For tax purposes, you will need to determine an accounting method when you file your first tax return. The two accounting methods are cash accounting and accrual accounting. The methods are about timing of transactions and when a transaction is recorded.
In cash accounting, a transaction is recorded when money actually changes hands. Income is recorded when you receive the money; if you perform a service and bill a client for that service, you don't record the income until the client sends you a check. Expenses are recorded when you pay them; if you receive a bill on August 15 and you don't pay the bill until September 1, you don't record the expense until September 1.
In accrual accounting, the transaction is recorded when it is established. In the examples above, income to you is recorded when you send out the bill, even though you have not yet been paid. The expense is recorded when you receive the bill, even though you have not paid.
Setting Your Accounting Method
Most small companies use the cash method of accounting, because it is simpler and easier to determine when to record income and expenses. You must use the accrual method if
- your business has sales of more than $5 million per year, or
- your business stocks an inventory of items that you will sell to the public and your gross receipts are over $1 million per year.
End of Year Transactions
At the end of your fiscal year, cash and accrual accounting must be considered in the timing of transactions. Here is how:
- Income If you are on accrual accounting and you want income in the current year, send out bills before the end of the year. If you want to delay income, don't send out bills until after the start of the next year. For cash accounting, pay the bill in the year when you expect the lowest total income.
- Expenses Take on expenses in the year when you want those expenses to be counted, to minimize your taxes. You don't necessarily have to pay the bill in that year, if you are using accrual accounting.