Common COGS Accounting Mistakes That Could Trigger an IRS Audit

As a contractor, you're accustomed to handling a large number of moving parts - labor costs, material 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, COGS errors can raise red flags with the IRS, resulting in audits and penalties. In this post, we'll go over the most prevalent COGS 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 profit. This impacts your taxable income and, eventually, your tax liability. If COGS is not calculated correctly, you risk overstating your expenses, which could result in an IRS examination for false reporting or tax fraud.

Read more: Cost of Goods Sold (COGS) in Construction: What It Is & How to Calculate

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.

Why it's important: Incorrect classification can distort your income statement and make it difficult to track your gross margin accurately. The IRS may scrutinize your tax returns if they detect costs that don't fit under COGS.

3. Incorrectly Accounting for Inventory

A lot of construction companies have trouble keeping track of their inventory correctly, especially when they buy materials in bulk and use them on more than one job. If you don't keep exact records of how your inventory is used, you could report wrong COGS, which could cause tax problems.

For example, if you buy a lot of lumber and use it for more than one project, you need to make sure that the cost of the lumber is properly split between the projects. If you don't, you might either overstate or underestimate your COGS, which could cause you tax problems.

Why it's important: Inventory accounting is very important to the IRS because it has a direct effect on cost of goods sold (COGS) and earnings. If you manage your inventory well, your COGS calculations will be accurate and show how much each job really costs.

Read more: Top Strategies for Efficient Construction Inventory Control

4. Not Accounting for All Direct Labor Costs

When contractors figure out COGS, they often only look at the cost of goods, but the cost of direct labor is just as important. If you don't keep track of the time that workers and subcontractors spend working directly on a project, you might get the COGS numbers wrong.

Let's say you hire a subcontractor to do work on a job that needs electricity work. Your COGS should include the cost of their work. You will have too much taxed income if it isn't, because your COGS will be too low.

Why it's important: Making sure you include all direct labor costs in your gross profit calculation is important for filing your taxes. If the IRS finds mistakes in your labor costs, they may decide to audit you. 

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.

Why it's important: Businesses must correctly report all direct costs to the IRS. If you don't record all of your project costs, the IRS may see it as an attempt to lower your taxable income and fine you a lot.

Read more: Best Practices for Tracking Cost of Goods Sold in Construction Projects

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. 

Read more: Outsource Bookkeeping: How to Hire A Construction Bookkeeper

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.