How Does Inventory Increase Net Income?

A client asked why increased inventory raised their net income. Most businesses categorize products for resale, supplies, and materials as Cost of Goods Sold (COGS), which directly reduces net income.

Year-End Inventory Adjustments

At year's end, accountants typically request ending inventory figures. They then reallocate funds from COGS to the balance sheet's inventory account. This adjustment lowers COGS and increases net income. Business owners often find this surprising, particularly during their first operating year.

Cash Flow vs. Taxable Income

Companies frequently have significant capital tied up in inventory. However, inventory costs remain non-deductible until products sell, potentially in the following year. This creates situations where businesses pay taxes on income despite minimal or negative cash flow. A practical strategy involves minimizing year-end inventory accumulation and restocking early in the next year.

Revenue Thresholds and Reporting Requirements

Currently, most businesses with gross revenue under $29 million need not report inventory. If your accountant requests inventory reporting despite falling below this threshold, seeking a second opinion may be prudent.

Exceptions: Cannabis and Section 280E

The cannabis industry faces specific requirements under Section 280E. These businesses must report inventory using methodologies that capitalize COGS, enabling deductions of otherwise non-deductible expenses. Businesses under the $29 million threshold may typically use cash accounting methods.