Robert A. & Gerri M. Smith - Page 6

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          prepared by Faw, signed by Mrs. Smith, and dated November 10,               
          1995, petitioners responded:                                                
               Inventory was counted at retail (market price).  After                 
               all inventory was counted and totaled, guns were marked                
               down 15% to cost (by multiplying retail price by 85%)                  
               and other inventory was marked down 40% to cost (by                    
               multiplying retail price by 60%).  This method of                      
               deriving the year-end inventory valuation has been used                
               by me since the inception of the business,                             
               approximately 30 years ago.                                            
          After reading the letter, Agent Brown determined that petitioners           
          had a 15-percent gross profit on guns and a 40-percent gross                
          profit on other goods.  Mrs. Smith intended, however, for the               
          percentages stated in her letter to reflect markup, rather than             
          gross profit percentages.  A markup percentage is profit divided            
          by cost while a gross profit percentage is profit divided by                
          sales.  For example, an item that costs $100 and sells for $118             
          has an 18-percent markup (i.e., $18 profit divided by $100 cost)            
          and a 15-percent gross profit (i.e., $18 profit divided by $118             
          sales).  Accordingly, a 15-percent gross profit is equal to an              
          18-percent markup, and a 40-percent gross profit is equal to a              
          67-percent markup.                                                          
               With the information from petitioners and third parties,               
          Agent Brown adjusted petitioners' cost of goods sold and                    
          reconstructed their gross receipts as follows:                              
                        1990                                1991                      
          original     amended     adjusted   original    amended    adjusted         
                                                                                     
          Gross Receipts              $916,099    $881,353   $1,001,017   $999,482   $992,372  $1,177,850
          Cost of Goods Sold           667,606     711,496      622,769   728,371     797,224     729,929
          Beginning Inventory        131,250     131,250      131,250   131,250      88,014     131,250





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