There are two basic ways to maintain your books and keep track of income and expenses: The cash method and the accrual method. (It is possible to use both, choosing one for accounting and another for tax purposes, but most business do not − talk to your accountant before you make that decision.)
According to the IRS*, most businesses with sales under $5 million a year can use either accounting method. However, businesses with sales greater than $5 million a year, or businesses that maintain an inventory of supplies or finished goods with gross receipts over $1 million a year, should use the accrual accounting method. In addition, all publicly-held companies must use the accrual method. (There are a few other tests used in special circumstances; see your accountant for specifics.)
If you run an all-cash business − receiving cash for goods sold and paying cash for all goods and services upon receipt − your books will look the same regardless of which accounting method you use. However, not very many businesses today operate without either accounts receivable or accounts payable. Credit – either extended or received – can change the picture dramatically.
Which is the best accounting method for your business? The answer depends in part on the type of business you run. Start-ups and small companies often use the cash basis method because it’s simple and less time-consuming, but most businesses use the accrual accounting method in order to maintain a clearer picture of their finances.
Accrual Method: Expenses are booked when goods or services are received, and income is booked when you make a sale − regardless of when you actually pay the bill or receive the check. If you order office supplies, you book the expense when the supplies are received, even if you do not intend to pay the bill for another 30 days. Income is booked on the day you perform a service or make a sale, not when you actually receive payment.
Cash Method: Expenses are booked when actually paid for and income is booked when actually received. For example, if you order office supplies, you book the expense when you pay the invoice, even if you received the supplies a month earlier. If you sign a contract to perform a service, you do not book the income until you receive the check for that service, even if you perform that service well in advance of payment.
Think of it this way: You handle your personal finances using the cash method. When you write a check, you enter the amount in your register. When you receive a paycheck, you enter that amount as a deposit. In a nutshell, that is cash-basis accounting. It’s simple, easy to understand, and lets you know exactly how much cash you have on hand.
Advantages and Disadvantages
A major negative with cash accounting is the risk of misunderstanding your company’s true financial position. If you extend credit to customers, buy on credit from suppliers, or receive advance payment for services, using the cash method could cause you to assume your business is performing a lot better − or a lot worse − than is actually the case. For example, if you purchase $10,000 worth of materials on credit, a quick glance at your books may indicate you are in great shape… because the $10,000 will not “hit the system” until you pay for those materials.
The accrual method provides a more accurate picture of income and debt, but it can be misleading in terms of cash flow. For example, you may show major income for a certain period − since a number of sales have been booked − but until you actually receive payment for those sales, you do not have access to those funds. Many businesses face cash flow problems because they lose sight of the amount of funds actually on hand, as opposed to the amount shown on their books.
Determining the recording date under the cash method is simple: When you pay a bill, record the expense. When you receive payment, record the income.
How do you choose the date to record income or expense under the accrual method?
- Income Recording: Income is entered in the books when you have completed providing a service or have delivered all the items requested by the customer. In terms of income, think “finished.”
- Expense Recording: The same is true for expenses; don’t record the expense until service is completed, items are received, etc. If work done for you is 90% complete, for example, and the remainder of the work will be completed a few weeks later, typically you won’t enter the expense until the remaining work is complete.
The IRS allows qualifying businesses to use the accrual method for accounting purposes and the cash method for income tax purposes. However, once you choose a method to use for tax purposes, you must stick with that method − even if it would be to your advantage to switch to the accrual method for tax purposes*. (You can request a change, but the IRS must approve that change.)
Let’s use a theoretical purchase to illustrate the tax implications of both methods. Say you purchase new office supplies on December 15, 2013 at a total cost is $2,500. The supplies are delivered on the 22nd, but you are not required to pay the invoice until 30 days from receipt of goods.
Using the accrual method, you book the expense on December 22, 2013 because that is when the supplies were actually received. As a result, the expense is shown on that year’s tax return, even though you will not actually pay for the supplies until January 2014.
Under the cash method, the expense is booked in January 2014 when you write a check to satisfy the invoice, and you cannot use the deduction against income on your 2013 tax return.
There are many options to be considered before deciding which accounting method to choose for your business. It’s best to consult an accountant before finalizing your decision, so that your books can be set up in the way that’s best for your current circumstances and that also gives you a good foundation for the future.
The information provided is presented for general informational purposes only and does not constitute tax, legal or business advice.