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Cash or accrual? What’s the difference?

July 31, 2020

When you start a business, you have many decisions to make. One of those is the method of accounting your business will use for reporting income and expenses on your tax return. It is an extremely important decision. With few exceptions, the method you choose can only be changed in the future with the IRS’s permission.

The two methods generally used are the cash method and the accrual method. The cash method is probably the easiest for most people to understand and the easiest for small business owners to use, but there are regulations to determine which small businesses are eligible to use the cash method.

The accrual method recognizes income when the services are rendered or the product is sold, regardless of the date that payment is received. You have “accounts receivable” in the form of money customers owe you. Expenses are handled in the same manner.  You deduct costs when they are “incurred,” (i.e. when supplies are purchased, services are rendered, etc.) even if payment is not made until a later date.  What you owe for purchases you’ve made constitutes your “accounts payable.”

The cash method is easier to understand and the resulting income is similar to, if not equal to, the cash flow of your business. Income is recognized only when payment is received from customers, and expenses are deducted only when payment is made for the goods or services purchased.

The accrual method better reflects the true economic results of operations, and the true economic assets and liabilities of a business (for that reason, it’s required in some cases for non-tax reporting purposes).  However, it is generally more complex and is a little more difficult to coordinate with annual tax planning for most businesses.  The cash method is the preferred method of many small business owners.  Not only is it easier to understand, but it is easier to control the timing of income recognition and business deductions which makes annual tax projections easier to adjust.  NOTE: A business that elects to report on the cash basis is not barred from selling to customers on credit or making business purchases on credit.  For bookkeeping and financial reporting purposes you may be eligible to report on a different basis than your elected tax basis.  This is another reason it is good to consult with your accountant regarding your accounting methods.

Also, prior to 2018, generally any business with gross receipts in excess of $5 million in that year, or any year prior, was not eligible to use the cash method and was required to use the accrual method for tax purposes.  However, the Tax Cuts and Jobs Act passed in late 2017 significantly increased the number of businesses eligible to use the cash method.  Currently, if your business’s average gross receipts for the prior 3 years is less than $26 million, you are likely eligible to use the cash method and thus eligible to apply for a change in accounting method.  Depending on the timing, these can sometimes result in significant tax savings in the year of change and can be a great tax planning tool.

All new business owners should meet with their accountants to discuss the pros and cons of each method and to decide what works best for their business.  Existing business owners should also have an understanding of what their current method of accounting is, and inquire of their accountants whether they’re eligible for a different method and the tax consequences of potential changes to their accounting method.

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