Inventory Cost or Market Value
If your business carries inventory, you will need to keep track
of it. For tax purposes, as well as for general management purposes,
you'll need to know the value of the inventory at the beginning
and end of the year.
Although there are many possible ways
of valuing inventories, the IRS strongly prefers that small business
retailers, wholesalers and manufacturers value inventories under either
of these methods:
- cost, or
- lower-of-cost-or-market-value
Cost method. If you are using the cost method,
the value of the inventory would be all the direct and indirect costs
of acquiring it. For example, the cost of goods you purchased would
be the invoice price, less appropriate discounts, plus transportation
or other charges you incur in acquiring the goods.
For goods
that you produced, the cost would be the cost of labor, materials,
and plant overhead used in production. Manufacturers must generally
use the uniform capitalization ("UNICAP") rules to determine exactly
which costs are to be included in the formula; if you are subject
to these rules, you'll probably need an accountant's help to interpret
and apply them. Luckily, resellers with average annual gross receipts
of $10 million or less for each of the last three tax years are exempt
from the UNICAP rules.
Lower of cost or market value. The
second method - the lower-of-cost-or-market method - in effect permits
you to reduce your gross income to reflect any reduction in the value
of inventories. This method is based on the assumption that if the
market value falls, the selling price falls correspondingly. If this
is so, a business owner will report a lower income, and thus defer
until the following year a part of the taxes that would otherwise
have to be paid under the cost method. One big drawback to using
this method is that you need to compute the value of your inventory
both ways in order to determine which is lower.
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Example In Year 1, John Richards purchased merchandise
for $50,000 and sold half of the goods for $60,000. On December 31,
Year 1, his inventory was $25,000 (under the cost method) and $15,000
(under the lower-of-cost-or-market method). In Year 2, he sells the
remaining goods for $50,000. If he had used the lower-of-cost-or-market
method, his income would have been $10,000 less in Year 1 and $10,000
more in Year 2 than if he had used the cost method, as shown below.
| |
Cost |
Cost or Market |
| Year 1 |
| Sales |
$60,000 |
$60,000 |
| Less: cost of sales (purchases, less ending inventory) |
-25,000 |
-35,000 |
| Gross income |
$35,000 |
$25,000 |
| Year 2 |
| Sales |
$50,000 |
$50,000 |
| Less: cost of sales (beginning inventory) |
-25,000 |
-15,000 |
| Gross income |
$25,000 |
$35,000 |
|
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In this example, the selling price of the goods in Year
2 is $10,000 less than in Year 1, the same amount by which the market
value of the goods sold in Year 1 fell below cost on December 31,
Year 1. But suppose that the selling prices do not drop in relation
to the market values. Then, the lower of cost or market method may
produce a higher total tax over a two-year period than would the cost
method because of an imbalance of income and the graduated tax rates.
This could happen, for example, if a tax rate increase takes effect
in Year 2.
If you are just starting your business and do not
use the LIFO cost method (see identification
of inventory items), you may select either the cost or the lower-of-cost-or-market
method of accounting. You must use the same method to value your
entire inventory, and you may not change to another method without
the IRS's consent.
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Save Time The IRS is less concerned about the
nuances of the specific inventory procedures you use, than with your
being consistent from year to year so that your inventory method accurately
reflects your income. You must use the same method to value
your entire inventory, and you may not change to another method without
the IRS's consent. |
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