Accrual to cash adjustments - Inventory based companies

Technical topics regarding tax preparation.
#1
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Hi Tax Pros, I hope everyone is well. I wondering if you keep the books in this way for inventory based companies. Most of our customers use QuickBooks. So we track AR, AP and Inventory on the books. The taxpayer (S corp) though is cash basis and making less than 25MM in gross receipts. We can then do an M1 accrual to cash adjustment for AR, AP and inventory. So this allows the taxpayer to keep track of their accrual items for book purposes and converts it to cash basis when the return is prepared. Does anyone do this for their inventory based customers? Thank you.
 

#2
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Changing answer:
Here’s a quick screen shot how someone else got sales, prepaid expenses, advance payments,etc out
https://www.svtuition.org/2014/07/how-t ... s.html?m=1

Consider modified cash basis.
https://yourbusiness.azcentral.com/cash ... 26804.html
Last edited by Treetopclimes on 28-Jun-2022 4:00pm, edited 7 times in total.
 

#3
JAD  
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I think that works for AR and AP but not inventory. If you are going to expense inventory, you have to have book conformity. There was another thread on this issue recently, including discussion of relatively new regs issued under 471.
 

#4
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JAD is basically asking why keep inventory at all if under $26M avg gross receipts in prior 3 years.
Article here:
https://www.thetaxadviser.com/issues/20 ... tions.html
 

#5
JAD  
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Sort of. I'm saying that the regs require book/tax conformity and have pretty detailed examples of what that means. In general, if you are maintaining an inventory account on the books, you have to report consistently for tax.
 

#6
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Most of the preparers on the forum are dealing with small taxpayers (under $26M gross receipts as adjusted for inflation, over prior 3 years). Just have an easy life and treat the Inventory as section 471(c) NIMS inventory method (Non-Incidental Materials and Supplies).

You buy the peanut butter to make the cookies in December. You capitalize the peanut butter. You sell the peanut butter cookies in January. You expense the peanut butter in January. Example, Reg. §1.471-1(b)(4)(iv)


If the taxpayer opts to treat inventory as non-incidental materials and supplies, the taxpayer initially capitalizes the items that would have made up inventory and then recovers the costs in the LATER of the taxable year when:

Such inventory is actually used or consumed in the taxpayer’s business, which is the the taxable year in which the taxpayer provides the items to its customer; or
The taxable year in which the taxpayer pays for (for a taxpayer using the overall cash method of accounting) or incurs (for a taxpayer using the overall accrual method of accounting) the costs of the items.

But yes, you can also make your life difficult and do inventory as a book method and then you do have to follow it for tax. But why.

This articles discusses inventory exception in more detail
https://www.currentfederaltaxdevelopmen ... format=amp
 

#7
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wwwcpa1biz, I don’t know if we were clear. Here are your options:

1. Elect as small business to use IRC 471(c) NIMS inventory method (Non-Incidental Materials and Supplies). Capitalize inventory, then expense the later of when inventory provided to customer or the inventory is paid for (cash basis) or expense is incurred (accrual). You can’t do this if your books are keeping inventory.

2. Elect as a small business to use cash method of accounting but under IRC 471(c) treat inventory same as applicable financial statement or, if the taxpayer does not have an AFS for the taxable year, the books and records of the taxpayer prepared in accordance with the taxpayer's accounting procedures. For you, this means you record Inventory, including purchases and sales, on accrual-basis, but all other expenses and income use the cash method (this basically sounds like modified cash accounting to me).

So, no, you can’t M-1 out the inventory. Chose an IRC 471(c) option: NIMS or AFS/books&records.

Also, if use 471(c) election for AFS/books & records, I don’t think you can’t M-1 out the A/P & A/R related to inventory (someone correct me on this if I’m wrong).
Last edited by Treetopclimes on 28-Jun-2022 8:23pm, edited 1 time in total.
 

#8
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It seems to get complicated about A/P, A/R, it looks like those using accrual AFS don’t adjust inc/exp for A/P & A/R related to inventory because all events test passed? Correct me if I’m wrong

“Notwithstanding the timing rules used in the taxpayer’s AFS, the amount of any inventoriable cost may not be capitalized or otherwise taken into account for Federal income tax purposes any earlier than the taxable year during which the amount is paid or incurred under the taxpayer’s overall method of accounting, as described in §1.446-1(c)(1). For example, in the case of an accrual method taxpayer, inventoriable costs must satisfy the all events test, including economic performance, of section 461. See §1.446-1(c)(1)(ii) and section 461 and the accompanying regulations.[41]

The proposed regulations provide the following example of the application of the AFS Section 471(c) Method:

Example, Proposed Reg. §1.471-1(5)(iv)

H is a calendar year C corporation that is engaged in the trade or business of selling office supplies and providing copier repair services. H meets the gross receipts test of section 448(c) and is not prohibited from using the cash method under section 448(a)(3) for 2019 or 2020. For Federal income tax purposes, H chooses to account for purchases and sales of inventory using an accrual method of accounting and for all other items using the cash method. For AFS purposes, H uses an overall accrual method of accounting. H uses the AFS section 471(c) method of accounting. In H’s 2019 AFS, H incurred $2 million in purchases of office supplies held for resale and recovered the $2 million as cost of goods sold. On January 5, 2020, H makes payment on $1.5 million of these office supplies. For purposes of the AFS section 471(c) method of accounting, H can recover the $2 million of office supplies in 2019 because the amount has been included in cost of goods sold in its AFS inventory method and section 461 has been satisfied.”
 

#9
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Thank you Tree. This does not make sense what you said:

1. Elect as small business to use IRC 471(c) NIMS inventory method (Non-Incidental Materials and Supplies). Capitalize inventory, then expense the later of when inventory provided to customer or the inventory is paid for (cash basis) or expense is incurred (accrual). You can’t do this if your books are keeping inventory.

How can you capitalize inventory and not keep inventory on the books?
 

#10
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When you keep accrual inventory on the books, you capitalize direct labor, direct materials, and direct factory overhead and calculate COGS.

So now, using Non-incidental material and supply method for tax purposes, you only capitalize raw material. This capitalized raw material retains the character of inventory, but you are expensing the direct labor and direct factory overhead. You are not calculating COGS, instead you substitute your NIMS expense as COGS.

Example:
You make peanut butter cookies. For purposes of this example, the only raw material you use is peanut butter. In December 2019 you start your business. You buy 4 jars of peanut butter for $4. You are on the cash method of accounting using NIMS inventory expense for both book and tax purposes (books are same as tax).

2019
Debit Asset (go wild call it whatever: Inventory/Peanut Butter/Raw Materials): $4
Credit Cash: $4
To record buying 4 jars of peanut butter in 2019 that cookies were made out of in 2019 but weren’t sold to customers

Debit Salary Exp: $15
Credit Cash:$15
To pay the worker wages to make the cookies (DIRECTLY expensed)


Jan 2020
Debit Cash:$6
Credit Sales: $6

Debit Non-Incidental Material and Supply Expense:$4
Credit Asset: $4
To record that incredibly stale cookies made in 2019 with $4 peanut butter were finally sold in 2020 for $6

So you don’t calculate inventory like you do if you had Applicable financial statements or a book method of calculating inventory. There is no COGS.

I get that it’s confusing that NIMS retains the character of inventory (you have to count the jars of peanut butter) but you aren’t calculating inventory for book purposes (no COGS).

I hope the example helped.
Last edited by Treetopclimes on 5-Jul-2022 5:46am, edited 5 times in total.
 

#11
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And here I illustrate the NIMS later of when delivered to customer or raw material is paid for rule. You are on the cash method of accounting using NIMS inventory expense for both book and tax purposes (books are same as tax).


2019
Debit Asset (go wild call it whatever: Inventory/Peanut Butter/Raw Materials): $4
Credit Accounts Payable-Inventory: $4
To record buying 4 jars of peanut butter in 2019 that cookies were made out of in 2019 but weren’t sold to customers

Debit Salary Exp: $15
Credit Cash:$15
To pay the worker wages to make the cookies (DIRECTLY expensed)


Jan 2020
Debit Cash:$6
Credit Sales: $6
To record that incredibly stale cookies made in 2019 with $4 peanut butter were finally sold in 2020 for $6

2021
Debit A/P-Inventory $4
Credit Cash $4

Debit Non-Incidental Material and Supply Expense:$4
Credit Asset: $4
To record that you finally paid the peanut butter supplier in 2021 and can now take the expense (because it’s the later of when supplied to the customer or the raw material is paid for).
Last edited by Treetopclimes on 5-Jul-2022 5:47am, edited 2 times in total.
 

#12
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Or, long story short, in your case, for book purposes, you are on accrual method with applicable financial statements. Your books “keep accrual inventory”/calculate COGS.

Option 1A. Change your tax method of accounting to cash basis, keeping inventory using NIMS. Since your book basis is accrual, you will have to make all sorts of M-1 adjustments to expense direct labor and direct overhead when paid instead of incurred, as well as capitalize/expense direct materials using NIMS rules (except being on accrual, the NIMS test is later of delivered to customer or incurred (different than when paid using cash basis for books). In other words, even using accrual for book purposes, you can still choose to use cash basis and NIMS expense for inventory for tax purposes. It’s just…a lot of M-1 adjustments. It would be easier to:

Option 1B. Change your book method of accounting to Cash basis using NIMS. Which is what most small businesses are going to do. Which is the example of peanut butter I show above.

Option 2. Use AFS method of 471. Or in really plain English, for tax purposes you are going to basically going to use modified cash method of accounting for tax purposes. So for tax, all your inventory adjustments to Sales, COGS, A/P Inventory, A/R inventory are all going to be the same as book (no M-1 adjustment). However, for all non-inventory items, you are going to be on cash basis and you will have an M-1 for the A/P and A/R relating to those non-inventory items.
Last edited by Treetopclimes on 5-Jul-2022 5:53am, edited 2 times in total.
 

#13
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Also, I apologize for incorrectly using the phrase:
You can’t do this if your books are keeping inventory.

It should have said:
You can’t do this (use NIMS expense in lieu of COGS) if you keep inventory for tax purposes.
You can elect to use NIMS expense for inventory when your books are on cash basis OR on accrual.
And the really big companies using accrual inventories for book purposes might make a NIMS election. But it’s so much work/M-1 adjustment. Most big companies are just going to use 471 AFS because it’s less M-1 adjustments. Alternatively, most smaller businesses will probably switch their books same as tax using NIMS expense instead of keeping accrual inventory for book purposes.

471 had an extremely hard time defining the word inventory, if you read the section for NIMS they had to differentiate between inventory as used normally and 471 NIMS “inventory.” Sorry about incorrect statement, I was going too fast.
 

#14
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If I understand all of this correctly, a cash basis taxpayer operating a business that sells items purchased for resale can simply expense the purchase of goods for resale in the year paid as long as no inventory is maintained.
 

#15
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No. The raw material/items bought for resale are expensed the later of when sold to customers or (for cash basis) when paid for. So if you bought the items for resale in 2019 and sold them in 2020, you would use cash basis with IRC 471 NIMS method of accounting for inventory and capitalize them in 2019 and expense them in 2020 (the later of when paid for or provided to customer). However, the direct labor and direct overhead would be expensed in 2019.
 

#16
JAD  
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Tree, You are correct if the taxpayer is using NIMS. But if instead the taxpayer is simply conforming to financial statements, and inventory is not maintained on the financial statements, the answer to rkrcpa's question is yes.
 

#17
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Here, starting with post #27

viewtopic.php?f=8&t=25387
 

#18
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The non AFS is so fact dependent that it’s hard to give any answer. Yes, if you absolutely keep no inventory or just take a physical count but assign no value to it (example for reordering)- yes, you can expense everything.

However, when they do a physical count and place a value on that inventory and provide it to anyone- external or internal- creditors, or shareholders or anyone else- that method is now the non AFS method. So they tell you they don’t keep inventory but in audit you find they do for some off the book purposes. Most of them have software tracking inventory- and that should be their non AFS method.

When what counts as”keeping inventory” off the books now influences what you must report on the books it can be a headache. And resellers don’t just throw stuff in a room- they know how many widgets they have. Reg. 1.471 had more examples for non AFS than NIMS or AFS.
 

#19
JAD  
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Yes, there are requirements to using the method, but the method still exists and should be included in a discussion of options. As for the hassle, I think for many businesses it is less hassle to meet the requirements than to deal with tracking NIMS.
 


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