Under U.S. Generally Accepted Accounting Principles, inventory accounting is governed primarily by FASB Accounting Standards Codification Topic 330, and the GAAP inventory rules cover three things: which costs a company capitalizes into inventory on the balance sheet, which cost flow assumption it uses to move those costs to cost of goods sold when items are sold, and how it writes inventory down when its value drops below what the books say.1Financial Accounting Foundation. GAAP and Private Companies Get any of the three wrong and two headline numbers move: the value of assets on the balance sheet and the cost of goods sold on the income statement.
What Counts as Inventory
Inventory is tangible property a company holds for sale, is producing for sale, or plans to consume in production. Manufacturers usually carry three categories: raw materials, work-in-process, and finished goods. Retailers and wholesalers carry only finished goods.
The harder question is ownership when the goods are physically somewhere else. Shipping terms control that. Under FOB shipping point, the buyer owns the goods the moment the seller hands them to a carrier, so they belong on the buyer’s balance sheet while still on the truck. Under FOB destination, the seller owns them until they arrive. A year-end count has to include owned goods in transit and exclude other companies’ goods sitting in the warehouse.
Consignment works the same way. The consignor keeps consigned goods on its books even though the items sit in the consignee’s store; the consignee never records them as an asset. Revenue passes only when the consignee sells to an end customer. Missing consigned inventory during a count can materially misstate assets.
Which Costs Go Into Inventory
GAAP requires companies to capitalize all costs needed to bring inventory to its present condition and location. Those costs sit on the balance sheet as an asset rather than hitting the income statement right away. The starting point is the purchase price net of trade discounts and allowances. Freight-in to get goods to the company’s facility is capitalized.
For manufacturers, capitalizable costs also include direct labor and a share of manufacturing overhead, both variable (indirect materials, for example) and fixed (factory rent, equipment depreciation). Fixed overhead has to be allocated based on the factory’s normal production capacity rather than actual output in an unusually slow or busy period. In a low-production quarter, unabsorbed overhead is expensed rather than loaded onto fewer units at an inflated per-unit cost.
Some costs are never capitalized. Selling expenses, general and administrative overhead, and abnormal amounts of wasted materials or spoilage are expensed as incurred. They either don’t relate to getting inventory ready for sale, or they represent inefficiencies that shouldn’t inflate an asset’s carrying value.
Interest
Interest on borrowed money can be capitalized into inventory only for assets that need an extended production period to get ready for sale, such as custom-built equipment, ships, or discrete real estate projects.2Financial Accounting Standards Board. Summary of Statement No 34 – Capitalization of Interest Cost Routinely manufactured goods produced in large quantities do not qualify. A consumer electronics maker expenses its borrowing costs; a shipbuilder on a two-year contract capitalizes the interest attributable to that project.
Cost Flow Methods
When a unit sells, the company needs a rule for deciding which unit’s cost moves to cost of goods sold. GAAP permits several assumptions, and the assumption does not have to match the physical order in which goods actually leave the warehouse.
First-In, First-Out
FIFO assumes the oldest units are sold first. COGS reflects earlier purchase costs, and ending inventory consists of the most recently acquired units. When prices are rising, FIFO produces the lowest COGS and the highest net income, along with a higher tax bill. The balance sheet payoff is that ending inventory closely approximates current replacement cost.
Last-In, First-Out
LIFO assumes the newest units are sold first, matching current costs against current revenue. During inflation, that produces higher COGS, lower reported income, and a lower tax bill. The tax advantage is the main reason companies adopt LIFO.
Federal tax law adds a conformity requirement: a company that uses LIFO on its tax return must also use LIFO in the financial statements it gives shareholders and creditors.3Office of the Law Revision Counsel. 26 USC 472 – Last-in, First-out Inventories The IRS regulation is explicit that any report or statement to shareholders, partners, or beneficiaries has to use the same LIFO method applied on the return.4eCFR. 26 CFR 1.472-2 – Requirements Incident to Adoption and Use of LIFO Inventory Method You cannot show investors a FIFO income statement while telling the IRS you use LIFO.
LIFO creates a known balance sheet distortion. Because the oldest, cheapest cost layers stay on the books, inventory can be dramatically understated relative to current prices. Companies have to disclose the LIFO reserve, which is the difference between the LIFO carrying value and what inventory would have been worth under FIFO, so that analysts can adjust for comparison.
The other risk is LIFO liquidation. If inventory quantities decline, the company dips into old, low-cost layers and pushes them into COGS. Income is artificially inflated, and an unexpected tax hit follows, which is the opposite of why most companies chose LIFO to begin with. When it happens, the effect on income has to be disclosed in the footnotes.
One boundary matters for any company with international operations or plans to list abroad: LIFO is permitted under U.S. GAAP but prohibited under IFRS.5KPMG. Inventory Accounting: IFRS Standards vs US GAAP
Weighted-Average Cost
The weighted-average method divides the total cost of all units available for sale by the total number of units and applies the resulting per-unit average to both COGS and ending inventory. Under a perpetual system, the average recalculates after every purchase; under a periodic system, it is computed once at period end. The method smooths out price swings and works well for homogeneous, physically commingled goods like chemicals or grains.
Specific Identification
Specific identification tracks the actual cost of each individual unit. When a unit sells, its exact purchase cost moves to COGS. The method fits high-value, distinguishable items such as vehicles, jewelry, custom machinery, and artwork, and it is common where regulation requires traceability, as in medical devices and aerospace components. The downside is administrative complexity, along with an opening for income manipulation: a company holding two identical items purchased at different prices could selectively sell the higher- or lower-cost unit to steer earnings. For that reason, specific identification is generally reserved for inventory where units genuinely differ.
Retail Inventory Method
Large retailers with thousands of SKUs often use the retail inventory method, which estimates ending inventory at cost by applying a cost-to-retail percentage. The company tracks inventory at retail prices and converts the ending retail value to cost using the computed ratio. It removes the need for item-level cost records and speeds up physical counts because items can be priced at their marked value. Companies using this method apply the lower of cost or market rule rather than the lower of cost and net realizable value test used by FIFO and weighted-average companies.6Financial Accounting Standards Board. Accounting Standards Update 2015-11 – Inventory (Topic 330) Simplifying the Measurement of Inventory
Writing Inventory Down
GAAP applies a conservative principle: inventory should never sit on the balance sheet at more than the company can realistically recover by selling it. Which test applies depends on the cost flow method.
Lower of Cost and Net Realizable Value
Companies using FIFO or weighted-average measure inventory at the lower of cost and net realizable value. NRV is the estimated selling price minus reasonably predictable costs to complete, sell, and ship.6Financial Accounting Standards Board. Accounting Standards Update 2015-11 – Inventory (Topic 330) Simplifying the Measurement of Inventory If a batch of electronics cost $50,000 to produce but can only be sold for $38,000 after shipping and disposal costs, inventory is written down to $38,000 and the $12,000 loss hits the income statement immediately.
Lower of Cost or Market
Companies using LIFO or the retail inventory method still follow the older lower of cost or market rule.6Financial Accounting Standards Board. Accounting Standards Update 2015-11 – Inventory (Topic 330) Simplifying the Measurement of Inventory Under LCM, “market” is replacement cost, capped at a ceiling equal to NRV and floored at NRV minus a normal profit margin. That three-way comparison is more involved than the NRV test. The 2015 FASB update that simplified valuation for FIFO and weighted-average users intentionally left LCM in place for LIFO and retail method companies.
How Write-Downs Get Recorded
A write-down debits COGS or a separate loss account and credits inventory, reducing the asset’s carrying value. The comparison can be done item by item, by category, or on total inventory; the item-level approach is the most conservative because gains on some items cannot offset losses on others.
Once inventory is written down under U.S. GAAP, the reduced amount becomes the new cost basis. The write-down cannot be reversed in a later period even if market conditions improve. That is another difference from IFRS, which does allow reversals up to the original cost. U.S. GAAP recognizes losses immediately but does not anticipate recoveries.
Periodic vs. Perpetual Tracking
GAAP does not require one tracking system over another, but the choice affects how current the data is and how strong internal controls are.
A periodic system updates inventory and COGS only at period end. The company takes a physical count to determine ending quantities, then computes COGS as beginning inventory plus net purchases minus ending inventory. Between counts, there is no running record. The system is cheaper and simpler, which appeals to smaller businesses, but shrinkage and theft go undetected until the next count and purchasing decisions rely on stale numbers.
A perpetual system records every transaction as it happens. Each purchase increases the inventory account and each sale reduces inventory and records COGS at the same time. Real-time visibility into stock and gross profit is the result, and modern point-of-sale and ERP systems have made perpetual tracking practical even for large product lines. It is now the dominant approach among mid-size and large businesses.
Perpetual records still drift from reality through theft, damage, scanning errors, and miscounts, so physical counts are still needed. Discrepancies are recorded as inventory shrinkage. Auditors are required to observe physical counts.7PCAOB. AS 2510 – Auditing Inventories
Balance Sheet Presentation and Disclosures
Inventory appears on the balance sheet as a current asset, usually after cash and receivables. The reported figure reflects the chosen cost flow method and any write-downs. For most companies, inventory is expected to convert to cash within one year or the normal operating cycle, whichever is longer.
The footnotes have to identify the cost flow method used. Manufacturers generally break inventory into raw materials, work-in-process, and finished goods so users can see where working capital sits and how far along production is. Material write-downs taken during the period have to be disclosed regardless of method.
LIFO companies have extra disclosures. They report the LIFO reserve so users can estimate a FIFO-equivalent value. If a LIFO liquidation happened, they disclose the effect on income, including the approximate dollar amount by which COGS decreased and net income increased from dipping into older cost layers.