Choosing an accounting method
Did you know you have choices about how to do your accounting? As long as you follow the IRS rules and regulations, you can pick the accounting method that’s best for your company and situation.
So, what’s an accounting method anyway?
An accounting method is a set of rules that determines when your income and expense are reported.
Normally you choose your method when you file your first tax return and you have to use the same method from year to year (of course we’re talking about the IRS, so you can bet there will be some exceptions). The two most common methods are the cash method and the accrual method, (often times fondly referred to as the CRUEL method because sometimes it seems like punishment to have to use it). There’s also a third way called the hybrid method.
Generally speaking, if you produce, purchase, or sell merchandise, you must use the accrual method to record your sales and purchases of merchandise. There are some exceptions and they depend upon which business activity code you use on your tax return. I’m referring to the six digit NAICS code that identifies your industry. If you file a Schedule C, you can find this number on Line . If you file as a partnership, you can find this on Line C of Form 1065 and if you file a corporate return, this number is on Line 2a of Schedule K on form 1120 or on line B of form 1120S.
What are the differences between the cash and the accrual method?
Cash based accounting is a system in which transactions are recorded on the actual date they occur. This means that you record a purchase on the date you pay for it and you record a sale on the date that you receive the money for it. Most individuals and businesses use this method.
Accrual based accounting is a system in which transactions are recorded in such a way as to try to match revenues received with the expenses that were necessary to earn them. When you use this system, you record a sale when you make it (even if you aren’t paid for it then). And you match the expenses of producing that sale (we call that cost of goods sold) by recording those costs in the same accounting period as the sale.
I think a numerical example here would help. I’ll keep the numbers simple and use just a few transactions to illustrate the accounting
Assume the following facts:
- On 01.01.09 you buy 3 blue widgets, each costing $100.
- On 06.01.09 you sell 1 blue widget for $200
- On 06.01.10 you sell the other 2 blue widgets for $ 200 each
On the Cash basis, your results would be:
2009: Sales $ 200, COGS $ 300 Loss <$100>
2010: Sales $400, COGS 0 Profit $ 400
If instead you had to use the accrual method of accounting, your results would be:
2009: Sales $ 200, COGS $ 100 Profit $100
2010: Sales $400, COGS 200 Profit $ 200
Notice that in both of these cases your total sales for the two years are $600, your total COGS is $300, and your total profit is $300. The difference between the two methods is when you report the costs of the items that are sold. In the cash method, it’s reported when paid. In the accrual method it’s reported in the same year as the item is sold, matching the costs to the revenue.
Even if you weren’t required to use the accrual method, I think that from a business management standpoint, it makes more sense because it more accurately represents the reality of what happened.
You might wish that you could show the loss in 2009 because it would reduce your taxes. But I still think that from a management standpoint that wouldn’t give you an accurate picture of how your business is doing. You might think that you’re being penalized by not being allowed to deduct the costs of all the widgets you bought in 2009, but what I’m saying is that you just have to wait to match up those costs to the sales in the year you actually sell them.
Hopefully that’s easy enough to understand when you only have 3 widgets to keep track of for a couple of years. But what do you do when you have dozens, or hundreds, or maybe even thousands of items that you’ve bought with the intention of reselling?”
There’s a formula that you use to calculate the correct COGS using the accrual method. It goes like this:
Inventory at the beginning of the year
+ purchases of inventory made during the year
- inventory at the end of the year
= COGS for the year
From this you can see how important it is to keep track of your purchases and to take inventory at the beginning and end of the year.