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Monday, September 2, 2013

Inventory Valuation

Inventory Valuation from a Tax Perspective
The cost of goods sold is the largest cost component in many businesses, so the method used to account for it can have a profound impact on the reported amount of taxable income. If a business wants to delay paying income taxes, it should employ a reporting system that uses a narrow definition of what is included in the inventory asset, so that all items falling outside of this definition are charged to expense as incurred.
Transfer of Title to Inventory
Part of the consideration of what constitutes taxable inventory is when the company takes title to and releases the inventory. Ideally, it should take title no sooner than when goods arrive at its receiving dock, and relinquish title as soon as finished goods depart its shipping dock. Doing so minimizes the recorded amount of the inventory asset. Thus, avoid all shipping terms that extend the ownership period.
Similarly, try to avoid consignment arrangements where the company retains title to goods that are being held and sold by a distributor. Doing so means that the company is extending its period of inventory ownership.
In situations where inventory is being used for demonstration purposes, the company will likely be forced to record the items as inventory or even fixed assets, though it may be possible to charge them to expense if they have little value once the demonstration period is over.
The Specific Identification Method
The most precise method for tracking the cost of inventory is the specific identification method, under which a cost is assigned to each individual unit of stock. This approach is usually only possible if each unit can be uniquely identified, which is not possible for goods sold in bulk. In this latter case, the Internal Revenue Service has expressed a preference for costing using either the FIFO or LIFO methods.
The FIFO and LIFO Methods
The FIFO (first in, first out) method assumes that the first unit to enter stock is the first one sold, which means that the earliest costs assigned to inventory are the first ones to be charged to expense when items are sold. If prices are rising (which is usually the case), this means that the remaining inventory will have a relatively high price, which means that the cost of inventory charged to expense is low, which creates more taxable income.
The LIFO (last in, first out) method assumes that the last unit to enter stock is the first one sold, which means that the latest costs assigned to inventory are the first ones to be charged to expense when items are sold. If prices are rising, this means that the remaining inventory will have a relatively low price, which means that the cost of inventory charged to expense is high, which creates the smallest amount of taxable income.
Thus, using the LIFO method is preferred in a period of rising prices if you are trying to avoid taxable income.
Other Inventory Valuation Issues
The following additional issues may apply to the valuation of inventory for tax purposes:
  • Retail method. An alternative way to value inventory is the retail method, under which the total selling price of the ending amount of goods in stock is reduced by the average markup percentage to derive the cost. This approach is mostly confined to retailers, who only have finished goods in stock.
  • Direct costing. Valuing inventory for tax purposes under the direct costing methodology is not allowed by the IRS, since no overhead costs would then be applied to inventory, resulting in much lower costs being accumulated in inventory.
  • Lower of cost or market. It is allowable for tax purposes to reduce the recorded value of inventory to the lower of its cost or market value, but not if the goods are being sold under a firm fixed price contract, or if the LIFO valuation method is being used.
  • Obsolete inventory. If a company has obsolete inventory in stock, it is allowable to reduce the value of these items for tax purposes to their estimated sale price, less any selling costs.
  • Multiple valuation methods. It is allowable to employ several different inventory valuation methods, one for book purposes and one for tax purposes. However, if the company is using LIFO valuation for tax purposes, it must also use this method for book reporting purposes. In addition, if a subsidiary of a financially-related cluster of businesses uses LIFO, then all of the businesses in this cluster must use LIFO for both tax and book reporting purposes.

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