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:

1. When you receive or pay cash doesn't matter. Income is recorded when you sell or deliver the product (i.e. when the purchaser becomes obligated to pay for it). Expenses are recorded when you become obligated to pay (i.e. when you sign a contract or receive a product). The accrual system uses accounts receivable and accounts payable…the cash system does not.
• In November 2015, you sell a $400 television on credit. You deliver it in December, but it isn't paid for until February. You must record the $400 as 2015 income, even though you won't get the cash until the following year. Bottom line: If you have credit customers at the end of the year, this can mean higher taxes for you.
• You buy and receive $4,000 in supplies on credit in 2015, but don't pay for them until 2016. Since in 2015 you obligated yourself to pay for these supplies, it is a 2015 business deduction, even though you never spent cash until 2016! Bottom line: Buying on credit at the end of the year can lower your taxes.
2. You cannot deduct the cost of your inventory until you have sold the inventory (or products containing that inventory).
• You buy $40,000 in inventory in 2015. At the end of 2015, $39,500 of the same inventory remains. You can only deduct $500 as a 2015 business expense!
3. Capital expenses are treated the same way for cash and accrual accounting.

Additional Help

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.