How to Choose Between Cash and Accrual

 

The accounting method you choose to use can determine if you show a profit or not in each year. This directly affects your business income taxes, and it may also impact whether you are able to obtain a loan or raise equity investments. Unlike other tax or accounting choices, you can’t choose what’s best from year to year — you must make a choice and stick with it for the long term.

What’s the Difference Between Cash and Accrual Accounting?

Your accounting method determines when transactions should be reported on your financial statements. The cash method is named because you record a transaction when you get the cash. In the accrual method, you report your accrued income and expenses when they were earned or incurred regardless of when the cash changes hands.

For example, say you sell a widget on December 15th and the customer pays $500 on January 15th as you agreed. In the cash method, the $500 is recorded as income on January 15th and, if your tax year follows the calendar year, goes on the new year’s taxes. In the accrual method, the $500 is recorded on December 15th and would be taxed in the previous year even though you didn’t receive the money until the new year.

What are the Advantages and Disadvantages of Each Method?

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.

Cash Method

The key advantage to 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 Method

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.

How to Choose 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

Year

Taxable Income –

IRS Initiates Change

Company Initiates Change

20 X 1

$320,000

20 X 2

$80,000

20 X 3

$80,000

20 X 4

$80,000

20 X 5

$80,000

Tax Planning for Millennials

Millennials are quickly taking over the workforce. It’s easy to adopt a do-it-yourself attitude however in many cases consulting a CPA for tax strategies can be extremely beneficial to eliminate the chance of a missed opportunity.

Finance a first-time home purchase
Finding the money for a down payment on a home can be daunting and it can seem tempting to seek alternative source, like tapping into a 401(k) from an old employer. An early distribution form a retirement plan can result in a 10% early-withdrawal penalty, but there’s a smarter approach that avoids penalties. By rolling that old 401(k) into an IRA you can take distributions for a first time home purchase (up to $10,000) and are not subject to the early-withdrawal penalty. However, it is important to be aware that those funds distributed will be included in income and subject to tax if they were contributed pretax.

Consider claiming educational expenses as a business deduction
Employees or those who are self-employed are able to claim educational expenses as an itemized business tax deduction. Employees may take a miscellaneous itemized deduction subject to 2%-of-adjusted-gross-income limitation as a work-related educational expense. The self-employed may deduct educational expenses as ordinary and necessary business expenses from gross self-employment income. The expenses MUST be for education that maintains or improved skills required in one’s trade or business. The maximum lifetime learning credit is $2,000 per year based on qualifying expenses of $10,000 for the year, with zero carryover. However, as a business or itemized deduction can take into consideration higher expense totals.

Take advantage of a cafeteria plan
Internal Revenue Code Sec. 125 allows employees to receive some of their compensation pretax for qualified expenses. CPAs might advice their millennial clients of the potential to avoid paying income tax and Federal Insurance Contributions Act tax (7.65%) on contributions to these plans. Cafeteria plans often include flexible spending arrangements for health care or dependent care expenses and qualified fringe benefits. These could save hundreds of dollars a year in taxes.

Manage student loans for optimal use of above-the-line deduction for interest paid
The general rule of thumb is to pay down student loans as early as possible because they cannot be discharged in bankruptcy and generally charge higher interest rates than safe investments. Although an adjustment to adjusted gross income (AGI) is available for student loan interest paid, it’s worth reinforcing that this deduction is limited to $2,500 and phases out at AGIs of $65,000 to $80,000. Student loan consolidation can reduce monthly payments as well as the total amount paid over the life of the loan. It’s important to take an inventory of all loans and consolidate only those current loans that are unqualified, so as not to lose credit for qualifying payments already made to date.

Addressing investment concerns
Young taxpayers may desire to invest, but find it difficult to pull together all the necessary funds. Converting a 401(k) to a Roth IRA is extremely beneficial. Investing is more tax-efficient within a tax-advantaged retirement accounts, such as a Roth IRA. This way when the funds are distributed in retirement they are not taxed.

Help sole proprietors understand their tax obligation
We see a lot of millennials that are creating craftsman-like businesses. It is extremely important to be aware of the importance of properly documenting ordinary and necessary business expenses. Time should be spent discussing listed property (furniture, equipment, and other property that might be fully deductible in the year of acquisition) as well as maintaining logs for business vehicle mileage and a detailed log of meals and entertainment.

 

New non-profit accounting standards

Not – for – Profit Groups Prepare for Major Changes to Guidance for Expenses, Investments

The FASB’s not-for-profit accounting standard is the first major update to not-for-profit reporting in more than two decades, and it aims to lend better insight into how an organization operates and manages its finances. Other changes to the financial reporting by not-for-profit groups may also be in store. The FASB recently published a proposal to clarify when and how to recognize contributions with conditions attached to them, which could mean that organizations will have to adjust when they recognize their revenue.

For museums, charities, and universities, change is coming.

Starting in 2018, these groups and other not-for-profit organizations must overhaul the way they report expenses and investments in their financial statements.

Other changes may be in store further ahead. The FASB on August 3, 2017, released for public comment a proposal that aims to make it easier for organizations to determine how to record the proceeds from grants and donations that have conditions attached to them. While it may not sound as big of a change as a financial statement makeover, the question has dogged financial reporting for years because contributions with conditions attached to them are recognized differently from other types of contributions, and the distinction could affect the timing of the recognition of potentially millions of dollars.

“People need to think about how these different things affect them”, said BDO USA LLP Assurance Director Lee Klumpp. “It could get really ugly for some of these nonprofits, especially if they don’t know what’s coming.”

 

December 2016 Tax Compliance Calendar

December 2016 Tax Compliance Calendar

FAQ: How Is Virtual Currency Taxed

FAQ: How Is Virtual Currency Taxed