(NOTE: This post fits in with a case study looking into tax implications of starting up a small business. Click here to go back to the start)
A while back, I addressed the cash and accounting methods and how to choose which one you want to use in a small business. I was trying to keep things simple, not an easy task when you’re dealing with the kind of regulations the IRS likes to pump out, so obviously there was a lot not covered.
One of my wife’s friends recently brought up a concern on Facebook. “An accountant told me I had to use the accrual method if I have inventory. Is that true?”
Ah, those darned accountants, always only half explaining things. It’s mostly justified, because talking about accounting for too long almost certainly puts their audience to sleep.
The short answer to that inventory accounting method question is, “Eh, sort of.”
Let’s get the legal reference out of the way up front. In Reg Sec. 1.446-1(c)(2)(i), we get the following:
In any case in which it is necessary to use an inventory the accrual method of accounting must be used with regard to purchases and sales unless otherwise authorized under subdivision (ii) of this subparagraph.
Let’s ignore the “unless otherwise authorized” portion, because that’ll lead us down another rabbit hole. It says that the accrual accounting method MUST be used, but ONLY with dealing with purchases and sales.
Quick refresher. Cash method means you don’t claim income until you get the cash, and you don’t claim a deduction until you hand over those dollar bills (putting it on a credit card is the same as paying cash, by the way). The accrual method means you claim income or a deduction as soon as the transaction’s set.
Let me explain the accrual method a bit more, since it’s a little confusing. We’ll use the example of a doctor, since it’s probably where most people see it in real life. Let’s say you go to Dr. X, who is removing an odd looking mole from your back. The doctor does her medical magic to remove the growth, but due to our complex insurance system she probably doesn’t get any cash for a month. However, because she already performed the procedure, and because she reasonably believes she’ll get paid, on the accrual method she’ll record income the day she removed that hairy mole.
Makes some sort of sense? Feel free to let me know if it doesn’t.
The Hybrid Method
Most small businesses are going to start out on the cash method for reasons I’ve discussed before. For legitimate reasons (there really is no sarcasm in that line, unlike almost every other time I use it), the government doesn’t trust us to use the cash method when it comes to inventory. So when it comes to inventory, your accounting method has to be accrual.
That leads us to the Hybrid Method. That means all your transactions will be on the cash method EXCEPT your inventory and sales.
In practice, it means life will go something like this. You buy a printer cartridge for your ink guzzling business printer and you deduct the expense when you pay for it. You pay for hosting space on the internet and you deduct it when you pay for it.
But let’s say you make a sale in 20X1 but won’t receive the cash until 20X2. The sale will have to go on your 20X1 income tax return. Or let’s say you put in an order for inventory in 20×1 but won’t actually pay for it until 20×2. The expense will go on your 20×1 income tax return.
Honestly, if you’re like the an independent contractor in our case study, it will make little difference except for when to report a couple sales at the end of the year.
You should note, though, that you’ll make one small change when filling out your 1040 Schedule C. Right at the top it’ll ask you which accounting method you use. Instead of checking “Cash” or “Accrual,” you’ll check “Other” and write in Hybrid. The IRS will know what you mean.