Has your business reached the point where you’re ready to hire your first employee or expand into new customer markets? If you’re currently using cash accounting to report business expenses and income, it may be time to revisit whether the accrual method of accounting will be more effective for your financial and tax reporting.
In accrual accounting, you record income when you complete a service or when goods are shipped and delivered. Although most small businesses, particularly sole proprietorships and partnerships, use the cash method, the IRS states, “If an inventory is necessary to account for your income, you must generally use an accrual method of accounting for sales and purchases.”
The inventories rule generally applies to businesses that gross receipts over $1 million per year. Certain organizations grossing sales over $5 million are also required to use accrual accounting to report business income and expenses.
If your business falls under these rules, or if you’re simply debating whether the accrual method is right for your business, read on for an overview on some of the benefits and drawbacks of accrual accounting.
How Accrual Accounting Works
Unlike cash accounting, where income is recorded when cash payments (these can also be credit-card receipts, checks or other forms of payment) are received from customers and expenses are recorded when cash is paid to vendors, accrual accounting focuses on when income is earned and expenses are incurred. Consequently, all transactions are recorded regardless of when cash exchanges hands.
For example, if you sell merchandise to a customer on store credit during the month of October, the accrual method dictates that you record the transaction immediately as an item in accounts receivable until you receive payment. Even if the customer doesn’t make a cash payment on the merchandise until December, the transaction should be recorded as income for the month of October.
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