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- iHaveNet.com: Small Business Guide
Small Business Money Matters
There are two methods of accounting used by small businesses -- cash and accrual.
The basic difference between the two accounting methods is the timing of income and expense recording. The best method for your company depends on a variety of factors which include the nature of your business, its legal business structure, and whether or not you extend credit.
You must choose between cash and accrual accounting and notify the IRS on your tax return which method you use.
What is cash basis method of accounting?
Most small businesses use the cash basis method of accounting, which is based on real-time cash flow.
In cash method, you report an expense when it is paid, and record income when it is received. So, the day you receive a check, it becomes a cash receipt. And you record your expenses when you pay your bills, not when the bill is received.
By the way, the word "cash" is not meant literally -- it also covers payments by check, credit card, barter, etc.
What is the accrual method of accounting?
With accrual accounting, you record income when it is earned, not when it is paid.
Similarly, you record your expenses when the obligation arises, not when you pay it. The tax code refers to this as recording income and expenses when they are "fixed" - when all the necessary events have occurred to receive the income or expense the liability. It is not necessary for cash to change hands.
Here's how accrual would work.
Say, for example, you're a consultant and you complete a job on December 15, but you haven't been paid for it. You recognize all expenses in relation to that contract when they were incurred, regardless of whether you've been paid yet or not. Both the income and expenses are recorded for the current tax year, even if payment is received and bills are paid the following February.
Who should use the accrual method?
Businesses are required to use the accrual method in several instances, including:
- if the business has inventory.
- if the business is a C corporation.
- if gross annual sales exceed $5 million (with certain exceptions for personal service companies, sole proprietorships, farming businesses, and a few others).
What are some examples of the differences between cash and accrual accounting?
In a number of instances, your bookkeeping method will have an impact on your taxes. Here are a few examples:
Accelerated expenses:
To accelerate expenses, accrual basis companies only need to record (not necessarily pay) every purchase and expense invoice by year-end. Cash basis companies must pay them off before the end of December.
Employee bonuses:
Cash method businesses can only deduct employee bonuses in the year they're paid. Accrual method businesses, on the other hand, can record the bonus in December, and pay the bonus over the next 2 1/2 months.
Can I change between cash and accrual methods in different tax years?
If you want to change your business' accounting methods, you may need to get permission from the IRS, which is concerned you might be seeking an unfair tax advantage.
To make the change, you would file IRS Form 3115 (Application for Change in Accounting Method). This form needs to be filed within 180 days before the end of the year for which you want to make the change.
You do not need permission if there is a "fundamental change" in your business - i.e. you move from a service business to one that carries inventory. You should seek the advice of your tax advisor to determine whether you need permission.
Small Business Guide
- Starting Up Your Business
- Coming Up With a Winning Business Idea
- Common Startup Mistakes
- The New Rules for Startups
- Business Incubator FAQs
- Naming Your Business
- Researching Your Business
- Your Personal Savings
- Registration, Licenses, and Permits
- Getting a Tax ID Number
- Fast-Growth Startup Resources
- Structuring Your Business
- Overview: Corporations
- State Offices of Incorporation
- Incorporate Out of State?
- Writing a Partnership Agreement
- Choosing a Board of Directors
- Basics of a C Corporation
- Basics of an S Corporation
- Basics of an LLC
- Basics of a Sole Proprietorship
- Basics of a Non-Profit Corporation
- Basics of a Professional Corporation
- Basics of a General Partnership
- Basics of a Limited Partnership
- Your Company's Public Relations
- Elements of a Successful Public Relations Campaign
- How to Use Your Press Coverage Effectively
- Press Releases
- How to Write a Successful Press Release
- Sample Product/Service Press Release
- Sample Commentary Press Release
- Sample Event Press Release
- Sample Tips Press Release
- Sample Personnel Press Release
- Effective Competitive Analysis
- Managing Purchasing to Maximize Cash Flow
- Top Six Pricing Mistakes Businesses Make
- How to Avoid Lowering Your Prices
- Bidding Basics
- Hiring Staff
- Creating an Effective Job Description
- Do You Know How to Pick Them?
- Little-Known Hiring Resources
- Classifying Contract Workers
- Tips for Successful Interviewing
- What You Can't Ask in a Job Interview
- New Hire Paperwork
- Small Business Insurance
- Types of Insurance for Small Businesses
- Small Business Insurance FAQs
- Insurance Resources for Small Businesses
- Home Office Insurance: Myths & Realities
- Small Business Resources
- Government Resources for Small Business on the Web
- Resources for Women Entrepreneurs
- Fast-Growth Startup Resources
- Small Business Security Resources
- Taking Time Off
- Your Pre-Vacation Checklist
- How to Take a Vacation
- Learning to Delegate
- Getting Away When You Can't Get Away
- Preparing for Tax Season
- Year-End Planning Tax Savers
- 10 Ways to Pay Less in Tax
- 25 Common Business Deductions and Expenses
- Avoid These Common Errors and Audit Triggers
- Understanding the Home Office Deduction
- Corporate Income Taxes Primer
- Employment Taxes Primer
- Sales Tax Primer
- Sole Proprietorships and Partnerships Tax Primer
- How to Get a Filing Extension
- Year-End Reconciliation
- Getting the Most from Your Accountant
- Developing Accurate Financial Projections
- Cash Flow
- 10 Ways to Help Increase Your Cash Flow
- Cash vs Accrual Accounting
- Bookkeeping and Record Keeping Basics
- Quick Ways to Get Through a Cash Crunch
- Projecting Cash Flow
- Cash Flow Triage
- Getting Funding
- Cash Flow Through Factoring
- Small Business Investment Corporations (SBIC)
- Traditional Funding Sources
- Non-Traditional Funding Sources
- Your Company's Credit
- How to Read a Business Credit Report
- Credit Terms Glossary for Your Small Business
- How to Protect and Improve Your Business Credit Rating
- Give Your Business the Financing Edge
- Employee Compensation
- Employee Benefits
- Bonuses: How To Be Fair
- Workers' Compensation Q&A
- Keeping Workers' Compensation Costs Down
- Payroll Management Choices
- Key Elements of Payroll
- Working with a Payroll Service Provider
- How to Create a Business Plan
Small Business Money Matters - Cash vs Accrual Accounting Methods
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