Contractor Accounting: Cash Accounting vs Accrual
Thursday, September 13, 2007
This is an ongoing series called Contractor Accounting 101:If you haven't done so, you'll need to decide whether your business will track accounting on a cash basis or an accrual basis. But those are annoying technical terms. What it means is how will you report expenses and income to the IRS? It's important because the tax man wants you to be consistent with this on a year to year basis. If you choose Cash or Accrual for one year, you'll have to do every year.
What is Cash Accounting?
This may sound simple, but cash accounting means that you count the income when you receive a payment. Or you count the expense when you make a purchase. You only record a transaction once everything is completed and nothing else is outstanding. Remeber that transactions are normal business activities - buying a tool, depositing a check, sending out an invoice, etc.
What is Accrual Accounting?
This method can be more complicated. In accrual accounting, you're counting income at the same time you send out your bill to a customer. Even though the customer might not send you a check for 21 days, you're counting the money immediately. It's the same for any expenses you have. If you owe money for a purchase (accounts payable) and you won't be paying until next month, you still count that expense immediately.
You can see where these methods might cause confusion or problems. Which is best? Cash accounting is similar to balancing your checkbook. Money in and money out. It's the best for any business that doesn't have problems collecting payments.
Accrual accounting is like using a credit card instead of a check to buy something. Even if you buy with a credit card, and you instantly write out a check and make your payment, you're still using accrual. With accrual, it is easier to match your income to your expenses because they are counted instantly. It makes you more accountable and helps you track exactly how profitable your company is. It's more expensive and time consuming to use accrual accounting, but you'll know exactly how well your company is doing and might prevent problems down the road.
RELATED POSTS:
Contractor Accounting 101 - Introduction
The Accounting Equation
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