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Chapter 8. Taxes: Don't Get Caught Aslee... > Which Accounting Method Should You U...

Which Accounting Method Should You Use?

The IRS requires that a business use a consistent accounting method for keeping its books. By accounting method, the IRS is referring to a set of rules for deciding when and how to report income and expenses. The two most commonly used accounting methods are the cash method and the accrual method.

  • Cash Method— The cash method is used most by individuals and small businesses. All income is taxable in the year it is received and all expenses are deductible when paid. There are a few exceptions when the cash method cannot be used.

    You may not use the cash method if (a) you are a partnership that has a corporation as a partner or (b) you produce, purchase, or sell merchandise and keep an inventory. In the case of the latter, you will need to use the accrual method.

    For example, a small publisher could not use the cash method because he or she would have books in inventory.

  • Accrual Method— The reason for an accrual system of accounting is to match income and expenses in the current year. If your business has an inventory then you are required to use the accrual method of accounting. Taxes are paid on earned income even if you haven't received those payments. Expenses can be deducted as they occur, whether or not those expenses have been paid or not. In other words, your income is recorded when an invoice is sent out and expenses are recorded when the bill is received. With the accrual method, there are receivables, (e.g., the money that is owed to your business but not yet received), and payables, (e.g., the money you owe but have not yet paid). For instance, you created and sold holiday gift baskets during the holiday week of December 24 through 31. You use a calendar year accrual method of accounting. Although your customers pay in January of the new year, you would include the amount received as part of your last year's income.


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