Cash Accounting? Or Accrual Accounting?
Which Should You Use?
Part 1 of a Three-Part Tutorial
As an encore entrepreneur, starting a new business, some issues can be postponed for a while. One that must be made early is your choice of accounting methods.
Your fundamental choices are cash accounting or accrual accounting. (There is also a hybrid approach that is occasionally used.)
For many businesses there is no choice to make. The Internal Revenue Service has imposed a method on them, at least for income tax purposes.
- Partnerships are required to use the accrual method, no matter their size. This also holds true for limited liability companies that are taxed as partnerships
- Sole proprietorships, C-Corps, and S-Corps must use the accrual method if they gross more than $10 annually (as averaged over a three-year period).
- This threshold drops to $1 million annually for businesses that can be classified as wholesale, retail, publishing, sound-recording, or mining.
As a small business startup you are not likely to fall into any of these categories, unless you are forming a partnership. The purpose of this article is to give you background information for choosing the method that makes the most sense for you and your business.
Use a Consistent Accounting Method
The Internal Revenue Service expects you to use the same accounting method from one tax-year to the next. This is because the two methods post income and expenses differently. And this in turn changes the point at which your income and expenses contribute to your tax liability.
In cash accounting, income is recorded at the moment that funds actually change hands. This means that your invoice to a customer is not considered income until the invoice is paid. The same is true with expenses. Bills from vendors are not treated as expenses until you pay the obligation.
In accrual accounting, income and expenses are recorded on the date that an obligation for payment occurs. So once you complete work or a delivery for a customer, the customer is obligated to pay you. The income is recorded at that point, even though actual payments may be days or even weeks into the future.
Similarly, once you make a purchase, you are obligated to pay the vendor. Under the accrual method this purchase is posted as an expense on the date that you obligated yourself to the purchase, whether you pay for it immediately or not.
Which brings us back to the IRS. Since your tax bite is based on when you incur income and expenses, in any given year your income tax liability can differ significantly dependent on the method that you are using.
You Aren't Allowed to "Game" the System
If the IRS allowed you to switch back and forth between accounting methods, you could "game" the system so that certain amounts of income seemed to "disappear.".
To illustrate, imagine making a big sale in December, with payment to occur the following January. If you are using the cash method, this income will not appear on the current year's revenue. It will appear next year, since that is when you will actually receive your money.
The IRS expects you to decide early on which accounting method you will use, then stick to it.
Now imagine that in January you switch to an accrual method. Even though you receive the payment in January, it represents income that you accrued the preceding December. Because you are now using an accrual method, and since the income was accrued the previous year, it will not appear as revenue in January.
In effect, this income merely "disappeared" from a tax standpoint. You could also make expenses "disappear" using a comparable technique.
This is why the IRS expects you to decide early on which accounting method you will use, then stick to it. IRS regulations include provisions for changing methods, but the IRS does not allow you to change methods randomly or repeatedly. Moreover, when you do change methods, you will have to recalculate prior year taxes to be sure that neither income nor expenses have "disappeared" in the changeover.
That being said, let's delve into the two accounting methods and identify the considerations that you should go into determining which to choose. Both have their advantages and disadvantages.
