Of the two main methods of accounting, accrual basis is the most common generally accepted accounting practice. Cash-basis accounting, while simpler and easier to conduct, does not provide as much economic accuracy as accrual. The simplicity of cash-basis accounting appeals to small businesses, and the Internal Revenue Service allows them to use this method, as long as specific requirements are met. For businesses that have inventory, the IRS generally requires businesses to use accrual-basis accounting. However, under certain circumstances, a business with inventory can use the cash accounting method.
Under cash-basis accounting, income is recorded only when received and expenses only when paid, regardless of when either is actually incurred. This differs significantly from the accrual method, in which income and expenses are recorded as soon as they are incurred, even if money is not received or paid out until long afterward. These differences highlight why it is necessary to use accrual-basis accounting to track inventory. Inventoried goods must be accounted for at the start and end of the tax year and, without tracking purchases and sales on accrual-basis, cash-basis principles would lead to large discrepancies between inventory accounting and reported expenses and income. Businesses with inventories almost exclusively use accrual-basis accounting to record their inventory, even if they may use cash-basis otherwise.
Companies utilizing the cash method for most transactions and the accrual method for inventory and other assets are using a hybrid method called modified cash-basis accounting. Combination approaches are allowable by the IRS provided they clearly demonstrate inflows and outflows accurately and are reported consistently. Inventory, including purchases and sales, must be treated on accrual-basis, but all other expenses and income may be considered under the cash method. If a business chooses to use the cash method for calculating income, however, then it must also use cash-basis for expenses. Companies may not use one method for income and a different one for expenses.
There are some exceptions made in the rule against cash-basis inventory, usually applied to sole proprietorships or very small businesses. To be exempt from reporting inventory, an individual taxpayer must not annually earn more than $1 million, as determined by annual gross receipt amounts for the past three years. Their business must also not qualify as a tax shelter. Small-business taxpayers may qualify as well, provided the business earns more than $1 million, but less than $10 million dollars, again as determined by annual gross receipts for the past three years. The business must also not otherwise be prohibited from following cash-basis accounting.
If a business falls under one of the exemptions that allows them to produce, purchase or sell inventory on a cash-basis accounting system, then it must follow a different set of guidelines for including inventory in its accounting. These businesses are permitted to record their inventory items as non-incidental materials and supplies. As part of this, items that would have been included in the business inventory may be deducted the year that either the item is sold or when it is purchased, whichever is later. For producers, any reasonable method may be used to determine raw material costs used to produce the finished goods that sold during the year.