Managed Accounting, Tax Accounting

How Poor E-Commerce Inventory Control Hurts You at Tax Time

Posted on June 25, 2024

By Michele Roletter

July 22, 2024

For most e-commerce business owners, inventory is one of their largest expenses. This means that inaccurate inventory controls can significantly impact your taxable income. As a result, Generally Accepted Accounting Principles (GAAP) and the Internal Revenue Service (IRS) look to regulate when a business can deduct inventory. In this article, we’ll explore how poor e-commerce inventory controls can hurt you at tax time and how different valuations impact your taxable income. If you have specific questions about your inventory controls, reach out to one of our team members.

The Relationship Between Inventory and Cost of Goods Sold

The raw materials, supplies, and finished goods you purchase cannot be immediately expensed. This is because GAAP follows the matching principle. The matching principle states that expenses and related revenue must be reported in the same period. Matching revenue and expenses generates accurate financial statements and minimizes the risk of business owners inflating net income by timing expense recognition.

This means when your business purchases inventory, you cannot deduct the cost until you sell the product. Once you sell the item, the expense moves from inventory on the balance sheet to cost of goods sold on the income statement.

Let’s say that you purchase 10,000 units for $50,000 or $5 each. By the end of the year, you have only sold 5,000 units. Instead of reporting the full $50,000 as cost of goods sold on the income statement, you are limited to $25,000 while the other $25,000 sits in inventory on the balance sheet.

E-Commerce Inventory Controls: Why Inventory Balances are Important

E-commerce inventory controls are crucial for accuracy in your taxable income. Although inventory discrepancies are considered temporary differences, meaning they eventually wash out, it’s important to report accurate figures to the IRS. Let’s go through two examples: overstating inventory and understanding inventory.

Overstating Inventory

Overstating inventory leads to higher taxable income. This is because the amount you are deducting as an expense in cost of goods sold is lower than it should be. For example, let’s say that your inventory balance is overstated by $15,000 and you currently report $50,000 in taxable income.

The cost of inventory on the balance sheet does not impact your taxable income. By overstating your inventory, you are overstating your taxable income by $15,000. With the proper e-commerce inventory controls, you would recognize this discrepancy and move the overstatement to the income statement, resulting in $35,000 of taxable income compared to $50,000.

Understating Inventory

Understating inventory results in overstating cost of goods sold, which leads to lower taxable income. Underreporting taxable income comes with serious fines, penalties, and back taxes, which is why e-commerce inventory controls are so important.

Using the above example, let’s say that you understated inventory by $15,000. This means that your cost of goods sold is overstated by $15,000 and your true taxable income should be $65,000. This can be a major problem for the IRS and state agencies.

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Inventory Valuation Methods and Taxes

When you have transparency and accuracy in your inventory, you have the ability to use different valuation methods for tax purposes. There are three main inventory valuation methods: LIFO, FIFO, and average cost. Let’s break down each of these methods in more detail.

Last In First Out (LIFO)

LIFO moves the latest purchased goods to cost of goods sold first. Let’s say you have the following inventory purchases:

  • January – 5,000 units at $5 each
  • March – 3,000 units at $5.50 each
  • June – 4,000 units at $6 each

By the end of the year, you’ve sold 6,000 units. The amount of expense in cost of goods sold would be comprised of 4,000 units at $6 each and 2,000 units at $5.50, which totals $35,000. In your ending inventory balance, you will have 5,000 units at $5 each and 1,000 at $5.50 each, which totals $30,500.

First In First Out (FIFO)

FIFO is the opposite of LIFO, moving the oldest goods to cost of goods sold first. Let’s assume the same inventory purchases and prices as the above method. The amount of expense moved to cost of goods sold for the year would be 5,000 units at $5 each and 1,000 units at $5.50 each, which totals $30,500. Your ending inventory would be made up of 2,000 units at $5.50 each and 4,000 units at $6 each, totaling $35,000.

Under FIFO, your taxable income for the year is higher because the goods purchased in January and March were cheaper than in June.

Average Cost

Due to its simplicity, reporting inventory using average cost is one of the most common valuation methods. Average cost is seen as a combination of LIFO and FIFO. Using the same factors as the first example, your average cost would be found by taking 5,000 units times $5, 3,000 units times $5.50, and 4,000 units times $6, for a grand total of $65,500.

Then, this number is divided by the total number of units, or 12,000, to get an average cost of $5.46 per unit. Our ending inventory balance and the amount in cost of goods sold would be $32,760.

The Bottom Line on E-Commerce Inventory Controls

E-commerce inventory controls are crucial when it comes to reporting accurate taxable income and minimizing your tax liability. For example, when LIFO and FIFO methods are deployed, you have the ability to alter your taxable income depending on where unit costs fall. However, without the proper e-commerce inventory control, your unit costs can easily become altered, resulting in misreported inventory and cost of goods sold.

Not to mention that e-commerce inventory controls impact other areas of your business, such as sales tax and inventory tax. Infusing comprehensive e-commerce inventory controls makes it easier to report inventory and cost of goods sold at tax time, helps your business properly plan and optimize reorder times, and increases profitability through careful cost analysis.

If handling the e-commerce inventory control of your business feels overwhelming, reach out to one of our tax experts. We can find solutions to your inventory management to ensure compliance with regulatory agencies and maximize insights into your inventory function.

Steve Solt headshot

Michele is an accomplished Accountant, bringing a wealth of knowledge and expertise to her current CPA role at KDG. Experienced in Sage Products, Tax Preparation, GAAP, Financial Accounting and Managerial Accounting. Michele has spent her career overseeing tax preparation and accounting services at a multitude of organizations, even owning her own successful CPA firm.

Want to learn more? Book a meeting with us today!

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