When you're self-employed, there are two primary methods of accounting: the cash method and the accrual method. Here is how they work and the potential advantages and disadvantages.
Cash Method vs Accrual Method
The cash method is when you report income as it’s being paid to you. Expenses are deducted at the time you paid for them.
By contrast, the accrual method is when you report income in the tax year that you’d expect to receive it (regardless of when the payment was received). Likewise, expenses are deducted in the tax year you would incur them (not when the payment was made).
- You receive a single payment of $1,000 in December from a customer that covered services for December and January. Using the cash method, you'd report the full $1,000 in this tax year. However, under the accrual method, you might take $500 this tax year and $500 next tax year.
- You pay for a 12-month lease that goes from this July to July of next year. Using the cash method, you'd deduct the full payment for the expense this tax year. On the other hand, if you used the accrual method, you'd deduct half of the expense for this tax year and the other half next year.
Why Your Accounting System Matters
The IRS requires that once you determine your method of accounting you’re consistent and stick with it for the entire tax year. Intermixing systems could cause mistakes or even bias how much taxable income your business has generated.
For most business owners, the cash method will be the simplest and easiest to keep track of. However, it can also be a bit misleading if certain payments or expenses are front-loaded into one tax year.
The accrual method takes a little more effort to track. Nevertheless, it does provide a more accurate picture of your business's cash flow and expenses. This is especially important if you maintain any sort of inventory.
For more information, please see IRS Publication 538 (01/2022): Accounting Periods and Methods.