Do you know if the accounting method you're using is the right one for your business?
The difference between cash and accrual accounting lies in the timing of when sales and purchases are recorded. Cash accounting recognizes revenue and expenses only when money changes hands, but accrual accounting recognizes revenue when it's earned, and expenses when they’re billed (not paid).
The cash basis is easy to determine when a transaction has occurred (the money is in the bank or out of the bank) without the need to track receivables or payables. Since transactions aren’t recorded, per se, until the cash is received or paid, the business’ income isn’t taxed until it’s in the bank.
In the accrual accounting method, revenues and expenses are recorded when they are earned, regardless of when the money is actually received or paid. The upside is a more realistic idea of income and expenses during a period of time, providing a long-term picture that cash accounting doesn’t provide. The downside is it doesn’t provide any awareness of cash flow. Accrual basis accounting without careful monitoring of cash flow can have potentially devastating consequences.
Let's say you own a business that sells machinery. If you sell $5,000 worth of machinery in December, under the cash method, that amount is not recorded in the books until the customer hands you the money or you receive the check.
Under the accrual method, the $5,000 is recorded as revenue immediately when the sale is made, even if you receive the money in January and thus pay taxes on it.
The same principle applies to expenses. If you receive an electric bill for $1,700, under the cash method, the amount is not added to the books until you pay the bill.
However, under the accrual method, the $1,700 is recorded as an expense the day you receive the bill.
Should I use cash or accrual?
If your business is a corporation (other than an S Corp) that averages more than $25 million in gross receipts over the past three years, the IRS requires you to use the accrual method. If your business doesn’t hit those criteria, you can use the cash method.
Keep in mind that the IRS requires companies to use and maintain the same accounting method to report taxable income for a year — so no changing halfway through a tax year.
Some businesses can choose the hybrid method of accounting, wherein they use accrual accounting for inventory and the cash method for their income and expenses.
If you’re unsure of which accounting method is best for your business, speak with us.
More Tax Tips
Would you like more year-end tax tips? Download our new, Year-End Tax Planning Guide.