If you are a small craft business, you may have been given advice that you can use the Cash-Basis Accounting approach for your bookkeeping.
This essentially means you claim expenses when they are paid and revenue when the cash is actually received. This is incredibly easy to account for as it essentially involves downloading your bank statements and using the dates and figures from this source to do your taxes.
Whilst the cash basis tends to generally work well for very small service based businesses, it does not provide as much accuracy as the accrual method and - more importantly for a crafter - makes it virtually impossible to track your inventory costs.
Why? Let’s use an example to illustrate the issue with cash accounting and inventory.
Say you purchase your materials on a 90 day payment terms on the 1st November. You receive the materials on the same date and get started making a batch of your product during the month of November. You then sell the products during December and make the final payment for your material purchase on the 5th Jan in the next year.
If you are tracking inventory, you’ll be using the COGS method to calculate your material inventory based costs.
However, at the end of your financial year, the materials do not yet have any inventory value in the cash based approach as the materials only turn up officially “in the books” on the 5th January - this is significantly after you have sold the products which contain them.
So, what do we do about the inventory value as at the 31 December? In the cash method, you would technically need to value this stock with a zero value, which would mean that the sales you have made in December were sold with a zero cost for this material.
Your materials are then provided with an inventory value long after they have been used - which is too late to be included in any of your inventory valuations: for the previous year on the 31 December, the stock existed in your inventory however had a zero value.
In the next year, the stock now does not exist as it has been used up, but now has a valuation due to the cash payment having been made on the 5th.
There is thus never a time in which the stock has both a quantity available and a unit cost associated with it, which results in a huge mess from an inventory tracking perspective.
Let’s now look at the same scenario using the Accrual method. The Accrual method differs from the cash method as it accounts for your expenses and revenue as soon as they are incurred. For purchases of materials, this is the date you ordered the stock, not the date you paid for it. For sales revenue, this is the date that the order was placed - regardless of weither the customer has paid for it or not.
So, back to the example: on the date of purchase, this expense is accounted for in the system as we are using the Accrual method.
As you also received the materials on the same day, the quantity purchased and the calculated unit cost can be included into your inventory asset valuation as of November 1st. During the month, you manufacture products using this material, which leads to the stock being costed using the correct unit price and your inventory value at close of year is correctly represented.
You pay your bill on the 5th January, however this event is not at all important in Accrual and does not have any impact on your inventory valuation.
Much more straightforward, don’t you think?
To reiterate: the key difference between the two systems is that in cash you can have a situation where stock arrives before it is accounted for, whereas for accrual the date of purchase always occurs before the stock arrives in your inventory.
This means that if you use the cash basis and are planning to track inventory, you won’t be able to track your material usage expenditure using COGS, and instead will need to claim all material purchases as indirect expenses in the year that they were fully paid for.