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If you’re an entrepreneur or small business owner, it’s a good idea to familiarize yourself with cash and accrual accounting methods.

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What is the cash method of accounting?

So what is the difference between cash and accrual methods? Cash and accrual methods are among the most common accounting methods, according to the IRS.

IRS Publication 538 (01/2022), Accounting Periods and Methods breaks down the two methods. First, the cash method of accounting is when money flows in or out of a business and the transaction takes place when the money is declared in the same year, while the expenses can be declared in the year of taxation in which they are spent.

What is the accrual method?

The accrual method, on the other hand, involves reporting income earned by a small business during the tax year, regardless of when it was received. Meanwhile, these expenses are deducted in the year they occur, regardless of when the actual payment is made.

Regardless of which method a small business uses, the IRS notes that a consistent method of payment must be used.

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Video Transcript | Jeffrey Levine, CPA and tax specialist, Buckingham Strategic Wealth

TheStreet, combined with our partners at TurboTax, provides year-round financial and tax strategies. Robert Powell of our Retirement Daily sat down with Jeffrey Levine, CPA and tax expert at Buckingham Strategic Wealth Partners, for the Q&A below on the two common accounting methods.

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Robert Powell: Three things are certain in life, death, taxes and tax advice with Jeffrey Levine of Buckingham Wealth Partners. Jeffrey, when we think of tax advice, there’s one that has to do with being a solo entrepreneur and whether to use the cash method or the accrual method.

Why most entrepreneurs choose the cash method

Jeffrey Levin: Absolutely. And the first thing I tell people when they decide to go with cash accounting or accrual accounting is that the cash method is much simpler. And that’s why the overwhelming majority of small businesses that can use this method use it because as regular taxpayers, the people on our individual tax returns, we use the tax payment basis for about everything.

Now, the cash basis method means that when you pay for something it is deemed paid, that seems logical, doesn’t it? When you pay for something, you have an expense. When you get income, you actually record income.

Example of accrual accounting method

Accrual accounting is a bit cruel in that it’s much, much more complicated. So, for example, let’s say Bob, I agreed to do some project work for a company and I did all the work and they haven’t paid me yet, but I finished it. Well, accrual is actually the income from that contract, right? I did all the work, so now I need to record that income, even though this company hasn’t paid me yet. And maybe they don’t pay me for another two or three months, and sometimes that can carry over to different years. It can therefore become much more complicated to use accrual accounting. We don’t really think about that.

Jeffrey Levine_QUOTE 8

Now the reason big companies do it right is if you’re a Fortune 500 company you’re publicly traded and you tend to use accrual accounting because that’s one way more accurate to record things. Because if I don’t get paid in two months, well, I still earned that income, right? If I’ve done everything I need to do to get paid. I’m just waiting for the check to come in the mail, but that lets investors know I did something to generate income.

Example of cash accounting method

With cash accounting, I may have a supplier who just won’t pay me. In fact, you know, if you imagine you’re doing all that work, and they just write you a check on December 31 of every year for your entire work year. Well, on December 30, it looks like you didn’t do anything. You have no income. You did absolutely nothing. But on December 31, it looks like you had the greatest day in the history of the world. Now, none of those things are really true, but in the cash-based system, that’s what it would look like.

In the accrual-based system you would effectively have that income, and I’m oversimplifying here to make it understandable for people, but you would effectively see that income is earned throughout the year while you’re actually doing the work. And the fact that you got paid on December 31 wouldn’t really have an impact on how your business looks on paper.

Editor’s note: The opinions expressed in this article are those of the authors. The content was rReviewed for tax accuracy by a TurboTax CPA expert.

The article and graphics were produced and edited by Zachary Faulds.