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Tax Accounting Using the Accrual Method

February 16, 2010

There are 2 types of tax accounting methods to use when submitting business figures to the Internal Revenue Service. These 2 methods are the cash and accrual methods. Choosing which method you use is determined by the company.

The decision can be as simple as a personal preference or many factors can play into the selection. Larger companies tend to have many factors like sale procedure, how many salesmen, volume of sales, number of sales, inventory, when the commission is paid, the percentage of operations are sales compared to production, accountant or business partner experiences, and the list goes on.

Accrual method of tax accounting records all sales and transactions at the time of the agreement. Even if the money does not exchange hands, according to the accounting record books, the sale is complete and accounted for.

This method takes discipline to make sure all payments are actually received. Since the books show the transaction as complete, a separate ledger must be kept to follow up with payment plans and collection. This can be especially difficult for small businesses that may not employ a secretary or accounting staff. With fewer numbers of sales, accrual accounting just means more work of entering sales and payments in two separate books.

If a company sells expensive products, partial payments on long payment plans are generally used. When using accrual accounting this can reflect the cash flow drastically different. If 3 items are sold in one month for $30,000 and next month 6 are sold for $60,000, it looks like twice the income. However, accrual accounting does not take the payment plans into account. Payment plans could range from 2 payments in 6 months to 24 payments over 2 years. Usually longer plans are needed for larger purchases which will show more inaccurate.

Let’s say a company just starts and has $30,000 in sales the first month, but each sale has a long-term payment plan. Only looking at accrual accounting would be misleading because only $3,000 was physically obtained. When you look to pay bills for operating expenses, accrual accounting will not show how much liquid finances you have to use.

After the tax accounting selection for the accrual method has been made it is difficult to change methods. If a change is absolutely necessary, there is a way. The last 2 consecutive years must have used the current method. The Secretary of the Treasury must receive a formal request. The business owner should consult with a certified public accountant to make sure this procedure is done correctly.

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