When you first start your firm, you have to make a decision on how you will manage accounting and tax payments. There are two options: the cash approach and the accrual strategy.
The Cash Approach
If you like simplicity, the cash technique is perhaps the best accounting choice. Income and deductions are typically claimed at the time of payment. The best way to demonstrate this is with an example.
For my new little business, I need to order business cards and stationery. I pay the money and get the stuff on November 18, 2005. I can use the cash method to deduct the amount off my 2005 tax return.
Some businesses are not allowed to use the cash approach. Only when their gross revenues for a given year are less than $5 million can C corporations use the cash method. Professional service companies are allowed to use the cash method, although farming companies may only do so if their gross revenues are under $25 million. In tax shelters, the cash approach is prohibited.
The Method of Accrual
The Accrual Method of Accounting is a little more complex. This method places more emphasis on the date of expense incurred than the date of payment. Although this may not sound like much, it can significantly affect both your books and your mental health.
Using the previous example, let’s say that on December 18, 2005, I order business cards and stationery. Despite receiving the items on December 30, 2006, I don’t make the payment until January 20. When may I submit a claim for the expense? This depends on when economic performance occurs.
Receiving commodities or services is often when economic performance occurs. One could claim that in the aforementioned situation, economic performance took place on December 30th when the invoice was delivered together with the stationery and business cards. I was therefore able to deduct the expense for the 2005 tax year.
To sum up
As you can see, the cash method is the less complicated of the two accounting techniques. To determine the best course of action for your business, speak with a tax professional.