Is Inventory a Current Asset?

Inventory is a broad term that covers merchandise available for sale, raw materials needed to produce goods or services, and partially completed goods in production. Inventories account for one of the primary sources of income for businesses. Retail and manufacturing businesses sell their stocks, while other companies use them to deliver a service.

Different businesses will have varying methods of classifying and managing their inventories, but the consensus is that inventories are reported as current assets if the company intends to sell them during the next accounting period or within the year from when they're added to the balance sheet.

Follow along as we discuss what constitutes current assets and when inventory qualifies as one.

Is Inventory an Asset or an Expense?

An asset is defined as an item with economic value that a business buys and stores with a plan to sell or use it to generate cash flow in the future. From an accounting standpoint, inventories are assets as long as there's an expectation that they'll be liquidated into cash or cash equivalents within a year or the next accounting period.

In a manufacturing setting, inventory is categorized into raw materials, work in progress, and finished products to reflect production stages. All the costs associated with purchasing and manufacturing inventory are included in an expense account called the cost of goods sold (COGS). Retail stores may not have a COGS account but choose to record a sale by deducting the amount from an inventory or purchases account.

There are times when businesses might be forced to expense inventories, such as:

When managing and storing unsold and excess inventory costs more than the value of the merchandise
When inventories have become spoilt, obsolete, or lost their value

When these circumstances happen, a business may choose to sell its inventories at a very low price or discard them altogether. Losses on inventory can be financially devastating to small businesses and large companies alike, especially if they happen frequently. That's why managing and correctly calculating how much inventory your business needs to stock is vital to its profitability.

What Type of Asset Is Inventory?

An asset is anything of value that a business buys to sell or use as a means to earn revenue. Examples of assets include cash, accounts receivables, inventories, machinery, land, and patents. Assets and liabilities are listed in a company's balance sheet.

To account for assets properly, they are further categorized into current assets and noncurrent assets. Current assets refer to cash, cash equivalents, short-term investments, and other assets that a business can quickly sell for cash when the need arises, usually within the year. For this reason, they are also referred to as liquid assets. Liquidity refers to how easily an asset can be converted into cash without affecting its market price. In contrast, noncurrent assets are assets that the company doesn't plan to sell or that will take longer than a year to sell.

There is another category under noncurrent assets: fixed assets. These are assets used in the business's operations that aren't for sale. Examples include machinery, land, and office furniture.

Inventory is classified as a current asset when it checks off the following criteria:

It's expected to be sold or used in the day-to-day operations of the business.
It's expected to be easily converted into cash or cash equivalents within a year or the next accounting period.
The proceeds from the sale of inventories are used to pay for the ongoing operating expenses of the business.

In the day-to-day operations of a company, the costs of raw materials and inventories fluctuate from when they are purchased to when they are subsequently sold. As a result, businesses need a way to effectively and accurately value stocks.

The following sections provide three methods of valuing inventory:

First In, First Out (FIFO)

Under the first in, first out (FIFO) method, you calculate the cost of goods sold (COGS) based on the oldest inventory price. This method assumes that the first items purchased will also be the first to be used or sold. The FIFO method is popular in manufacturing and food service settings where inventory can spoil or expire.

Last In, First Out (LIFO)

Under the last in, first out (LIFO) method, you record the COGS using the price of the most recent stocks purchased, and the value of the remaining inventory is based on earlier costs. Businesses that use the LIFO method assume that the last items delivered will be the first to be used or sold.

Average Cost Method

The average cost method is also called the weighted-average way. To account for your COGS under this method, you'll divide the total cost of merchandise purchased or produced during a specific accounting period by the total number of items bought or manufactured. The value of the remaining inventory will also be valued based on the average cost you've calculated.

How Do You Manage Inventory?

Whether you're in the resale, manufacturing, or food service industry, you need an effective system for managing your inventory to avoid losses from having too much or too little. You have too much inventory if you're experiencing frequent losses from spoilt or expired stocks. If you're constantly out of stock and can't fulfill customers' orders, you also need a more efficient management system.

Here are a few tips you can implement while you develop an inventory management system:

Set a standard number. Keep track of your sales or the amount of materials you use for production and determine a minimum number that you should have on hand at all times. Make sure to order only when your stocks are below the predetermined levels.
Audit regularly. It's not a "set it and forget it" kind of system. Keep tracking your sales and inventory throughout the year to verify that the standard you've set is still realistic and accurate. Your audit may include:
Learn how to forecast your inventory needs accurately. Forecasting can be difficult, but you can still try projecting future sales by looking at the following:

Counting all your inventory items at a predetermined time during the year
Spot-checking (choosing a product, counting it, and comparing the number to what it's supposed to be at random times during the year)
Cycle counting (count a different product on a rotating schedule each week or month, with higher-value items counted more frequently)
Trends in the market or upcoming events
Last year's sales during the same week or month
Your business growth this year
The overall economy
If you have any upcoming promotions

Let Skynova Help You Manage Your Small Business Bookkeeping

Inventory management helps you generate more revenue and maintain a healthy cash flow for your business. Track your sales and invoices with Skynova's all-in-one invoicing and accounting software for small business owners. This accounting software keeps accurate records of your income and expenses, which you can use to track your sales and help you make better projections for your inventory needs.

You can also create financial statements like balance sheets and cash flow statements at any time. Explore Skynova's software products for all your business needs — you'll find free templates, resources, and articles to help you run and grow your business.

Notice to the Reader

The content within this article is meant to be used as general guidelines and may not apply to your specific situation. Always consult with a professional accountant for specific advice regarding bookkeeping best practices.