The Cash or Accrual Method of Accounting for Small Home Businesses
Small-business owners should understand the difference between cash and accrual methods of accounting. The simpler cash basis comes with some limitations; the more complicated accrual method allows greater flexibility for businesses with long operating cycles and gives them room to grow. The IRS lets small-business owners choose their method.
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Cash Basis
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Cash basis accounting recognizes income and expenses when cash changes hands. For example, under cash basis accounting, a business recognizes the expense of a new computer at the time of payment, not shipment. On the income side, a company recognizes income when customers pay, not necessarily when the service is performed.
Accrual Basis - Expenses
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With accrual accounting, the situation becomes a little more complicated. A business recognizes expenses when they're incurred, not when payment takes place. For example, a company places a computer order on December 31. The computer leaves the factory on January 1 and arrives on January 3. According to generally accepted accounting principles, the company should incur the expenses in January, though whether on January 1 or January 3 depends on the transfer of legal title, which usually depends on which party paid for shipping.
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Accrual Basis - Income
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A business recognizes revenue under the accrual basis when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered; the seller's price to the buyer is fixed or determinable; and collection is reasonably assured. Generally, this means that once services are provided, there is a contract or agreement, the price is no longer being negotiated, and the company can collect, then recognize revenue. All of these criteria must be met or, under the accrual method, income cannot be recognized, even if cash changed hands.
Considerations
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If your small home business will remain a small home business, then the simplicity of cash basis accounting should be attractive. However, if you extend credit to customers and have a long accounting cycle -- long periods of time between incurring an expense or producing revenue compared with the time that the actual cash changes hands, then the accrual method makes a better choice. Also, if you plan to obtain financing, eventually sell the business, or otherwise expand, then accrual is a good option. The IRS will not allow you to change mid-year.
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