When you start a business, you have many decisions to make. One is the method of accounting your business will use for reporting income and expenses on your tax return.
Two methods generally used are “cash” and “accrual”. The cash method is the easiest to implement. Under the cash method, you recognize income when you receive a payment from a customer. You take a deduction when you pay qualifying expenses.
If you choose the accrual method, you recognize income when you render services or sell your products. That is true even if you are not expecting to receive payment for several months. The money your customers owe you is your “accounts receivable.” One the expense side, if you buy something today and pay for it later, you deduct the cost now. What you owe for purchases you have made is your “accounts payable.”
The cash method more closely reflects your cash flow – how money is coming in and out of your business. The drawback is that your records may not help you track now much people owe you or how much debt your business owes.
The accrual method better reflects how your business is actually doing because you can match income and expenses in the proper period.
As a new business owner, you will want to consider the pros and cons of each method before you decide what works best for your business. The nature of your business may require that you use the accrual method. Keep in mind that if you want to change from one method of accounting to another later, you made need to get IRS approval. For assistance in making this and other decisions for your new business, please consult your tax professional.