When working with clients on tax preparation and tax planning, one of our focuses is to minimize the likelihood of an Internal Revenue Service (IRS) audit. It is surprising how many business owners do not take precautionary steps to minimize the odds that their company is selected for an IRS audit examination. For example, although the IRS requires businesses which maintain inventories to physically count the inventory on hand every year, far too many business owners claim they don’t have the time to take a physical inventory or do not see the benefit of an annual physical inventory. These business owners simply report the same inventory balance on their books every year.
It can be time-consuming to conduct a physical inventory. There are essentially three steps involved in taking a physical inventory:
- Count—first you count all of the items in your inventory
- Identification—next you choose a method of identification which basically means how you match the inventory items to the cost. Common methods include the Specific Identification Method (used when you can match the actual cost of each item individually), FIFO (first-in first-out) or LIFO (last-in last out) methods
- Valuation—finally you need to value the inventory and this is an area that can have the greatest impact on calculating your taxable income. Commonly used methods include the actual cost you paid for the items and the lower of the actual cost or the current market value
Once the physical inventory is taken and valued, the inventory balance shown on the books as of the date of the physical inventory is increased or decreased and an offsetting entry is recorded to the cost of sales (COS) (or cost of goods sold). The change to the COS will impact the company’s taxable income which is why the IRS is concerned about physical inventories. Remember this simple formula: Beginning inventory + purchases – ending inventory = COS.
If audited by the IRS, the business owner will be asked to produce [Read more…] about ANNUAL PHYSICAL INVENTORY REQUIREMENT