I will be going through parts of the IRS' Schedule C Profit or Loss From Business and the accompanying form 1125-A Cost of Goods Sold. I’ll do this over the next few months. Click here for a pdf of Schedule C Instructions by the IRS, at bottom of page.
Here we go. After your name, as proprietor, your SS# or EIN, there is the question F about your accounting method. How do you keep track of your income and expenses? Your choice, per IRS, is Cash or Accrual or Other. ‘Love the Other, which I’m ignoring here.
One difference between Cash and Accrual is in the timing of a transaction associated with actual dollars of income or expenses. The other difference is how inventory and its monetary value show up in your records.
The cash method is more commonly used in small businesses. In the cash method, income is counted when income is actually received and expenses are counted when they are actually paid.
In the accrual method, revenues are matched to expenses at the time in which the transaction occurs rather than when payment dollars are received. All meaningless words so far?
Let's isolate an example. Say I send 20 items at $50 each ($1,000 total) to a shop that will sell them on consignment. Here is the cash version, in which my inventory dropped by 20 immediately and my cash increased as items were sold and I received payment.
Here are the same 20 items at $50 each in the accrual version. This time, the monetary value of those shipped items appeared in my accounting program. The monetary value went into an account called Accounts Receivable, a holding place for "items-I-still-own-but-have-not-been-paid-for". They don't just disappear as they did above. They are still on my books, so to speak. As they sold and I was paid, my cash increased and the Accounts Receivable decreased.
The cash versus accrual method decision comes down to what kind of records you keep. How connected is your inventory to your accounting program? Some keep inventory here and accounting there. Some have programs that keep both. And we're back to QuickBooks. In my opinion, QuickBooks is not ideal, but it seems to be the universal program.
The advantages and disadvantages of each method are numerous and complicated. If you are interested, read on. If not, this is about all I can handle today, too.
The accrual method shows the ins and outs of business assets, income, and expenses more accurately. Careful though, because on paper your income report may show thousands of dollars in sales and receipts (in Accounts Receivable), while in reality your bank account is empty because you haven't yet been paid.
Though the cash method might show you've got lots of cash on hand, it could be misleading in terms of long-term business. For example, maybe the beginning of your year is spectacularly profitable. You get excited and go to Hawaii. But then, the rest of the year is slow and now you have a bunch of credit card debt.
It's a good idea to generate inventory and accounting reports on a monthly basis. Ponder them and insights may come. To have an accurate picture of your business' finances, you need more than just a collection of monthly reports and annual totals that go onto your Schedule C. It would be best to understand what your numbers mean and how to use them to answer financial questions. Find some adult-education courses, or find a professional. I’ve seen a lot of commercials lately for the Better Business Bureau at https://www.bbb.org/. That would be a good place to start.