Two Types of Business Accounting Methods
Although certain hybrid methods exist, the two primary types of business accounting methods are the cash accounting method and the accrual accounting method. The cash method is often used by sole proprietors or independent contractors. However, anyone, from the smallest business to the largest corporation, can use the accrual method. Once you choose an accounting method, you typically must continue to use the same method every year unless you receive permission from the Internal Revenue Service to change methods.
If you purchase or manufacture goods that produce income for your business, you may not be able to use the cash method of accounting. You can choose to use the accrual method for all of your accounting, but you also can choose a hybrid method of accounting. Under the hybrid method, you use the accrual system for sales and inventory purchases. You can then use the cash method to account for other revenue, such as interest income, and overhead expenses, such as utilities. As a small business, however, you might be eligible for an exemption that allows you to use the cash method even if you have an inventory. If your three-year average gross receipts are between $1 and $10 million annually for every year since and including the year ending Dec. 31, 2000, you might be eligible for the exemption. If you do not operate your business as a tax shelter, and if your three-year average gross receipts are less than $1 million for every year since and including 1998, you might also be eligible.
Cash Accounting Basics
With the cash method accounting system, you report income at the time you receive it and expenses when you actually make payment for the bill. The IRS considers income received when you have unrestricted access to the payment. Therefore, you cannot delay depositing checks you receive to move income from one tax year to the next. Once the check is in your possession, you must include it as income for the year even if you cannot deposit it. For example, if you receive a check late in the day on Dec. 31, 2012, but cannot deposit it until Jan. 2, 2013, include the payment in your 2012 income.
Accrual Accounting Basics
The accrual method of accounting allows you to match revenue with the expenses incurred to generate the revenue during the same accounting period. You recognize sales when they occur, not when you receive the money. You recognize expenses when you incur the liability, not when you pay the bill. Your accrual must be based on a reasonable expectation that payment will occur, and you must have the right to the revenue or the liability to pay the expense. In other words, the events must have already happened, and you must have a realistic estimate of what the financial impact will be.
Multiple Businesses and Personal Accounting
If you own more than one business, you might be able to choose a different system for each business. To qualify, each business must stand alone, with a separate, complete set of records and books. You cannot take advantage of the different methods to obscure the actual income earned by each. For example, you cannot transfer inventory or have one business pay expenses for the other. You are not required to use the same accounting method for personal expenses that you use for your business accounting.
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