When you file a tax return for your small business, one of the questions on the form asks about your accounting method: cash or accrual. This applies whether you’re a sole proprietor filing on Schedule C, a partnership or LLC that uses Form 1065, or a corporation filing Form 1120 or 1120S.
If you’re new to accounting and bookkeeping, you might not realize that deciding whether your business uses the cash or accrual accounting method is a pretty significant decision.
Cash vs. Accrual Method of Accounting
The difference between the cash versus the accrual accounting method comes down to the timing of when revenue and expenses are recorded in your books.
Accrual Basis Accounting
Under the accrual method, a business records revenue when earned and expenses when they are incurred, regardless of when the business actually receives or pays out cash. To keep track of revenue due and expenses owed, companies that use the accrual method use Accounts Receivable and Accounts Payable.
To illustrate, imagine a web development company completes a project for a client and sends them an invoice for $1,000. The web development company earned money, but it hasn’t yet received the cash. Under the accrual method, the company would record $1,000 worth of revenue on its books and an Account Receivable of $1,000.
Two weeks later, the client pays the invoice with a check for $1,000, which the web development company’s accountant deposits into the company’s business checking account immediately. The accountant would remove the $1,000 Account Receivable from the books, and record the same amount as an increase to its checking account balance.
Likewise, say the web development company buys office supplies on credit from a local office supply company. When the company purchases $500 worth of supplies, the accountant books $500 as Office Supplies Expense, with a corresponding Accounts Payable for the same amount.
Thirty days later, when the company pays the bill from the office supply company, it will reverse the $500 entry from Accounts Payable and reduce their cash balance by the same amount.
Cash Basis Accounting
In cash-based accounting, a business records income when it is received and expenses when they are paid — in other words, when cash changes hands.
Companies that operate on the cash basis of accounting don’t use Accounts Receivable or Accounts Payable.
Following the example above, the web development company would record revenue from the $1,000 project when they actually received payment from the client, whether the client paid in advance or 90 days after the project was complete. And the company wouldn’t record an expense for the $500 in office supplies until it paid for them.
Which Accounting Method Should You Use?
The cash method of accounting is easier to use, so it’s often the accounting method of choice for small businesses. However, the accrual method gives the company’s owners or shareholders a better idea of income and expenses over a given period.
For example, say the web development company launches a big marketing campaign that brings in several new clients. This increase in activity comes with a corresponding increase in expenses. The company has to hire more employees and buy more desks and computer equipment, but it won’t get paid for all of these new projects until clients pay their invoices next month.
If the company uses the cash basis of accounting, when the business owner reviews the company’s financial statements, it’s going to look like the company is in bad shape: expenses are through the roof while revenues are stagnant.
On the other hand, if the company uses the accrual method of accounting, revenues and expenses are matched to the appropriate month, quarter, or year. It gives the business owner a more accurate view of how the business is doing.
In some cases, businesses are required to use the accrual method of accounting. The IRS requires a business to use the accrual method if:
- The business is a C corporation with average gross receipts of more than $25 million in the past three years
- The business is a partnership with a C corporation as a shareholder and average gross receipts of more than $25 million in the past three years
- The business is a tax shelter
If your business doesn’t meet that threshold, you’re allowed to use the cash method.
However, your accountant might recommend that you use the accrual method anyway — especially if your business involves a lot of inventory. That’s because the cash method of accounting doesn’t properly account for inventory that the company has purchased but not yet sold, so the business can’t rely on its financial statements to make business decisions.
Accrual Method for Books, Cash Method for Tax
If you handle your own bookkeeping and tax preparation, you’ll likely stick with the cash method of accounting for simplicity. However, if you work with an accountant, they might recommend using the accrual method of accounting for your books and the cash method of accounting for tax purposes.
Why? Because it helps to ensure you only pay taxes on the money in your pocket.
To illustrate, say our web development company started operations in December of 2020 and did $20,000 worth of work that month. The company sends invoices to their clients for that work on the last business day of the year. The company won’t collect that $20,000 until January of 2021. Meanwhile, the business purchased $2,000 worth of supplies in December of 2020.
If the web development company is an accrual basis taxpayer, they will have to pay taxes on $18,000 (that’s $20,000 minus $2,000 of supplies expense) of income when they file their 2020 tax return, even though they didn’t receive the money until 2021.
However, if the business is a cash basis taxpayer, they can choose to pay the $2,000 invoice for supplies in December of 2020 and claim a loss for 2020. That’s because the company didn’t receive any revenue in 2020, but paid $2,000 worth of expenses.
Cash basis taxpayers don’t have to pay taxes on income until it’s actually in their possession, and they generally have greater control over when they pay for expenses. That’s the basis of many tax planning strategies: defer taxable income to next year and accelerate deductions in the current year.
Using the accrual method for books and the cash basis for a tax return might be a little complicated for business owners who handle their own bookkeeping and tax returns. However, if you work with a CPA or another qualified tax preparer, ask whether the cash or accrual accounting method is a better fit for your business.
If you’ve been preparing your tax returns one way and need to switch to the other method, you’ll need to file Form 3115 to get approval from the IRS.