9058 / What is inventory accounting? What methods are generally used by taxpayers to account for inventory?
Editor's Note: Under the 2017 tax reform legislation, taxpayers that meet the gross receipts test (see Q 9044) are no longer required to account for inventory under IRC Section 471 and can instead use a method of accounting for inventory that either (1) treats inventory as non-incidental materials and supplies or (2) matches the taxpayer's method of inventory accounting as used for financial accounting purposes.1 Under prior law, taxpayers were only permitted to account for inventory as materials and supplies that are non-incidental if they had average gross receipts of less than $10 million.2
Taxpayers that fail the gross receipts test are not eligible for the new rules governing inventory accounting. The $25 million threshold will be indexed annually for inflation; the 2026 amount is $32 million. The new rules governing inventory accounting are effective for tax years beginning after December 31, 2017.
Inventory accounting is generally required in any case where the IRS feels it is necessary in order to accurately reflect a taxpayer's income (but see Editor's Note, above). Inventory accounting usually becomes important in cases where the taxpayer's business involves the production and sale of goods or the purchase and resale of goods.
As a general principle, IRC Section 471 has historically required that a taxpayer's inventory accounting method must: (1) conform as closely as reasonably possible to the best accounting practice used in the taxpayer's business3 and (2) clearly reflect the taxpayer's income.4 Under the regulations, therefore, there is no one particular accounting method that must be used in all circumstances to account for inventory. Instead, the method chosen must reflect the realities of the taxpayer's business. As such, greater weight is given to consistency than to the actual valuation method chosen.5
There are various methods of inventory accounting, including first-in, first-out (FIFO), last-in, first-out (LIFO) and specific identification methods.
The FIFO method of accounting assumes that the first items of inventory purchased by the taxpayer are the first items that are sold. As such, the inventory that remains at the end of the taxpayer's accounting period is valued based on the most recent purchase price.6
Conversely, under the LIFO method, the most recent items of inventory that are purchased are considered to be the first items sold. Under the LIFO method, inventory is valued based on its cost, rather than its market value.7
Rather than focusing on the flow of inventory, the specific identification method requires that the taxpayer keep records so that it may assign a specific cost to each item of inventory.8
Certain taxpayers are either prohibited or are given the option to not use the inventory method of accounting. They include:
(1) Real estate dealers – A taxpayer that is in the business of selling real properties is not permitted to use the inventory method;9
(2) Farmers – A taxpayer engaged in a farming business may use either the inventory or the cash method in reporting income;10
(3) Real estate investment mortgage units are exclusively governed by Sections 860A through 860G.11 These entities are not permitted to use the inventory methods under Section 471.
Though greater weight is given to consistency than to the method of inventory accounting chosen, certain inventory accounting methods are specifically prohibited under Treasury Regulation Section 1.471-2(f), including the following:
(1) Deducting a reserve for price changes or an estimated depreciation in the value of inventory;
(2) Carrying inventory at a nominal price or at less than its proper value;
(3) Omitting portions of the inventory;
(4) Using a base-stock method based on a normal quantity and constant price;
(5) Including in-transit goods in inventory where title to such goods is not yet vested in the taxpayer;
(6) Using a direct cost method by a manufacturer, under which only direct production costs and variable overhead costs are allocated to inventory; and
(7) Using a prime cost method by a manufacturer, under which only direct production costs are allocated to inventory.
If a taxpayer has used a prohibited inventory method, IRS consent is still required to change
the method unless automatic approval is available under Revenue Procedure 2011-14 (see Q 9042).12
Planning Point: FIFO or LIFO? Choosing LIFO is enticing in a capital-heavy business when the costs of the goods sold are increasing. This will reduce the current tax burden. However, LIFO often increases administrative time and paperwork. LIFO can affect valuation in the sale of a business as it postpones the inevitable until the sale of the business. Technology businesses often exist in a deflationary world, where the costs of their inventory decrease as computing power (and other technologies) increase year over year. FIFO is also accepted by the International Financial Reporting Standards Board (IFRS), and LIFO is not.
1. IRC § 471(c)(1).
2. IRC § 471.
3. Geometric Stamping Co. v. Comm., 26 TC 301 (1956), acq., 1958-1 CB 4 (re: importance of consistency).
4. Treas. Reg. § 1.471-2(c). See also Walmart v. Comm., TC Memo 1997-1 (8th Cir. 1998) (upholding the estimate for inventory shrinkage).
5. Treas. Reg. § 1.471-2(b).
6. Treas. Reg. § 1.471-2(d); ARB No. 43, Chapter 4, Statement 4 (AICPA, 1953) (FASB Accounting Standards Codification 330-10-30).
7. IRC § 472(b)(2).
8. Treas. Reg. § 1.471-2(d).
9. Rev. Rul. 69-536, 1969-2 CB 109, amplified in Rev. Rul. 86-149, 1986-2 CB 67; Atlantic Coast Realty Co. v. Comm., 11 BTA 416 (1928); Miller Development Co. v. Comm., 81 TC 619 (1983).
10. Treas. Reg. § 1.471-6(a).
11. Rev. Rul. 95-81.
12. Treas. Reg. § 1.446-1(e)(2)(i).