There are two primary accounting methods – cash and accrual. The IRS would prefer that you use the accrual method because it generally accelerates taxes. But tax law allows you to use the cash method if your annual revenue is under $10 million.
The cash method is very simple. Revenue is recognized on the income statement when money is actually received (not when the product is shipped or service delivered) and expenses are recorded when bills are actually paid (not when the purchase order is issued or the bill is received).
The accrual method is more complex, but accounting software has eased the burden significantly. Revenue is recognized when it is earned (i.e., when the service and/or product is delivered). Expense is recognized when the liability is incurred (i.e., when the purchase order is issued). This method was developed to more accurately report the financial performance of a business. Generally, it does so, rendering more useful and informative financial statements. But for many businesses, the accrual method causes income to be recognized earlier than it would under the cash method. This can be particularly true in businesses that purchase large quantities of products in advance of customer purchases or payments such as retailers and contractors. This can cause income tax to become due before cash is actually received from sales. That’s not good for cash flow.
In sum, owners of businesses with revenues under $10 million not using the cash method should consider doing so. Talk to your accountant.
This article originally appeared in The Business Owner Journal, the periodical of choice for owners of small and midsize private businesses. All rights reserved, D.L. Perkins LLC. © 2012.
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