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Chapter 2

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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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Last modified: May 21, 2004