You must generally take inventories into account at the beginning and end of your tax year when the production, purchase, or sale of merchandise is an income-producing factor in your business. However, certain small business taxpayers may be able to adopt or change to the cash method of accounting and may not be required to account for inventories. For more information, including the definition of a small business taxpayer, see Publication 553, Highlights of 2000 Tax Changes.

If you are required to account for inventories, include the following items when accounting for your inventory.

• Merchandise or stock in trade.
• Raw materials.
• Work in process.
• Finished products.
• Supplies that physically become a part of the item intended for sale.

You must value your inventory at the beginning and end of each tax year to determine your cost of goods sold (Schedule C, line 42). To determine the value of your inventory, you need a method for identifying the items in your inventory and a method for valuing these items.

Inventory valuation rules cannot be the same for all kinds of businesses. The method you use to value your inventory must conform to generally accepted accounting principles for similar businesses and must clearly reflect income. Your inventory practices must be consistent from year to year.

For more information about inventories, see Publication 538.

If you must account for an inventory in your business, you must use an accrual method of accounting for your purchases and sales. See chapter 2.

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