NFIB

Accounting Methods 101
04/ 15/ 2002


The first decision that must be made for accounting purposes is to set the time span for the tax year. Most small businesses use a calendar year, or one that begins on January 1 and ends on December 31. The other option is the use of a fiscal year, where the twelve month period begins and ends on specific dates because of the nature of the business. The Internal Revenue Service (IRS) will approve this option only if there is a convincing business reason for doing so.

The tax year is important because the IRS wants to know the business income and expenditure during that specific twelve month period designated as the taxable year. To provide that information, businesses must provide complete and auditable accounting records. In today's Workshop, Edith Helmich describes basic components of accounting records.

Accounting records are based on individual transactions, which consist of three components: (1) a contract, (2) delivery of goods or services, and(3) payment. Because these three components may not occur at the same time, every business has to decide whether the accounts will be maintained with one of the two following methods:

Cash method -- the transaction (income or expense) is reported the year payment is made or received.

Accrual method -- the transaction is reported when the goods or services are delivered.

Most sole proprietorships and some partnerships operate under the cash method. Although larger businesses and corporations are more likely to use the accrual method, the nature of the business and pattern of sales should be the determining factor.

At least two exceptions to the above are depreciation and inventory, both important business components because of federal tax issues. Depreciation reduces taxable income by deducting a portion of the cost of equipment or buildings, purchased for business purposes, during the deemed life of the property. Inventory is a special accounting device for accumulating costs for the creation of goods, and deducting that cost only when the goods are sold. Federal laws define the specific circumstances under which depreciation and inventory can be used.

Clearly, even basic accounting principles are risky for the new business owner who tries to set up his books without the counsel of a qualified accountant and/or attorney. An investment in professional expertise and advice will insure that accounting methods meet federal legal requirements, as well as providing useful data for business operation and planning.

After securing adequate professional counsel, computer software is available to help maintain daily, routine account books. An accountant is recommended for the preparation of formal organized and comprehensive financial statements.

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