There are several accounting procedures that can be used to reduce company income tax liability. Since the income tax rate is based on net profits as reported on the income statement, most methods are focused on reducing profits without negatively affecting cash flow. One method is through accelerated depreciation of equipment assets. This will increase expense to reduce profits. Yet another method is through inventory valuation methods to reduce gross profit.
Inventory Valuation and Affects on Gross Profit
Gross profit is determined by subtracting cost of goods sold from sales. Cost of goods sold is generally determined by inventory value. In fact the reciprocal general ledger account for inventory is the cost of sale. When a sale is posted to the books, the cost of sale is increased and inventory is decreased by the same amount. As an example, if a widget was sold for $100 and has an inventory value of $50, the sales journal entry would be.
Debits
- Cash $105 (increase)
- Cost of goods sold $50 (increase)
Credits
- Sales $100 (increase)
- Sales tax $5 (increase)
- Inventory $50 (decrease)
Income Tax Liability and Inventory Valuation Reduction
A higher inventory amount would naturally reduce the gross profit amount. Using the above example, if the cost of inventory could be booked at a higher amount it would reduce gross profit, thereby having the same reduction affect on taxable net profit.
In the above example the gross profit is $50 (sales less cost of goods sold). If the inventory value were say $60 per widget, the gross profit would be reduced to $40. If 1,000 widgets were sold, that would equal a reduction in net income of $10,000.
Last In First Out (LIFO) Inventory Valuation Method
In times of inflation and rising prices, LIFO is a method that can be used to increase cost of goods sold. Increasing the cost of goods sold will reduce profits, which would reduce income tax liability. This method considers that the most recent inventory (last-in) purchased is the first to be sold (first-out). As an example lets assume that there are 1,000 widgets in inventory.
LIFO Example
- 300 widgets purchased in January @ $40 each
- 300 widgets purchased in May @ $50 each
- 400 widgets purchased in August @ $60 each
Using the LIFO method, the last inventory purchased would be the actual value that’s used as the cost of goods sold. If 300 widgets were sold in September, the cost of sale would be 300 x $60 for a total of $18,000. If the first in first out method were used the cost of sales would be 300 x $40 for a total of $12,000. Using the LIFO method would reduce taxable income by $6,000 ($18,000 - $12,000).
There are regulations that must be adhered to when using certain valuation methods for accounting purposes. Once a method is used, it may prohibitive to change. Before adopting an inventory valuation method, a certified public account (CPA) or other tax professional should be consulted.
James Clausen - Clausen received a Bachelors Degree in Business Administration in Automotive Management and Marketing at Northwood University, graduating ...
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