Small Jewelry Business on Etsy Accrual vs Cash Accounting

[ClareCA]

Hi there, I have a full time job and a small side business on Etsy selling handmade jewelry.  I acquired a lot of the material that I use to make and sell handmade jewelry in prior years and have kept receipts and good accounting of those materials even though it was more of a hobby in prior years.  I sell finished products on Etsy and haven't reported the income (don't yell at me, please) because I have spent way, way more in materials than I will ever make back (yes, I know I should have been reporting).  At the current rate of my sales, it will take me about 20 years to break even in materials alone (yes, I'm that stupid).  Etsy sent me a 1099-k for 2022, and so what I am trying to figure out is whether to use the Cash Method or the Accrual Method of Accounting.  Since I purchased so much of my materials in prior years, I don't anticipate purchasing a great deal more in future years, and so if I use the Cash Method, I think it will look like I am making a profit when I'm really not.  This year, I made around $8000 but I also purchased about $8000 in more materials but I think the purchasing of materials will go down over time.  I have a method for determining the cost of goods sold.  When figuring out what price to set for an item, I usually double the amount of materials and add a small amount, around $25, for my labor in making, photographing, describing, listing, wrapping, packing, and preparing for shipment.  And so I figure I can take the number of items sold, subtract that $25 from each item, and then 50% of that is the material cost after removing things like Etsy fees, etc.  I had planned to use Accrual Method since I don't anticipate purchasing a great deal more materials in the future, but I am not sure if that is the best way to go.  I think I have enough materials to work with for a long while, but there are always a few things to replenish.  Thank you in advance.

[AliciaP1]

How you handle the accounting of your business does not affect how you report your taxes.  The question about the method of accounting is referring to your bookkeeping method.  You will still report your activities for taxes as the cash method.  Most small business owners, who don't have an accountant, use the cash method for their accounting as well.  

When you enter your business activities into TurboTax this year you should enter the value of your materials at 01/01/2022 as beginning inventory and then proceed with your transactions to report your cost of goods sold.  To get to this section in TurboTax Online you can follow these steps: 

1. Within your tax return use the magnifying glass icon to search for Schedule C
2. Click the Jump to link
3. Click Edit for the line of work
4. Scroll down to Expenses and click Start or Edit if the category you want is shown
   • If you don't see the category you want listed click Add expenses for this work
   • Scroll to and mark the box for Inventory - if you don't see it on the list, scroll down to the Less Common section and click the down arrow and show more until you do
5. Walk through the steps entering beginning and ending inventory values along with any purchases made in 2022

[ClareCA]

Thank you so much for your reply, @AliciaP1 So, when Turbo Tax asks me which method of Accounting I use, I am assuming that they share that with the IRS, and I think you have to stick to that and not change it, and so I am still confused about whether to select Accrual vs Cash.  I thought that Accrual might be more relevant because it doesn't matter when I purchased those materials, but I can expense them when the items sell that contain those materials.  If I have the Cash Method of accounting, I expense only the materials that I bought in 2022; right?  Also, TT starts the inventory at $0 on January 1st.  It says it must be that way, but it truth, I have thousands of dollars in materials and inventory (unsold items).  I don't think I am required to enter inventory; right?  What would be the advantage of doing so?  I am just concerned that if I stick with the Cash Method of Accounting, I won't be able to expense as much in the future since I plan to purchase less for my shop.  Many thanks for your assistance.

[AliciaP1 · Accepted solution]

If you report with the accrual method of accounting, you will need to report the income for all the pieces you have made, including the ones you haven't sold.  Under the cash method, you only report income for the money received from sales.  For inventory, and the connected cost of goods sold, even using the cash method, you expense materials (cost of goods sold) as you sell them, not as you purchase them.  So, if you sold 20 pieces in 2022 for $1000 and that cost you $400 in materials and labor, and you purchased $300 in materials, your income would be $1,000 and your cost of goods sold would be $400.  Your inventory value would go up $300 and down by $400, so a net decrease of $100.  In the end, the cash basis of accounting is most beneficial to you.

And you (and TurboTax) are correct, since you have not reported this income before, you should be reporting that your business started in 2022 (or you could be raising a concern,  and beginning inventory should be $0.  List the value of your inventory (everything you had as of 01/01/2022) as Cost of Purchases and your actual 2022 materials purchases and labor costs for pieces completed in 2022 under the respective categories.  Be sure, when you value your ending inventory, you have valued the cost of the pieces made but not sold in 2022, including your labor.

@ClareCA