Reporting Business Income and Expenses: Which Accounting Method is Right for You?

  by Caron Beesley, Moderator

I have addressed some key tax consolidations that small business owners and employers need to be aware of as we head into tax season, including the specific tax requirements that impact employers this time of year as well as changes to tax law that can benefit all businesses during the 2010 tax filing season.

While these considerations are very important, especially if you are new to business ownership, is also important you establish and follow clear accounting methods and periods to ensure you are accurately reporting all income and expenses for the tax year tha-s just passed.

Whether you follow a calendar year, a fiscal year or a short tax year, each tax payer is required by the IRS to use a consistent accounting method (i.e. how your compan-s transactions are recorded in your financial records), but how do you determine wha's right for your small business?
Below are some tips for choosing an accounting method and tax year for your business.

Choosing an Accounting Method

The two most commonly used accounting methods are cash and accrual. They key difference relates to how you account for how money goes in and out of your business.

1. Cash Method: This is a popular choice for small businesses because of its simplicity. Using this method your gross income is not counted until payment is actually received. Likewise, expenses are not counted until they are paid. For example, if a painter completes a project in November 2010, but does't get paid until January 2011, under the cash method you would report this income in January, whereas if you used the accrual method you would report it in November.

For expenses, the same model applies.
The cash method is ideally suited to sole proprietors, freelancers and smaller un-incorporated businesses that have less complex finances and do't wish to hire or outsource their accounting processes to a specialist.

Advantages/Disadvantages: While the cash method gives a solid view of cash flow, the downside of is that it does't give a true picture of profitability or trending. For instance, you may have had a really busy August, but because you did't get paid until September or October, those months are artificially skewed as peak months.

2. Accrual Method: With this method, income transactions are reported in the year that services were performed or all products were delivered, regardless of when the income was received or you get paid. As a rule of thumb, the job completion date should be your guide for recording the income in your books. Expenses are counted as transactions when you receive the goods or services (when you became liable for the expense) - regardless of whether you paid for them in that tax year or not and can be deducted as business expenses on your 2010 tax return, even if you didn't pay for them until January 2011.

Advantages/Disadvantages: The advantages and disadvantages of accrual accounting methods, basically flip are essentially the same as the cash method, but flipped. So, while the accrual method gives you a solid view of income and outgoings, it can make cash flow trickier to assess. Because although your books may show significant booked income, there's a possibility you may not have received that cash in hand yet.

What the IRS Says about Accounting Methods

The IRS offers more information on business accounting methods online in Publication 538 Accounting Methods and Periods. But as a general rule it's good to be aware of these basics when it comes to choosing your accounting method:

• You must choose an accounting method when you file your first tax return. To change the method down the line requires approval from the IRS.
• No single accounting method is required. You must use a system that clearly reflects your income and expenses, and back it up with good record-keeping.
• Use the same accounting method from year to year.

Choosing a Tax Year

Your tax year determines what specific period of time you report your income and expenses - it's also known as your fiscal or accounting year.
Again you have two choices:

1. Calendar Year - Running from January 1 to December 31, the calendar year is adopted by most small businesses as their tax year simply because it is easy and intuitive (corporations are the only business type who cannot use this method).

2. Fiscal Year - A fiscal year runs for 12 consecutive months ending on the last day of any month except December 31.

As with accounting methods, consistency is required, you must use your chosen tax year method for your first business tax return and for all subsequent future returns. If you need to change your tax year, you will need to file Form 1128, Application to Adopt, Change, or Retain a Tax Year, searchable on http://www.irs.gov./