If you decide to keep your own books, or even if you hire an
accountant, you should know a few things about accounting methods. An
accounting method is simply a set of rules used to determine when and how
you report your income and expenses. You choose your method of accounting
when you file your first tax return. The two most commonly used accounting
methods are the cash method and accrual method.
Cash Method
This is the accounting method used by individuals and many small
businesses. Due to its simplicity, it may be appropriate for your small
business. Determining gross income with the cash method is merely a matter
of adding up the cash, checks, and fair market value of property and
services you receive during the year. Using this method, your income for
the year includes all checks you receive, regardless of when you cash the
checks or withdraw the money. You cannot avoid paying tax by not
depositing checks or credit card charge slips.
Using the cash method, your business
expenses are usually deducted in the year you pay them. For example, you
order some office supplies from a mail order catalog in November 2004, and
they arrive in December. You send a check to pay for them in January 2005.
Under the cash method, that business expense deduction should be claimed
on your 2005 tax return because that is the year you pay for the supplies.
Certain businesses cannot use the cash
method. In addition, special rules apply for the accounting of inventory.
See
IRS Publication 538, "Accounting Periods
and Methods."
Accrual Method
This method of accounting is more precise than the cash method. Its main
purpose is to match income and expenses in the correct year.
Under the accrual method, income is
reported in the year in which all events that fix your right to receive it
have occurred, and you can determine the amount with reasonable accuracy,
even if you received the income in a different year. For example, the
accrual method calls for you to report income for the year when you
perform a service for a customer. It doesn t matter that your customer
doesn t pay you until the following year.
Similarly, you generally deduct your
business expenses in the year you become liable for them, regardless of
when you actually paid them. Let's look at the office supply example
again. Under the accrual method, you can deduct the business expenses for
supplies on your 2004 tax return, the year you ordered the supplies, and
they were delivered. You sent a check to pay them in January 2005. You can
deduct the expenses in 2004, because that is when you became liable for
the expense.
Once you decide which accounting method is
the right one for your business, you must follow it consistently.
Generally you cannot change your method of accounting unless you get
special permission from the IRS to change.
See
IRS Publication 538, "Accounting Periods
and Methods."
