“We have an inventory of parts we ordered and never returned to the vendor for whatever reason. What percentage of depreciation (from price when originally purchased) is calculated into our selling of the part to the customer? Or do we just sell it for whatever we feel is reasonable?”
Asked by: Loretta Tanzo, body shop secretary
Question answered by: Hank Nunn
This question seems simple at first glance, but the answer is far from that. I have several follow-up questions: How are these parts shown on the financial statements? How many parts are there, and what was their cost? Can any be returned?
Let’s assume that, over a period of years, we’ve accumulated an inventory of parts that we did not return for a variety of reasons. We paid for the parts on account or by check when they were received and absorbed them into our direct cost of parts. We’ll estimate the value of the parts at $10,000, which is not an uncommon scenario.
The result of this sloppy recordkeeping is much more significant than just the clutter of a $10,000 pile of parts. The first impact is an understatement of parts gross profit on the profit and loss statement. I assume that the parts have never been inventoried and are not shown on the balance sheet as inventory. The result is an understatement of current assets, which can affect the financial condition of the business and increase the cost to borrow money. It also reflects poorly on business valuation, resulting in a reduction of owner’s equity in both cash flow and asset valuation appraisals of the company.
Share this information with the owner. This is important!
Taxes
This understatement of inventory also has significant tax implications. Personally, I was educated on this topic by an IRS auditor a few years ago. That was an expensive lesson! Penalties and interest exceeded the tax liability. The issue is an understatement of income. We probably recognized the expense when we bought the part, but we didn’t adjust our inventory to reflect the added parts. The IRS views that as income and, in an audit, they’ll happily charge taxes, penalties and interest.
In this scenario, depreciation does not apply as we never recognized the asset.
What to Do
So, what should we do about it? First, the owner should meet with their CPA to review the issue. I’m answering this question based on assumptions. I’ve run into this before, and it’s not uncommon. But I’m not familiar with the particulars of your case and I’m not a CPA/controller. Get the CPA/controller involved!
As a general guideline, count the inventory and put it on the balance sheet at your cost. Going by our assumptions, this will result in a one-time increase in inventory of $10,000, which will result in a $10,000 reduction in cost of goods sold – and $10,000 higher net taxable income and appropriate taxes. The good news is you can elect to correct and take three years to recognize the income (the business can get that option if you volunteer the information to the IRS when you file the return; otherwise, if they catch it in an audit, things get a lot more expensive).
You cannot depreciate the inventory like a fixed asset. You could look at the $10,000 “found” inventory to determine whether or not it’s still current/worth what the shop paid for it. If it turns out the inventory is obsolete and of no value in the marketplace, you could increase it by the calculated current wholesale value (what you would pay for it), resulting in a smaller impact. If you’ve counted $10,000 of inventory at cost but you’ve analyzed the value and know it’s only worth $5,000 at the pricing you currently pay, then you would increase the inventory by $5,000.
When you sell the items, re-enter the cost and reduce the inventory.
So, this is a big issue! Bring it to the owner’s attention and get the CPA involved.
Like I said, this is not uncommon! Many collision repair balance sheets do not reflect inventory or work-in-process (WIP), resulting in erroneous gross profit on the P&L and understated current assets on the balance sheet.
So, fix it…now! Check with the CPA, but you would probably be wise to make the correction in the 2012 financials to avoid higher taxes in 2013.
Paint & Materials
Since you have this issue with parts, you might consider doing a full inventory of the paint and associated materials you have in inventory as well. Those items are usually understated on the balance sheet, if they show up at all. You might as well make sure WIP is accounted for. Once these items are corrected, it’s easy to maintain going forward. Collision shops should not have much inventory. Aside from the paint materials and associated products, the hard parts should all be considered WIP.
Management System
Going forward, if you don’t have one, get a computerized management system and enter every part, invoice and credit to avoid having inventory build up again over time. Review parts handling and institute a “mirror matching” process so that incorrect or damaged parts are caught before they’re accepted. Don’t just sign invoices and accept parts! If a part is missing, wrong or damaged, ask the vendor to reissue the invoice less the bad or missing part to minimize the hassle of dealing with credits and double entry into the management system.
Work with the CPA. Fix this. Then make sure it doesn’t come back to haunt the business in the future!
Hank Nunn is a 37-year industry veteran of the collision repair industry and president of H W Nunn & Associates Inc., a collision industry training and consulting company. He may be reached at [email protected].
