Two forms of accounting are available to companies -- the cash basis and the accrual basis. Companies with sales of $5 million per year or more, and smaller companies with high levels of inventory, are required to use the accrual basis for tax purposes. If your company buys or sells on credit, which accounting method you use may have significant accounting and tax consequences.
Cash-basis accounting is how most people manage their personal finances. Using cash-basis accounting, you record income on the date that you actually receive it, regardless of when the transaction took place or when the money came due. Likewise, you record expenditures on the date that you actually spend the money, whether by cash or by check.
Accrual-basis accounting is based on the movement of money on paper -- the date that a financial obligation arises, not the date that money actually changes hands. If, for example, you sign a purchase contract on June 1 but don't pay for the item until July 15, you must record the expenditure on June 1. Likewise, if your customer purchases an item today and pays 90 days later, you record it as income today.
Pros and Cons
The main advantage of cash-basis accounting is that it keeps track of actual cash flow. Its main disadvantage is that it can misrepresent the health of your company -- even if business is in decline, it may look healthy on paper if it is receiving money today that was earned a year ago. The main advantage of accrual-basis accounting is that it presents a relatively accurate picture of your company's underlying financial health. If accrual-basis accounting makes it difficult to keep track of cash flow, you can use it for external purposes only (financial statements and tax returns, for example) and keep a separate set of books using cash-basis accounting.
Your company's income tax burden can vary according to the timing of its income and expenditures. If income recorded near the end of the tax year would put your company into a higher tax bracket, cash-basis accounting would allow you to bill a client late this year and allow him to pay early next year, thereby deferring the reportable income until next year. On the other hand, if a purchase recorded this year would allow you to write it off on this year's tax return, the accrual basis would allow you to buy now, pay later and take the deduction this year.
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