If your business involves the production, purchase, or sale of merchandise, how you account for inventory and cost of sales will have a significant impact on your net earnings for income tax purposes. You need to use the accrual method for accounting and a way to identify the inventory sold and its value.
Inventory valuation methods are not the same for all businesses, but the method used must be in accordance with generally accepted accounting principles and practices normally used in that business, it must clearly reflect income, and it must be used consistently from year to year.
Inventory valuation rules for tax purposes must not conflict with the uniform capitalization rules that apply for businesses that produce real or tangible personal property or that acquire property for resale. Also, when determining inventory values, traders in securities must take into account any mark-to-market election they might make.
Items to Include in Inventory
Depending on the type of your business, you may have different types of inventories. If you are in the business of manufacturing or producing goods for sale, you probably have inventories for raw materials, work in process, and finished products. If you have different products, you may keep track of different inventories within each of these general groups.
Merchandise is generally considered to be finished goods you have produced or purchased, that are available for sale to customers. At any given point in time, merchandise can be in any one of various stages in the sales cycle. In addition to the inventory you physically hold in your store, warehouse, storeroom, or other part of your place of business, the following merchandise should also be included in your inventory for income tax purposes:
Merchandise that you have purchased, and for which title has passed to you, including merchandise in transit. The terms of purchase will generally tell you when title passes, for example free on board (FOB), free along side (FAS), or cost, insurance and freight (CIF).
Goods that are under contract for sale, but that you have not yet applied to the contract.
Goods that you own and have consigned out to another location. (You have consigned the goods but have not sold them or transferred ownership.)
Goods that are held for sale at show rooms, or other points of sale outside your normal place of business.
If you sell by mail and your sales terms are cash on delivery (COD), you should keep the merchandise in your inventory until payment is received from the buyer.
Merchandise that should not be included in your inventory include:
Goods that have been sold, and title has passed to the buyer.
Goods you are holding on consignment.
Goods you have ordered for future delivery, but for which you do not yet have title.