When you start a new business, you need to make a lot of important decisions. One of those decisions is whether to use the cash or accrual method (or basis) of accounting. There are some important distinctions that could impact your business in different ways, so it is important to fully understand both methods before selecting an accounting method.
A business owner who chooses the cash basis of accounting must report revenues on his or her income statement in the period when payment is actually received from a customer.
For example, if your business' fiscal year ends on December 31, you must report all of your income received between January 1 and December 31. If you complete a transaction for a customer on December 1, 2017 and the customer does not pay their bill until January 1, 2018, you would include the income on your tax reporting for the fiscal year ending December 31, 2018, not for the year in which you completed the work or invoiced the customer (2017).
Similarly, business expenses under the cash basis of accounting are reported when the business actually pays the bill, rather than when the bill is actually payable. So, a bill for services that your business receives on December 15, 2017 but does not pay until January 14, 2018 would be an expense reported for 2018, not for 2017.
Under the cash method of accounting, accounts receivable and accounts payable are not recognized.
While the cash method is the most common choice for small businesses, the accrual method is more commonly used than cash accounting overall. Under the accrual method of accounting, revenues are reported in the period when they are actually earned, which is not necessarily when the business collects the income.
Let's go back to our example of using a business with a fiscal year ending December 31. If a customer transaction is completed and the bill for goods or services is payable on December 1, then that income must be reported in that same fiscal year, regardless of when the customer actually pays their bill. Even if the income is not received until February of the following year, it still must be reported for the fiscal year when it was actually earned.
Expenses are handled similarly under the accrual method of accounting. Expenses that are payable in one fiscal year but not paid until the next fiscal year are, nevertheless, reported for the fiscal year when they were due and payable.
In order to evaluate the options, it is helpful to consider both the positives and the negatives associated with both the cash and accrual methods of accounting.
Small business owners often prefer the cash method of accounting, simply because it is easy to understand and makes bookkeeping more straightforward. Tracking money in and out of the business bank account is easy; there is no need to worry about accounts receivable or accounts payable.
The accrual method of accounting does require staying on top of accounts receivable and accounts payable, which can add a layer of complexity that some business owners would prefer to avoid. Small business owners, in particular, may not want to deal with the added paperwork and bookkeeping required to manage the business' books under the accrual method. One alternative to hiring a bookkeeper is to invest in software that can help automate and simplify the process.
The accrual method can provide a more accurate and realistic picture of income and business expenses for any given time period since they are reported during the time period they are earned or incurred, regardless of when they are received or paid. This can help businesses with their long-term strategic planning. When using the cash method, it is more difficult to evaluate and plan based on reported revenues and expenses since they are not recorded when they are earned or incurred.
For example, a small business whose sales go up in the summer months might want to consider adding temporary staff for that time period in future years, or planning to hold off on projects that could disrupt the business during busy periods. Under the accrual method, it is easy to see exactly which months were the busiest and which were the slowest. Under the cash method, however, this is not as clear. The numbers may look skewed if a big portion of income earned in July is not actually received until September or October. This can make planning ahead more of a challenge.
As any small business owner will attest, understanding cash flows can be critical in the business' success. The accrual method of accounting does not give an accurate picture of the business' cash flow. On paper, the business might look successful. However, if there are significant outstanding accounts receivable, the business might not actually have any assets in its bank accounts. This can result in significant cash flow problems.
The cash method of accounting, on the other hand, will provide an adequate picture of how much cash is on hand at any given time.
The accounting method you choose for your business will impact your taxes, so business owners should understand the implications of choosing one method over the other. There are advantages and flexibility under both the cash method and accrual method of accounting.
Under the accrual method, businesses report their income when it is earned, and report their expenses when they are incurred. This is relatively straightforward; although, it can result in a business paying taxes on income it has not yet collected. However, the opposite is also true. A business that receives an advance payment in one calendar year for services or goods that will actually be provided in the following calendar year can delay paying taxes until the following tax year, even though they received and had use of the funds before they were due.
On the flip side, using the cash method of accounting means that a business that incurs significant business expenses at the end of one fiscal year but does not pay them until the following fiscal year cannot deduct those expenses in the year they were incurred. The business may enjoy a bigger deduction for the following fiscal year (the year they paid the bills); however, this can make it difficult to plan taxes with any degree of accuracy.
Some businesses actually use a combination of the cash and accrual accounting methods, referred to as a hybrid method. Under a hybrid approach, the business uses the accrual method of accounting for their inventory, but uses the cash method of accounting for the business' revenues and expenses.
According to the IRS, businesses can actually choose any combination of accounting methods as long as the method clearly reflects the business' income, and as long as the business consistently uses the same method for reporting and taxes. There are, however, a few restrictions that business owners need to be aware of:
Choosing an accounting method for your business will impact your business for years to come, so it is important to make an informed decision. Businesses should first identify whether they are required by law to use one accounting method over another. If they are free to choose an accounting method, evaluating the pros and cons as they relate to the specific business' size, needs, and future growth goals can help business owners be confident they have made the right choice.
For many small businesses, the cash method of accounting is attractive because it is relatively simple. There is no need to keep track (for tax purposes) of accounts payable or receivable because income and expenses are reported when they are received and paid. Under the cash method, it is also easy for the business to identify its available cash at any given time.
According to IRS guidelines, "if an inventory is necessary to account for your income, you must generally use an accrual method for purchases and sales." Generally speaking, that rule is understood to apply to businesses with gross receipts of greater than $1 million each year. Most partnerships and sole proprietorships choose the cash method of accounting.
When you file your first tax return for your business' income, you will need to choose a method of accounting and use it on all of your future tax returns. Businesses can choose to change their method of accounting after the business has already filed using the other method; however, they must get prior approval from the IRS by filing Form 3115 (Application for Change in Accounting Method).
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