Inventory accounting: Methods, benefits, and how your business can get started

Published Monday 27 October 2025

Table of contents

• What is inventory?
• What is inventory accounting?
• Types of inventory
• Inventory accounting methods
• Benefits of inventory accounting
• How to record inventory transactions
• Inventory accounting compliance and GAAP rules
• Get started with inventory accounting
• FAQs on inventory accounting

Key takeaways

• Choose the appropriate inventory valuation method (FIFO, LIFO, or weighted-average cost) based on your business type and stick with it consistently to ensure accurate financial reporting and tax compliance.

• Record inventory purchases as current assets on your balance sheet, then transfer costs to the Cost of Goods Sold (COGS) expense account when items sell to accurately calculate profit margins.

• Track three essential metrics for each inventory item—quantity on hand, total cost, and selling price—to make informed purchasing decisions and optimize cash flow management.

• Conduct regular physical inventory counts and maintain detailed transaction records for all purchases, sales, returns, and adjustments to ensure your financial statements remain accurate and reliable.

What is inventory?

Inventory is the goods your business owns and intends to sell to customers for profit. You list these items as assets on your balance sheet until you sell them.

Your inventory includes:

• Raw materials: Components used to create finished products
• Work-in-progress: Partially completed items still in production
• Finished goods: Completed products ready for sale
• Items for resale: Products bought specifically to sell without modification

Equipment, supplies, and tools you use to run your business aren't inventory – they're business expenses. If you run an ecommerce business and a third party ships goods directly to your customer, you don't have inventory. Only goods you own count as inventory.

What is inventory accounting?

Inventory accounting is the process of tracking, valuing, and managing your inventory from purchase to sale. It helps you understand the true cost and value of goods you own, enabling better pricing, tax compliance, and business decisions.

Why inventory accounting matters:

• Accurate pricing: Know your true costs to set profitable prices
• Tax compliance: Report inventory values correctly for tax purposes
• Cash flow management: Track money tied up in unsold goods
• Insurance coverage: Document inventory values for proper coverage
• Business valuation: Show accurate asset values to lenders or buyers
• Profit analysis: Identify which products generate the most profit

Types of inventory

Inventory includes four main types. Knowing each type helps you track what you have on hand.

• Raw materials: These are the basic components you use to create your products. For your bakery, raw materials include flour, sugar, and eggs.
• Work-in-progress (WIP): Work-in-progress inventory is partially finished and not ready for sale. For example, dough rising before baking.
• Finished goods: Finished goods are products you can sell, such as freshly baked bread.
• Maintenance, repair, and operations (MRO): Maintenance, repair, and operations items help you run your business but aren't part of your final product. Examples include cleaning supplies or packing boxes.

Inventory accounting methods

How you value your inventory affects your balance sheet and income statement. There are a few common methods for tracking the cost of goods sold (COGS).

• First-In, First-Out (FIFO): This method assumes the first items you bought are the first ones you sell. Use this method if you sell perishable goods, such as food, to avoid spoilage.
• Last-In, First-Out (LIFO): With this method, you sell the most recently purchased items first. This can help if you sell non-perishable goods. LIFO is allowed under US Generally Accepted Accounting Principles (GAAP) – you must apply under Internal Revenue Code section 472. However, International Financial Reporting Standards (IFRS) do not allow LIFO.
• Weighted-Average Cost (WAC): This method uses the average cost of all goods in inventory. It helps you manage price changes and works well for many businesses.

Benefits of inventory accounting

Inventory accounting benefits help you save money and increase profits through better decision-making.

Revenue optimization

• Prevent stockouts: Keep items in stock so you don't miss sales
• Identify bestsellers: Focus resources on high-performing products
• Plan seasonal promotions: Use sales data to time marketing campaigns

Cost reduction

• Minimize storage costs: Order optimal quantities to reduce warehousing expenses
• Avoid write-offs: Spot slow-moving items early so you can take action
• Negotiate bulk discounts: Use purchasing data to secure better supplier rates

Financial management

• Improve cash flow: Reduce money tied up in excess inventory
• Accurate profit margins: Track true product costs for better pricing
• Tax optimization: Time purchases strategically to manage tax obligations

Xero inventory management features help you track your sales and inventory levels.

How to record inventory transactions

Recording inventory correctly helps you keep accurate financial statements. Follow these two steps:

1. When you buy inventory, record it as a current asset on your balance sheet.
2. When you sell an item, move its cost from the inventory asset account to the Cost of Goods Sold (COGS) expense account.

First, when you purchase inventory, you record it as a current asset on your balance sheet. Then, when you sell an item, you move its cost from the inventory asset account to an expense account called Cost of Goods Sold (COGS). This ensures your profit for the sale is calculated correctly.

Inventory accounting compliance and GAAP rules

Use consistent rules to keep your financial reports reliable. In the US, most businesses follow Generally Accepted Accounting Principles (GAAP). Consistent inventory valuation helps you secure loans and attract investors. If your average annual gross receipts are $26 million or less, the IRS doesn't require you to follow capitalization rules.

Get started with inventory accounting

To get started with inventory accounting, track three key metrics: quantity on hand, total cost, and selling price. This data helps you calculate profit margins, manage cash flow, and make informed purchasing decisions.

Follow these essential steps to set up your inventory accounting:

1. Choose your accounting method: Select first-in, first-out (FIFO), last-in, first-out (LIFO), or weighted average costing
2. Set up tracking systems: Use inventory management software or spreadsheets
3. Conduct regular counts: Schedule physical inventory counts to verify records
4. Record all transactions: Track purchases, sales, returns, and adjustments
5. Calculate key metrics: Monitor inventory turnover, carrying costs, and profit margins

Xero inventory management features automate these steps, so you spend less time on manual work and get more accurate results. Try Xero free for one month to see how easy it is.

FAQs on inventory accounting

Here are common questions and answers small business owners might have about handling their inventory accounting.

What are the 4 types of inventory?

The four main types of inventory are raw materials, work-in-progress (WIP), finished goods, and maintenance, repair, and operations (MRO) items.

How do you record inventory in accounting?

When you buy inventory, you record it as an asset. When you sell it, you move its cost from the inventory asset account to the cost of goods sold (COGS) expense account.

What are the GAAP rules for inventory?

Generally Accepted Accounting Principles (GAAP) require you to use the same method for valuing inventory, such as first-in, first-out (FIFO) or last-in, first-out (LIFO). You must value inventory at the lower of cost or market value.

This is similar to International Accounting Standard (IAS) 2, which requires inventory to be measured at the lower of cost and net realizable value.

When should my business start using inventory accounting?

Start using inventory accounting as soon as you buy and hold goods for resale. Tracking inventory from day one helps you manage cash flow and make better decisions.

What's the difference between inventory accounting and expense tracking?

Inventory accounting tracks goods you plan to sell as assets until you sell them. Expense tracking records costs for items you use to run your business, such as office supplies.