Methods of Inventory Valuation - General Principles

Methods of Inventory Valuation - General Principles

By Leslie J. Schneider  J.D. C.P.A.

Cost of goods sold is generally one of the largest offsets to a business owner's taxable income. But cost of goods sold is an accounting concept that is often difficult to calculate because it cannot be computed directly. Instead, cost of goods sold is calculated by first determining inventory. Consequently, inventory determination and valuation practices are the keys to determining the costs of goods sold, and thus taxable income. Because of the importance of inventories in determining taxable income, taxpayers, the IRS, and Congress are all focusing more attention on inventory issues and the related tax consequences.

This analysis provides an understanding of the general principles involved in the methods of inventory valuation, and then explores the emerging issues in this area. First, this analysis explores how the taxpayer adopts a method of accounting for inventories. A taxpayer's method of accounting for inventory must clearly reflect income in order for it to be used for tax purposes. In deciding whether a particular method of inventory accounting clearly reflects income, significant weight is generally accorded to trade practice.

Consistency is critical for the taxpayer. The taxpayer must use a consistent inventory method from one year to the next, determine opening and closing inventory within the same year on a consistent method, and value all of the items in its inventory on a consistent method. A taxpayer must also verify its inventories with a physical count at least once a year. Finally, the regulations contain a list of inventory methods that are specifically prohibited from being used for tax purposes.

Adoption of a Method of Accounting for Inventories

A taxpayer normally adopts a method of accounting for inventories by utilizing that method in computing taxable income on its tax return. A method of accounting for inventory must be adopted in the taxpayer's first tax return in which it has inventory, even if the choice of methods has no effect on its income determination for such initial year.

This analysis provides an in-depth understanding of the general principles behind the methods of inventory valuation for federal income taxation purposes.

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