There are two methods of accounting: cash basis and accrual basis. These methods provide guidelines on how to record transactions and apply income tax. You can change which method you use after you open your business, but you will only be able to change it at the start of a new year. Now let’s get into what these two methods are.
Cash Basis Accounting
This is the simpler of the two methods. It’s similar to how you may keep track of your own finances. You account for cash when it’s received and expenses when they’re paid for.
For example, if you send out an invoice for a client project in July, but don’t receive payment until August, you record the revenue for August. This also applies to income tax and deductions. If you get billed in December 2020 but don’t pay until January 2021, the tax deduction applies to 2021.
Since your books are always updated to show the cash you have on hand, it gives you a good look at your day-to-day finances. However, this method doesn’t provide comprehensive information about income for a given period.
Accrual Basis Accounting
With accrual basis accounting, you record transactions when revenue is earned and expenses when they are incurred, using accounts payable and accounts receivable.
If we use the example from above, the invoice sent out in July will be accounted for in July, even if you received the money for it in August. Taxes work in a similar fashion. Bills received in December 2020 will be deducted from your 2020 taxes, regardless if you pay them in 2021. One consideration with taxes is that if you have unpaid invoices, you’re still responsible for paying taxes on that income.
Using this method provides you with a bigger picture of your income and expenses for a period of time. This gives you the opportunity to see which periods were busy and which ones were slower, allowing you to adjust how you do business.
What Method Should I Use for My Business?
If you're a corporation (excluding S-corps) that grosses more than $25 million in a tax year, then you are required to use the accrual basis method. Otherwise, it is your choice as to what method you want to use. Many small businesses without inventory use the cash basis method because it is easier. However, the accrual basis method helps you plan for the future since you get a better idea of cash flow for a given period.
The method that may be best for your business varies based on your business activities. If you’re trying to decide which is best for you, we recommend you speak with your accountant or bookkeeper. If you’re looking for a bookkeeper to help record your business transactions, our bookkeepers are happy to help! Please feel free to contact us or give us a call at (360) 756-5020.
For more information on accounting methods, check out the IRS Publication 538: Accounting Periods and Methods.