There are two primary accounting methods used by businesses in recording and reporting financial transactions: cash-basis accounting and accrual-basis accounting. The difference between the two determines when income and expenses are recorded, which can have an effect on profit and loss, as well as income taxes.
Under the cash basis of accounting, transactions are recorded when cash is received or paid. In other words, revenue is recorded when cash payment is received for the sale of products or services, and expenses are recorded when cash is paid to vendors for purchases of products or services. Most small businesses and individuals operate on a cash basis and prepare their income taxes using this method.
Under the accrual method of accounting, rather than recording revenues and expenses when cash changes hands, revenues are recorded when earned and expenses are recorded when incurred. The IRS requires businesses that hold merchandise in inventory to use the accrual method. (An exception to this rule are businesses with an average annual gross receipts figure over the last three years of $1 million or less; these businesses are not required to use the accrual method.)
Examples of cash and accrual accounting
Say you are a maintenance company providing services to commercial customers for their heating and cooling systems. On October 15 you complete a job for a customer and issue an invoice for services rendered. On October 29 your customer issues a check, which you receive and deposit into the bank on October 31.
Under the cash basis of accounting method, you would recognize the revenue for this sale on October 29, when the cash is received. Under the accrual basis method, you would recognize the revenue for this sale on October 15, when you issued the invoice. You can see that when transactions occur during the same month or tax year, the difference between the two methods may not seem important. However, the impact is more evident around the end of the tax year because the method your business uses would determine which tax year you would record revenues and expenses.
The Combination Method
There is a third accounting method allowed by the IRS under certain circumstances — the Combination Method. This method, however, is typically not used because it is less clearly defined and more difficult to manage. Basically, the IRS allows for any combination of cash, accrual, and other methods of accounting if it illustrates a clear picture of your revenue and expenses and you apply the method consistently. As you can see, this definition is quite broad and allows for a great deal of interpretation, which can be problematic in the event of an audit. For most businesses owners, choosing either the cash or accrual method and applying it consistently is the best option.
How accounting software can help
When determining which accounting method to use, accounting programs can be helpful. Most accounting software allows you to set up your accounting system using either the cash or accrual method, and some even allow you to switch back and forth between methods when viewing reports. This can be helpful when analyzing how each method affects your profit, loss, and, ultimately, the tax effect.