| An inventory is an itemized list of goods held for sale or for consumption in a manufacturing or merchandising business. In order to properly calculate gross profit from operations, leading to a determination of taxable income for that business, the taxpayer must adopt a method of valuing its inventory.
Either of two common bases for valuing inventory may be adopted: cost, or the lower of cost of market. Opening and closing inventories must be valued by the same method, and if the lower of cost or market is used, cost and market value are determined as to each item, not to the inventory as a whole.
Inventory at Cost: Uniform Capitalization Rules
Under uniform capitalization rules, all costs allocable to real and tangible personal property that is acquired for resale or is produced by the taxpayer must be included in the cost of inventory. The costs attributable to inventory must be added to the costs of producing or purchasing the inventory. In addition, interest costs paid or incurred to finance the construction, manufacture, or development of property produced by the taxpayer must be capitalized and added to the cost of the inventory.
The uniform capitalization rules do not apply to inventories valued at market.
Inventory at "Cost or Market"
When a taxpayer chooses a "cost or market" method of valuing inventory, the market value of each item is compared to the cost of the item, and the lower of the two values is used to value the inventory. If the inventories are valued at cost, they are subject to the uniform capitalization rules.
"First-In, First-Out" (FIFO) Rule
When various items of inventory have been so commingled that they cannot be matched with specific invoices in order to determine their cost, the taxpayer is entitled to make an assumption about which items were sold and which remain in inventory. The FIFO method assumes that items produced or purchased first were sold first. Therefore, the items remaining in inventory are matched with the most recent costs.
"Last-In, First-Out" (LIFO) Rule
Under the LIFO method of valuing inventory at cost, it is assumed that the newest items are sold or used up first and that the remaining inventory consists of the oldest purchases. A taxpayer does not have to get advanced permission from the Internal Revenue Service to use the LIFO method, but he must adopt it on the return for the year in which the method is first used. If LIFO is used for income tax purposes, it must also be used to prepare annual financial statements used to get credit or to report to owners.
Dollar-Value LIFO Method
Under this method, taxpayers value inventory by comparing the total dollar value of the beginning and ending at a base year and then convert any increase to current prices by means of governmental indices. This method, along with Simplified Dollar-Value LIFO, eliminates the need to determine quantity increases for each item in the inventory and then pricing them.
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