When it comes to keeping track of a company’s revenue and expenses, there are two methods you can use: the cash method and the accrual method. In most cases, you’ll have the freedom to pick which method you will use for your business. Each has its advantages and disadvantages, so you should be sure you are using the method that best fits your company’s needs.
The cash method The cash method is the more commonly used method of the two for small business accounting purposes. Using this strategy, you do not count income until a cash or a check has been received and you do not count expenses until they have actually been paid out.
For example, imagine you are hired to do a job, but know you will not get paid in full until a month after the job is complete. Under the cash method, you would not record that payment until the day you receive the cash, whereas under the accrual method, you would record the income as soon as you send the invoice.
Using the cash method you would include all income items you have actually or constructively received over the course of the tax year in your gross income. This includes any property or services you receive, including their fair market value as part of your income for the year.
The accrual method With the accrual method, you count transactions as soon as your company receives an order, delivers an item or performs services—regardless of when the money actually changes hands. It might not always be easy to determine when the purchase or sale occurred. The best strategy is to use the date on which the job was completed. You should wait and record income until you have finished a service or delivered all goods, and then wait to record expenses until the service is completed, as well. You must use the accrual method if either of the following apply to your business:
Your business has sales in excess of $5 million per year
Your business has an inventory of items sold to the general public and has gross receipts of more than $1 million each year
Using the accrual method, you would record in your gross income any amount of money owed to you during the tax year, so long as you can calculate that amount to a reasonable degree of accuracy.
The method you choose for your business accounting may also affect the tax deductions you claim in a given year. For example, if you complete a job in December, but do not get paid for that work until January of the following year, then you would not claim that income on your tax return if you are using the cash method.
Consider all this information as you decide which accounting method is best for your small business. You may also consult a financial advisor to learn more about your options.