Accounting Methods

There are two methods of accounting: cash basis and accrual basis.

Cash basis means you pay tax on money you actually receive. It's the more straight-forward of the two methods. It also gives a more accurate picture of the cash you really have in your business, record-keeping is minimized, and it often permits tax savings by shifting income or expenses from one year to another. Cash basis accounting means that you probably can do your taxes yourself instead of hiring someone to wade through the morass for you, especially if you hire it done once and use that as a template in following years (assuming there are no gigantic changes in the way you run your studio).

In the accrual system, you declare as income - - and pay taxes on! - - all money you -should- be paid, whether or not you actually receive it. Yes, even when people stiff you, you must declare what they owed as income and pay taxes on it (more about this below). You deduct business expenses when they happen ("are incurred" is accounting lingo), independent of whether you actually make the payment at the same time. Businesses that use accrual basis do so (among other reasons) because they want to keep a close eye on their costs for manufacturing or selling goods compared to the revenue generated from them. Expenses claimed are the costs of generating the income produced in the same time period. Therefore, the business can get a good idea of profitability for a specific part of the year.

For most piano teachers with a private studio, cash basis is best. Most other professionals also use cash basis (doctors, etc.). If you retail music and materials to your students and others (you buy at a lower price than for what you sell), you will need to use accrual basis accounting because of your inventory.

Now, what about the inequity for accrual basis businesses regarding paying tax on money they never received? This is the bad debt provision on Schedule C comes in (look for it on the deduction list). This is where you list the amount of money that you never received. This amount is "backed out" of your income so you don't "pay tax" on it.

Cash basis businesses that cannot collect money owed them are out of luck. If you can't collect your debts, the IRS has no sympathy for you. As far as they are concerned, you taught for free out of the goodness of your heart. You are taxed only on money you actually -receive-. Since you never took possession of money from the people who don't pay you, you don't owe tax on it and the IRS isn't going to give you a break because you should have received it but didn't! The obvious thing to do is to have a good tuition collection system so you are never left with a bad debt!

copyright 1998, Martha Beth Lewis, Ph.D.
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