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Small Change, Big Tax Savings: Cash vs Accrual Method of Accounting

R.C. Thornton & Associates, LLC, is a Phoenix, AZ – based accounting  firm.  Chuck Thornton is the firm’s President.

 

Hey wait!  Don’t go away.

I know accounting methods sounds like a boring topic, especially if you didn’t major in accounting.

Well…not so fast!

What if a little-known method to saving you big tax money has been sitting in front of your nose the whole time…something that can mean differences in thousands of dollars in tax?

The fact is this: accounting methods matter, and choosing the wrong one can cost you a pretty penny.  Learn a bit more about accounting methods, and see how your business may be able to save:

 

Why accounting methods matter- a primer.

Generally, there are two methods of accounting used by small businesses – cash and accrual. The basic difference between the two methods is the timing of how income and expenses are recorded. You choose your method of accounting when you file your first tax return.

If you ever wish to change your accounting method after that, you’ll need to file for IRS approval, which can be a time-consuming process.

But what if I told you that changing accounting methods is often worth the hassle and time?

While no single accounting method is required of all taxpayers, the IRS says you must use a system that clearly shows your income and expenses, and maintain records that will enable you to file a correct return. If you do not consistently use an accounting method that clearly shows your income, your income will be figured under the method that, in the opinion of the IRS, clearly shows your income.

 

What is the cash method of accounting?

Most small businesses use the cash basis method of accounting, which is based on real time cash flow. Under the cash method, income is recorded when it is received, and expenses are reported when they are paid.

For example, if you receive a check in the mail, it becomes a cash receipt (and is recorded as income). Likewise, when you pay a bill, you record the payment as an expense. The word “cash” is not meant literally – it also covers payments by check, credit card, etc.

So here’s the punchline: you only owe tax on money you have “cash-in-hand”, not from money someone is supposed to pay you, but hasn’t.

 

What is the accrual method of accounting?

Where’s the cash?  That’s the question many business owners ask their CPA when they are told they owe taxes, but have no cash to pay it.

Under the accrual method, you record income when it is earned, not necessarily when it is received.

Likewise, you record your expenses when the obligation arisesnot necessarily when you pay the bills.

In short, the accrual method of accounting matches revenue and expenses when they occur whether or not any cash changes hands.

For example, suppose you’re hired as a consultant and complete a job on December 29th, but you haven’t been paid for it. You would still recognize all expenses you incurred in relation to that engagement regardless of whether you’ve been paid yet or not. Both the income and the expenses are recorded for that year, even if payment is received and bills are paid the following January.

Well, that’s no good!  You can owe taxes on money you haven’t even received yet!

Businesses are required to use the accrual method of accounting in several instances, including:

  • If the business has inventory.
  • If the business is a C corporation with gross annual sales exceeding $5 million (with certain exceptions for personal service companies, sole proprietorships, farming businesses, and a few others).

 

What if you have two or more separate businesses?

If you operate two or more separate and distinct businesses, you can use a different accounting method for each if the method clearly reflects the income of each business. The businesses are considered separate and distinct if books and records are maintained for each business. If you use the accounting methods to create or shift profits or losses between the businesses (for example, through inventory adjustments, sales, purchases, or expenses) so that income is not clearly reflected, the businesses will not be considered separate and distinct.

 

Wrap up and Take Away

Think about it: most business that extend credit have an opportunity to delay taxation on their receivables until they collect the cash.  Not a bad result…certainly better than paying tax on money you don’t have!

Unless you like paying tax on money you don’t have…there are a few of those kind of people out there.

So do you have a change to use the cash method of accounting?  If you are already on the accrual method can you change to the cash?  And what about customer deposits, alternative minimum tax, and unique methods for specific industries like contractors?

Getting a little excited?  Good! Stay tune and check in for future blog articles on this topic.


Pursuant to Circular 230, as promulgated by the US Department of the Treasury, any U.S. federal tax advice that is contained in this article is not intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose.

The writer is not responsible for providing such advice to the reader unless specifically retained by the reader. Readers of this article are advised to seek professional assistance of a qualified practitioner before implementing any ideas expressed in this article.

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