Among the many decisions faced by new business owners, deciding on an accounting method can be particularly important. Most businesses choose either the cash or accrual method. Both of these techniques record financial transactions that will be reflected in the business’s income tax returns. For this reason, the Internal Revenue Service requires businesses to use the same accounting method year after year. It can be extremely difficult to change accounting methods down the road, and there’s no guarantee the IRS will allow a business owner to do so. In other words, this is a very consequential decision.
Understanding the pros and cons of cash and accrual accounting can help business owners select the method that best fits their needs, or which they are obliged by law to follow. Tweet ThisThe IRS spells out its guidelines in Publication 334, but we’ll discuss the basics of business accounting methods below.
Under a cash accounting system, transactions are recorded when money actually changes hands. Expenses and income are recorded as bills are paid, or when payments are received by credit card, check, cash, or another method.
Cash accounting requires only single-entry bookkeeping, which is quite similar to balancing a checkbook. The business’s balance sheet reflects actual cash on hand. Many small business owners choose cash accounting because of its inherent simplicity. Cash accounting is also advantageous for understanding cash flow, since it reflects money on hand. However, businesses that extend credit or offer deferred payments can find it difficult to operate purely on the cash accounting method.
Let’s say that Business A has invoiced Business B for $500 of computer hardware. In the cash accounting method, there would be no record of this sale until the invoice was paid. However, treating substantial earnings or expenses this way can make it difficult to get an accurate picture of a business’s profitability.
In fact, Publication 334 prohibits businesses that earn over $1 million per year and that “produce, purchase, or sell merchandise” from using the cash method. These businesses are required to keep inventory and use the accrual accounting method.
Accrual accounting records transactions when they happen, rather than at the time the funds are transferred. Income from sales made on credit is recorded immediately. The cost of purchases made on deferred payment plans or credit are deducted at the time of the exchange, rather than when the business pays its balance. Installment plans can complicate matters, since the full cost or revenues are recorded at the time of the transaction. Thee business owner will need to track the balance owed versus payments made in order to determine when the debt is truly paid off.
The accrual accounting method conforms to GAAP (generally accepted accounting principles) standards. While the necessary bookkeeping is more complex than that required by cash accounting, accrual accounting has the advantage of providing a more accurate picture of profits.
Cash Flow Forecasting
Cash and accrual accounting methods record costs and earnings in different ways, so your cash flow forecasting will need to reflect this. The formermethod provides an up-to-date view of your cash flow since sales and debts show up when money changes hands. Accurately applying the accrual method will record transactions in the correct tax period, but business owners must separately record when money is deposited or debited to keep cash flow estimates in line with reality.
Business accounting is a challenge for many people. As is so often the case in complex financial matters, consulting with a tax professional is highly recommended.
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