Discussion Archives:Accounting for Inventory Under Cash Basis

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Discussion Forum Index --> Tax Questions --> Accounting for Inventory Under Cash Basis


Cross Accounting (talk|edits) said:

25 May 2005

Recently one of my clients has been audited. He sells toys at a toy store as an S Corporation. His sales have been under one million and he has elected to use the cash basis. In these first couple years he has been adding inventories and expensing 100% of the inventory purchases as costs of goods sold.

The auditor keeps asking for an inventory amount. While the auditor has not yet made a change, I am sensing he is going to try and back out $200,000 worth of inventory from an expense to inventory as an asset. It has been my impression that as long as sales are under $1,000,000 then cash basis expensing can be used even on inventory items. Can anyone lend me a hand to help me show the auditor this in the code or in a regulation? Thanks, Cross Accounting

Jack Chen (talk|edits) said:

25 May 2005
Hi, I believe you still need to have inventory even if you are allowed to use cash method. The inventoriable items are deductible in the year in which they are actually consumed and used (or sold), or in the year in which the taxpayer actually pays for the items, which ever is later.
NOTE: The original posting contained copyrighted material and has been removed. Please refer to Regulation §1.162-3, for more information.

Hope this will help. Jack Chen, CPA

Jalex11 (talk|edits) said:

25 May 2005
You must use an inventory method. I would take current inventory at LCM and work with the Revenue Agent.

KittyForTax (talk|edits) said:

27 May 2005
Even though your client is allowed to use the cash basis for and is not required to carry an AR or AP for tax purposes he can only expense the item that have actually been sold and therefore must maintain an inventory to come up with an accurate figure. The only way he can not have an inventory is if he sells on a party plan and therefore does not buy until the order is received and therefore does not have any inventory. Kitty McDowell E.A.

Cross Accounting (talk|edits) said:

13 June 2005
The 1.162-3 code seems too broad. Are you sure this is for cash basis instead of accrual basis. This extends beyond inventory to supplies. As an example, I had a contractor buy $40,000 worth of cord for the Super Bowl in December of '04 that was consumed by his own company one month later. I can't write-off the $40,000 in supplies?

1. Are you guys sure 1.162-3 applies for cash basis? It looks awfully accrually. So everyone here still thinks I was too aggressive in expensing inventory upon purchase? I guess all my Mary Kay and Tupperware people are going to have to start carrying inventory again?

2. While I'm starting to lose my confidence in inventory expensing, what do you guys and gals think about the expensing on the cord above? I'm still inclined to take it as a $40,000 expense (Company revenue $540,000), but it might be more out of stubborness than code even though I want to follow the code.

3. Where is the destinction bewtween consumed vs. resold in 1.162-3 "Cost of Materials".

Thanks everyone for your valuable input. I really enjoyed and dreaded reading 1.162-3. I guess I just want a little more confirmation before I go and switch my thinking around here. Sincerely, Cross Accounting.

Mark (talk|edits) said:

23 December 2005
Rev. Proc. 2001-10

This revenue procedure modifies and supersedes Rev. Proc. 2000- 22, 2000-20I.R.B. 1008, and provides that the Commissioner of Internal Revenue will exercise his discretion to except a qualifying taxpayer with average annual gross receipts of $1,000,000 or less from the requirements to use an accrual method of accounting under section 446 of the Internal Revenue Code and to account for inventories under section 471. Section 471 provides that whenever, in the opinion of the Secretary, the useof inventories is necessary to clearly determine the income of the taxpayer,inventories must be taken by the taxpayer. Section 1.471-1 requires a taxpayerto account for inventories when the production, purchase, or sale of merchandiseis an income-producing factor in the taxpayer's business.

DZCPA (talk|edits) said:

23 December 2005
I would write off the cord since in is not a income-producing factor.

Michael P Kelly, CPA (talk|edits) said:

4 January 2006
I think the following will answer your question, from the IRS tax topics number 408:

"Be aware that Revenue Procedure 2001–10 & Revenue Procedure 2002–28 specifically state when you can deduct the costs for the inventoriable items that are being treated as materials and supplies that are not incidental within the meaning of Treasury Regulation 1.162–3. In the case of a cash method taxpayer, the cost for these items cannot be deducted until the year in which (1) you sell the items or (2) you pay for them, whichever is later."

So basically the exemption from inventory afforded by the 2 Rev Proc's is a lot of BS, because you must still account for your inventory. You cannot deduct the expense until you sell the merchandise.

Michael

Solomon (talk|edits) said:

5 January 2006
If the business has the same mark up on the product, then just reduce gross sales by the mark up percentage to arrive at the sales cost and thus avoid cost of sales data. Enter that number on Purchases line on schedule C. This is a simple way for clients that don't keep decent records for beginning and ending inventories.

DAVEG (talk|edits) said:

21 February 2006
DEDUCTION FOR INVENTORY IS AN EXPENSE WHEN THE ITEMS ARE PAID FOR AS PER ANY OTHER CASH BASIS EXPENDITURE PROVIDING THE COMPANY SALES ARE LESS THAT A MILLION DOLLARS.

PDXCPA (talk|edits) said:

21 February 2006
DAVEG, can you specifically support your response? 2002-28 is what I've used to explain to cash clients the requirement for ending/beg inventory counts for reduction or change to COGS.

Captcook (talk|edits) said:

21 February 2006
This is in some way a judgement call, but look at §1.471-2 (2): It(the valuation of inventory) must clearly reflect income. Valuing at $0 (expensing) or cost of what is actually on hand are two different methods of valuation.

If sales are below $1M and there is approximately $200K of inventory floating around, I would have a hard time justifying that this method clearly reflects income. I can't find where it says that cash basis taxpayers must keep record of inventories, but I clearly remember I was taught to do exactly that using a hybrid system.

DR BRISKET (talk|edits) said:

21 February 2006
I was taught in a small merchandising business to use accrual accounting through cost of goods sold, and cash basis for all other disbursements if the business is indeed cash basis. This means all inventory purchases should be booked through accounts payable rather than from cash disbursements. This is particularly true at year end if delivery is taken on a truck load of goods, and is included in a physical year end inventory count. Merchandise purchases must be adjusted for beginning and year end inventory counts. I suspect the reason your S-Corp client was audited was for not showing inventory on his balance sheet in a merchandising business.


Sheldon (talk|edits) said:

23 October 2007
duplicate question removed, see link below

TheTinCook (talk|edits) said:

23 October 2007
It's been adressed on your post in this other thread. Artists can deduct all expense in current year?

CrowJD (talk|edits) said:

23 October 2007
I brought this up once in the accounting forum, and now that it's up again, I have an excuse... Eligible businesses (like the toy store way above) that choose not to maintain inventories must still treat merchandise on hand at the end of the tax year in the same manner as materials or supplies. Ok, materials and supplies treatment: Reg. 1.162-3 essentially requires that expense be matched with use. The cost of supplies on hand at end of year are totaled, carried forward, and deducted in the year the supplies are used. Sounds like accrual to me; what labor is exactly being saved here if you applied this to small business "inventory".! This is one of those things you find in practice that are like a pebble in your shoe. Someone thought to put this 1 mil. inventory exception in there, but for what practical purpose, I have not been able to determine. Is it perhaps a valuation method issue you can skip? But I would have to disagree with the posters above who say that you can merely expense all goods held for sale in a small cash basis business like this. P.S. for instance, concretely, would you skip all COGS calculation on the return, and place all "matched inventory" costs under supplies? Seems like this says you could. But why would you?
FYI: This discussion was bumped by someone with a new response to the 2005 question, but then (perhaps realizing, belatedly, that a toy store is likely to be a retail operation, so his advice would not have applied) he went back and deleted a few of his own posts. The other posts which follow were made in response to 2/27/10 posts that've since been deleted.

Ksnoopytax (talk|edits) said:

27 February 2010
I must work with a different set of IRS auditors than you but the IRS auditors I have dealt with so far have been more than reasonable and could have been alot harder on the clients than they were.


Ksnoopytax (talk|edits) said:

27 February 2010
Missouri

DouglasHolbrook (talk|edits) said:

27 February 2010
Actually, under Rev Proc 2002-28 7.02(2), a taxpayer using this PR must treat inventoriable items in the same manner as materials and supplies that are not incidental under § 1.162–3. This means that purchased goods (but not labor or overhead) used in inventory that are "not incidental" must be capitalized. In the above case, $200,000 in a business with < $1MM of revenue can certainly be argued as being "not incidental".

MYCPA (talk|edits) said:

27 February 2010
I understand that, which is why I placed that disclaimer (assuming your client is not classified as a "retail trade" within the meaning of NAICS codes 44 and 45) in my post. My client owns a beauty salon (the provision of services) and her inventory is incident to those services.

RoyDaleOne (talk|edits) said:

27 February 2010
Regs. Sec. 1.162-3. Cost of materials.


Taxpayers carrying materials and supplies on hand should include in expenses the charges for materials and supplies only in the amount that they are actually consumed and used in operation during the taxable year for which the return is made, provided that the costs of such materials and supplies have not been deducted in determining the net income or loss or taxable income for any previous year. If a taxpayer carries incidental materials or supplies on hand for which no record of consumption is kept or of which physical inventories at the beginning and end of the year are not taken, it will be permissible for the taxpayer to include in his expenses and to deduct from gross income the total cost of such supplies and materials as were purchased during the taxable year for which the return is made, provided the taxable income is clearly reflected by this method.

EXAMPLE 1: John is a roofing contractor and a qualifying small 
    business taxpayer eligible to use the cash method under Notice 2001- 
    76. John, a calendar year taxpayer, chooses to use the cash method 
    described in Notice 2001-76 and to not account for inventories. John 
    enters into a contract with a homeowner in December 2001 to replace 
    the homeowner's roof. John purchases roofing shingles from a local 
    supplier and has them delivered to the homeowner's residence. He pays 
    the supplier $5,000 for the shingles on their delivery later that 
    month. John replaces the homeowner's roof in December 2001, and gives 
    the homeowner a bill for $15,000 at that time. He receives a check 
    from the homeowner in January 2002. John deducts the $5,000 cost of 
    the shingles on his 2001 federal income tax return and includes the 
    $15,000 in income in 2002 when he receives the check from the 
    homeowner. 
 
    EXAMPLE 2: The same facts as Example 1, except that John does not 
    replace the roof until January 2002, and is not paid until March 
    2002. Because the shingles are not used until 2002, their cost can 
    only be deducted on John's 2002 federal income tax return 
    notwithstanding that John paid for the shingles in 2001. Thus, on his 
    2002 return, John must report $15,000 of income and $5,000 of 
    deductions.

MYCPA (talk|edits) said:

27 February 2010
To: RoyDaleOne,

Although you only copied and paste Treas. Reg. 1.162-3, and couple examples from "Notice 2001-76," without positing any analysis, I am assuming that you concur that pursuant to Rev. Proc. 2002-28 & Treas. Reg. 1.162-3, certain "qualifying small business" taxpayers may use the cash method of accounting for inventory (as materials and supplies) for both "non-incidental" and "incidental" materials and supplies. Is that assumption correct?

RoyDaleOne (talk|edits) said:

27 February 2010
The assumption is correct, and, I was providing the information without comment.

No analysis is needed, because the regulations, and other guidance clearly provide for such treatment.

The purpose in posting the information was to include this portion for readers information "provided the taxable income is clearly reflected by this method.", as an additional requirement.

I generally try to provide guidance to matter about the issue at hand. This is because I attempt to respond only to actual questions and not "theory" type questions. So much of the correct comments depend on the fact and circumstances of the situation that it is very difficult to get the facts and circumstances clearly defined.

Taxalmancer (talk|edits) said:

27 February 2010
Readers of this thread, and other threads regarding the use of the cash method, had better be absolutely sure they understand the definition of "qualifying small business". Without a clear understanding of the term one could easily use the cash method that would otherwise not be allowable.

The best articles I've read on this subject come from Tax Advisor.

[1]

[2]

[3]

DouglasHolbrook (talk|edits) said:

27 February 2010
MYCPA and Roy, don't overlook the final clause "provided the taxable income is clearly reflected by this method". In my example, if using this method will reduce taxable income by 20%, then it may very well be disallowed or up to outside forces to come up with a number.

MYCPA (talk|edits) said:

28 February 2010
I agree with DouglasHolbrook.

RoyDaleOne (talk|edits) said:

28 February 2010
My post clearly state that clause was the primary purpose of the posting, thanks for the heads up.

Wiles (talk|edits) said:

10 September 2010

The following is my understanding and I believe it has already been stated above, but my client just played the "that's not fair" card, so I just want to make sure.

The cash basis method for inventory requires an accrual-basis adjustment. You cannot deduct COGS that have been paid for until those items are sold. Those stay on the balance sheet as inventory. My client understands this part.

However, this accrual-basis adjustment is only a one way street. You cannot deduct COGS that are in "A/P" at year-end even though those items are sold during the year.

My client says that this seems to fly in the face of the "provided the taxable income is clearly reflected by this method" clause of Reg §1.162-3, but that is too bad. If you want to take a COGS deduction against its related Sale, then you better write a check for that item before the year closes.

Is this correct?

Seaside CPA (talk|edits) said:

10 September 2010
If client is on cash basis, why does he have A/P? Were purchases made with a credit card?

Wiles (talk|edits) said:

10 September 2010
All businesses, whether they are on the cash basis or accrual basis, have "A/P". For some, this is a liability sitting on their balance sheet. For others, this is a liability sitting in unopened envelopes on their desk.

Seaside CPA (talk|edits) said:

10 September 2010
Yes all businesses have A/P; however, all businesses may not deduct their A/P.

MWPXYZ (talk|edits) said:

10 September 2010
I believe the discretion that the IRS has been given to allow the cash basis of accounting for small businesses with inventory has allowed the IRS to create a method that does not meet the "provided the taxable income is clearly reflected by this method" criteria. After all, if you do not use the accrual method with inventory there is bound to be odd results.

But a taxpayer must meet the "provided the taxable income is clearly reflected by this method" criteria; unless following closely a method specifically allowed by the IRS.

So, I think yur client must choose between continuing with the "unfair" cash method or switching to hydrid or acrual.

Doug M (talk|edits) said:

10 September 2010
Wiles--this is what I do. And I disagree with your last sentence. The client takes a physical inventory at year end. That is the asset you book at 12/31/09, the cost method that you use for valuation of the inventory.

For that cost to be accurate, you need to account for those items that you have not yet paid for. Lets say you get a huge shipment at year end, that you pay for in Jan.

The people who take the physical inventory have no idea what has been paid for and what has not.

So, you book an A/P for those items that have not been paid for but were included in the physical count. And you record this liability.

Now, do your normal CGS accounting as you now have accounted for your inventory correctly. It is a hybrid, but it works and is accurate.

Harry Boscoe (talk|edits) said:

10 September 2010
But the cash basis taxpayer is not allowed to record the payable. The cash basis taxpayer doesn't get to deduct what's not been paid for.

Are we reading the same things?

Seaside CPA (talk|edits) said:

10 September 2010
For cash basis, don't you take the deduction on the latter of the date of sale, or the date of payment? Unless the items were purchased with a credit card, I don't think he should get the deduction.

RoyDaleOne (talk|edits) said:

10 September 2010
There are restrictions on what a cash basis may deduct even if the item is paid for. <<< ---- Harry great use of for.

The recording of the a payable for items that are unsold, and are in the physcial "inventory" by a cash basis taxpayer does not result in a deduction.

Seaside CPA (talk|edits) said:

10 September 2010
Correct RoyDale. I read Wiles post to say that the items are not in inventory at year-end because they were sold during year, however were not paid for.

Kevinh5 (talk|edits) said:

10 September 2010
some people call that 'stolen'

Doug M (talk|edits) said:

10 September 2010
There is no deduction. The accounting entry is A/P and Inventory. Nothing is going to CGS.

I am not taking a deduction for anything by recording the A/P on the books.

It is simple matching. If it is sold, a corresponding entry to CGS is made to match the sale revenue.

If you leave the A/P off the books, you will have sales with no matching CGS.

What you are saying is not to count inventory if it is not paid for? Never seen that in the tax law or the accounting books. And, by inference, you are stating that if you sold inventory tiems before year end that were not paid for, to ignore those sales??

Or, do you record the sale with no CGS?

RoyDaleOne (talk|edits) said:

10 September 2010
Pub 538

"Materials and supplies that are not incidental. If you account for inventoriable items as materials and supplies that are not incidental, you will deduct the cost of the items you would otherwise include in inventory in the year you sell the items, or the year you pay for them, whichever is later. If you are a qualifying taxpayer under Revenue Procedure 2001-10 and a producer, you can use any reasonable method to estimate the raw material in your work in process and finished goods on hand at the end of the year to determine the raw material used to produce finished goods that were sold during the year. If you are a qualifying small business taxpayer under Revenue Procedure 2002-28, you must use the specific identification method, the first-in first-out (FIFO) method, or an average cost method to determine the amount of your allowable deduction for non-incidental materials and supplies consumed and used in your business. See section 4.02 in Revenue Procedure 2001-10 or section 4.05 in Revenue Procedure 2002-28 for more information. Also, see Example 15 and Example 17 through Example 20 in section 6 of Revenue Procedure 2002-28."

Bilbo (talk|edits) said:

11 September 2010
Harry,

For AP and Cash Basis taxpayers, I don't have AP for expenses - other than payroll taxes. I do have expenses for inventory and fixed assets. To put both on the balance sheet, I need the offsetting credit. Much like if I borrowed money I would have to record the offsetting liability to cash.

Generally for this sort of AP, I don't put in "AP". I put it in other liabilities as "Due for Inventory" or something like that.

Bilbo

Sylvia11 (talk|edits) said:

6 October 2010
Well this goes back to what WILES was saying " You cannot deduct COGS that are in "A/P" at year-end even though those items are sold during the year." .

What happens if cash basis client can't take the deduction for "inventory purchased" because it is still owed to a related party (sister corp) at end of year but the inventory was sold in current year? Does the matching principle of matching the sales with COGS tromp the dissallowance of the expense under the related persons rules per pub 538 and IRC 267(b)(12)? Should the liability be set up as a loan?

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