What Accounting Basis means for your business
Deciding on which basis of accounting to use for your business will determine how you record your transactions in any given period. Of the several methods, whichever is chosen, the business owner must be consistent in its use thereof for tax reporting and bookkeeping purposes. In order to change, they must file a request with the IRS. The most common bases of accounting are the accrual basis, the cash basis, and the income tax basis.
The accrual basis of accounting records transactions in the same period of which the related transaction occurs, regardless of whether cash is received or not. For instance, if you purchase equipment in 2009, but don’t pay for it until 2010, under the accrual method you would still include the purchase on your books for 2009. The purpose here is to match the income and expenses in the same period. The IRS has clearly defined tests that outline these events. For instance, income is considered earned on the earliest date of these occurrences: • When you receive payment. • When the income amount is due to you. • When you earn the income. • When title has passed. And expenses become deductible when: • The all-events test has been met. The test is met when: o All events have occurred that fix the fact of liability, and o The liability can be determined with reasonable accuracy. • Economic performance has occurred. The cash basis of accounting records transactions when cash is collected or paid. Using the same example above is you purchase equipment in 2009, but don’t pay for it until 2010, under the cash method you would include the purchase in 2010, when cash is paid. Income includes amounts that you actually or constructively received and expenses include amounts that you actually paid or contest owing. But it does not include amounts that were paid in advance. Expenses paid in advance must be capitalized or recorded as assets. The income tax basis of accounting is the method used to file your taxes. It’s a combination of the cash basis and the accrual basis. Although businesses are allowed to take this approach, the IRS does impose restrictions on its use. Some of those restrictions would be: • If an inventory is necessary to account for your income, you must use an accrual method for purchases and sales. • If you use the cash method for reporting your income, you must use the cash method for reporting your expenses. • If you use an accrual method for reporting your expenses, you must use an accrual method for figuring your income. Whatever method you choose to report your income and expenses, it must be held consistent throughout. Just remember to choose a method that best reflects your reporting of income and expenses.
About the Author
Jacqueline Williams is Founder and Chief Financial Strategist of JE Financial Services (JEFS), a Baltimore based Bookkeeping and training services firm. JEFS specializes in providing training & development workshops focused on records management & systems implementation. In addition, JEFS provides the following services; Bookkeeping Training & Services, Payroll, Tax Preparation, Business Development & Consulting Services. Jacqueline is responsible for providing strategic direction for the company and developing and managing the company’s training programs. Jacqueline brings to her clients more than 20 years’ experience in the accounting profession. Visit our website at http://www.bookkeepingsuccess.com to download a free copy of “Selecting the right Bookkeeper for your Business”
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