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Accounting methods for small businesses

Written By: Martina James

All small business owners in the United States are required by the Internal Revenue Service (IRS) to choose an accounting method for their business when they file the first income tax return that includes Schedule C, Profit or Loss From Business. Once the choice of accounting method is set up, it can only be changed with approval of the IRS. An accounting method is a list of rules that dictate when and how income and expenses for a business are recorded. The cash accounting method and the accrual accounting method are two of the most popular choices for small businesses.

With the cash method, income and expenses are recorded when they are actually paid. That means that money only leaves or comes into the business account at the time of disbursement or receipt. For example, if a home improvement company installs a garage door for a customer on Dec. 30, 2014 but does not receive payment for the service until January 2, 2015 the income will be recorded for the 2015 tax year. The same rule applies to expenses. For example, if the same home improvement company writes a check for a recurring bill such as the phone bill on Dec. 30, 2014 but the amount of the check is not deducted from the business account until Jan. 3, 2015, this expense will also be recorded for the 2015 tax year.

With the accrual method, income and expenses are recorded when services are completed, not when payment is actually received or disbursed. For example, if the home improvement company from the earlier example installs a garage door for a customer on Dec. 30, 2014, it would record this income for the 2014 tax year, even if the customer did not pay until Jan. 2, 2015. Again, expenses are handled the same way. If the home improvement company writes a check for a phone bill on Dec. 30, 2014, it would record this expense for the 2014 tax year even if the amount of the check were not deducted from the business account until Jan. 3, 2015.

Most sole proprietors and small companies that are not incorporated chose to use the cash method simply because it is easier for them to keep records on their own without hiring an accounting firm. The cash method can only be used if no inventory is involved, which usually means a business provides services only. If a business is selling, purchasing or producing merchandise, an inventory must be kept and the accrual accounting method has to be used. However, there are exceptions to this rule. If a business produces $1 million or less in income in a year, the cash accounting method can be used regardless of the line of business they are in.

Both the cash and accrual accounting methods have pros and cons. There is no right or wrong accounting method. Which one a small business owner chooses or prefers for his company may depend on factors such as the size of the business or tax deductions. Small businesses often start out with the cash method and change to the accrual method after the business grows.