One of the most misunderstood concepts out there involves how to account for inventory costs. What is cost of goods sold? Do I have to calculate it?
I get these questions all the time. I’ve also frequented forums on ebay, amazon, and etsy to read the back-and-forth among fellow sellers trying to educate each other with sometimes misguided advice.
Not everyone is interested in a technical explanation, so before I get into it, I’ll just give you the answer.
No, you most likely cannot count your inventory purchases as expenses. You generally cannot count your inventory as a deductible expense until you sell it. That is what’s known as your “cost of goods sold.”
There is an exception out there that many people misinterpret to mean that they don’t have to calculate their cost of goods sold. If your business meets the criteria of having less than $1 million in gross receipts (among some other criteria), you don’t have to use the accrual method of accounting (see below). But this does not necessarily mean you can expense your inventory upon purchase.
If you want to know why that is, read on.
Cash method vs. that other thing (Accrual method)
We first need to make the distinction between a cash-basis business and an accrual-basis business. People get anxious when they hear words like “accrual method” or “cash method,” but the idea is simple. The difference between these two methods is in the timing.
A business that is on a cash basis recognizes (or “counts”) revenue when cash is received from a customer. It would recognize expenses when cash is actually paid out. spent.
With the accrual basis of accounting, you recognize revenue when it is earned. You recognize expenses when they are incurred–which is often at a different time from when the payment is made. If you make use of accounts payable or accounts receivable, you probably have an accrual-based business.
Most small businesses use the cash method for simplicity. Businesses with inventory, however, are generally required to account for the inventory on an accrual basis. Don’t take it from me. That’s straight from the IRS website:
Most individuals and many sole proprietors with no inventory use the cash method because they find it easier to keep cash method records. However, if an inventory is necessary to account for your income, you must generally use an accrual method of accounting for sales and purchases. For more information, see Inventories , later.
What this means is that you can only deduct the cost of the inventory when you sell it, not when you purchase it.
Were this not the case, it would be very easy to manipulate business earnings for any given year. If I wanted to reduce my profit to lower my taxes, all I’d have to is purchase a bunch of inventory before the end of the year. The IRS does not go for that.
The “exception” to the rule
The questions I get arise from the IRS guidelines a little further down on the same webpage. They give some parameters of businesses who are exempt from accounting for inventory using the accrual method. The main stipulation is that such businesses need to have less than $1 million average gross receipts.
If you qualify for the alternative treatment, which most small businesses do, you are not required to account for your inventory using the accrual method.
But hold on!
This does not necessarily mean you can use the cash-basis method either.
What it means is that you can account for inventoriable items as materials and supplies that are not incidental.
This is what the IRS has to say about it:
If you produce, purchase, or sell merchandise in your business, you must keep an inventory and use the accrual method for purchases and sales of merchandise. However, the following [$1 million or less of average annual gross receipts] taxpayers can use the cash method of accounting even if they produce, purchase, or sell merchandise. These taxpayers can also account for inventoriable items as materials and supplies that are not incidental.”
Many people interpret that to mean that if they make less than $1 million in sales they don’t have to track inventory, but that is not the case.
We have to clarify what is meant by accounting for “inventoriable items as materials and supplies that are not incidental.”
Accounting for inventoriable items as materials and supplies that are not incidental
Try to say that 3 times fast.
“Not incidental” materials are those that required to manufacture your products. They are essential to the creation and selling of your product.
“Incidental” materials, on the other hand, are materials that are not directly involved in the production of your finished product.
The IRS guidance states that “not incidental” materials and supplies are deductible in the year they are used or paid, whichever is later.
Yes you read that correctly.
This means that all materials and supplies that are directly used to produce your goods must be accounted for:
- In the year you provided them as finished goods to customers, or
- In the year you originally paid for the material
Whichever is later.
Most businesses I’m familiar with pay for their goods before selling them. If that’s the case, you are required to account for your inventory using the accrual method-recognizing the cost when you sell it (#1).
But if for some reason you don’t pay for your goods until after you sell them (#2), you can recognize the cost when you pay. I’ve don’t know of many businesses that actually do this (none actually), so the whole option is basically a big “thanks for nothing IRS.”
Hence, my “probably not” opening line. The moral of the story is: keep track of your inventory!
At a minimum, keep records of the the purchase date, purchase price, date of sale, and selling price. This will enable you or your accountant to come up with the “cost of goods sold” during the year.
And that, my friends, is not an incidental thing.
It’s not too late to get on my calendar for taxes! Hold your slot here: https://calendly.com/marktewcpa/tax-prep-reservation