When you start a business, you have many decisions to make. One of those is the method of accounting your business will use for reporting income and expenses on your tax return. It is an extremely important decision. With few exceptions, the method you choose can only be changed in the future with the IRS’s permission. The two methods generally used are the cash method and the accrual method. The cash method is probably the easiest for most people to understand and the easiest for small business owners to use. This method recognizes income when you receive a payment from a customer, and a deduction is taken when you pay cash or write out a check for a bill you have to pay.
The accrual method recognizes income when the services are rendered or the product is sold, despite the fact that you may not get paid for several months. You have “accounts receivable” in the form of money customers owe you. Expenses are handled the same way. If you buy something today, but don’t pay for it until later, maybe even next year, you would deduct the cost now. What you owe for purchases you’ve made constitutes your “accounts payable.”
The cash method is easier to understand and more closely reflects how money is coming in and out of the business. However, it doesn’t tell you how much people owe you or how much debt the business owes. The accrual method better reflects how the business is actually doing, but it is more complex and, for most business owners, more difficult to understand.
All new business owners should sit down with their accountants to discuss the pros and cons of each method and to decide what works best for their business. Many businesses are required by tax law to use the accrual method for tax reporting.