Debits and credits present and accounted for. 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.
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 2003, and they arrive in December. You send a check to pay for them in January 2004. Under the cash method, that business expense deduction should be claimed on your 2004 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 IRS Publication 538, "Accounting Periods and Methods."
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 2003 tax return, the year you ordered the supplies, and they were delivered. You sent a check to pay them in January 2004. You can deduct the expenses in 2003, 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."
Information courtesy of the Internal Revenue Service.