Why You Want to Use Accrual Accounting for Inventory

When you're first learning about inventory and cost of goods sold, one of the most challenging things to understand is the way it moves through the financial side of your business. When you purchase inventory for your business and you expense it right away, this is considered cash based accounting.

Expensing it right away looks like this. Let's say I'm starting my new ecommerce business and I purchase $50,000 worth of inventory to get off the ground. If the full 50,000 hits my books as an expense in the same month that the cash draw hits my account, I will show a huge loss in that month and artificial profits in the months that follow. It would look like this in my books. As you can see, I show a huge loss in January when the expense hits, and I show huge profits in February and March because I have no product costs.

I like to say that your financials tell a story about your business. When you're accounting for cost of goods sold in this way, the story you're telling isn't complete 'cause you're leaving out key details. This may not seem like a big deal at first, but a few months down the road when you're trying to make strategic decisions like, can I hire new employees, can I take on new marketing expenses, or can I purchase that new warehouse, you'll be making decisions based on inaccurate margins.

1:28 How accrual should work

Instead, inventory expenses should be held on the balance sheet as an asset until that inventory is actually sold. Thus, the name cost of goods sold.

The journal entry to establish it on the balance sheet would look like this, but the way it would impact your profit and loss statement when it's expensed correctly would look like this. You can see that the month of January had $10,000 in sales, resulting in $5,000 moving from inventory to cost of goods sold, and it looks much the same for February and March.

At the end of March, I would still have an inventory asset on the books of $19,000, because I started with a $50,000 purchase followed by three months worth of sales. That left me with an ending inventory balance of $19,000.

You can see that this example is telling a beautiful story of consistent gross profit margins of 50% each month. Using the accrual method of inventory accounting now lets you plan the rest of your expenses from an informed place, because you know your profit margins.

2:29 How accrual affects profitability

Now, for you ecommerce seasoned pros, I wanted to quickly touch on how the accrual method affects profitability. The larger your inventory ending balance is, the lower your cost of goods sold number will be, thus increasing your profits. But higher profits also mean more taxable income.

This might not be the result you're after, or maybe it is. Are you trying to maximize profits because you're trying to sell your business, or are you trying to minimize profits to reduce your taxable income? I'm obviously not telling you to cook the books, but you should definitely be considering these priorities when you're trying to make decisions on how you want to handle inventory.

3:04 The inventory penalty explained

One last thing I wanted to mention. It's not unusual for our clients to come to us and ask us about what they call the inventory penalty when they're expensing inventory at the time of purchase. They tell us that their tax accountant comes back and increases their taxable income because of inventory, which ends up costing them more on their taxes. What is this nonsense and why is it happening?

Sadly, when your company expenses inventory right away, your cost of goods expense is too high. Then when your tax accountant comes in at the end of the year and adjusts to account for ending inventory that you still have, that decreases your cost of goods expense, which in turn increases your taxable income. Unfortunately, even though this is incredibly frustrating, it is very valid and completely accurate.

3:49 Two ways to make the year-end adjustment

When inventory is counted at the end of the year, it almost always requires an inventory adjustment to true it all up to the ending count. You can make this adjustment by tying the count to the balance sheet balance and adjusting the remaining SKU values, or you can make the adjustment by flushing out the balance sheet balance difference through the cost of goods sold. One of these methods will optimize for profits. The other will optimize for the lowest tax liability.

As you can see, your financials will continue to tell a story about your business. You'll have to decide if you'd rather choose cash based and only get part of the story, or accrual based where you get the full story, allowing you to make better business decisions.

If you need help with your inventory accounting, please let us know through the link below. See you on the next video.