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Cash method is a money term you need to understand. Here’s what it means.
What is the cash method?
Under the cash method, income is not counted until payment is actually received, and expenses are not counted until they are actually paid. The cash method is the more commonly used method of accounting by small businesses.
For example, a small business makes a sale in December but isn’t paid until February. Under the cash method, the business would record payment in February.
The cash method is also known as cash-basis accounting, cash receipts and disbursements method of account, and cash accounting.
Many small business owners choose the cash method of accounting because it’s a simpler form of bookkeeping. It’s easy to track money as it moves in and out of a bank account because it doesn’t take into account receivables or payables.
In addition, the cash method is easier to audit and less of a burden administratively, but it can be less accurate.
Under the other main form of accounting — accrual accounting, transactions are counted when they occur, regardless of when the money for them (receivables) is actually received or paid.
For instance, under the cash method, payment of business expenses may be speeded up before year end to increase the business’s tax deductions. Conversely, billing for services may be put off until year end, so that payments won’t be received until the new year, postponing tax payments on that income.
The IRS says a business must use accrual accounting if it has sales of more than $5 million a year or if it has inventory to account for. But, the IRS also may favor the accrual method, since there’s less opportunity for manipulation.
The purpose of an accrual method of accounting is to match income and expenses in “the correct year,” the IRS says.
Cash method example
Jerry’s Plumbing Service cleans out two drains on the same day. The first customer pays him $200 on the spot. The second customer tells Jerry that he’ll pay $200 next week. Under the cash method of accounting, Jerry only records $200 as income. Under the accrual method, Jerry records both services as income, creating an accounts receivable line in his books.
Later in the day, Jerry orders $10,000 in parts from a supplier with a promise to pay in 30 days. Under a cash method, the $10,000 doesn’t get recorded in his books until he pays for the parts. Under the accrual method, Jerry records a $10,000 liability that same day.
The accrual method would give a much clearer picture of Jerry as a borrower, but the cash method can have advantages for tax purposes. The Joint Committee on Taxation estimated that if all businesses used the accrual method of accounting, American businesses would have paid $10.7 billion more in U.S. federal taxes between 2014 and 2018.
What triggers an audit? Find out what the IRS doesn’t want you to know.
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