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Cash method accounting
Cash basis accounting
means that income and expenses are recognized
when the money is paid. Cash basis is
contrary to Generally Accepted Accounting
Principles (GAAP,) but GAAP is not law.
The Internal Revenue Code allows some US
businesses to report income on the cash method XE "cash method:definition" . Generally, if a business carries an inventory, whether for resale or for inclusion in manufactured goods, the accrual method is required. The purchase of inventory is not considered an expense, but an exchange of one asset for another, or acquisition of an asset and a liability, together. While the inventory is still there, it is something of value that you own. The expense is incurred when the inventory is no longer in your possession, whether in the original form, or in the form of goods made from the original. When the inventory goes out of your possession, as part of value delivered to a customer, then it is an expense. Note here the coincidence of the income earning activity (delivering value to the customer) and the expense.
Service businesses
typically do not have inventory, and may have
the option of reporting income using the cash
method. This depends on the type of
organization, and is a matter, not merely of
law, but of tax law, so the rules are not
simple. They also may change, and that
is why you should refer to the current edition of IRS Publication 334, Tax Guide for Small Businesses.
Changing accounting
methods is something else. Once a
business files a first income tax return, the
method is locked in. It is necessary to
petition The Lord High Extractioner in order
to change from cash basis to accrual, or
accrual basis to cash. (The IRS does
require prior approval.) And start by talking to your accountant. You may have to change methods if you change your type of business organization.
Cash basis accounting
being contrary to GAAP, it lacks accepted
rules. One problem relates to advance
payments, before delivery of the related
goods or services. QuickBooks is
designed to do accrual basis accounting, but
includes cash basis reports. These
reports recognize income as being earned when
the cash is received, or when the value (goods and/or services) is delivered, whichever is later.
This is built into the program and there is
no way to change it. In cases where
these transactions span the end of a tax
year, you have another reason for referring
to the Tax Guide for Small businesses.
Cases may arise where you have to edit your
transactions in QuickBooks, so that income is
shown as IRS rules require.
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