There are two primary methods of tax and accounting that your business can utilize to report income and expenses: cash accounting and accrual accounting. The major difference between the two methods involves when the transactions are recorded. With cash accounting, revenue and expenses are recorded when it is received or when it is paid out; with accrual accounting, transactions are recorded when revenue is earned and when the expenses are consumed.
Let’s understand both the tax and accounting methods – how they differ, the implications of each method on your business, and how to determine which is the best method suited for you.
An Overview of Accrual Accounting
Accrual based accounting records revenue and expenditure as they are incurred and earned, regardless of when the cash or payment is received or paid. If your business sells a product in May but doesn’t receive the revenue till June, for example, you record the transaction in May, regardless of when you receive the revenue.
The benefit of accrual-based accounting is that it provides a more realistic view of your expenses and income. The only downside of this method is that it can be deceiving about your profitability, giving you less awareness of the actual cash flow. Even if the business appears to have positive cash flow, it doesn’t actually reflect the true picture of your bank account. Still, accrual-based accounting is generally preferred because it better complies with IRS requirements and gives you that long-term visibility into your small business accounting.
An Overview of Cash Accounting
The cash-based accounting method recognizes revenue only when the cash is received, and expenses when the cash is paid. Using the aforementioned example, if you sell a product in May but don’t receive the revenue until June, the cash accounting method doesn’t recognize the transaction until the cash has actually been received, that means to record the transaction in June.
The benefit of cash accounting is that your bank account is a real-time reflection of the resources you have at your disposal. The downside of this tax and accounting method is that there is a delay in revenue and expense recognition. So, if you make a sale in May, but don’t recognize that revenue until the transaction is processed one month later, you have less visibility into your business long-term.
Tax Implications of Cash and Accrual Accounting Methods
Businesses must figure out their taxable income and file a yearly return. Choosing between cash or accrual accounting method depends on the type of product or service you provide and of course, the size of your business.
If your business generates less than five million dollars in revenue, the IRS permits the use of cash-based accounting. Therefore, small businesses are more likely to use cash accounting. On the other hand, anything over the limit of five million dollars requires the accrual method of accounting.
Which Accounting Method Should Your Business Use?
- Cash Accounting
Many small businesses usually opt to use cash accounting because it is the simplest method to record transactions and cash flow. The cash method of small business accounting makes it easier to track how much cash your business has at any given time. There is no need to track receivables or payables, and your business doesn’t have to pay income tax on any revenue until it is deposited into your bank account. Cash accounting gives you an idea of the funds in your bank account and an immediate look at your business’ financial position in terms of liquidity.
Benefits of Cash Accounting
- Immediate view of your business
- Low maintenance
- Easy to track your cash-flow at any given time
- No need to pay income tax until your cash is in the bank
- Accrual Accounting
The accrual method is the focus of professional small business accounting because it prevents manipulation of income by matching the expenses incurred in a period of time to the income earned in that period. Accrual accounting accurately reflects the financial position of your business by reflecting the revenues that have been earned to the expenses that have been incurred during a given period of time. When compared to cash accounting, accrual accounting tracks cash much more effectively by allocating cash flows to the appropriate period. It also provides a better outlook into the financial statements of the company, allowing for smarter business decisions and future growth.
Benefits of Accrual Accounting
- A long-term view of your business
- Tracks cash most effectively
- Prevents income manipulation
- Provides a defined look at the financial health
The Accrual Method Is Better…In Most Cases
It is generally recommended to use the accrual method of accounting because it helps your business better comply with IRS rules and regulations. Also, it helps to accurately reflect the actual financial situation of your business. While cash accounting may be easier to understand, accrual accounting is often more through and may even be a legal requirement for small business accounting. If you choose to use the accrual method, remember it will affect your tax return as it can change which year you record certain incomes and expenses, and it can also dramatically change the appearance of your financial statements.
Final Note: Make accounting practices a top priority to ensure your tax and accounting is in order before it is too late.
Gta Accountant 