The value of inventory is a major factor when income tax time comes around each year. The method you choose to use to value the inventory is very important.
There is basically the following types of inventory valuing, however, there are only 2 that we will cover.
Lower of Cost or Market Method
Perpetual or Book Inventory
The first 2, Cost Method and Market Method are the only 2 that will be addressed in this session of study.
There are certain goods that cannot be sold. These are goods you cannot sell at normal prices or in the usual way because of damage, imperfections, shop wear, changes of style, odd or broken lots, or other similar causes, including secondhand goods taken in exchange. You should value these goods at selling price minus direct cost of disposition, no matter what method you use to value the rest of your inventory. If these goods consist or raw materials or partly finished goods held for use or consumption, you must value them on a reasonable basis, considering their usability and condition. Do not value them for less than scrap value. This method does not, however, apply to goods accounted for under the last in first out method of accounting. (the last – in first-out) or LIFO method assumes the items of inventory you purchased or produced last are sold or removed from inventory first. Items included in closing inventory are considered to be from the opening inventory in the order of acquisition and acquired in that tax year.
To properly value your inventory at cost, you must include all direct and indirect costs associated with it. The following rules apply.
1. For merchandise on hand at the beginning of the tax year, cost means the inventory price of the goods
2. For merchandise purchased during the year, cost means the invoice price less appropriate discounts plus transportation or other charges incurred in acquiring the goods. It can include other costs that have to be capitalized under the uniform capitalization rules
3. For merchandise produced during the year, cost means all direct and indirect costs that have to be capitalized under the uniform capitalization rules.
Discounts. A trade discount is a discount allowed regardless of when the payment is made. Generally, it is for volume or quantity purchases. You must reduce the cost of inventory by a trade (or quantity) discount.
A cash discount is a reduction in the invoice or purchase price for paying within a prescribed time period. You can choose whether or not to deduct cash discounts, but you must treat them the same from year to year. If you do not deduct cash discounts from inventory costs, you must include them in gross income.
OR MARKET METHOD
Under the lower of cost or market method, compare the market value of each item on hand on the inventory date with its cost and use the lower value as its inventory value. This method applies to the following:
1. Goods purchased and on hand
2. The basic elements of cost (direct materials, direct labor, and an allocable share of indirect costs) of goods being manufactured and finished goods on hand.
This method does not apply to the following. They must be inventoried at cost.
1. Goods on hand or being manufactured for delivery at a fixed price on a firm sales contract (that is, not legally subject to cancellation by either you or the buyer).
2. Goods accounted for under the LIFO method.
Under ordinary circumstances for normal goods, market value means the usual bid price on the date of inventory. This price is based on the volume of merchandise you usually buy. For example, if you buy items in small lots at $10 an item and a competitor buys identical items in larger lots at $8.50 an item, your usual market price will be higher than your competitor’s.
LOWER THAN MARKET
When you offer merchandise for sale at a price lower than market, in the normal course of business, you can value the inventory at the lower price, less the direct cost of disposition. Figure these prices from the actual sales for a reasonable period before and after the date of your inventory. Prices significantly different from the actual prices are not acceptable. They do not reflect the market. If no market exists, or if quotations are given without reference to actual conditions because of an inactive market, you must use the available evidence of fair market price on the dates nearest your inventory date. This evidence could include:
1. Specific purchases or sales you or others made in reasonable volume and in good faith, or
2. Compensation amounts paid for cancellation of contracts for purchases commitments.