Accounting is one of those aspects of running a small business that many owners dread. Even if you take the smart route and hire a professional to prepare your business taxes, you still need to keep track of your income and expenses on a regular basis. Doing so helps you to keep tabs on your company’s cash flow and financial health, and also makes tax time less of a headache. There are two basic business accounting methods: cash and accrual.
With the cash basis method of accounting, you record incoming payments as you receive them and outgoing payments as you send them off. It is a lot like balancing a checkbook. If you purchase a computer on a 90-days-same-as-cash plan and don’t make a payment until day 82, then day 82 is where the expense shows up in your books. If you invoice a customer on October 3, and they do not pay you until January 2, that income is recorded on January 2. You can see from these examples that using the cash basis method can affect in which tax year or quarter your transactions appear.
Accrual basis accounting is slightly more involved than cash basis because you do not record transactions as money changes hands. Instead, you record a debit or a credit on the transaction date, regardless of when funds are sent or received. For example, the above-mentioned computer purchase would be recorded on the day you receive the computer, even if you do not pay a cent until nearly three months later. Likewise, the customer who paid in January will have generated an income entry in your October books because that is when you sent the invoice.
Monitoring Cash Flow
When you use the cash method of accounting, it is easy to know how much cash you have on hand as long as you keep your books up-to-date. However, cash on hand can be deceiving because it does not necessarily show the big picture. For example, if you recently made a large purchase on credit, the accrual method would show the total purchase amount as already deducted from your company’s overall funds. With the cash method, the same purchase will not be recorded until you start paying the bill, giving you the false impression that your business has more spending money than it actually does. Although the cash method does make cash-on-hand calculations simpler, it can be quite misleading when it comes to representing the general health of your company’s finances.
Considerations Based on Business Type
The cash method is undoubtedly the simplest way of keeping accounts, especially for small businesses, and is permitted for businesses with annual sales of less than $5 million. However, the IRS requires that the accrual method be used for any type of inventory a company may carry. One exception to this requirement is a small business averaging $1 million or less in annual gross receipts for the current and two preceding tax years. For other possible exceptions, consult a tax professional or the IRS tax guide.
Hybrid Accounting Method
Some business owners decide to use the accrual method for any inventory they may carry and the cash method for everything else. This is known as the hybrid or combination accounting method. Whether you decide to do this or not will depend on your situation and the advice of your tax professional. However, anytime you use the accrual system for inventory accounting, remember to include finished products as well as any materials that will eventually become part of a finished product.
There may be advantages to using one accounting method over another, especially if you carry inventory or if you have complex paying and receiving processes. The system you choose will depend on your company’s structure and needs, but the money that flows in and out of your business will be the same, no matter how you record it.
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