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Accrual and Cash Basis accounting

Most businesses that have sales of less than $5 million per year are free to choose which accounting method to adopt. But if your business stocks an inventory of items that you will sell to the public, the IRS requires you to use the accrual accounting method. Inventory includes any merchandise you sell as well as supplies that will physically become part of an item intended for sale.

Whichever method you select, it's important to realize that either one gives you only a partial picture of the financial condition of your business.

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The explanation: The main difference between accrual and cash basis accounting is the timing of when revenue and expenses are recognized. The cash method is most used by small businesses. The cash method accounts for revenue only when the money is received and for expenses only when the money is actually paid out. Cash receipt or payment can be in the form of cash, check, credit card, electronic transfer, or other means used to pay for an item.

The courts have ruled that credit cards balances are considered debt. It's treated the same way as if you went to the bank, got a loan, and used cash or a check to purchase the items. On your accounting books, you would debit the expense account and credit the credit card liability account.Under IRS rules, even if you are using cash basis accounting, you are allowed to take deductions for business credit card purchases before you've paid the credit card bill. However if you use a store charge card, then you cannot deduct it until you pay. Those are considered accounts payable.

Cash-basis accounting does a good job of tracking cash flow, but it does a poor job of matching revenues earned with money paid out for expenses. This deficiency is a problem particularly when, as it often happens, a company buys products in one month and sells those products in the next month.

On the other hand, the accrual method accounts for revenue when it is earned and expenses goods and services when they are incurred. With accrual accounting, you record all transactions in the books when they occur, even if no cash changes hands. For example, if you sell on store credit, you record the transaction immediately and enter it into an Accounts Receivable account until you receive payment. Accrual accounting is the most common method used by businesses.

The accrual method of accounting is the preferred method because it provides:

  1. a more complete reporting of the company's assets, liabilities, and stockholders' equity at the end of an accounting period, and
  2. a more realistic reporting of a company's revenues, expenses, and net income for a specific time interval such as a month, quarter or year.

With some transactions, it's not so easy to know when the sale or purchase has occurred. The key date here is the job completion date. Not until you finish a service or deliver all the goods a contract calls for can do you put the income down in your books. If a job is mostly completed but will take another 30 days to add minor changes to the actual job, technically it doesn't go on your books until the 30 days have passed. The key date here is the job completion date.

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