When you start a business, you have many decisions to make. One very important decision is the method of accounting your business will use for reporting income and expenses on your tax return. The two methods most commonly used are Cash and Accrual.
The cash method is the easiest to implement, and is also the most commonly used. Under the cash method of accounting, you recognize income when you receive a payment from a customer and you take a deduction when you pay qualifying expenses. If you perform services but do not receive the payment until the next tax year, that payment is not considered income until received in that next tax year.
The cash method closely reflects your cash flow — how money is coming in and out of your business. The drawback is that your records may not help you track how much people owe you or how much debt your business owes.
If you choose the accrual method, you recognize income when you render services or sell your products, even if you do not expect to receive payment for several months. The money your customers owe you is your “accounts receivable.” On the expense side, if you buy something today and pay for it later, you deduct the cost now. What you owe for purchases you’ve made is your “accounts payable.”
The accrual method better reflects how your business is actually doing because you can match income and expenses in the proper period.
As a new business owner, you will want to consider the pros and cons of each method before deciding which is best for your business. The nature of your business may require that you use the accrual method, though most small businesses with sales under $5 million per year can choose either method. Businesses with inventory would typically use the accrual method.
Once you commit to a method, if you later want to change to a different method, you may need to get approval from the IRS to do so. Speak with your accountant before deciding the method that will be best for your new business.[/fusion_builder_column][/fusion_builder_row][/fusion_builder_container]