Choices -- and consequences -- abound when valuing your inventory
By Cora M. Barnhart • Bankrate.com

Sept. 9, 1999 -- Are you a business owner with a closet full of items that didn't sell this tax season? If a business makes or buys goods for sale, it can deduct the cost of these goods if it maintains inventories.

This tax tip explains what kinds of items are included in inventories. It also clarifies the rules of the road for determining the cost of items in an inventory.

Show me the money
In general, inventories are goods a business owner ordinarily holds for sale in a business. They also include raw materials and supplies that will become part of the sales merchandise.

The standards for valuing inventory aren't the same for all businesses, but there are some general rules. First, a business must select a method that conforms to generally accepted accounting principles for similar businesses. The method selected should also be consistent each year.

In addition, the business should also use the accrual method of accounting. The accrual method reports income in the tax year it is earned, regardless of when payment is received, and deducts expenses in the tax year they are incurred, regardless of when payment is made.

Items included in inventory
Business owners should include the following items in inventory:

• Merchandise or stock in trade
• Raw materials

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• Work in process
• Finished products
• Supplies that physically become a part of the item intended for sale

Items excluded from inventory
Business owners shouldn't include the following merchandise and assets in inventory:

• Sold goods with a title that has passed to the buyer
• Goods consigned to a business
• Goods ordered for future delivery if the business doesn't have title
• Land, buildings and equipment used in the business
• Notes, accounts receivable and similar assets
• Real estate held for sale by a real estate dealer in the ordinary course of business
• Supplies that don't physically become part of the item intended for sale

Specific identification method
Business owners who can match the actual cost of the specific items in an inventory to their respective costs can use the specific identification method. At first glance, determining the cost of an item held in inventory may seem straightforward; however, this can actually be pretty complicated.

Some businesses simply can't match items with their specific costs. It may be the case that a business has identical goods intermingled in its inventory, making it impossible to identify one piece with one specific invoice.

Rather than throwing their hands up in frustration, business owners carrying inventories like these can value the costs of these items without incurring the wrath of the IRS. The IRS has designated two methods for identifying the cost of goods in inventory.

Our friends, FIFO and LIFO
The first-in first-out (FIFO) method assumes the items purchased or produced first are the first items sold. The items in inventory at the end of the tax year are matched with the costs of items of the same type that were most recently purchased or produced.

The last-in first-out (LIFO) method assumes the items of inventory purchased or produced last are sold or removed from inventory first. Items included in closing inventory are considered to be from the opening inventory in the order of acquisition and acquired in that tax year.

What is the bottom line with respect to using a particular method? Basically, different income results. The difference depends on price trends of the goods in those inventories. Consider inflationary periods. Since prices are rising, LIFO will produce a larger cost of goods sold. This means the resulting inventory will be worth less.

Contrast the result obtained using LIFO to the result using FIFO. Since the first goods in would be the first goods sold, the resulting cost will be lower. This means the resulting inventory will be worth more.

Given the apparent tax advantages of LIFO in inflationary periods, it may seem like a no-brainer for a business owner to use this method for identifying inventory. However, be forewarned that the rules for using the LIFO method are very complex.

Also, business owners should remember that prices don't always increase. The decision to use LIFO could result in something unanticipated -- a higher tax bill.

Consider the consequences of using LIFO if prices are decreasing instead of increasing. Because the last goods in are the first goods out, the final cost of goods sold will be less. This means the resulting inventory will be worth more, increasing the tax liability.

-- Posted Sept. 9, 1999