Cash or Accrual Accounting… you may have heard these terms or have even seen them in your accounting software. But what do they really mean, and which one do you need to use?
Both methods are acceptable to the IRS under certain circumstances until a specific revenue criteria is met (generally $25 million). You cannot jump back and forth between methods, and if you do want to make a change, you must request permission from the IRS.
Cash Basis
Most small business owners use this method to calculate their income, expenses and net profit for taxes. Under cash basis, only the cash in and out is recorded on the books. If you use your bank and credit card feeds or statements to record all your transactions, you are using the cash basis method. This is the simplest method to use.
Accrual Basis
Accrual basis means that you put the entries on your books at the time the transaction takes place. For example, when you provide the service, it is income even if the client doesn’t pay for two months. Expenses are entered as bills on the day you owe the money - not the day you receive or pay the bill. This method is more complex but can provide a truer financial picture.
Tax Implications
Each type of accounting has pros and cons from a tax standpoint. Eventually, over the lifetime of the business, everything gets put on the tax return. It’s just the timing that’s different. If you wish to change your accounting type, you must request this change from the IRS on Form 3115. You are also required to use accrual basis if you have average annual revenue of over $26 Million for 3 years. Your tax CPA is the best one to advise you from a tax standpoint.
Which Should I Use?
For most small business owners, a cash basis is sufficient for tax purposes. However, we still recommend at least a modified accrual basis for their books. Using only a cash basis really doesn’t show the business owner the true picture of how their business is doing. On a cash basis, large deposits show as income, but the expenses won’t be recorded until later when the work is performed. With delays in collections, revenue will look lower than it really is if you are trying to match your expenses and your revenue.
Most basic software programs allow you to create reports using either method. There are some other adjustments that can be made for a pure accrual system, but as long as you input all of your invoices and bills regardless of payment status, you can have a fairly basic idea of where your business really stands.
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