The accounting method you currently use for your small business may no longer be appropriate due to changes in market conditions or within your company. The IRS generally allows taxpayers to change their method, but you need to consider several factors — related to both accounting and taxes — to determine which method best suits your needs.
There are a variety of available accounting methods, but the two most popular are:
1. Cash-basis accounting. Under this method, your business records income as cash is received. For instance, if you bill a customer in March but don't receive payment until April, you'd record the sale in April.
Similarly, cash-basis businesses record expenses as they're paid, regardless of when they're incurred. So, if you receive a bill from a vendor in March with net 30 terms and pay in April, you'd record the expense in April.
2. Accrual-basis accounting. The accrual method "matches" revenue with the related expenses by recording revenue when it's earned and expenses when they're incurred. For example, if you bill a customer in March but don't receive payment until April, you'd record the sale in March (a month earlier than under cash-basis accounting). For financial reporting purposes, revenue recognition isn't tied to when you receive a payment from the customer.
Likewise, if you missed your March rent payment of $5,000 and pay double the amount in April, you'd still record $5,000 of rent expense in both March and April. The missed payment would appear on the balance sheet as an accrued expense (a liability) in March.
Both methods come with advantages and disadvantages. Cash-basis accounting, for example, has a short learning curve and simplifies recordkeeping. It mirrors your cash flow and short-term financial health, making it easy to assess your cash position and how it fluctuates over the year.
However, cash-basis accounting can present a distorted picture of your company's operations and provide opportunities for dishonest people to manipulate the financial statements to suit their needs. For instance, a manager who's paid a bonus based on year-end earnings could hold checks at the end of the accounting period to artificially boost cash-basis profits for the current period. Or, when buying out a retiring partner using a multiple of the prior year's earnings, the remaining partners could delay depositing a large payment from a customer at year end to artificially lower cash-basis profits. Because cash-basis accounting doesn't properly match revenue and expenses to the periods in which they're earned and incurred, it can be hard to compare a company's performance over time under this method.
In addition, a cash-basis balance sheet doesn't show certain familiar line items, such as:
This can make it difficult to evaluate a company's working capital needs. Cash-basis accounting also doesn't conform with U.S. Generally Accepted Accounting Principles (GAAP), so external comparisons with public and private companies may not necessarily be meaningful.
Accrual-basis accounting gives a more accurate long-term view of your financial situation, enabling more-informed decision making. It's also required for publicly traded companies under GAAP and preferred by many stakeholders, such as lenders and investors.
But accrual-basis accounting is generally more burdensome. Booking revenue and expenses requires multiple journal entries. For example, an accrual-basis business will record revenue and a receivable (an asset) when products are delivered or services are rendered. Then it removes the receivable from the books when the customer pays the invoice. (The receivable might also be removed from the balance sheet if product is returned or an uncollectible balance is written off.)
Likewise, expenses must be recorded as incurred, regardless of when they're paid. Tracking expenses under the accrual method results in the creation of various balance sheet accounts, such as WIP, prepaid assets, accruals and payables.
Cash-basis accounting may appeal to sole proprietors or other small businesses in the early stages of development, especially if the company doesn't maintain product inventory. You generally can apply this method yourself, without investing much time or hiring a CPA.
This method also provides tax planning opportunities. For example, if you expect your tax rates to be the same (or lower) next year, you could hold off on billing and accelerate paying expenses at year end to lower taxable income in the current tax year and defer some of your tax obligation until next year. Conversely, if you expect tax rates to be higher next year, you could do the reverse: ramp up collections and wait to pay expenses after year end. This strategy would increase your taxable income for the current tax year — before tax rates go up next year.
Larger, more complex businesses generally opt for accrual-basis accounting. Not only do lenders and investors generally prefer GAAP financials, federal or state tax law may require accrual-basis accounting. Under current tax law, for 2023, a business that produces, purchases or sells merchandise generally must use the accrual method for sales and purchases of merchandise if it has average gross receipts of more than $29 million over a three-year period (up from $27 million for 2022). This threshold is indexed annually for inflation.
And some states mandate that sales tax returns be filed on an accrual basis. If you don't track and plan carefully in these states, you might get hit with a sales tax bill on payments you haven't yet collected. This can choke your cash flow.
After you've filed the first federal tax return for your business, you generally must obtain IRS approval to change your accounting method from cash to accrual (or vice versa). Contact your tax professional to determine the optimal method for your circumstances and file the necessary forms.
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