How to Choose Between Cash and Accrual Accounting
The accounting method you choose determines when you report revenue and expenses relative to the transactions taking place. Choosing one method over the other influences the amount of profit you report in a given year, directly affecting your business income taxes. Profit reporting may also impact your business’s loan eligibility or equity-raising opportunities.
While some tax and accounting choices are flexible from year to year, your business’s accounting system must remain consistent. You can only undergo an accrual to cash conversion with approval from the Internal Revenue Service (IRS). Due to the process’s financial significance and rigidity, it’s important to analyze the differences between accrual and cash accounting and determine which is the best fit for your business.
What’s the Difference Between Cash and Accrual Accounting?
Cash and accrual accounting approach revenue and expense reporting in distinct ways.
What Is the Cash Basis of Accounting?
In the cash method, your business reports revenue when it receives the payment for a sale or when it sends a payment for an expense. The agreement for a sale or expense can often occur days or weeks before the payment process. Cash accounting saves reporting until that time.
What Is the Accrual Basis of Accounting?
The accrual method sees businesses report revenue or expenses at the time of the purchase agreement. Your business would report a sale or expense on the same day it provides or receives the product or service. Reporting occurs immediately regardless of when the cash changes hands.
Accrual vs. Cash Basis Accounting in Practice
To further understand cash and accrual accounting, say you sell a $500 widget on December 15 to a customer who pays on January 15, a month later. In the cash method, your business reports $500 in revenue on January 15 despite coming to the sales agreement a month earlier. In the accrual method, you record the $500 transaction on December 15 — the day you provided the widget.
The difference in when you report this $500 transaction is especially impactful if your tax year follows the calendar year. Under cash accounting, the revenue and tax obligations count toward the new year when you collect the payment. The accrual accounting method would require you to count the sale toward the previous year’s earnings despite receiving payment during the new year.
The most important thing to understand is that the accounting method you choose doesn’t affect how much money you make or lose. It simply affects when you record a transaction. While your taxes might be slightly impacted depending on your tax bracket, if the method you chose increased or decreased your taxes in one year, that difference will generally be offset in the next year.
What Are the Advantages and Disadvantages of Cash and Accrual Accounting?
Cash and accrual accounting each exist for a reason — various advantages and disadvantages will influence your choice between one or the other.
Cash Accounting Pros and Cons
The key advantage of the cash method is simplicity. You can simply look at your checkbook and sales receipts to add up your profits and losses. You also know exactly how much cash you have at any given time.
The downside is that when you receive or send cash may not accurately reflect when you earned or incurred an expense.
Accrual Accounting Pros and Cons
The key advantage to the accrual method is smoothing out your profits and losses. When you make or receive a large payment for something that happened over a period of several months, accrual accounting divides the transaction over those months.
The downside to the accrual method is that it takes extra work to figure out how all your transactions should be recorded in your books. You also need to keep separate cash flow statements to know how much cash you have on-hand at any given time.
Choosing Between Cash and Accrual
You are generally free to choose either method for any reason at all. Many small businesses use cash accounting because it’s easier. If you’re looking to raise funds, outside investors often prefer to see books using the accrual method so they can view the big picture of the company’s financials.
You must use the accrual method for tax purposes if:
- Your average annual gross receipts over three years exceed $5 million
- You hold products in inventory and your gross receipts exceed $1 million per year
- You are a publicly traded company that is required to follow Generally Accepted Accounting Principles(GAAP)
Changing Accounting Methods
Businesses may not freely change their accounting methods to prevent them from using changes to avoid taxes. Once you’ve selected your accounting method and filed taxes under that method, you must request IRS approval for any changes to your accounting method.
If an approved change results in an adjustment to your taxable income, you will receive credit for the difference/payment in the tax year in which the change is approved. The company can also elect to recognize one-fourth of the adjustment in the four succeeding years starting with the year of the adjustment.
For example:
Company Z, a calendar-year corporation, has a net positive section 481(a) adjustment of $320,000 at the end of year 20X1. If Company Z initiates a change in its accounting method under revenue procedure 97-27 for the 20X2 tax year, the company will recognize one-fourth of the 481(a) adjustment in the four succeeding years, start with 20X2. However, if Company Z is under examination for 20X1 and the IRS makes an accounting change adjustment, the entire section 481(a) adjustment will be taxable in the year of examination.
Choose the Optimal Accounting Method for Your Business
Your chosen accounting method will significantly impact your business’s revenue reporting requirements and tax obligations, so partner with Marshall Jones to make the right decision. Our team of certified public accountants and advisors can analyze your situation to determine the ideal accounting method and help you switch if necessary. For more information on our bookkeeping and tax planning services, please contact us online today!
