When starting a business, you must determine your method for accounting and paying taxes. The two choices are the cash method and the accrual method.
Cash Method
The cash method is probably your best accounting choice if you want simplicity. Generally, income and deductions can be claimed when payment is received or made. This is best shown with an example.
I open a small business and have to order business cards and stationery. I received the products and paid 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 cash 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 is on the date the expense is incurred, not paid. Although this may seem slightly different, it can play havoc with your books and peace of mind.
Using our previous example, assume I ordered business cards and stationary on 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 could 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.