There are two basic ways to maintain your books and keep track of income and expenses: The cash method and the accrual method. ( It is possible to use both, choosing one for accounting and another for tax purposes, but most business do not − talk to your accountant before you make that decision. )
Most businesses with sales under $5 million a year can use either accounting method. Businesses with sales greater than $5 million a year , or businesses that maintain an inventory of supplies or finished goods with gross receipts over $1 million a year must use the accrual accounting method. In addition, all publicly-held companies must use the accrual method. ( There are a few other tests used in special circumstances; see your accountant for specifics. )
With those constraints in mind, which is the best method? The answer depends in part on the type of business you run; start-ups and small companies often use the cash basis method because it's simple and less time consuming, but most businesses operate using the accrual accounting method in order to maintain a clearer financial picture.
Let's look at both methods:
Think of it this way: You handle your personal finances using the cash method. When you write a check you enter the amount in your register; when you receive a paycheck you enter that amount. In a nutshell, that is cash basis accounting. It's simple, easy to understand, and lets you know exactly how much cash you have on hand.
Advantages and Disadvantages
A major negative with cash accounting is the risk of misunderstanding your company's true financial position. If you extend credit to customers, buy on credit from suppliers, or receive advance payment for services, using the cash method could cause you to assume your business is performing a lot better − or a lot worse − than is actually the case. For example, if you purchase $10,000 worth of materials on credit, a quick glance at your books may indicate you are in great shape… because the $10,000 will not "hit the system" until you pay for those materials.
The accrual method provides a more accurate picture of income and debt, but it can be misleading in terms of cash flow. For example, you may show major income for a certain period − since a number of sales have been booked − but until you actually receive payment for those sales, you do not have access to those funds. Many businesses face cash flow problems because they lose sight of the amount of funds actually on hand as opposed to shown on the books.
Determining the recording date under the cash method is simple: When you pay a bill, record the expense. When you receive payment, record the income.
How do you choose the date to record income or expense under the accrual method? It's easy:
The IRS allows most businesses to use the accrual method for accounting purposes and the cash method for income tax purposes. However, and this is a key point, once you choose a method to use for tax purposes, you must stick with that method − even if it would be to your advantage to switch to the accrual method for tax purposes. (You can request a change, but the IRS must approve that change.)
Let's use a theoretical purchase to illustrate the tax implications of both methods. Say you purchase new office furniture on December 15th ; and the total cost is $2,500. The furniture is delivered on the 22nd, but you are not required to pay the invoice for thirty days from receipt of goods.
Using the accrual method, you book the expense on December 22 nd , because that is when the furniture was physically received. As a result, the expense is shown on this year's taxes and you can show the deduction this year, even though you will not actually pay for the furniture until late-January next year.
Under the cash method, the expense is booked in January when you write a check to satisfy the invoice, and you cannot use the deduction against income on this year's taxes.
One last note: If you run an all-cash business − receiving cash for goods sold and paying for all goods and services upon receipt − your books will look the same regardless of which accounting method you use. Credit − either extended or received − will change the picture dramatically.