There are a few more items that must be understood regarding financial recordkeeping. First is the method for recording the records. There are two basic methods for measuring transactions: the cash method and the accrual method.
Cash-method accounting is a system into which income is recorded when it is received and expenses are recorded when they are paid. With cash accounting, there is no effective method to accurately reflect inventory costs. Thus, Internal Revenue Service regulations require that the cash method of accounting may only be used by those few businesses that are solely service businesses and do not sell any materials to their customers at all, even a few spare parts. If a business sells any type of product or material whatsoever, it must use the accrual method of accounting. (An exception to this general rule is allowed for any corporation or partnership with annual gross receipts of under $5 million.)
The accrual method of accounting counts income and expenses when they are due to the business. Income is recorded when the business has a right to receive the income. In other words, accounts receivable (bills owed to the business) are considered as income that has already been received by the business. Expenses are considered and recorded when they are due, even if they are not yet paid. In other words, accounts payable (bills owed by the business) are considered expenses to the business when they are received, not when they are actually paid. The vast majority of businesses will wish to use the accrual method of accounting. A business must choose to keep its records either on the accrual basis or on the cash basis. Once this decision is made, approval from the IRS must be obtained before the method can be changed. After you select the type of accounting you will use, please consult a tax professional if a change in the system must be made.
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