To account for inventory, you pick a system for tracking what you hold, a method for valuing it, and a consistent way to record purchases, sales, write-downs, and shrinkage in your books. Federal tax law then layers its own requirements on top, with a meaningful carve-out for smaller businesses. The choices matter because they change your reported profit, your balance sheet, and your tax bill from the same underlying transactions.
Pick a Tracking System First
Your first decision is how often your records update.
A periodic system refreshes inventory only at set intervals, usually monthly, quarterly, or yearly. You count what’s on hand physically, then back into cost of goods sold using beginning inventory plus purchases minus ending inventory. Between counts, the ledger balance is only as current as your last count. Smaller retailers and low-volume operations often stay with this approach because it needs less technology.
A perpetual system records every transaction as it happens. Stock coming in debits inventory; a sale credits inventory and debits cost of goods sold on the spot. Barcode scanners and point-of-sale software handle most of the entries, so you see a running quantity and dollar balance any time you look. The cost is software, hardware, and disciplined data entry. Businesses with high transaction volumes or perishable goods usually find the visibility worth it.
Even a perpetual system needs periodic physical counts. They catch theft, damage, and data-entry errors that no software will flag on its own.
Pick a Valuation Method
The tracking system counts units. The valuation method decides which costs attach to units sold and which stay on the balance sheet. Four methods dominate U.S. practice, and each produces different figures for cost of goods sold, ending inventory, and net income from identical transactions.
First-In, First-Out
FIFO treats the oldest units as sold first. Your earliest purchase costs flow to the income statement, and the inventory left on the balance sheet reflects your most recent prices. It fits perishables, pharmaceuticals, and anything with an expiration date. When prices are rising, FIFO produces a higher ending inventory value, a lower cost of goods sold, higher reported profit, and a higher tax bill.
Last-In, First-Out
LIFO reverses the assumption: the newest units are treated as sold first. Recent, typically higher costs hit the income statement, which trims reported profit. The inventory sitting on your balance sheet carries older costs that may not reflect current prices at all. In an inflationary environment, LIFO lowers taxable income compared to FIFO, which is why many U.S. companies use it. International Financial Reporting Standards prohibit LIFO, so companies reporting under IFRS cannot use it.
LIFO comes with strings. If you use it on your tax return, you must also use it in financial reports to shareholders, partners, and creditors. This is the LIFO conformity rule. You cannot show investors higher FIFO income while claiming lower LIFO income to the IRS.
The difference between your inventory’s FIFO value and its LIFO value is the LIFO reserve, usually disclosed in the notes to financial statements. When a LIFO company draws down old inventory layers, those long-deferred low costs finally hit the income statement, producing a taxable-income spike known as LIFO liquidation. Supply chain disruptions that force sell-through of old stock can trigger it unexpectedly.
Weighted Average Cost
Weighted average blends every purchase cost together. Divide total cost of goods available for sale by total units available, and the resulting per-unit average applies to both what you sold and what you kept. This smooths out price swings and suits businesses moving interchangeable goods like hardware, chemicals, or raw materials. Its effect on reported income during inflation sits between FIFO and LIFO.
Specific Identification
Specific identification follows each individual item’s actual cost from purchase through sale. It’s the most precise method and the only one that works for vehicles, jewelry, artwork, or custom machinery. For a business moving thousands of identical widgets, it isn’t practical. Serial numbers, lot codes, and barcodes make it feasible for the businesses that need it.
What Goes Into Inventory Cost
The dollar figure you record is more than the invoice price. Inventory cost includes every expenditure needed to bring goods to their current condition and location. For a purchased product, start with the gross invoice price and add inbound transportation, import duties, in-transit insurance, and any taxes tied to the purchase.
Subtract early-payment discounts. A common arrangement gives 2 percent off for paying within 10 days. Whether you record the full price and adjust later or start with the discounted figure depends on your accounting policy, but the discount reduces the cost basis either way. Returns and allowances for defective goods, supported by supplier credit memos, also reduce inventory cost.
Manufacturers capitalize more. Beyond raw materials, you include direct labor and a share of production overhead: factory rent, utilities, equipment depreciation, and indirect labor like supervisors. Abnormal costs, such as moving inventory between warehouses after an unplanned shutdown, are expensed immediately rather than folded into inventory value.
Recording Purchases and Sales
Under a perpetual system, every inventory movement gets a journal entry. A credit purchase debits inventory and credits accounts payable. A cash purchase credits cash instead.
Selling inventory takes two entries. The first records revenue: debit cash or accounts receivable, credit sales revenue. The second captures cost: debit cost of goods sold, credit inventory. Together they reflect both the income earned and the asset that left your warehouse.
Under a periodic system, purchases during the period go to a temporary Purchases account instead of directly into inventory. At period-end, after the physical count, you close that account and adjust inventory to the counted value. Fewer entries during the period, but one lump adjustment at the end that can be harder to trace back to individual transactions.
Writing Inventory Down When Value Drops
You cannot keep inventory on the balance sheet at cost when the goods have lost value. If net realizable value falls below recorded cost, you write it down. Net realizable value is the estimated selling price in the ordinary course of business, minus the predictable costs of completing, selling, and shipping the goods.1Financial Accounting Standards Board. Accounting Standards Update 2015-11, Inventory (Topic 330) You never write inventory up above original cost.
This lower-of-cost-or-net-realizable-value rule applies to inventory valued under FIFO, weighted average, and specific identification. LIFO and the retail inventory method still use the older lower-of-cost-or-market framework, where “market” means current replacement cost bounded by a ceiling and a floor.1Financial Accounting Standards Board. Accounting Standards Update 2015-11, Inventory (Topic 330)
The write-down entry debits cost of goods sold (or a separate loss account) and credits inventory. The goods stay on your shelves, but the financials now reflect their reduced economic value. This adjustment matters most at year-end, when overstated inventory would inflate both assets and gross profit.
Handling Shrinkage
Shrinkage is the gap between records and reality. Theft, damage, spoilage, and administrative errors all contribute. After a physical count reveals the discrepancy, debit a shrinkage expense account and credit inventory. The expense hits the period you discover the loss, not the period it happened, because you rarely know when goods actually disappeared.
Count frequency should track risk. High-value and fast-moving items warrant weekly or daily cycle counts; mid-tier items monthly; slow-moving or low-value stock quarterly. Even businesses with perpetual systems and barcode scanning should count their highest-risk categories regularly, because perpetual records are only as accurate as the data entered.
Federal tax law permits using shrinkage estimates between counts, but only if you conduct regular counts at each location and adjust the estimates when actual shrinkage differs from what you projected.2Office of the Law Revision Counsel. 26 U.S. Code 471 – General Rule for Inventories
IRS Rules, Elections, and Method Changes
Once you adopt a valuation method for tax purposes, you cannot simply switch the next year. Changing methods, whether from FIFO to LIFO, LIFO to weighted average, or any other shift, requires filing Form 3115, Application for Change in Accounting Method, with the IRS.3Internal Revenue Service. About Form 3115, Application for Change in Accounting Method A first-time LIFO election specifically requires Form 970 filed with the return for the year you adopt it.
Electing LIFO locks you in: you must keep using it in every later tax year unless the IRS authorizes a change. And the conformity rule means your reports to shareholders, partners, and creditors must also use LIFO. Violating conformity can lead the IRS to revoke your election retroactively, forcing a recalculation of taxable income for the affected years.4Office of the Law Revision Counsel. 26 U.S. Code 472 – Last-In, First-Out Inventories
Section 263A, the uniform capitalization rules, requires businesses to capitalize certain indirect costs into inventory that might otherwise be deducted as period expenses, including portions of administrative overhead, warehouse costs, and purchasing department expenses. The rules apply to manufacturers, retailers, and wholesalers above the small-business threshold.
The Small-Business Exception
For tax years beginning in 2026, businesses with average annual gross receipts of $32 million or less over the preceding three years are exempt from UNICAP.5Internal Revenue Service. Rev. Proc. 2025-32 The same gross receipts test exempts qualifying small businesses from the general requirement to maintain inventories under Section 471(a). A qualifying business can treat inventory as non-incidental materials and supplies, deducting the cost when items are used or sold, or simply follow whatever method its financial statements use.2Office of the Law Revision Counsel. 26 U.S. Code 471 – General Rule for Inventories Switching to this simplified treatment still requires Form 3115, but the change is generally treated as initiated by the taxpayer with IRS consent already granted by statute.
If your business is above the threshold, expect the full weight of the inventory rules: careful cost capitalization under UNICAP, a consistent valuation method, formal method-change requests to move off it, and conformity between your books and your tax return if you elect LIFO. If you’re under it, the accounting picture is considerably simpler.