Physical Inventory and Cycle Counting - Scan2Track

Why do a Physical Inventory?

A Physical Inventory is an accounting procedure that all firms conducting business in the United States must do to conform to Internal Revenue Service tax regulations. The physical inventory must be conducted at least once a year and conform to standard accounting practice so that inventories on-hand are properly valued. This is defined in section 471 and 472 of the Internal Revenue Code. Rules specific to the capitalization of inventory are detailed in section 263A of the Internal Revenue Code. The U.S. tax code as of January 1999 is as follows:

Sec. 471. General rule for inventories

(a) General rule
Whenever in the opinion of the Secretary 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 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.

(b) Estimates of inventory shrinkage permitted
A method of determining inventories shall not be treated as failing to clearly reflect income solely because it utilizes estimates of inventory shrinkage that are confirmed by a physical count only after the last day of the taxable year if -

(1) the taxpayer normally does a physical count of inventories
at each location on a regular and consistent basis, and
(2) the taxpayer makes proper adjustments to such inventories
and to its estimating methods to the extent such estimates are
greater than or less than the actual shrinkage.

Sec. 472. Last-in, first-out inventories

(a) Authorization
A taxpayer may use the method provided in subsection (b) (whether or not such method has been prescribed under section 471) in inventorying goods specified in an application to use such method filed at such time and in such manner as the Secretary may prescribe. The change to, and the use of, such method shall be in accordance with such regulations as the Secretary may prescribe as necessary in order that the use of such method may clearly reflect income.

(b) Method applicable
In inventorying goods specified in the application described in subsection (a), the taxpayer shall:

(1) Treat those remaining on hand at the close of the taxable
year as being: First, those included in the opening inventory of
the taxable year (in the order of acquisition) to the extent
thereof; and second, those acquired in the taxable year;
(2) Inventory them at cost; and
(3) Treat those included in the opening inventory of the
taxable year in which such method is first used as having been
acquired at the same time and determine their cost by the average
cost method.

(c) Condition
Subsection (a) shall apply only if the taxpayer establishes to the satisfaction of the Secretary that the taxpayer has used no procedure other than that specified in paragraphs (1) and (3) of subsection (b) in inventorying such goods to ascertain the income, profit, or loss of the first taxable year for which the method described in subsection (b) is to be used, for the purpose of a report or statement covering such taxable year -

(1) to shareholders, partners, or other proprietors, or to
beneficiaries, or
(2) for credit purposes.

(d) 3-year averaging for increases in inventory value
The beginning inventory for the first taxable year for which the method described in subsection (b) is used shall be valued at cost. Any change in the inventory amount resulting from the application of the preceding sentence shall be taken into account ratably in each of the 3 taxable years beginning with the first taxable year for which the method described in subsection (b) is first used.

(e) Subsequent inventories
If a taxpayer, having complied with subsection (a), uses the method described in subsection (b) for any taxable year, then such method shall be used in all subsequent taxable years unless -

(1) with the approval of the Secretary a change to a different
method is authorized; or,
(2) the Secretary determines that the taxpayer has used for any
such subsequent taxable year some procedure other than that
specified in paragraph (1) of subsection (b) in inventorying the
goods specified in the application to ascertain the income,
profit, or loss of such subsequent taxable year for the purpose
of a report or statement covering such taxable year (A) to
shareholders, partners, or other proprietors, or beneficiaries,
or (B) for credit purposes; and requires a change to a method
different from that prescribed in subsection (b) beginning with
such subsequent taxable year or any taxable year thereafter. If paragraph (1) or (2) of this subsection applies, the change to, and the use of, the different method shall be in accordance with such regulations as the Secretary may prescribe as necessary in order that the use of such method may clearly reflect income.

(f) Use of government price indexes in pricing inventory
The Secretary shall prescribe regulations permitting the use of suitable published governmental indexes in such manner and circumstances as determined by the Secretary for purposes of the method described in subsection (b).

(g) Conformity rules applied on controlled group basis

(1) In general
Except as otherwise provided in regulations, all members of the
same group of financially related corporations shall be treated
as 1 taxpayer for purposes of subsections (c) and (e)(2).
(2) Group of financially related corporations
For purposes of paragraph (1), the term ''group of financially
related corporations'' means -

(A) any affiliated group as defined in section 1504
determined by substituting ''50 percent'' for ''80 percent''
each place it appears in section 1504(a) and without regard to
section 1504(b), and
(B) any other group of corporations which consolidate or
combine for purposes of financial statements.

Sec. 263A. Capitalization and inclusion in inventory costs of certain expenses

(a) Nondeductibility of certain direct and indirect costs

(1) In general
In the case of any property to which this section applies, any
costs described in paragraph (2) -

(A) in the case of property which is inventory in the hands
of the taxpayer, shall be included in inventory costs, and
(B) in the case of any other property, shall be capitalized.

(2) Allocable costs
The costs described in this paragraph with respect to any
property are -

(A) the direct costs of such property, and
(B) such property's proper share of those indirect costs
(including taxes) part or all of which are allocable to such
property.
Any cost which (but for this subsection) could not be taken into
account in computing taxable income for any taxable year shall
not be treated as a cost described in this paragraph.

(b) Property to which section applies
Except as otherwise provided in this section, this section shall apply to -

(1) Property produced by taxpayer
Real or tangible personal property produced by the taxpayer.
(2) Property acquired for resale

(A) In general
Real or personal property described in section 1221(1) which
is acquired by the taxpayer for resale.
(B) Exception for taxpayer with gross receipts of $10,000,000
or less
Subparagraph (A) shall not apply to any personal property
acquired during any taxable year by the taxpayer for resale if
the average annual gross receipts of the taxpayer (or any
predecessor) for the 3-taxable year period ending with the
taxable year preceding such taxable year do not exceed
$10,000,000.
(C) Aggregation rules, etc.
For purposes of subparagraph (B), rules similar to the rules
of paragraphs (2) and (3) of section 448(c) shall apply. For purposes of paragraph (1), the term ''tangible personal property'' shall include a film, sound recording, video tape, book, or similar property.

(1) Personal use property
This section shall not apply to any property produced by the
taxpayer for use by the taxpayer other than in a trade or
business or an activity conducted for profit.
(2) Research and experimental expenditures
This section shall not apply to any amount allowable as a
deduction under section 174.
(3) Certain development and other costs of oil and gas wells or
other mineral property
This section shall not apply to any cost allowable as a
deduction under section 263(c), 263(i), 291(b)(2), 616, or 617.
(4) Coordination with long-term contract rules
This section shall not apply to any property produced by the
taxpayer pursuant to a long-term contract.
(5) Timber and certain ornamental trees
This section shall not apply to -

(A) trees raised, harvested, or grown by the taxpayer other
than trees described in clause (ii) of subsection (e)(4)(B)
(after application of the last sentence thereof), and
(B) any real property underlying such trees.

(6) Coordination with section 59(e)
Paragraphs (2) and (3) shall apply to any amount allowable as a
deduction under section 59(e) for qualified expenditures
described in subparagraphs (B), (C), (D), and (E) of paragraph
(2) thereof.

(d) Exception for farming businesses

(1) Section not to apply to certain property

(A) In general
This section shall not apply to any of the following which is
produced by the taxpayer in a farming business:

(i) Any animal.
(ii) Any plant which has a preproductive period of 2 years
or less.

(B) Exception for taxpayers required to use accrual method
Subparagraph (A) shall not apply to any corporation,
partnership, or tax shelter required to use an accrual method
of accounting under section 447 or 448(a)(3).

(2) Treatment of certain plants lost by reason of casualty

(A) In general
If plants bearing an edible crop for human consumption were
lost or damaged (while in the hands of the taxpayer) by reason
of freezing temperatures, disease, drought, pests, or casualty,
this section shall not apply to any costs of the taxpayer of
replanting plants bearing the same type of crop (whether on the
same parcel of land on which such lost or damaged plants were
located or any other parcel of land of the same acreage in the
United States).
(B) Special rule for person with minority interest who
materially participates
Subparagraph (A) shall apply to amounts paid or incurred by a
person (other than the taxpayer described in subparagraph (A))
if -

(i) the taxpayer described in subparagraph (A) has an
equity interest of more than 50 percent in the plants
described in subparagraph (A) at all times during the taxable
year in which such amounts were paid or incurred, and
(ii) such other person holds any part of the remaining
equity interest and materially participates in the planting,
maintenance, cultivation, or development of such the plants
described in subparagraph (A) during the taxable year in
which such amounts were paid or incurred.
The determination of whether an individual materially
participates in any activity shall be made in a manner similar
to the manner in which such determination is made under section
2032A(e)(6).

(3) Election to have this section not apply

(A) In general
If a taxpayer makes an election under this paragraph, this
section shall not apply to any plant produced in any farming
business carried on by such taxpayer.
(B) Certain persons not eligible
No election may be made under this paragraph by a
corporation, partnership, or tax shelter, if such corporation,
partnership, or tax shelter is required to use an accrual
method of accounting under section 447 or 448(a)(3).
(C) Special rule for citrus and almond growers
An election under this paragraph shall not apply with respect
to any item which is attributable to the planting, cultivation,
maintenance, or development of any citrus or almond grove (or
part thereof) and which is incurred before the close of the 4th
taxable year beginning with the taxable year in which the trees
were planted. For purposes of the preceding sentence, the
portion of a citrus or almond grove planted in 1 taxable year
shall be treated separately from the portion of such grove
planted in another taxable year.
(D) Election
Unless the Secretary otherwise consents, an election under
this paragraph may be made only for the taxpayer's 1st taxable
year which begins after December 31, 1986, and during which the
taxpayer engages in a farming business. Any such election,
once made, may be revoked only with the consent of the
Secretary.

(e) Definitions and special rules for purposes of subsection (d)

(1) Recapture of expensed amounts on disposition

(A) In general
In the case of any plant with respect to which amounts would
have been capitalized under subsection (a) but for an election
under subsection (d)(3) -

(i) such plant (if not otherwise section 1245 property)
shall be treated as section 1245 property, and
(ii) for purposes of section 1245, the recapture amount
shall be treated as a deduction allowed for depreciation with
respect to such property.

(B) Recapture amount
For purposes of subparagraph (A), the term ''recapture
amount'' means any amount allowable as a deduction to the
taxpayer which, but for an election under subsection (d)(3),
would have been capitalized with respect to the plant.

(2) Effects of election on depreciation

(A) In general
If the taxpayer (or any related person) makes an election
under subsection (d)(3), the provisions of section 168(g)(2)
(relating to alternative depreciation) shall apply to all
property of the taxpayer used predominantly in the farming
business and placed in service in any taxable year during which
any such election is in effect.
(B) Related person
For purposes of subparagraph (A), the term ''related person''
means -

(i) the taxpayer and members of the taxpayer's family,
(ii) any corporation (including an S corporation) if 50
percent or more (in value) of the stock of such corporation
is owned (directly or through the application of section 318)
by the taxpayer or members of the taxpayer's family,
(iii) a corporation and any other corporation which is a
member of the same controlled group described in section
1563(a)(1), and
(iv) any partnership if 50 percent or more (in value) of
the interests in such partnership is owned directly or
indirectly by the taxpayer or members of the taxpayer's
family.

(C) Members of family
For purposes of this paragraph, the term ''family'' means the
taxpayer, the spouse of the taxpayer, and any of their children
who have not attained age 18 before the close of the taxable
year.

(3) Preproductive period

(A) In general
For purposes of this section, the term ''preproductive
period'' means -

(i) in the case of a plant which will have more than 1 crop
or yield, the period before the 1st marketable crop or yield
from such plant, or
(ii) in the case of any other plant, the period before such
plant is reasonably expected to be disposed of.
For purposes of this subparagraph, use by the taxpayer in a
farming business of any supply produced in such business shall
be treated as a disposition.

(B) Rule for determining period
In the case of a plant grown in commercial quantities in the
United States, the preproductive period for such plant if grown
in the United States shall be based on the nationwide weighted
average preproductive period for such plant.

(4) Farming business
For purposes of this section -

(A) In general
The term ''farming business'' means the trade or business of
farming.
(B) Certain trades and businesses included
The term ''farming business'' shall include the trade or
business of -

(i) operating a nursery or sod farm, or
(ii) the raising or harvesting of trees bearing fruit,
nuts, or other crops, or ornamental trees.
For purposes of clause (ii), an evergreen tree which is more
than 6 years old at the time severed from the roots shall not
be treated as an ornamental tree.

(5) Certain inventory valuation methods permitted
The Secretary shall by regulations permit the taxpayer to use
reasonable inventory valuation methods to compute the amount
required to be capitalized under subsection (a) in the case of
any plant.

(f) Special rules for allocation of interest to property produced
by the taxpayer

(1) Interest capitalized only in certain cases
Subsection (a) shall only apply to interest costs which are -

(A) paid or incurred during the production period, and
(B) allocable to property which is described in subsection
(b)(1) and which has -

(i) a long useful life,
(ii) an estimated production period exceeding 2 years, or
(iii) an estimated production period exceeding 1 year and a
cost exceeding $1,000,000.

(2) Allocation rules

(A) In general
In determining the amount of interest required to be
capitalized under subsection (a) with respect to any property -

(i) interest on any indebtedness directly attributable to
production expenditures with respect to such property shall
be assigned to such property, and
(ii) interest on any other indebtedness shall be assigned
to such property to the extent that the taxpayer's interest
costs could have been reduced if production expenditures (not
attributable to indebtedness described in clause (i)) had not
been incurred.

(B) Exception for qualified residence interest
Subparagraph (A) shall not apply to any qualified residence
interest (within the meaning of section 163(h)).
(C) Special rule for flow-through entities
Except as provided in regulations, in the case of any
flow-through entity, this paragraph shall be applied first at
the entity level and then at the beneficiary level.

(3) Interest relating to property used to produce property
This subsection shall apply to any interest on indebtedness
allocable (as determined under paragraph (2)) to property used to
produce property to which this subsection applies to the extent
such interest is allocable (as so determined) to the produced
property.
(4) Definitions
For purposes of this subsection -

(A) Long useful life
Property has a long useful life if such property is -

(i) real property, or
(ii) property with a class life of 20 years or more (as
determined under section 168).

(B) Production period
The term ''production period'' means, when used with respect
to any property, the period -

(i) beginning on the date on which production of the
property begins, and
(ii) ending on the date on which the property is ready to
be placed in service or is ready to be held for sale.

(C) Production expenditures
The term ''production expenditures'' means the costs (whether
or not incurred during the production period) required to be
capitalized under subsection (a) with respect to the property.

(g) Production
For purposes of this section -

(1) In general
The term ''produce'' includes construct, build, install,
manufacture, develop, or improve.
(2) Treatment of property produced under contract for the
taxpayer
The taxpayer shall be treated as producing any property
produced for the taxpayer under a contract with the taxpayer;
except that only costs paid or incurred by the taxpayer (whether
under such contract or otherwise) shall be taken into account in
applying subsection (a) to the taxpayer.

(h) Exemption for free lance authors, photographers, and artists

(1) In general
Nothing in this section shall require the capitalization of any
qualified creative expense.
(2) Qualified creative expense
For purposes of this subsection, the term ''qualified creative
expense'' means any expense -

(A) which is paid or incurred by an individual in the trade
or business of such individual (other than as an employee) of
being a writer, photographer, or artist, and
(B) which, without regard to this section, would be allowable
as a deduction for the taxable year.
Such term does not include any expense related to printing,
photographic plates, motion picture films, video tapes, or
similar items.

(3) Definitions
For purposes of this subsection -

(A) Writer
The term ''writer'' means any individual if the personal
efforts of such individual create (or may reasonably be
expected to create) a literary manuscript, musical composition
(including any accompanying words), or dance score.
(B) Photographer
The term ''photographer'' means any individual if the
personal efforts of such individual create (or may reasonably
be expected to create) a photograph or photographic negative or
transparency.
(C) Artist

(i) In general
The term ''artist'' means any individual if the personal
efforts of such individual create (or may reasonably be
expected to create) a picture, painting, sculpture, statue,
etching, drawing, cartoon, graphic design, or original print
edition.

(ii) Criteria
In determining whether any expense is paid or incurred in
the trade or business of being an artist, the following
criteria shall be taken into account:

(I) The originality and uniqueness of the item created
(or to be created).
(II) The predominance of aesthetic value over utilitarian
value of the item created (or to be created).
(D) Treatment of certain corporations

(i) In general
If -

(I) substantially all of the stock of a corporation is
owned by a qualified employee-owner and members of his
family (as defined in section 267(c)(4)), and
(II) the principal activity of such corporation is
performance of personal services directly related to the
activities of the qualified employee-owner and such
services are substantially performed by the qualified
employee-owner,
this subsection shall apply to any expense of such corporation
which directly relates to the activities of such
employee-owner in the same manner as if such expense were
incurred by such employee-owner.

(ii) Qualified employee-owner
For purposes of this subparagraph, the term ''qualified
employee-owner'' means any individual who is an
employee-owner of the corporation (as defined in section
269A(b)(2)) and who is a writer, photographer, or artist.

(i) Regulations
The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out the purposes of this section, including -

(1) regulations to prevent the use of related parties,
pass-thru entities, or intermediaries to avoid the application of
this section, and
(2) regulations providing for simplified procedures for the
application of this section in the case of property described in
subsection (b)(2).