Small Business Accounting:

How to Value Your Inventory

If you are a business owner with leftover inventory in your warehouse, you can deduct the cost of these items on your tax return. Two things need to happen for this deduction to work. First you need to have qualified items in storage. Inventory that includes merchandise or stock in trade, raw materials for merchandise that you sell, any works in process, finished products that you intend to sell, or supplies that will physically become parts of the items you will eventually sell. The key here is the products or properties you are holding in the warehouse or storage for selling, one way or the other they are intended to go out.

Inventory that is not considered is merchandise that has already been sold to the customer with a title, or goods that are being ordered by you that you don’t hold the title for, land, building, or equipment you use in your business, goods that are consigned to your business, supplies that don’t physically become part of the goods that you sell, notes or accounts receivable or similar assets, plus real estate that is held by a real estate dealer or to be sold in the ordinary course of his business.

Now that we know what the IRS considers inventory, let’s look at ways to determine the cost of the items in inventory. Most businesses use the accrual method of accounting to begin with. This method reports income in the tax year that you earn it , not when the payments are physically received, and deducts the expenses as they are incurred not when the payments are made. Following are some ways to determine the cost of the items in inventory:

• Specific identification method this where you use your invoices to identify specific items with their costs. But sometimes even this simple and straightforward method can’t yield satisfactory results. Due to the similarity in products or a glitch in the paperwork system, some items can’t be specifically identified. In that case, look at the following two methods outlined by IRS:

1. First-in-first-out method is where the first items that are produced or bought are assumed to be the first ones sold. This way at the end of the year, whatever is left in the inventory is matched with the costs of the similar items that were most recently bought or produced. Using this method during inflation, the items in inventory will be worth more.
2. Last-in-first-out method this is where the last items that were produced or bought by your business are the first ones to be sold. This way at the end of the year, whatever is left in the inventory is matched with the cost of the items in the opening inventory. Using this method during inflation, the items in inventory will be worth less.