How to Calculate Final Inventory for Tax Reporting

Final inventory, also known as ending inventory, represents the value of goods a business has available for sale at the close of an accounting period. This figure directly influences a company’s profitability and its tax obligations for the year. The process involves determining the physical quantity of goods on hand and then assigning a monetary value to that stock.

The Function of Final Inventory in Financial Reporting

The value of final inventory is a direct input into the Cost of Goods Sold (COGS) calculation, which is used to determine a company’s profitability. The formula is: Beginning Inventory + Purchases – Final Inventory = COGS. This calculation shows how much the inventory sold during a period cost the business.

Consider a business that starts the year with $20,000 in inventory. During the year, it purchases an additional $100,000 of goods. At the end of the year, a physical count and valuation determine the final inventory is worth $30,000. Using the COGS formula ($20,000 + $100,000 – $30,000), the Cost of Goods Sold for the year is $90,000.

Gross profit is calculated as Revenue – COGS. If the business generated $200,000 in revenue, its gross profit would be $110,000 ($200,000 – $90,000). This gross profit figure is the starting point for determining the company’s net income, upon which taxes are based. The valuation of final inventory has an inverse relationship with COGS and a direct relationship with profit.

If the final inventory in the example was valued lower at $15,000, the COGS would increase to $105,000 ($20,000 + $100,000 – $15,000). This higher COGS would reduce the gross profit to $95,000 ($200,000 – $105,000). A lower reported profit results in a lower taxable income for the period, showing how the final inventory valuation impacts a company’s tax liability.

A Simpler Method for Small Businesses

Many small businesses may not need to use detailed inventory accounting methods. Businesses that have average annual gross receipts of $30 million or less for the three prior tax years are generally exempt from the requirement to keep inventories.

Instead, these qualifying businesses can treat their inventory costs as non-incidental materials and supplies. This allows them to deduct the cost of goods in the year they are used or consumed, rather than when they are sold, which can be a much simpler accounting method.

Determining Physical Inventory Quantities

Before a dollar value can be assigned, a business must determine the physical quantity of goods it holds. The two primary systems for tracking inventory quantities are the periodic and perpetual systems. The choice between these systems often depends on the size of the business and the volume of transactions.

The periodic inventory system relies on a physical count of inventory, performed at the end of an accounting period. This process involves manually counting, weighing, or measuring every item in stock. A “cut-off” procedure ensures that all sales and purchases are recorded in the correct accounting period. For example, goods that have been sold but not yet shipped must be excluded from the final count.

In contrast, a perpetual inventory system uses technology to track inventory in real-time. As items are sold or received, inventory management software immediately updates the records, providing a continuous count of inventory. While this system offers greater control, it is not immune to errors from theft or data entry mistakes. For this reason, businesses using a perpetual system still conduct physical counts to verify the accuracy of the system’s records and make adjustments.

Assigning a Cost to Final Inventory

Once the quantity of inventory is known, a cost must be assigned to those units to determine the final inventory’s total value. The Internal Revenue Service (IRS) allows several valuation methods, and the choice can affect both the final inventory value and COGS. Once a business selects a costing method, it must use it consistently in subsequent years.

The IRS allows four primary methods for costing inventory:

• First-In, First-Out (FIFO): This method assumes that the first units purchased are the first ones sold. This means the inventory remaining at the end of the period is composed of the most recently purchased items. In an environment of rising prices, FIFO results in a higher final inventory value and a higher tax liability.
• Last-In, First-Out (LIFO): This method operates on the opposite assumption that the most recently purchased units are the first ones sold. Consequently, the ending inventory is valued using the costs of the earliest purchases. When prices are rising, LIFO produces a lower final inventory value and a lower tax liability. If LIFO is used for tax purposes, it must also be used for financial reporting.
• Weighted-Average Cost: This method smooths out price fluctuations by calculating the average cost of all goods available for sale during the period. This average cost is then applied to the units in final inventory. It is calculated by dividing the total cost of goods available for sale by the total number of units available for sale.
• Specific Identification: This method is used for businesses with unique, high-value items like cars or fine jewelry. It allows a business to track the actual cost of each specific item sold and assign that cost directly.

Reporting Final Inventory on Tax Returns

After calculating the final inventory value, the figure must be reported on the business’s annual tax return. The specific form used depends on the business structure.

Sole proprietorships and single-member LLCs report inventory on Schedule C (Form 1040), Profit or Loss from Business. Part III of this form is for the Cost of Goods Sold, where the taxpayer must enter the beginning inventory, the cost of purchases, and the final inventory value. The beginning inventory for the year should match the prior year’s ending inventory.

Partnerships (filing Form 1065) and corporations (filing Form 1120 or 1120-S) report their COGS on Form 1125-A, Cost of Goods Sold. This form requires separate lines for inventory at the start of the year, purchases, and inventory at the end of the year. It also asks the taxpayer to specify the valuation method used for the inventory.