From the Nolo eCommerce Center
All businesses need to choose one of these methods of accounting: cash or accrual.

It’s important for you to understand the basics of the two principal methods of keeping track of a business’s income and expenses: cash method and accrual method (sometimes called cash basis and accrual basis). In a nutshell, these methods differ only in the timing of when transactions both sales and purchases are credited or debited to your accounts. If you use the cash method, income is counted when cash (or a check) is actually received and expenses are counted when actually paid. But under the more common accrual method, transactions are counted when they happen regardless of when the money is actually received or paid.

So with the accrual method, income is counted when the sale occurs, and expenses are counted when you receive goods or services you don’t have to wait until you see the money, or until you actually pay money out of your checking account. With some transactions, it’s not so easy to know when the sale or purchase has occurred. The key date here is the job completion date. Not until you finish a service or deliver all the goods a contract calls for can do you put the income down in your books. If a job is mostly completed but will take another 30 days to add the finishing touches, technically it doesn’t go on your books until the 30 days pass.

Say you purchase a new laser printer on credit in May and pay $1,000 for it in July, two months later. Using cash-method accounting you would record a $1,000 payment for the month of July, the month when the money is actually paid. But under the accrual method, the $1,000 payment would be recorded in May, when you take the laser printer and become obligated to pay for it. Similarly, if your computer installation business finishes a job on November 30, 2002, and doesn’t get paid until January 10, 2003, you’d record the payment in January 2003 if you use the cash method. Under the accrual method the income would be recorded in your books in November of 2002.

The most significant way your business is affected by the accounting method you choose involves the tax year in which income and particular expense items will be counted. For instance, if you incur expenses in the 2002 tax year but don’t pay them until the 2003 tax year, you won’t be able to claim them in 2002 if you use the cash method. But as you should now understand, you would be able to claim them if you use the accrual method, since the very essence of that system is to record transactions when they occur, not when money actually changes hands.

Example 1:

Zara runs a small flower shop called ZuZu’s Petals. On December 22, 2002, Zara buys a set of new lighting equipment for her shop for which she will be billed $400. She installs the lighting equipment that day, but according to the terms of the purchase doesn’t pay for it for 30 days. Under her accrual system of accounting, she counts the $400 expense during the December 2002 accounting period, even though she didn’t actually write the check until January of the next year. This means that Zara can deduct the $400 from her taxable income of 2002.

 

Example 2:

Scott and Lisa operate A Stitch in Hide, a leather repair shop. They’re hired to repair an antique leather couch, and they finish their job on December 15, 2002. They bill the customer for $750, which they receive on January 20, 2003. Since they use the accrual method of accounting, Scott and Lisa count the $750 income in December 2002, because that’s when they earned the money by finishing the job. This income must be reported in their 2002 tax return even though they don’t receive the money that year.

The cash and accrual methods can produce the same results.

As you can readily see, the results produced by the cash and accrual accounting methods will only be different if you do some transactions on credit. If all your transactions are paid in cash as soon as completed, including your sales and your purchases, then your ledgers will look the same, regardless of what method you use.

Tax Years and Accounting Periods

Income and expenses must be reported to the IRS for a specific period of time, called your tax year, your accounting period or your fiscal year. But unless there is a valid business reason to use a different period, or unless your business is a corporation, you’ll have to use the calendar year, beginning on January 1 and ending on December 31. Most business owners do use the calendar year for their tax year, simply because they find it easy and natural to use. If you do want to use a different period, you must request permission from the IRS by filing Form 8716, Election to Have a Tax Year Other Than a Required Tax Year. Also, your fiscal year can’t begin and end on just any day of the month; it must begin on the first day of a month and end on the last day of the month one year later.

Most businesses that have sales of less than $5 million per year are free to choose which accounting method to adopt. But if your business stocks an inventory of items that you will sell to the public, the IRS requires that the accrual accounting method be used. Inventory includes any merchandise you sell as well as supplies that will physically become part of an item intended for sale.

Whichever method you use, it’s important to realize that either one only gives you a partial picture of the financial status of your business. While the accrual method shows the ebb and flow of business income and debts more accurately, it may leave you in the dark as to what cash reserves are available which could result in a serious cash flow problem. For instance, your income ledger may show thousands of dollars in sales, while in reality your bank account is empty because your customers haven’t paid you yet.

And though the cash method will give you a truer idea of how much actual cash your business has, it may offer a misleading picture of longer-term profitability. Under the cash method, for instance, your books may show one month to be spectacularly profitable, when actually sales have been slow and, by coincidence, a lot of credit customers paid their bills in that month. To have a firm and true understanding of your business’s finances, you need more than just a collection of monthly totals; you need to understand what your numbers mean and how to use them to answer specific financial questions.

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