Publication 538 - Accounting Periods And Methods (Page 16 of 23) in pdf

method. You must file the form (or the statement) with

Discounts. A trade discount is a discount allowed re-

your timely filed tax return for the year in which you first

gardless of when the payment is made. Generally, it is for

use LIFO.

volume or quantity purchases. You must reduce the cost

of inventory by a trade (or quantity) discount.

Differences Between

A cash discount is a reduction in the invoice or pur-

chase price for paying within a prescribed time period.

FIFO and LIFO

You can choose either to deduct cash discounts or in-

clude them in income, but you must treat them consis-

Each method produces different income results, depend-

tently from year to year.

ing on the trend of price levels at the time. In times of infla-

tion, when prices are rising, LIFO will produce a larger

Lower of Cost or Market Method

cost of goods sold and a lower closing inventory. Under

FIFO, the cost of goods sold will be lower and the closing

Under the lower of cost or market method, compare the

inventory will be higher. However, in times of falling pri-

market value of each item on hand on the inventory date

ces, the opposite will hold.

with its cost and use the lower of the two as its inventory

value.

Valuing Inventory

This method applies to the following.

The value of your inventory is a major factor in figuring

your taxable income. The method you use to value the in-

Goods purchased and on hand.

ventory is very important.

The basic elements of cost (direct materials, direct la-

The following methods, described below, are those

bor, and certain indirect costs) of goods being manu-

generally available for valuing inventory.

factured and finished goods on hand.

Cost.

This method does not apply to the following. They must

Lower of cost or market.

be inventoried at cost.

Retail.

Goods on hand or being manufactured for delivery at

a fixed price on a firm sales contract (that is, not le-

Goods that cannot be sold. These are goods you can-

gally subject to cancellation by either you or the

not sell at normal prices or they are unusable in the usual

buyer).

way because of damage, imperfections, shop wear,

Goods accounted for under the LIFO method.

changes of style, odd or broken lots, or other similar cau-

ses. You should value these goods at their bona fide sell-

Example. Under the lower of cost or market method,

ing price minus direct cost of disposition, no matter which

the following items would be valued at $600 in closing in-

method you use to value the rest of your inventory. If

ventory.

these goods consist of raw materials or partly finished

goods held for use or consumption, you must value them

on a reasonable basis, considering their usability and con-

Item

Cost

Market

Lower

$300

$500

$300

dition. Do not value them for less than scrap value. For

. . . . . . . . . . . . . . . . . .

200

100

. . . . . . . . . . . . . . . . . .

more information, see Regulations section 1.471-2(c).

450

200

. . . . . . . . . . . . . . . . . .

Total

$950

$800

$600

. . . . . . . . . . . . . . . .

Cost Method

You must value each item in the inventory separately.

To properly value your inventory at cost, you must include

You cannot value the entire inventory at cost ($950) and

all direct and indirect costs associated with it. The follow-

at market ($800) and then use the lower of the two figures.

ing rules apply.

Market value. Under ordinary circumstances for normal

For merchandise on hand at the beginning of the tax

goods, market value means the usual bid price on the

year, cost means the ending inventory price of the

date of inventory. This price is based on the volume of

goods.

merchandise you usually buy. For example, if you buy

For merchandise purchased during the year, cost

items in small lots at $10 an item and a competitor buys

means the invoice price minus appropriate discounts

identical items in larger lots at $8.50 an item, your usual

plus transportation or other charges incurred in acquir-

market price will be higher than your competitor's.

ing the goods. It can also include other costs that have

Lower than market. When you offer merchandise for

to be capitalized under the uniform capitalization rules

sale at a price lower than market in the normal course of

of section 263A of the Internal Revenue Code.

business, you can value the inventory at the lower price,

For merchandise produced during the year, cost

minus the direct cost of disposition. Determine these pri-

means all direct and indirect costs that have to be

ces from the actual sales for a reasonable period before

capitalized under the uniform capitalization rules.

and after the date of your inventory. Prices that vary mate-

rially from the actual prices will not be accepted as reflect-

ing the market.

Page 16

Publication 538 (December 2016)

Publication 538 - Accounting Periods And Methods Page 16

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