One of the more important things to consider when starting a new business is the decision to use the cash or accrual accounting method. This decision is not just another item to check off your to do list, but one that has repercussions on how you do your taxes and on the future of your business. The key item to consider is which method will most clearly reflect the financial outcomes of your business.
It is also important to note that once a method of accounting is established, it must continue to be used, or the taxpayer must file an accounting method change to request consent to change their method of accounting. This can get tricky, and end up costing you time and money to accomplish, so make sure you think through which method works best before you start recording transactions. Plus, by knowing what to expect, it will make it a little easier on you at tax time (which we can all agree, is a pretty nice thing).
So I get they’re different. But how are they different?
Cash basis accounting is probably the most common for small business owners, often because of its simplicity. Income is reported when cash, or the constructive receipt of cash, is IN HAND. Same principal applies for expenses. You don’t report, or deduct, your expenses until they’re actually paid.
Accrual basis accounting is a little more complex. Income is reported when it is EARNED. This means it may often be recorded before payment is actually in hand. Expenses follow the same vein, and are reported when they occur and are fixed as to the amount.
Okay, but which is better?
It depends on your business type and what you do. The accrual basis of accounting helps you better understand the current condition of your business finances, while the cash basis of accounting focuses on your current cash on hand. The accrual method may allow you to see a better picture of your financial position and company profits because it reports everything earned during a period as well as expenses incurred. You need to also keep in mind, while the cash basis offers simplicity in application, there are some limitations on the use of the cash method of accounting. Further, accrual accounting is generally used by a business that has inventories as part of their business operation.
What about tax reporting?
The type of accounting method you choose affects your tax deductions. It’s a subtle difference, but an important one. Say you, a calendar year taxpayer, received an expense invoice in November 2015 and pay it on January 15, 2016. Under the cash method, you won’t be able to deduct that expense until you report taxes for 2016. However, under the accrual method, you can claim the deduction in 2015 if all events have happened to fix the amount due.
Now, let’s talk about income reporting. You, again a calendar year taxpayer, invoice a customer in November 2015 for services performed and they pay you January 15, 2016. If you’re using the accrual method, you’ll pay tax in 2015 on services for which you haven’t actually received payment, since the right to receive, and the amount of payment to be received, was known and fixed in 2015. However, under the cash method, you would pay tax on the service completed once the cash was in hand in 2016.
The moral of the story?
It’s important to understand your business and your finances. By understanding your books and where you’re headed, you’ll be able to choose the accounting method that works best for you.
Still not sure what we’re talking about?
Here’s the truth: taxes are complex and complicated. You don’t have to know it all. We can help.