two forms of accounting used by businesses - cash and accrual. The
basic difference between the two methods is the timing of income and
expense recording. The best method for your company depends on a variety
of factors that include the nature of your business, its legal business
structure, and whether or not you extend credit.
You must choose between
cash and accrual accounting and notify the IRS on your tax return
which method you use.
The Cash Method
Most small (one or two-person)
businesses use the cash basis method of accounting, which is based
on real-time cash flow. In cash method, you report an expense when
it is paid, and record income when it is received. So, the day you
receive a check, it becomes a cash receipt. And you record your expenses
when you pay your bills, not when the bill is received.
By the way, the word "cash"
is not meant literally - it also covers payments by check, credit
card, barter, etc.
The Accrual Method
With accrual accounting,
you record income when it is earned, not when it is paid. Similarly,
you record your expenses when the obligation arises, not when you
pay it. The tax code refers to this as recording income and expenses
when they are "fixed" - when all the necessary events have
occurred to receive the income or expense the liability. It is not
necessary for cash to change hands.
You're a consultant and
you complete a job on December 15, but you haven't been paid for
it. You recognize all expenses in relation to that contract when
they were incurred, regardless of whether you've been paid yet or
not. Both the income and expenses are recorded for the current tax
year, even if payment is received and bills are paid the following
Who should use the Accrual Method
Businesses are required
to use the accrual method in several instances, including:
- if the business has
- if the business is a
- if gross annual sales
exceed $5 million (with certain exceptions for personal service
companies, sole proprietorships, farming businesses, and a few others).
Differences between cash and accrual accounting
In a number of instances,
your bookkeeping method will have an impact on your taxes.
- Accelerated expenses:
To accelerate expenses, accrual basis companies only need to record
(not necessarily pay) every purchase and expense invoice by year-end.
Cash basis companies must pay them off before the end of December.
- Employee bonuses: Cash
method businesses can only deduct employee bonuses in the year they're
paid. Accrual method businesses, on the other hand, can record the
bonus in December, and pay the bonus over the next 2 1/2 months.
cash and accrual methods in different tax years
If you want to change your
business' accounting methods, you may need to get permission from
the IRS, which is concerned you might be seeking an unfair tax advantage.
To make the change, you would file IRS Form 3115, Application for
Change in Accounting Method. This form needs to be filed within 180
days before the end of the year for which you want to make the change.
You do not need permission if there is a "fundamental change"
in your business - i.e. you move from a service business to one that
carries inventory. You should seek the advice of your tax advisor
to determine whether you need permission.