Amending Form 1120 For An Error

[wescpa]

A client recently discovered a software glitch relating to his inventory. He has went back to 2012 and 2013 and tied down the inventory for those years and he is planning to amend those years for the change. How many years back does he need calculate the error (could be 6 years if he can even find the information)? I can only think of three ways to handle this when amends 2012 and 2013: 1) he flushes the $700,000 adjustment (cumulative loss from years prior) through the 2012 income as a line item(?); 2) he changes the 2012 beginning balance sheet for the prior years' cumulative error as a credit to inventory and debit to retained earnings (he will not get any loss carry forwards, but it will also keep from opening more audit years) or 3) he continues to amend all of the prior years affected -- and opens up many audit years. Any guidance on this is very much appreciated!

[Roland Slugg]

I can only think of three ways to handle this when amends 2012 and 2013:

Instead of amending the 2012 and 2013 returns he may wish to consider option ....

4) Do nothing. Just make sure the 2014 inventory is correct, and all prior errors will be corrected, on an overall basis, in one fell swoop. (You didn't mention the 2014 tax year, so I'm assuming that either that return is on extension, or the corporation has a fiscal year ending in 2015.)

Inventory errors automatically self-correct the following year via an offsetting error in the opposite direction. Therefore, the cumulative net error ... even if mistakes occurred in each of the past 3, 5, 10 or even more years ... is equal to the amount by which the inventory was misstated in the corp's last tax return. This is not to say the corp hasn't underpaid or overpaid its taxes for those years. I'm sure it has. But unless there has been a significant tax underpayment or overpayment, on a cumulative basis, which the current year's correct inventory will not equitably recover/offset, I would advise the client to do nothing more. In no case would I suggest making a "correction" to retained earnings or foregoing a $700,000 loss of some sort.

I'm curious about that $700,000 you referred to in your option #1. $700,000 is a BIG error! Are the company's sales and net income so large and its inventory so huge that no one suspected an error of that magnitude? Was the 2012 inventory really overstated by $700k? Didn't any alarm bells go off saying there was something way off here? Is it possible that your own thinking about this is faulty?

[Snaggletooth]

Inventory

Inventory is self-correcting, cumulatively for all years, in any year in which the inventory is correctly stated. I share Roland's concern about $700,000 but you didn't tell us in the original post whether this was an inventory error or some other type of NOL.

Inventory errors are very common, even substantial ones, and they occur every year. IRS does not want a taxpayer to respond with an amended return every time an error is discovered. Unless there is a huge error (like $700,000), and the tax brackets are different for some of the years, this taxpayer would be better off not filing an amended return at all. Just my two cents.

[kathyc2]

Instead of amending the 2012 and 2013 returns he may wish to consider option ....

4) Do nothing. Just make sure the 2014 inventory is correct, and all prior errors will be corrected, on an overall basis, in one fell swoop. (You didn't mention the 2014 tax year, so I'm assuming that either that return is on extension, or the corporation has a fiscal year ending in 2015.)

Inventory errors automatically self-correct the following year via an offsetting error in the opposite direction. Therefore, the cumulative net error ... even if mistakes occurred in each of the past 3, 5, 10 or even more years ... is equal to the amount by which the inventory was misstated in the corp's last tax return. This is not to say the corp hasn't underpaid or overpaid its taxes for those years. I'm sure it has. But unless there has been a significant tax underpayment or overpayment, on a cumulative basis, which the current year's correct inventory will not equitably recover/offset, I would advise the client to do nothing more. In no case would I suggest making a "correction" to retained earnings or foregoing a $700,000 loss of some sort.

I'm curious about that $700,000 you referred to in your option #1. $700,000 is a BIG error! Are the company's sales and net income so large and its inventory so huge that no one suspected an error of that magnitude? Was the 2012 inventory really overstated by $700k? Didn't any alarm bells go off saying there was something way off here? Is it possible that your own thinking about this is faulty?

But, by doing this, you would be using a beginning inventory number that you know is incorrect, and therefore signing a tax return that you know is incorrect.

If I'm understanding the OP, the error is known to have occurred in closed years.

Tough call as to what to do, but the offset to the write-down of inventory to equity is a valid option IMO.

[wescpa]

Thank you for your input. They have a large amount of inventory and the error seems to have built on itself. I have not filed the 2014 tax return yet. So how would I show the inventory adjustment in the 2014 tax return without putting it through net income? I am afraid an entry to retained earnings in 2014 might be construed as a dividend unless I note it in the M-2 or do I just adjust the beginning retained earnings and inventory on the 2014 tax return? I was going to amend 2012 and 2013 because the COS was understated and taxable income was overstated.

[kathyc2]

It's been a few years since I prepared an 1120, so take it w/ a grain.

Couldn't you put it on line 6 of M-2 other decreases?

Alternately, you could use same beginning inventory as reported on p/y return and then do a negative line 5 other costs on 1125A.

IMO, if you are amending anyway it makes sense to put the adjustment on earliest year.

[Nashville]

Forego the deduction?

Kathy's advice seems to cram the $700,000 overstatement into retained earnings without getting the benefit of the loss in any of the "open" years. I would hate to lose such a large deduction this way, but if it is known to exist from "closed" years, ethically, there may not be a choice. And her adjustment to retained earnings on M-2 would be one good way to handle it.

Two possibilities cross my mind: 1) The amount of inventory carried may be so large that $700,000 is not material. Not much chance of this unless the client is carrying $20,000,000 or more of inventory. In that case, I wouldn't worry about such an amount falling into Cost of Sales in the year discovered. 2)$700,000 may be abnormally large if the normal inventory balance is less than that described above. If that is the case, then it perplexes me how this could have escaped discovery - similar to what Roland has already discussed. I believe someone in the company knew (or should have known) this and there be a nefarious reason for it. If there is fraud involved, this may open the door for deducting in the year of discovery instead of the year of the shortage.

[kathyc2]

Kathy's advice seems to cram the $700,000 overstatement into retained earnings without getting the benefit of the loss in any of the "open" years. I would hate to lose such a large deduction this way, but if it is known to exist from "closed" years, ethically, there may not be a choice. And her adjustment to retained earnings on M-2 would be one good way to handle it.

Two possibilities cross my mind: 1) The amount of inventory carried may be so large that $700,000 is not material. Not much chance of this unless the client is carrying $20,000,000 or more of inventory. In that case, I wouldn't worry about such an amount falling into Cost of Sales in the year discovered. 2)$700,000 may be abnormally large if the normal inventory balance is less than that described above. If that is the case, then it perplexes me how this could have escaped discovery - similar to what Roland has already discussed. I believe someone in the company knew (or should have known) this and there be a nefarious reason for it. If there is fraud involved, this may open the door for deducting in the year of discovery instead of the year of the shortage.

It may not have come across that way, but I meant adjusting for the missed deduction that was attributable to closed years, and then either amending for any differences from open years or just truing up open years in 2014 depending if difference of income/tax is material or not.

Good catch on the fraud potential.

[Roland Slugg]

Fraud? Income has been overstated every year for several years, and some of you are characterizing that as ... fraud?

If this were my client, I would advise the owner to use the correct inventory on this year's books, then use that inventory and the resulting COGS on the corporation's 2014 tax return, flushing the correction of the entire $700k of cumulative errors into that year. I would not dream of voluntarily foregoing a tax deduction for all or any portion of that $700k, so the idea of charging retained earnings is timid in the extreme.

The IRS isn't staffed with an army of geniuses, you know. How do you think an agent would even spot this error ... assuming the corp's return is selected for audit in the first place? And what do you think he'd do if he did spot it ... go back several years and correct all those returns? You're kidding me. Besides, that $700k might result in a current year loss, and if it does, that loss can be carried back anyway ... achieving a similar overall result, more or less.

[kathyc2]

Fraud? Income has been overstated every year for several years, and some of you are characterizing that as ... fraud?

No on was "characterizing" it as fraud. But it may be a possibility. There are plenty of reasons that it may be beneficial for a company to overstate income. I know of a company that intentionally overstated inventory so bank wouldn't cut off line of credit. Think outside investors, employee wanting to keep jobs, etc. Or... it may have just been a error.

[kathyc2]

Fraud? Income has been overstated every year for several years, and some of you are characterizing that as ... fraud?

If this were my client, I would advise the owner to use the correct inventory on this year's books, then use that inventory and the resulting COGS on the corporation's 2014 tax return, flushing the correction of the entire $700k of cumulative errors into that year. I would not dream of voluntarily foregoing a tax deduction for all or any portion of that $700k, so the idea of charging retained earnings is timid in the extreme.

The IRS isn't staffed with an army of geniuses, you know. How do you think an agent would even spot this error ... assuming the corp's return is selected for audit in the first place? And what do you think he'd do if he did spot it ... go back several years and correct all those returns? You're kidding me. Besides, that $700k might result in a current year loss, and if it does, that loss can be carried back anyway ... achieving a similar overall result, more or less.

I don't think you meant it that way, but your post makes it sound like the likelihood of being "caught" is the determining factor on it an action is ethical or not.

[wescpa]

The error was found when the old company accountant quit and a new one was hired. She noticed that the COS was not coming out of inventory properly and there were many items left on the inventory listing that were long gone. It is possible there was fraud and that has occurred to me, but in the end the client has to properly report the open years right? Would fraud really change anything?

[kathyc2]

The error was found when the old company accountant quit and a new one was hired. She noticed that the COS was not coming out of inventory properly and there were many items left on the inventory listing that were long gone. It is possible there was fraud and that has occurred to me, but in the end the client has to properly report the open years right? Would fraud really change anything?

Are you saying that they relied on their perpetual inventory system for years and never took physical inventory or cycle counts? Yikes!