When beginning a business, you need to determine the method you plan to use for accounting and paying your taxes. The two options are the cash method and the accrual method.
If you are looking for simplicity, the cash method is probably your best accounting choice. Generally, income and deductions can be claimed when payment is actually received or made. This is best shown with an example.
You opened a small business and have to order business cards and office supplies. You receive the products and pay the invoice on October 28, 2013. Under the cash method, I can deduct the cost on my 2013 tax return.
Some businesses are restricted from using the cash method. C corporations may only use the cash method if they have less than $5 million in gross revenues for a particular year. Professional Service Corporations can use the cash method without limit, while farming corporations can due so if gross revenues are less than $25 million. Tax shelters are prohibited from using the cash method.
The Accrual Method of accounting is a little more complex. Under this method, the focus in on the date the expense is incurred, not paid. Although this may seem a small difference, it can play havoc with your books and piece of mind.
Using the previous example, assume you order business cards and supplies on the December 28, 2013. I receive the products on December 30th, but don’t pay the invoice until January 20, 2014. When can the expense be claimed? It depends on when economic performance occurred.
Generally, economic performance occurs when goods or services are provided to you. In the above example, economic performance would arguably occur when the business cards and stationary were delivered with the invoice on December 30th. Thus, I would be able to deduct the expense for the 2014 tax year.
As you can see, the cash method is the easier of the two accounting methods. To determine the best method for your business, speak with your tax professional.