Inventory accounting tracks the cost of goods a business holds for sale or production. It records those costs as an asset, assigns costs to units using a method permitted by the applicable reporting rules, and generally recognizes the cost as an expense when the related goods are sold. The rules depend on the framework and jurisdiction: IFRS and U.S. federal tax guidance do not offer identical method choices.
How inventory accounting works
Inventory accounting connects purchases and production to the cost of goods sold and the value of stock still on hand. The basic flow is to record goods and production costs, determine which costs belong in inventory, assign those costs to units, measure inventory under the applicable rules, and reconcile recorded quantities with physical stock.
- Record purchases and production. Add the costs that qualify as inventory costs under the applicable accounting framework.
- Assign costs to goods. Use a permitted cost formula, such as specific identification, FIFO, or weighted average where allowed.
- Measure stock on hand. Apply the relevant measurement rules, including any required write-downs.
- Recognize expense on sale. When goods are sold, move their carrying cost from inventory to cost of goods sold or the equivalent expense caption.
- Reconcile quantities. Compare book records with physical stock and adjust records as appropriate.
For example, a purchase is recorded as inventory rather than immediately as an expense. When the goods are later sold, their carrying amount is recognized as an expense in the period the related revenue is recognized. IAS 2 describes this expense-recognition relationship in its inventory standard.
What costs belong in inventory?
Under IAS 2, inventory cost includes costs of purchase, costs of conversion, and other costs incurred to bring inventory to its present location and condition. Conversion costs include direct labor and production overhead. Which specific costs qualify depends on the applicable standard and circumstances; do not assume every business expense can be added to inventory.
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Inventory accounting methods: how the cost formulas differ
Cost formulas determine which costs are assigned to goods sold and which remain in closing inventory. They do not necessarily describe the exact physical units that moved out of the warehouse.
| Method | How it assigns cost | Context in the cited guidance |
|---|---|---|
| Specific identification | Matches the actual cost to individually identified inventory items. | IAS 2 applies it to items that are not ordinarily interchangeable. IRS Publication 538 also describes matching actual cost where items are identifiable. |
| FIFO | Assumes the first goods acquired or produced are the first sold, consumed, or disposed of. | IAS 2 permits it for ordinarily interchangeable inventory; IRS Publication 538 describes it for U.S. federal tax inventory. |
| Weighted average | Assigns an average unit cost across interchangeable inventory. | IAS 2 permits it for ordinarily interchangeable inventory. IRS guidance also describes average-cost approaches in relevant contexts; the calculation cadence is not one universal rule. |
| LIFO | Assumes the most recently acquired or produced goods are the first sold, consumed, or disposed of. | Discussed in IRS U.S. tax guidance. IAS 2 lists FIFO and weighted average for ordinarily interchangeable items, not LIFO. |
Specific identification
This method works when individual items can be traced to their actual costs, such as distinct or non-interchangeable goods. It is not necessarily practical for high-volume stock made up of interchangeable units.
FIFO
FIFO is a cost-flow assumption: the earliest costs are assigned to goods sold first. It does not establish that the particular physical units leaving a business were literally the oldest ones.
Weighted average
Weighted average spreads an average cost across interchangeable inventory. The cited sources do not establish a single calculation frequency for every business, so whether an entity uses a periodic or continuously updated average depends on its circumstances and applicable rules.
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LIFO and price movements
For the FIFO-versus-LIFO comparison described in IRS Publication 538, rising prices produce higher cost of goods sold and lower closing inventory under LIFO than FIFO; falling prices produce the opposite comparison. This is a cost-allocation effect under the conditions described by the IRS, not a guarantee about every business’s reported results.
How inventory is measured under IAS 2
IAS 2 states that “Inventories are measured at the lower of cost and net realisable value.” Net realisable value is the estimated selling price in the ordinary course of business, less estimated costs of completion and costs necessary to make the sale.
If net realisable value falls below cost, the inventory is written down and the loss is expensed when it occurs. If a qualifying reversal later occurs, it reduces inventory expense in the period of the reversal. These are IAS 2 requirements for IFRS reporting; they should not be assumed to describe every tax or accounting framework.
Independent reader supportYour contribution helps us test, update, and keep practical guides available for everyone.How IFRS and U.S. tax rules differ
IAS 2 governs inventory measurement for entities applying IFRS. For ordinarily interchangeable inventory, it permits FIFO or weighted average, while specific identification applies to non-interchangeable items. The standard does not list LIFO as a cost formula for interchangeable inventory.
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U.S. federal tax guidance has its own rules and method descriptions, including FIFO and LIFO. The statutory framework in 26 U.S.C. § 471 says that when inventory is necessary to clearly determine taxable income, it must be taken on a basis prescribed by the Treasury Secretary that conforms as nearly as possible to best accounting practice in the trade or business and clearly reflects income. The cited code text is the 2024 U.S. Code edition. U.S. tax treatment should be checked for the relevant tax year; a method permitted for one purpose or framework is not automatically available for another.
Physical inventory and recordkeeping in the U.S. tax context
IRS Publication 538 says a taxpayer may figure the cost of goods on hand using perpetual or book inventory when records follow sound accounting practices. The records charge inventory for the actual cost of goods purchased or produced and credit it for goods used, transferred, or sold. The publication also says physical inventory should be taken at reasonable intervals and book inventory adjusted to actual inventory. This is U.S. tax guidance; confirm the rules applicable to the tax year in question.
For practical reconciliation, compare the quantities recorded in the books with the quantities counted, investigate differences, and update records to reflect actual inventory. The IRS guidance supports the count-and-adjust principle, but does not establish a single interval suitable for every business.
Quick Recap
Choosing a method: questions to resolve
- Are items individually identifiable or interchangeable? Specific identification is relevant to distinct, traceable items; FIFO and weighted average are options for ordinarily interchangeable items under IAS 2.
- Which rules govern the reporting or tax purpose? Identify the applicable framework and jurisdiction before choosing a method. IFRS financial reporting and U.S. federal tax guidance differ, especially on LIFO.
- How do price movements affect cost allocation? The IRS describes different FIFO and LIFO results when prices rise or fall; those results concern the comparison in its publication.
- Can the records support the method? Consider whether the business can maintain traceable costs or averages and reconcile book quantities with physical stock.
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