Common COGS Accounting Mistakes That Could Trigger an IRS Audit
- Cost Construction Accounting
- Apr 11, 2025
- 6 min read
Updated: Mar 5
As a contractor, you're accustomed to handling a large number of moving parts, labor costs, raw materials purchases, and the day-to-day responsibilities associated with running a construction business. However, one area that frequently presents issues is Cost of Goods Sold (COGS) accounting. While it may appear to be a simple element of your bookkeeping, errors in calculating cost of goods sold can raise red flags with the IRS, resulting in audits and penalties. In this post, we'll go over the most prevalent COGS in accounting mistakes that could result in an IRS audit and how to avoid them.
What Is COGS and Why Is It Important?
COGS, or Cost of items Sold, refers to the direct costs associated with manufacturing the items or services that your company sells. COGS in the construction sector comprises expenses such as materials, direct labor, subcontractor fees, and even project-related overhead costs. Correctly calculating COGS guarantees that your financial reports accurately represent your company's profitability and helps you avoid IRS investigation.
How Does COGS Affect Your Taxes and Income Statement?
When filing taxes, deduct COGS from revenue to calculate gross income and operating income. This impacts your taxable income and, eventually, your tax liability. Changes in COGS directly affect the amount of income tax owed by the business, since a higher COGS reduces taxable income and thus lowers income tax, while a lower COGS increases taxable income and income tax. If COGS is not calculated correctly, you risk overstating your expenses or misclassifying operating expenses, which could result in an IRS examination for false reporting or tax fraud.
Accounting Methods and Their Impact on COGS Reporting
The way you account for inventory can have a significant impact on how cost of goods sold is reported in your financial statements. Businesses typically choose between several inventory valuation methods, including First-In-First-Out (FIFO), Last-In-First-Out (LIFO), and the Average Cost Method. Each of these accounting methods assigns inventory costs differently, which can affect your reported gross profit and net income.
1. Misclassifying COGS and Other Expenses
Misclassifying costs is one of the most common mistakes people make when they do COGS accounting. A lot of the time, contractors mix up COGS with running costs like marketing, insurance, and general office costs. Cost of goods sold (COGS) should only include costs that are directly linked to a project or the creation of goods and services.
A construction company might include costs like office rent or advertising that aren't directly related to a job or service in their COGS by mistake. Instead, these should be thought of as running costs.
Why it's important: If you don't label your costs correctly, it can throw off your financial statements and make it hard to keep track of your profit margins. The IRS may scrutinize your tax returns if they detect costs that don't fit under COGS.
2. Failing to Keep Accurate Records
Proper record-keeping is essential for accurate COGS calculations. Without thorough documentation of all costs, including invoices for raw materials, labor costs, subcontractor payments, and inventory valuation method details, your COGS calculation could be off. This includes correctly tracking beginning inventory and ending inventory balances for each accounting period. Tracking both inventory sold and inventory remaining is essential for accurate COGS calculation, as it ensures that only the cost of inventory actually sold is included in the expense, while the most recently produced units may remain in inventory depending on your valuation method (such as FIFO).
It is also important to record all costs associated with acquiring inventory, such as freight, raw materials, and other direct expenses, to ensure your COGS reflects the true cost of goods available for sale. Inventory levels and the chosen inventory valuation method directly affect COGS, impacting gross profit and financial reporting accuracy. Maintaining precise inventory records is crucial for determining cost, as it allows for proper assessment of financial health and supports strategic business decisions.
3. Incorrectly Accounting for Inventory
Many construction companies struggle with inventory accounting, especially when purchasing materials in bulk and using them across multiple projects. If you don’t allocate inventory costs properly between projects or fail to account for storage costs, your reported COGS may be inaccurate. Shipping costs are another direct expense to consider in COGS, as they can significantly impact the total cost of acquiring inventory. Additionally, sales costs—such as raw materials, labor, storage, and other direct costs—should be included as part of the direct costs associated with producing and selling goods.
Why it’s important: Inventory valuation method and inventory costs directly affect your cost of goods sold and gross profit. Proper inventory management ensures your COGS reflects the true costs incurred during the accounting period. Managing inventory effectively is crucial for accurate COGS calculation and overall profitability.
4. Not Accounting for All Direct Labor Costs
Direct labor costs are a vital component of COGS in accounting. Contractors sometimes overlook including all labor costs directly involved in production, such as workers' wages and subcontractor fees. Omitting these costs results in understating COGS and overstating taxable income.
Why it's important: Including all direct costs incurred, including labor costs, ensures accurate gross profit calculation and compliance with tax laws. The IRS may audit your business if labor costs are misreported.
5. Underreporting Project Costs
Understating project costs is another COGS mistake that can trigger an IRS audit. This includes forgetting to include smaller direct expenses like equipment rentals, fuel, or disposal fees. The goods sold cost should encompass all such direct expenses related to the production and sale of tangible products, ensuring nothing is omitted from the calculation.
Why it’s important: All costs incurred directly in producing goods or services must be reported as COGS. Accurately capturing the true cost of production is essential for proper financial reporting and compliance. Underreporting these costs can be seen as an attempt to lower taxable income, leading to penalties.
How to Avoid COGS Mistakes and IRS Audits
1. Keep Thorough Records of All Direct Costs Involved
Maintain accurate, up-to-date records of all costs related to your projects, including invoices, time logs, subcontractor agreements, and inventory records. This will help you calculate COGS accurately and prepare for potential audits.
2. Use a Bookkeeping System That Works for Construction
Spend your money on a bookkeeping system that is made for the building business. This will help you keep track of COGS, inventory, materials, and labor prices, as well as project-specific costs.
3. Consult a Professional Bookkeeper
Hiring an experienced bookkeeper will save you time, cut down on mistakes, and make sure that your COGS is calculated properly. They can also help you keep up with IRS rules and avoid making mistakes that could cost you a lot of money and lead to an audit.Â
How Construction Cost Accounting Can Help
Even though you need to keep track of COGS yourself, hiring a professional accounting service can save you time, lower the chance of mistakes, and make sure your financial reports are correct. Construction Cost Accounting helps contractors like you keep track of your costs of goods sold, project costs, and general financial health.
There are a lot of challenges that come with running a construction business. We're here to make sure that your COGS is tracked correctly, your tax returns are filed correctly, and your business runs easily. You might want to work with us for ease of use, accuracy, and peace of mind, so you can worry less about IRS checks and focus on growing your business.
Conclusion
Understanding and accurately recording COGS in accounting is crucial for contractors to stay compliant with IRS rules and maintain accurate financial statements. Avoid common mistakes like misclassifying operating expenses, underreporting project costs, or poor inventory management to reduce the risk of IRS audits. With the right tools and professional help, managing COGS and your business's finances can be straightforward and stress-free.
