The timing of your inventory purchases and sales can have a huge impact on company profits and your tax liability. To understand how inventory impacts a firm’s tax liability, consider the concept of accrual accounting, the issue of inventoriable costs, and inventory valuation methods. You can use this knowledge to project your company profits and calculate the related tax liability.
The Relationship Between Inventory and Accounting
The timing of expenses will impact your company profit and the tax on that profit. Almost all businesses operate using accrual accounting, which means that revenue is recorded when earned and expenses are posted when incurred. Accrual accounting matches revenue with the expenses incurred to produce the revenue.
Assume, for example, that a restaurant owes employees $3,000 for wages earned in the last week of December of 2016. The next payroll pay date is January 5th of 2017. The restaurant incurred $3,000 in payroll expenses to earn revenue during the last week of 2016. Therefore, the $3,000 is a payroll expense in 2016, even though it is not paid until 2017.
This process matches 2016 revenue earned with expenses incurred in 2016. Under accrual accounting, the movement of cash does not drive the accounting entries.
What Are Inventoriable Costs?
Accrual accounting also applies to inventory. When a company sells an item out of inventory, revenue (a sale) is generated, and cost of goods sold is posted to the accounting records. The cost recorded determines the profit on the sale and the eventual tax on the profit.
Inventoriable costs are expenses that should be included with the merchandise held in inventory. Accountants define inventoriable costs as the cost paid to the supplier, plus all costs incurred to “prepare the inventory for sale”. Freight costs are inventoriable costs, as well as costs incurred to make changes or additions to the items in inventory. As an example, when a retailer adds their brand name or logo to an inventory item, it is an inventoriable cost.
Why the Timing of Expenses Is Important
Imagine walking into a sporting goods store that is carrying $300,000 of inventory. None of those costs have been expensed yet. Instead, those costs remain “attached” to each inventory item until the item is sold. Unlike many other expenses, inventory costs do not become expenses until a sale takes place. So, the recognition of these expenses is delayed.
The matching principle means that sales and cost of sales are incurred in the same time period. If the shop sells $300,000 in inventory at a total sale price of $350,000 in March, for example, the store generates revenue ($350,000), cost of sales ($300,000) and profit of $50,000—all in the same month of March.
In many instances, the value placed on a particular inventory item will be different, depending on when the item was purchased. These differences in inventory valuation impact both profits and a firm’s tax liability.
How to Value Your Inventory
A business needs to make decisions about a variety of accounting principles, including inventory valuation. Specifically, you must choose a method to value the inventory you carry, and that decision has an impact on the inventory asset balance, your cost of sales and your profit. As a result, your firm’s tax liability is affected by the inventory valuation method you choose.
Once you select a method, you need to use that method consistently each year. This accounting principle of consistency allows a financial statement reader to compare your results from one year to the next. If you change your inventory valuation method, it distorts your cost of sales and profit results. Here’s an example:
Carpio Hardware operates five hardware stores and generates $10 million in sales. The hardware stores carry lawn mowers in inventory. Here is Carpio’s current lawn mower inventory: