Accounting refers to the recording, analyzing, and reporting of the financial transactions for a business. It is an essential process, without which the business could not function. If an individual owns a business, it is in their best interest to become familiar with record keeping systems, accounting terms, and cash versus accrual accounting.
The cash method and the accrual method, also known as cash basis and accrual basis, are the two main methods of keeping track of the income and expenses of a business. In the majority of situations, the business can choose which method the business owners want to use.
At the most basic level, the two methods differ in the timing of when a transaction, including a sale or a purchase, is credited or debited to an account. It is important to learn the advantages and disadvantages of both, how they work, and their tax consequences in order to choose the better method for an individual’s business.
What is Cash Method Accounting?
Cash method accounting occurs when the business records an item of income or an expense when it is paid. The cash method does not indicate only the receipt or use of actual dollars, or cash. It refers to any kind of payment, including:
- Bartering; and
- Credit cards.
The majority of businesses that sell services use the cash method accounting for income and expenses. In this method, the business simply reports income in the year it was received and expense income in the year it was paid. The majority of small businesses and individuals also use this method of accounting.
The cash method does provide a more accurate picture of how much actual cash a business has, but it may provide a misleading picture of longer-term profitability. Under the cash method, a business’ books may show one month to be extremely profitable, when, in reality, sales have been slow and, by coincidence, many credit customers paid their bills in that month.
Are There any Income Tax Issues with Cash Method Accounting?
Yes, there may be some income tax issues with cash method accounting. There are several federal income tax rules of which a business should be aware.
One issue includes the legal doctrine of constructive receipt. This requires counting some items as income prior to their actual receipt. This means that the individual or business has income for tax purposes as soon as that income is available or is credited to their account, even if they do not immediately accept it.
On the other hand, in cash method accounting, an individual or business is not permitted to take a deduction in the current year for items that are paid but not yet received. Therefore, the taxpaying individual or business should be particularly aware of year end income and expenses.
What is Accrual Method Accounting?
In the accrual method of accounting, income is treated as received when it is earned, regardless of when it is actually received. On the other hand, expenses are recorded at the time the obligation to pay arises, and not necessarily when a payment is actually made.
Several types of businesses prefer this method, including:
- Manufacturers; and
- Businesses with inventories of goods.
When using the accrual method, it shows the ebb and flow of business income and expenses or debts more accurately. However, it does not show what cash reserves are available, which may result in a cash flow issue. For example, an income ledger may show thousands of dollars in revenue or sales, which in reality, the bank account is empty because the customers have not paid yet.
How does a Business Determine a Transaction Date?
In some cases, with the accrual method, it may be difficult to determine when a sale or purchase occurred. The important date is the job completion date.
Income should not be recorded until the business finishes a service or delivers all of the goods and contract provisions required. Once those are completed, the business can record the income in its books.
An item should not be recorded as an expense until the service is completed or until all of the goods have been received and installed, if needed. In other words, if a job is almost complete but will take another 30 days to totally finish, it technically does not go on the business’ books until the 30 days passes.
What are Some Examples of the Two Different Methods?
Suppose a landscaping business finishes a job in April, but does not get paid until three months later, in July. Under the cash method, the business would record the payment in July. Under the accrual method, the business would record the income in its April books.
Suppose an individual purchases a new fax machine on credit in January and pays $1,000 for it in March, two months later. Under the cash method, the business would record a $1,000 payment in March, the month in which the money is actually paid. Under the accrual method, the business would record the $1,000 payment in January, the month they bought the fax machine and became obligated to pay for it.
Are There any Income Tax Issues with Accrual Method Accounting?
Yes, there are some income tax issues that arise with the accrual method of accounting. Accrued income and expenses are required to meet the all events tests of the Internal Revenue Service (IRS) to become fixed.
The all events tests means that all events required to secure the right to receive a payment or to cause a liability for that expense must have occurred. After those requirements are satisfied, the income or expense becomes fixed, as if it actually happened, whether or not any money has actually changed hands.
When is a Business Required to Use the Accrual Method?
A business is required to use the accrual method when the business has sales of more than $5 million per year or the business stocks an inventory of items that they will sell to the public and their gross receipts are over $1 million per year. Inventory includes any merchandise the business sells as well as any supplies that will physically become part of an item that is intended for sale.
Are There any Other Accounting Issues a Business Should be Aware of?
Yes, there are other tax issues a business should be aware of. For example, business income and expenses must be reported to the IRS for a specified period of time, known as the tax year, accounting period, or fiscal year.
Unless there is a valid reason to use a different period, or the business is a corporation, the business is required to use the calendar year, which begins on January 1 and ends on December 31. If a business wants to use a different period, they may request one. However, the fiscal year must begin on the first day of a month and end of the last day of the previous month one year later.
Do I Need a Lawyer?
It is essential to have the assistance of an experienced tax attorney for any accounting issues you may face. Accounting issues and tax issues may become complicated very quickly. This is especially true for businesses that often deal in large amounts of goods.
If you are an inventory business, you may greatly benefit from the services of an accountant and a tax attorney. An accountant can assist you with setting up and maintaining streamlined accounting and inventory systems. A tax lawyer can assist you in choosing the best accounting method for your business and help you ensure you are reporting your income properly. In addition, should you encounter any issues with a tax authority, your attorney is the one who is best suited to assist you in avoiding any troubles.