Cash Method Versus Accrual Accounting

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What Is Cash Method Accounting?

Cash method accounting refers to recording an item of income or expense when it is paid. Cash method does not literally mean only receipt or use of actual dollars. It covers any kind of payment including checks, barter, and credit cards. Most businesses selling services use cash method accounting for income and expenses. Under cash method accounting one simply reports income in the year received and expense income in the year paid. Most small businesses and individuals use this method of accounting.

Are There any Income Tax Issues to Watch Out for with Cash Method Accounting?

There are a few special federal income tax rules to watch out for. One is the legal doctrine of "constructive receipt," which requires counting some items as income before you actually receive them. This means you have income, for tax purposes, as soon as it is available or credited to your account (even if you don't take it). On the other hand, you are not allowed to take a deduction in the current year for items paid for but not yet received. Taxpayers should be particularly aware of end of the year income and expenses.

What Is Accrual Method Accounting?

With accrual accounting, income is treated as received when it is earned, regardless of when it is actually received. On the other side, an expense is recorded at the time the obligation arose (not necessarily when it is paid). Corporations, manufacturers and particularly businesses with inventories of goods prefer to use this method

Are There any Income Tax Issues to Watch Out for with Cash Method Accounting?

Accrued income and expenses must meet what the IRS calls the "all events test" to become fixed. This means that all events required to secure a right to receive the income, or to cause a liability for the expense, must have happened. At that point in time the income or expense becomes fixed, whether or not any cash has changed hands.

Do I Need a Lawyer to Help Me with my Method of Accounting for Tax Purposes?

Especially if you are an inventory business, you should hire the services of an accountant and an attorney. The accountant can help you set up and maintain streamlined accounting and inventory systems. The attorney can help you choose the right accounting method, and help you make sure you are reporting your income properly. Additionally, should you fall into trouble with the tax authority an attorney is best suited to help you get out of trouble.

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Last Modified: 11-05-2010 03:33 PM PDT

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