As a business owner each year there will come a time when the bookkeeper or CPA will ask:
What is the value of your ending inventory?
This question can cause panic and stress for business owners when a good inventory management system is not in place. More importantly, most owners do not understand how inventory affects business and individual income taxes. First, let’s discuss the most common ways to value inventory:
· Actual Cost – Each piece of inventory is tracked by its actual cost. When the item is sold the actual cost is expensed. This method is typically used by businesses that have larger ticket items or low volume of inventory. Variations of the actual cost method are below:
o First-In, First-Out (FIFO) – The first items purchased are calculated as the first to be sold. This method will result in a lower cost of goods sold amount in a period of rising costs to purchase inventory (regular inflation). Lower costs of goods sold results in increased net income, which results in increased taxes.
o Last-In, Last-Out (LIFO) – The last items purchased are calculated as the first to be sold. This would be for a business that consistently has older inventory left over after they year is closed. LIFO results in higher costs of goods sold and lower taxes in a period of rising costs.
· Average Cost – The weighted average is calculated on all units available for sale during a specific period (week, month, year, etc). The amount on hand at the end of the year would represent the average cost of items purchased throughout the year. This method is typically used by businesses that sell a large amount of small tickets items.
Whatever method is chosen, it is important that it is consistently applied. Once the business decides the most reasonable way to value inventory, costs of goods sold are calculated for taxes according to the following formula:
Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold
Here are the facts for an example: beginning of the year inventory was $10,000, purchases for the year were $50,000, and end of the year inventory is $20,000. Current year cost of goods sold would not be the $50,000 spent, but the following:
$10,000 + $50,000 – $20,000 = $40,000 Cost of Goods Sold deduction
This $40,000 is the deduction taken on the tax return even though $50,000 was spent during the year. The IRS only allows businesses to deduct what they sell in the current year. This can be tough for start up businesses when a large cash outflow occurs to purchase inventory, but they are not allowed to see the tax benefit by expensing those items until they are sold. As time goes on cost of goods sold should increase or decrease relative to sales. Whether it is monthly, quarterly, or yearly inventory should be adjusted to what is actually on hand to produce accurate financial statements. For tax purposes if inventory is overstated this will result in decreased expenses for the year and more taxable income to you as the business owner. This is why we stress the important of keeping an accurate account of inventory that is on hand.
Keeping up with inventory throughout the year will greatly reduce stress at year end and will ensure income taxes are not being overpaid due to poor inventory management. Please contact us if you are interested in learning more about how inventory affects your tax situation.