There are two basic accounting methods available to most small businesses: cash or accrual.
Cash method. If you use the cash method of accounting, you record income only when you receive cash from your customers. You record an expense only when you write the check to the vendor. Most individuals use the cash method for their personal finances because it's simpler and less time-consuming. However, this method can distort your income and expenses, especially if you extend credit to your customers, if you buy on credit from your suppliers, or you keep an inventory of the products you sell.
Accrual method. With the accrual method, you record income when the sale occurs, whether it be the delivery of a product or the rendering of a service on your part, regardless of when you get paid. You record an expense when you receive goods or services, even though you may not pay for them until later. The accrual method gives you a more accurate picture of your financial situation than the cash method. This is because you record income on the books when it is truly earned, and you record expenses when they are incurred. Income earned in one period is accurately matched against the expenses that correspond to that period, so you get a better picture of your net profits for each period.
Pros and cons. The cash method is easier to maintain because you don't record income until you receive the cash, and you don't record an expense until the cash is paid. With the accrual method, you will typically record more transactions. For example, if you make a sale on account (or, on credit), you would record the transaction at the time of the sale, with an entry to the receivables account. Then, when the customer pays their bill, you will record the receipt on account as another transaction. With the cash method, the only transaction that is recorded is when the customer pays the bill. If you are using computer software to do your accounting, this is probably not a big concern, since the computer program automates much of the extra effort required by the accrual method.
Another issue to be considered is the accounting method you use for tax purposes. For convenience, you probably want to use the same method for your internal reporting that you use for tax purposes. However, the IRS permits you to use a different method for tax purposes. Some businesses can use the cash method for tax purposes. If you maintain an inventory, you will have to use the accrual method, at least for sales and purchases of inventory for resale.
We recommend the accrual method for all businesses, even if the IRS permits
the cash method, because accrual gives you a clearer picture of the financial
status of your business. You probably need to keep a record of accounts
receivable and accounts
payable anyway, so you are already keeping track of all the information
needed to do your books on the accrual basis. If you are using a computer
program, there really isn't much extra effort involved in using the accrual