26 U.S.C. § 471 — General rule for inventories

(a) General rule. Whenever the Secretary decides that using inventories is necessary to clearly figure out a taxpayer's income, the taxpayer must take inventories. They must use a method the Secretary approves — one that follows the best accounting practices for that trade or business as closely as possible, and that most clearly reflects the taxpayer's income. (b) Estimates of inventory shrinkage allowed. A method for figuring inventories isn't treated as failing to clearly reflect income just because it estimates inventory shrinkage that gets confirmed by a physical count only after the last day of the tax year, as long as: (1) the taxpayer normally does regular physical counts of inventory at each location, and (2) the taxpayer properly adjusts its inventories and estimating methods when the estimates turn out too high or too low compared to actual shrinkage. (c) Exemption for certain small businesses. (1) In general, a taxpayer that isn't a tax shelter barred from cash-method accounting under section 448(a)(3), and that meets the gross-receipts test of section 448(c) for a tax year, doesn't have to follow subsection (a) for that year. Instead, its inventory accounting method is fine as long as it either (i) treats inventory as materials and supplies that aren't "incidental," or (ii) matches the method the taxpayer uses in an applicable financial statement, or if there is none, in its own books and records. (2) "Applicable financial statement" has the meaning given in section 451(b)(3). (3) For a taxpayer that isn't a corporation or partnership, the gross-receipts test is applied as if each of its trades or businesses were its own corporation or partnership. (4) Any accounting-method change made under this subsection is treated, for section 481 purposes, as started by the taxpayer with the Secretary's consent. (d) Cross reference. For rules on capitalizing direct and indirect property costs, see section 263A.