Best practices with inventory and how it affects your accounting and taxes

Inventory sounds like a warehouse problem. In reality, it's an accounting problem — and a tax problem. The moment goods sit on your shelves, the IRS and your financial statements both have opinions about them. Choose the wrong valuation method, skip a physical count, or let your books fall out of sync with your stock levels, and you're looking at overstated profits, understated deductions, or a balance sheet that doesn't reflect reality. For product-based businesses across Northeast Indiana — manufacturers in Allen County, contractors stocking materials, retailers in Fort Wayne — getting inventory right is one of the highest-leverage moves you can make.

What exactly is inventory in accounting terms?

Inventory is a current asset on your balance sheet representing goods you hold for sale, goods in the process of being made, or raw materials used to produce finished products. It flows through your income statement as Cost of Goods Sold (COGS) only when a sale occurs — not when you buy or receive the stock. That timing distinction is everything: it determines your gross profit, your taxable income, and the period in which deductions land.

Inventory breaks into three classic buckets:

• Raw materials — components purchased but not yet used in production.

• Work-in-progress (WIP) — items partially assembled or processed.

• Finished goods — products ready to sell.

At what point does the IRS actually require formal inventory accounting?

The IRS requires accrual-basis inventory accounting when a business's average annual gross receipts exceed the small-business threshold — currently $30 million (inflation-adjusted) for tax years beginning in 2024. Below that threshold, qualifying businesses may use the cash method and treat inventory costs as materials and supplies, deducting them when paid rather than when sold. But crossing that line — or choosing to ignore formal inventory accounting when you shouldn't — carries real consequences.

Here's how to think about it practically:

• Under $30M and eligible for the exception? You can skip formal inventory accounting under the tax rules, but that doesn't always mean you should. If your margins are thin, your stock levels volatile, or you're seeking financing, a proper perpetual inventory system gives you visibility that cash-basis books simply can't. Lenders and buyers want to see accurate inventory on the balance sheet — not a simplified deduction schedule.

• Over $30M or not eligible? Formal inventory accounting under the accrual method is mandatory, and non-compliance creates audit exposure. The IRS can restate your income using an allowable method, which often means a larger tax bill plus interest and penalties.

• Somewhere in between — growing fast? If you're approaching the threshold, start building proper inventory systems now. Retrofitting accrual accounting and restating prior-year returns after the fact is significantly more painful and expensive than transitioning proactively. Our cleanup and catch-up bookkeeping team handles exactly this kind of transition.

The threshold also applies per-entity, so S-corp or partnership structures with multiple related entities may aggregate gross receipts for this test under the tax-shelter and related-party rules — another reason to run your structure by your CPA / EA at Warrior before assuming the exception applies.

Which inventory valuation method is right for your business?

Your valuation method determines which costs get expensed as COGS now versus which stay on the balance sheet as an asset — directly controlling your taxable income. The three most common methods each produce different outcomes in periods of changing prices.

First-In, First-Out (FIFO)

FIFO assumes the oldest inventory is sold first. During inflationary periods — which have been persistent in recent years — FIFO produces lower COGS and higher reported profits, meaning a higher tax bill. On the upside, your ending inventory on the balance sheet reflects more current (higher) costs, making the balance sheet look stronger to lenders.

Last-In, First-Out (LIFO)

LIFO assumes the newest inventory is sold first. In an inflationary environment, this pushes higher recent costs into COGS, reducing taxable income. It's a legitimate tax-deferral strategy for U.S. businesses — but note that LIFO is not permitted under International Financial Reporting Standards (IFRS) and requires a LIFO conformity election with the IRS.

Weighted Average Cost

This method smooths cost fluctuations by averaging the cost of all inventory available for sale. It's simpler to maintain and works well for businesses selling homogeneous products — think bulk materials or commodity goods common in Northeast Indiana manufacturing.

The method you pick must be applied consistently. Switching requires IRS approval (Form 3115, Application for Change in Accounting Method).

How does inventory affect your accounting and taxes?

Inventory affects your taxes through COGS, which is subtracted from revenue before calculating gross profit — and therefore before calculating taxable income. Higher COGS lowers your tax bill; lower COGS raises it. Every dollar of unsold inventory sitting on your shelf at year-end is a dollar not deducted until it sells.

A few specific tax considerations for inventory-heavy businesses:

• Year-end physical counts matter. Your ending inventory figure directly feeds into next year's beginning inventory and this year's COGS calculation. An inflated ending inventory count understates COGS and overstates profit — the IRS has seen this error before.

• Write-downs for obsolete inventory. If inventory is damaged, obsolete, or worth less than its recorded cost, you may be able to write it down to its net realizable value and recognize a loss. Document the condition carefully.

• Section 263A (UNICAP rules). Larger businesses may need to capitalize certain indirect costs — like storage and purchasing overhead — into inventory rather than expensing them immediately. Small-business exceptions apply; confirm with your CPA at Warrior.

For product-based businesses filing as S corporations, accurate inventory also affects shareholder distributions and basis calculations. Our S-corp tax services team handles these intersections regularly.

What are the best practices for keeping inventory and accounting in sync?

Inventory and accounting fall out of sync faster than most owners expect — and the gap compounds every month it's ignored. These practices keep both sides of the ledger telling the same story.

1. Conduct regular physical counts

At minimum, perform a full physical inventory count at year-end. High-volume businesses benefit from cycle counting — auditing a rotating subset of SKUs throughout the year — to catch discrepancies before they snowball. Discrepancies between your physical count and your books should be investigated and adjusted promptly.

2. Use inventory management software that integrates with your accounting platform

Manual spreadsheets are a recipe for errors. Tools like QuickBooks, Fishbowl, or inFlow sync inventory movements to your general ledger in real time, automatically updating COGS when a sale posts. If your QuickBooks inventory records are already messy, our QuickBooks cleanup service can restore order before the errors compound.

3. Set reorder points and track shrinkage

Reorder points prevent stockouts that disrupt revenue, but they also guard against over-purchasing that ties up cash. Separately, track shrinkage — loss from theft, damage, or spoilage — as a distinct line item. Undocumented shrinkage inflates your apparent COGS and distorts margins.

4. Reconcile inventory to your general ledger monthly

Your inventory asset account on the balance sheet should match your perpetual inventory system at the end of every month. If it doesn't, find out why before month-end close. Common culprits: unrecorded returns, vendor credits posted to the wrong account, or receiving errors.

5. Separate purchasing authority and recordkeeping

Internal control basics: the person who orders inventory shouldn't be the only person who records its receipt. This separation deters both fraud and honest errors. For family-owned businesses in Indiana where one person often wears many hats, even a simple second-reviewer checklist adds meaningful protection.

How can poor inventory accounting hurt your business?

Sloppy inventory records create a cascade of downstream problems that go well beyond a messy balance sheet. Overstated inventory inflates assets and net income, making the business look more profitable than it is — a problem if you're seeking a loan, bringing on a partner, or planning an exit. Understated inventory does the opposite: it deflates profits and could trigger unwanted IRS scrutiny if COGS looks suspiciously high relative to revenue.

Cash flow is the most immediate victim. Buying too much inventory locks up working capital. Buying too little creates stockouts that cost sales. Neither shows up clearly until your books accurately reflect what's on hand and what it cost.

If you're considering selling your business or bringing in investors, clean inventory records are non-negotiable in due diligence. Buyers discount heavily — or walk away — when inventory valuations are inconsistent or unsupported. Our succession and exit planning team has seen deals derailed by exactly this issue.

Sources

1. Publication 538: Accounting Periods and Methods. Internal Revenue Service. 2024. https://www.irs.gov/pub/irs-pdf/p538.pdf

2. Rev. Proc. 2023-34: Inflation Adjustments for Tax Year 2024. Internal Revenue Service. 2023. https://www.irs.gov/pub/irs-drop/rp-23-34.pdf

3. Publication 538: Accounting Periods and Methods — LIFO Method. Internal Revenue Service. 2024. https://www.irs.gov/pub/irs-pdf/p538.pdf

4. About Form 3115: Application for Change in Accounting Method. Internal Revenue Service. https://www.irs.gov/forms-pubs/about-form-3115

5. IRC Section 263A — Capitalization and Inclusion in Inventory Costs of Certain Expenses. Internal Revenue Service. https://www.irs.gov/irm/part4/irm_04-046-004