It’s been awhile since my last accounting lesson on the forum, here’s a rundown on accounting methods.
Businesses have two options for accounting methods: Cash Basis and Accrual.
Cash Basis
This method is straight forward, you just follow the cash. You record revenue when cash is received, you record expenses when cash is spent.
Pros: Easy to understand and comparatively easy to manage.
Cons: Limits the amount of useful analysis you can get from your financial statements.
Accrual
This method is more complex. Revenue and expenses are recorded when they occur, not when the money moves. Example, revenue is recorded when you issue an invoice, even if that invoice won’t be paid for a month or two. Same thing for expenses, if you have Net30 terms with McMaster or someone like that, you record the expense when you order the goods (technically when you receive the goods), even if you don’t pay the bill for 30 days.
Pros: Significantly improved reporting and analytics, especially if you’re trying to compare monthly performance.
Cons: Can be confusing and is a bit harder to manage.
Software
If you use accounting software like QuickBooks, you can actually do both methods at the same time, switching between them is as easy as hitting a toggle button.
Taxes (USA)
You should talk to a CPA, but pretty much everyone on here, big and small, will file their taxes using a cash basis. This is where the ability to switch between methods comes in handy. For example, at the company I work at we do very detailed accrual accounting because that gives us the strongest reporting and analytics (and is required by investors/banks), but we file taxes on a cash basis.
Inventory
If you’re using cash basis, your inventory can be managed separately in whatever system works for you. When using cash basis, inventory is tracked just to know how much stuff you have and what you might need to order, but it isn’t a component of your financial statements. When you purchase raw materials/components, the entire amount is recorded to Cost of Goods Sold (COGS). COGS could actually be renamed “Purchases”. A tax accountant might make a year end adjustment to account for the inventory you have on hand and remove that amount from your annual COGS.
Using accrual accounting, when you purchases raw material/components it gets recorded to an inventory account. Inventory is an asset on your balance sheet, it doesn’t show up on your income statement (Profit & Loss statement, P&L). When that inventory is consumed and sold, it moves from the inventory account on your balance sheet to the COGS account on the P&L. This is where “Cost of Goods Sold” gets it’s name, it’s the costs directly associated with what was sold, no more no less.
If you’re using the accrual method, your inventory management system should be native or linked to your accounting software. If it’s not, you’ll need to make manual journal entries to get everything recorded correctly, which is a big pain.
This is a good article to learn more and see comparative examples of cash vs accrual for inventory tracking.
My Recommendation
Use cash basis. Unless you’re a high volume production shop, the benefits of using accrual accounting do not out weigh the cost/effort needed to use accrual accounting. Use whatever system works for you for inventory management, it doesn’t need to sync with your accounting records. Just make sure you can properly value the inventory you have on hand at year end. If you want to understand your margins for price setting or just general knowledge, make proforma statements in a spreadsheet like mentioned in these posts. It’s like using the accrual method for a one-time analysis.