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How To Account for Inventory for Income Tax Purposes 
by kmhagen September 01, 2005

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.

Inventory Identification Methods

How you identify items in inventory and determine which have been sold will depend on the nature of the products, the volume of products, how they are tracked, and inventory rotation.  It will also depend on the uniformity or uniqueness of the products.  For example, if you sell products that are custom made, you will probably be able to use the specific identification method.  You will be able to determine the costs that make up each item in inventory.


If you cannot specifically identify the cost of each item in inventory, or the same types of goods are intermingled in your inventory and cannot be specifically matched to a particular sales invoice, you can use either the FIFO or LIFO inventory valuation method.

Under the FIFO (first-in-first-out) method, you assume that the goods you purchased or produced first (the goods that came into your inventory first) are the first ones to be sold or otherwise disposed of (the first ones to go out of your inventory).  Therefore, at the end of the year, the items in inventory are assumed to be the last ones to be purchased or produced, and are valued at the most recent purchase or production prices.

Under the LIFO (last-in-first-out) method, you assume the opposite – that the last goods you purchased or produced are the first to be sold or disposed of.  So your inventory at the end of the year consists of the earliest goods purchased or produced, valued at the earliest prices.

The inventory identification method you use will affect your inventory value and your cost of sales.  During periods of rising prices, the FIFO method will generally result in a lower cost of sales amount than the LIFO method.  When prices are falling, the opposite would be true.

Applying LIFO

Two of the pricing methods that can be used in applying LIFO for tax purposes are:

  • the dollar-value method, in which goods and products must be grouped into one or more pools or classes, depending on the kinds of items in inventory, and
  • the simplified dollar-value method, in which general categories of multiple pools of inventory are established.  Annual changes in the prices of these pools of inventory are estimated based on the appropriate government price indexes.

The LIFO method is adopted by filing Internal Revenue Service (IRS) Form 970, Application To Use LIFO Inventory Method.

Inventory Valuation Methods

In addition to determining the method for identifying inventory items, you must have a method for valuing those items, and for calculating cost of goods sold.  The inventory valuation methods that can generally be used for income tax purposes are:

  • cost,
  • lower of cost or market, or
  • retail.

Cost Method

When you value your inventory at cost, you have to include all direct and indirect costs involved in acquiring or producing your inventory.  The cost of merchandise you purchase includes the invoiced purchase price less any trade or other discounts, plus any transportation, shipping, or other costs you incur in acquiring the merchandise.  These include any costs you must capitalize under the uniform capitalization rules.  If you manufacture or produce merchandise, you must include in inventory all the direct and indirect costs involved in the manufacture or production process; here again following the uniform capitalization rules.

There are two different types of discounts that should be taken into account:

  • Trade discounts are price reductions (generally for the quantity or volume of purchases) that apply regardless of when payment is make.  These discounts reduce the cost of inventory.
  • Cash discounts are reductions for prompt payment, generally expressed as a percentage of the invoice amount for payment within a certain number of days.  Cash discounts can be either be treated as reductions of the cost of inventory, or can be included in income for tax purposes.  The method chosen must be consistently applied.

Lower of Cost or Market

Under this method, you determine the market value of each item on hand as of the inventory date, compare the market value with the cost of each item, and use the lower of the two as the inventory value of that item.

The lower of cost or market method can be used for goods purchased and on hand, and for the basic components of work in process and finished goods, including direct materials, direct labor, and certain indirect costs.

This method cannot be used for goods that are being produced for delivery at a fixed price under a firm sales contract.  Neither can it be used for inventory identified under the LIFO method.  In these cases, the inventory must be valued at cost.

When you use the lower of cost or market method, you must value each item of inventory (or groups of items that are the same) separately.  You then take the lower amount between cost or market value for each item, and add them together to arrive at the total inventory value.  You do not compare the total cost to the total market value and take the lower amount.

For example:

  • You have three items in inventory:  Product A has a cost of $10, Product B has a cost of $15, and Product C has a cost of $18.  The total cost of the three is $43.
  • Product A has a market value of $12, Product B has a market value of $14, and Product C has a market value of $11.  The total market value of the three is $37.
  • Taking the lower of cost or market by product results in:  Product A: $10; Product B: $14; Product C: $11.  The total is $35.  This is the lower of cost or market for the inventory.

Market value means the usual bid price to you, under normal circumstances for normal goods.  This may not be the same price that the same goods are available to a different buyer.  Prices could vary depending on the volume of goods you are buying, for example.

Retail Method

Under the retail method, you take the total retail selling price of each item in inventory and reduce it by the average margin, expressed as a percentage of the selling price, to determine the approximate cost of the item.

To determine the value of the ending inventory under the retail method, you need to:

  1. Calculate the average percentage markup.
    • Add up your total retail selling prices of the goods you had in your opening inventory and your total retail selling prices of all the goods you purchased during the year, adjusting the prices for any markups or markdowns you applied.
    • Add up the total cost of the goods in your opening inventory and the total cost of the goods you purchased during the year
    • Divide the difference between total retail selling prices and total costs by the total retail selling prices.  This will be the average percentage markup.
  2. Calculate ending inventory value at retail as follows:
    • Take the total value of your opening inventory and your total purchases for the year at your retail selling price (from the first part of step 1.)
    • Add markups and subtract markdown.
    • Subtract sales for the year, at the retail selling price, from the total in a).
  3. Multiply the ending inventory value at retail (from step 2) by the percentage markup (calculated in step 1).
  4. Subtract the percentage markup (from step 3) from the ending inventory value at retail (step 2) in order to arrive at the ending inventory value at cost.


Your records at the end of the tax year show the following:

  • Your opening inventory has a cost of $35,000 and a retail value of $40,000.
  • You had purchases during the year at a cost of $53,000.  The retail value of those purchases was $59,000.
  • Your sales for the year, at retail value, were $75,000.
  • You had markups of $1,500 and markdowns of $500.

Using the retail method, you would calculate your ending inventory value as follows:

  • The total cost of opening inventory and purchases is $88,000 ($35,000 plus $53,000).
  • The total retail value is $100,000 ($40,000 in opening inventory plus $59,000 retail value of purchases during the year plus net markups of $1,000).
  • The markup percentage is 12% ($12,000 divided by $100,000).
  • Ending inventory at retail value is $25,000 ($100,000 minus sales of $75,000).
  • The markup percentage in ending inventory is $3,000 (12% x $25,000).
  • Ending inventory at cost is therefore $22,000.

 If you are using the retail method of valuation with the LIFO method of identification, you must adjust the inventory value at the end of the year to reflect price changes since the end of last year (this year’s opening inventory balance).  Generally, you will have to develop your own retail price, based on an analysis of your own data, in order to make this adjustment.

Resellers who use the retail method for calculating their inventory and cost of goods sold amounts, can use this method for tax purposes if they state on their tax return that they are using this method.  Accurate records must be kept, and this method must be used consistently every year, unless the IRS allows a different method to be used.

Different classes of goods may have different markup percentages, and records should be kept of each type or class of goods.  The records should support the calculation of the markup percentage, and should therefore include the dates and amounts of sales invoices, any markups or markdowns, and the cost of the respective goods.  Accumulated records should also be kept of inventory amounts, purchases, and sales of each type or class of goods.

Manual Calculation or Perpetual Inventory System

You can do the inventory and cost of goods sold calculation manually, when you prepare your income tax return, or you can maintain a perpetual or book inventory as part of the accounting system for your business.  You need to take physical inventories at regular intervals and adjust your book inventory to agree with the actual physical inventory amounts.


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