Small businesses may start off using the cash-basis method of accounting. But many eventually convert to accrual-basis reporting to conform with U.S. Generally Accepted Accounting Principles (GAAP). For income tax purposes you can still file differently. Although there are mother hybrid options the typical choices are limited to two.
Both cash and accrual accounting methods are commonly used for keeping track of transactions; the main difference between them is the timing of when the transactions are recorded.
- Using the cash method, you record transactions when money is exchanged — meaning when cash is received or spent. This method often allows you to defer the recognition of income.
- Using the accrual method, you record transactions when goods or services are delivered or received, regardless of when the cash is exchanged. This method often allows you to accelerate the recognition of income.
For example, if you purchase inventory on January 1st and it is delivered the same day, but you won’t pay for the goods until April 1st, you would wait until April 1st to record the purchase if using the cash method. On the other hand, if using the accrual method, you would record the purchase on January 1st, when the goods are delivered.
The cash method can seem more straightforward and intuitive than the accrual method, but it needs to provide more accurate information. With the cash method, you don’t have any information about money you are owed or owe until it is received or paid. With the accrual method, you can see the complete picture of your financial position, as this method records all transactions when they occur, regardless of when the cash is exchanged.
Under the cash method, companies recognize revenue as customers pay invoices and expenses when they pay bills. As a result, cash-basis entities may report fluctuations in profits from period to period, especially if they’re engaged in long-term projects. This can make it hard to benchmark a company’s performance from year to year — or against other entities that use the accrual method.
Businesses that are eligible to use the cash method of accounting for tax purposes have the ability to fine-tune annual taxable income. This is accomplished by timing the year in which you recognize taxable income and claim deductions.
Normally, the preferred strategy is to postpone revenue recognition and accelerate expense payments at year end. This strategy can temporarily defer the company’s tax liability. But it makes the company appear less profitable to lenders and investors.
Conversely, if tax rates are expected to increase substantially in the coming year, it may be advantageous to take the opposite approach — accelerate revenue recognition and defer expenses at year end. This strategy maximizes the company’s tax liability in the current year when rates are expected to be lower.
The more complex accrual method conforms to the matching principle under GAAP. That is, companies recognize revenue (and expenses) in the periods that they’re earned (or incurred). This method reduces major fluctuations in profits from one period to the next, facilitating financial benchmarking.
In addition, accrual-basis entities report several asset and liability accounts that are generally absent on a cash-basis balance sheet. Examples include prepaid expenses, accounts receivable, accounts payable, work in progress, accrued expenses and deferred taxes.
Public companies are required to use the accrual method. But small companies have other options, including the cash method.
Thanks to the Tax Cuts and Jobs Act (TCJA), more companies are eligible to use the cash method for federal tax purposes than under prior law. Under prior law, the gross receipts threshold for the cash method was only $5 million. In turn, this change has caused some small companies to rethink their method of accounting for book purposes.
The TCJA liberalized the small business definition to include those that have no more than $25 million of average annual gross receipts, based on the preceding three tax years. This limit is adjusted annually for inflation. For tax years beginning in 2021, the inflation-adjusted limit is $26 million. For 2022, it’s $27 million.
In addition, for tax years beginning after 2017, the TCJA modifies Section 451 of the Internal Revenue Code so that a business recognizes revenue for tax purposes no later than when it’s recognized for financial reporting purposes. So, if you use the accrual method for financial reporting purposes, you must also use it for federal income tax purposes.
For more information
There are several viable reasons for a small business to switch to the accrual method of accounting. It can help reduce variability in financial reporting and attract financing from lenders and investors who prefer GAAP financials. But, if you’re eligible for the cash method for tax purposes, you may want to switch to that method for the simplicity and flexibility in tax planning it provides. Contact us to discuss your options and pick the optimal method for your situation.
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MillerMusmar CPAs is an established accounting firm with offices in Reston, Virginia. We have a twenty-five-year history of providing top-quality auditing, tax, and accounting services to clients throughout the Washington Metropolitan area and internationally. By combining the expertise of a mid-sized firm with personal attention, we are both large and small enough to deliver a responsive service to our clients. For more information, please visit our website at www.MillerMusmar.com.