Choosing an Accounting Method
An accounting method is simply a way that determines how your income and expenses are calculated and reported. Every taxpayer is different, so it is recommended that you choose which accounting method best suits you and is the best representation of your income. There are two main methods: cash basis of accounting and accrual basis of accounting.
This accounting method records income when received and expenses when paid. Its key selling point is the simplicity of recording transactions, and it very intuitive to many business owners. Since money is only recorded when money comes in or out, taxpayers believe they have more room to manipulate the amount of taxes paid by recording expenses right away and putting off income until the next tax year, which lowers the amount of taxable income the company has. However, due to constructive receipt (income is considered in your possession when available for you to use), the IRS is trying to suppress taxpayer’s ability to manipulate their incomes.
Contrasting from the cash basis, the accrual basis records income when earned (i.e. when goods are delivered or services are done), and expenses when they come up as a result of the income earned or service performed. This way of accounting typically gives a better representation of net income earned for the year.
To paint a better picture of each accounting method, let see it in an example:
A contractor which does the work first and bills their customers later; say he does the work in 2007 and the bill is to be paid in 2008. Using the cash basis, he would record the expenses in 2007(materials, salaries, etc.) and the income would be recorded in 2008, since he didn’t receive money until then. With the accrual basis, it does not matter when the customer paid the bill; it only matters when the project was done. Both the expenses for the job and the income that is to be earned would be recorded in 2007, since the project was done in 2007. Even though he didn’t actually receive the money until 2008, he earned his income in 2007 by completing the project.
For small businesses with a small number of transactions, where the cash can immediately be paid right after the good is sold or service is done (example: a shoe shiner); it may be easier for them to keep track of things if they used the cash basis. For tax purposes, they usually require the cash basis, since they tax on tangible profits you made for the year. However, if your company is publicly traded on the stock market, a corporation with yearly sales exceeding $5 million, or if your company has any inventory, the accrual method is required. Businesses who offer credit to their customers would be better off using the accrual basis, since not only will it give a better representation of what income you earned that year (so you can know exactly how much your business is worth), but also you can keep better track of who still owes you money. Using the cash basis you will only know what money you received but you have no way of differentiating between who paid and who still needs to pay. To give you less of a headache, it would be better if you used the accrual basis.
Keep in mind that you must use the same accounting method year to year; you cannot change it just because you want to. If you require a change in accounting methods, you must apply and gain IRS approval first.
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Disclaimer:
The information on this page is not to be taken in place of the advice of a tax specialist. Please consult a qualified tax specialist for help making decisions involving your business.