Small Business Owners Should Run Their Profit & Loss Reports on a Cash and an Accrual Basis

Small businesses with Product Inventory use the “Accrual Accounting Method” to record their Inventory Assets on their Balance Sheet. They may still use the “Cash Accounting Method” for everything else. If Product Inventory is required to account for your business Income, you must generally use the “Accrual Accounting Method” for Sales and Purchases.

Unless you sell your Product Inventory, it is not Taxable. The value of your Inventory is calculated into your COGS (cost of goods sold) expense to determine the Taxable Profit on Inventory Sold. If Inventory is unlikely to be sold, it may be written off or written down in value. You can NEVER Depreciate Inventory, as it is Property that you are holding for Sale to your business customers.

At the end of the tax year, your business will be taxed on the Profits it made for the year. Your Inventory does indirectly affect your Profits. Your Inventory lowers your profits, which lowers your Taxable Income. Your Profits are your Total Revenue minus your COGS (cost of goods sold) expense.

Your unsold Inventory is an Asset on your Balance Sheet that is not taxable. Gross Profits are calculated by deducting the COGS (cost of goods sold) expense from your Total Income. You increase your Gross Profits by decreasing your COGS (cost of goods sold) expenses. Inventory, Sales and Purchases of Inventory for Sale must be reported on an “accrual basis”. However, all other expenses and Income can be reported on a “cash basis”.

If You Use a Cash Accounting Method for Your Income; you Must Use a Cash Accounting Method for Your Expenses

Small businesses that use a “Cash Accounting Method” to calculate their business Income must also use this method to calculate their expenses. Businesses use the “Cash Accounting Method” to defer taxes until Income is received. Many of today’s small businesses choose to charge their customers for Products and Services sold at the time of Sale, regardless of whether the Product or Service has been delivered.

A business can charge for a monthly subscription automatically on the 1^st of every month for that month’s services. In this case, they are not extending payment terms to their customers, they are recording Sales and Payments simultaneously, doing business on a “cash basis” and recording Income on a “cash basis”. This is typically recorded with a Sales Receipt in QuickBooks Online.

Many of today’s small businesses pay for Goods and Services at the time of purchase. These purchases may be business operating expenses, or the cost of goods or services sold. It is less common these days for small businesses to pay vendor invoices at-a-later-date with payment terms. Even credit card charges come through bank feeds as “Cash Basis” expenses. Many of today’s business expenses are recorded in the same month they are incurred.

Looking at Profit & Loss Reports on a Cash and an Accrual Basis is Very Insightful to Small Business Owners

As a small business owner, you watch your “cash-flow” very closely. You need to know that you earn enough Income to operate your business, and that you are successfully replacing your Employment Income with your Business Revenues, assuming you had a job before you became self-employed. You also need to know if your Business is Profitable and if you can increase your “Equity” with “Retained Earnings“. Running your Profit & Loss Report on both a “Cash” and an “Accrual” basis will provide you with valuable insights.

Note that you can do this regardless of your QuickBooks Online Company Setup. If you customer invoices are not “automatically” paid, there can be a “significant” difference in your “Total Income” and “Net Income” when you compare the two report types. It is possible to have a “negative” Net Income on a “Cash” basis Profit and Loss Report while showing a “positive” Net Income on an “accrual” basis Profit and Loss Report. It is your unpaid customer invoices and unpaid vendor expenses that determine these differences. Review your cash and accrual basis reports each month so that you have a better understanding of your business cash flow, revenues and expense trends.