Accounting for the Cash
,The first decision a small business owner must make before setting up an accounting system is whether to operate the business on a cash basis or accrual basis. Basically, these methods affect how you record your transactions as well as when you add transactions to your accounts.
DEFINITION
Cash-basis accounting is based on cash flow. You report expenses when you lay out the cash. You report income when cash is received. In addition to hard cash, income is counted as received when you get a check, credit card payment, or any other method common in your business. The same is true for expenses—whether you pay them by cash, check, credit card, or other method. Essentially, cash has changed hands when you control the money. Accrual accounting is based on when the transaction happens, regardless of whether cash changes hands. So income is counted when it is earned, and expenses are counted when goods or services are received, even if cash has not been exchanged.
To see how these two types of accounting systems work, suppose Tom has his own painting contracting business. He finishes a paint job on December 20, 2010, but he is not paid until January 3, 2011. How would he account for his income under the two accounting scenarios?
Under cash-basis accounting, Tom would not record the payment for the job until January 3, 2011, and therefore would not have to report the income on his 2010 taxes. He probably had expenses related to the job for which he paid cash. Those expenses would be written off in 2010.
If Tom used the accrual accounting method, he would record his payment when the job was completed in December 2010 and indicate in his records that a payment was due from the customer in accounts receivable. Tom would report both his income and expenses for the job in 2010.
DEFINITION
Accounts receivable is where a business records income due on sales or services that will be collected at a later date.
As you can see from this example, your choice of accounting method not only affects how you figure out your profit and losses for any given time period, but it can also affect when you pay taxes on income and report expenses. If all your transactions are paid in cash as soon as they are completed, including both your sales and any related purchases or expenses, then your books for both types of accounting will look the same.
In reality few businesses work totally on a cash basis. Even if you do get paid in cash upon completion of each job, you probably have expenses prior to the completion of that job. Also, you are likely to purchase equipment and supplies in your business that are used over a number of months or years or make major purchases on credit and pay for them later.
Many small businesses use what is called a modified cash-basis accounting method. These businesses record most transactions when cash is exchanged, but account for certain transactions, such as the purchase and use of equipment, over time using a method called depreciation.
DEFINITION
Depreciation reduces the value of an asset over a set number of years and records an expense for that asset as it depreciates.
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