What method of accounting do you use for your business bookkeeping? If possible, keep your bookkeeping simple and just use the cash method (I list below the few situations where the IRS does not allow the cash method).
When it comes to bookkeeping, there are primarily three accounting methods – (1) the cash method, (2) the accrual method, and (3) a hybrid method. According to a survey of small business owners: **
- 41% use the simple cash method of accounting,
- 19% use the accrual method,
- 12% use a hybrid method, and
- 28% did not know what method of accounting was being used, probably because they trust an accountant for their small business accounting.
Each method has its own advantages and disadvantages.
The cash basis accounting method is the easiest method to understand and administer. After all, it is the method we all use for our personal finances. Therefore we are most familiar with this method. The cash method basically traces the flow of cash through the business. When I receive cash, I record income. When I pay a bill, I record an expense. At the end of the month I look to see if I have more cash than when I started the month. If I do, that means I had a good month – income exceeded expenses; I made a profit. For the small business owner, cash flow is critical, and that’s exactly what the cash method of bookkeeping tracks best.
Admittedly, the accrual accounting measures net earnings more accurately than the cash method. However, the accrual method of accounting is far more complex. It attempts to record income when it is earned rather than when it is received, and expenses when they are incurred rather than when they are paid. This tends to match income and expenses better. Many small business owners who choose this method have to rely on expensive accounting professionals.
Hybrid accounting methods of accounting combine two or more accounting methods. Because tax rules generally require inventories to be accounted for on the accrual method, some businesses use the accrual method to account for inventories, while incorporating the cash method for everything else. Manufacturers, wholesalers, retailers and mining operations usually are excluded from using the cash method due to the rules about inventory.
When the IRS says “no” …
The IRS also imposes certain size limitations on the use of the cash method. Generally, to be able to use simple bookkeeping, your business must fit one of the following three categories:
- Taxpayers with average annual gross receipts of $1 million or less, even if they carry inventories,
- C corporations (and partnerships that have a C corporation partner) with average annual gross receipts of $5 million or less and do not carry inventories, or
- Service industry taxpayers (that do not fall into category 2) with average annual gross receipts of $10 million or less, even if they carry incidental inventories.
Average annual gross receipts are based on the immediately preceding three-year period.
If your small business is not limited to the IRS requirements, why not choose the simple bookkeeping method that is easiest and least expensive to employ? The cash method of accounting. Patriot Software offers a simple cash basis accounting software for small business. Try it free for 30 days.
**Survey conducted by the National Federation of Independent Business in 2006 and submitted to the House Ways and Means committee.