Proper accounting for inventory is important for manufacturers, distributors and resellers. Costs associated with inventory generally represent the largest annual expenditure for these types of businesses.
The use of inventories for financial and tax accounting is necessary to properly match costs against revenues to clearly reflect income in the appropriate reporting period.
There are two primary methods available for valuing inventory:
Cost is the price you pay to acquire the inventory. It includes direct and indirect costs. Historical cost is the primary method of valuing inventory for accounting purposes.
2. Lower of cost or market
This measures the residual usefulness of inventory based on its market value. Any loss in market value is accounted for in the period in which it occurs.
There are other methods of valuing inventory limited specifically to subnormal or unsalable goods, appreciated inventory, e.g. precious metals, and inventory that has been combined with other items of inventory.
There are also several methods available for valuing the flow of inventory costs:
1. Specific identification
Values each item of inventory separately at its actual purchase or production price. You primarily use this method for large and expensive items that aren’t interchangeable.
Items like jewelry, automobiles, or heavy machinery and equipment.
2. FIFO (first-in, first-out)
The FIFO method assumes the first goods purchased or produced are the first goods sold. You value the ending inventory at the most recent purchase or production costs.
3. LIFO (last-in, first-out)
Assumes that the most recent goods purchased or produced are the first goods sold.
Ending inventory must be calculated by taking beginning inventory quantities and earliest purchases and working forward until all units of inventory on hand at year-end have been costed.
You can only state LIFO inventories at cost – not by using lower of cost or market.
4. Average costing
You can compute average costing in several ways. Normally, the calculation involves the use of a weighted average of beginning inventory and purchases made during the year.
Below is a brief description of some planning items related to inventory accounting.
As a business grows and increases its on-hand inventory during a period of inflationary costs, taxpayers using FIFO for inventory accounting may be able to file an election to adopt the LIFO method to defer income and reduce their taxable income.
Electing to use the Simplified or IPIC method can mitigate some of the complexities of calculating LIFO.
As part of year-end closing procedures, inventory should be reviewed to determine if there are any obsolete or damaged items on hand.
You can write these items down to their probable selling price unless you used the LIFO method. To claim the deduction, the inventory items must be offered for sale within 30 days of the inventory write-off date.
263A – Uniform capitalization rules
Taxpayers with inventory including most manufacturers and resellers/distributors must comply with IRC §263A. This requires the capitalization of otherwise deductible overhead expenditures that support the production or acquisition activities of the company.
A thorough and complete §263A calculation must consider all applicable overheard costs and capitalize them using a reasonable method such as based on square footage of buildings or time spent on specific activities.
In many cases, taxpayers haven’t complied with these rules at all. Or, they’ve capitalized too little which exposes them to significant income recognition if audited by the IRS.
If you perform inventory counts other than at year-end, the IRS allows you to accrue a deduction for inventory shrinkage. The deduction is based on inventory shrinkage estimates.
Shrinkage is primarily attributed to employee and customer theft, damage, and bookkeeping error which cause a taxpayer’s actual inventory to be less than the amount on its books.
When estimating inventory shrinkage, you can apply a historical ratio based on actual physical inventories that have taken place in the past.
A change to using an inventory shrinkage calculation is a change in accounting method that must comply with IRS procedures.
Have questions about year-end inventory planning? Let’s talk!