There are two forms of accounting used by businesses - cash and accrual. The basic difference between the two methods is the timing of income and expense recording. The best method for your company depends on a variety of factors that include the nature of your business, its legal business structure, and whether or not you extend credit.

You must choose between cash and accrual accounting and notify the IRS on your tax return which method you use.

The Cash Method

Most small (one or two-person) businesses use the cash basis method of accounting, which is based on real-time cash flow. In cash method, you report an expense when it is paid, and record income when it is received. So, the day you receive a check, it becomes a cash receipt. And you record your expenses when you pay your bills, not when the bill is received.

By the way, the word "cash" is not meant literally - it also covers payments by check, credit card, barter, etc.

The Accrual Method

With accrual accounting, you record income when it is earned, not when it is paid. Similarly, you record your expenses when the obligation arises, not when you pay it. The tax code refers to this as recording income and expenses when they are "fixed" - when all the necessary events have occurred to receive the income or expense the liability. It is not necessary for cash to change hands.

Example:

You're a consultant and you complete a job on December 15, but you haven't been paid for it. You recognize all expenses in relation to that contract when they were incurred, regardless of whether you've been paid yet or not. Both the income and expenses are recorded for the current tax year, even if payment is received and bills are paid the following February.

Who should use the Accrual Method

Businesses are required to use the accrual method in several instances, including:

• if the business has inventory.
• if the business is a C corporation.
• if gross annual sales exceed $5 million (with certain exceptions for personal service companies, sole proprietorships, farming businesses, and a few others).

Differences between cash and accrual accounting

In a number of instances, your bookkeeping method will have an impact on your taxes.

Examples:

• Accelerated expenses: To accelerate expenses, accrual basis companies only need to record (not necessarily pay) every purchase and expense invoice by year-end. Cash basis companies must pay them off before the end of December.
• Employee bonuses: Cash method businesses can only deduct employee bonuses in the year they're paid. Accrual method businesses, on the other hand, can record the bonus in December, and pay the bonus over the next 2 1/2 months.

Changing between cash and accrual methods in different tax years

If you want to change your business' accounting methods, you may need to get permission from the IRS, which is concerned you might be seeking an unfair tax advantage. To make the change, you would file IRS Form 3115, Application for Change in Accounting Method. This form needs to be filed within 180 days before the end of the year for which you want to make the change. You do not need permission if there is a "fundamental change" in your business - i.e. you move from a service business to one that carries inventory. You should seek the advice of your tax advisor to determine whether you need permission.