It’s that time of year: Tax Time. Since I, too, have taxes on my mind, I thought I would spend the next few weeks blogging about some tax and bookkeeping related items that will help you and your new business get off to a good start.
Before you start operating your new business, you must elect a system of accounting and, once selected, you need to stick to that system. The IRS does not want to play catch up in figuring out how you’re keeping your books, and to keep it simple, there are only a handful of systems allowed. The two main systems are the cash method and the accrual method. In addition, the IRS permits a hybrid method of cash and accrual, and may permit other forms of accounting allowable under IRS code. But let’s stick with the main ones.
The cash method accounts for income and outflow in real time. Income is recognized when received by the business. Expenses are considered deductible when paid. So work invoiced or billed in one financial year (i.e. December) and paid in the next (January) is not taxable the year it was invoiced but rather in the year that the money was actually received (January). Expenses coming due in one financial year and paid in the next are considered deductions in the year they were actually paid, not the year they were invoiced. So by real time we mean that income is recognized when it is really received and expenses are recognized when they are really paid.
Under the accrual method, income is recognized when it’s earned, whether or not the funds are actually received. Similarly, expenses are deductible when incurred, whether or not it takes some time to actually pay them off. So a business with a calendar (December 31st) year-end which sends out invoices in December and is paid in January is still responsible for taxes on the amount invoiced for the calendar tax year that ended in December. Again, under the cash method, taxes on the invoiced amount wouldn’t be due until the invoiced amount was actually received. So accrual is not real time receipts but rather real time billed. I prefer the certainty of receiving cash over the hope of billing for it.
Most businesses elect the cash system of accounting unless inventory is a large part of the business. No matter which method is chosen, the IRS requires business owners to make a choice and, once that choice is made, you need the IRS’s permission to change it.