When inventory is used to support the sale of goods, the type of accounting method used to determine what is included in inventory and how its cost is established are crucial to the development of an accurate amount of reported taxable income.
From the perspective of the IRS, the types of items that should be included in a company’s inventory are the same as those authorized under generally accepted accounting principles – that is, raw materials, work-in-process, finished goods, and supplies that are integrated into the finished product. A company that wants to avoid tax payments will likely attempt to narrowly define what is included in inventory, so that all items falling outside that definition will be charged to expense, thereby reducing the level of taxable income.
The area in which large shifts in the level of inventory are most likely to occur is in the definition and recognition of the point at which a company obtains title to inventory, and when this title is transferred to another entity. For example, once a company pays for raw materials or merchandise, that inventory should be recorded on the company’s books, even though it may very well be still in transit to the company. At the other end of the sales cycle, goods should no longer be included in inventory once they have been handed over to a third party freight company for delivery to a customer, except for the case where the shipping terms specify that the company retains title to the goods until they reach the customer’s receiving dock. This later instance is similar to a cash on delivery (COD) arrangement, where the company should continue to record an item as being in stock until it is paid for by the customer at the time of delivery. If goods have been sent to a distributor under a consignment agreement, then the company retains title to the products until sold, and so those items must continue to be recorded in inventory. If the company is the distributor, and is receiving consigned goods, then of course the reverse situation applies, and it should not record the inventory as its own asset. Additionally, any inventory used for marketing purposes, such as display items, should also be recorded in inventory.
Once the quantity of inventory on hand has been firmly established, the next issue is to properly determine its cost in a manner that is acceptable to the IRS. The most approved method for doing so is the specific identification method, under which a company tracks the exact cost of each item in stock. This is easiest to do if each unit of stock is clearly identifiable, but in most cases this is not practical, especially when there are large quantities of each item running through the warehouse. In this later case, the IRS prefers that either the FIFO or LIFO methods be used.
Under the FIFO method, the assumption is that the first product purchased will also be the first one to be used, and so the earliest cost at which a product was purchased will be the first one applied to the sale of a product. This tends to result in a higher level of ending inventory dollars, on the assumption that inventory costs are constantly rising (as is generally the case in an inflationary economy). The opposite philosophy is true under the LIFO assumption, which assumes that the last item purchased will be the first one used. This method tends to result in a lower ending inventory valuation, since the most recent (and higher) costs will have been charged to the cost of goods sold. Companies that are trying to avoid paying income taxes will have a preference for the LIFO method, since it yields a lower level of reported earnings.
A company can convert to the LIFO method by filing Form 970, Application to use LIFO Inventory Method, with the IRS.
It is also possible to use the Retail Method for valuing inventory for tax purposes. This method is most commonly applied to the inventories of retailers or distributors, who have nothing but finished goods in stock. To derive costs under the retail method, the total selling price of goods in stock is reduced by the average markup originally applied to the inventory, thereby yielding a close approximation to the original cost. The first step in this process is to determine the markup percentage. To do so, add together the total retail price of all goods in the beginning inventory and the total retail price of all items purchased subsequently. Then subtract the total cost of goods sold contained within the beginning inventory and the cost of all items subsequently purchased from the total price just calculated. Finally, divide the result, which is the total markup dollars, by the total selling price that was initially calculated. With the markup percentage in hand, we can now multiply it by the total retail price of the ending inventory, which results in the total markup dollars in the ending inventory. By subtracting this amount from the total retail price of the ending inventory, we arrive at the cost of the ending inventory. Since there may be different markup percentages for different classes of product, it is more accurate to cluster together products with similar markup percentages into groups, and calculate the cost of each inventory group separately.
If a company uses the retail method in conjunction with the LIFO valuation method, then it must adjust its ending retail selling prices so that they factor in the impact of price markdowns and markups. If the retail method is used without the LIFO valuation method, then the ending retail selling prices can only be adjusted for markups, not markdowns.
It is not acceptable under IRS rules to apply the direct costing method to inventory. Under this practice, all costs not directly associated with a product (such as most overhead costs) are charged directly to the cost of goods sold during the current period, rather than being allocated to ending inventory. If this method were allowable, a company could charge off a larger part of its costs in the current period, thereby reducing the amount of taxable income.
No matter which method (specific identification method, FIFO, LIFO, or retail method) is used, there is still the issue of what costs to allocate to the cost of each inventory item. For example, if a company buys raw materials under a volume purchasing discount, it cannot charge to inventory the list price, but rather only the price paid, which is net of the volume discount. On the other hand, the amount of any cash discount taken in exchange does not have to be factored into the inventory valuation (but whatever method chosen must be used consistently).
A company should not artificially inflate the value of any inventory on hand, so one should periodically reduce the inventory valuation by comparing the current market price that can be obtained for each inventory item to its cost, and adjust its recorded cost down to the lower of cost or market. This is also in accordance with generally accepted accounting principles. This rule does not apply for tax purposes if the inventory being reviewed is to be sold to a customer under a firm fixed price contract, nor does it apply to any inventory that is accounted for under the LIFO valuation method.
There will also be cases in which a company has second-hand or damaged goods in stock that it cannot sell at full price. Though it may be tempting to write off the total value of these items, thereby increasing the cost of goods sold and reducing the level of reported income, the IRS prefers that a company never value them at less than their scrap value, and preferably at their estimated sale price (less the cost of disposition); by requiring this higher valuation, the IRS ensures that the amount of taxable income reported will be higher than if the value of these items were simply eliminated from the inventory valuation.
It is allowable to value a company’s inventory using one method for book purposes and another for tax purposes, except in the case of the LIFO inventory valuation method. In this case, the tax advantages to be gained from the use of LIFO are so significant that the IRS requires a user to employ it for both book and tax purposes. Furthermore, if LIFO is used in any one of a group of financially-related companies, the entire group is assumed to be a single entity for tax reporting purposes, which means that they must all use the LIFO valuation approach for both book and tax reporting. This rule was engendered in order to stop the practice of having LIFO-valuation companies roll their results into a parent company that used some other method of reporting, thereby giving astute companies high levels of reportable income and lower levels of taxable income at the same time.