Tax aspects of inventories;

              l^te clax ^Aspect
Why should there be a continuing interest in the tech­niques
of valuing inventories? The simple answer is that
"inventory" is one of the most important factors in the
existence of any business. It accounts for a large part
of the company's investment in assets, and it is usually
the largest single cost on the income statement. It is
important, therefore, to know what is an "acceptable"
inventory for tax purposes; what the Internal Revenue
Service is doing in this area to insist that taxpayers
follow accepted rules; and what the courts have said
about the subject.
"Inventories" is a subject that is too often taken for
granted, insofar as income taxes are concerned. That
is, "good" accounting dictates what to do and we
naturally follow along for tax return purposes, accepting
the bcok inventory as correct for tax purposes with no
further thought given to this item. But how many peo­ple,
and especially those responsible for tax planning
and tax returns, have become involved in the technical
tax ru!es? These rules are discussed in the following
paragraphs, and their implications analyzed.
THE TAX LAW- SECTION 471:
Perhaps the natural starting point is a glance at the
law on this subject, since in the final analysis this will
dictate the acceptability of an inventory for tax pur­poses,
and will also enable an appreciation of the
"problems" involved. This very brief "law" is Section
471, the General Rule for Inventories:
"Whenever in the opinion of the Secretary or his
delegate the use of inventories is necessary in
order clearly to determine the income of any tax­payer,
inventories shall be taken by such taxpayer
on such basis as the Secretary or his delegate
may prescribe as conforming as nearly as may be
to the best accounting practice in the trade or busi­ness
and as most clearly reflecting the income."
This one sentence is then "interpreted" by the IRS
in several pages of Regulations, and in greater detail
than the basic law itself.
The basic law contains two tests to which every in­ventory
must conform:
First, it must conform as nearly as possible to the
best accounting practice in the trade or business, and
Second, it must clearly reflect income.
It follows, then, from the first test that inventory rules
cannot be uniform but must follow trade customs within
the scope of the best accounting practice in the par­ticular
trade or business.
The second test, the clear reflection of income, re­quires
that the inventory practice of a taxpayer be con­sistent
from year to year. Consistency, however, is not
sufficient as a test if, in other respects, the inventory
fails "clearly to reflect income." Consistency in turn
has three aspects:
1. Consistency in the method or basis used from year
to year;
2. Consistency in the method or basis applied as to
all items in one inventory; and
3. Consistency in the method used in the opening
and closing inventories of the taxable year.
Thus, inventories must be calculated according to
acceptable accounting practices and must also clearly
reflect income.
The regulations, in explaining the basic law, indicate
that the most common inventory valuation methods are
cost and cost or market, whichever is lower. These
terms are then defined as follows:
"Cost" in regard to "normal" inventory is defined in
three different ways:
(1) In the case of merchandise on hand at the be­ginning
of the taxable year, the inventory price of
such goods;
16 THE QUARTERLY