktake annually on 30 June for tax return purposes. It’s good practice to increase the frequency of stocktaking as your stock on hand grows, moving to quarterly and monthly as needed. But it can be a labour-intensive job manually checking all the stock on hand against your inventory records, so you need to assess what cycle of stocktaking is relevant for your business. Once stocktakes become laborious, it’s time to think about moving to a perpetual system and upgrading software.
Xero Inventory
Xero can track up to 4,000 inventory items in the periodic system and is suitable for relatively simple stock management.
If you have a large and complex inventory, you record the sale of goods before they are purchased, you assemble goods from components, or you require purchase orders and delivery note receipts, you’ll need an add-on inventory solution to integrate with Xero.
This also applies to goods purchased overseas for which landing costs and freight are paid separately. You’ll need a more sophisticated app to track overseas purchases and landed costs.
Want to Get Control of Your Inventory?
If you’d like an appraisal or upgrade of your current stock management system, talk to us at On The Money Bookkeepers Melbourne, as we can help assess what kinds of systems and accounting are best for you. We can also review the relevant accounts in your financial statements to determine the COS percentages, other inventory-related expenses and margins.
We’d love to streamline your stock management systems and help you understand how inventory costing impacts your financial success.