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§ 2.13 INVENTORYclearly reflect economic gain or profit to the person. Because the inventory of aperson is dynamic, constantly changing as goods are sold and new inventory isadded to stock, means and methods for identifying and valuing the constantlychanging stock in trade must be employed. Inasmuch as income tax is assessedon an annual basis, the means and methods used must account for yearly changein inventories.The main reason for utilizing inventories is to match costs of doing businesswith the revenues generated by sales of the items. As more directly stated in thefederal tax law, it is to clearly reflect income. Indeed, the federal tax lawrequires that inventories be used when necessary to clearly determine a person’sincome. 38A simple example shows the importance of inventories in measuringincome. In this illustration, a taxpaying business has an inventory of five items.Each item cost the business $20. Three of the items in the inventory were sold.Each item was sold for $30. The three sales generated a total revenue to the businessof $90 (3 × $30 = $90). The three inventory items cost the business $20, so thetotal cost of the goods sold was $60 (3 × $20 = $60). The revenue of $90 less thecost of goods sold of $60 results in a net income of $30. The $30 represents theeconomic gain after taking into account the cost of the inventory sold.This example may be varied by assigning the items of inventory differentcosts: item 1, $20; item 2, $22; item 3, $25; item 4, $27; and item 5, $30. If threeitems were sold for the same $30, how would one measure the value of the costof the goods sold so as to get a true measure of economic profit? If items one,two, and three were sold, their cost would be $67 with a resulting net income of$23 ($90 – $67 = $23). If items three, four, and five were sold, their cost would be$82 with a net income of only $8 ($90 – $82 = $8). If one were able to individuallyidentify each item sold, one could accurately match the item with its cost and geta clear picture of income; if not, it would be impossible to get a clear reflection ofincome. Although it may be possible to track and account for a very small inventoryof items, the task becomes impractical as the inventory grows and as theinventory of goods turns over during the taxable year.To deal with this problem of valuation, two methods are utilized. The first isthe cost method. It measures the value of an item of inventory on the basis of itsactual cost. The second is the cost or market method. It measures the cost of inventoryitems based upon their cost or fair market value, whichever is lower.The valuation methods are used in conjunction with methods of tracking(identifying) the items of inventory. Two tracking methods are used. The firstmethod is the first-in, first-out (FIFO) method, which assumes that the items ofinventory that are first acquired are the items that are first sold. Either the cost orthe cost or market method of valuation may be used. The different valuationmethods have an effect on the amount of income that is deemed to be receivedby the taxpayer in its yearly accounting period. In periods of inflation or risingmarket prices, income (profits) tends to be greater, whereas in periods of deflationor falling markets, income (profits) tends to be less when cost is used ratherthan cost or market valuation.38 IRC § 471. 39