All businesses need to choose either the cash or accrual accounting method.

It's important to understand the basics of the two principal methods of keeping track of a business's income and expenses: cash method and accrual method (sometimes called cash basis and accrual basis). In a nutshell, these methods differ only in the timing of when transactions, including sales and purchases, are credited or debited to your accounts. The accrual method is the more commonly used method of accounting.

Under the accrual method, transactions are counted when the order is made, the item is delivered, or the services occur, regardless of when the money for them (receivables) is actually received or paid. In other words, income is counted when the sale occurs, and expenses are counted when you receive the goods or services. You don't have to wait until you see the money, or actually pay money out of your checking account, to record a transaction.

Under the cash method, income is not counted until cash (or a check) is actually received, and expenses are not counted until they are actually paid.

Determining the Transaction Date

With the accrual method, sometimes it's not so easy to know when the sale or purchase has occurred. The key date here is the job completion date. Not until you finish a service, or deliver all the goods a contract calls for, do you put the income down in your books. Likewise, you don't record an item as an expense until the service is completed or all goods have been received and installed, if necessary. (If a job is mostly completed but will take another 30 days to add the finishing touches, technically it doesn't go on your books until the 30 days pass.)

Choosing an Accounting Method

Most small businesses (with sales of less than $5 million per year) are free to choose which accounting method to adopt. But if your business stocks an inventory of items that you will sell to the public, the IRS requires that you use the accrual method of accounting. Inventory includes any merchandise you sell, as well as supplies that will physically become part of an item intended for sale.

Whichever method you use, it's important to realize that either one gives you only a partial picture of the financial status of your business. While the accrual method shows the ebb and flow of business income and debts more accurately, it may leave you in the dark as to what cash reserves are available, which could result in a serious cash flow problem. For instance, your income ledger may show thousands of dollars in sales, while in reality your bank account is empty because your customers haven't paid you yet.

And though the cash method will give you a truer idea of how much actual cash your business has, it may offer a misleading picture of longer-term profitability. Under the cash method, for instance, your books may show one month to be spectacularly profitable, when actually sales have been slow and, by coincidence, a lot of credit customers paid their bills in that month. To have a firm and true understanding of your business's finances, you need more than just a collection of monthly totals; you need to understand what your numbers mean and how to use them to answer specific financial questions.

Claiming Tax Deductions

The most significant way your business is affected by the accounting method you choose involves the tax year in which income and particular expense items will be counted.

For instance, if you incur expenses in the 2006 tax year but don't pay them until the 2007 tax year, you won't be able to claim deductions for them in 2006 if you use the cash method. But you would be able to claim them if you use the accrual method, since under that system you record transactions when they occur, not when money actually changes hands.