When starting a business, you have to determine the method you are
going to use for accounting and paying taxes. The two choices are the
cash method and the accrual method.
Cash Method
If you are looking for simplicity, the cash method is probably your
best accounting choice. Generally, income and deductions can be claimed
when payment is actually received or made. This is best shown with an
example.
I open a small business and have to order business cards and
stationary. I receive the products and pay the invoice on November 18,
2005. Under the cash method, I can deduct the cost on my 2005 tax
return.
Some businesses are restricted from using the cash method. C
corporations may only use the cash method if they have less than $5
million in gross revenues for a particular year. Professional Service
Corporations can use the cash method without limit, while farming
corporations can due so if gross revenues are less than $25 million.
Tax shelters are prohibited from using the cash method.
Accrual Method
The Accrual Method of accounting is a bit more complex. Under this
method, the focus in on the date the expense is incurred, not paid.
Although this may seem a small difference, it can play havoc with your
books and piece of mind.
Using our previous example, assume I order business cards and
stationary on the December 18, 2005. I receive the products on December
30th, but don’t pay the invoice until January 20, 2006. When can the
expense be claimed? It depends on when economic performance occurred.
Generally, economic performance occurs when goods or services are
provided to you. In the above example, economic performance would
arguably occur when the business cards and stationary were delivered
with the invoice on December 30th. Thus, I would be able to deduct the
expense for the 2005 tax year.
In Closing
As you can see, the cash method is the easier of the two accounting
methods. To determine the best method for your business, speak with a
tax professional.
