Discussion Archives:Accounting for Inventory Under Cash Basis

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

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

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.

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.

"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

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.

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.

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?

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.

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

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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?

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.

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.

Are we reading the same things?

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.

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?

"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."

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

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?