We need to first examine the different methods of accounting available for tax reporting purposes. Cash basis of accounting - This method is the easiest to use and simplest to understand. Generally, income is recognized as cash received and expenses are deducted when paid. Service type businesses, and those without an inventory, typically use the cash basis of accounting for computing taxable income. Accrual basis of accounting - This method more accurately reflects the income actually produced by the company.
Income is recognized for tax purposes as earned and expenses are deducted as incurred.
The actual timing of when receivables are collected and when payables are paid has no bearing on the calculation of taxable income. Retail and wholesale businesses, manufacturing companies, and companies that maintain an inventory typically use the accrual basis of accounting for tax reporting purposes. It is the accrual basis taxpayer that becomes managed by cash flow. The differences between taxable income versus cash flow are primarily issues of timing. The strategy is to match cash flow out with deductible expenditures, and cash flow in with income recognized, however, tax law gets in our way.