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 the physical inventory count sheets, the valuation of those items, and the IRS will want to take a tour of your facilities to observe your inventory. Thus it is important that you maintain these inventory sheets for several years.
What happens if you don’t take a physical inventory? Let’s look at a hypothetical case. Since your beginning and ending inventory will always be the same, you have effectively told the IRS that you do not take a physical inventory. Thus, you have misstated your inventory and cost of sales. All business owners represent on their annual IRS tax return that the information submitted on the return is true and correct and acknowledge such by signing the return under penalties of perjury. You may now have set yourself up for the IRS to impose penalties. In addition, the fact that the inventory balances have not changed between tax years has given the IRS audit leverage. If the IRS feels that the inventory is overstated, it will likely propose that the inventory be written down. If you are thinking that this is a good thing because when the inventory is written down the COS is increased and taxable income decreases, you will be in for an unpleasant surprise. If a physical inventory has not been taken in the past three years, the business will likely be unable to prove in what year the write-down had occurred. The agent will argue that the inventory was overstated more than three years ago, and thus the statute of limitations is closed for those years and you have just lost a valuable tax deduction.
The benefits of taking a physical inventory are numerous. In addition to being in compliance with the IRS, a physical inventory gives you a better financial picture of your company’s COS margins. It also alerts your employees that you regularly monitor your inventory and that could discourage employee theft. It will alert you if you are holding slow-moving or obsolete inventory that needs to be immediately addressed. It is important that a physical inventory be taken at least annually. Some business taxpayers choose the time of year when inventory levels are low and employees are not busy. This results in less time to count the inventory on hand and impairs the business operations the least.
If you want to discuss your tax preparation or tax planning concerns with an experienced tax professional, we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA office to discuss your situation. You can also schedule a consultation at Click Here.