Whenever someone opens a business that involves an inventory, a question that comes up after some time is; How do I value the taxes on something that is continuously fluctuating? How do I evaluate something that has a different value when I buy it versus when I sell it, and it is on the market?
No matter how confusing this all sounds, business owners have multiple methods to simplify matters.
3 Factors that will determine your inventory value
- Cost – This is the price you paid for the items in your inventory.
- Market value – This involves evaluating your stock based on the market value of the goods on the specific valuation date.
- Retail – This method involves calculating the value of inventory on your selling price and then reducing a specific markup percentage to arrive at the final cost.
While calculating your inventory value by using any of the above factors, if you come across any item that you consider ‘damaged’ or ‘worthless,’ you may exclude it from your calculation.
Now, as for the methods of calculation, the IRS (Internal Revenue Service) prefers the FIFO (First in, First Out) and LIFO (Last in, First Out) methods, but there are also other methods that the IRS allows. The IRS recommends both methods for Stock Valuation, especially in the case of taxes.
The first in, first out method in inventory valuation
First In, First Out (FIFO) assumes that the first things that went into the stock were the first ones to be sold. This is amazingly effective when prices are rising (this is the usual case), and the value of the inventory is recorded to be higher. As the earlier and cheaper items in the stock are subtracted from the entire value of the old and new (expensive) items, this creates a more considerable taxable amount. However, suppose this method is used in bookkeeping. In that case, it can attract investors to put money in your company and make it easier for your business to get loans for expansion, which is beneficial for many companies even though it leads to a higher tax.
The last-in-first-out method of calculating the stock value
The Last in, First Out (LIFO) method assumes the last item to be bought for resale is the first item to be sold. When prices increase, the item at the highest expense is the first one to be sold and, therefore, deducted from the sum of old (cheap) and new (expensive) goods in the inventory. This leads to an overall lower taxable income.
Now, some would be wondering if a mixture of FIFO and LIFO could be adopted into the accounting of a particular business. Even though using multiple valuation methods is allowed, if a company is utilizing LIFO in tax, they must also use it in bookkeeping. Moreover, if a company’s subsidiary is operating LIFO, then the entire company must also employ LIFO in calculating its stock value.
Nevertheless, LIFO is the preferred calculation method for many companies, especially those who are looking to cut their taxes.
Advice for inventory valuation methods and the effect of stock size on tax and business
Deciding which method to use depends on the goals of your business, whether you are looking for a lower tax bill or wanting to build strong financial books to attract investors. Some people think that maintaining a large inventory can benefit them from taxable income. However, this is a misconception.
Items in the inventory do not give out any tax-deductible effect until and unless they are considered ‘worthless’ or sold, both of which result in them being removed from the stock. You must also ensure that your inventory is not too small, as it gives no advantages in terms of taxes. The ideal solution is to maintain a flow in your stock that involves a delicate balance between the purchases into the stocks and the sales that get out of the stock. This is also beneficial for businesses as it cuts down the costs of borrowing money for stock or paying for the storage of supplies.
You should consult an accountant to advise you on the stock valuation methods and help you manage your business’s financial records.About Complete Controller® – America’s Bookkeeping Experts Complete Controller is the Nation’s Leader in virtual bookkeeping, providing service to businesses and households alike. Utilizing Complete Controller’s technology, clients gain access to a cloud platform where their QuickBooks™️ file, critical financial documents, and back-office tools are hosted in an efficient SSO environment. Complete Controller’s team of certified US-based accounting professionals provide bookkeeping, record storage, performance reporting, and controller services including training, cash-flow management, budgeting and forecasting, process and controls advisement, and bill-pay. With flat-rate service plans, Complete Controller is the most cost-effective expert accounting solution for business, family-office, trusts, and households of any size or complexity.