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Cash Basis, Accrual for Inventory


Randall
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Client sells software.  Not a physical item but I think it should be treated as inventory.  He paid his cost ($250k) in 2021 but didn't receive his payment from customers until January, 2022.  S Corp is on cash basis.  But I understand that this should be treated on accrual basis and sales and purchases should be consistent.  Client has inquired about this.  My references are IRC 446 and 471 plus the regs 1.446-1 and 1.471-1.  Just looking for reassurance here and any other references.

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How would you value the unsold software? It is not something sitting on a shelf. Exception if the party is a reseller of some sort and bought a certain number of licenses.

What if the client only compiles the software as needed? What if there is an update, how do you handle the now spoiled inventory of software never compiled or sold?

Compare to you being able to perform x number of returns per year. Are those inventoried?

Just another viewpoint.

For instances:

I may have more than one revision in a day, and some revisions which are never licensed.

Moat software is licensed, not sold. Ownership is rarely transferred. Exception might be made for custom software, but that would likely be for hire, not created and held for later sale. 

Compare to a bakery. Is there inventory of yet unsold products? No. The supplies are inventory, not the goods made from the supplies. 

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"Software capitalization rules for external-use software

The capitalization rules for external-use software differ from those involving internal-use software and can be more strict. External-use software refers to tools that a company plans to sell, lease or market to external users. Here are the stages of this process:

Preliminary stage: During the preliminary stage and before the software is technologically feasible, companies expense costs as incurred. This stage involves activities to understand the goals for the product's features, like research, initial project planning, prototyping and design work.

Technologically feasible stage: Technological feasibility of a software product occurs when the organization has completed all planning, designing, coding and testing activities and a design or working model is ready for customer testing. Costs involve coding, testing and labor costs, and companies can capitalize on these expenses.

Available for sale stage: Once a software product meets technical performance requirements and is available for sale and release to customers, a company starts recording expenses as incurred. The remaining costs involve maintenance and support, error correction, troubleshooting and discovery."

These are GAAP not Tax Guidelines

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Contrary thought. Note the part about aims to sell or market.

 

”The distinction is important because software capitalization requirements are different between the two. For software that the organization aims to sell or market, most (if not all) of the development cost is expensed as incurred. For software that the organization will deliver as a service, on the other hand, much of the development cost will likely have to be capitalized. Although these guidelines seem straightforward enough, the timing of a shift from on-premises to cloud delivery may not always be clear.”

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20 hours ago, Randall said:

Client sells software.  Not a physical item but I think it should be treated as inventory.  He paid his cost ($250k) in 2021 but didn't receive his payment from customers until January, 2022.  S Corp is on cash basis.  But I understand that this should be treated on accrual basis and sales and purchases should be consistent.  Client has inquired about this.  My references are IRC 446 and 471 plus the regs 1.446-1 and 1.471-1.  Just looking for reassurance here and any other references.

 

https://www.thetaxadviser.com/issues/2021/may/highlights-small-business-taxpayer-regulations.html

Read the part about being exempt from sec 471, especially where it says that those costs treated as NIMS still retain the character of inventory, that being exempt from 471 doesn't mean an immediate write-off, and this paragraph from the article:

Quote

For taxpayers that choose to use the NIMS inventory method, the final regulations clarify that even though these amounts are treated as nonincidental materials and supplies, they still retain their character as inventory. The final regulations do not change the position that inventory treated as nonincidental materials and supplies is "used and consumed" in the tax year the taxpayer provides the inventory to a customer, and costs are recovered through costs of goods sold in that year or the tax year in which the costs are paid or incurred (in accordance with the taxpayer's method of accounting), whichever is later. The final regulations retain the general rule from the proposed regulations that the "used and consumed" threshold for NIMS is met only when the taxpayer sells the inventory. As such, manufacturers that convert raw materials into a work in progress or finished goods by year end but have not yet sold the inventory will not be able to deduct the costs under the final regulations.

 

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4 hours ago, Randall said:

What about the matching of sales and costs?  The cost was paid in 2021.  Cash basis.  But the revenue was received in 2022.  Cash basis.  If costs are recorded, shouldn't sales be using the accrual basis as to match in the same year?

 

This a big gray area that has a lot of nuanced interpretation depending on the facts and circumstances which will need some detailed research.

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8 minutes ago, cbslee said:

This a big gray area that has a lot of nuanced interpretation depending on the facts and circumstances which will need some detailed research.

 From the article I linked to and that portion of the quoted material I had in bold, it seemed to be clear (at least to me) that in Randall's fact pattern, the costs that were paid in the 1st year would be recorded as inventory and not recognized as a cost of goods sold until the subsequent year when the sale was actually consummated and the product was delivered to the customer.

What am I missing in this case that needs further research?

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35 minutes ago, jklcpa said:

 From the article I linked to and that portion of the quoted material I had in bold, it seemed to be clear (at least to me) that in Randall's fact pattern, the costs that were paid in the 1st year would be recorded as inventory and not recognized as a cost of goods sold until the subsequent year when the sale was actually consummated and the product was delivered to the customer.

What am I missing in this case that needs further research?

Frankly, I found the original post a bit light on details.

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17 minutes ago, cbslee said:

Frankly, I found the original post a bit light on details.

 Did you mean Randall's post or my first post? The linked article had references directly to the final regs and all of the pertinent code sections. I didn't think it was necessary to quote or reprint the entire article in my post. 

 Anyway, hopefully Randall has enough of a lead for where to look for additional information to draw a conclusion. 

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