Understanding inventory accounting: A guide to the top methods and software 

Accurate inventory accounting is a crucial part of your company’s financial management.

Keeping a close eye on how much stock you have—and how quickly it’s moving—helps you make smart, data-driven decisions that can significantly affect your bottom line. 

But it can feel challenging to get a handle on all the details, especially for smaller business owners who might not have a dedicated accounting expert on board. 

This article explains the basics of inventory accounting and how it works.

We’ll look at the different methods of accounting for inventory, define key terms, and highlight the benefits you can expect from effective inventory management in your business. 

Here’s what we’ll cover: 

What is inventory accounting? 

Inventory accounting is the process of tracking and recording the value of your company’s goods and materials for financial reporting and management purposes. 

Inventory covers anything your business holds for resale or production at the end of an accounting period, including both finished products and raw materials.

Because these items have value, they need to be accounted for just like the rest of your finances.

In general, inventory falls into three categories: 

• Raw materials: The basic materials used in production 

• Work-in-Progress (WIP): Items that are partway through the production process 

• Finished goods: Completed products ready to sell. 

On your balance sheet, inventory is an asset because it’s expected to convert to cash (or be used up) within a year.

However, one of the main challenges in inventory accounting is working out how to value your stock accurately.

Shifts in market demand, consumer preferences, or even inflation can affect the worth of your products. 

For instance, if the cost of materials changes over time—say components go from $10 each to $12 each mid-year–you need a clear method for assigning value to your inventory.

Proper accounting and valuation methods help make sure your financial statements always reflect the true value of your assets. 

What are the accounting rules for inventory and stock in the US? 

To keep things accurate, you need to follow recognized standards.

In the US, GAAP (Generally Accepted Accounting Principles) allows different ways to assign value to inventory, including FIFO, LIFO, and WAC. 

First in, first out (FIFO) 

The first in, first out (FIFO) method assumes that the first goods you acquire will be the first ones sold.

This often aligns with how many businesses naturally operate—especially those dealing with perishable goods. 

In many cases, this reflects how the flow of business works anyway.

If you run a company that supplies perishable goods such as fresh food, it’s the only logical way to operate.

As your stock ages, it will spoil, so selling the oldest stock first makes sense. 

For example, if you run a business making fruit baskets, you might: 

• Buy 200 dragon fruits at $2 each (Day 1) 

• Buy another 200 dragon fruits at $2.50 each (Day 2) 

• Sell 200 dragon fruits on Day 3 

With FIFO, the cost of goods sold would be $400 (200 x $2), and the total $500 from the second batch would remain in your ending inventory. 

Even for non-perishable stock, FIFO often gives a more accurate picture of your company’s finances because it uses recent purchase costs for inventory valuation. 

Last in, first out (LIFO) 

Not all businesses use FIFO. Some choose last in, first out (LIFO), which assumes that the most recently purchased items are sold first.

This can add complexity because you need to track older stock that isn’t considered “sold” yet. 

However, LIFO can sometimes reduce your tax liability in an inflationary environment by showing higher costs for goods sold, which lowers your reported profit.

Keep in mind that while LIFO is allowed under GAAP in the US, it’s not permitted under IFRS, the rules many other countries follow. 

Weighted average cost (WAC) 

Using the weighted average cost (WAC) method involves calculating an average unit cost based on all purchases: 

WAC per unit = (beginning inventory value + purchases)/ total number of units in inventory 

This gives different results depending on whether you use a periodic inventory system or a perpetual inventory system. 

• Periodic inventory system: You count inventory at the end of a period and apply product costs to find your ending inventory and cost of goods sold (COGS). 
• Perpetual inventory system: You continuously track inventory and COGS in real-time. This is often called the “moving average cost” method. 

The WAC method is permitted under both the GAAP and IFRS accounting rules. 

What is GAAP? 

GAAP (Generally Accepted Accounting Principles) is the set of standardized accounting rules in the U.S. that ensures financial statements are consistent and transparent across different companies and industries.  

Created by the Financial Accounting Standards Board (FASB), GAAP covers a wide range of accounting topics and is critical for preventing fraud, simplifying audits, and helping investors compare financial statements.  

Public companies must follow GAAP, and many private companies opt for it as well, especially if they want to maintain credibility with lenders or attract new investors. 

Main inventory accounting methods 

There are two different methods of accounting: cash-based and accrual-based.

The main difference between the two is the timing of when you record revenue and expenses. 

Cash basis accounting 

In cash-basis accounting, transactions are recorded only when money changes hands—when you receive or pay cash.  

It’s straightforward and popular among very small businesses, but it can be misleading for inventory purposes.

If you’ve ordered raw materials worth $5,000 in Q1 but don’t pay until Q2, your Q1 statements might look like you have an extra $5,000 you haven’t actually spent yet. 

For this reason, cash-basis inventory accounting isn’t recognized by many regulatory bodies (including GAAP) and can skew a company’s financial picture. 

Accrual basis accounting 

Accrual-basis accounting is more traditional and widely accepted for handling inventory.

You record sales when they occur (even if the cash hasn’t arrived yet) and expenses when they’re incurred (even if you haven’t paid them yet).  

This method offers a clearer picture of your financial health at any given moment and is essential for most businesses carrying significant levels of inventory. 

Cash-basis accounting is a reasonable option for small businesses such as cafes, where the goods are paid for at the point of sale.

However, for manufacturers, e-commerce stores, wholesalers, or any other business that carries a lot of inventory, accrual-based accounting is the best choice. 

Understanding inventory costing 

To value your inventory on the balance sheet, you need to calculate its cost accurately, especially if goods go through multiple stages.

A common formula looks like this: 

Beginning inventory + net purchases—cost of goods sold = ending inventory 

In other words, you start with the inventory you had at the beginning of the period, add any new materials, and then subtract the cost of goods sold to find your ending inventory. 

Key terms and formulas in inventory accounting 

We’ve mentioned some of these before, but it’s worth taking a moment to nail down some clear definitions of a few key terms in inventory accounting.  

Beginning inventory 

The beginning inventory is a measure of a company’s inventory at the start of any given financial reporting period.

You calculate it by adding up the value of any materials on hand that are used to make finished goods, all products that are in the middle of the manufacturing process, and any items the company has manufactured but not yet sold. 

Beginning inventory = value of raw materials + products being made + products made but not yet sold 

Ending inventory 

Similarly, ending inventory refers to the total inventory a company has at the end of the reporting period.

To work this out, take the figure for the beginning inventory, add the value of the raw materials the company has purchased during the period, then subtract the cost of the goods sold.

Note that the ending inventory becomes the beginning inventory of the following period. 

Ending inventory = beginning inventory + net purchases—cost of goods sold 

Inventory turnover 

Inventory turnover measures how many times a company sells its entire inventory during a defined period (usually one year).

In essence, it’s an indicator of how fast a company manages to sell its stock. A low turnover suggests slow sales, while a high turnover indicates stock is selling fast. 

To calculate inventory turnover, work out the average inventory value by adding together your beginning inventory and ending inventory for the period, then divide by two. You then divide the cost of goods sold by this figure. 

Inventory turnover = cost of goods sold / average value of inventory 

(where average inventory = (beginning inventory + ending inventory) / 2) 

Cost of goods sold (COGS) 

COGS, also known as the cost of goods sold, includes all costs a company incurs to produce goods during the reporting period.

This not only means the cost of any raw materials used to create the goods but also the cost of labor involved in making them. It doesn’t include indirect expenses like marketing costs. 

To calculate COGS, take the value of the beginning inventory, add the net purchases for the period, and subtract the ending inventory. This is a rearrangement of the ending inventory formula. 

COGS = beginning inventory + net purchases—ending inventory 

Inventory shrinkage 

An undesirable but common inventory expense is shrinkage.

This occurs when a business has fewer products in stock than it should have, according to the inventory records. 

There can be a number of reasons why this happens: 

• spoilage of perishable goods 

• damage that renders the stock unsaleable 

• human error 

• theft 

Whatever the reason for inventory shrinkage, it’s crucial to track it so you can make an allowance for it in the accounts.

Simply express the difference between the actual inventory and the recorded inventory as a percentage of the recorded inventory. 

Inventory shrinkage rate = 100 x (recorded inventory − actual inventory) / recorded inventory 

Inventory write-off 

Inventory write-off is the formal process of recognizing lost or damaged inventory in your accounts.

It reduces your net profit by the value of the unsaleable or missing items.  

It’s different from a write-down, which is when the value of inventory is reduced, but the stock can still be sold. 

This one doesn’t have a formula as such because it’s a process rather than a calculation.

Here’s how it works: 

• Step 1: Identify the damaged or missing inventory items in the stock. 

• Step 2: Calculate the value to assign to them by multiplying the unit cost by the number of missing items. 

• Step 3: Record the written-off inventory as an expense in a designated inventory write-off expense account. 

• Step 4: Update your inventory system to remove the unsaleable units. 

• Step 5: Debit the COGS on the balance sheet and credit the inventory write-off expense account. If it’s a significant amount, you should also record it separately in the company’s income statement. 

For completeness and in case of later auditing, make a note of the reason for the write-off. 

How to record inventory and cost of goods sold 

Calculating the cost of goods sold vs. inventory is one thing, but it’s also important to have an understanding of how to record them in the books. 

The key thing to remember is that before inventory is sold, it counts as an asset.

Once the stock is sold, the cost of those goods becomes an expense. You then transfer this cost from the balance sheet to the income statement. 

Essentially, the cost of goods sold is set against the revenues the company brings in from the sale of those goods.

When you deduct the cost of goods sold from net sales, you get the company’s gross profit figure. 

For example, let’s suppose a company sells copies of one specific book.

We’ll choose that to strip out any complications that might arise from a manufacturing process or having items that are kept as bulk inventory; in this hypothetical case, identical goods are bought and then sold with no processing involved. 

Here’s a very simplified example of how to record the inventory and COGS.

We’ll assume 10 books are sold during the first quarter of 2024, and the cost of the book rises over time. 

Step / Date	Number of books	Unit cost	Total cost	Notes
Beginning inventory (12/31/23)	10	$20	$200	–
Purchase (Jan 2024)	10	$22	$220	–
Purchase (Feb 2024)	15	$25	$375	–
Purchased (Mar 2024)	10	$27	$270	–
Subtotal: Goods available for sale	45	–	$1,065	Sum of all inventory on hand in Q1 ($200 + $220 + $375 + $270)
Less: Books sold	–	–	–	In Q1, 10 books are sold. Under FIFO, these come from the oldest batch (cost = $20 each).
COGS (10 units x $20)	10	$20	$200	This is the “Cost of Goods Sold” transferred to the income statement.
Ending inventory (01/31/24)	35	–	$865	$1,065 (available)—$200 (COGS) = $865 remains on the balance sheet as an asset

If you sell each book for $30, your total revenue on the 10 books sold in Q1 is $300 (10 x $30).

Subtracting the $200 COGS (from the FIFO batch) leaves you with a gross profit of $100 for that period. 

Advantages of inventory accounting 

There are a number of advantages of inventory accounting, all connected to the fact that it provides clarity about the health of a business.

Here are a few of the main ones: 

Reduces the risk of cash flow problems

Tracking stock levels accurately means you won’t allocate too much cash to excessive levels of inventory, so you can deploy any available cash more strategically. 

Helps optimize profit margins

Keeping a close eye on inventory makes sure you’re tracking costs accurately, helping to boost your profit margins. 

Helps maximize sales

When a particular product is selling fast, you can make sure to increase production or stock more so you don’t miss out on potential sales. 

Allows for accurate write-offs

Inventory accounting lets you monitor shrinkage effectively so you can account for it accurately in your financial reporting. 

Minimizes storage costs

If an item isn’t selling well, you order less of it and don’t have to pay as much to keep it in storage. 

Improves marketing effectiveness

When you track inventory accurately, you’ll spot patterns in sales trends that can be helpful for creating more effective marketing campaigns. 

In addition to these benefits, there’s a very simple reason why using inventory accounting is a good idea.

It’s imperative that companies know what assets they own for both tax and operational reasons. 

That can be a challenge.

But it’s one that’s crucial to meet head-on. Luckily, there are some excellent tools available to help your business do just that. 

Keep your business on track with inventory management  

Track stock levels automatically and avoid problems with over or understocking with dedicated inventory management software. 

The software allows you to monitor inventory in real-time across multiple locations, automating regular tasks such as order processing and reordering.

It’s the best way to make sure you deliver to your customers on time, every time.