When you operate a small business as a sole proprietor, you must complete Schedule C of the IRS Form 1040. This form outlines your profit and expenses for operations. Selecting between a cash accounting and accrual accounting approach for your business impacts your results.
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Cash Basics and Considerations
A cash accounting approach is straightforward. You recognize revenue as earned when you actually receive payment for it. Similarly, you recognize expenses when you make payments. In addition to its simplicity, a key benefit of the cash method is that you might have the option of using Schedule C-EZ. This alternate form is for proprietors who have relatively small income, no employees and no inventory. The key drawback of the cash approach is that it doesn't offer the clearest picture of your business' financial situation.
Accrual Basics and Considerations
The accrual method is a bit more complex, but it does offer a truer picture of your business situation. With the accrual approach, you recognize revenue and expenses at the time they occur -- not when they are paid. If a customer buys on account, for instance, you record revenue when the agreement is made. Service firms struggle with the challenges of recognizing materials costs with an accrual system. However, a service company that sells related products and that averages gross receipts under $10 million can use the cash approach. When you carry inventory or use the accrual method, you must file the regular Schedule C.