There are two accounting methods used by businesses to keep track of income and expenses, and it’s critical to understand the differences between the two.
Cash-basis accounting is the simpler method. It’s generally available to businesses with no more than $10 million in annual sales and to professional services firms of any size. There is a lower $5 million threshold for C corps, and for partnerships in which a C corp is a partner. Accrual-basis accounting generally must be used by nonprofessional services firms with annual sales of more than $10 million. An exception to this general rule: Certain businesses with inventory are required to use the accrual basis for the purchases and sales of merchandise if annual sales exceed $1,000,000.
The cash-basis and accrual-basis methods of accounting differ primarily in the timing of when transactions are credited and debited to accounts. With cash-basis accounting, revenue is recognized when payment of invoices is received, and expenses are recognized when they’re paid.
With accrual-basis accounting, revenue is recognized when it’s earned, and expenses are recognized when they’re incurred. Accrual-basis accounting conforms to the matching principle under Generally Accepted Accounting Principles. In other words, revenue and expenses are matched to the time periods when they’re actually earned or incurred.
For example, ABC Consulting finished an engagement in December and invoiced the client $10,000 upon completion of the job. It received a check for payment in January. Using cash-basis accounting, income of $10,000 is recorded in January.
In addition, ABC Consulting purchased several new office computers in December for $5,000. The seller offered 30 days “same as cash” financing, so ABC didn’t pay for these computers until January. Using cash-basis accounting, it would record the $5,000 expense in January, not December. By contrast, if ABC used a credit card to make the purchase, it would record the purchase in December.
Now consider XYZ Manufacturing Co., which sold a piece of machinery to a client for $10,000 in December but didn’t receive a check for payment until January. Using accrual-basis accounting, the company would record the $10,000 as revenue in December instead of waiting until January.
XYZ also bought $5,000 worth of office equipment in December on credit and paid for it in January. Using accrual-basis accounting, this $5,000 expense would be recorded in its books in December, when it took possession of the office equipment.
Income and expense timing
Potential tax ramifications are key factors to consider when deciding which accounting method to use. The main factor involves the timing of income and expenses at the end of the year.
Businesses that use cash-basis accounting are able to take advantage of a popular year-end tax planning strategy in which revenue recognition is postponed until January and business expenses are accelerated into December. This can be done by not invoicing work completed in December until early January, and buying and paying for deductible assets in December instead of waiting until January.
This may lower your current taxes by deferring taxable income into the next year while accelerating deductible expenses into the current year. However, this strategy typically isn’t as easily available to businesses that use accrual-basis accounting.
Is simplicity worth it?
Because of its simplicity, many small businesses use cash-basis accounting for as long as they can — until they reach the IRS thresholds previously discussed. But there are some potential drawbacks.
For example, companies that use cash-basis accounting sometimes report large fluctuations in profits from one period to the next due to the timing of payment receipts. This can make it hard to get an accurate picture of long-term profitability. It also makes it tough to benchmark performance from one year to the next and against similar businesses that use accrual-basis accounting.
Be sure to talk to your accounting professional for more guidance in determining the right accounting method for your business.