Inventory is the stock of goods and materials a business holds to sell, to make into something it will sell, or to use up while producing goods or delivering a service. In accounting, inventory is an asset while it sits unsold. When it is sold, its recorded cost moves out of the balance sheet and onto the income statement as an expense, usually called cost of goods sold (COGS), in the same period as the revenue it helped produce.
What counts as inventory
The international accounting standard for inventories, IAS 2, covers assets that fall into three groups: items held for sale in the ordinary course of business, items in the process of being produced for sale, and materials or supplies that will be consumed in producing goods or delivering services. In practice that usually means:
- Merchandise held for resale. A retailer’s shelf stock or a wholesaler’s warehouse goods.
- Work in progress. Partly built products, such as furniture in the workshop or software hardware still being assembled.
- Finished goods. Completed products waiting to be sold.
- Raw materials and production supplies. Lumber, fabric, packaging, or other inputs consumed in making products or delivering a service.
Not every purchase is inventory. Equipment, vehicles, and buildings that a business uses over several years are generally recorded as property, plant, and equipment and depreciated, not carried as inventory. The test is whether the item is held for sale, being made for sale, or consumed in producing what is sold.
Inventory is an asset until it is sold
Buying inventory does not create an expense on the day of purchase. The cost is held on the balance sheet as an asset. The expense appears when the goods leave the business through a sale, which is the point at which the related revenue is recognized. A business that buys $25,000 of stock in March and sells half of it in March has $12,500 of expense in March and $12,500 still sitting as an asset.
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This timing is why inventory matters for profit. A business that counts too much ending inventory understates cost of goods sold and overstates profit for the period. A business that counts too little does the reverse.
How cost of goods sold is calculated
For a merchandising business, cost of goods sold is worked out from three balances. The steps are:
- Start with beginning inventory, the value on hand at the start of the period.
- Add purchases during the period, plus any other inventoriable costs such as freight-in that are part of bringing goods to their present condition and location.
- Subtract ending inventory, the value still on hand at the end of the period, counted and valued at the end of the period.
The formula is:
Beginning inventory + purchases (and applicable inventoriable costs) − ending inventory = cost of goods sold
Illustration with hypothetical figures: beginning inventory of $10,000, purchases of $25,000, and ending inventory of $8,000 give cost of goods sold of $27,000 before any other adjustments. The figures are arithmetic only, not a reported business result. The same closing-inventory relationship appears in IRS guidance for Schedule C, where closing inventory is subtracted from the cost of goods available for sale to arrive at cost of goods sold.
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What goes into the cost of inventory
Under IAS 2, inventory cost includes three broad categories:
- Costs of purchase, such as the price paid, import duties, and transport, net of trade discounts and rebates.
- Costs of conversion, which for a manufacturer include direct labour and a systematic share of production overhead, such as factory rent and equipment running costs.
- Other costs incurred in bringing inventory to its present location and condition.
Selling costs, such as advertising and sales commissions, are not part of inventory cost under IAS 2. Storage costs are generally excluded unless they are needed in the production process before a further stage of production.
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Measurement: lower of cost and net realisable value
IAS 2 sets the measurement rule in one sentence: “Inventories shall be measured at the lower of cost and net realisable value” (IAS 2, paragraph 9). Cost is the amount described above. Net realisable value (NRV) is the estimated selling price in the ordinary course of business, less the estimated costs of completing the item and the costs necessary to make the sale.
NRV is an entity-specific estimate. It is not the same as fair value, which reflects the price a market participant would pay in an arm’s-length transaction. A write-down is needed when NRV falls below cost, which can happen with damaged goods, obsolete stock, or falling selling prices.
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Cost-flow formulas
When identical units are bought at different prices, a business needs a rule to decide which cost goes to cost of goods sold and which stays in ending inventory. IAS 2 allows the methods in the table below. The choice depends on the type of inventory.
| Method | When IAS 2 applies it | How cost is assigned |
|---|---|---|
| Specific identification | Items that are not ordinarily interchangeable, and goods produced or segregated for specific projects | The actual cost of each identified item is traced to the sale or to ending inventory |
| First-in, first-out (FIFO) | Ordinarily interchangeable items | The earliest purchased or produced units are assumed sold first, so ending inventory holds the most recent costs |
| Weighted average | Ordinarily interchangeable items | Cost is the weighted average of similar items at the start of the period plus those bought or produced during it; the average may be recalculated periodically or as each shipment arrives, depending on circumstances |
The IAS 2 formulas are the ones the standard permits for financial reporting under IFRS. Tax rules and other national accounting frameworks can allow or restrict different methods, so the framework that applies to your reporting must be checked before a method is chosen.
Independent reader supportYour contribution helps us test, update, and keep practical guides available for everyone.U.S. tax rules are a separate question
Financial reporting under IFRS and U.S. federal income tax are not the same system. IRS Publication 334 (2025 edition) explains that a business producing, purchasing, or selling merchandise generally must keep inventory and use an accrual method for purchases and sales, subject to exceptions.
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The same publication describes a qualifying small-business taxpayer as one with average annual gross receipts of $31 million or less for the three prior tax years, indexed for inflation, and not a tax shelter. A qualifying small business may choose not to keep inventory, but must still use a method that clearly reflects income. The 2025 edition describes options that treat certain items as non-incidental materials and supplies, or follow the business’s financial accounting treatment. Because the threshold is indexed and rules change, confirm the current-year figures in the latest IRS publication or with a qualified tax professional before relying on them.
Common mistakes when working with inventory
- Expensing purchases immediately. Unsold goods belong on the balance sheet; only the cost of goods sold moves to the income statement.
- Ignoring the ending count. Cost of goods sold is only as accurate as the ending inventory figure subtracted from the total available.
- Carrying obsolete or damaged stock at full cost. Under IAS 2, compare cost with NRV and write down where NRV is lower.
- Applying one framework’s rules to another. Accounting for financial statements and tax reporting can produce different inventory values and different cost-flow choices.
If you are comparing treatments across frameworks, identify the framework and jurisdiction first. Then compare the items in scope, the measurement basis, the cost components, the permitted cost-flow method, the timing of expense recognition, and any small-business exceptions.
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