Accounting Methods for Tax Purposes (Cash vs. Accrual)

Introduction: In accounting, businesses have the option to use either the cash basis or accrual basis method to record their financial transactions. Each method has its advantages and disadvantages, particularly concerning tax implications.

Cash Basis Accounting: Under the cash basis method, revenue is recorded when cash is received, and expenses are recorded when cash is paid out. This method is straightforward and easy to implement, making it popular among small businesses and sole proprietors. However, it may not accurately reflect the financial performance of a business, especially if significant transactions occur outside the cash receipt or payment period.

Accrual Basis Accounting: Accrual basis accounting records revenue when it is earned and expenses when they are incurred, regardless of when cash is exchanged. This method provides a more accurate picture of a business's financial performance, aligning revenues and expenses with the period in which they occur. However, it requires more complex record-keeping and may result in discrepancies between taxable income and actual cash flow.

Tax Implications: For tax purposes, businesses must choose between the cash basis and accrual basis methods. The choice can significantly impact taxable income and tax liabilities. Under the cash basis method, businesses recognize income when received and deduct expenses when paid, potentially deferring taxable income to future years. In contrast, the accrual basis method may accelerate recognition of income and expenses, affecting the timing of tax liabilities.

Question:

Which accounting method records revenue when cash is received and expenses when cash is paid out?

A) Accrual basis B) Cash basis C) Hybrid method D) Modified cash basis