U.S. Generally Accepted Accounting Principles set the rules for how a company puts inventory on its balance sheet, moves its cost to the income statement when goods are sold, and writes it down when it loses value. The core GAAP inventory rules live in FASB Accounting Standards Codification Topic 330 and apply to every public company and to private businesses that report on a GAAP basis.1Financial Accounting Foundation. GAAP and Private Companies Three decisions do most of the work: what belongs in inventory, what costs attach to it, and how to measure it going forward.
What Counts as Inventory
Inventory under GAAP is tangible property you hold for sale, are producing for sale, or will consume in production. A manufacturer typically carries three buckets: raw materials, work-in-process picking up labor and overhead as it moves through the plant, and finished goods ready to ship. A retailer or wholesaler usually carries only finished goods.
The harder question is ownership. Goods you own count as your inventory even when they are sitting in someone else’s warehouse or on a truck, and goods you do not own stay off your books even when they are in your building. Shipping terms decide this. Under FOB shipping point, title passes when the seller hands the goods to the carrier, so the buyer owns inventory in transit. Under FOB destination, the seller keeps title until the goods arrive. A year-end count has to pick up what you own in transit and leave out what belongs to someone else on your floor.
Consignment follows the same logic. The consignor keeps the goods on its balance sheet while they sit in the consignee’s store, and the consignee records nothing until it sells to an end customer. Missing consignment goods during a count is a common way companies misstate assets.
What Costs Go Into Inventory
GAAP requires you to capitalize every cost necessary to bring inventory to its present condition and location. Those costs sit on the balance sheet as an asset until the goods are sold; only then do they move to cost of goods sold.
The starting point is the purchase price, net of trade discounts and allowances, plus freight-in to get the goods to your facility. Manufacturers add 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 plant’s normal production capacity, not actual output in an unusually slow or busy quarter. In a slow quarter, the unabsorbed overhead gets expensed instead of being loaded onto fewer units at an inflated per-unit cost.
Some costs never go into inventory. Selling expenses, general and administrative overhead, and abnormal amounts of waste or spoilage are expensed as incurred. They either do not relate to getting inventory ready for sale or represent inefficiency that should not inflate an asset.
Interest
Interest on borrowings can be capitalized into inventory only for assets that take an extended period to get ready for sale, such as ships, custom equipment, or discrete real estate projects. Goods produced on a repetitive basis in large quantities do not qualify, so a consumer electronics manufacturer expenses its borrowing costs while a shipbuilder working a two-year contract capitalizes the interest attributable to that build.2Financial Accounting Standards Board. Summary of Statement No 34 – Capitalization of Interest Cost
Purchase Discounts
When a supplier offers an early-payment discount like “2/10, net 30,” you can record inventory either way. The gross method puts inventory on the books at the full invoice price and treats the discount as a reduction only if you pay in time. The net method records inventory at the discounted price from the start and books a missed discount as an expense called purchase discounts lost. The net method is considered more theoretically sound because it treats late payment as a financing cost, but many companies use the gross method because it is simpler.
Cost Flow Methods
Once inventory is on the books, you need a rule for which unit’s cost moves to COGS when a sale happens. GAAP permits several, and the method does not have to match the physical order goods actually leave the warehouse.
FIFO
First-in, first-out assumes the oldest units sell first. COGS reflects earlier purchase prices, and ending inventory consists of your most recent buys. When prices are rising, FIFO produces the lowest COGS and the highest reported income, which means a higher tax bill. The upside is a balance sheet where inventory sits close to current replacement cost.
LIFO
Last-in, first-out assumes the newest units sell first, pushing current costs into COGS. During inflation that lowers reported income and the tax bill, and the tax saving is the main reason companies adopt it.
Federal tax law imposes a conformity requirement: if you use LIFO on your tax return, you have to use LIFO in the financial statements you give shareholders and creditors.3Office of the Law Revision Counsel. 26 USC 472 – Last-in, First-out Inventories The IRS regulation requires any report or statement to shareholders, partners, or beneficiaries 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 has two well-known distortions. The first is that old, cheap cost layers can sit on the balance sheet for years, understating inventory badly. Companies have to disclose the LIFO reserve, the difference between the LIFO carrying value and what inventory would have been under FIFO, so analysts can convert for comparison. The second is LIFO liquidation. If quantities on hand fall, you dip into those old cheap layers and push them into COGS, inflating income and triggering an unexpected tax hit. When that happens, the effect on income has to be disclosed in the footnotes.
LIFO is permitted under U.S. GAAP but prohibited under IFRS, which matters for any company with international operations or non-U.S. listing plans.5KPMG. Inventory Accounting: IFRS Standards vs US GAAP
Weighted Average
Weighted average divides the total cost of units available for sale by the total units to produce a single average cost, applied 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 lands between FIFO and LIFO. It suits homogeneous goods that are physically commingled, like chemicals or grains.
Specific Identification
Specific identification tracks each unit’s actual cost. When a unit sells, its exact cost goes to COGS. The method fits high-value, distinguishable items like vehicles, jewelry, custom machinery, and artwork, and is also common where regulation demands traceability, such as medical devices and aerospace parts. The downside is administrative load, and because two identical items bought at different prices give the seller a choice of which cost to recognize, specific ID creates room for earnings management. For that reason it is generally kept to inventory where units genuinely differ in cost or character.
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 ratio to the retail value on hand. RIM avoids item-level cost records for every product and speeds up physical counts because items can be priced at the ticketed retail value. Companies using RIM apply the lower of cost or market rule rather than the simpler net realizable value test used by FIFO and weighted-average filers.6Financial Accounting Standards Board. Accounting Standards Update 2015-11 – Inventory (Topic 330) Simplifying the Measurement of Inventory
Writing Inventory Down
GAAP enforces a conservative principle: inventory should not sit on the balance sheet at more than you can realistically recover by selling it. The exact test 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 the goods.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 now only be sold for $38,000 after shipping and disposal costs, inventory drops to $38,000 and the $12,000 loss hits the income statement in the current period.
Lower of Cost or Market
Companies using LIFO or RIM 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 “Market” means replacement cost, capped at a ceiling (NRV) and floored at NRV minus a normal profit margin. That three-way comparison is more involved than the straight NRV test. The 2015 FASB update that simplified things for FIFO and weighted-average users deliberately left LCM in place for LIFO and retail method companies.
No Reversals
The write-down can be applied item by item, by category, or to total inventory, and item-by-item 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 value becomes the new cost basis. If market conditions later improve, you cannot write it back up. That is a one-way door, and it is a key difference from IFRS, which does allow reversals up to the original cost.
Periodic vs. Perpetual Tracking
GAAP does not require either system, but the choice affects how current your numbers are and how strong your controls look.
A periodic system updates inventory and COGS only at the end of the period. You take a physical count, then back into COGS using beginning inventory plus net purchases minus ending inventory. Between counts there is no running record. It is cheaper to run, but theft and shrinkage are invisible until the next count, and purchasing and pricing decisions depend on stale data.
A perpetual system records every transaction as it happens. Each purchase raises the inventory account; each sale drops inventory and books COGS in the same entry. Modern point-of-sale and ERP systems have made this feasible even for large product catalogs, and it is the dominant approach at mid-size and larger companies.
Even with perpetual tracking, physical counts are still necessary. Book records drift from reality through theft, damage, scanning errors, and miscounts, and the periodic count reconciles the two with any gap booked as shrinkage. PCAOB auditing standards require auditors to observe physical counts, though for companies with reliable perpetual records the observation can be scheduled at dates other than year-end.7PCAOB. AS 2510 – Auditing Inventories
Presentation and Disclosure
Inventory shows up on the balance sheet as a current asset, usually listed after cash and receivables, at the figure that reflects the cost flow method and any write-downs already recorded. For most companies the assumption is that inventory will convert to cash within a year or the normal operating cycle, whichever is longer.
The footnotes have to carry enough context for a reader to evaluate the number. At a minimum you identify the cost flow method. Manufacturers typically break the balance into raw materials, work-in-process, and finished goods so analysts can see where working capital is concentrated and how far along production is.
LIFO companies have more to disclose. The LIFO reserve has to be reported so analysts can estimate what inventory would have been worth under FIFO. If a LIFO liquidation occurred, the footnote should quantify the effect on income, including the approximate amount by which COGS fell and net income rose from dipping into old cost layers. Material write-downs taken during the period have to be disclosed regardless of the cost flow method in use. Analysts rely on the cost flow method to compare competitors, on the LIFO reserve to adjust valuations, and on write-down disclosures to judge how well management is reading its own inventory.