A taxpayer’s accounting method must clearly reflect income. § 446(b). Reg. § 1.471-1(a) provides in part:
In order to reflect taxable income correctly, inventories at the beginning and end of each taxable year are necessary in every case in which the production, purchase, or sale of merchandise is an income-producing factor.
A taxpayer who sells from inventory who uses the cash method can too easily manipulate the cost of the goods that he/she/it sells. Hence the regulations require that such taxpayers match the cost of goods sold with the actual sale of the goods. Reg. § 1.446-1(c)(2)(i) provides:
In any case in which it is necessary to use an inventory the accrual method of accounting must be used with regard to purchases and sales unless otherwise authorized ...
Reg. § 1.61-3(a) provides in part:
In general: In a manufacturing, merchandising, or mining business, “gross income” means the total sales, less the cost of goods sold ...
Thus, a formula for determining gross income for sales from inventory is the following:
GR MINUS COGS EQUALS GI
GR − COGS = GI
GR = gross revenue
COGS = cost of goods sold
GI= gross income.
The formula for determining COGS is the following:
OI PLUS P MINUS CI = COGS
OI + P − CI = COGS
OI = opening inventory
P = purchases of or additions to inventory
CI = closing inventory.
The Code presumes that taxpayer makes sales from the first of the items that he/she/it purchased and placed in inventory, i.e., “first-in-first-out” or FIFO. § 472. However, taxpayer may elect to treat sales as made from the last inventory items purchased, i.e., “last-in-first-out” of LIFO.
1. On December 31, 2011, taxpayer opened a retail store for business and spent $10,000 to acquire 2000 toolboxes at $5 each. During 2012, taxpayer paid $6000 to acquire 1000 more toolboxes at $6 each. Taxpayer sold 2500 toolboxes for $10 each.
- Taxpayer’s gross revenue was $25,000, i.e., 2500 x $10.
- Taxpayer’s opening inventory was $10,000. Taxpayer’s purchases were $6000.
- At the end of the year, taxpayer’s had 500 toolboxes remaining in inventory.
- If we use the FIFO method, we presume that taxpayer sold the toolboxes that he/she/it already had at the beginning the year plus the ones he/she/it purchased earliest in the year. Hence taxpayer presumptively sold the 2000 toolboxes that he/she/it had on hand at the first of the year plus 500 more that he/she/it purchased.
COGS = $10,000 + $6000 − $3,000 = $13,000
GI = $25,000 − $13,000 = $12,000.
- The value of the opening inventory of 500 toolboxes at the beginning of the next year is $3000, i.e., 500 x $6.
2. Now suppose that taxpayer has adopted the LIFO method.
- Taxpayer’s gross revenue remains $25,000.
- Taxpayer’s opening inventory remains $10,000, and taxpayer’s purchases remain $6000.
- At the end of the year, taxpayer still has 500 toolboxes on hand.
- Under the LIFO method, we presume that taxpayer sold the toolboxes that he/she/it purchased last in time. Thus, we presume that taxpayer sold (in order) the 1000 toolboxes that he/she/it purchased during the years plus 1500 that he/she/it had on hand at the first of the year.
COGS = $10,000 + $6000 − $2500 = $13,500.
GI = $25,000 − $13,500 = $11,500.
- The value of the opening inventory of 500 toolboxes at the beginning the next year is $2500.
Taxpayer’s gross income was less when the price of inventory increased during the year using the LIFO method rather than the FIFO method.
Reg. § 1.471-2(c) permits a FIFO-method taxpayer to elect to value inventory at cost or market, whichever is lower.
3. Same facts as number 1, except that the fmv of toolboxes fell to $4 by the end of the year. $4 is less than $6, so taxpayer will value the toolboxes in inventory at $4 rather than $6.
- Taxpayer’s closing inventory = 500 x $4 = $2000.
COGS = $10,000 + $6000 − $2000 = $14,000
GI = $25,000 − $13,000 = $11,000.
If taxpayer anticipates a loss on inventory before it is sold, he/she/it might elect cost or market valuation of inventory, whichever is lower.