“An accountant is someone who solves a problem you didn’t know you had in a way you don’t understand.”
OK, that old line, as with many jokes, contains a certain amount of truth. You’re a business owner and you’re an expert in your particular field. You’re not supposed to know the intricacies of accounting and taxes. So yeah, there can be “problems you didn’t know you had” and to be sure, that’s where a good accountant comes in. But solving it “in a way you don’t understand”? I’m not sure that’s the wisest approach. Do you need to become an accounting expert? Of course not. Again, that’s your CPA’s job. But I do think that it’s healthy for you to have a general understanding of what problems can exist, and ultimately how an advisor can best solve them for you.
I don’t usually write “Accounting 101” type articles. Normally I focus on the tax code, business strategy, and other things in that same vein. But based on some business tax returns I’ve seen recently I thought it might be good to write a few articles focused on some key accounting principles that can have a huge effect on a company’s profit and loss in a given year. If you have at least a decent working knowledge of these matters, it becomes a relatively easy process for us together to plan around them accordingly. If you don’t have this basic understanding you can find yourself with unexpected pain come tax season.
And keep in mind, these are not comprehensive or exhaustive discussions of the intricacies of accounting. Trust me, you probably wouldn’t want me to write anything that long or detailed (unless you happened to be suffering from insomnia, in which case an in-depth treatise on business accounting would probably be just what you needed). Instead, these quick recaps will simply serve as an effective “heads-up” about certain important issues and will help you to see whether a more serious look into your business accounting practices are needed.
For this article, we’re going to talk about inventory timing.
Year End Inventory and Cost of Goods Sold
Constantly keeping track of inventory is a pain. Unless you are a retail operation and keep up with specific items for reordering purposes or are a company that bills material costs back to the customer, many people just put the entirety of a purchase straight into Cost of Goods Sold (COGS). And for a lot of small or incidental items, this can make practical sense. No one wants to put 100 $1.00 widgets into inventory as separate items and then reduce the inventory count one at a time each time you sell one for $2. For small businesses, and in particular for small dollar and small quantity inventory items, there is the assumption that these will be used in short order and the purchase just goes straight to COGS.
The only issue with this is the tax calculation for COGS and how this can impact larger inventory purchases. For tax purposes COGS is calculated in this way on an annual basis:
Beginning of Year Inventory
Less: End of Year Inventory
Really, that makes sense if you think about it; it is Cost of Goods SOLD after all. Inventory is an asset and shouldn’t be expensed until used. If your inventory stayed constant and level year to year this would be fine. But think about a scenario where a company started the year with $10,000 of inventory, had purchases throughout the year of $300,000, and ended with $40,000 in inventory:
Less: Ending Inventory
This company legitimately spent $300,000 throughout the year (and has the lack of cash on hand to prove it) but is only getting $270,000 of expense when tallying taxable profits. That could easily be an additional $10,000 in taxes they did not plan for – for this tax year at least.
This of course swings both ways. If we reverse the beginning and ending inventory the above scenario then the company had COGS of $330,000 for the year. Theoretically and over time this all evens out. But year to year it has the potential to wreak havoc on a company’s profit and loss. Furthermore, extremely large swings in a given year could potentially move the company’s profits into a higher tax bracket due to an artificially overstated profit in that year, something that might not balance out next year.
Any potential surprises are easily avoided keeping an eye on this and consulting with your tax advisor a few times throughout the year. It is a bit of extra work and money, but both are well spent given the alternative of a large and unnecessary tax bill.
Any accounting, business, or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.