Small business owners and entrepreneurs can often operate on the razor's edge between financial gains and commercial loss. The sometimes disconcerting fluctuations of income and expense are the price of being your own boss. Of course, maintaining close watch over such movements is necessary to stay in business and remain afloat; losses gone unanswered lead to bankruptcy.
Yet there is another reason to be meticulous about cash flow: It determines how much you owe to the U.S. government when the year is done. Accounting for business profit and loss is done on Schedule C of the Internal Revenue Service (IRS) 1040. Completing this schedule can be done in more than one way.
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All About Schedule C
Schedule C is designed for sole proprietors, or single-member limited liability companies, on whom business tax obligations directly fall. Two additional qualifications are necessary per the IRS form. First, the business must be fundamentally conducted to earn income and/or profits. Beyond its purpose, the enterprise must function in a relatively uninterrupted fashion.
While its two prominent sections are, naturally, income and expenses, there is one preliminary line that is essential to how the IRS analyst will evaluate the return. Line F asks the taxpayer to indicate what Schedule C accounting method is used for the calculations.
Cash Accounting Method
The chosen accounting method is the set of guidelines by which a business reports its revenues and input costs. One of these, very popular with sole proprietors, is cash accounting. Under this system, payments are recorded when they are made. Likewise, incoming monies are logged upon receipt.
Also called cash-basis accounting, this approach takes no heed of funds due or owed when work is done. Instead, cash must be in hand, either the proprietor's hand or that of a vendor, before the transaction is recognized on the books.
Cash accounting is often preferable for sole proprietors and smaller firms because it is a simpler method. Landscapers, tow truck drivers and others, for example, who do a thriving business at the end of a given year are often not paid until well into January. Their books, therefore, will not reflect what was due to them but only what was paid to them that year. Not only does this keep their taxable income lower for the year, it provides the IRS with a more precise reckoning of annual intake.
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Accrual Accounting System
Accrual is another accounting method that Schedule C users may select. In stark contrast to the cash accounting method, accrual focuses on when an obligation is formed as opposed to when it is fulfilled.
This means, to use the landscaper example, when the hedges are trimmed and new sod is installed, the owner will enter the price of the services into the financial ledger as income rather than wait for payment to be made. On the flip side, the purchase of fertilizer or pesticide is entered as an expense when the chemicals arrive, not necessarily when the landscaper sends in a check.
While this technique may be disconcerting to the strict bean counters, it provides a clearer window on business activity during the year, when the revenue was generated and the charges incurred as opposed to when accounts were squared.
Consider also: Examples of Cash vs. Accrual Basis Accounting
Other Accounting Methods
What is the accounting method for Schedule C that is the best? There's actually a hybrid accounting method that fuses the cash and accrual techniques. In short, cash is used for immediate expenses, and projected revenue is employed for investment planning and business operation forecasting.