Accounting Method-Cash vs. Accrual

You have established a legal entity and are ready to start your active trade or business. Before you take the leap and actually start business you need to choose an accounting method. The most commonly used accounting methods are cash and accrual. The major difference between the two methods relates to when income and expense is actually recognized.

Under the cash method of accounting income and expense is generally not recognized until cash or other assets actually change hands. If you receive an invoice from a merchant on 12/14/2009 but do not pay the bill until 1/5/2010 the expense is deductible on the entity’s 2010 income tax return. Recognition of income works the same way. If you bill a client on 12/14/2009 but do not receive payment until 1/5/2010 then you recognize the income on the entity’s 2010 income tax return. Remember that the day you receive a check is the day the IRS considers the payment to be received and not the day you actually cash the check.

Under the accrual method of accounting income and expense is generally recognized in the year the income or expense is incurred. If you receive and invoice from a merchant on 12/14/2009 you are able to deduct the expense on the 2009 income tax return even if the bill is not paid until 1/5/2010. If you bill a client on 12/14/2009 you need to recognize the income on the 2009 income tax return even if you do not receive payment until 1/5/2010.

For more information on this subject read the IRS article at IRS.GOV