In this article, we cover whether inventory is an asset or an expense. We also share our 10-step process to determine if it’s an expense or an asset. Read on to learn more.
Inventory is considered an asset because it represents items that a business intends to sell for profit, either in their original form or as part of a finished product. It only becomes an expense when the inventory is sold or written off, at which point it is recognized as the cost of goods sold (COGS) on the income statement.
Example: A bakery buys 100 sacks of flour for $5 each, totaling $500, which is recorded as an asset in its inventory. When the bakery uses the flour to make bread, the cost of the flour used ($5 per sack) is then recorded as an expense under the cost of goods sold (COGS).
Here are some of the common inventory items that are considered as assets:
Materials like metals, wood, or textile fabrics that are yet to be processed are assets. They represent the essential inputs that will be converted into finished goods, holding inherent value for manufacturing.
These are goods that are partially completed. They represent an investment in production but aren't yet ready for sale, holding value as they progress toward becoming sellable items.
Items like manufactured smartphones, ready-to-sell garments, or packed food items are assets. They are direct outcomes of the production process and represent immediate or future sales revenue for a business.
For retailers, items bought for resale, such as clothing, electronics, or books, are assets. These items represent potential sales and revenue once they are sold to the end customer.
For businesses dealing in machinery or vehicles, spare parts like engine components or replacement gears are assets. They hold value either for sale or for internal use in repairs and maintenance.
Items like boxes, bottles, labels, or bags used to pack and ship products are assets. They play a crucial role in product delivery and presentation, thus holding value for businesses.
Goods that have been sold or dispatched but haven't reached their destination are still assets. They represent a value as they're either expected to be received in inventory or result in revenue once delivered to the customer.
For businesses in the food industry, items like fresh produce, dairy products, or meat are assets. Though they have a limited shelf life, they hold value due to their potential for immediate sales.
Goods provided to a third party (consignee) but still owned by the consignor (primary business) are assets. They remain assets for the consignor until they are sold by the consignee.
Items stocked up for particular seasons or events, like winter jackets for winter or decorations for Christmas, are assets. They represent potential sales during specific periods or seasons.
Use our 10-step process to determine if your inventory is an asset or expense. Simply follow the steps below:
Ask: Is the item currently held for sale or has it been sold?
Example: At Sunlit Farms, they question whether a stockpile of corn has been sold or if it's still awaiting buyers.
If the item is listed under "Current Assets" as inventory, it's an asset.
Note: Items remain as assets on the balance sheet as long as they are not sold or written off.
Example: Moonrise Jewelers observes its balance sheet and notices that a set of diamond necklaces is recorded under "Current Assets."
If the item has been sold, its cost will move from the balance sheet to the income statement. Check sales invoices or receipts to confirm the sale of the item.
Example: AeroFly Airlines examines its sales invoices to confirm if airplane seats for a specific flight have been sold.
Look for an entry under "Cost of Goods Sold" (COGS). If the item's cost appears here, it has transitioned from an asset to an expense.
Example: SeaBreeze Cosmetics spots an entry for its summer collection under "Cost of Goods Sold."
Determine if the item has been written off due to damage, obsolescence, or other reasons.
If written off, it would be recorded as an expense, often under categories like "Inventory Write-off" or "Loss on Obsolete Inventory".
Example: Polar Lights Clothing inspects its records to determine if last year's winter collection was written off due to slow sales.
Understand where the item stands in the business cycle:
Raw Materials -> Work in Progress -> Finished Goods -> Sold Goods.
Only the "Sold Goods" stage transitions the item's cost from an asset to an expense.
Example: StoneCraft Masonry follows its bricks from raw clay to shaped bricks to construction projects. They identify the majority are still in the "Finished Goods" stage.
High inventory turnover (indicating rapid selling) might suggest more inventory is becoming an expense. Conversely, low turnover could indicate more inventory retained as assets.
Example: SkyHigh Drones observes that it has a high inventory turnover, indicating that its drones are selling rapidly.
Recognize the inventory valuation method in use (FIFO, LIFO, Weighted Average, etc.).
The method can impact when and how inventory costs are recognized as expenses.
Example: Desert Mirage Textiles realizes it employs the Weighted Average method for its fabric bolts, influencing their cost recognition.
Some businesses might have seasonal inventory builds. For example, retailers might stock up before holidays. During these periods, the inventory (asset) count might be higher, but post-holiday or season, more items will transition to expenses as sales occur.
Example: SpringBlossom Florists stocks up on specific flowers before Valentine's Day, anticipating a sales surge during the holiday.
If your business undergoes a financial audit, the auditor will verify the correct classification of inventory. Any discrepancies or misclassifications will be highlighted to ensure accuracy.
Example: SolarBeam Energy undergoes a financial audit, and the auditor confirms their classification of solar panels in inventory.
Starry Night Coffee is a specialty coffee retailer. They've recently launched a new line of coffee beans called "Galaxy Blend," and they wish to understand if their inventory for this product line is considered an asset or an expense. Here’s how they implemented our process:
Starry Night Coffee currently holds 10,000 bags of Galaxy Blend, of which 3,000 have been sold.
Upon checking, Galaxy Blend appears listed under "Current Assets" as inventory, valued at $150,000.
Sales invoices confirm that 3,000 bags were sold for a total revenue of $90,000.
There's an entry under "Cost of Goods Sold" (COGS) for $45,000, indicating the cost for the sold bags.
Records indicate 100 bags were damaged during transport and written off. These are recorded as an "Inventory Write-off" expense of $1,500.
The Galaxy Blend has transitioned from Raw Materials (imported beans) to Finished Goods (roasted and packed beans). Only the 3,000 sold bags have transitioned to the "Sold Goods" stage.
Given that they've sold 3,000 out of 10,000 bags in just a month, their turnover suggests a decent rate, indicating some of the inventory is becoming an expense but a good portion remains an asset.
Starry Night Coffee uses the FIFO method. So, the oldest inventory (costing less due to older contracts) is considered sold first, influencing COGS.
With Christmas approaching, Starry Night has increased its inventory expecting higher sales. This means the current high inventory count might reduce significantly post-holiday season.
Starry Night Coffee's annual audit confirms the classification of Galaxy Blend's inventory. The auditors adjusted for the write-offs and confirmed the COGS as per the FIFO method.
The majority of the Galaxy Blend remains an asset on the balance sheet, valued at $105,000 (considering the initial value, the sales, and the write-offs). Only the portion that's sold or written off transitions to an expense in the form of COGS or write-offs.
We hope our article has now left you with a better understanding of whether inventory is an asset or an expense and how to determine if it’s an expense or asset using our process.
If you enjoyed this article, you might also like our article to determine if inventory is a long term asset or our article on fixed asset inventory.
