Inventory/Cost Of Goods Sold 2021 | Best Guide - CPA Clinics
Accounting for inventory is necessary to reflect gross profit when the production, purchase, or sale of merchandise is an income-producing factor. However, if an inventory is necessary to account for your income, you generally must use and accrual method of accounting for sales and purchases, unless you are a small business taxpayer.
You are a small business taxpayer if you have average annual gross receipts of $26 million (2021) or less for the prior three tax years and are not a tax shelter.
All taxpayers must use a method of accounting for inventory that clearly reflects income. If you choose not to keep an inventory, you will not be treated as failing to clearly reflect income if your method of accounting for inventory treats inventory as non-incidental material or supplies, or conforms to your financial statement treatment of all inventories.
If a business manufactures products or purchases them for resale, some expenses are included in figuring cost of goods sold (COGS). Expenses includable in COGS are not deductible until the item is sold, even if the business qualifies to use the cash method of accounting. The following are examples of expenses that go into calculating COGS.
The cost of goods sold deduction is calculated as follows.
The taxpayer must have a method for identifying and valuing the items in inventory. One of the following methods is generally used.
For example, a car dealership can identify specific inventory items and match them with specific cost invoices. If the specific identification method cannot be used, FIFO or LIFO is generally used.
The FIFO method assumes that items purchased or produced first are the first items sold, consumed, or otherwise disposed of. Items in inventory at the end of the tax year are matched with costs of similar items that were most recently purchased or produced.
The LIFO method assumes that items of inventory purchased or produced last are the first items sold, consumed, or otherwise disposed of. LIFO rules are complex. IRS approval is required and may be obtained by filing Form 970, Application to Use LIFO Inventory Method.
Unless a deduction was claimed in a previous year, the cost of materials and supplies is generally deductible when actually consumed and used during the tax year. If items that would normally be required to be included in inventory are treated as materials and supplies, the cost is deductible in the year the inventory item is sold, or the year the materials and supplies are paid for, whichever is later.
If incidental materials and supplies are kept on hand, the cost of these is deductible at the time of purchase if:
The following methods are available for valuing inventory
The cost method values ending inventory with the invoice cost of similar items, plus other direct and indirect costs that are required to be added to inventory. The FIFO cost method takes the invoice price of similar items most recently purchased and applies that price to the quantity of items on hand at the end of the year.
This method compares the market value of each item on hand with its cost at the time inventory is taken. The lower of the two is the value of inventory. If there is a drop in the current price of items that are similar to items remaining in ending inventory, the cost of goods sold deduction will be higher using the market value rather than cost to value ending inventory. The lower of cost or market method is not allowed for LIFO, or for goods that will be delivered at a fixed price on a firm sales contract.
