The two most common accounting methods available to businesses are the cash and accrual methods. Small businesses typically prefer to use the cash method if it is an available option to them. The cash method is preferred due to the simplicity of record keeping and because it allows the company to defer the taxation of their income until they actually receive payment. On the other hand, the accrual method attempts to match the income to the year when it is actually earned, regardless of when payment is received.
That being said, there are various limitations on what companies are permitted to use the cash method. These limitations can be due to industry type, entity structure, and/or revenue volume. For example, manufacturing companies with average revenue in excess of $1 million are not permitted to use the cash method, regardless of entity structure. On the other hand, a C-corporation with average revenue in excess of $5 million is not permitted to use the cash method, regardless of industry type.
Under the cash method of accounting, income is recognized when payment has been actually or constructively received. Expenses are deductible when the amount is actually paid. Under the Accrual method, income is recognized once the “all events test” has been met. The all events test is met when all events have occurred which establish the right to a payment or the fact of a liability and the amount can be determined with reasonable accuracy. For expenses to be deductible, the expense needs to meet the all events test and “economic performance” must occur. Economic performance, generally, occurs when property or services are provided by the other party. There are many exceptions to these general rules for both the cash and accrual methods depending on the nature of a transaction. For example, a cash-basis taxpayer can deduct an amount accrued for a profit sharing contribution, provided it is paid by the due date of the return. On the other hand, an accrual method taxpayer must recognize prepaid rental income, despite the payment being for the use of the property in the following year.