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There are two main methods of accounting: cash basis and accrual basis. Using the cash basis method, income and expenses are recorded at the time money exchanges hands, regardless of when the income was earned or the debt was incurred. In the accrual method, income and debt is recorded at the time it is earned or incurred, regardless of when it is paid. Some small businesses may also use a hybrid form which combines the two methods.
Most self-employed and unincorporated small businesses use the cash basis because of its simplicity. If a contractor finishes a job on 20 December, but does not get paid until 20 January, he includes the income in January. Preparing a balance statement and tax return is relatively simple, because he simply needs to look at his deposits and his paid bills to determine the profit or loss for the year. If someone does not pay what they owe him, he does not have to adjust the next year’s balance sheet with a bad debt deduction, because he had never included the money owed to him in his accounts. While this method does not give an accurate picture of monthly expenses and profitability, it does let a person know exactly how much cash he has on hand at all times.
The accrual method may be a bit more difficult, yet the generally accepted accounting principles require all corporations to use the accrual method. Expenses and income are recorded at the time they are incurred or earned. For example, if lumber for a construction project is delivered in July, then the expense is recorded in July, even if the bill is not paid until August or later. If the project is completed in December, but the terms of the agreement allow the customer to delay payment for 30 days, then the income from the project is counted in December and included on that year’s tax return, provided that the company uses the calendar year as its fiscal year.
Other debts which may be paid quarterly are also allocated in accounts for each month of liability when using the accrual method, and not just when the debt is paid. For example, if a corporation pays an annual premium of $1200 US Dollars (USD) for property insurance, an account will be set up which records a $100 USD expenditure for insurance each month. In this way the accrual method has the advantage of giving a much more accurate picture of monthly operating expenses than the cash method. An annual profit and loss statement based upon accrual accounting also provides a more accurate picture the organization's overall profitability.
There are some drawbacks to any accounting method, and the accrual method is no different. A company can look very good on paper, and yet be cash poor and behind in their debts, especially if the customers are no longer paying their invoices in a timely manner. The accrual method assumes all accounts are in good standing, but if a customer is delinquent or in default, then the company may not be able to pay their debts either. If a customer defaults on a debt, then the company must compute and record a bad debt deduction to correct the records and recoup any taxes paid on revenues which were never actually received.