In the case of auditing a business, the Revenue Agent may be interested in verifying gross receipts, inventories, and purchases. The IRS will do this in the event that inventories are a material income producing factor. This Revenue Agent will gather information from the business and apply a gross profit test to establish a ratio for the business.
Once a ratio has been determined through using the gross profit test, the Revenue Agent will go back to prior years of the business to compare the ratio of those years and also the ratio of other businesses in the industry.
Errors in Reporting Gross Profit
Below you will find a few common situations where errors can occur when reporting gross profit:
1. Reporting errors can occur for purchases. This can happen by not including costs properly as part of the cost of sales, purchases are not reduced for returned merchandise, and purchase discounts have not been recorded correctly.
2. Reporting errors can occur for inventory. This can happen by not having inventory properly valued, ending inventory is understated, and inventories are not used even though they are a material producing factor.
3. Reporting errors can occur for gross receipts. This can happen by including costs not subject to the gross profit ratio, some account receivables were left out when using the accrual basis of accounting, income that was constructively received was not reported, installment sales were incorrectly reported, and theft of inventory was not accounted for.
These are just the most common errors that have occurred in the past; there are many more that are possible which can be discovered by a Revenue Agent.