What is this debate between cash vs. accrual accounting, and why is it such a big deal?
Everyone seems to talk about how complex inventory accounting is, and maybe you’re wondering why. After all, it seems like it should be pretty straightforward, right? You know what you order and how much it costs. So you just record that as cost of goods sold, right?
Well, unfortunately, it’s not as simple as that.
In this article, we’ll explain:
- The difference between cash and accrual accounting
- How inventory moves through your business
- Why you should consider doing your accounting by the accrual method
In short, we’ll explain what all this hubbub is all about!
Cash vs. Accrual Accounting for Inventory Purchases
One of the most challenging things when you are first learning about inventory and cost of goods sold is understanding the way it moves through the financial side of your business.
Money leaves your business when you pay for inventory, but it’s not typically expensed when it’s paid for the way it would be if you paid a gas bill or a marketing bill.
If it IS expensed right away, it’s considered cash basis accounting. This is “a method where revenue is recorded when the cash is actually received; likewise, expenses are recorded when they are paid.”
Expensing it right away looks like this:
|
Account |
Debit |
Credit |
|
Cost of Goods Sold |
$50,000 |
|
|
Cash |
$50,000 |
(As a reminder, the terms “debits” and “credits” in the accounting world are not used the same as they are in regular life.)
Inventory purchases represent a large expense that benefits your business for many months, maybe even years to come.
If you expense all that inventory right when you purchase it, it becomes very hard to understand whether your business is profitable or not. It also skews your margins, both now and in the future.
What Cash Based Accounting Looks Like on Your Books
Let’s say I’m starting a new business, so I purchase $50K of inventory to start with.
I can’t sell inventory I haven’t purchased (unless I’m drop-shipping), so this expense is necessary right away.
If the full $50K hits my books as an expense in the month the cash draw hits my account, I will show both a huge loss in that month AND artificial profits in the months that follow.
It would look like this….
|
January |
February |
March |
|
|
Sales |
$10,000 |
$12,000 |
$20,000 |
| Cost of Goods Sold |
($50,000) |
$0 |
$0 |
| Gross Profit | ($40,000) | $12,000 |
$20,000 |
I would show a huge loss in January when the expense hits, as well as gains in February and March, but with no product costs at all.
This is not an accurate picture.
The problem is that in the coming months when I am trying to figure out if I can afford new employees, new marketing expenses, or new warehouses, I will be making decisions based on inaccurate margins.
What Accrual Accounting Looks Like on Your Books
Instead, inventory expenses should be held on the Balance Sheet as an asset until that inventory is actually sold, hence the name, “cost of goods sold.”
The journal entry to establish it on the balance sheet would look like this:
|
Account |
Debit | Credit |
|
Inventory |
$50,000 |
|
| Cash |
$50,000 |
The way it would impact my Profit and Loss Statement when it is expensed correctly over time would look like this:
|
|
January | February | March |
|
Sales |
$10,000 | $12,000 | $20,000 |
| Cost of Goods Sold | ($5,000) | ($6,000) |
($10,000) |
| Gross Profit | $5,000 | $6,000 |
$10,000 |
At the end of March, I would still have an inventory asset on the books of $19,000 because:
|
$50,000 Beginning purchase in January ($5,000) January’s cost of Goods sold coming out of inventory ($6,000) February’s cost of Goods sold coming out of inventory ($10,000) March’s cost of Goods sold coming out of inventory $19,000 Ending inventory on the balance sheet at the end of March |
You can see that I also show nice, consistent gross profit margins of 50% each month. This allows me to plan the rest of my expenses from an informed place of accurate costs.
Using the accrual method of inventory accounting allows you to accurately see how much you have left as an inventory asset at the end of the month. And, it gives you accurate margins to plan around.
Incidentally, the journal entry to record cost of goods sold each month would look like this:
|
Account |
Debit |
Credit |
|
Cost of Goods Sold |
$XXXX | |
| Inventory |
$XXXX |
You can learn how to create a COGS journal entry in QuickBooks Online here.
How the Accrual Accounting Method Affects Profitability
This section is for business owners who are more seasoned pros. Since you understand the way that inventory should move through your books, you can also appreciate the impact that inventory can have on profits.
The larger your inventory ending balance, the lower your costs of goods sold number and the higher your profits.
Higher profits also mean more taxable income.
This may not be the result you are after, or maybe it is?
Are you trying to maximize profits because you are trying to sell, or trying to minimize profits to reduce your taxable income?
We are certainly not suggesting you cook your books, but you can consider these priorities when deciding how to handle inventory decisions.
Costing Methods
One of the ways this is true is when deciding on a costing method for your inventory. The options you have available include:
- FIFO
- LIFO
- Average weighted cost
We will talk more about these costing options in later blogs, but keep in mind that they have huge impacts on your reflected profitability.
End Count Adjustments
Another area where your choices affect profitability is in how you choose to handle end count adjustments. We will also discuss this more in later sections as well, but we want it to be on your radar now.
Inventory Penalty
We often get asked about what our clients call the inventory penalty when they are expensing right away. They say their tax accountants are coming back and increasing their taxable income because of inventory, which costs them more in taxes.
What is happening here?
When a company expenses all their inventory right away, their COGS expense is too high. When their tax accountant adjusts at the end of the year to account for ending inventory that is still owned by the company, it decreases their COGS expense, which increases their taxable income.
This is valid and correct, even if it frustrating.
Often when inventory is counted at the end of the year, it requires an inventory adjustment to true it all up to the ending count. You can make this adjustment by tying the count to the Balance Sheet balance and adjusting the remaining SKU values. Or you can make that adjustment by flushing out the Balance Sheet balance difference through cost of goods sold.
(Choosing between these options assumes you don’t have any responsibility to follow GAAP for an outside party.)
One method will optimize for profits and the other option will optimize for the lowest tax liability.
As you can see, cash vs. accrual accounting is something you really need to consider for your ecommerce business. There are pros and cons to both, but accrual will give you better numbers that you can count on to help you make better decisions for your business.
If you need help with your inventory accounting, let us know. We’re happy to help!
