Jerry and Kaylee are diving into the essential business accounting methods and inventory valuation strategies. They're breaking down cash, accrual, and hybrid accounting methods plus FIFO, LIFO, and so much more, so you'll better understand how the choices business owners make can impact their profits and taxes.
When you’re advising a small-business owner, accounting method decisions often show up as “bookkeeping details.” In reality, they shape timing of taxable income, reported profitability, and even how cleanly you can analyze trends for planning. Two big levers matter most:
We provide more information in the podcast above, but here's a simple breakdown of the accounting methods for small businesses, including what each method is, why clients choose it, and what it does to taxes and financial statements.
First, let's look at the three ways a business can recognize income and expenses: cash basis, accrual basis, and hybrid.
Short answer: Cash basis accounting is a method where revenue is recorded only when the business receives cash and expenses are only recorded when they are paid. Basically, it follows the movement of cash in and out of the business's bank account, not when the business sends invoices or receives bills.
Small business owners may prefer this because it's straightforward, especially in businesses where there's little to no inventory. However, cash basis can make planning tricky because the month-to-month results fluctuate and are harder to plan for, which can distort budgeting and profitability analysis.
Short answer: Accrual basis accounting is a method where the business records revenue when it is earned and expenses when they are incurred, regardless of when cash changes hands. It focuses more on the economic activity, like when work is done or when obligations are created, rather than the timing of cash payments.
This method tends to produce cleaner operating statements, which is pretty helpful for a planner who is evaluating margins, recurring profitability, and debt capacity. It's important to remember that when a taxpayer maintains inventory, regulations generally require the accrual method for determining purchases and sales (i.e., inventory-based businesses often can’t run purely on cash accounting for those items).
Short answer: Hybrid accounting combines cash and accrual, so some income and expenses are handled on a cash basis, but others are handled on an accrual basis. This is often encountered in small businesses that maintain inventory and are required to use accrual for purchases/sales of goods but prefer cash treatment for other items because it’s simpler and can provide flexibility.
As a financial planner, it's important to understand that hybrid accounting is where misunderstanding is likely to happen, so always confirm which line items are on cash vs. accrual so you don’t misread margins or working capital needs.
If a client sells a product or goods, the next piece of the puzzle is inventory accounting, which drives COGS (income statement) and ending inventory (balance sheet). The two types are first-in, first-out and last-in, first out and the method chosen can affect taxable income.
FIFO matches the first costs with the first units sold. Ending inventory is valued using more recent costs. In rising prices (inflation), FIFO generally produces:
LIFO matches the last costs with the first units sold. Ending inventory is matched with older costs. In rising prices (inflation), LIFO generally produces:
This is why training materials often frame LIFO as a way to reduce taxable income during inflationary periods, since it tends to increase COGS and reduce inventory values.
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