What is the difference between the cash inventory method and the accrual inventory method?

Answer

For resellers, the two most commonly referenced methods to handle inventory are the cash inventory method and the accrual inventory method.

Cash inventory records an expense when you buy inventory, accrual inventory records an expense when the item sells. If you use the cash inventory method, you record your inventory purchases as expenses when you purchase them. If you use the accrual inventory method, you track your inventory with its purchase date and purchase price. When the item sells, it is recorded as an expense.

In MRG, this means that you don't need to track inventory if you use the cash inventory method. However, if you use the accrual inventory method, you need to have all your inventory recorded in MRG with purchase dates and purchase prices to accurately account for your business. This information should also be entered on sales.

Additional Information

The cash inventory method is faster and easier to use than the accrual inventory method, so why use the accrual inventory method? The reasoning behind using the accrual method is that it is a more accurate reflection of the business. This is because cost gets aligned with revenue in a very accurate way. This is beneficial for evaluating your business operations because you can see a more accurate picture of what's happening. It can also be beneficial from a tax perspective. Consider the following example:

1. You buy $10,000 of inventory in year 1 and make $5,000 of sales (a total of $1,000 of your inventory is depleted)
2. You buy another $10,000 of inventory in year 2 and make another $5,000 of sales (a total of $1,000 of your inventory is depleted)
3. In year 3, you don't buy any inventory, but make $90,000 in sales (the remaining $18,000 of your inventory is depleted)

Using the cash inventory method, the following would happen:

1. In year 1, you report a loss of $5,000 and don't pay any taxes on your business income
2. In year 2, you report a loss of $5,000 and don't pay any taxes on your business income
3. In year 3, you report a profit of $90,000 and pay taxes on all of it (and some of the money is taxed at a higher rate)

Using the accrual inventory method, the following would happen:

1. In year 1, you report a profit of $4,000 and pay taxes on it
2. In year 2, you report a profit of $4,000 and pay taxes on it
3. In year 3, you report a profit of $72,000 and pay taxes on it

This example is painting in broad strokes, but the principles can be seen. Accrual method resulted in a more accurate picture of the business operations and resulted in paying taxes on $80k of profit vs $90k of profit.

What method should I use?

We advise users to talk with their CPA about which accounting method to adopt. Also, if you were wanting to change methods, this is another scenario where consulting a CPA would be beneficial.