There are two methods by which most accounting is done and by which income is reported to the IRS. There is the Cash method and the Accrual method.
These two things are basically the methods of business keeps track of its income and expenses. They have to do with the timeframe in which debits and credits are made. Which method a business uses is entirely up to them. However, it is important to understand how each one works.
The cash method is the common way in which small business tracks their debits and credits. With this method, income is not counted until cash is actually received, and expenses are not counted until they are actually paid.
The accrual method is income that is counted when the sale occurs. It is also the method by which expenses are counted when the goods or services are obtained. In this method, you don’t have to have money in hand or actually pay money out, to record a transaction.
Choosing a method
As stated, you are free to choose whichever method you want for your business, with some exceptions. NOLO.com states that the exceptions are as follows:
Most small businesses (with sales of less than $5 million per year) are free to adopt either accounting method. You must use the accrual method if:
- your business has sales of more than $5 million per year, or
- your business stocks an inventory of items that you will sell to the public and your gross receipts are over $1 million per year. Inventory includes any merchandise you sell, as well as supplies that will physically become part of an item intended for sale.
Cash: Pros and Cons
Pro: provides a more accurate picture of how much actual cash your business has and you can deduct expenses in the year they are paid instead of having to wait until the related revenue is earned and reportable.
Con: may offer a misleading picture of longer-term profitability. You also need to report revenue as soon as payment is received, which means you may end up paying tax on the gross amount if your deductible expenses aren’t reported until a future tax year.
Accrual: Pros & Cons
Pro: shows the fluctuation of business income and debts more accurately.ou can deduct expenses in the year you receive the underlying service or property and become liable for payment, even if you don’t actually make payment until a future tax year.
Con: Does not show accuracy in which cash reserves are available. In addition, you will have to report income in the year your customers have a legal obligation to make payment, not at the time of actual payment. Because of this, you may end up paying tax on money you didn’t receive during the tax year.
Again, most small businesses function well on the cash method. This is the easiest to track and manage. However, there was a recent article written by Forbes in the Entrepreneur section of its website that might interest those considering the accrual method. It discusses some little known tax advantages of this method. You can find that article here.
No matter what method chosen, it is important to be knowledgeable about the choices available. Both cash and accrual have their advantages and should be considered with care.