Basic accounting rules and standard industry practices form the foundation of generally accepted accounting principles, or GAAP. The Financial Accounting Standards Board codifies these practices into more formal and detailed guidelines for business accountants. Generally accepted principles require the accrual method for both revenue and expenses. However, the Internal Revenue Service allows a choice of methods for some small businesses.
The accrual basis for revenues means that a business records income on the date it earns it. For example, if your business sells merchandise, you record the income when you make the sale; you don't wait to actually receive a check or electronic payment. If the transaction takes place over a period of time, normally your company records the fee only when it completes the service or delivers the final merchandise. In contrast, a company using the cash method of accounting records revenue when it actually receives the payment.
The accrual basis also requires a company to record or recognize expenses on the date it incurs them. For example, your company buys office equipment in December and pays for it the following January. You must record the expenditure in December according to the accrual method. On the other hand, if you use the cash method, you must record it in January. In this case, the choice of accounting method determines the year in which a business records an expense.
Advantages of GAAP
Generally accepted accounting principles help ensure that a company's books represent its true financial condition. Businesses that use the accrual method with generally accepted accounting standards have better transparency. Consistent methods require a business to account for revenues and expenses in the same way from year to year. Continuing adherence to these principles makes it more difficult for companies to conceal problems and hide income or expenses. In addition, investors can accurately compare the profitability different companies that use the same accrual method.
Internal Revenue Service
The Internal Revenue Service requires large companies and those that keep an inventory to use the accrual method of accounting. The method is important to the IRS because it can affect total taxes due each year by changing when income or expenses appear on tax returns. Many sole proprietors have the right to chose the cash or accrual method, and some can use a combination. However, a business must use the same method each year unless it applies to the IRS for permission to change.
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