What Counts as Inventory (and What Does Not)
Inventory is an asset held for sale in the ordinary course of business, or goods that will be used to produce items for sale. In accounting terms, inventory is expected to be converted into revenue within the normal operating cycle (often within a year).
Inventory vs. Supplies vs. Fixed Assets
Beginners often mix these categories because they can all be “things you buy.” The difference is how the item is used and how it provides value.
- Inventory: Items you sell (merchandise) or items that become part of what you sell (materials/components). Example: a retailer’s shirts for resale; a bakery’s flour used to make bread for sale.
- Supplies: Items you consume to run the business but that do not become the product sold. Example: printer paper, cleaning supplies, small office consumables. These are typically expensed as used (or sometimes as purchased if immaterial).
- Fixed assets (property, plant, and equipment): Long-lived resources used to operate the business over multiple periods. Example: ovens, delivery vans, shelving, manufacturing equipment. These are not “sold in the normal course”; they support operations and are expensed over time through depreciation.
A quick test: If you expect to sell it to customers (or it becomes part of what you sell), it is likely inventory. If you expect to use it repeatedly to run the business for years, it is likely a fixed asset. If you expect to consume it internally and it doesn’t become the product, it is likely supplies.
Where Inventory Appears in the Financial Statements
Balance Sheet: Inventory as a Current Asset
Inventory appears on the balance sheet under Current Assets because it is expected to be sold (or used in production and then sold) in the near term.
| Statement | Section | Typical Line Item |
|---|---|---|
| Balance Sheet | Current Assets | Inventory |
| Income Statement | Expenses | Cost of Goods Sold (COGS) |
Income Statement: How Inventory Becomes COGS
Inventory is not an expense when purchased. It becomes an expense when the related goods are sold. At that point, the cost of the goods sold is recognized as COGS on the income statement.
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This is an application of the matching principle: costs are recognized in the same period as the revenue they helped generate.
Timeline: Purchase → Storage → Sale → Expense Recognition
Think of inventory moving through a simple lifecycle. The accounting follows that lifecycle.
1) Purchase goods → 2) Store/hold goods → 3) Sell goods → 4) Recognize expense (COGS)Step-by-step: What the Accounting Is Trying to Do
- At purchase: You have acquired an asset (inventory). No expense yet because no revenue has been earned from those goods.
- During storage: Inventory remains an asset on the balance sheet. It represents future economic benefit (future sales).
- At sale: Two things happen conceptually: (1) you earn revenue, and (2) you “use up” the inventory that was sold.
- Expense recognition: The cost of the sold items is recognized as COGS in the same period as the sale revenue.
In other words: buying inventory changes the mix of assets (cash decreases, inventory increases). selling inventory converts the asset into an expense (inventory decreases, COGS increases) while also recording revenue.
Mini Example: Beginning Inventory, Purchases, Ending Inventory
Assume a small retailer tracks inventory over a month. We will focus on how the Inventory account changes and how that connects to COGS.
Given
- Beginning inventory (start of month): $1,000
- Purchases during the month: $2,500
- Ending inventory (end of month count): $700
Step 1: Compute Cost of Goods Available for Sale
These are the goods you had available to sell during the period.
Cost of Goods Available for Sale = Beginning Inventory + Purchases= $1,000 + $2,500 = $3,500Step 2: Compute Cost of Goods Sold (COGS)
If $700 remains at the end, then the rest must have been sold (or otherwise removed from inventory). Under basic inventory accounting, COGS is calculated as:
COGS = Beginning Inventory + Purchases − Ending Inventory= $1,000 + $2,500 − $700 = $2,800Interpretation: The business “used up” $2,800 of inventory in generating sales during the month, so that amount is recognized as an expense (COGS) on the income statement.
Step 3: Show How the Inventory Account Changes
You can visualize the Inventory account as increasing with purchases and decreasing with the cost of items sold, ending at the physical count value.
| Inventory Account Movement (Month) | Amount |
|---|---|
| Beginning balance | $1,000 |
| + Purchases (added to inventory) | $2,500 |
| − Cost transferred out as COGS (items sold) | ($2,800) |
| = Ending balance | $700 |
Matching Emphasis: When the Expense Happens
Notice what did not happen: the $2,500 of purchases did not automatically become an expense when bought. Instead, only the portion of inventory that was actually sold during the month ($2,800, which includes some beginning inventory) became COGS. The remaining $700 stays on the balance sheet as an asset until it is sold in a future period.
