 Income tax 2022-2023. Figuring gross profit. Let's do some wealth preservation with some tax preparation. Most of this information comes from the tax guide for small business for individuals who use Schedule C Publication 334 Tax Year 2022. You can find on the IRS website, irs.gov, irs.gov. Support accounting instruction by clicking in the link below, giving you a free month membership to all of the content on our website, broken out by category, further broken out by course, each course then organized in a logical, reasonable fashion, making it much more easy to find what you need than can be done on a YouTube page. We also include added resources, such as Excel practice problems, PDF files, and more like QuickBooks backup files when applicable. So once again, click the link below for a free month membership to our website and all the content on it. We're looking at the income tax formula. We're focused on line one income. Remembering the first half of the income tax formula is an essence and income statement, although an outline just to scaffolding other forms and schedules flowing into these line items. The Schedule C being one of them for business income, it being an essence and income statement in and of itself with business income minus business expenses, the net income then rolling in from Schedule C to line one income of our income tax formula. Looking at the first page of the form 1040, we note that the Schedule C would flow into the Schedule 1, which would then flow into line eight here of page one of the form 1040. This is a Schedule C where we have the profit or loss from business where we can see it's an income statement because we have income and the expenses. All right. So now we're going to be focusing in on figuring the gross profit. Remembering that the Schedule C is an essence and income statement. If you're dealing with a non manufacturing or a company that doesn't deal with inventories, then it's going to be more of a simple type of calculation, possibly more of like a one step type of income statement, you might call it, where you have income minus the expenses. But if you have a manufacturing company or one that purchases and sells inventory of merchandising type of company, then you have to deal with inventory and the cost of good sold is that major expense, which represents the consumption of the inventory. And we want to match out that consumption of the inventory that was used to help generate the revenue in the same time period. Therefore, we have more of a multi step income statement in that case, having a pit stop on the way down the road to get to net income. The bottom line of the income statement that being the gross profit revenue minus cost of good sold gives us the gross profit. So okay, after you have figured the gross receipts from your business chapter five and the cost of good sold chapter six, you are ready to figure your gross profit. So it's not really like yucky gross or anything. So don't get like scared of it. It's not icky gross. It's just called gross profit. So you must determine gross profit before you can deduct any business expenses. So the business expenses are going to be after this kind of step along the way. So these expenses are discussed in chapter eight. Now notice, you kind of get the idea that business expenses are different than cost of good sold, but really note that this is just a different categorization. The cost of good sold is in essence and expense, but it's just that big massive expense for those companies that deal with inventory of the cost of the inventory that is in essence being expensed. So businesses that sell products figure your gross profit by first figuring your net receipts figure net receipts line three on schedule C by subtracting any returns and allowances line two from gross receipts line one. So in other words, we're looking at the revenue side of things. When we think about the revenue side, we could have these returns and allowances, which we talked a little bit about in prior presentations, meaning if someone returns the inventory, that kind of negates the sale that took place. What are you going to do in that case? Are you going to reduce the inventory line item itself, the revenue, the sales line, not usually because we don't like decreasing the sales line. Instead, we create another account, not an expense account, but it acts like an expense account in that it's going to be up in the revenue kind of section. You might call it a contra revenue account, which is going to be a decrease to the sales line to get to basically the net sales line as opposed to net income line, right? So returns and allowances include cash or credit refunds you make to customers rebates or other allowances off the actual sales price. So next subtract the cost to goods sold, which we talked about in a prior presentation, line four from net receipts line three, the result is gross profit. That's just the subtotal on the way down the way because the cost to goods sold is such an important number. We want to have its own little subtotal category up top businesses that sell services. You do not have to figure the cost of goods sold. If the sale of merchandise is not an income producing factor for your business. So if your service business, you got no cost of goods sold. So the gross profit calculation isn't really a thing so much in that case because you're not dealing with inventory and therefore not cost of goods sold. And therefore gross profit isn't a thing. Your gross profit is the same as your net receipts gross receipts minus any refunds, rebates or other allowances. Most professions and businesses that sell services rather than products can figure gross process profit directly from net receipts in this way. In other words, you're just going to carry down your sales number to the gross profit as if because there's nothing to subtract from it, because there's no cost to goods sold illustration. So this illustration of gross profit section of the income statement of a retail business shows how gross profit is figured. So you got the income statement for a year ended December 31st, 2022. You got the gross receipts. Again, they're not really gross. That's just your revenue account. Don't be grossed out by it or anything. 400,000. And then you're going to subtract out the returns and allowances. People returned the merchandise. It negates the gross receipts or the revenues. Should you just decrease the revenue by that 14,940? No. Should we expense it? No. We're going to put it up top as a contra revenue account acting kind of like an expense account, but we want to break it out up top in the contra revenue. That gives us our net receipts. Is net receipts the same as net income? No. Net income is after all the expenses and whatnot. This is net receipts, our net sales line up top. That comes out to the 385,60 minus the cost of goods sold, the cost of the inventory, the expense of us consuming the inventory to generate the revenue. In this case of 288,140, that gives us our gross profit of the 96,920. So the gross profit is that the same as net income? No. It's just a pit stop on the way. It's only subtracting out one of the expenses, the big one, the cost of goods sold. All the other expenses need to be subtracted out from it before we get to the bottom line of the income statement or the schedule C, in essence, net income. So this is going to be the cost of goods sold calculation. We had to calculate the cost of goods sold to get to this number for the cost of goods sold here, the 288,140 cost of goods sold. That's going to be, I think, on part three of the schedule C, where we kind of summarize this cost of goods sold calculation. So let's take a look at that. That's where we have the beginning inventory. Inventory should be the same as the ending inventory in the prior year, plus purchases, how much we purchase for inventory, 285,900. So the beginning inventory, 37,845 plus purchases, 285,900 minus items withdrawn for personal use. So we dipped into our own stash and we decreased the inventory by 2,650. The other side going to draws, because we drew it out for our personal use, which is a balance sheet account not on the income statement. So that comes out to the 283,250. That's the 285,900 and the 2,650, 283,250. So the 37,845 plus the 283,250 gives us the goods available for sale throughout the entire year. Did we have $321,095 in inventory at any given time in the year? No. That's how much we would have had if we hadn't sold any inventory throughout the entire year. Imaginary number, our stockpile of inventory as if the entire year was one point in time and we didn't sell any of it. Minus the ending inventory, the stuff that we didn't sell in dollars, measured in dollars, 32,955 gives us the cost of goods sold, the 288,140, which we could see on the income statement helping us to calculate the gross profit. There's the 288,140. Okay. So items to check. Item one, check the weather forecast. Consider the following items before figuring your gross profit, gross receipts at the end of each business day, make sure your records balance with your actual cash and credit receipts for the day. You may find it helpful to use cash registers to keep track of receipts. You should also use a proper invoicing system and keep a separate bank account for your business. So depending on the type of business that you have, if you sell inventory in a store or something like that, having an accounting system like a cash register type of system, checking your receipts to your physical cash and the revenue that you've collected, those internal controls are useful from a bookkeeping standpoint. Sales tax collected. Check to make sure your records show the correct sales tax collection. This is getting more into bookkeeping kind of situations. We talked a little bit about sales tax in the past. If you sell inventory, it's likely in the United States that the state and local government may force you to charge sales tax, which is in essence supposed to be a tax on the person purchasing, the customer, not on you, the business owner, but you are the collection agent. And therefore you have to increase the price of your sale by whatever the sales tax is and collect that pay that to the government. How are you going to record that? Well, for example, if you sold something for $10 and you had to charge $2 of sales tax, then you should basically record revenue of $10 and the $2 should be a liability that you have collected. And then you're going to pay it to the government reducing the liability and reducing the cash account when you pay it to the government instead of recording $12 as revenue, including the sales tax, and then having an expense of $2. You can see the net income would be the same either way. You might say, what's the difference? Because the theory is that it's not really your income. You're just the tax collector. So you shouldn't have income and expense. It should just be an off-income statement item. Accounting software is quite useful to help you to kind of account for that stuff. This question does come up if you deal with taxes with people that have to deal with sales tax because when they pay the sales tax, they're like, hey, I need a sales tax expense. But if they didn't include the sales tax and revenue, which they shouldn't have, then it wouldn't make sense to have the sales tax expense. And if they did include the sales tax and revenue, you would think that you would need to reduce the revenue to what your actual revenue was because sales tax shouldn't be part of revenue technically. Okay, so if you collect state and local sales taxes imposed on you as the seller of goods or services from the buyer, you must include the amount collected in gross receipt. If you are required to collect state and local taxes imposed on the buyer and return them over to state or local government, you generally do not include these amounts in income. One more time. If you collect state and local sales tax imposed on you as the seller of goods and services from the buyer, you must include the amount collected in gross receipts. If you are required to collect state and local taxes imposed on the buyer and turn them over to state or local governments, you generally do not include these amounts in income. Inventory at beginning of year, compare this figure with last year's ending inventory. The two amounts should usually be the same. So when you're checking your income statement to see if there's any kind of red flags or things that should be jumping out at you, one thing that should be jumping out of you that you should be double checking is that the beginning inventory you have matches the ending inventory in the prior year. If it does not, you would need to explain why or it looks like a red flag, something that the IRS might question you about. Purchases. If you take any inventory items for your personal use, use them yourself, provide them to your family or give them as personal gifts, etc. Be sure to remove them from cost of goods sold for details on how to adjust cost of goods sold. See merchandise withdrawal from sale in chapter six. So in other words, if you're dipping into your own stash of inventory, then you have to properly account for that is in essence withdrawal type of situation. Inventory at the end of the year. Check to make sure your procedures for taking inventory are accurate. So notice when you're tracking inventory, you might be using a perpetual inventory system or a periodic inventory system. In other words, a periodic inventory system is one where you do a physical count periodically and make the adjustment reducing inventory and recording cost of goods sold on that periodic basis based on the physical count, either weekly, nightly or yearly monthly. If you were to do a perpetual inventory system, the system will be reducing the inventory and recorded the related cost of goods sold at every sale, which more sophisticated software would be able to do. But you still need to do a physical count to make sure the system is working properly and to make sure your ending inventory is accurate and make sure it ties out to reality, the physical count accounting for shrinkage and spoilage and that kind of stuff. Use inventory forms and adding machine tapes as the only evidence for your inventory. So inventory forms are available at office supply stores. These forms have columns for recording the description, quantity, unit price, and value of inventory items. So you can track your inventory. You might use different methods of inventory tracking first in, first out. Well, first in, first out, that's me. Last and first out, weighted average, specific identification, so on. Each page has space to record who made the physical count, who priced the items, who made the extensions, and who proof read the calculations. These forms will help you confirm that the total inventory is accurate. They will also provide you with a permanent record to support its validity. Inventories are discussed in chapter two. So testing gross profit for accuracy. If you are in a retail or wholesale business, you can check the accuracy of your gross profit figure. First, divide gross profit by net receipts. The resulting percent measures the average spread between merchandise cost of goods sold and the selling price. Next, compare this percent to your markup policy. So in other words, if you're trying to, trying to say, does this gross profit calculation look reasonable? Well, if you can kind of think about the relationship, the ratios between the gross profit and your, and your sales, and think about, is that, is that similar to the ratio that I usually have for my markup of my inventory? So if I just buy and sell inventory, what is the markup of the inventory, you would expect to have a similar kind of relationship to the totals at the end of the year because the sales are a result of simply selling inventory and the cost of goods sold represents the cost of the inventory. So you would expect to have a similar relationship. Now, if you have a more complex business where you have, you know, other income or you're marking up and down the inventory all the time, the prices and costs are fluctuating all the time, then that's going to be a little bit more difficult to do like a, like a double check or comparison. But clearly, you can look at these ratios and get a general idea if they're similar to your markup ratios to get an idea if the gross profit looks reasonable. So next, compare this percent to your markup policy. Little or no difference between these two percents show that your gross profit figure is accurate. A large difference between these percentages may show that you did not accurately figure sales, purchases, inventory, or other items of costs. You should determine the reason for the difference. Now you can also imagine that the IRS on their side of things might look at similar ratios from similar industries. So they're going to say, well, you're in this particular industry. I've, they've got evidence on the market average for those industries. If your ratio looks widely different than the market average, you would think that that might be something that would be like a red flag to the IRS. I'm not saying that's exactly how they do their auditing process, but just if you were just to use ratio analysis, then, then you would, you know, you would think that would be a reasonable way if you were trying to figure out if someone's making an accurate return to kind of look at things, right? So, so you might think of it from that perspective as well. Obviously, it should, it should reflect a reasonable analysis of your markup. And if you have a competitive business, then you would think that would be somewhere in the range of other type of businesses, you know, around you, at least in, in your location. So example, Joe Abel operates a retail business on the, on the average, he marks up his merchandise so that he will realize a gross profit of 300, I'm sorry, 33 and one third percent on its sales. So the net receipts, gross receipts minus returns and allowances. So showing on his income statement are 300,000. So his cost of goods sold is 200,000. This results in a gross profit of 100,000. So sales minus cost of goods sold. He's making 100,000. He's selling for 300,000. The cost of goods sold, the cost of the inventory that was sold is 200,000. Therefore, the gross profit, not the net income, the gross profits 100,000. To test the accuracy of this year's results, Joe divides gross profit 100,000 by net receipts. That's the sales 300,000. The revenue side, the result is 33 and one third, which confirms his markup percent. So in this example, it's perfect. It's exact, which would mean that he didn't like make any variance in his markup percents through the entire year. And he sold everything constant through the whole year. So you can see it's not a perfect kind of system, but it can give you a general example. So additions to gross profit. If your business has income from a source other than its regular business operations, enter the income online six of schedule C and add it to gross profit. The result is gross business income. Some examples include income from an interest bearing checking account, income from scrap sales, income from certain fuel, tax credits and refunds and amounts recovered from bad debt.