When starting a business, one of the key decisions you'll face is selecting the appropriate accounting method for managing your finances and paying taxes. The two primary options are the cash method and the accrual method.

Cash Method

For those seeking simplicity, the cash method is often the best choice. Under this method, you recognize income and deductions when cash is actually received or paid.

Example: Suppose you open a small business and order business cards and stationery. If you receive the products and pay the invoice on November 18, 2005, you can deduct that expense on your 2005 tax return.

However, some businesses are restricted from using the cash method. C corporations may only adopt this method if their gross revenues are under $5 million for the year. Professional Service Corporations can use the cash method without limitations, while farming corporations can do so if their gross revenues are less than $25 million. Tax shelters are prohibited from using the cash method altogether.

Accrual Method

The accrual method of accounting is more complex. This approach focuses on recognizing expenses when they are incurred, rather than when they are paid.

Example: Let’s say you order business cards and stationery on December 18, 2005. You receive the products on December 30 but don’t pay the invoice until January 20, 2006. When can you claim the expense? It depends on the timing of economic performance.

Economic performance generally occurs when goods or services are provided to you. In this case, since the business cards and stationery were delivered with the invoice on December 30, you would be able to deduct the expense for the 2005 tax year.

In summary, the cash method offers a simpler approach to accounting, while the accrual method provides a more accurate reflection of financial performance over time. To determine which method is best for your business, it's advisable to consult with a tax professional.