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Cash or accrual? Choosing your
business' method of accounting
In addition to decisions that affect the day to
day operations of the company, the new business owner will also be
faced with accounting and tax related decisions. Whether to use the
cash or accrual method of accounting, for example, although not
always a matter of choice, is an important decision that must be
considered carefully.
Generally, there are two methods of accounting
used by small businesses – cash and accrual. The basic difference
between the two methods is the timing of how income and expenses are
recorded. You choose your method of accounting when you file your
first tax return. If you ever wish to change your accounting method
after that, you’ll need to file for IRS approval, which can be a
time-consuming process.
While no single accounting method is required of
all taxpayers, you must use a system that clearly shows your income
and expenses, and maintain records that will enable you to file a
correct return. If you do not consistently use an accounting method
that clearly shows your income, your income will be figured under
the method that, in the opinion of the IRS, clearly shows your
income.
What is the cash method of accounting?
Most small businesses use the cash basis method
of accounting, which is based on real time cash flow. Under the cash
method, income is recorded when it is received, and expenses are
reported when they are paid. For example, if you receive a check in
the mail, it becomes a cash receipt (and is recorded as income).
Likewise, when you pay a bill, you record the payment as an expense.
The word "cash" is not meant literally – it also covers payments by
check, credit card, etc.
What is the accrual method of accounting?
Under the accrual method, you record income when
it is earned, not necessarily when it is received. Likewise, you
record your expenses when the obligation arises, not necessarily
when you pay the bills. In short, the accrual method of accounting
matches revenue and expenses when they occur whether or not any cash
changes hands. For example, suppose you’re hired as a consultant and
complete a job on December 29th, but you haven’t been
paid for it. You would still recognize all expenses you incurred in
relation to that engagement regardless of whether you’ve been paid
yet or not. Both the income and the expenses are recorded for that
year, even if payment is received and bills are paid the following
January.
Businesses are required to use the accrual method
of accounting in several instances, including:
- If the business has inventory.
- If the business is a C corporation with gross annual sales
exceeding $5 million (with certain exceptions for personal
service companies, sole proprietorships, farming businesses, and
a few others).
If you operate two or more separate and distinct
businesses, you can use a different accounting method for each if
the method clearly reflects the income of each business. The
businesses are considered separate and distinct if books and records
are maintained for each business. If you use the accounting methods
to create or shift profits or losses between the businesses (for
example, through inventory adjustments, sales, purchases, or
expenses) so that income is not clearly reflected, the businesses
will not be considered separate and distinct.
As stated previously, you choose your method of
accounting when you file your first tax return. Because there are
advantages and disadvantages to each of the accounting methods, it
is important that you make the right decision. If you need
assistance in determining the best accounting method for your
business, please do not hesitate to call. |
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