Cash flow accounting lets you recognize your inventory costs and income when you buy or sell your items. This gives you an accurate picture of your cash inflow and outflow so you know how much business cash you have on hand at any given time. When you prepare you business tax return, the same principles apply. You only report the cash you made from your sales and deduct your inventory purchase costs when inventory sells. The remaining inventory is carried on your books until it is sold, at which time you report the sale and the purchase cost on that year's income tax return.

Small-Business Exemption

A small-business owner can use the cash flow accounting method instead of the accrual method by meeting the Internal Revenue Service exemption requirements. For each of the prior tax years, your gross receipts must be more than $1 million but under $10 million. To calculate your average gross receipts, add the three prior years' gross receipts together and divide the total by three. Your business cannot be organized as a C corporation or a partnership that has a C corporation as one of its partners, nor can it be used as a tax shelter. Your principal business activity must be recognized by the North American Industry Classification System.

Cash Method and COGS

For tax purposes under the cash method, inventory is only recognized when it is paid for or sold. When you purchase and pay for your inventory, it is classified as an asset and listed on the balance sheet. It is not part of the cost of goods sold until it is used or sold. If you purchase inventory using your vendor’s in-store credit or trade credit, that inventory is not reported on your tax return or included with your cost of goods sold until it is paid for or sold.

Inventory Journal Entries

With financial accounting, you use the same inventory journal entries whether you are a cash method or accrual method taxpayer. When you purchase inventory, you debit inventory and credit either cash or accounts payable. If you operate a manufacturing firm, you debit work in process and credit inventory when you put inventory into production. When the work is finished, you debit finished goods and credit work in process. When you make a sale, both retail and manufacturing firms debit cash or accounts receivable and credit sales.

Inventory Tax Deduction

Cash method taxpayers report the actual income they receive and disburse on their tax return. When you calculate the cost of goods sold, only the inventory that is paid for or sold is included. You must include any inventory you paid for even if you have not received it. For example, if you must prepay an inventory order before receiving it, you can deduct the cost on your tax return when you make the payment. The remainder of your inventory remains on your books and is reported on your financial statements.