Cost or Market Value
If your business carries inventory, you will need to keep
track of it. For tax purposes, as well as for general management
purposes, you'll need to know the value of the inventory
at the beginning and end of the year.
Although there are many possible ways of valuing inventories,
the IRS strongly prefers that small business retailers,
wholesalers and manufacturers value inventories under either of
these methods: (1) cost, or (2) cost or market, whichever is
If you are using the cost method, the value of the inventory
would be all the direct and indirect costs of acquiring it. For
example, the cost of goods you purchased would be the invoice
price, less appropriate discounts, plus transportation or other
charges you incur in acquiring the goods.
For goods that you produced, the cost would be the cost of
labor, materials, and plant overhead used in production.
Manufacturers must generally use the uniform capitalization
("unicap") rules to determine exactly which costs are
to be included in the formula; if you are subject to these
rules, you'll probably need an accountant's help to interpret
and apply them. Luckily, resellers with average annual gross
receipts of $10 million or less for the last three tax years are
exempt from the unicap rules.
The second method - the lower of cost or market method - in
effect permits you to reduce your gross income to reflect any
reduction in the value of inventories. This method is based on
the assumption that if the market price falls, the selling price
falls correspondingly. If this is so, a business owner will
report a lower income, and thus defer until the following year a
part of the taxes that would otherwise have to be paid under the
cost method. One big drawback to using this method is that you
need to compute the value of your inventory both ways in order
to determine which is lower.
In Year 1, John Newsome purchased merchandise
for $50,000 and sold half of the goods for
$60,000. On December 31, Year 1, his inventory
was $25,000 (under the cost method) and $15,000
(under the lower of cost or market method). In
Year 2, he sells the remaining goods for
$50,000. If he had used the lower of cost or
market method, his income would have been
$10,000 less in Year 1 and $10,000 more in Year
2 than if he had used the cost method, as shown
|Less: cost of sales (purchases, less
|Less: cost of sales (beginning inventory)
In this example, the selling price of the goods in Year 2 is
$10,000 less than in Year 1, the same amount by which the market
value of the goods sold in Year 1 fell below cost on December
31, Year 1. But suppose that the selling prices do not drop in
relation to the market values. Then, the lower of cost or market
method may produce a higher total tax over a two-year period
than would the cost method because of an imbalance of income and
the graduated tax rates. This could happen, for example, if a
tax rate increase takes effect in Year 2.
If you are just starting your business and do not use the
LIFO cost method (see identification
of inventory items), you may select either the cost or the
lower-of-cost-or-market method of accounting. You must use the
same method to value your entire inventory, and you may not
change to another method without the IRS's consent.
The IRS is less concerned about the nuances
of the specific inventory procedures you use,
than with your being consistent from year to
year so that your inventory method accurately
reflects your income.
You must use the same method to value your
entire inventory, and you may not change to
another method without the IRS's consent.