Estimating Ending Inventory for a prior year 1040 audit - Restaurant

[Judy rocks]

I'm helping with a 2013 audit for a restaurant that has never calculated an Ending Inventory.
We have no ending inventory for 2013 for the audit of a form 1040 schedule C restaurant audit.
Are there any methods for calculating a past ending inventory that work for a restaurant audit?

[ttbtaxes]

I don't have first-hand experience but would suggest that you take a look at Rev. Proc. 2000-22 and the $1,000,000 exception, the IRS Audit Technique Guide for restaurants pages 5-1 and 6-4, and IRS Letter Ruling 201439001

[kathyc2]

I'm helping with a 2013 audit for a restaurant that has never calculated an Ending Inventory.
We have no ending inventory for 2013 for the audit of a form 1040 schedule C restaurant audit.
Are there any methods for calculating a past ending inventory that work for a restaurant audit?

There are different ways you could back into a reasonable ending inventory number. I'm not clear what your goal is. Is the IRS asking for an inventory number that they will either accept or reject on a correspondence audit? Is the IRS doing a full onsite audit to come up with a number which the client could either accept or try to refute?

[DaveO]

I have used a daily average food cost for an ending inventory before. For a Mexican place I used 7 days. Total food cost for year $100,000/365*7=$1918. The auditor may want to see a higher number but the owner said he kept very few items over a week.

[Judy rocks]

IRS audit with no ending inventory

I'm taking over an audit for a restaurant for 2013. The client didn't state an ending inventory on the tax return. I'm anticipating a request for an ending inventory for the year ending 12/31/2013. Any suggestions? This is an office audit in Santa Ana.

[Judy rocks]

Inventory method

I have good numbers for purchases of food and sales. I can divide purchases of food by days open or sales to get daily food cost. My concern is for the ending inventory number.

[kathyc2]

I can give you some ideas as to how I would go about coming up with a number, but it might save a lot of typing if you provide a little more info.

Was 2013 the first year in business? If so, in what month did it start?
What was the COS % for the food part on the return (line 36 divided by line 7)?

[Judy rocks]

1st year

The first year in business was 2012.
No ending inventory on 2012 tax return.

On the tax return in the Cost of Goods Sold section they only had purchases and zero ending inventory.
Income 362K
total purchases and cost of good sold 177K
line 7 is 362K
line 36 is 177K
line 36/line 7 is .4889

I can give you some ideas as to how I would go about coming up with a number, but it might save a lot of typing if you provide a little more info.

Was 2013 the first year in business? If so, in what month did it start?
What was the COS % for the food part on the return (line 36 divided by line 7)?

[Nashville]

14 days

The first year in business was 2012.
No ending inventory on 2012 tax return.

On the tax return in the Cost of Goods Sold section they only had purchases and zero ending inventory.
Income 362K
total purchases and cost of good sold 177K
line 7 is 362K
line 36 is 177K
line 36/line 7 is .4889

Judy, regardless of what you use, the auditor is going to compare it to the "industry average" which they have amongst their statistical data. For lack of anything better, I would assume 14 days. This would be $177,000 X 14/365 or $5,524. This would add $5,524 to the restaurant income if they had not previously reported inventory. The auditor will compare this to his "industry average".

The spoilage, refrigeration capacity, etc. tells me it would be difficult for a restaurant to retain more than 14 days' supply for most items.

[Burke]

I am thinking more like 7 days for anything perishable. But would inventory also contain things like napkins, plastic tableware, straws, cups and the like? If there were such items, I would think there would be no more than 6 mos supply on hand at any given time, maybe 3 mos, depending on the restaurant's sales turnover. Think Costco. The type of restaurant would also factor in. Fast food or high-end?

[kathyc2]

Ok, I thought is may be that it was only in operation a few months in 2013, and by only using a short time for sales the margin might be totally whack. The 49% is higher than the industry benchmark of 32-38% but not absurdly so. Not all that unusual for a low volume business especially if owners don’t have much management experience. Using inventory of 3,404 (7 days) would give you a margin of 48% and 6,808 (14 days) 47%.

Using 40% tax rate (25% marginal and 15% SE) you are respectively looking at 1,350 or 2,700 in tax. Remember that inventory is self correcting, so if the estimate is off one way of the other it will flush out on the 2015 return. So, other than when (not if) tax is paid, all you are really looking at is the underpayment penalty and interest.

If you go with the number of days theory, I would look at the December purchases to make sure they are not unusually high.

Another alternative would be to take an inventory now, and then take life of business sales / life of business purchases less inventory to come up with a average margin and apply that to 2012 sales to back into 12.31.12 inventory. But since it's likely you are not looking at a large adjustment, the time to take inventory mid- year may not be justified.

[Judy rocks]

Just what I was looking for Kathy - thanks!

This is the kind of outlook that I was looking for.
When the auditor begins to talk about estimating an ending inventory it is no time to "get up speed" on an issue.
Thanks for the info.
I'll be more prepared for the audit.

Ok, I thought is may be that it was only in operation a few months in 2013, and by only using a short time for sales the margin might be totally whack. The 49% is higher than the industry benchmark of 32-38% but not absurdly so. Not all that unusual for a low volume business especially if owners don’t have much management experience. Using inventory of 3,404 (7 days) would give you a margin of 48% and 6,808 (14 days) 47%.

Using 40% tax rate (25% marginal and 15% SE) you are respectively looking at 1,350 or 2,700 in tax. Remember that inventory is self correcting, so if the estimate is off one way of the other it will flush out on the 2015 return. So, other than when (not if) tax is paid, all you are really looking at is the underpayment penalty and interest.

If you go with the number of days theory, I would look at the December purchases to make sure they are not unusually high.

Another alternative would be to take an inventory now, and then take life of business sales / life of business purchases less inventory to come up with a average margin and apply that to 2012 sales to back into 12.31.12 inventory. But since it's likely you are not looking at a large adjustment, the time to take inventory mid- year may not be justified.

[kathyc2]

Thought of another idea. If they mainly use one supplier such as Sysco, that company may be able to provide a report showing items purchased and dates and average usage. If they don't, they may be able to provide a csv file of the last 3-6 months of 2013 purchases for you to do some excel data analysis on.

Remember that restaurants are cash intensive and the IRS may well be looking at if all sales are reported. I'm a bit of a control freak, so I'd probably want to do my own analysis on this before that audit so as not to be blindsided.

Good luck!