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When Inventories are Necessary

Inventories are a company’s asset.  Merchandise, raw materials, and products are the common inventories of a company.  Products include finished and unfinished products not sold.  Inventories are liquid cash for a company.  Inventory can be easily converted into cash.  Inventories can be valued by adopting different methods.  The lowest value of an asset is usually used in financial statements to reduce tax liability.  A tax payer is required to inventory goods for computing taxable income.  A taxpayer filing his/her first return can choose any permissible method for computing income on that return.  However, a tax payer must adopt a method s/he uses in keeping his/her books.

Inventory exist every where.  Inventory flows through the supply chain and sits in warehouses, distribution centers, and store shelves.  It’s at the heart of cash flow and working capital management. Manufacturing, distribution, and retail can’t function without inventory.

As a major investment, inventory serves many purposes, such as:

  • ensuring that a customer’s order is sent complete and on time;
  • providing a defense against supply chain uncertainty and unpredictability;
  • decoupling manufacturing operations;
  • assuring an uninterrupted supply of seasonal products; and
  • taking advantage of volume discounts.

The necessity of having inventory has be balanced against the substantial cost of ordering, carrying, and storing inventories.  Inventory assumes capital costs, service costs, and storage costs.

Where the production, purchase, or sale of merchandise is an income-producing factor, inventories at the beginning and end of each tax year are necessary.  Inventory is necessary even where a taxpayer provides valuable services.

Inventory can become a serious burden with regards to the cost of running a company. Huge amounts of inventory mean excessive maintenance costs.  The management segment of the company sometimes does not realize the additional or excess inventory.  When a company can successfully manage its inventory, the company becomes able to manage the business for profit.  When a company is under the burden of inventories, it is bound to burden the owner with additional liabilities.

Inventory management aims to ensure a consistent delivery of the right product in the right quantity to the right place at the right time.  The purpose must be achieved without excess and obsolete inventory.

The general rule regarding inventories is provided in the Internal Revenue Code.  The use of inventories is necessary to determine the income of a taxpayer.  In order to reflect taxable income correctly, inventories are necessary in every case in which the production, purchase, or sale of merchandise is an income-producing factor[i].  A taxpayer must comply with the instruction of the Secretary of the IRS.  The method adopted must be the best accounting practice in the trade or business and the method that most clearly reflects income[ii].

However, the Secretary’s discretion regarding inventory is limited.  The abuse of discretion of power depends upon whether the inventory determination is without sound basis in fact or law[iii].

[i] Fame Tool & Mfg. Co. v. Commissioner, 334 F. Supp. 23, 27 (S.D. Ohio 1971).

[ii] 26 USCS § 471.

[iii] Ansley-Sheppard-Burgess Co. v. Commissioner, 104 T.C. 367, 371 (T.C. 1995).

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