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goods sold, plus any income from investments and from incidental
or outside operations or sources.” The regulations thus
recognize that a necessary step in the calculation of the gross
income from sales (at least in a manufacturing, merchandising, or
mining business) is a determination of the cost of goods sold.
That recognition implies the use of inventories, to determine the
cost of goods sold.1 Section 1.162-1(a), Income Tax Regs.,
confirms the role that inventories play in the determination of
1 The determination of cost of goods sold and gross income
from sales for a manufacturer involves the use of inventories
pursuant to the basic accounting equation described below:
Beginning inventory $ XXX
Purchases of inventory XXX
Production costs incurred XXX
Total cost of goods
available for sale XXX
Less: Ending inventory XXX
Cost of goods sold $ XXX
Gross receipts from sales $ XXX
Less: Cost of goods sold XXX
Gross income from sales (sec. 61) $ XXX
It can be seen from the foregoing equation that the amount
of a taxpayer’s ending inventory and cost of goods sold both have
a very direct effect on the amount of the taxpayer’s gross income
from sales; however, those effects are exerted in opposite
directions. All other things being constant, as a taxpayer’s
ending inventory increases in amount, its cost of goods sold
decreases, and its gross income from sales increases. In
contrast, as a taxpayer’s ending inventory decreases in amount,
its cost of goods sold increases, and its gross income from sales
decreases. The foregoing equation and comment appear in
Schneider, Federal Income Taxation of Inventories, sec. 1.01,
pp. 1:4-1:5 (1999).
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