There are two basic forms of accounting that should be used to track your revenues and expenses – cash basis and accrual basis. Cash basis means that you recognize the income when you receive it and you recognize expenses when you actually pay them. Accrual basis means that you recognize income when you have the right to earn it and expenses at the point that you actually owe them. You don’t have to wait until you actually receive or pay out the cash.
For example, let’s use an event planner. You recognize income when you receive payment from the hostess and you recognize expenses when you pay them. With accrual basis, you recognize the income as soon as your services are done, when that project is over, when that event is a wrap. And you recognize expenses even if you have not made payment on it. So if you received rental equipment on account, at the time that you take it out the store you are obligated to pay the fee and must recognize the expense at that point in time. You didn’t charge them a card. But the vendor let you “borrow” the items.
Understanding the difference the two is key to managing your flow and for filing your taxes. With taxes, for cash basis you recognize income when you receive it and only when you receive it, so those clients who owe you money, you don’t have to pay taxes on them. But for the expenses, you can only deduct the ones you pay out the door. So using my previous example, you can’t deduct those expenses incurred on account because you have not yet paid them. If you are accrual basis, you could in fact deduct those expenses, but you will also have to recognize the revenue you had not received yet too.
Which method of accounting do you use for your business? Do you fully understand why? If not, consult with your tax accountant or CPA or bookkeeper to gain clarity and make sure you understand which one works best for your business.
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