Accrual vs. the Cash Method of Accounting: Inventory Reporting Risks
After the Tax Cuts and Jobs Act (TCJA), pharmacies have the option to use the cash or accrual methods of accounting. However, the IRS has not clarified the rules for properly reporting inventory under these methods. There are tax advantages under the cash or accrual methods, but each pharmacy must decide how to approach inventory reporting for the best outcome and managed risk — if and when the IRS clarifies rules down the road.
Scotty Sykes, CPA, CFP,® discusses considerations when reporting inventory on your pharmacy’s tax return, such as the pros and cons of the de minimus election. Learn why you need a clearer approach that fits your unique business situation.
Discuss your ideas with Sykes & Company, P.A. counselors and advisors. Our pharmacy advisory services team can help to assess your unique tax situation and provide guidance to manage future risk. For more clarity, see our video on the differences in bookkeeping and accounting for your pharmacy business.
If you prefer to read this content, the video transcript is below.
Under tax reform, what options can help pharmacists account for inventory?
Under the Tax Cuts and Jobs Act, there’s a whole new set of rules for inventory and how to handle that with the cash method of accounting. You can leave inventory as is, keep it on your books, really you don’t change anything. You can treat inventory as non-incidental materials and supplies which essentially, generally speaking, is like keeping inventory on your books. There’s really, you won’t see a big change there.
But one of the areas that some of these others in the industry are touting is the de minimis election. So if you elect to treat inventory as non-incidental materials and supplies and you elect the de minimis election, essentially you can write off all that inventory for the tax purposes. Now what’s the kicker about the de minimis election, you need to be aware of if you’re doing it that way, you have to also write it off on your books and records. That is clear cut in the law. So if you’re doing it that way, you’re going to be writing it off on your books and records, and that’s going to absolutely diminish any advisory, any financial statements, any numbers you get out of that accounting system will be essentially worthless if you do not have inventory on the books. So you have to be aware that you don’t want to go that route unless you are sure that you’ve spoken to your advisors on that’s what you want to do.
The other option that pharmacies have available is to treat it according to their books and records. And the Congress was not clear at all what that means; IRS has no idea what that means. They’re on record saying we don’t know what that means. So under this method, essentially, it’s assumed you can write off inventory on your tax return, but keep it on your books and records, and the journal entries that you’re doing between book and tax is considered your books and records. So there’s an argument that, you write it off for tax purposes but keep it on your books for accrual accounting and for financial statement purposes. Whereas as I mentioned earlier, when you do that in materials and supplies, and then you make that de minimis election, you have to write it off on your books and on the tax return.
What are the consequences if pharmacists report their inventory incorrectly?
So if you’ve been working with advisors that haven’t really clarified the uncertainties in this inventory area and you’ve taken maybe an aggressive position as it stands now — it may be totally fine in the future when the IRS clarifies; it may not. But if you’ve taken a position where you’re writing off inventories and an IRS auditor were to come in and challenge any position you have taken and win, you’re going to see penalties and interest potentially on underreporting of income.
And you have to weigh all those options to determine what’s best for you. I know at Sykes & Companywe have our preferred method of treating this topic. We discuss the options with the clients. We advise them on the issues, the concerns, the uncertainties in this area, and make the best decision with the client on what they need to be doing. So we’re happy to go over that with you if you ever have any questions.