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Cash Vs. Accrual Method of Accounting
There are two basic methods of accounting: the cash method and the accrual method. A business must identify the method it uses on its income tax returns.
[For companies with less than $5 million in gross receipts, the IRS allows the cash method regardless of the type of business activity.
For companies with gross receipts in excess of $5 million who sell materials, the accrual method is required.]
Cash Method
Under this method, income is recorded when payment is received. Expenses are recorded when payment is made. This method works well for firms that do not sell any materials to their customers,
i.e. firms that do not carry or handle inventory.
Accrual Method
Under this method, income is recorded when the product is delivered or the service performed. Expenses are recorded when a product is received or a service has been rendered. Under the accrual method, the recognition of income or expense is not tied to the payment. This method gives rise to Accounts Receivable - money that is due to the business from its customers; and to Accounts Payable - money that the business owes to its vendors.
Example: A contractor buys materials for $ 400 to paint a house. The job is completed on Dec 21st, 2006. The contractor issues an invoice for $1500 to its customer. The customer pays $800 right away and $700 in January of 2007.