Each business must make a determination of which of the two accounting methods they choose to implement, the accrual method or cash method. The two methods require different processes and treatment for when and how income and business expenses are recorded on the company books. There is no “right” answer for every business and making a decision about which method is correct for your business largely depends upon your individual operation.
The cash method of accounting requires that you enter a record of payment by customers on the date it actually happens and you actually have the money in hand. The same is true for recording expenses under this method as you enter a record of cost at the time you actually write the check or submit payment. Some people refer to this method as the “simple accounting method” as it is very similar to how most of us keep track of our money in our checking accounts. This makes it somewhat second nature for most people and a logical approach that is easy to understand.
The big issue with the cash method is it can be difficult to accurately account for situations when you extend credit to customers. If you extend credit on one day and receive payment several weeks later, then it can leave one wondering exactly how to enter that into the books using the cash method. Additionally, if a group of payments are delayed and then all arrive at one time then it can make it difficult to see an accurate picture of revenue trends for a business.
If a business decides to use the accrual method then they will make entries on the company books not when a transaction actually takes place, but when it is due or scheduled. For example, if you sell five barrels for ten dollars each on January 5 but will not receive payment until January 15, then using the accrual method you would enter a $50 income as of January 5. The entry is recorded using the date of sale and not the date payment actually happens.
Many feel this is a more accurate way of viewing the overall financial picture of a business and it provides a more accurate view of real profits and losses. By keeping a separate record for accounts receivable and payable, it allows you to track cash flow and the current financial position of a business as well.
If your business has less than five million dollars in sales annually, then you are allowed to use either the cash or accrual method. However, the IRS requires businesses that keep an inventory to use the accrual method for the purposes of tracking inventory merchandise. Because of IRS rules trying to mix the two methods can become difficult but it is possible and some business choose that route.
The accrual method in some cases may be advantageous because it allows a business some choice in when they actually invoice customers. However, there are many factors to consider and most of the time the effects on your taxes are very dependent on how your individual business is set up.