Inventory for taxes/cogs – special case of returns

[sonia]

This is a question for tax nerds. T-Satt – I’m looking at you! 🙂

One of the ways to provide COGS numbers for taxes is to use the schedule C worksheet where you provide various numbers including the cost of your inventory at the beginning of the year, and the cost of your inventory at the end of the year. I have a question about what to do in the following case:

May 2016: purchase item for $10
Dec 30th, 2017: item sells for $100
Jan 15th, 2018: item is returned
July 2018: item sells for $100 and is not returned.

In my year-end 2016 inventory, the $10 is included. That’s fine and easy.

On January 1st, 2018, I tally my 2017 end of year inventory and the $10 item is no longer included, b/c it was sold before the end of the year. Fine.

But then when the item comes back on Jan 15th, I naturally want to add it back to my inventory list b/c it IS once again in my physical inventory. Question is: Do I also add it back into my 2017 year-end inventory number that I use for taxes? If I don’t add it back to the 2017 year-end number, then aren’t I basically getting a $10 deduction in 2017, and then again in 2018, when I should only be getting it once?

I have a feeling that I’m making something complicated out of a very simple concept, but for some reason this scenario has left me totally confused about what to do. It came up b/c I actually had several high-dollar returns in early January.

[junque redux]

Maybe it helps to think of it this way…in December 2017, you made $90 profit. When you refund the $100 in January 2018, you are really giving back your $90 profit, and buying the item back for its original $10 cost. So now you put that item back in your inventory in 2018 at $10. Yes, there are 2 deductions, but you effectively paid for them item twice.

[sonia]

junque redux,
Thanks so much for your answer! I didn’t reply earlier b/c I’m still trying to wrap my head around it. And now I have some follow-up questions b/c there’s something I’m just not getting.

1) If I’ve effectively paid for the item twice, then at the time of the return in January 2018, do I add $10 to my tally of inventory purchases for the year 2018 to be later used on schedule C line 36 (“purchases less cost of items withdrawn for personal use”)?

2) It seems that in order to give back the $90 profit in January 2018 (and not give back $100), I should also record a COGS of -$10 for the return transaction. Yes?

thanks again

[junque redux]

hi sonia,

Yes to #1, no to #2. Your 2018 transaction is: you added $10 of inventory and refunded $100. So if you think of it mathematically, your net refund is… -$100 refund + $10 inventory addition = -$90 refund.

It works because you didn’t actually spend $10 cash money for that $10 worth of inventory…that’s where you effectively get your $10 back out of the $100. Hopefully that makes sense and doesn’t just muddy the waters.

[sonia]

Thanks junque redux. It sounds like what you’re saying is that at the time of the return, I put the $10 back into the value of my inventory AND I add $10 to my tally of inventory purchases for the year. And the reasoning behind this is that part of the return is basically just a different way of buying inventory, so I should do what I normally do when I buy inventory.

T-Satt, Thanks for the detailed explanation. I now totally get what you’re saying at the end about “you HAVE to increase your financial record of the value of your inventory.” Totally on board with that now. Would you agree with junque redux that I need to also add $10 to my tally of inventory purchases for the year? Unfortunately, I have no accounting background so the journal entry stuff confuses me even though you very kindly broke it down to the basics for me. I just use godaddy like a spreadsheet to track inventory and inventory purchases.

So grateful for this help!

[junque redux]

sonia,

Just record a refund of $100. Then pretend you bought another $10 item, and record that as an inventory purchase. That will bring your inventory up another $10. t-satt’s journal entries are correct, but for your purposes, just pretend you spent $10 cash on the item. That should work out in your bookkeeping scheme, I think.

To look at it from a different perspective, suppose that the item had broken in transit, and you refunded the buyer’s money without getting anything back. Then you purchased a completely different $10 item. Those two transactions together would have cost you $110 out of your pocket. With the transaction you currently have, you get the same net outcome ($100 refund, $10 new inventory) but only have to pay $100 to get it. Maybe it makes sense that way?

[T-Satt]

It really depends on how you get your inventory value at the end of the year. Whether you put it as a purchase, or just add it to your list of inventory, it doesn’t matter.

Think of it this way. If it was returned in January of 2018 and it did NOT sell in 2018, how would you make sure that your year end inventory had the value included? That is what matters.

[sonia]

“Whether you put it as a purchase, or just add it to your list of inventory, it doesn’t matter.”

Actually I think it does matter a lot that it is in both places, as “inventory purchases during the year” and “year-end inventory” are 2 different values that are asked for on different lines of the COGS section of Schedule C.

Lets say your inventory at beginning of year was 0, then all you bought in the entire year was a $10 item and didn’t sell anything, so your inventory at the end of the year is $10, and purchases for the year was $10 also. Then the schedule C calculation makes your COGS $0, which is correct. But if you don’t put $10 down in both places (eg, you only put it down in value of inventory), then your COGS will be off by $10.

[T-Satt]

Sonia, you are correct, and I wasn’t thinking as much about the Schedule C calculation. For that reason, I think you have to NOT show a return as an Inventory Purchase for the Schedule C.

Let’s look at the scenario of we sold out our inventory in 2017 down to $0, and the only transaction for the year is the return. If we treat the return as just a return (not a new purchase):

Schedule C:
Beginning Inventory: $0
+ Inventory Purchases: $0
– Ending Inventory: $10
= COGS: ($10)

We show a negative COGS, as we should, since the return gave us negative sales.

2018 P&L should show

Sales: ($100)
COGS: ($10)
Loss: ($90)

If you treat the return as a new purchase:

Schedule C:
Beginning Inventory: $0
+ Inventory Purchases: $10
– Ending Inventory: $10
= COGS: $0

2018 P&L would show

Sales: ($100)
COGS: ($0)
Loss: ($100)

That second scenario is not correct. For purposes of the Schedule C calculation, all returns should NOT be added to the Inventory Purchases for the year.

[sonia]

Thanks T-Satt. That makes sense. So all I have to do for a return is put the item (and it’s associated cost) back into inventory.

I have actually been doing that all along, but the way I was doing it in GoDaddy was causing some other unintended consequences that only really mattered when the purchase and return were in different years, resulting in my total confusion.

All is clear now, thanks!

[T-Satt]

Sonia, Junque is taking you in the right direction. Hopefully to make this make sense, let’s look at the impact on the financials for each year. Let me lay out how you would do the journal entries to account for each transaction. If you don’t care about that part (it helps me lay it out in my head), then you can skip to the paragraphs at the end.

2017
Purchase item for $10

Debit Inventory $10
Credit Cash $10.

This is only on the balance sheet, moving $10 from the asset Cash to the asset Inventory

Sell item for $100

Debit Cash $100
Credit Sales $100
Debit COGS $10
Credit Inventory $10

Removes the asset from the balance sheet for $10, adds the asset Cash for $100

End of 2017 Financials

Balance Sheet – $100 Cash
Profit & Loss – $100 Sales, $10 COGS

2018
Item is Returned

Debit Inventory $10
Credit COGS $10
Debit Sales $100
Credit Cash $100

You are basically reversing the sales transaction. You will also notice that you now have a negative P&L of $90 (Reduced sales by $100, Reduced COGS by $10)

Item resells

Sell item for $100
Debit Cash $100
Credit Sales $100
Debit COGS $10
Credit Inventory $10

The effect of this transaction essentially zeros out the return transaction. At the end of the day, these two are net $0

I realize all of this is doing it like a dorky accounting nerd would do this with journal entries (I can’t escape who I am), but that helps to explain what the answer should be and we can make sure we get there.

Now in your case, you ain’t doing these transactions. You are calculating your COGS at the end of each year. So here is the important part to getting this right. You HAVE to make sure that you have accurate inventory numbers at the end of the year. Your inventory HAS to match your record of inventory for taxes.

So to boil this down. When you get a return, you HAVE to increase your financial Inventory record to account for that return. Spreadsheet, the Easy Auction Tracker file, SixBit, even by hand, it doesn’t matter. When you get a return, you HAVE to increase your financial record of the value of your inventory. If you do that, you will be fine.

[sonia]

“Then pretend you bought another $10 item, and record that as an inventory purchase.”

Yes – makes complete sense now. Thanks junque redux!!

Your explanations are very intuitive – much appreciated.

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