Maintaining accurate inventory numbers is essential for proper business operations. Unfortunately, it is usually not cost effective for businesses to physically count their inventory each month for reporting purposes. One way to account for inventory is using the cash method of accounting, which provides a simple accounting method for businesses to use when calculating inventory.
The cash method of accounting is a simple accounting system where income is reported when cash is received and expenses are reported when cash leaves the business. Most businesses use the accrual method of accounting, which is required by law. Small businesses with less than $1 million in gross annual sales may elect to use the cash method of accounting for their business.
Under a pure cash method accounting system, inventory would be expensed on the general ledger when purchased by the business. Any money spent under cash accounting creates an expense; once the purchased inventory is sold, a sale is shown because cash has come into the business.
Under the Internal Revenue Service Procedure 2000-22, slightly different guidelines should be followed when accounting for inventory under the cash method. Inventory is not recorded until it is paid for; once the business has paid the supplier for the inventory, it is listed as an asset on the balance sheet. Once the inventory is sold to a customer, it is moved to the cost-of-goods-sold account. The IRS dictates that cost of goods sold be recognized when it is paid for by the business or the inventory is sold to customers, which ever is later. This allows year-end sales to be recognized in one year and the cost of goods sold in another, alleviating tax liability issues at year end.
Under the cash method of accounting, inventory adjustment may be needed at year end to accurately reflect the current amount on hand at the company. These adjustments result when payments are made for inventory on-hand at year end but paid for in the next year.
The cash method of accounting presents a distinct disadvantage for business owners. Although sales may look extremely high and inventory extremely low in one month, it could be the result of timing issues for payments. Payments from customers may have been high since they are paying their bills all in one month, not from current month sales. Inventory may be low because payments have not been made for the inventory on-hand; therefore, it is not recorded on the general ledger. Although the cash method presents good information on actual cash flow, it cannot accurately report sales and inventory without some research into the numbers.