We all know the rules. With a company’s first tax return, you select a method of accounting. Most professional tax programs default to the cash method of accounting, so it is the method that is usually selected by most tax professionals. However, I want you to think about this election the next time you just mark off cash and continue on. First, let’s discuss the various accounting methods that we can use for taxation.
This is the most commonly selected accounting method by most small businesses. Under the cash method, you recognize income when it is paid, and expenses (less those put on a credit card) when they are paid as well.
For instance, let’s say that you have a company in its first year, and they present you with accrual-based financial statements. Why are their books on the accrual method of accounting? Because a business owner needs to know how much money they are owed and how much they owe other people. However, according to the financial statements, in the first year, the business has $75,000 in accounts receivable and no accounts payable. Their net taxable income under the accrual method statements is $25,000. When you convert the statements to the cash method of accounting, the net income would be ($50,000) — which seems appealing. However, you have to think about tomorrow.
Determining a company’s method of accounting on their first tax return seems very simple, but the fact of the matter is that it will stick with the company, unless you ask for permission to change it.
Let’s discuss the different methods of accounting: