Cost of goods sold?

[appelman]

A number of my self-employed clients, who keep no inventory, and who are not engaged in manufacturing, marketing, distributing, or retailing of goods, nevertheless like to report a significant portion of their expenses under "cost of goods sold", either as "materials and supplies" or as "other costs." My inclination has been to move these into various expense categories. Is there any good rationale for having expenses as CGS under these circumstances?

[OtisMozzetti]

No, there is not any sound reason for such reporting. Moreover, I am aware of at least one Tax Compliance Officer at the building about 10 miles south of you who based selection of a return for examination in part upon anamolies spotted within the inventory calculation that had been filed.

[taxxcpa]

Cost of Sales

I used to have a Doctor client who used Cost of Goods Sold for payroll expense. His theory was that it caused his gross profit to be lower which he thought would make him less likely to be audited.

As far as I am concerned, it was wrong, but since there was no misstatement of income, no harm was done.

[Burke]

It may not make any difference on the bottom line for income taxes, but for localities who have Business Gross Profits taxes, it does. However, arbitrarily allocating materials and supplies to COGS when it is not appropriate brings the tax preparer into the fraudently reporting of income to avoid taxes in these cases, IMO.

[taxxcpa]

Cost of Goods sold.

It may not make any difference on the bottom line for income taxes, but for localities who have Business Gross Profits taxes, it does. However, arbitrarily allocating materials and supplies to COGS when it is not appropriate brings the tax preparer into the fraudently reporting of income to avoid taxes in these cases, IMO.

Only if it actually results in lowering taxes.

In Texas there is a margin tax for corporations and LLCs which should not include expenses that are not actually part of Cost of Sales. In the case of the Doctor I mentioned, he was a sole proprietor and it was before Texas had the margin tax.

Sometimes it is hard to tell whether materials and supplies are used directly or indirectly. A contractor may buy materials that go into construction but also may buy office supplies which would not be a cost of sales. Some supplies are not described sufficiently for the tax preparer to tell the difference.

[oceanlovin'ea]

jewelry

I have a client who makes jewelry, really nice jewelry. She is now getting some great exposure for her work.

It has always been a little challenging to categorize her costs. Her stones, jewels and such are considered cost of goods sold. When she buys hooks, string, thread, etc., I have expensed that stuff. You really can't take each piece she makes and say this hook costs 15 cents and this much thread is 1.00.

Linda

[Nashville]

CGS - yes!

In the purest sense of the phrase, Cost of Goods Sold should reflect only those costs which are so inexorably tied to the sale that the very substance of the sale could not have occurred without those costs. For example, a car dealer buys a car for $6000, adds another $500 in repair, then sells the car for $10,000.

Clearly the $6000 paid for the car is the "substance" of the sale, one could also argue that the $500 was further investment and should thus be CGS as well.

A clerk is paid for document preparation, and the sale could not be legally consummated without this function. However, this is perceived as fulfilling a legal requirement, and is removed from the "substance" of the sale, thus most accountants would not classify her salary as CGS. The dealership also has lot rent, overhead expenses, etc. and these are not tied to the sale, regardless of their status as an ordinary and necessary expense.

However, I would leave the "purest" approach to insert further definition by the IRS. The IRS insists that certain indirect expenses be considered part of inventory. They do this so they can collect billions of $$$ which otherwise would be deductible in the year incurred. This is commonly tied to basic inventory by means of an overhead rate. When the base inventory becomes cost of sales, then so does that portion of overhead which attaches thereunto.

So if anyone thinks margins cannot be impacted by indirect costs, think again. Don't think you're doing the IRS a favor by keeping all indirect costs "below the line" especially when IRS itself insists on converting these costs into inventory.

Separation of indirect costs into inventoriable and non-inventoriable costs is a GAAP discussion, can get very theoretical and argumentative even among GAAP experts, and probably should be left off this thread for the sake of brevity.

[JG EA]

Even when no inventory at the end of the year.

A non GAAP comment.
Say a client has a side business.
Materials that are part of the TP's finished product, I feel go into COG's.
One reason: If a business is operating at a loss some year, you can clearly see if it is a realistic business by the gross income. If the loss is created by depreciation or some other important reason, I can feel good about the loss being justified under scrutiny.