Inventory accounting guide: methods and how it works

Published Friday 3 April 2026

Table of contents

• What is inventory?
• Types of inventory
• What isn't inventory?
• What is inventory accounting?
• Inventory valuation methods
• How inventory accounting affects your financial statements
• Benefits of inventory accounting
• How to do inventory accounting
• Manage your inventory accounting with Xero
• FAQs on inventory accounting

Key takeaways

• Choose the right inventory valuation method for your business, with FIFO or weighted average being the most straightforward options for small businesses, as your choice directly affects your reported profits and tax calculations.
• Set up a systematic tracking process by recording all inventory purchases with dates, quantities, and costs, then conduct regular physical counts to catch discrepancies between your records and actual stock levels.
• Include all relevant costs in your inventory value such as purchase price, shipping, handling, and import duties, but exclude ongoing storage costs and administrative expenses to maintain accurate financial records.
• Use inventory accounting strategically to maximise sales by avoiding stockouts, reduce storage costs on slow-moving items, and improve cash flow by identifying which products tie up too much money in stock.

What is inventory?

Inventory refers to the items your business has bought with the intention of selling to customers. These items may be resold without change, or they could be combined into a new product.

In accounting terms, inventory is a current asset on your balance sheet. It represents the value of goods you hold for sale or use in production. This practice is governed by global standards since the International Accounting Standards Board adopted IAS 2 Inventories.

Types of inventory

Businesses typically work with four main types of inventory. Understanding which categories apply to you helps you track and value stock accurately.

• Raw materials: Items you purchase to manufacture products, such as fabric for a clothing business or timber for furniture making
• Work-in-progress (WIP): Partially completed products that are still in production, like assembled but unpainted furniture
• Finished goods: Completed products ready for sale to customers
• Maintenance, repair, and operations (MRO): Supplies used to support production but not included in the final product, such as cleaning materials or machine lubricants

Most retailers deal mainly with finished goods. Manufacturers typically track all four types.

What isn't inventory?

Not everything your business buys counts as inventory. Here's what typically doesn't qualify:

• Equipment and supplies: Work tools, vehicles, and stationery are recorded as expenses, not inventory
• Dropshipped goods: If a third party ships products directly to your customer, you don't own the goods, so they're not your inventory
• Consumables: Items you use to run your business rather than sell aren't inventory

The key rule: You must own something for it to be inventory.

What is inventory accounting?

Inventory accounting is the process of tracking, valuing, and recording the cost of your inventory. It helps you determine what your stock is worth and how much it costs to hold.

Inventory appears as a current asset on your balance sheet. But its value can drop quickly if items become old, damaged, or out of date, or if market prices fall. Storage also adds ongoing costs.

Accurate inventory accounting matters for:

• Pricing decisions: Knowing your true costs helps you set profitable prices
• Tax calculations: Inventory value affects your taxable income
• Insurance coverage: Accurate records ensure you're properly covered
• Budgeting and forecasting: Understanding inventory costs supports better planning
• Business valuation: Buyers and investors need reliable inventory figures

Inventory valuation methods

Inventory valuation methods determine how you assign costs to the items you sell and the stock you keep. The method you choose affects your reported profit and tax bill.

Here are the four main approaches:

• First-In, First-Out (FIFO): Assumes the oldest inventory sells first. When prices rise, FIFO shows higher profits because older, cheaper stock is matched against sales revenue.
• Last-In, First-Out (LIFO): Assumes the newest inventory sells first. When prices rise, LIFO shows lower profits because recent, more expensive stock is matched against sales. LIFO is allowed in the US but not in many other countries that follow International Financial Reporting Standards (IFRS), which outlines permitted methods in the revised IAS 2.
• Weighted average cost: Calculates an average cost for all units available during the period. This smooths out price fluctuations and simplifies record-keeping.
• Specific identification: Tracks the actual cost of each individual item. This works best for high-value or unique products like vehicles or custom furniture.

Most small businesses use FIFO or weighted average because they're straightforward and widely accepted.

How inventory accounting affects your financial statements

Inventory accounting directly impacts two key financial reports: your balance sheet and your income statement.

Balance sheet impact

Inventory appears as a current asset. Its value represents what your unsold stock is worth at a specific point in time. Accurate inventory records ensure your balance sheet reflects your true financial position.

Income statement impact

Your inventory valuation method determines your cost of goods sold (COGS). Here's the basic formula:

Beginning inventory + Purchases − Ending inventory = Cost of goods sold

Higher COGS means lower reported profit. Lower COGS means higher reported profit. The method you choose directly affects your taxable income.

Cash flow considerations

Money tied up in inventory stays locked away from other uses. Tracking inventory turnover helps you see how quickly stock converts to sales and cash.

Benefits of inventory accounting

Good inventory accounting helps you save money and make money. Here are the key benefits:

• Maximise sales: Avoid stockouts on products customers want to buy
• Lower storage costs: Reduce orders on slow-moving items to cut storage fees and write-offs
• Negotiate better deals: Identify high-volume items and shop for bulk discounts
• Calculate true profit margins: Track actual stock costs to see which products make you money
• Plan smarter promotions: Spot seasonal trends and time your marketing accordingly
• Control tax timing: Manage when you purchase inventory to affect your taxable income
• Improve cash flow: Free up money tied in slow-moving stock for debt repayment or business improvements

How to do inventory accounting

Getting started with inventory accounting means understanding how much stock you have, what you're spending on it, and what you're selling it for. Here's how to set up a system that works.

1. Choose your inventory valuation method: Decide whether FIFO, LIFO, weighted average, or specific identification fits your business. Your choice affects profit calculations and taxes.
2. Set up your tracking system: Use accounting software like Xero to record inventory purchases, movements, and sales in one place.
3. Record inventory purchases: Log each purchase with the date, quantity, unit cost, and supplier details.
4. Track inventory movements and sales: Update records when stock moves between locations or sells to customers.
5. Conduct regular physical counts: Compare actual stock levels to your records to catch discrepancies.
6. Reconcile and adjust records: Correct any differences between physical counts and recorded amounts.
7. Value ending inventory: Calculate the total value of remaining stock at the end of each accounting period.

Learn more in our guide to inventory.

Manage your inventory accounting with Xero

Tracking inventory can be simple. Xero's accounting software helps you record purchases, monitor stock levels, and calculate inventory value, all in one place.

With features like automated bank feeds and real-time reporting, you can spend less time on bookkeeping and more time running your business. Get one month free and see how Xero simplifies your inventory accounting.

FAQs on inventory accounting

Here are answers to common questions about inventory accounting.

Which inventory accounting method should I use?

Most small businesses use FIFO or weighted average because they're simple and widely accepted. Your accountant can help you choose based on your industry and tax situation. There can be exceptions to the rules for inventory and accounting for businesses under certain revenue thresholds.

What costs should be included in my inventory value?

Include the purchase price plus any costs to get inventory ready for sale, such as shipping, handling, and import duties. Exclude storage costs and administrative expenses.

How often should I count and value my inventory?

Count physical inventory at least once a year for tax purposes. Many businesses do quarterly or monthly counts to catch discrepancies early.

Do I need special software for inventory accounting?

Basic inventory tracking is possible with spreadsheets. But accounting software makes it easier to record transactions and generate reports accurately. For example, one survey found 79% of finance leaders reduced month-end close time after adopting an accounting software solution.

What happens if I value my inventory incorrectly?

Incorrect inventory values lead to inaccurate profit figures and tax calculations. You may underpay or overpay taxes, and your financial statements won't reflect your true business position.