Published on May 4th, 2016 | by Millennium Magazine Staff0
Understanding Cash Accounting vs. Accrual Accounting
The most obvious method of accounting used by small businesses is called the cash method. This involves recording income when you receive payment for services rendered. Similarly, expenses are only counted when the money leaves your account.
Cash accounting is particularly useful for helping you accurately manage cash flow because it only records revenues and expenses when they appear in your account. This way you know how much cash you have on hand a particular moment.
For most of the year this has little impact on your taxes. However, if you file your tax returns using the calendar year, and invoice a client on December 15th but don’t get paid until January 5th. Under the cash method, you would record that income in the new tax year. The same goes for expense checks. If you make a purchase in December but the supplier doesn’t cash it until January, you can’t claim that deduction in the year which you wrote the check.
The cash method can also skew the big picture. If you generate a lot of revenue in one year, but didn’t receive payment until the next, your books can look slanted – showing too little profit and negative cash flow one year, and too much the next.
Tip: Cash flow accounting is also limited to certain business types. Corporations (other than S corporations), for example, with average gross receipts over $5 million can’t use the cash method. Read more about excluded entities.
The alternative method to cash accounting is called accrual accounting.
Instead of recording income when you receive it, with the accrual method, income is recorded when the sale is made, even if you don’t get paid for another 30-60 days. Similarly, expenses are recorded when services or goods are received, not when you pay for them.
This may seem confusing, but the accrual method can actually provide a more accurate picture of your business operations than the cash method. Instead of showing what cash you have on hand, the accrual method gives you a better idea of what you earn each month (as opposed to the cash method which only records payments when they are made). Of course, the downside is that you get a less than accurate representation of cash flow (although a cash flow forecast and statement can help with this).
Another consideration is time. With the accrual method, you’ll have to deal with more bookkeeping (recording both the date of the sale and the date when payment is received).
The Hybrid Method of Accounting
You don’t have to actually stick to the cash or accrual method. The IRS permits businesses to use any combination of cash, accrual, and other methods if the combination accurately reflects your income and you use it consistently. However, there are restrictions. If your inventory is necessary to account for your income, you must use the accrual method for purchases and sales. Read more about exceptions.
Which Accounting Method is Best for your Business?
There is no right accounting method for all businesses. Both cash accounting and accrual accounting have their pros and cons and its best to consult your accountant and tax preparer to find the best fit for your business. As a general rule, certain businesses prefer one over the other depending on the following factors:
Business Size. Smaller businesses like sole proprietorships and partnerships may prefer cash accounting for its simplicity and minimal bookkeeping. Businesses often switch to accrual accounting as their businesses grow to more accurately reflect their revenue and expenses.
Tax Deductions. Depending on the type of business you run, cash or accrual accounting may be more beneficial when filing your taxes. If you incur expenses in December 2016, but don’t pay for them until January 2017, you can still claim tax deductions for 2016 if you use accrual accounting. On the other hand, you would not be able to claim deductions until the 2017 tax year if you use cash accounting.
Internal Accounting. Using the same accounting method internally and for tax purposes is a good practice because it simplifies the accounting process when calculating your income and expenses. However, the IRS does allow you to use a different method for internal accounting and tax accounting, if you decide to do so.
Read more about accounting periods and methods from the IRS. This Small Business Taxes Virtual Workshop also offers useful pointers on accounting methods for new businesses.