Most of us think of income and expenses in terms of cash received or spent. However, the IRS requires most businesses which use inventories to use accrual accounting - where cash is almost irrelevant. We're introducing the two major accounting methods to you because each can greatly affect your quarterly and annual taxes!
Cash method: for businesses without inventories
The cash accounting method operates almost like your checking account. Record income when you are paid by your customers and record your expenses as you pay your bills. You have a profit when you have cash at the end of the month.
One major difference between the cash accounting system and your checking account is that you have to spread out capital expenditures over several years. Thus, your cash accounting records may show you have $15,000 profit, but your actual checking account may be $0 because you spent a lot of money on capital expenditures (equipment) which can only be expensed over several years.
There is no way to get around this since the accrual system treats capital expenditures the same way. Note: The IRS has a schedule showing the number of years equipment and other capital goods must be written off.
Accrual method...required for businesses with inventory
The accrual system doesn't care when cash was paid or received. It tries to track when obligations were made to pay or receive money. It also tries to match inventory expenses with the income it generates. For tax purposes, there are three basic things to remember:
Unless you're a bookkeeping pro, you'll probably need to hire a CPA, bookkeeper or tax advisor. However, we also suggest that you learn something about accounting, so you will know what their numbers mean. Talk to your tax advisor, read a simple accounting book and/or take a community college class on business accounting.