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ASK ALAN | BY ALAN FRIEDMAN : A MOVING TARGET nventory valuation impacts tory valuation basics. One goal count and cost your year-end a ’s bal- of any business is to deter- inventory than to look up the ance sheet and P&L, as well mine accurately how much net invoice cost for the hundreds or as the amount of income tax profit has been made during a thousands of products you’ve paid. Without an accurate given time period. To do so, sold during the year, most busi- Iinventory valuation, net profits we must accurately account nesses use this method with the can be materially overstated or for all and expenses help of their computers. I agree understated, causing endless in that period. this is the preferable and problems for a business owner. Sales is easy— add up the arguably best method of valuing In the last five articles of money you’ve collected and and calculating this year-long series on inven- factor in your accounts receiv- costs of goods sold, but it also tory management, we’ve dealt able (sales made but not yet has its share of problems. with the nature of music retail collected). Operating expenses inventory and many of the is equally as straightforward — INVENTORY INSANITY challenging issues surrounding add up the money you’ve spent could fill up this whole maga- it. This article will deal with and factor in any accounts I zine on the difficulties and arguably its most elusive aspect: payable (expenses incurred but oddities of determining an how to value it for financial not yet paid for). But as most accurate inventory on any and tax-reporting purposes. Tracking of you know, there’s one major given day. A word of warning. Yes, I expense most music dealers Shrinkage, returned and am going to deal with the most inventory find difficult to determine: the consigned goods, and count- taboo subject of inventory valu- worth and . ing, costing and timing prob- ation: the purposeful overstate- The easiest way to calculate lems between the arrival of ment or understatement of its impact on cost of goods sold is to start inventory and receipt of its inventory reported on financial profits and with the inventory value at the corresponding invoice are just statements and tax returns. beginning of a time period a few reasons why inventory Trust me, you won’t be happy taxes (let’s assume a year), add what can be a moving target. as I attempt to humiliate and better and potentially make was purchased during that year To illustrate this point, let’s guilt you into the proper valua- your business healthier. I can and subtract the inventory assume it’s the end of your fis- tion and reporting of inventory. hear the groans already. value at the end of the year. cal year and you’ve finished But like a big, distasteful This assumes inventory that’s counting and reconciling your spoonful of medicine, properly INVENTORY VALUATION 101 no longer around has been sold inventory against what your valuing your inventory will, in efore I start lecturing you, — or stolen. computer says you have in the long run, make you feel B let’s go over some inven- Since it’s easier to physically stock. You print a list of your

OCTOBER 2006 | MUSIC INC. | 41 inventory, and it totals inventory assumes the earliest on your inventory levels, SOME COOL TAX TIPS $500,000 at cost, including inventory purchased is the turns, GMROI, resulting cash f your store is financially freight-in. But you’ve acciden- first to be sold. During periods flow and, of course, your I healthy and your bankers are tally included $10,000 of con- of inflation, the use of FIFO store’s profitability, or lack behind you, you may want to signed goods in your valuation. will result in a lower cost of thereof. consider the tax minimization You’ve also included an early goods sold, higher inventory strategy of writing down or shipment of $30,000 of step-up value and higher net income. DON’T BE STUPID ABOUT TAXES writing off inventory. There are band instruments received on Last-in, first-out (LIFO). ere’s where I start to upset certain instances when inven- the last day of the year but The LIFO method assumes the H you. While the amount of tory can be valued at less than without a corresponding P.O. latest inventory purchased is income taxes you pay is impor- cost or written off completely. or invoice (which hasn’t been the first to be sold. During peri- tant, it’s a secondary issue, in Using the “lower of cost or included in accounts payable). ods of inflation, the use of LIFO my opinion. Fixing a cash- market” method of inventory And there’s $20,000 of old gear will result in a higher cost of flow problem will be much valuation, taxpayers can value that’s now worth less than goods sold, lower inventory easier when it’s the result of a items at the lower of cost or $1,000. (Remember, an item is value and lower net income. profitable store’s growing tax market price. (Market price gen- only worth its cost when Weighted average. Under liability, as opposed to an erally means the current street there’s a chance of selling it this method, both inventory unprofitable store that pays no price.) IRS regulations let inven- above that cost.) and cost of goods sold are tax. I’ll never understand the tory be valued lower than its Now look at the chart based on the average cost of all store owner who insists on cost if it was offered for sale below. If these common occur- items bought during a period. paying no income tax whatso- prior to year-end at a price rences have taken place and Specific cost. Under this ever, without any regard to lower than its replacement cost. you aren’t aware of them or method, both inventory and whether the store is profitable. There are a few other legiti- haven’t adjusted them, the left cost of goods sold are based on Some of you have figured mate ways to get tax relief via side of the chart is the fantasy the actual cost for each item out that you can inflate net the reduction of inventory. For you’re reporting. The right bought during the period. income by inflating your year- example, a “C” corporation can side is the reality. You now Each of these inventory end inventory value. I would donate inventory to qualified have a gross mis-statement of valuation methods have vary- never condone the purposeful organizations like schools and cost of goods sold, gross profit ing effects on net income, overstatement of inventory by receive a limited deduction of and, ultimately, net income. income taxes paid and cash a music products retailer. up to two times the cost basis Bad, very bad. flow. But just because the Why? When you over-inflate of that inventory. inventory, you’re lying to your- self about the profitability of FINAL THOUGHTS IN THEORY IN REALITY your business and lying to the ut more important than tax SALES $1,000,000 $1,000,000 reader of your financial state- B deductions is the overall COST OF GOODS SOLD ments. (Ever heard the term management of your inventory. Beginning Inventory (Jan. 1) 400,000 400,000 “bank fraud”?) Believe me, you won’t remem- You’re also exposing your ber the tax benefits of showing Purchases 750,000 750,000 accountants to greater risk losses every year when it’s time Total inventory available for sale 1,150,000 1,150,000 when they sign off on your to retire and sell your business, Ending Inventory (Dec. 31) (500,000) (440,000) financial statements, and pos- and nobody will give you a dime COST OF GOODS SOLD 650,000 710,000 sibly, you’re paying too much for your loser store. GROSS PROFIT 350,000 290,000 in taxes on the overstated Take measures to nail down income. Lastly, you’re putting the moving inventory target. off the inevitable: dealing with Without a true valuation, you’ll RULES FOR THE GOOSE & GANDER LIFO method results in lower the lack of profits when the never know how much money s most business owners have taxable income doesn’t mean valuation issue reappears next you’re making, or not making. Adifferent reporting objectives it’s right for your business. year. No, it doesn’t go away. You’re also going to frustrate for financial statements and tax Also note that once you Conversely, you now know your accountant, which will returns, there are different ways pick an inventory valuation you can reduce taxes by lower- turn him or her into an even of valuing inventory for book method, you generally have to ing your year-end inventory more miserable human being, if and income tax purposes. The stick with it. You can’t change value. I don’t advocate this that’s possible. MI following are more common methods every year without either, unless it’s warranted methods allowed by Generally raising eyebrows from and legitimate. But contrary to Alan Friedman, C.P.A., provides accounting Accepted Accounting Principles: bankers, credit managers and popular belief, I don’t want to and financial services to music industry clients. He is a frequent speaker at NAMM U. First-in, first-out (FIFO). the IRS. What’s most impor- see anyone pay more than his seminars and can be reached at 860-521- The FIFO method of valuing tant is having a good handle or her fair share of tax. 3790 or [email protected].

42 | MUSIC INC. | OCTOBER 2006