A business isn’t one until it earns revenues and incurs expenses. Meanwhile, it is also isn’t a well-managed business if you don’t have books to record these transactions. The problem, however, is that not everyone is really sure how to write them in the journal entries, ledgers, or even financial statements.
In general, there are two ways on how to recognize and write revenues and expenses. These are called cash basis and accrual basis accounting.
Accrual Basis vs. Cash Basis
Both of them do realize revenues and record expenses. However the way they are written and when set the difference. In the accrual method of accounting, you record the expenses and revenues on the date they are earned, not when they are realized. More details are available on accounting bookkeeping
For a clearer illustration, read the example: X Company has sold 15 computer units on August 29, 2012, but they’re expected to be paid on October 20, 2012. In the accrual method of accounting, you already recognize it as sales; hence, you already have the following entry in the book:
|Accounts Receivables||$4 500|
But if you’ll notice, you don’t receive any money on August 29 but later on October 20.
It’s quite the opposite when it comes to cash basis. Expenses and sales are recorded only when cash is received or spent. Thus, using the same example, you’ll record the transaction as sales only on October 20.
Cash basis accounting sounds much easier than accrual basis accounting. However, a lot of businesses use the latter. This is because it follows the matching principle of GAAP (generally accepted accounting principles). According to the concept, an accountant should record expenses and sales on the period they happen and not when there’s change of hands. It also reflects more accurately the operations of the business.
GAAP, though, is simply a list of concepts or principles that are considered ideal by the industry. A business is free to choose the recognition method it prefers.
The Effects on Your Tax Deductions
Nevertheless, choosing the ideal method for your business is essential because of tax deductions. Businesses do pay a lot of taxes to the IRS, but there are also a lot of deductions that can be charged against your taxable income. When you can enjoy the tax deductions depends on the method you’ve picked. For instance, if the expenses are to be recognized the following year, 2013, you cannot apply it to your taxes for 2012.
Keep in Mind
A number of business people are confused when the actual accounting period begins and ends. The IRS has the answer: the recommended calendar period is from January 1 to December 31. Unless you have a valid reason why you should choose another date or period or unless your business is a corporation, you cannot change the mentioned duration. Further, if you want to change yours, you still have to ask permission from the IRS.
Also, when you are using an accrual basis accounting, you should also adjust the entries in the book to reflect correct balances and attributions of figures.