There are two accepted methods of accounting for federal tax purposes – Accrual and Cash. The main difference between these two methods is the timing of transactions. As a small business owner you need to be aware of the differences, the advantages and the disadvantages of each method before choosing one for your business.
Most small business owners are able to choose which method they want to use for their business for tax purposes. In some cases though, you have no choice but to you the accrual method. This is when:
1. Your sales are more than $5 million per year or
2. Your business stocks an inventory of items that you will sell to the public and your gross receipts are over $1 million per year
The cash method of accounting is the most commonly used method for small businesses. When using the cash method you do not recognize income until the cash is actually received. You also do not recognize expenes until the cash is actually paid out.
The accrual method of accounting is different from the cash method in that you recognize income when a sale occurs, even if you have not yet received the cash from it. You also count expenses when you receive the goods or services, even if you have not paid for them yet. With the accrual method you do not have to wait until you receive or pay money to show the income and expenses
The advantage of the accrual method is that it more accurately shows you a picture of how your business is doing because it shows the ebb and flow of income and debts. The disadvantage of the accrual method is that it can lead to cash flow problems because it does not always show you an accurate picture of cash on hand. You also have to keep accounts payable and accounts receivable records which leads to recording more transcations.
The advatages of the cash method are that it gives you a better picture of your current cash on hand and it is also easier to maintain when it comes to bookkeeping. The disadvantage is that it can give you a misleading picture of longer-term profitablity.
When you are a new business owner it is important to discuss with your tax preparer which method of account is best for you and your business. Accural vs. cash method of account can be an important decision that you must make when first starting your business.